-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, SBpryztyS06JovW2nZZmG5WNOAwC6p5gkrHCdTMrLhoku67nGWLfcXRVH+zi6Xwp f8eoGpqrrgZ/E7ArEGKhDw== 0001144204-05-003057.txt : 20050202 0001144204-05-003057.hdr.sgml : 20050202 20050202152247 ACCESSION NUMBER: 0001144204-05-003057 CONFORMED SUBMISSION TYPE: SB-2 PUBLIC DOCUMENT COUNT: 5 FILED AS OF DATE: 20050202 DATE AS OF CHANGE: 20050202 FILER: COMPANY DATA: COMPANY CONFORMED NAME: PATRIOT SCIENTIFIC CORP CENTRAL INDEX KEY: 0000836564 STANDARD INDUSTRIAL CLASSIFICATION: COMMUNICATIONS EQUIPMENT, NEC [3669] IRS NUMBER: 841070278 STATE OF INCORPORATION: DE FISCAL YEAR END: 0531 FILING VALUES: FORM TYPE: SB-2 SEC ACT: 1933 Act SEC FILE NUMBER: 333-122472 FILM NUMBER: 05569186 BUSINESS ADDRESS: STREET 1: 10989 VIA FRONTERA CITY: SAN DIEGO STATE: CA ZIP: 92127 BUSINESS PHONE: 8586745000 MAIL ADDRESS: STREET 1: 10989 VIA FRONTERA CITY: SAN DIEGO STATE: CA ZIP: 92127 FORMER COMPANY: FORMER CONFORMED NAME: PATRIOT FINANCIAL CORP DATE OF NAME CHANGE: 19920521 SB-2 1 v011943_sb2.txt AS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION ON JANUARY 31, 2005 REGISTRATION NO. 333-__________ UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM SB-2 REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933 ----------- PATRIOT SCIENTIFIC CORPORATION (Name of small business issuer in its charter) DELAWARE 3699 84-1070278 (State or Jurisdiction of Primary SIC Code (I.R.S. Employer Incorporation or Organization) Identification Number) 10989 VIA FRONTERA SAN DIEGO, CALIFORNIA 92127 (858) 674-5000 (Address and telephone number of principal executive offices) LOWELL W. GIFFHORN, SECRETARY PATRIOT SCIENTIFIC CORPORATION 10989 VIA FRONTERA SAN DIEGO, CALIFORNIA 92127 (858) 674-5000 (Name, address and telephone number of agent for service) ----------- COPIES TO: OTTO E. SORENSEN, ESQ. LUCE, FORWARD, HAMILTON & SCRIPPS LLP 600 WEST BROADWAY, SUITE 2600 SAN DIEGO, CALIFORNIA 92101 (619) 236-1414 (619) 232-8311 (FAX) ----------- APPROXIMATE DATE OF PROPOSED SALE TO THE PUBLIC: AS SOON AS PRACTICABLE AFTER THE EFFECTIVE DATE OF THIS REGISTRATION STATEMENT. ----------- If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. |_| If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. |_| If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. |_| If delivery of the prospectus is expected to be made pursuant to Rule 434, please check the following box. |_| THE REGISTRANT HEREBY AMENDS THIS REGISTRATION STATEMENT ON SUCH DATE OR DATES AS MAY BE NECESSARY TO DELAY ITS EFFECTIVE DATE UNTIL THE REGISTRANT SHALL FILE A FURTHER AMENDMENT WHICH SPECIFICALLY STATES THAT THIS REGISTRATION STATEMENT SHALL THEREAFTER BECOME EFFECTIVE IN ACCORDANCE WITH SECTION 8(A) OF THE SECURITIES ACT OF 1933 OR UNTIL THE REGISTRATION STATEMENT SHALL BECOME EFFECTIVE ON SUCH DATE AS THE COMMISSION, ACTING PURSUANT TO SAID SECTION 8(A), MAY DETERMINE. ----------- CALCULATION OF REGISTRATION FEE
- -------------------------------------------------------------------------------------------------------- Proposed Maximum Title of Each Class of Proposed Maximum Aggregate Amount of Securities Amount to be Offereing Price Per Offering Registration to be Registered Registered Unit (6) Price Fee - -------------------------------------------------------------------------------------------------------- Common Stock, $0.00001 par value (1) 23,859,897 0.091 2,171,251 255.56 - -------------------------------------------------------------------------------------------------------- Common Stock, $0.00001 par value (2) 14,681,137 0.091 1,335,983 157.25 - -------------------------------------------------------------------------------------------------------- Common Stock, $0.00001 par value (3) 3,087,130 0.091 280,929 33.07 - -------------------------------------------------------------------------------------------------------- Common Stock, $0.00001 par value (4) 5,408,391 0.091 492,164 57.93 - -------------------------------------------------------------------------------------------------------- Common Stock, $0.00001 par value (5) 796,000 0.091 72,436 8.53 - -------------------------------------------------------------------------------------------------------- TOTAL 47,832,555 0.091 4,352,763 512.32 - --------------------------------------------------------------------------------------------------------
(1) Shares of the Registrant's common stock, $.00001 par value per share, are being registered for resale on behalf of certain selling security holders. The common stock being registered is issuable to the selling security holders on their conversion of the Company's 8% Convertible Debentures issued on September 28, 2004 through January 17, 2005 (the "Series G Debentures"). The terms of the SeriesG Debentures do not fix the number of common shares that may be issuable upon conversion; however, the Company hereby registers a good faith estimate of the maximum number of shares it anticipates to issue upon conversion. The Company will not rely on Rule 416 of Regulation C if the conversion price results in an insufficient number of shares being registered. In the event that the number of shares actually issued exceeds the number of shares included in the registration fee table, the Company will file a new registration statement to cover the resale of any additional shares. (2) Shares of the Registrant's common stock, $.00001 par value per share, are being registered for resale on behalf of certain selling security holders. The common stock being registered is issuable to the selling security holders on their exercise of warrants issued in conjunction with Series G Debentures issued between September 28, 2004 and January 17, 2005. (3) Shares of the Registrant's common stock, $.00001 par value per share, are being registered for resale on behalf of certain selling security holders. The common stock being registered is issuable to the selling security holders on their conversion of the Company's 8% Convertible Debentures issued on December 1, 2003 through May 11, 2004 (the "Series E Debentures"). The terms of the Series E Debentures do not fix the number of common shares that may be issuable upon conversion, however, the Company registered the resale of 50,479,573 shares of common stock issuable upon exercise of the Series E Debentures on Form SB-2, file number 333-115752, which became effective on June 7, 2004. The number of shares registered was a good faith estimate of the maximum number of shares it anticipated to issue upon conversion. The number of shares issuable will exceed the original number registered shares due to a drop in the price of the Company's stock. The Company is hereby registering an additional number of shares which it believes is a good faith estimate of the maximum number of shares it anticipates to issue upon conversion. The Company will not rely on Rule 416 of Regulation C if the conversion price results in an insufficient number of shares being registered. In the event that the number of shares actually issued exceeds the number of shares included in the registration fee. (4) Shares of the Registrant's common stock, $.00001 par value per share, are being registered for resale on behalf of certain selling security holders. The common stock being registered is issuable to the selling security holders on their exercise of warrants which were issued from June 14, 1999 through September 22, 2003, which shares had been previously registered on Forms S-1 and SB-2, and whose registration statements have since become stale. (5) Shares of the Registrant's common stock, $.00001 par value per share, are being registered for resale on behalf of a security holder. The common stock being registered was issued to the selling security holder as payment for services. (6) Estimated solely for purposes of calculating the registration fee in accordance with Rule 457(c) under the Securities Act of 1933, as amended (the "Act"), based on the average of the closing bid and asked prices for the Registrant's Common Stock (the "Common Stock") as reported on the OTC Electronic Bulletin Board on January 28, 2005. The information in this preliminary prospectus is not complete and may be changed. These securities may not be sold until the registration statement filed with the Securities and Exchange Commission (SEC) is effective. This preliminary prospectus is not an offer to sell nor does it seek an offer to buy these securities in any jurisdiction where the offer or sale is not permitted. SUBJECT TO COMPLETION; AS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION ON JANUARY 31, 2005 P R O S P E C T U S PATRIOT SCIENTIFIC CORPORATION 10989 Via Frontera San Diego, California 92127 (858) 674-5000 THE OFFERING The resale of up to 47,832,555 shares of common stock in the over-the-counter market at the prevailing market price or in negotiated transactions. o up to 26,947,027 shares are issuable to the selling shareholders as conversion shares upon the conversion of our 8% Convertible Debentures. o up to 14,681,137 shares are issuable to the selling shareholders as warrant shares upon the exercise of warrants issued in conjunction with our 8% Convertible Debentures. o up to 5,408,391 shares are issuable to the selling shareholders as warrant shares upon the exercise of warrants previously registered whose registration statements have gone stale. o up to 796,000 shares were issued to a selling shareholder as payment for services it provided. We will receive no proceeds from the sale of the shares by the selling shareholders. We may receive proceeds of up to $428,114 from the exercise of warrants. TRADING SYMBOL PTSC (Over-the-counter Electronic Bulletin Board) THIS INVESTMENT INVOLVES A HIGH DEGREE OF RISK. Please refer to Risk Factors Beginning on Page 9 THE SECURITIES AND EXCHANGE COMMISSION (SEC) AND STATE SECURITIES REGULATORS HAVE NOT APPROVED THESE SECURITIES OR DETERMINED IF THIS PROSPECTUS IS TRUTHFUL OR COMPLETE. ANY REPRESENTATION TO THE CONTRARY IS A CRIMINAL OFFENSE. THIS PROSPECTUS IS NOT AN OFFER TO SELL THESE SECURITIES, NOR IS THE SOLICITATION OF AN OFFER TO BUY THESE SECURITIES, IN ANY STATE WHERE THE OFFER OR SALE OF THESE SECURITIES IS NOT PERMITTED. Please read this prospectus carefully. It describes our company, finances and products. Federal and state securities laws require that we include in this prospectus all the material information that you will need to make an investment decision. We have not authorized anyone to provide you with information that is different from that which is contained in this prospectus. The following table of contents has been designed to help you find important information contained in this prospectus. We have included subheadings to aid you in searching for particular information you might want to return to. We encourage you to read the entire prospectus. TABLE OF CONTENTS
Page ---- PROSPECTUS SUMMARY 5 About our company 5 About our convertible debentures 5 About our warrant shares we are registering 7 Additional shares we are registering 7 Key facts 7 RISK FACTORS 9 Related to our business Our major product line has had limited revenues 9 We have incurred significant losses and may continue to do so 9 Our limited sales and marketing experience has effected our revenue 9 Our products may not be completed on time 10 Related to our industry The market in which we operate is highly competitive 10 Protection of our intellectual property is limited; there is a risk of claims for infringement 11 We may be impacted as a result of terrorism 12 Related to our offering and share price We will require additional financing 12 Large block sales of our stock may decrease the price of our stock 12 Our stock is subject to penny-stock rules which limits our ability to attract competitive funding 13 The price of our stock could be subject to short sale pressure 14 On a significant drop in the price of our stock, we could be subject to a change in control 14 We will need to increase our authorized number of common shares 14 Forward-looking statements 16 PLAN OF DISTRIBUTION 16 SELLING SHAREHOLDERS 17 THE COMPANY 18 General 18
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Page ---- Background 19 Business 20 Available information 20 Organization and corporate development 20 Internet growth and the emergence of the java programming language 21 Microprocessor technology 22 General background 22 Industry background 22 Technology description 24 The Ignite microprocessor as a java processor 24 Stage of development 25 Business strategy 26 Competition 27 High speed data communications products 28 Research and development 28 Licenses, patents, trade secrets and other proprietary rights 28 Marketing and distribution 30 Dependence upon single customers 30 Facilities 31 Employees 31 Government regulation 31 USE OF PROCEEDS 31 LITIGATION 31 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 32 Critical Accounting Policies 33 Results of operations for the three and six months ended November 30, 2004 and 2003 36 Results of operations for the years ended May 31, 2004 and 2003 42 Capital resources and liquidity 44 New accounting pronouncements 47 Income taxes 47 CHANGES IN ACCOUNTANTS 47 MANAGEMENT 48 Identification of directors and executive officers 48 Biographical information 48 Indemnification of officers, directors and others 49 Executive compensation 50 Option grants 51 Aggregated option exercises and fiscal year-end values 51 Compensation of directors 52 Employee contracts 52 PRINCIPAL SHAREHOLDERS 53
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Page ---- CERTAIN TRANSACTIONS 55 TRADING MARKET AND RELATED MATTERS 56 DESCRIPTION OF SECURITIES 57 LEGAL MATTERS 58 EXPERTS 58 INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULE F-1
4 PROSPECTUS SUMMARY ABOUT OUR COMPANY We develop, market, and sell microprocessors, our technology behind the microprocessors, and complementary products which enable computers and other data processing devices to communicate. These products can be used to connect to the Internet or other telecommunication networks. The microprocessor technology product line accounted for approximately 18% of our revenue in fiscal 2004. The balance of our fiscal 2004 revenue was generated from a communications product line that, subsequent to a completed last buy program, is now generating minimal revenue. We also have a patent for special radar technology which, if fully developed, may allow a potential licensee to penetrate the ground or structures to find various objects. We also owned gas plasma antenna technology which we sold for $250,000 in August 1999. In October 2003, we received a final royalty payment of $75,500 from the sale of the gas plasma technology. Our strategy is to exploit our microprocessor technologies through product sales, licensing, and strategic alliances and to litigate against those who may be infringing on our patents. Our auditors have stated in their report on our consolidated financial statements as of and for the year ended May 31, 2004, substantial doubt about our ability to continue operating as a going concern because of recurring net losses and negative cash flows from operations. We have an accumulated deficit of $52,023,610 as of November 30, 2004 and a history of substantial operating losses, net losses and negative cash flow. We have our principal executive offices at 10989 Via Frontera, San Diego, California 92127. Our telephone number is (858) 674-5000, and our website is www.ptsc.com. ABOUT OUR CONVERTIBLE DEBENTURES OVERVIEW. From September 28, 2004 through January 17, 2005, we sold to and received cash from certain of the selling shareholders an aggregate of $490,000 of 8% convertible debentures with two year maturity dates. In addition, the debenture holders received warrants exercisable into up to 21,690,815 shares of our common stock. INITIAL NUMBER OF SHARES DEBENTURES MAY BE CONVERTED INTO. The debentures can be converted into a number of our common shares based on either a negotiated number of shares or the following calculation: the amount of the debenture divided by 115% of the volume weighted average price for our common stock for the ten days prior to the debenture date. RESETS OF CONVERSION PRICE AND CONVERSION SHARES. A reset date occurs on each three month anniversary of the closing date of each debenture and on the date the registration statement of which this prospectus is a part becomes effective. If the volume weighted average price for our common stock for the ten days previous to the reset date is less than the conversion price in effect at the time of the reset date, then the number of common shares issuable to the selling shareholder on conversion will be increased. If the conversion price is reset, the debenture can be converted into a number of our common shares based on the following calculation: the amount of the debenture plus any unpaid accrued interest divided by the reset conversion price which shall equal the volume weighted average price for our common stock for the ten days previous to the reset date. 5 WARRANTS. Concurrent with the issuance of the convertible debentures, we issued warrants to purchase up to 21,690,815 shares of our common stock to the debenture holders. These warrants are exercisable for from five to seven years from the date of issuance at initial exercise prices equal to either a negotiated exercise price or 115% of the volume weighted average price for our common stock for the ten days prior to the debenture date. The warrant exercise prices are subject to being reset on each six month anniversary of their issuance for 7,009,678 shares of common stock and are fixed at prices ranging from $0.0167 to $0.04 per share for the remaining 14,681,137 shares of common stock. The warrant holders for warrants to purchase up to 7,009,678 shares of common stock have entered into lock-up agreements whereby they have agreed not to exercise their warrants until our shareholders approve an increase in the authorized number of common shares. OPTIONS TO PURCHASE ADDITIONAL DEBENTURES. Subject to the price of our common stock being equal to or greater than $0.20 per share and a two year limitation, the debenture holders may purchase additional debentures equal to the value of their initial debentures. The price at which the optional additional debentures could be converted would initially equal 115% of the volume weighted average price for our common stock for the ten days prior to the date on which the optional additional debentures were sold. The optional additional debentures would carry the same warrant amounts and reset privileges as the initial debentures. SHAREHOLDER APPROVAL. We may currently issue more than 20% of our outstanding shares under the convertible debentures. If we become listed on the Nasdaq Small Cap Market or Nasdaq National Market, then we would be required to obtain shareholder approval to issue more than 20% of our outstanding shares at less than fair market value. Since we are currently a bulletin board company, we do not need shareholder approval. RESTRICTIVE COVENANTS. For a period of 18 months from the date of the debentures, we are prohibited from engaging in certain transactions without obtaining the debenture holders' prior written approval. These types of transactions include the issuance of any debt or equity securities in a private transaction which are convertible or exercisable into shares of common stock at a price based on the trading price of the common stock at any time after the initial issuance of such securities; the issuance of any debt or equity securities with a fixed conversion or exercise price subject to adjustment; and any private equity line type agreements. Also, so long as the debentures or warrants are outstanding, we may not, for less than $250 million, sell, convey, dispose of, spin off or assign any or all of our intellectual property without the prior written consent of the debenture or warrant holder. RIGHT OF FIRST REFUSAL. The debenture holders have a right of first refusal to purchase or participate in any securities offered by us in any private transaction which closes on or prior to the date that is two years after the issue date of each debenture. DEBENTURE HOLDERS' RIGHT OF INDEMNIFICATION. We are obligated to indemnify the debenture holders (including their stockholders, officers, directors, employees and agents) from all liability and losses resulting from any misrepresentations or breaches we made in connection with the convertible debenture, our registration rights agreement, other related agreements, or the registration statement of which this prospectus is a part. 6 WARRANT SHARES WE ARE REGISTERING In addition to the 14,681,137 shares issuable on the exercise of warrants issued with fixed conversion prices between September 28, 2004 and January 17, 2005, we are registering an additional 5,408,391 shares issuable on the exercise of warrants issued prior to September 28, 2004. These warrant shares were initially registered on Form SB-2 registration statements which went effective on October 5, 1999 and November 18, 2003 and Form S-1 registration statements which went effective on November 5, 2001 and March 7, 2003. The financial statements filed as a part of these registration statements have since become stale which has necessitated this re-registration. ADDITIONAL SHARES WE ARE REGISTERING From December 1, 2003 through May 11, 2004 we sold to and received cash from selling shareholders an aggregate of $1,527,500 of 8% convertible debentures with two year maturity dates. In June 2004, a registration statement on Form SB-2 went effective for the resale of up to 50,479,573 shares of our common stock issuable on the conversion of the debentures. Since the terms of the debentures did not fix the number of shares that may be issuable on conversion, we registered a good faith estimate of the maximum number of shares we anticipated to issue upon conversion. On reset dates, as defined in the debentures, the price of our common stock has been lower than the original anticipated lowest conversion price. This has caused the number of common shares which may be issued as a result of conversion to be greater than the original number of shares registered. Accordingly, we are registering an additional 3,087,130 shares of common stock to cover the shortfall. We are also registering 796,000 shares that were issued as restricted shares to a vendor in exchange for services it provided.
KEY FACTS Shares being offered for resale to the public 47,832,555 (20.5% of our shares currently outstanding) Total shares outstanding prior to the offering 232,890,435 as of January 31, 2005 Total shares outstanding assuming completion 279,926,990 of the offering Total shares that would be outstanding assuming full conversion of the current offering and exercise of all outstanding debentures, options and warrants 399,984,740 Price per share to the public Market price at time of resale Total proceeds raised by offering None. However we may receive proceeds of up to $428,114 on the exercise of warrants Convertible debentures A form of our convertible debenture is included as an exhibit to this registration statement Dividend policy We have never paid a dividend and do not anticipate paying a dividend in the foreseeable future
7 RISK FACTORS Before purchasing any of the common shares, you should carefully consider the following factors relating to our business and prospects. RELATED TO OUR BUSINESS PATRIOT'S MICROPROCESSOR TECHNOLOGIES HAVE RESULTED IN LIMITED REVENUES AND SEVERAL RELATED PRODUCTS ARE STILL IN THE DEVELOPMENT STAGE We are in the development stage on several components of our microprocessor technology product line, and the products which have been commercialized have resulted in limited revenues. Our other product lines have not generated enough revenue to support our company. Therefore, we have limited financial results upon which you may judge our potential. We may not become profitable. We have experienced in the past and may experience in the future many of the problems, delays and expenses encountered by any early stage business, many of which are beyond our control. These include: o substantial delays and expenses related to testing and development of our new products, o production and marketing problems encountered in connection with our new and existing products and technologies, o competition from larger and more established companies, and o lack of market acceptance of our new products and technologies. PATRIOT HAS A HISTORY OF LOSSES, EXPECTS FUTURE LOSSES AND MAY NOT ACHIEVE OR SUSTAIN ANNUAL PROFITABILITY We expect to incur operating losses in the future. Sales of our products may never generate sufficient revenues to fund our continuing operations. We may never generate positive cash flow or attain profitability. To date, we have incurred significant losses. As of November 30, 2004, our accumulated deficit was $52,023,610. For the six months ended November 30, 2004 and the fiscal years ended May 31, 2004 and 2003, we incurred net losses of $2,179,592, $4,149,978 and $3,888,299, respectively. Because of this record of losses, there is substantial doubt about our ability to continue as a going concern. These losses have resulted primarily from: o significant costs associated with the development of our products, o costs associated with the marketing of those products, and o the interest charges and expenses related to previous equity and debt financings. Should our losses continue and should we be unable to fund our operations from external sources, we would need to cease doing business and/or liquidate or sell our assets. 8 PATRIOT'S LIMITED SALES AND MARKETING EXPERIENCE HAS AFFECTED OUR REVENUE Our operating results depend to a large extent on our ability to successfully market and sell our products. We currently have limited marketing capabilities and need to hire additional sales and marketing personnel. In part as a consequence of our limited resources, we may not be able to recruit, train, or retain qualified personnel to sell and market our products and may not be able to develop a successful sales and marketing strategy. We also have very limited marketing experience. There can be no assurance that any marketing efforts undertaken by us will be successful or will result in any significant sales of our products. A continued lack of significant revenues from the sale of our products would require us to cease doing business and/or liquidate or sell our assets. PATRIOT MAY EXPERIENCE DIFFICULTIES IN THE INTRODUCTION OF NEW PRODUCTS THAT COULD RESULT IN PATRIOT HAVING TO INCUR SIGNIFICANT UNEXPECTED EXPENSES OR DELAY THE LAUNCH OF NEW PRODUCTS Our technologies and products are in various stages of development. Our development stage products may not be completed in time to allow production or marketing due to the inherent risks of new product and technology development, limitations on financing, competition, obsolescence, loss of key personnel and other factors. Although we may license some of our technology at its current stage of development, there can be no assurance that we will be able to do so or that any revenues generated from licensing would be sufficient to support operations at their current level. Unanticipated technical obstacles can arise at any time and result in lengthy and costly delays or in a determination that further development is not feasible. Discovery of microprocessor design errors, frequent in the industry prior to and after production, could result in lengthy and costly redesign, fabrication (production) and testing in an industry where new technology rapidly eclipses prior innovations. The development of our technologies has taken longer than anticipated and could be additionally delayed. Therefore, there can be no assurance of timely completion and introduction of improved products on a cost-effective basis, or that such products, if introduced, will achieve market acceptance such that, in combination with existing products, they will sustain us or allow us to achieve profitable operations. RELATED TO OUR INDUSTRY INTENSE COMPETITION IN THE MARKET FOR MICROPROCESSORS COULD PREVENT PATRIOT FROM INCREASING OR SUSTAINING REVENUE AND PREVENT PATRIOT FROM ACHIEVING OR SUSTAINING PROFITABILITY Our products could be rendered noncompetitive or obsolete. Technological competition from larger and more established microprocessor companies is significant and expected to increase. Most of the companies with which we compete and expect to compete have far greater capital resources and more significant research and development staff and marketing and distribution programs and facilities, and many of them have substantially greater experience in the production and marketing of products. Staff cut backs by us, which have been occasioned by financial constraints, have increased the differences in capacity between us and certain of our competitors. Our ability to compete effectively may be adversely affected by the ability of these competitors to devote greater resources to the sale and marketing of their products than we can. In addition, one or more of our competitors may succeed or may already have succeeded in developing technologies and products that are more effective than any of those we currently offer or are developing. 9 PATRIOT'S LIMITED ABILITY TO PROTECT ITS INTELLECTUAL PROPERTY MAY INADVERTENTLY ADVERSELY AFFECT ITS ABILITY TO COMPETE A successful challenge to our ownership of our technology could materially damage our business prospects. Our technologies may infringe upon the proprietary rights of others. Licenses required by us from others may not be available on commercially reasonable terms, if at all. We rely on a combination of patents, trademarks, copyrights, trade secret laws, confidentiality procedures and licensing arrangements to protect our intellectual property rights. We currently have eight U.S. patents issued and three U.S. patents pending. We have one patent issued in Europe and have filed an application for another patent in Europe, Japan and elsewhere. Any issued patent may be challenged and invalidated. Patents may not issue from any of our pending applications. Any claims allowed from existing or pending patents may not be of sufficient scope or strength to provide significant protection for our products. Patents may not be issued in all countries where our products can be sold so as to provide meaningful protection or any commercial advantage to us. Our competitors may also be able to design around our patents. Vigorous protection and pursuit of intellectual property rights or positions characterize the fiercely competitive semiconductor industry, which has resulted in significant and often protracted and expensive litigation. Therefore, our competitors may assert that our technologies or products infringe on their patents or proprietary rights. Problems with patents or other rights could increase the cost of our products or delay or preclude new product development and commercialization by us. If infringement claims against us are deemed valid, we may not be able to obtain appropriate licenses on acceptable terms or at all. Litigation could be costly and time-consuming but may be necessary to protect our future patent and/or technology license positions or to defend against infringement claims. Also, we have initiated legal actions against companies we believe are infringing on our patents. They in turn have counter sued and are asking for declaratory relief that their products do not infringe on our patents. See Legal Proceedings. We did not develop the technology which is the basis for our products. This technology, which was originally known as the ShBoom technology, was acquired through a series of agreements from one of two persons who are shown as co-inventors or certain patents, Russell Fish. Charles Moore, the other identified co-inventor, has since assigned his interest in the ShBoom technology to Daniel Leckrone and Technology Properties Limited. We have filed a legal action against Charles Moore, Daniel Leckrone and Technolgy Properties Limited to correct and clarify the inventorship, and therefore ownership, of divisions of the orginal ShBoom technology. We are contending that Russell Fish was the sole inventor of the technology covered by three subsequently issued patents, that Charles Moore was the sole inventor of the technology covered by three subsequently issued patents and that the two jointly are the inventors of the technology covered by one subsequently issued patent. In order to prosecute patent infringement cases, all owners need to participate in and agree to proceed with the actions. Therefore, if our action against Charles Moore, Daniel Leckrone and Technology Properties Limited is not successful, our ability to prosecute patent infringement cases with regard to one of the patents we contend was invented by Russell Fish, and the resultant monetary damages which may be awarded as a result of those infringements, may be diluted, if we are able to proceed with our patent infringement cases at all. Technology Properties Limited has exploited and may continue to exploit the technology, independently of our rights to do so, by selling at least one license to a potential infringer. We are contending that Technology Properties Limited does not own at least three of the patents they are licensing. There can be no assurance that we will prevail in the patent litigation efforts against Charles Moore, Daniel Leckrone and Technology Properties Limited and, if we are not successful, the value of our patent portfolio would be diminished. See Legal Proceedings. 10 PATRIOT MAY FACE INTERRUPTION OF PRODUCTION AND SERVICES DUE TO INCREASED SECURITY MEASURES IN RESPONSE TO TERRORISM Our business depends on the free flow of products and services through the channels of commerce. Recently, in response to terrorists' activities and threats aimed at the United States, transportation, mail, financial and other services have been slowed or at certain times stopped altogether. Further delays or stoppages in transportation, mail, financial or other services could have a material adverse effect on our business, results of operations and financial condition. Furthermore, we may experience an increase in operating costs, such as costs for transportation, insurance and security, as a result of these activities and potential activities. We may also experience delays in receiving payments from payers that have been affected by terrorist activities and potential activities. The U.S. economy in general is being adversely affected by terrorist activities and potential activities, and any economic downturn could adversely impact our results of operations, impair our ability to raise capital or otherwise adversely affect our ability to grow our business. RELATED TO OUR OFFERING AND SHARE PRICE PATRIOT MAY NOT BE ABLE TO OBTAIN ADDITIONAL CAPITAL TO FUND ITS OPERATIONS WHEN NEEDED A lack of additional funding could force us to substantially curtail or cease our operations, which would have a material adverse effect on our business. Our ability to raise additional funds under the debenture agreement is subject to certain conditions. These conditions include the effectiveness of a registration statement covering the resale of the shares sold on the conversion of the debentures or the exercise of the warrants issued concurrently with the debentures. We estimate our current annual cash requirements to sustain our operations to be $1.8 million. There can be no assurance that any future funds required will be generated from operations or from other potential sources. Further, any such required funds may only be available on unattractive terms and may significantly dilute the value of our existing shares. IF THE SELLING SHAREHOLDERS SELL A LARGE NUMBER OF PATRIOT SHARES ALL AT ONCE OR IN BLOCKS, THE MARKET PRICE OF OUR SHARES WOULD MOST LIKELY DECLINE The selling shareholders are offering all of the common stock offered through this prospectus. The selling shareholders are not restricted in the price at which they can sell the common stock. Shares sold at a price below the current market price at which the common stock is trading may cause the market price to decline. The shares of common stock that are issuable on the conversion of the debentures or exercise of the warrants issued concurrently with the debentures represent 21% of our outstanding shares. However, should the price of our stock drop, the number of common shares issuable on the conversion of these debentures, plus the conversion of currently outstanding previously issued debentures, would be subject to reset provisions which would substantially increase the number of common shares to be issued. To the extent the selling shareholders, and holders of currently outstanding previously issued debentures, convert and then sell their common stock, the common stock price may decrease due to the additional shares in the market. This could allow the selling shareholders, and holders of currently outstanding previously issued debentures, to convert their convertible debentures into even greater amounts of common stock, the sales of which would further depress the stock price. Accordingly, we do not know the exact number of shares that will be issued on the conversions of the debentures. The following table presents the potential number of shares that could be issued and the total number of shares outstanding under several alternative scenarios: 11
- ------------------------------------------------------------------------------------------------------------ Market If December 31, 2004 Market Price Decreases Price as of December 31, 2004 25% 50% 75% - ------------------------------------------------------------------------------------------------------------ Market price (conversion price) $ 0.080 $ 0.060 $ 0.040 $ 0.020 - ------------------------------------------------------------------------------------------------------------ Common stock currently outstanding 232,890,435 232,890,435 232,890,435 232,890,435 - ------------------------------------------------------------------------------------------------------------ Number of shares issuable on conversion 43,191,503 43,191,502 43,223,475 68,464,488 - ------------------------------------------------------------------------------------------------------------ Number of warrants issuable on exercise 120,065,478 120,065,478 120,065,478 120,065,478 - ------------------------------------------------------------------------------------------------------------ Potential common stock outstanding 396,147,416 396,147,415 396,179,388 421,420,401 - ------------------------------------------------------------------------------------------------------------ Dilutive effect to current shareholders 70% 70% 70% 81% - ------------------------------------------------------------------------------------------------------------
In addition, at the option of the debenture holders, interest accruing at the annual rate of 8% can be converted into shares of our common stock at the same time and at the same conversion price as the principal portion of the debenture. Should the debenture holders accumulate interest, a larger number of shares would be issued on conversion; and if the price of the common stock declines, the reset provisions which allow greater amounts of shares to be issued would also be in effect for the interest portion of the debenture. As of November 30, 2004, $77,557 interest was payable to the debenture holders which could be converted into 2,047,381 shares of common stock at an average conversion price of $0.038. THE MARKET FOR PATRIOT'S STOCK IS SUBJECT TO RULES RELATING TO LOW-PRICED STOCK WHICH LIMITS OUR ABILITY TO ATTRACT COMPETITIVE FUNDING Our common stock is currently listed for trading in the NASD Over-The-Counter Bulletin Board Market and is subject to the "penny stock rules" adopted pursuant to Section 15 (g) of the Securities Exchange Act of 1934, as amended. In general, the penny stock rules apply to non-NASDAQ or non-national stock exchange companies whose common stock trades at less than $5.00 per share or which have tangible net worth of less than $5,000,000 ($2,000,000 if the company has been operating for three or more years). Such rules require, among other things, that brokers who trade "penny stock" to persons other than "established customers" complete certain documentation, make suitability inquiries of investors and provide investors with certain information concerning trading in the security, including a risk disclosure document, quote information, broker's commission information and rights and remedies available to investors in penny stocks. Many brokers have decided not to trade "penny stock" because of the requirements of the penny stock rules, and as a result, the number of broker-dealers willing to act as market makers in such securities is limited. The "penny stock rules," therefore, may have an adverse impact on the market for our common stock and may effect our ability to attract competitive funding. 12 OUR SHARE PRICE COULD BE LOWERED AS A RESULT OF SHORT SALES The downward pressure on the price of our common stock as the selling shareholders convert and sell material amounts of common stock could encourage short sales by the selling shareholders or others. When an investor sells stock that he does not own, it is known as a short sale. The seller, anticipating that the price of the stock will go down, will buy the stock at a later date. If the price of the stock goes down, the seller will profit to the extent of the difference between what he originally sold it for less what he later had to buy it for. Short sales enable the seller to profit in a down market. Short sales could place significant downward pressure on the price of our common stock. ON A SIGNIFICANT DROP IN THE PRICE OF OUR STOCK, WE COULD BE SUBJECT TO A CHANGE IN CONTROL There is a possibility that a significant number of shares, the exact number of which we do not know, of our common stock could be issued on the conversion of the debentures. This possibly could result in a change in control of our company. Such a change in control could have a material adverse effect on our operations and business plans. We are unable to determine the impact such a change in control could have on our company. OUR SHAREHOLDERS WILL NEED TO INCREASE THE AUTHORIZED NUMBER OF SHARES We currently have 400,000,000 shares of common stock authorized for issuance. The number of common shares currently outstanding plus the number of common shares reserved for issuance on the conversion of debenture principal and accrued interest, and exercise of warrants and options as of January 28, 2005 is as follows: Common stock currently outstanding 232,890,435 Reserved for issuance Stock option plans 8,181,688 Warrants 111,883,790 Convertible debentures 47,028,827 ----------- Common stock fully diluted 399,984,740 ----------- In addition, as of January 17, 2005, we have negotiated with eight investors a lock up of warrants exercisable for up to 19,009,678 shares of our common stock. These shares are not included in the common stock fully diluted amount of 399,984,740 common shares reflected above. In order to obtain additional equity financing, provide for reservation of the locked up warrants and to accomplish other corporate objectives, we will need to obtain the approval of shareholders owning a majority of our common stock to increase the number of authorized shares. We anticipate to hold an annual shareholders' meeting during the second quarter of this calendar year at which time we will propose an increase in authorized shares. There can be no assurance that the shareholders will approve the proposal. Should the shareholders not approve the proposal and we were unable to fund our operations from external sources, we would need to cease doing business and/or liquidate or sell our assets. 13 FORWARD-LOOKING STATEMENTS This prospectus includes "forward-looking" statements within the meaning of Section 27A of the Securities Act of 1933, Section 21E of the Securities Exchange Act of 1934, and the Private Securities Litigation Reform Act of 1995, and we desire to take advantage of the "safe harbor" provisions in those laws. Therefore, we are including this statement for the express purpose of availing ourselves of the protections of these safe harbor provisions with respect to all of the forward-looking statements we make. The forward-looking statements in this prospectus reflect our current views with respect to possible future events and financial performance. These forward-looking statements are subject to certain risks and uncertainties, including specifically the absence of significant revenues and financial resources, a history of losses, no assurance that the development of technology can be completed or that its completion will not be delayed, significant competition, the uncertainty of patent and proprietary rights, uncertainty as to royalty payments and indemnification risks, trading risks of low-priced stocks and those other risks and uncertainties discussed herein that could cause our actual results to differ materially from our historical results or those we anticipate. In this prospectus, the words "anticipates," "believes," "expects," "intends," "future" and similar expressions identify certain forward-looking statements. You are cautioned to consider the specific risk factors described in "Risk Factors" and elsewhere in this prospectus and not to place undue reliance on the forward-looking statements contained in this prospectus, which speak only as of the date of this prospectus. We undertake no obligation to publicly revise these forward-looking statements to reflect the effect of events or circumstances that may arise after the date of this prospectus. All written and oral forward-looking statements made subsequent to the date of this prospectus and attributable to us or persons acting on our behalf are expressly qualified in their entirety by this section. PLAN OF DISTRIBUTION After the effective date of the registration statement of which this prospectus is a part, each selling shareholder will be free to offer and sell his or her common shares at such times, in such manner and at such prices as he or she may determine. The types of transactions in which the common shares are sold may include transactions in the over-the-counter market (including block transactions), negotiated transactions, the settlement of short sales of common shares, or a combination of such methods of sale. The sales will be at market prices prevailing at the time of sale or at negotiated prices. Such transactions may or may not involve brokers or dealers. The selling shareholders have advised us that they have not entered into any agreements, understandings or arrangements with any underwriters or broker-dealers regarding the sale of their securities. The selling shareholders do not have an underwriter or coordinating broker acting in connection with the proposed sale of the common shares. The selling shareholders may effect such transactions by selling common stock directly to purchasers or to or through broker-dealers, which may act as agents or principals. Such broker-dealers may receive compensation in the form of discounts, concessions, or commissions from the selling shareholders. They may also receive compensation from the purchasers of common shares for whom such broker-dealers may act as agents or to whom they sell as principals, or both (which compensation as to a particular broker-dealer might be in excess of customary commissions). 14 The selling shareholders and any broker-dealer that acts in connection with the sale of common shares may be "underwriters" within the meaning of Section 2(11) of the Securities Act. Any commissions received by such broker-dealers and any profit on the resale of the common shares sold by them while acting as principals may be deemed to be underwriting discounts or commissions. Because the selling shareholders may be "underwriters" within the meaning of Section 2(11) of the Securities Act, the selling shareholders will be subject to prospectus delivery requirements. Selling shareholders also may resell all or a portion of their common shares in open market transactions in reliance upon Rule 144 under the Securities Exchange Act, provided they meet the criteria and conform to the requirements of such Rule. SELLING SHAREHOLDERS SELLING SHAREHOLDERS The following table sets forth certain information with respect to the selling shareholders as of January 28, 2005. Except as set forth below, none of the selling shareholders currently is an affiliate of ours, and none of them has had a material relationship with us during the past three years. None of the selling shareholders are or were affiliated with registered broker-dealers.
Beneficial Maximum Number Amount and Percentage of Ownership of of Shares of Common Stock After the Sale Common Stock as Common Stock -------------------------------- Name of January 28, 2005 Offered for sale Number % ---- ------------------- ---------------- ------ -------------- Caplan, Stan 6,296,130 (1) 887,097 5,409,033 2.31% Daniels, Richard 4,895,862 (2) 1,167,568 3,728,294 1.59% Gabourel, Victor 4,500,915 (3) 1,760,000 2,740,915 1.17% Haw k Associates Inc. 2,122,496 (4) 796,000 1,326,496 * Lincoln Ventures LLC 82,730,918 (5) 35,192,108 47,538,810 17.73% (6) Mt Savage Productions 1,000,000 (7) 873,665 126,335 * Opperman, Wayne 5,985,000 (8) 4,385,000 1,600,000 * Nunes, Daniel 1,127,233 (9) 443,549 683,684 * Yen, Tony 500,000 500,000 - * Zolin, James & 6,195,408 (10) 1,827,568 4,367,840 1.86% Josehine
(1) Includes 2,694,444 and 1,908,137 shares of common stock issuable upon the conversion of previously issued convertible debentures and the exercise of previously issued warrants, respectively. The resale of these shares has been previously registered. This number also includes 806,452 shares of common stock issuable upon the exercise of a warrant that has been locked up until such time as an increase in the authorized number of common shares has been approved by our shareholders. (2) Includes 2,728,294 shares of common stock issuable upon the exercise of previously issued warrants. The resale of these shares has been previously registered. This number also includes 1,000,000 shares of common stock issuable upon the exercise of a warrant that has been locked up until such time as an increase in the authorized number of common shares has been approved by our shareholders. (3) Includes 1,090,915 shares of common stock issuable upon the exercise of previously issued warrants. The resale of these shares has been previously registered. This number also includes 1,600,000 shares of common stock issuable upon the exercise of a warrant that has been locked up until such time as an increase in the authorized number of common shares has been approved by our shareholders. 15 (4) Includes 200,000 shares of common stock issuable upon the exercise of outstanding stock options. Frank Hawkins has ultimate voting and/or investment control over the securities owned by Hawk Associates. (5) This number includes 992,633 and 19,414,635 shares of common stock issuable upon the conversion of previously issued convertible debentures and the exercise of previously issued warrants, respectively. The resale of these shares has been previously registered. This number also includes 27,131,542 shares of common stock issuable on the exercise of outstanding warrants previously issued to Lincoln which have not been registered but are currently exercisable. (6) The shares issuable to Lincoln on the exercise of warrants would not be deemed beneficially owned (due to exercise restrictions within the warrants) within the meaning of Sections 13(d) and 13(g) of the Exchange Act to the extent that their acquisition in a warrant exercise by Lincoln would cause Lincoln to own in excess of 4.99% of our outstanding common stock immediately following such exercise. By the terms of the warrants, the 4.99% limitation may be increased to a maximum of 9.99% if the Company accepts a tender offer and a change in control takes place. Therefore, it is expected that Lincoln will not beneficially own more than 9.99% of our outstanding common stock at any time. Roy Adams has ultimate voting and/or investment control over the securities owned by Lincoln. (7) This number includes 126,335 shares of common stock issuable upon the exercise of previously issued warrants. The resale of these shares has been previously registered. Elwood G. Norris has ultimate voting and/or investment control over the securities owned by Mt. Savage Productions. (8) This number includes 1,600,000 shares of common stock issuable upon the exercise of a warrant that has been locked up until such time as an increase in the authorized number of common shares has been approved by our shareholders. (9) This number includes 280,458 shares of common stock issuable upon the exercise of previously issued warrants. The resale of these shares has been previously registered. This number also includes 403,226 shares of common stock issuable upon the exercise of a warrant that has been locked up until such time as an increase in the authorized number of common shares has been approved by our shareholders. INFORMATION ABOUT US THE COMPANY Patriot Scientific Corporation was organized under Delaware law on March 24, 1992, and is the successor by merger to Patriot Financial Corporation, a Colorado corporation incorporated on June 10, 1987. Our address is 10989 Via Frontera, San Diego, California 92127, and our telephone number is (858) 674-5000. Our home page can be located on the World Wide Web at http://www.ptsc.com. We develop, market, and sell microprocessors, our technology behind the microprocessors, and complementary products which enable computers and other data processing devices to communicate. These products can be used to connect to the Internet or other telecommunication networks. The microprocessor technology product line accounted for approximately 18% of our revenue in fiscal 2004. The balance of our fiscal 2004 revenue was generated from a communications product line that, subsequent to a completed last buy program, is now generating minimal revenue. We also have a patent for special radar technology which, if fully developed, may allow a potential licensee to penetrate the ground or structures to find various objects. We also owned gas plasma antenna technology which we sold for $250,000 in August 1999. In October 2003, we received a final royalty payment of $75,500 from the sale of the gas plasma technology. Our strategy is to exploit our microprocessor technologies through product sales, licensing, strategic alliances and to litigate against those who may be infringing on our patents. 16 In 1997, we emerged from the development stage primarily as a result of the acquisition of Metacomp Inc. We merged Metacomp's product line, high speed communications equipment for the internet market, into Patriot. We have subsequently reduced the communications product line to minor activity since the products have reached the end of their life cycles and we were unsuccessful in developing follow on products. There can be no assurance that we can achieve profitable operations, and we may need additional financial resources during the next twelve months. BACKGROUND In February 1989, we completed our initial public offering under a registration statement on Form S-18 under the Securities Act of 1933. This offering raised gross proceeds of $50,000 and net proceeds of approximately $28,640 upon the sale of 2,500,000 units at $.02 per unit. Each unit sold in the public offering consisted of one common share and one Class A common stock purchase warrant exercisable to acquire one share of common stock and one Class B common stock purchase warrant. All Class A and Class B warrants have since been exercised or have lapsed. On May 12, 1992, we redomiciled ourselves from Colorado to Delaware by merging into a wholly owned Delaware subsidiary, Patriot Scientific Corporation, organized for that purpose. The reincorporation resulted in a reverse stock split. Three shares of the Colorado corporation, par value $.00001, were converted into one share of the Delaware corporation, par value $.00001. The reincorporation also effected a change in our charter and bylaws and a name change to Patriot Scientific Corporation. In May 1993, we registered under the Securities Act of 1933 a total of 7,631,606 shares issuable upon the exercise of outstanding Class A and Class B common stock purchase warrants. Upon the exercise of those warrants, we received net proceeds of $3,343,915 and issued 7,538,102 common shares. None of such warrants remain outstanding. Effective May 31, 1994, we entered into an asset purchase agreement and plan of reorganization with nanoTronics Corporation located in Eagle Point, Oregon and Helmut Falk. We issued a total of 8,500,000 restricted common shares to nanoTronics to acquire certain microprocessor technology of nanoTronics. The technology acquired was used to develop a sophisticated yet low cost microprocessor. 5,000,000 of the shares were issued on a non-contingent basis, and the remaining 3,500,000 shares were issued subject to the terms of an earnout escrow arrangement, which concluded on May 31, 1999. Effective December 26, 1996, we acquired 96.9% of the outstanding shares of Metacomp, Inc., a California corporation, from 56 shareholders in exchange for the issuance of 1,272,068 shares of our common stock. Based on the closing price of our common stock of $1.375 on the date of the acquisition, the price of the acquisition was $1,749,094. This business combination was accounted for as a pooling-of-interests. 17 BUSINESS AVAILABLE INFORMATION We file reports, proxy statements and other information with the SEC, and these reports may be inspected and copied at the public reference facilities maintained by the SEC at 450 Fifth Street, N.W., Judiciary Plaza, Washington, D.C. 20549. You may obtain information on the operation of the public reference room by calling the SEC at 1-800-SEC-0330. The same information may be obtained at the following Regional Offices of the SEC: 75 Park Place, New York, New York 10007, and the Northwest Atrium Center, 500 West Madison Street, Suite 1400, Chicago, Illinois 60621. Copies of such material may be obtained from the Public Reference Section of the SEC's Washington, D.C. office at prescribed rates. We mail a copy of our Annual Report on Form 10-K along with a proxy statement to our shareholders prior to our annual meeting. We have filed a registration statement on Form SB-2, of which this prospectus is a part, with the SEC. This registration statement or any part thereof may also be inspected and copied at the public reference facilities of the SEC. Our filings may also be accessed through the SEC's web site (http://www.sec.gov) or by visiting our web site at (http://www.ptsc.com) and linking to the SEC's site. ORGANIZATION AND CORPORATE DEVELOPMENT. Our business involves the following technologies: o Ignite microprocessor technology, and o high-speed data communications technology. The stage of development of each of our technologies is as follows: o Ignite microprocessor. This technology is generating minor amounts of revenue from the sale of development boards, microprocessors and initial license fees related to the microprocessor application. We run the technology on a 0.18-micron microprocessor, which is in current production. We have ported the WindRiver VxWorks operating system and the Sun Microsystems personalJava virtual machine to the microprocessor. In addition, the technology is available for sale as intellectual property, which enables the prospective customer to incorporate the microprocessor functions with other parties' applications to arrive at a system on a chip solution. Although we anticipate the Ignite technology to be our main product line, it accounted for only about 18% of our revenue in fiscal year 2004. 18 o High-speed data communications. Revenue from this technology was phased out during fiscal year 2002 as a result of the products reaching the end of their life cycles. During fiscal 2002 we initiated a last time buy program and, except for minor repeat orders, have discontinued this product line. We have decided to concentrate our efforts on the Ignite microprocessor technology. Although the communications product line accounted for approximately 82% of our fiscal year 2004 revenue, we anticipate that the Ignite microprocessor will be our main product line in the future. Due to our small size and staffing overlaps among the technologies, certain personnel may work on any or all of our technologies from time to time. During at least the last three years, we have focused the majority of our efforts on the Ignite technology. The Ignite technology is targeted for the embedded controller and Java language processor marketplaces. INTERNET GROWTH AND THE EMERGENCE OF THE JAVA PROGRAMMING LANGUAGE. The Internet is a global web of computer networks. This "network of networks" allows computers connected to the Internet to "talk" to one another. The Internet provides organizations and individuals with new means to conduct business. Commercial uses of the Internet include business-to-business and business-to-consumer transactions, product marketing, advertising, entertainment, electronic publishing, electronic services and customer support. We believe that organizations will also increasingly use the Internet and private Intranet networks to improve communications, distribute information, lower operating costs and change operations. Use of the Internet has grown rapidly and has had an impact on many industries, including computer hardware, software and peripheral industries. The rapid growth in popularity of the Internet is in part due to continuing penetration of computers and modems into U.S. households, growth of the informational, entertainment and commercial applications and resources of the Internet, the growing awareness of such resources among individuals, and the increasing availability of user-friendly navigational and utility tools which enable easier access to the Internet's resources. The growth of the Internet and corporate Intranets is creating a demand for hardware, software and peripherals. Software, such as Java, has been developed to serve the requirements of Internet users. Java is a programming language that was originally developed for personal digital assistant devices and television set top boxes. It was formally announced as an object-oriented language for the Internet in May 1995 by Sun Microsystems Inc. A large number of major computer, software, browser and on-line service provider companies have licensed the Java language. Accordingly, Java is a fundamental platform for Internet related applications. A significant number of Java applications, or applets, are now available on the Internet. These applications not only enhance web pages but also perform many functions of traditional computer software programs. Our Ignite technology lends itself to potential markets in which the use of Java is prevalent. 19 With Java, data and programs do not have to be stored on the user's computer but can reside anywhere on the Internet to be called upon as needed. Among its various attributes, two key features of Java are (1) its ability to run on a variety of computer operating systems thus avoiding the problem of incompatibility across networks, and (2) security, because Java enables the construction of virus-resistant, tamper-resistant systems by using resource-access control and public-key encryption. Because of Java's useful features, it has also become a popular programming language for embedded applications. Since Java is designed to run on multiple types of devices and operating systems, it allows developers to write a program once for many types of operating systems, instead of having to write new versions for each type. Java does this by interpreting a program's commands into something that a particular type of computer can understand. This interpretive design runs programs slower than if they were tailored for each type of computer and is resulting in a need for specialized microprocessors and compilers to increase Java's speed. The growth of Java is causing a number of companies to consider it as a basis for a new style of computing tailored to the Internet and not encumbered by the limitations of, or requiring, traditional computer operating systems. The concept is to design inexpensive access devices to communicate via the Internet. OUR MICROPROCESSOR TECHNOLOGY. General Background. In 1991, nanoTronics Corporation was formed and acquired a base technology for an advanced microprocessor integrated on a single computer chip. nanoTronics subsequently engaged in substantial technical development and fabricated a first-generation microprocessor in early 1994. Since the acquisition of the technology from nanoTronics, effective May 31, 1994, we have been engaged in enhancing the microprocessor design, adding additional technical features to further modernize the design, and improving and testing the new design. We initially fabricated a prototype 0.8-micron microprocessor in May 1996. The next generation was a 0.5-micron microprocessor that was delivered in September 1997. The 0.5-micron microprocessor was employed in demonstrations for prospective customers and was shipped in limited numbers to customers as an embedded microprocessor. In 1998 we introduced a 0.35-micron microprocessor whose features included a reduction in size and improved performance. In addition, in September 2000 we completed a VHDL model of this technology which enables customers to purchase intellectual property incorporating microprocessor functions with other parties' applications to arrive at a system on a chip solution. By purchasing this software model, customers can significantly reduce their time to market by simulating results as opposed to trial and error commitments to silicon production. In 2003 we further reduced the size of our silicon production to 0.18-microns. Industry Background. The semiconductor logic market has three major sectors: o standard logic products, o application specific standard products, and o application specific integrated circuits. 20 Standard logic products, such as the Intel's X86 and Pentium and Motorola's 680X0 microprocessor families, are neither application nor customer specific. They are intended to be utilized by a large group of systems designers for a broad range of applications. Because they are designed to be used in a broad array of applications, they may not be cost effective for specific applications. Application specific integrated circuits are designed to meet the specific application of one customer. While cost effective for that application, application specific integrated circuits require large sales volumes of that application to recover their development costs. Application specific standard processors are developed for one or more applications but are not generally proprietary to one customer. Examples of these applications include modems, cellular telephones, other wireless communications devices, multimedia applications, facsimile machines and local area networks. We have designed our microprocessor to be combined with application specific software to serve as an embedded control product for the application specific standard processor market sector. Application specific standard processors are typically used in embedded control systems by manufacturers to provide an integrated solution for application specific control requirements. Such systems usually contain a microprocessor or microcontroller, logic circuitry, memory and input/output circuitry. Electronic system manufacturers combine one or more of these elements to fit a specific application. The microprocessor provides the intelligence to control the system. The logic circuitry provides functions specific to the end application. The input/output circuitry may also be application specific or an industry standard component. The memory element, if not on the microprocessor, is usually a standard product used to store program instructions and data. In the past, these functions have been executed through multiple integrated circuits assembled on a printed circuit board. The requirements for reduced cost and improved system performance have created market opportunities for semiconductor suppliers to integrate some or all of these elements into a single application specific standard processor or chip set, such as the Ignite family of microprocessors. The Ignite family provides close integration of the microprocessor and input/output function with the logic circuitry, thereby providing an advanced application specific standard processor. Embedded control systems enable manufacturers to differentiate their products, replace less efficient electromechanical control devices, add product functionality and reduce product costs. In addition, embedded control systems facilitate the emergence of completely new classes of products. Embedded control systems have been incorporated into thousands of products and subassemblies worldwide, including automotive systems, remote controls, appliances, portable computers and devices, cordless and cellular telephones, motor controls and many other systems. Microprocessors are generally available in 4-bit through 64-bit architectures, which refers to the amount of data they can process. 4-bit microprocessors are relatively inexpensive, typically less than $1.00 each. Although they lack certain performance and features, they account for more than 40% of worldwide microcontroller volume. Also in general use today are 8-bit architectures, generally costing $1.00 to $10.00 each and accounting for an additional 40% of worldwide microcontroller volume. To date 16-bit, 32-bit and 64-bit architectures, with typical costs of over $10.00 each, have offered very high performance, but are generally considered to be expensive for high-volume embedded control applications. The use of 16-bit, 32-bit and 64-bit architectures offers fewer internal limitations, making programming easier and providing higher performance. Although generally more expensive per unit and requiring more support logic and memory, these devices offer many advantages for more sophisticated embedded control systems. 21 Electronic system designers, driven by competitive market forces, seek semiconductor products with more intelligence, functionality and control that can be used to reduce system costs and improve performance. For these needs, the Ignite product family was designed to be a sophisticated 32-bit microprocessor with advanced features. The Ignite product family uses a smaller number of transistors compared to other RISC (reduced instruction set computor) processors, which results in less power consumption and more economical prices compared to other embedded control applications. This creates the opportunity for the development of new, cost-effective applications. Technology Description. Conventional high-performance microprocessors are register-based with large register sets. These registers are directly addressable storage locations requiring a complex architecture that consumes costly silicon. This conventional architecture provides processing power for computer applications but complicates and slows the execution of individual instructions and increases silicon size, thereby increasing the microprocessor cost. Our technology is fundamentally different from most other microprocessors, in that the data is stored in groups and certain information is known to be at the top of a stack as opposed to being stored in a register. Our microprocessor employs certain features of both register and stack designs. The resultant merged stack-register architecture improves program execution for a wide range of embedded applications. Our design combines two processors in one highly integrated package, a microprocessing unit for performing conventional processing tasks, and an input-output processor for performing input-output functions. This replaces many dedicated peripheral functions supplied with other processors. The microprocessor's design simplifies the manipulation of data. Our architecture employs instructions that are shrunk from 32-bits to 8-bits. This simplified instruction scheme improves execution speed for computer instructions. Our architecture incorporates many on-chip system functions, thus eliminating the requirement of support microprocessors and reducing system cost to users. The 0.8-micron microprocessor was designed to operate at a speed of 50Mhz; the 0.5-micron microprocessor at a speed of 100Mhz; the 0.35-micron microprocessor at 150MHz; and the 0.18-micron to operate at speeds in excess of 300Mhz. They are all compatible with a wide range of memory technology from low cost dynamic random access memory to high-speed static random access memory. The microprocessors can be packaged in various surface-mount and die-form packaging. There can be no assurance that the designed speed will be achieved with the production model of the 0.18-micron microprocessor or future versions or that all of the desired functions will perform as anticipated. Our technology is not designed or targeted to compete with high-end processors for use in personal computers. It is targeted for embedded control applications. We believe that the features described above differentiate the Ignite family from other 8-bit to 64-bit microprocessors targeted for embedded control applications. Considering the reduced requirement for support microprocessors, the Ignite family is intended to be available at a high volume price that should be price competitive with high-end 8-bit microprocessor and general 16-bit microprocessor systems but with higher performance (speed and functional capability). The Ignite family has been designed to allow high-speed and high-yield fabrication using generally available wafer fabrication technology and facilities. 22 The Ignite Microprocessor as a Java Processor. We believe the Ignite microprocessor architecture is capable of being an efficient and cost effective Java programming language processor, because Java is designed to run on a stack-oriented architecture and the Ignite architecture executes the virtual stack machine internal to Java efficiently. Many Java operation codes or instructions require only a single 8-bit Ignite family instruction to be executed, providing a performance advantage over other more expensive processors that require six or more 32-bit instructions to do the same task. This feature allows the execution of Java programs with increased speed and reduced code size thereby enabling lower system memory costs. In addition, the incorporation of many on-chip system functions is expected to allow the Ignite family to perform most of the other functions required of an Internet computer device or Java accelerator, thereby eliminating components. Since Internet computers are designed to be inexpensive appliances for Internet access, cost, speed and performance are expected to be key requirements for designers. We believe the Ignite technology can compete favorably on the basis of such requirements, although there can be no assurance we can successfully exploit Java related applications or that competitors will not create superior Java processors. We have ported the Java operating environment to the Ignite family, which currently uses the C programming language for software support. We are a licensee of Sun Microsystems Inc. This enables us to develop and distribute products based on Sun's personalJava, a platform on which to run Java applications. We have also licensed from Wind River an operating system, VxWorks, and entered into a relationship with Forth Inc. whereby Forth will provide software support and operating system development tools for the Forth Programming language. We believe this solution is competitive in the Java virtual machine and embedded applications markets. We believe that, if the implementation is successfully completed, the Ignite family will be competitive with Java microprocessors announced by competitors. However, there can be no assurance of successful implementation of this package of software or of a market for an Ignite family Java microprocessor. Stage of Development. In early 1994, nanoTronics initiated production of a first generation of wafers at a contract fabrication facility using 6 inch wafers employing 0.8-micron double-metal CMOS technology. After the May 31, 1994 acquisition, we improved the original design, added new features and performed simulations and tests of the improved designs. In October 1995, a run of six wafers of second generation 0.8-micron microprocessors was fabricated by a contract fabrication facility. Subsequently, we tested these microprocessors, while completing a C computer language compiler and preparing application development tools. The compiler and application development tools are necessary to enable system designers to program the Ignite family for specific applications. We made corrections to the design suggested by the testing of prototype units and produced an additional run of second generation microprocessors from remaining wafers in May 1996. In July 1996, we employed these microprocessors in demonstration boards for use by developers and prospective customers and licensees. In December 1997, we completed development of and started shipping a 0.5-micron microprocessor based on the Ignite technology and found that 0.5-micron double-metal CMOS technology improved operating speed, reduced power requirements, reduced physical size and reduced fabrication cost. In May 1998, we began a production run of a 0.35-micron microprocessor that further increased operating speed and cost performance over the previous generations of the Ignite family of microprocessors. 23 At each stage of development, microprocessors require extensive testing to ascertain performance limitations and the extent and nature of errors (bugs), if any. When significant limitations or errors are discovered, additional rounds of design modifications and fabrication are required prior to having functional and demonstrable microprocessors for prospective customers and licensees. Although our 0.5 and 0.35-micron microprocessors have been sent to prospective customers in anticipation of production orders, there can be no assurance that we, during our continued testing of these products, will not identify errors requiring additional rounds of design and fabrication prior to commercial production. Additional delays could have an adverse effect on the marketability of our technology and financial condition. In September 2000, we completed the VHDL soft-core version of the Ignite microprocessor family. The hardware design inside a microprocessor, or silicon device, can be represented as a software program. This, in essence, replaces the old style of designing microprocessors using schematics. VHDL is the predominant software language used to design semiconductors. In addition to the design aspects, VHDL also contains sophisticated simulation tools that allow the designer to simulate the functionality of the entire design before committing to silicon. Also VHDL enables a designer to easily modify and enhance the design. A design represented in VHDL goes through a synthesis process whereby it is converted to the most basic element of a design, logical gates. This gate level representation in turn is used with computer aided engineering tools to translate the design into the most fundamental component of semiconductors, transistors. The characteristics of the transistors can be given as a library to a foundry. Therefore, a design represented in VHDL is technology and foundry independent and can be targeted for any given transistor geometry (such as 0.18, 0.25, or 0.35- micron) for any foundry of choice. We have developed marketing materials, product manuals and application development tools for use by licensees and customers. The manuals and tools are necessary to enable system designers to quickly and easily program the Ignite family for specific applications. We believe that the Ignite family is ready for licensing or sale and that any additional changes encountered in current testing will be minor and can be made during subsequent production runs of Ignite family microprocessors for customers, when and if orders are obtained. We also believe the core technology is ready for licensing for use by others to develop custom microprocessors. Business Strategy. The increasing demand for embedded control has helped to make the market for microprocessors one of the largest segments of the semiconductor logic market. This demand will drive the need for embedded processors. Our strategy does not entail competing directly with suppliers who have multiple microprocessor types addressing all parts of the embedded systems market, but on identifying certain market niches that the Ignite microprocessor would best address due to its low cost, low power consumption, small number of transistors and higher performance. Because of the above factors, we intend to focus the majority of our efforts on the embedded microprocessor business, a market without an established base of microprocessor products and for which we believe the Ignite microprocessor has desirable technical and market advantages. 24 We believe that our architecture is suited for controller applications requiring high performance and low system cost, such as smart cards, cell phones, printers, video terminals, robotics, motion controllers, industrial controllers, digital communication devices, video games, kiosks, cable and satellite modems and TV set top boxes. We expect that early licensing of the technology and product applications will focus on embedded control. We have two international representatives for foreign markets and are addressing the domestic market with an in-house business development person. We also have a strategic alliance with an outside microprocessor design house. We believe the appropriate approach for us initially lies in a balanced effort of cultivating licensees and developing specific product enhancement partnerships, producing original equipment manufactured products, and providing technical support to third parties on a contract basis. The overall balance of these approaches will be monitored and modified as we attempt to ascertain and capitalize on the highly dynamic and competitive embedded microprocessor market. There can be no assurance that we can successfully exploit our microprocessor technology. Subject to the availability of financial and personnel resources, while we are commercializing the Ignite family and the core technology, our strategy is to also design and develop future versions of the microprocessor with more demanding sub-micron technology and with more features. However, our resources are limited, and there can be no assurance that we will be able to continue microprocessor enhancement. Initial fabrications of the 0.8-micron and 0.5-micron processors were performed by contract fabrication facilities. The 0.35-micron microprocessor was fabricated by a contract fabrication facility that had agreed to provide production quantities for our customers. We have completed work with a contract fabrication facility and our design house partner to produce a 0.18-micron version of the Ignite family. There can be no assurance fabrication facilities will be available to produce the Ignite family in the future. However, since there are a large number of fabrication facilities with the capability to produce the Ignite family of microprocessors, we believe microprocessors can be produced on a contract basis. Industry shortages of fabrication facilities that may exist and are predicted to exist in the future are generally limited to the more demanding architectures. If a shortage of fabrication facilities develops, it could have a material adverse effect on our financial condition. Competition. The semiconductor industry is intensely competitive and has been characterized by price erosion, rapid technological change and foreign competition in many markets. The industry consists of major domestic and international semiconductor companies, most of which have greater financial, technical, marketing, distribution, development and other resources than we do. The market for microprocessors and for embedded control applications is at least as competitive. While our strategy is to target high-volume licensees and microprocessor customers requiring more sophisticated but low-cost, low-power consumption devices, we can still expect significant competition. We may also elect to develop embedded control system products utilizing our own architecture or by contract for other manufacturers. 25 We expect that the Ignite family, if successfully commercialized in the embedded controller market, will compete with a variety of 16/64-bit microprocessors including those based on intellectual property from ARM and MIPS and microprocessors from Hitachi, Motorola and IBM. As a Java processor, we expect our Ignite family will compete with a broad range of microprocessors including those incorporating co-processor accelerator technology. The producers of these microprocessors have significantly greater resources than we do. A new entrant, such as ours, is at a competitive disadvantage compared to these and other established producers. A number of factors contribute to this, including: o the lack of product performance experience, o lack of experience by customers in using application development systems, o no record of technical service and support, and o limited marketing and sales capabilities. HIGH SPEED DATA COMMUNICATIONS PRODUCTS. The communication products that reached the end of their life cycles are: VME Product Line - a line of high-speed communications products developed under European standards. Some of our customers for these products included the military as well as large satellite based data communications companies. Atcomm2/4 Product Line - an intelligent two or four channel product that was used for high-speed data communications. Except for minor repeat orders, we no longer support this product line. We have disposed of or fully reserved the communication product line inventory and are concentrating our efforts and resources on Ignite. RESEARCH AND DEVELOPMENT. Our current development efforts are focused on improvement of, and additional features for, the Ignite family of microprocessors. The development of this technology has taken longer than anticipated and could be subject to additional delays. Therefore, there can be no assurance of timely or successful marketing of this technology. We incurred research and development expenditures of $549,756 and $723,287 for our fiscal years ended May 31, 2004 and 2003, respectively. The majority of these expenditures have been devoted to our microprocessor technology. We believe that technical advances are essential to our success and expect that we will, conditioned on the availability of funds, continue to expend substantial amounts on research and development of our technology. However, there can be no assurance that such research and development efforts will result in the design and development of a competitive technology in a timely manner. LICENSES, PATENTS, TRADE SECRETS AND OTHER PROPRIETARY RIGHTS. We rely on a combination of patents, copyright and trademark laws, trade secrets, software security measures, license agreements and nondisclosure agreements to protect our proprietary technologies. Our policy is to seek the issuance of patents that we consider important to our business to protect inventions and technology that support our microprocessor technology. 26 We have seven U.S. patents issued dating back to 1989 on our microprocessor technology. We have one microprocessor technology patent issued in five European countries and one patent issued in Japan and may file additional applications under international treaties depending on an evaluation of the costs and anticipated benefits that may be obtained by expanding possible patent coverage. In addition, we have one U.S. patent issued on ground penetrating radar technology and one U.S. patent issued on one of the communications products. In addition to such factors as innovation, technological expertise and experienced personnel, we believe that a strong patent position is becoming increasingly important to compete effectively in the semiconductor industry. It may become necessary or desirable in the future for us to obtain patent and technology licenses from other companies relating to certain technology that may be employed in future products or processes. To date, we have not received notices of claimed infringement of patents based on our existing processes or products; but, due to the nature of the industry, we may receive such claims in the future. We believe that we may have claims against numerous companies that use semiconductors with capabilities in excess of 125 MHz in their products. In December 2003, we initiated legal actions against five companies to enforce our patents. In February 2004, Intel initiated a legal action against us and we filed a counterclaim against them related to the initial five lawsuits. There can be no assurance that we will be successful in enforcing any potential patent claims against these or other companies. Also in February 2004, we initiated a legal action against several entities, one of which was a co-inventor for some of the technology, to clarify the inventorship and ownership of each of our granted patents. See Legal Proceedings. Based on the asset purchase agreement and plan of reorganization between Patriot, nanoTronics and Mr. Falk, we were the recipients of a number of warranties and indemnities. We believe nanoTronics has been liquidated and, due to Mr. Falk's death in July 1995, we may be limited in our ability to obtain satisfaction should we have any future claims against nanoTronics or its successor, the Falk Family Estate. We have entered into the following licenses related to the microprocessor technology: o Sierra Systems. In June 1994, we entered into an agreement with Sierra Systems whereby we could provide the C programming language on the Ignite microprocessor. We currently provide development boards with the C programming language. o Sun Microsystems Inc. In June 1997, we entered into an agreement with Sun Microsystems, Inc., which enabled us to develop and distribute products based on Sun's Java technology. In June 1998, we exercised an option under that agreement to license from Sun, personalJava, a smaller platform on which to run Java applications that did not include an operating system. We determined that personalJava is better suited to the markets available to the Ignite microprocessor. We have ported personalJava to the Ignite microprocessor. 27 o Wind River. In July 1997, we entered into an agreement with Wind River that provided us with a license for an operating system, VxWorks, to be used in conjunction with personalJava. We have ported VxWorks to the Ignite. o Forth Inc. In July 1997, we entered into a license agreement with Forth Inc. whereby Forth will provide software support and operating system development tools for the Forth programming language. We have one U.S. patent on our ground penetrating radar technology. No foreign application has been made. There are a large number of patents owned by others in the radar field generally and in the field of ground penetrating radar specifically. Accordingly, although we are not aware of any possible infringement and have not received any notices of claimed infringement, we may receive such claims in the future. There can be no assurance that any patents will be issued from pending or future applications or that any patents that are issued will provide meaningful protection or other commercial advantages to us. Although we intend to protect our rights vigorously, there can be no assurance that these measures will be successful. We generally require all of our employees and consultants, including our management, to sign a non-disclosure and invention assignment agreement upon employment with us. MARKETING AND DISTRIBUTION. Our products are marketed through a combination of direct sales and distributors. Approximate sales by principal geographic area (as a percentage of sales) for fiscal years ended May 31 were as follows: 2004 2003 ----- ----- Domestic sales 92% 91% Foreign sales Europe 8% 9% ----- ----- Total sales 100% 100% ===== ===== All of our operating assets are located within the United States. While sales to certain geographic areas generally vary from year to year, we do not expect that changes in the geographic composition of sales will have a material adverse effect on operations. DEPENDENCE UPON SINGLE CUSTOMERS. Ten percent (10%) or more of our consolidated net sales were derived from shipments to the following customers for the fiscal years ended May 31as follows: 2004 2003 ------- ------- nTelesis $25,000 $ -- Blue Tech Inc. 18,000 -- Litton Systems 9,000 -- Long Wave, Inc. -- 43,000 General Dynamics -- 23,000 Centratech -- 15,000 Advanced Relay -- 15,000 28 All of the above sales were shipped against multiple purchase orders from each customer. nTelesis is owned by an executive officer of the company. We had no backlog as of May 31, 2004 or 2003. FACILITIES. We have one 10,300 square foot office located at 10989 Via Frontera, San Diego, California. The facility is leased through July 2006. During the period July 2002 through August 2004, we sublet approximately 5,000 square feet of our facility to an independent third party. In August 2004, we negotiated a termination of the sublease. We are currently looking to re-sublease the 5,000 square feet. The reduced floor space provides adequate and suitable facilities for all of our corporate functions. EMPLOYEES. We currently have five personnel. One person is employed in research and development, one in marketing and sales and three are engaged in general and administrative activities. We also engage additional consultants and part-time persons as needed from time to time. Our future success depends in significant part upon the continued services of our key technical and senior management personnel. The competition for highly qualified personnel is intense, and there can be no assurance that we will be able to retain our key managerial and technical employees or that we will be able to attract and retain additional highly qualified technical and managerial personnel in the future. None of our employees is represented by a labor union, and we consider our relations with our employees to be good. None of our employees is covered by key man life insurance policies. GOVERNMENT REGULATION. To our knowledge, our products are not subject to governmental regulation by any federal, state or local agencies that would affect the manufacture, sale or use of our products, other than occupational health and safety laws and labor laws which are generally applicable to most companies. We cannot, of course, predict what sort of regulations of this type may be imposed in the future but do not anticipate any unusual difficulties in complying with governmental regulations which may be adopted in the future. We have not incurred costs associated with environmental laws and do not anticipate such laws will have any significant effect on our future business. USE OF PROCEEDS We will not receive any proceeds from the resale of these securities. We may receive proceeds on the exercise of the warrants of up to $428,114. LEGAL PROCEEDINGS In December 2003 we filed several lawsuits in United States District Courts against companies we contend are infringing on our patent number 5,809,336 entitled "High Performance Microprocessor Having Variable Speed Clock." The defendants and suits are as follows: 29
Defendant U.S. District Court Case Number - --------- ------------------- ----------- Sony Corporation of America Southern District of New York 03CV10142 Fujitsu Northern District of California C035787 Toshiba America, Inc. Southern District of New York 03CV10180 NEC USA, Inc. Eastern District of New York CV036432 Matsushita District of New Jersey 03CV06210
We are requesting the courts to enjoin the defendants from making use of our patent and are requesting damages for past infringements. In February, with the consent of the defendants and ourselves, the above five actions were consolidated into the Fujitsu action in the Northern District of California under case number C035787. In February 2004, Intel Corporation filed a lawsuit against us in the United States District Court- Northern District of California, case number C040439, in which they are requesting a declaratory judgment that their microprocessors, used by the defendants in our consolidated suit, do not infringe our patent. We filed a counterclaim against Intel contending that they also are infringing on our patent, and Intel asserted an affirmative defense that our 5,809,336 patent is invalid. Also in February 2004, we filed a lawsuit in the United States District Court- Northern District of California, case number C040618, against Charles H. Moore, Technology Properties Limited, and Daniel E. Leckrone. Charles Moore, a co-inventor of the basic ShBoom technology, is listed as an inventor on several of the issued patents which were divided from the basic ShBoom technology. Moore transferred his interest in the ShBoom technology to Daniel Leckrone and Technology Properties Limited. We are contending that Russell Fish, the other co-inventor from whom we obtained ownership interests in the ShBoom technology, is the sole inventor of certain of the issued patents. We are requesting the court to declare inventorship and ownership on each of our granted patents related to the suits discussed above and other unasserted claims of infringement Patriot believes it has. The Intel lawsuit has been stayed pending the results of the Moore lawsuit. 30 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW Patriot Scientific Corporation ("the Company") develops, markets, and sells microprocessors, the technology behind the microprocessors, and complementary products which enable computers and other data processing devices to communicate. These products can be used to connect to the Internet or other telecommunication networks. The microprocessor technology product line accounted for approximately 18% of our revenue in fiscal 2004. The balance of our fiscal 2004 revenue was generated from a communications product line that, subsequent to a completed last buy program, is now generating minimal revenue. We also have a patent for special radar technology which, if fully developed, may allow a potential licensee to penetrate the ground or structures to find various objects. We also owned gas plasma antenna technology which we sold for $250,000 in August 1999. In fiscal 2004 we received a final royalty payment of $75,500 from the sale of the gas plasma technology. Our strategy is to exploit our microprocessor technologies through product sales, licensing, strategic alliances and to litigate against those who may be infringing on our patents. Management's discussion and analysis of results of operations and financial condition are based upon the Company's financial statements. These statements have been prepared in accordance with accounting principles generally accepted in the United States of America. These principles require management to make certain estimates, judgments and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates based on historical experience and various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. CRITICAL ACCOUNTING POLICIES AND ESTIMATES We have identified nine accounting principles that we believe are key to an understanding of our financial statements. These important accounting policies require management's most difficult, subjective judgments. 1. Going Concern These financial statements are presented on the basis that the Company is a going concern. Going concern contemplates the realization of assets and the satisfaction of liabilities in the normal course of business over a reasonable length of time. The Company has incurred significant operating losses and has had negative cash flows from operating activities for each of the years ended May 31, 2004 and 2003, had negative working capital and a stockholders' deficit for the year ended May 31, 2003 and used convertible debentures for raising substantially all of its working capital. These factors raise substantial doubt as to the Company's ability to continue as a going concern. For the years ended May 31, 2004 and 2003 our independent certified public accountants modified their opinion as to an uncertainty regarding our ability to continue as a going concern. Management's plans to eliminate the going concern situation include, but are not limited to, the following: 1. Obtain additional equity or debt financing from investors including the exercise of outstanding warrants. 2. Obtain revenue producing contracts by successfully negotiating licensing, development and product opportunities within the microprocessor market place. 31 3. Aggressively pursue patent infringement opportunities by litigating with companies alleged to be infringing on our issued patents. 4. If funds are not satisfactorily available to continue operations at our current level, put in place cost reduction programs. Such reduction programs could include a scale back in the support of the microprocessor technology with total emphasis being placed on patent infringement activity. If, in the future, there is patent infringement success, additional funds would be available for the microprocessor technology. 2. Marketable Securities As part of the sale of our gas plasma antenna technology we received restricted securities in a company that is traded on the OTC bulletin board. The securities can be traded under Rule 144. We reflect the value of those securities based on the closing price as of the end of our reporting period. Any unrealized gain or loss between reporting periods is reflected in our consolidated statement of operations as non-operating income or loss. 3. Property, Equipment and Depreciation Property and equipment are stated at cost. Depreciation is computed over the estimated useful life of three to five years using the straight-line method. Long-lived assets and certain identifiable intangibles to be held and used by the Company are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. We continuously evaluate the recoverability of our long-lived assets based on estimated future cash flows and the estimated fair value of such long-lived assets, and provide for impairment if such undiscounted cash flows are insufficient to recover the carrying amount of the long-lived asset. 4. Patents and Trademarks Patents and trademarks are carried at cost less accumulated amortization and are amortized over their estimated useful lives of four years. The carrying value of patents and trademarks is periodically reviewed and impairments, if any, are recognized when the expected future benefit to be derived from an individual intangible asset is less than its carrying value. 5. Revenue Recognition We recognize revenue on the shipment to our customers of communication products, microprocessor integrated chips and evaluation boards. We also derive revenue from fees for the transfer of proven and reusable intellectual property components or the performance of engineering services. We enter into licensing agreements that will provide licensees the right to incorporate our intellectual property components in their products with terms and conditions that will vary by licensee. Generally, these payments will include a nonrefundable technology license fee, which will be payable upon the transfer of intellectual property, or a nonrefundable engineering service fee, which generally will be payable upon achievement of defined milestones. In addition, we anticipate these agreements will include royalty payments, which will be payable upon sale of a licensee's product, and maintenance and limited support fees. We will classify all revenue that involves the future sale of a licensee's products as royalty revenue. Royalty revenue will be generally recognized in the quarter in which a report is received from a licensee detailing the shipments of products incorporating our intellectual property components (i.e., in the quarter following the sale of licensed product by the licensee). We will classify all revenue that does not involve the future sale of a licensee's products, primarily license fees and engineering service fees and maintenance and support fees, as contract revenue. License fees will be recognized upon the execution of the license agreement and transfer of intellectual property, provided no further significant performance obligations exist and collectibility is deemed probable. Fees related to engineering services contracts, which will be performed on a best efforts basis and for which we will receive periodic milestone payments, will be recognized as revenue over the estimated development period, using a cost-based percentage of completion method. Annual maintenance and support fees, which will be renewable by the licensee, will be classified as contract revenue and will be amortized over the period of support, generally 12 months. 32 6. Research and Development Costs Research and development costs are expensed as incurred. 7. Stock Options The Company applies Accounting Principles Board ("APB") Opinion 25, "Accounting for Stock Issued to Employees," and related Interpretations in accounting for all stock option plans. Under APB Opinion 25, compensation cost has been recognized for stock options granted to employees when the option price is less than the market price of the underlying common stock on the date of grant. SFAS No. 123, "Accounting for Stock-Based Compensation," and SFAS No. 148, "Accounting for Stock-Based Compensation-Transition and disclosure," require the Company to provide pro forma information regarding net income as if compensation cost for the Company's stock option plans had been determined in accordance with the fair value based method prescribed in SFAS No. 123. To provide the required pro forma information, the Company estimates the fair value of each stock option at the grant date by using the Black-Scholes option-pricing model. SFAS No. 148 also provides for alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. The Company has elected to continue to account for stock based compensation under APB No. 25. The Company applies SFAS No. 123 in valuing options granted to consultants and estimates the fair value of such options using the Black-Scholes option-pricing model. The fair value is recorded as consulting expense as services are provided. Options granted to consultants for which vesting is contingent based on future performance are measured at their then current fair value at each period end, until vested. 8. Income Taxes Deferred income taxes are provided for by recognizing temporary differences in certain income and expense items for financial and tax reporting purposes. Deferred tax assets consist primarily of income tax benefits from net operating loss carry-forwards. A valuation allowance has been recorded to fully offset the deferred tax asset as it is more likely than not that the assets will not be utilized. The valuation allowance increased approximately $441,000 for the year ended May 31, 2004, from $14,291,000 at May 31, 2003 to $14,732,000 at May 31, 2004. 33 9. Debt Discount We issue warrants as part of our convertible debentures and other financings. We value the warrants using the Black-Scholes pricing model based on expected fair value at issuance and the estimated fair value is recorded as debt discount. The debt discount is amortized to non-cash interest over the life of the debenture assuming the debenture will be held to maturity which is normally 2 years. If the debenture is converted to common stock previous to its maturity date, any debt discount not previously amortized is expensed to non-cash interest. RESULTS OF OPERATIONS Three months ended November 30, 2004 compared to three months ended November 30, 2003. Selected Financial Information
Three Months Ended Increase 11/30/2004 11/30/2003 (Decrease) % Statements of Operations Revenue $ 18,748 $ 51,960 $ (33,212) -63.9% Cost of revenue -- 4,259 (4,259) -100.0% % of revenue 0% 8% -8% -100.0% Gross profit 18,748 47,701 (28,953) -60.7% % of revenue 100% 92% 8% 8.9% Operating expenses Research and development 54,037 112,391 (58,354) -51.9% General and administrative 392,552 321,132 71,420 22.2% Total operating expenses 446,589 433,523 13,066 3.0% Gain (loss) on marketable securities 2,444 (23,234) 25,678 NM Interest expense (648,223) (539,234) 108,989 20.2% Gain on sale of technology -- 75,500 75,500 NM Other income 479 -- 479 NM Net loss (1,073,141) (872,790) 200,351 23.0% Net loss per share basic and diluted $ (0.01) $ (0.01) $ -- 0.0%
Revenues Our revenue decrease of $33,212, or 63.9%, was due to a continuing lack of significant revenue producing contracts. Our microprocessor product line has failed to generate any significant contracts. We continue to receive minor follow-on orders for the communication products that have reached the end of their life cycle. We no longer market these products but do fill follow-on orders when economically feasible. We anticipate that future revenue will be derived from successful microprocessor technology efforts in the form of licensing and royalties and the successful collection of patent infringement proceeds from litigation and settlement. Cost of Revenue Our cost of revenue decrease of $4,259, or 100%, was commensurate with the reduction in revenue. We fully reserved our inventory in fiscal 2002 and, therefore, minor amounts of existing inventory can be resold at a zero cost basis. However, in order to fulfill the minor follow-on orders for communication products, we normally must procure a portion of additional components and assemblies. We anticipate that future cost of revenue will be commensurate with the success of receiving microprocessor licenses and royalties and patent infringement proceeds. 34 Research and Development
Three Months Ended Increase 11/30/2004 11/30/2003 (Decrease) % Research and Development Personnel (including consultants) $ 50,620 $ 99,477 $ (48,857) -49.1% Facilities 3,407 12,914 (9,507) -73.6% Other research and development expenses 10 -- 10 NM --------- --------- --------- $ 54,037 $ 112,391 $ (58,354) -51.9%
The $58,354, or 51.9%, reduction in research and development was attributed to a reduction in personnel. In addition, there has been no significant increase in depreciable equipment related to research and development for the past three years resulting in a lower depreciation amount charged to facilities expense. When and if funds become available, we anticipate an increase in research and development to upgrade the tools which are used by our potential customers to implement the microprocessor technology and to expand our offerings on which our microprocessor can run to include additional operating systems. General and Administrative
Three Months Ended Increase 11/30/2004 11/30/2003 (Decrease) % General and Administrative Personnel (including consultants) $134,733 $121,094 $ 13,639 11.3% Professional fees 122,793 44,917 77,876 173.4% Facilities 65,662 61,759 3,903 6.3% Other general and administrative expenses 69,364 93,362 (23,998) -25.7% -------- -------- -------- $392,552 $321,132 $ 71,420 22.2%
The $71,420, or 22.2%, increase in general and administrative expenses was attributed to an increase in personnel costs as a result of expensing stock options to consultants. Professional fees increased $77,876 primarily as a result of patent infringement costs increasing ($84,000) offset by a decrease in costs associated with registration statements and auditing of our financial statements ($6,000). Other general and administrative expenses decreased as a result of licenses and dues increasing ($17,000) offset by a reduction in shareholder related expenses ($46,000) as a result of not holding an annual meeting during FY2005. We anticipate general and administrative expenses to remain stable at the current levels until such time as contract revenue and patent litigation proceeds are recognized at which time additional personnel and other fees would be expected to increase. 35 Other Income (expense)
Three Months Ended 11/30/2004 11/30/2003 Change % Other income (expense) Gain (loss) on marketable securities $ 2,444 $ (23,234) 25,678 -110.5% Other income 479 -- 479 NM Gain on sale of technology -- 75,500 (75,500) NM Interest expense, paid in cash or accrued (41,070) (38,718) (2,352) 6.1% Non-cash interest expense (607,153) (500,516) (106,637) 21.3% ---------- ---------- ---------- $(645,300) $(486,968) $(158,332) 32.5%
The increase in other expenses, net of other income, of $158,332, or 32.5%, was primarily attributable to the final payment related to the sale of our gas plasma antenna technology received during fiscal year 2004 ($75,000) and by the non-cash interest expense recognized on the amortization and cancellation of debt discounts related to our convertible debentures and the recognition of expense on the issuance of warrants related to our financings ($107,000) partially offset by the reduction of a loss on marketable securities which were received as partial consideration for the sale of our gas plasma antenna technology ($26,000). We anticipate that the non-cash interest expense will remain stable over the balance of fiscal 2005 due to a large debt discount remaining on our books as of November 30, 2004 ($1,375,000) which will be recognized as expense via amortization over 24 months if the underlying debentures are not converted. If the debentures are converted before maturity, any remaining debt discount will be written off in its entirety at the time of conversion. 36 Six months ended November 30, 2004 compared to six months ended November 30, 2003. Selected Financial Information
Six Months Ended Increase 11/30/2004 11/30/2003 (Decrease) % Statements of Operations Revenue $ 21,298 $ 63,200 $ (41,902) -66.3% Cost of revenue -- 10,472 (10,472) -100.0% % of revenue 0% 17% -17% -100.0% Gross profit 21,298 52,728 (31,430) -59.6% % of revenue 100% 83% 17% 19.9% Operating expenses Research and development 182,341 261,513 (79,172) -30.3% General and administrative 772,954 672,602 100,352 14.9% Total operating expenses 955,295 934,115 21,180 2.3% Gain (loss) on marketable securities (12,219) (23,234) 11,015 -47.4% Interest expense (1,281,128) (1,196,216) 84,912 7.1% Gain on sale of technology -- 75,500 75,500 NM Other income 47,752 -- 47,752 NM Net loss (2,179,592) (2,025,337) 154,255 7.6% Net loss per share basic and diluted $ (0.01) $ (0.02) $ (0.01) -50.0%
Revenues Our revenue decrease of $41,902, or 66.3%, was due to a continuing lack of significant revenue producing contracts. Our microprocessor product line has failed to generate any significant contracts. We continue to receive minor follow-on orders for the communication products that have reached the end of their life cycle. We no longer market these products but do fill follow-on orders when economically feasible. We anticipate that future revenue will be derived from successful microprocessor technology efforts in the form of licensing and royalties and the successful collection of patent infringement proceeds from litigation and settlement. Cost of Revenue Our cost of revenue decrease of $10,472, or 100%, was commensurate with the reduction in revenue. We fully reserved our inventory in fiscal 2002 and, therefore, minor amounts of existing inventory can be resold at a zero cost basis. However, in order to fulfill the minor follow-on orders for communication products, we normally must procure a portion of additional components and assemblies. We anticipate that future cost of revenue will be commensurate with the success of receiving microprocessor licenses and royalties and patent infringement proceeds. 37 Research and Development
Six Months Ended Increase 11/30/2004 11/30/2003 (Decrease) % Research and Development Personnel (including consultants) $ 171,247 $ 232,691 $ (61,444) -26.4% Facilities 8,060 28,054 (19,994) -71.3% Other research and development expenses 3,034 768 2,266 295.1% --------- --------- --------- $ 182,341 $ 261,513 $ (79,172) -30.3%
The $79,172, or 30.3%, reduction in research and development was attributed to a reduction in personnel. In addition, there has been no significant increase in depreciable equipment related to research and development for the past three years resulting in a lower depreciation amount charged to facilities expense. When and if funds become available, we anticipate an increase in research and development to upgrade the tools which are used by our potential customers to implement the microprocessor technology and to expand our offerings on which our microprocessor can run to include additional operating systems. General and Administrative
Six Months Ended Increase 11/30/2004 11/30/2003 (Decrease) % General and Administrative Personnel (including consultants) $ 239,402 $ 259,068 $ (19,666) -7.6% Professional fees 247,852 129,754 118,098 91.0% Facilities 145,754 147,121 (1,367) -0.9% Other general and administrative expenses 139,946 136,659 3,287 2.4% --------- --------- --------- $ 772,954 $ 672,602 $ 100,352 14.9%
The $100,352, or 14.9%, increase in general and administrative expenses was attributed to a decrease in personnel costs ($20,000) offset by an increase in professional fees of $118,098 primarily as a result of patent infringement costs increasing ($142,000) offset by a decrease in costs associated with registration statements and auditing of our financial statements ($24,000). We anticipate general and administrative expenses to remain stable at the current levels until such time as contract revenue and patent litigation proceeds are recognized at which time additional personnel and other fees would be expected to increase. 38 Other income (expense)
Six Months Ended 11/30/2004 11/30/2003 Change % Other income (expense) Gain (loss) on marketable $ (12,219) $ (23,234) 11,015 -47.4% securities Other income 47,752 -- 47,752 NM Gain on sale of technology -- 75,500 (75,500) NM Interest expense, paid in cash or accrued (88,564) (77,632) (10,932) 14.1% Non-cash interest expense (1,192,564) (1,118,584) (73,980) 6.6% ----------- ----------- ----------- $(1,245,595) $(1,143,950) $ (101,645) 8.9%
The increase in other expenses, net of other income, of $101,645, or 8.9%, was primarily attributable to the final payment related to the sale of our gas plasma antenna technology received during fiscal year 2004 ($75,000) and by the non-cash interest expense recognized on the amortization and cancellation of debt discounts related to our convertible debentures and the recognition of expense on the issuance of warrants related to our financings ($74,000) partially offset by the reduction of a loss on marketable securities which were received as partial consideration for the sale of our gas plasma antenna technology ($11,000) and a one-time settlement with a subtenant who abandoned our adjoining space ($47,000). We anticipate that the non-cash interest expense will remain stable over the balance of fiscal 2005 due to a large debt discount remaining on our books as of November 30, 2004 ($1,375,000) which will be recognized as expense via amortization over 24 months if the underlying debentures are not converted. If the debentures are converted before maturity, any remaining debt discount will be written off in its entirety at the time of conversion. 39 RESULTS OF OPERATIONS FOR THE YEARS ENDED MAY 31, 2004 AND MAY 31, 2003 Selected Financial Information
Year Ended Increase 5/31/2004 5/31/2003 (Decrease) % Statements of Operations Revenue $ 76,417 $ 123,903 $ (47,486) -38.3% Cost of revenue 10,472 18,660 (8,188) -43.9% % of revenue 14% 15% -1% -9.0% Gross profit 65,945 105,243 (39,298) -37.3% % of revenue 86% 85% 1% 1.6% Operating expenses Research and development 549,756 723,287 (173,531) -24.0% General and administrative 1,253,559 1,821,902 (568,343) -31.2% Total operating expenses 1,803,315 2,545,189 (741,874) -29.1% Gain on sale of technology 75,500 -- 75,500 NM Loss on marketable securities (45,354) -- (45,354) NM Interest expense (2,443,024) (1,448,544) 994,480 68.7% Interest income 270 191 79 41.4% Net loss (4,149,978) (3,888,299) 261,679 6.7% Net loss per share basic and diluted (0.03) (0.04) (0.01) -25.0%
Revenues Our revenue decrease of $47,486, or 38.3%, was due to a continuing lack of significant revenue producing contracts. Although our bid and proposal activity remains high, our microprocessor product line has failed to generate any significant contracts. We continue to receive minor follow-on orders for the communication products that have reached the end of their life cycle. We no longer market these products but do fill follow-on orders when economically feasible. During fiscal 2004, we had an engineering design contract for approximately $25,000 with a company owned by one of our executive officers. We anticipate that future revenue will be derived from successful microprocessor technology efforts in the form of licensing and royalties and the successful collection of patent infringement proceeds from litigation and settlement. Cost of Revenue Our cost of revenue decrease of $8,188, or 43.9%, was commensurate with the reduction in revenue. We fully reserved our inventory in fiscal 2002 and, therefore, minor amounts of existing inventory can be resold at a zero cost basis. However, in order to fulfill the minor follow-on orders for communication products, we normally must procure a portion of additional components and assemblies. We anticipate that future cost of revenue will be commensurate with the success of receiving microprocessor licenses and royalties and patent infringement proceeds. 40 Research and Development
Year Ended Increase 5/31/2004 5/31/2003 (Decrease) % Research and Development Personnel (including consultants) $ 480,967 $ 610,416 $(129,449) -21.2% Facilities 66,294 104,832 (38,538) -36.8% Other research and development expenses 2,495 8,039 (5,544) -69.0% --------- --------- --------- $ 549,756 $ 723,287 $(173,531) -24.0%
The $173,531, or 24%, reduction in research and development was attributed to a reduction in personnel costs, primarily consulting costs, as the development of our softcore microprocessor technology has reached a leveling off point. In addition, there has been no significant increase in depreciable equipment related to research and development for the past three years resulting in a lower depreciation amount charged to facilities expense. When and if funds become available, we anticipate an increase in research and development to upgrade the tools which are used by our potential customers to implement the microprocessor technology and to expand our offerings on which our microprocessor can run to include additional operating systems. General and Administrative
Year Ended Increase 5/31/2004 5/31/2003 (Decrease) % General and Administrative Personnel (including consultants) $ 491,898 891,851 $ (399,953) -44.8% Professional fees 228,935 272,296 (43,361) -15.9% Facilities 308,207 324,726 (16,519) -5.1% Other general and administrative expenses 224,519 333,029 (108,510) -32.6% ----------- --------- ------------- $ 1,253,559 1,821,902 $ (568,343) -31.2%
The $568,343, or 31.2%, reduction in general and administrative expenses was attributed to a reduction in personnel costs, including consulting ($87,000), prior employee legal settlement costs ($76,000), and non-cash compensation related to investor relations ($207,000). Professional fees decreased as a result of fewer registration statements being filed during fiscal 2004. Other general and administrative expenses decreased as a result of a one time write off of prepaid royalties in fiscal 2003 ($48,000), a one time write off of impaired patent costs in fiscal 2003 ($77,000), and reduced insurance costs ($35,000) partially offset by an increase in shareholder costs ($112,000) which includes annual meeting expenses and investor relations. We anticipate general and administrative expenses to remain stable at the fiscal 2004 levels until such time as contract revenue and patent litigation proceeds are recognized at which time additional personnel and other fees would be expected to increase. 41 Other income (expense)
Year Ended 5/31/2004 5/31/2003 Change % Other income (expense) Sale of technology $ 75,500 $ -- $ 75,500 NM Loss on marketable securities (45,354) -- (45,354) NM Interest income 270 191 79 41.4% Interest expense, paid in cash or accrued (149,102) (143,587) (5,515) 3.8% Non-cash interest expense (2,293,922) (1,304,957) (988,965) 75.8% ----------- ----------- ----------- $(2,412,608) $(1,448,353 $ (964,255) 66.6%
The increase in other expenses, net of other income, of $964,255, or 66.6%, was primarily attributable to the non-cash interest expense recognized on the amortization and cancellation of debt discounts related to our convertible debentures and the recognition of expense on the issuance of warrants related to our financings. We anticipate that the non-cash interest expense will increase over the fiscal 2004 amount due to a large debt discount remaining on our books as of May 31, 2004 ($2,075,146) which will be recognized as expense via amortization over 24 months if the underlying debentures are not converted or written off in their entirety on the conversion of the underlying debentures. 42 CAPITAL RESOURCES Working Capital
Increase 11/30/2004 5/31/2004 (Decrease) Current assets $ 430,746 $ 701,879 $(271,133) Current liabilities 377,942 548,042 (170,100) --------- --------- --------- Working capital $ 52,804 $ 153,837 $(101,033) ========= ========= ========= Long-term debt $ 484,760 $ 230,007 $ 254,753 ========= ========= ========= Stockholders' equity (deficit) $(272,234) $ 148,179 $(420,413) ========= ========= =========
Statements of Cash Flows Select Information
Six Months Ended Increase 11/30/2004 11/30/2003 (Decrease) Net cash provided (used) by: Operating activities $(799,601) $(859,475) $ 59,874 Investing activities $ -- $ (14,695) $ 14,695 Financing activities $ 616,397 $ 847,897 $(231,500)
Balance Sheet Select Information
Increase 11/30/2004 5/31/2004 (Decrease) Cash and cash equivalents $ 172,736 $ 355,940 $(183,204) ========= ========= ========= Prepaid expenses $ 243,990 $ 322,068 $ (78,078) ========= ========= ========= Accounts payable and accrued expesnes $ 233,494 $ 294,702 $ (61,208) --------- --------- ---------
The decrease in working capital of $101,033 and stockholders' equity (deficit) of $420,413 was attributable to a reduction in cash flows from financing activities ($231,500) by the company during the six months ended November 30, 2004. This slow down in financing activities was a result of the higher than normal cash and cash equivalents available at the beginning of the year ($355,940). LIQUIDITY We estimate our current cash requirements to sustain our operations for the next twelve months through November 2005 to be $1.8 million. Since we are no longer supporting the communications product line, we are assuming that there will be no communications product revenue. We have issued 8% convertible debentures as our primary source of funding since 2002. At the option of the debenture holders, they may purchase additional debentures up to $1 million at any time during the two years following their purchase as long as the price of our common stock is in excess of $0.20 per share. During the first six months ended November 30, 2004, we obtained $452,500 from the issuance of 8% convertible debentures and $164,432 from the exercise of warrants. Subsequent to November 30, 2004, we obtained $25,000 from the issuance of 8% convertible debentures and $169,032 from the exercise of warrants. 43 If warrants are not exercised in sufficient amounts, then we may not have funds sufficient to meet our cash requirements. In such circumstances, we would need to secure additional debt and/or equity financings with individual or institutional investors. In addition, we would be required to make additional cost reductions if our cash requirements cannot be met from external sources. We expect that the $1.8 million requirement will be provided by: o additional debt and/or equity financings; o proceeds from the exercise of outstanding stock options and warrants; and o proceeds from revenue contracts and patent enforcement activities. In addition, we have formulated additional cost reduction plans which can be implemented if the required funds are not obtainable. As of November 30, 2004, we also have remaining $400,000 under an accounts receivable factoring agreement with our bank. As of November 30, 2004, we did not have any accounts receivables eligible for factoring. We anticipate our future revenue to be derived primarily from the sale of licenses, royalties and the proceeds from litigation or settlements of patent infringement cases. To receive this revenue, we may require additional equipment, fabrication, components and supplies during the next twelve months to support potential customer requirements and further develop our technologies and to fund the expenses of protracted patent enforcement litigation. Product introductions such as those currently underway for the Ignite microprocessor may require significant product launch, marketing personnel and other expenditures that cannot be currently estimated. Further, if expanded development is commenced or new generations of microprocessor technology are accelerated beyond current plans, additional expenditures we cannot currently estimate, may be required. It is possible therefore, that higher levels of expenditures may be required than we currently contemplate resulting from changes in development plans or as required to support new developments or commercialization activities or otherwise. If we are unable to obtain the necessary funds, we could be forced to substantially curtail or cease operations, which would have a material adverse effect on our business. Further, there can be no assurance that we will be able to timely receive shareholder approval to increase the number of authorized shares or that required funds, if available, will be available on attractive terms or that they will not have a significantly dilutive effect on our existing shareholders. As such, there is substantial doubt about our ability to continue as a going concern. The consolidated financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result from our possible inability to continue as a going concern. 44 NEW ACCOUNTING PRONOUNCEMENTS In April 2003, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standard ("SFAS") No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities." SFAS No. 149 amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives) and for hedging activities under SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." SFAS No. 149 requires that contracts with comparable characteristics be accounted for similarly. SFAS No. 149 is effective for contracts entered into or modified after June 30, 2003, and for hedging relationships designated after June 30, 2003. The adoption of this statement did not impact our financial position or results of operations. In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity." SFAS No. 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003, except for mandatorily redeemable financial instruments of nonpublic entities. The adoption of this statement did not impact our financial position or results of operations. In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123R ("SFAS123R"), Share-Based Payment, an amendment of FASB Statements Nos. 123 and 95. SFAS 123R eliminates the ability to account for share-based compensation transaction using APB 25 and would require that such transactions be accounted for using a fair-value-based method and recognized as expenses in statement of operations. SFAS 123R allows for the use of a modified version of prospective application, which requires that the fair value of new awards granted after the effective date of SFAS 123R, plus unvested awards at the date of adoption, be expensed over the applicable vesting period. The provisions of SFAS 123R will be effective for interim or annual reporting periods beginning after December 15, 2005 for the companies that file as small business issuers. The Company is currently evaluating the impact the implementation guidance and revisions included in SFAS 123R will have on its consolidated financial statements. INCOME TAXES Deferred income taxes are provided for by recognizing temporary differences in certain income and expense items for financial and tax reporting purposes. Deferred tax assets consist primarily of income tax benefits from net operating loss carry-forwards. A valuation allowance has been recorded to fully offset the deferred tax asset as it is more likely than not that the assets will not be utilized. The valuation allowance increased approximately $378,000 for the six months ended November 30, 2004, from $14,732,000 at May 31, 2004 to $15,110,000 at November 30, 2004. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. 45 MANAGEMENT The following table and biographical summaries set forth information, including principal occupation and business experience, about our directors and the executive officers at January 1, 2005:
NAME AGE POSITION AND OFFICES DIRECTOR SINCE - ---- --- -------------------- -------------- David H. Pohl 67 Director April 2001 Jeffrey Wallin 57 President and CEO n/a Lowell W. Giffhorn 57 Executive Vice President, CFO, Secretary and August 1999 Director Carlton M. Johnson, Jr. 45 Director August 2001 Helmut Falk, Jr. 48 Director December 1997 Gloria Felcyn 57 Director October 2002 Patrick Nunally 41 Vice President and CTO n/a
BIOGRAPHICAL INFORMATION DAVID H. POHL. Mr. Pohl has served on our board of directors since April 2001, and served as an officer of the Company from January 2001 to March 2002. Except for his service with PTSC, Mr. Pohl has been in the private practice of law, counseling business clients since 1997, and from 1995 to 1996 was Special Counsel to the Ohio Attorney General. Previously, he was a senior attorney with a large U.S. law firm, and held positions as a senior officer and general counsel in large financial services corporations. Mr. Pohl earned a J.D. degree in 1962 from the Ohio State University College of Law, and also holds a BS in Administrative Sciences from Ohio State. Mr. Pohl is also a director of Peregrine Pharmaceuticals, Inc., a publicly held company. JEFFREY E. WALLIN. Mr. Wallin has served as our Chief Executive Officer and President since March 2002. Since 1999, Mr. Wallin has been president of SDMC Inc., a consulting company serving the multimedia system integration and communications markets. From 1996 to 1999, Mr. Wallin was President and CEO of TV/COM International, a division of Hyundai that developed and manufactured end-to-end digital communications systems. Previously Mr. Wallin held senior level management positions with Snell & Wilcox, General Instrument, now a major division of Motorola, and Teledyne Corporation. Mr. Wallin obtained a B.S. degree from Bemidji State University in 1970. LOWELL W. GIFFHORN. Mr. Giffhorn was the principal in his own financial management consulting firm from August 1996 until joining Patriot as Chief Financial Officer (CFO) in May 1997. Mr. Giffhorn has served on our board of directors since August 1999. From June 1992 to August 1996 and from September 1987 to June 1990 he was the CFO of Sym-Tek Systems, Inc. and Vice President of Finance for its successor, Sym-Tek Inc., a major supplier of capital equipment to the semiconductor industry. Mr. Giffhorn obtained a M.B.A. degree from National University in 1975 and he obtained a B.S. in Accountancy from the University of Illinois in 1969. Mr. Giffhorn is also a director and chairman of the audit committee of DND Technologies, Inc., a publicly held company. 46 CARLTON M. JOHNSON, JR. Mr. Johnson was appointed a Director on August 5, 2001. Mr. Johnson is in-house legal counsel for Swartz Investments, LLC, a position he has held since June 1996. Mr. Johnson has been licensed to practice law in Alabama since 1986, Florida since 1988, and Georgia since 1997. He has been a shareholder in the Pensacola, Florida AV rated law firm of Smith, Sauer, DeMaria & Johnson and as President-Elect of the 500 member Escambia-Santa Rosa Bar Association. He also served on the Florida Bar Young Lawyers Division Board of Governors. Mr. Johnson earned a degree in History/Political Science at Auburn University and a Juris Doctor degree at Samford University - Cumberland School of Law. Mr. Johnson is also a director and member of the audit committee of Peregrine Pharmaceuticals, Inc., a publicly held company. HELMUT FALK, JR. Since 1992, Dr. Falk has been the Director of Anesthesia for the Johnson Memorial Hospital in Franklin, Indiana. Dr. Falk received his D.O. from the College of Osteopathic Medicine of the Pacific in 1987 and his B.S. in Biology from the University of California, Irvine in 1983. Dr. Falk is the son of the late Helmut Falk, who was the sole shareholder of nanoTronics and the Chairman and CEO of Patriot until his death in July 1995. Dr. Falk is also an heir to the Helmut Falk Estate, which is the beneficial owner of the Company's shares held by the Helmut Falk Family Trust. GLORIA FELCYN. Ms. Felcyn was appointed a Director and chairman of our audit committee on October 10, 2002. Since 1982 Ms. Felcyn has been the principal in her own public accounting firm. Ms. Felcyn received a B.S. degree in Business Economics from Trinity University in 1968. PATRICK O. NUNALLY. Dr. Nunally joined us as Vice President of Business Development and Chief Technical Officer in June 2001, previous to which he had been providing consulting services to us since May 2000. Dr. Nunally has more than 20 years of entrepreneurial experience in semiconductor and embedded processor design. From December 1998 to May 2000, he was President and CEO of Intertech, a company he founded specializing in intellectual property development for embedded processor and communications systems. From June 1998 to December 1998, he was President and CEO of Gruppe Telekom, Inc., a licensee of Interactive Video and Data Service Spectrum. From April 1996 to June 1998, he served as Chief Technical Officer and co-founder of Aristo, now PlayNet Inc., a Java-based games company. Dr. Nunally also held other senior management positions with Wave Interactive Network, Sensormatic Video Products Division, Intellisys Automation Inc., E-Metrics Inc., General Dynamics Corporation and Interstate Electronics. Dr. Nunally received his PhD in Electrical Engineering from the Pacific Western University in 1996, a MBA from the University of LaVerne in 1993 and a BS in Electrical and Electronics Engineering from California State Polytechnic University in 1987. There is no family relationship between any of our executive officers and directors. INDEMNIFICATION OF OFFICERS, DIRECTORS AND OTHERS As permitted by Delaware law, our certificate of incorporation provides that we will indemnify our officers, directors, employees and agents. This includes indemnification against attorneys' fees and other expenses and liabilities they incur to defend, settle or satisfy any civil or criminal action brought against them arising out of their association with or activities on behalf of us. However, they will not be indemnified if they are adjudged to have acted with gross negligence or to have engaged in willful misconduct. We may also bear the expenses of such litigation for any such persons upon their promise to repay such sums if it is ultimately determined that they are not entitled to indemnification. Such expenditures could be substantial and may not be recouped, even if we are so entitled. We have provided for indemnification for liabilities arising under the Securities Act of 1933 as they may be permitted to directors, officers or persons controlling us. The SEC has informed us that such indemnification is against public policy and may be unenforceable. 47 ITEM 10. EXECUTIVE COMPENSATION There is shown below information concerning the compensation of our chief executive officer and the most highly compensated executive officers whose salary and bonus exceeded $100,000 (each a "Named Officer") for the fiscal years ended May 31, 2004, 2003, and 2002. Summary Compensation Table
Annual Cash Compensation Long-Term Compensation Name and Fiscal Repriced All Other Principal Position Year Salary Bonus (# of Shares) Options Compensation ------------------ ---- ------ ----- ------------- ------- ------------ Jeff Wallin 2004 $145,933(1) Nil 673,000 None None President and CEO 2003 $127,650(1) Nil 250,000 None None 2002 $ 68,800(1) Nil 1,000,000 None None Lowell W. Giffhorn 2004 $148,800(1) Nil 239,000 None None Exec. V.P., CFO and Secy. 2003 $150,779(1) Nil 115,000 None None 2002 $139,908(1) Nil 255,000 None None Joey Maitra (3) 2004 $131,040(1) Nil 125,000 None None VP Engineering 2003 $131,040(1) Nil 100,000 None None 2002 $125,058(1) Nil 335,000 None None Patrick O. Nunally 2004 $180,000(1) Nil 173,000 None None VP and CTO 2003 $189,521(1) Nil 400,000 None $52,500 (2) 2002 $173,046(1) Nil 250,000 None $105,000 (2)
(1) Included in the salaries of Mssrs. Wallin, Giffhorn, Maitra and Nunally is cash compensation of $400 per month for a car allowance. (2) Payments through November 30, 2002 to Dr. Nunally for assignments to the Company of intellectual property rights. The rights were returned to Dr. Nunally in April 2003. (3) Mr. Maitra's employment was terminated in July 2004 per the terms of his employment contract. The Company maintains employee benefits that are generally available to all of its employees, including medical, dental and life insurance benefits and a 401(k) retirement savings plan. The Company did not make any matching contributions under the 401(k) plan for any of the above named officers during the fiscal years ended May 31, 2004, 2003 and 2002. 48 OPTION GRANTS Shown below is information on grants of stock options pursuant to the Company's 1992, 1996, 2001 and 2003 Stock Option Plans to the Named Officers reflected in the Summary Compensation Table shown above. Option Grants Table for Fiscal Year Ended May 31, 2004
Potential Realizable Value Percent of of Assumed Annual Total Rates Options of Stock Price Granted to Appreciation Number of Employees in Exercise Expiration for Option Term (1) Name Options Granted Fiscal Year Prices Dates 5% ($) 10% ($) ---- --------------- ----------- ------ ----- ------ ------- Jeffrey E. Wallin 673,000 30.5 $0.035-$0.11 12/18/08-3/18/09 $ 16,844 $37,222 Lowell W. Giffhorn 239,000 10.8 $0.035-$0.05 10/23/08-12/18/08 $ 2,706 $ 5,981 Joey Maitra 125,000 5.7 $ 0.035 12/18/2008 $ 1,191 $ 2,633 Patrick Nunally 173,000 7.8 $ 0.035 12/18/2008 $ 1,649 $ 3,644
(1) These amounts represent certain assumed rates of appreciation only. Actual gains, if any, on stock option exercises are dependent upon the future performance of the company's common stock, overall market conditions and the executive's continued involvement with the company. The amounts represented in this table will not necessarily be achieved. AGGREGATED OPTION EXERCISES AND FISCAL YEAR-END OPTION VALUES There were no exercises of stock options for the fiscal year ended May 31, 2004 by any of the officers reflected in the Summary Compensation Table shown above. Shown below is information on fiscal year-end values under the Company's 1992, 1996, 2001 and 2003 Stock Option Plans to the officers reflected in the Summary Compensation Table shown above.
Number of Unexercised Value of Unexercised Options Held At In-The-Money Options At May 31, 2004 May 31, 2004 ------------ ------------ Name Exercisable Unexercisable Exercisable Unexercisable ---- ----------- ------------- ----------- ------------- Jeffrey E. W allin 1,520,000 423,000 $ 7,875 $ 6,834 Lowell W . Giffhorn 565,000 169,000 $ 2,740 $ 5,541 Joey Maitra 385,000 175,000 $ 750 $ 5,688 Patrick Nunally 950,000 173,000 $ 12,600 $ 6,834
The fair market value of the unexercised in-the-money options at May 31, 2004 was determined by subtracting the option exercise price from the last sale price as reported on the over the counter bulletin board on May 31, 2004, $0.074. The Company has not awarded stock appreciation rights to any of its employees. The Company has no long-term incentive plans. 49 COMPENSATION OF DIRECTORS No direct or indirect remuneration has been paid or is payable by us to the directors in their capacity as directors other than the granting of stock options. We expect that, during the next twelve months, we will not pay any direct or indirect remuneration to any directors of ours in their capacity as directors other than in the form of stock option grants or the reimbursement of expenses of attending directors' or committee meetings. EMPLOYMENT CONTRACTS The Company entered into a consulting agreement dated as of March 18, 2004, with SDMC, Inc. whereby SDMC will provide the services of Mr. Wallin to be the President and Chief Executive Officer of the Company. The agreement is for a term through March 18, 2005 providing for payments of $145,200 per annum and provides for automatic one year renewals unless either party gives a notice at least 30 days but not more than 60 days prior to any anniversary date. The agreement provides for a bonus of up to 50% of the annual base consideration for the applicable year. The agreement also provides for potential bonuses to be paid based on the increase in the price of the Company's common stock. Should the price of the common stock reach $0.25 for twenty consecutive days, SDMC would receive a cash payment of $10,000. Additional payments will be made to SDMC in the following amounts if the price of the Company's common stock reaches the following thresholds: $0.40- $20,000, $0.50- $20,000, $0.60- $30,000, $0.80- $30,000, and $1.00- $50,000. The Company may terminate SDMC's agreement with or without cause, but termination without cause (other than disability or death) would result in severance payments equal to the lesser of (i) four months of the then current compensation or (ii) the balance remaining of the current compensation for the term of his agreement. If a change in control, as defined in the agreement, occurs during the term of his agreement, and if Mr. Wallin refuses to accept or voluntarily resigns from a position other than a qualified position, as that term is defined in the agreement, then SDMC will receive a lump sum severance payment equal to twelve months of the then current compensation. Under the agreement, the Company granted SDMC options to purchase 500,000 common shares, 250,000 vesting on March 18, 2004 and 250,000 vesting on September 18, 2004. The Company also placed in escrow four months of payments which shall be released to SDMC on the termination of Mr. Wallin's services for any reason other than cause or his resignation. The Company entered into an employment agreement dated as of September 1, 2004, with Mr. Giffhorn providing for his employment as Executive Vice President and Chief Financial Officer. The agreement is for a term through September 1, 2005, providing for a base salary of $144,000 per annum. The base salary may be increased at the discretion of the Board of Directors. The agreement provides for a bonus of up to 50% of the annual base salary for the applicable year. The agreement also provides Mr. Giffhorn with a monthly car allowance of $400. The Company may terminate Mr.Giffhorn's employment with or without cause, but termination without cause (other than disability or death) would result in severance payments equal to four months of the then current base salary. If a change in control, as defined in the agreement, occurs during the term of his agreement, and if Mr. Giffhorn refuses to accept or voluntarily resigns from a position other than a qualified position, as that term is defined in the agreement, then he will receive a lump sum severance payment equal to twelve months of his then current salary. Under the agreement, the Company granted Mr. Giffhorn a fully vested stock option to purchase up to 300,000 common shares as of September 1, 2004 and committed to issue additional fully vested stock options each in the amount of 125,000 common shares on August 31, 2005 and August 31, 2006. 50 The Company entered into an employment agreement dated June 1, 2004, as amended on July 12, 2004, with Dr. Nunally providing for his employment as the Chief Technical Officer of the Company. The agreement is for a term through June 1 2005, providing for a base salary initially of $124,800. The base salary may be increased at the discretion of the Board of Directors. The agreement provides for a bonus of up to 50% of the annual base salary for the applicable year. The agreement also provides Dr. Nunally with a monthly car allowance of $400. The Company may terminate Dr. Nunally's employment with or without cause, but termination without cause (other than disability or death) would result in severance payments equal to the lesser of (i) two months of the then current base salary or (ii) the balance remaining of the current base salary for the term of his agreement. If a change in control, as defined in the agreement, occurs during the term of his agreement, and if Dr. Nunally refuses to accept or voluntarily resigns from a position other than a qualified position, as that term is defined in the agreement, then he will receive a lump sum severance payment equal to the lesser of (i) two months of the then current base salary or (ii) the balance remaining of the current base salary for the term of his agreement. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The following table sets forth, as of January 28, 2005, the stock ownership of each officer and director of the Company, of all officers and directors of the Company as a group, and of each person known by the Company to be a beneficial owner of 5% or more of its Common Stock. Except as otherwise noted, each person listed below is the sole beneficial owner of the shares and has sole investment and voting power over such shares. No person listed below has any option, warrant or other right to acquire additional securities of the Company, except as otherwise noted. 51 Name and Address Amount & Nature Title of Beneficial of Beneficial Percent of Class Owner Ownership of Class -------- ----- --------- -------- Common stock Gloria Felcyn, CPA 1,758,000 (1) * par value 10989 Via Frontera $0.00001 San Diego, CA 92127 SAME Helmut Falk, Jr. 2,728,231 (2) 1.2% 10989 Via Frontera San Diego, CA 92127 SAME Lowell W. Giffhorn 1,219,948 (3) * 10989 Via Frontera San Diego, CA 92127 SAME SDMC, Inc. 1,770,000 (4) * 10989 Via Frontera San Diego, CA 92127 SAME David H. Pohl 275,000 (5) * 10989 Via Frontera San Diego, CA 92127 SAME Patrick O. Nunally 962,700 (6) * 10989 Via Frontera San Diego, CA 92127 SAME Carlton M. Johnson, Jr. 275,000 (7) * 10989 Via Frontera San Diego, CA 92127 All directors & officers 8,988,879 (8) 3.8% as a group (9 persons) * Less than 1% 1) As trustee of the Helmut Falk Family Trust and executor of the Helmut Falk estate, Ms. Felcyn effectively controls the shares which were, subject to an escrow arrangement, originally issued to nanoTronics in connection with the ShBoom technology acquisition and shares that remain from 5,000,000 non-escrowed shares that were originally issued to nanoTronics in connection with the ShBoom technology acquisition and were subsequently transferred to the Helmut Falk Family Trust and shares that were obtained on the conversion of 8% Convertible Debentures and the exercise of warrants. Includes 250,000 shares issuable upon the exercise of outstanding stock options. 52 2) Includes 315,000 shares issuable upon the exercise of outstanding stock options. 3) Includes 995,000 shares issuable upon the exercise of outstanding stock options. 4) Includes 1,770,000 shares issuable upon the exercise of outstanding stock options. 5) Includes 275,000 shares issuable upon the exercise of outstanding stock options. 6) Includes 950,000 shares issuable upon the exercise of outstanding stock options. 7) Includes 275,000 shares issuable upon the exercise of outstanding stock options. 8) Includes 4,158,879 shares issued and outstanding and 4,830,000 shares issuable upon exercise of stock options. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS There were no transactions, or series of transactions, during fiscal 2004 and 2003, nor are there any currently proposed transactions, or series of transactions, to which the Company is a party, in which the amount exceeds $60,000, and in which to its knowledge any director, executive officer, nominee, five percent or greater shareholder, or any member of the immediate family of any of the foregoing persons, has or will have any direct or indirect material interest other than as described below. In June 2000, we entered into a three-year, $80,000 secured promissory note receivable with James T. Lunney, a previous Chairman, President and CEO. The note bore interest at the rate of 6% with interest payments due semi-annually and the principal due at the maturity of the note. Mr. Lunney pledged 100,000 shares of Patriot's common stock that he held on the date of issuance as security for this note. In April 2003, we negotiated an early payment discount and Mr. Lunney paid $60,000 to retire this note. From June 10, 2002 through August 23, 2002, we issued to Gloria Felcyn, Trustee of the Helmut Falk Family Trust, two 8% Convertible Debentures with accumulative principal balances of $275,000 due June 10, 2004 through August 23, 2004. The initial exercise prices ranged from $0.0727 to $0.08616 and were subject to a downward revisions if the price of our stock was lower on any three month anniversary of the debentures or on the date that a statement registering the resale of the common stock issuable upon conversion of the debentures becomes effective. Also, in conjunction with the debentures, we issued five year warrants to purchase up to 4,102,431 shares of our common stock at an initial exercise prices ranging from $0.0727 to $0.08616 subject to reset provisions on each six month anniversary of the issuance of the warrants. If the price of our common stock is in excess of $0.20 per share, Ms. Felcyn has a two year option to purchase up to an additional $275,000 of 8% Convertible Debentures on the same terms. Ms. Felcyn converted the debentures into 6,810,102 shares of common stock in July and November 2003 and exercised the warrants into 4,102,431 shares of common stock in July 2003 and January 2004. 53 During October 2002 through December 2002, we entered into three 8% short-term notes with Gloria Felcyn, the trustee for the Falk Family Trust, aggregating $180,000 with initial maturity dates ranging from January 1 to January 31, 2003. In July 2003 we issued a new 8% short-term note in the amount of $200,354 with a maturity date of October 7, 2003 in exchange for cancellation of the three 8% short term notes issued in October through December 2002, the accrued interest on the cancelled notes and an additional $10,000 in cash. In January 2004, as part of the exercise of the warrants, the $200,354 note was exchanged for four $25,000 6% notes and shares of common stock which were issued to the beneficiaries of the trust. The 6% notes have a maturity date of September 1, 2005. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Our common stock is traded in the over-the-counter market and is quoted on the NASD OTC Bulletin Board system maintained by the National Association of Securities Dealers, Inc. Prices reported represent prices between dealers, do not include markups, markdowns or commissions and do not necessarily represent actual transactions. The market for our shares has been sporadic and at times very limited. The following table sets forth the high and low closing bid quotations for the Common Stock through January 28, 2005 and the fiscal years ended May 31, 2004 and 2003. BID QUOTATIONS HIGH LOW Fiscal Year Ending May 31, 2005 First Quarter $ 0.09 $ 0.03 Second Quarter $ 0.05 $ 0.03 Third Quarter (Through January 28, 2005) $ 0.13 $ 0.05 Fiscal Year Ending May 31, 2004 First Quarter $ 0.07 $ 0.04 Second Quarter $ 0.08 $ 0.04 Third Quarter $ 0.17 $ 0.03 Fourth Quarter $ 0.15 $ 0.08 Fiscal Year Ended May 31, 2003 First Quarter $ 0.08 $ 0.06 Second Quarter $ 0.14 $ 0.04 Third Quarter $ 0.09 $ 0.04 Fourth Quarter $ 0.09 $ 0.04 We have approximately 580 shareholders of record as of January 28, 2005. Because most of our common stock is held by brokers and other institutions on behalf of stockholders, we are unable to estimate the total number of stockholders represented by these record holders. We have never paid a cash dividend on our common stock and do not expect to pay one in the foreseeable future. 54 DESCRIPTION OF SECURITIES Our authorized capital stock consists of 400,000,000 shares of common stock, $.00001 par value per share. At January 28, 2005, a total of 232,890,435 common shares were issued and outstanding. The holders of common stock are entitled to one vote for each share held. The affirmative vote of a majority of votes cast at a meeting which commences with a lawful quorum is sufficient for approval of most matters upon which shareholders may or must vote, including the questions presented for approval or ratification at the Annual Meeting. However, removal of a director from office or repeal of the certificate of incorporation in its entirety require the affirmative vote of a majority of the total voting power for approval, and certain other matters (such as shareholder amendment of the bylaws, and amendment, repeal or adoption of any provision inconsistent with provisions in the certificate of incorporation regarding indemnification of directors, officers and others, exclusion of director liability, and our election not to be governed by statutory provisions concerning business combinations with interested shareholders) require the affirmative vote of two-thirds of the total voting power for approval. Common shares do not carry cumulative voting rights, and holders of more than 50% of the common stock have the power to elect all directors and, as a practical matter, to control the company. Holders of common stock are not entitled to preemptive rights, and the common stock may only be redeemed at our election. A special meeting of shareholders may be called by or at the request of: o the Chairman of the Board (if one has been appointed by the Board), o the President or any two directors, and o persons owning in the aggregate not less than 20% of the issued and outstanding common shares entitled to vote in elections for directors. After the satisfaction of requirements with respect to preferential dividends, if any, holders of common stock are entitled to receive, pro rata, dividends when and as declared by the board of directors out of funds legally available therefor. Upon our liquidation, dissolution or winding-up, after distribution in full of the preferential amount, if any, to be distributed to holders of the preferred stock, holders of common stock are entitled to share ratably in our assets legally available for distribution to our shareholders. Our board of directors is authorized to issue 5,000,000 shares of undesignated preferred stock, $.00001 par value, without any further action by the stockholders. The board of directors may also divide any and all shares of preferred stock into series and fix and determine the relative rights and preferences of the preferred stock, such as the designation of series and the number of shares constituting such series, dividend rights, redemption and sinking fund provisions, liquidation and dissolution preferences, conversion or exchange rights and voting rights, if any. Issuance of preferred stock by the board of directors will result in such shares having dividend and/or liquidation preferences senior to the rights of the holders of common stock and could dilute the voting rights of the holders of common stock. There are currently no shares of preferred stock issued and outstanding. We have not paid any cash dividends to date, and no cash dividends will be declared or paid on the common shares in the foreseeable future. Payment of dividends is solely at the discretion of our board of directors. 55 Interwest Transfer Company, Inc., 1981 East 4800 South, Suite 100, Salt Lake City, Utah 84117, acts as our transfer agent and registrar for our common stock. Their telephone number is (801) 272-9294. LEGAL OPINION Luce, Forward, Hamilton & Scripps LLP, 600 West Broadway Street, Suite 2600, San Diego, California 92101 will pass on the validity of the common stock offered by us. EXPERTS The financial statements included in this Prospectus and in the Registration Statement have been audited by Nation Smith Hermes Diamond, independent certified public accountants, to the extent and for the periods set forth in their report (which contain an explanatory paragraph regarding the Company's ability to continue as a going concern) appearing elsewhere herein and in the Registration Statement, and are included in reliance upon such report given the authority of said firm as experts in auditing and accounting. 56 Index to Consolidated Financial Statements
Report of Nation Smith Hermes Diamond, Independent Certified Public Accountants ....................... F-2 Consolidated Balance Sheets as of May 31, 2004 and 2003 .......... F-3 Consolidated Statements of Operations for the Years Ended May 31, 2004 and 2003 .................................................. F-4 Consolidated Statement of Stockholders' Equity (Deficit) for the Years Ended May 31, 2004 and 2003 .............................. F-5 Consolidated Statements of Cash Flows for the Years Ended May 31, 2004 and 2003 .......................................... F-6 Summary of Accounting Policies ................................... F-7-F-12 Notes to Consolidated Financial Statements ....................... F-13-F-26 Consolidated Balance Sheets as of November 30, 2004 (unaudited) and May 31, 2004 ............................................... F-27 Consolidated Statements of Operations for the Three and Six Months ended November 30, 2004 and 2003(unaudited) .................... F-28 Consolidated Statements of Cash Flows for the Six Months ended November 30, 2004 and 2003 (unaudited) ................... F-29 Notes to Unaudited Consolidated Financial Statements ............. F-30-F-39
F-1 REPORT OF INDEPENDENT REGISTERED CERTIFIED PUBLIC ACCOUNTING FIRM To the Stockholders and Board of Directors Patriot Scientific Corporation San Diego, California We have audited the accompanying consolidated balance sheets of Patriot Scientific Corporation as of May 31, 2004 and 2003, and the related consolidated statements of operations, stockholders' equity (deficit) and cash flows for each of the years in the two year period ended May 31, 2004. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above, present fairly, in all material respects, the consolidated financial position of Patriot Scientific Corporation at May 31, 2004 and 2003, and the consolidated results of its operations and its cash flows for each of the years in the two year period ended May 31, 2004, in conformity with accounting principles generally accepted in the United States of America. The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the financial statements, the Company has suffered recurring losses from operations, has negative cash flows and has negative working capital that raise substantial doubt about its ability to continue as a going concern. Management's plans in regard to these matters are also described in Note 1. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. /s/ Nation Smith Hermes Diamond San Diego, California July 8, 2004 F-2 Patriot Scientific Corporation Consolidated Balance Sheets
May 31, 2004 2003 - -------------------------------------------------------------------------------------------------- ASSETS (Notes 4 and 5) Current assets: Cash and cash equivalents $ 355,940 $ 32,663 Marketable securities 22,646 -- Accounts receivable, net of allowance of none and $10,000 for uncollectible accounts 1,225 3,866 Prepaid expenses 322,068 93,030 - -------------------------------------------------------------------------------------------------- Total current assets 701,879 129,559 Property and equipment, net (Note 2) 68,389 153,530 Other assets 41,221 53,220 Patents and trademarks, net of accumulated amortization of $501,235 and $450,926 114,739 128,925 - -------------------------------------------------------------------------------------------------- $ 926,228 $ 465,234 ================================================================================================== LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT) Current liabilities: Secured note payable (Note 4) $ -- $ 635,276 Current portion of 8% Convertible Debentures, net of debt discount of $27,180 and $103,121 (Note 5) 145,320 121,879 Secured notes payable to shareholders 100,000 180,000 Accounts payable 134,600 397,180 Accrued liabilities 160,102 245,822 Current portion of capital lease obligation 8,020 6,405 - -------------------------------------------------------------------------------------------------- Total current liabilities 548,042 1,586,562 8% Convertible Debentures, net of debt discount of $2,047,966 and $709,890 (Note 5) 227,701 280,110 Long term portion of capital lease obligation 2,306 10,326 Commitments and contingencies (Notes 1, 6 and 10) Stockholders' equity (deficit) (Notes 5 and 6): Preferred stock, $.00001 par value; 5,000,000 shares authorized: none outstanding -- -- Common stock, $.00001par value; 400,000,000 shares authorized: 171,156,363 and 106,547,807 issued and outstanding at May 31, 2004 and 2003, respectively 1,712 1,066 Additional paid-in capital 49,990,485 44,281,210 Accumulated deficit (49,844,018) (45,694,040) - -------------------------------------------------------------------------------------------------- Total stockholders' deficit 148,179 (1,411,764) - -------------------------------------------------------------------------------------------------- $ 926,228 $ 465,234 ==================================================================================================
See accompanying report of independent registered certified public accounting firm, summary of accounting policies and notes to consolidated financial statements. F-3 Patriot Scientific Corporation Consolidated Statements of Operations
Years Ended May 31, 2004 2003 - -------------------------------------------------------------------------------- Net sales (Note 11): Product $ 74,017 $ 108,403 Licenses and royalties 2,400 15,500 - -------------------------------------------------------------------------------- Net sales 76,417 123,903 - -------------------------------------------------------------------------------- Cost of sales 10,472 18,660 - -------------------------------------------------------------------------------- Gross profit 65,945 105,243 Operating expenses: Research and development 549,756 723,287 Selling, general and administrative 1,253,559 1,821,902 - -------------------------------------------------------------------------------- Operating expenses 1,803,315 2,545,189 - -------------------------------------------------------------------------------- Operating loss (1,737,370) (2,439,946) - -------------------------------------------------------------------------------- Other income (expenses): Sale of technology 75,500 -- Loss on marketable securities (45,354) -- Interest income 270 191 Interest expense (Notes 4, 5 and 6) (2,443,024) (1,448,544) - -------------------------------------------------------------------------------- Other income (expenses) (2,412,608) (1,448,353) - -------------------------------------------------------------------------------- Net loss $ (4,149,978 $ (3,888,299) - -------------------------------------------------------------------------------- Basic and diluted loss per common share (Note 7) $ (0.03) $ (0.04) - -------------------------------------------------------------------------------- Weighted average number of common shares outstanding during the period (Note 7) 139,767,276 93,791,470 - --------------------------------------------------------------------------------
See accompanying report of independent registered certified public accounting firm, summary of accounting policies and notes to consolidated financial statements. F- 4 Patriot Scientific Corporation Consolidated Statements of Stockholders' Equity (Deficit) Years Ended May 31, 2004 and 2003
Common Stock Additional Accumulated Stockholders' Shares Amount Paid-in Capital Deficit Equity (Deficit) ------ ------ --------------- ------- ---------------- Balance, June 1, 2002 81,465,757 $ 815 $ 41,360,101(1) $(41,805,741) $ (444,825) ==================================================================================================================================== Issuance of common stock at $.03 to $.05 per share (Note 6) 3,765,266 38 120,312 -- 120,350 Collection of note receivable (Note 3) -- -- 80,000 -- 80,000 Issuance of common stock for services at $.04 to $.06 per share 2,780,000 28 148,772 -- 148,800 Conversion of debentures payable plus accrued interest at $.04 to $.05 per share (Note 4) 18,536,784 185 836,375 -- 836,560 Value of warrants issued -- -- 1,735,650 -- 1,735,650 Net loss -- -- -- (3,888,299) (3,888,299) - ------------------------------------------------------------------------------------------------------------------------------------ Balance, May 31, 2003 106,547,807 $ 1,066 $ 44,281,210 $(45,694,040) $ (1,411,764) ==================================================================================================================================== Issuance of common stock at $.025 to $.034 per share (Note 6) 1,800,752 18 50,422 -- 50,440 Exercise of warrants and options at $.0172 to $.04 per share 11,184,175 112 285,832 -- 285,944 Issuance of common stock for services at $.043 to $.117 per share 1,126,496 11 59,841 -- 59,852 Conversion of debentures payable plus accrued interest at $.017 to $.064 per share (Note 5) 50,497,133 505 1,757,123 -- 1,757,628 Value of warrants issued -- -- 3,556,057 -- 3,556,057 Net loss -- -- -- (4,149,978) (4,149,978) - ------------------------------------------------------------------------------------------------------------------------------------ Balance, May 31, 2004 171,156,363 $ 1,712 $ 49,990,485 $(49,844,018) $ 148,179 ====================================================================================================================================
See accompanying report of independent registered certified public accounting firm, summary of accounting policies and notes to consolidated financial statements. (1) Additional Paid-In Capital included a note receivable of $80,000 and additional paid-in capital of $41,440,101 at June 1, 2002. F-5 Patriot Scientific Corporation Consolidated Statements of Cash Flows Increase (Decrease) in Cash and Cash Equivalents
Years Ended May 31, 2004 2003 - ------------------------------------------------------------------------------------------- Operating activities: Net loss $(4,149,978) $(3,888,299) Adjustments to reconcile net loss to cash used in operating activities: Amortization and depreciation 135,450 258,915 Provision for doubtful accounts -- 24,000 Non -cash interest expense related to convertible debentures, notes payable and warrants 2,293,922 1,304,957 Gain on sale of technology (75,500) -- Unrealized loss on marketable securities 45,354 -- Common stock, options and warrants issued for services 59,852 148,800 Changes in: Accounts receivable (18,639) (33,346) Prepaid and other assets (217,039) 216,195 Accounts payable and accrued expenses (149,394) 83,016 - ------------------------------------------------------------------------------------------- Net cash used in operating activities (2,075,972) (1,885,762) - ------------------------------------------------------------------------------------------- Investing activities: Note receivable (Note 3) -- 60,000 Proceeds from sale of technology 7,500 -- Purchase of property, equipment and patents, net (36,123) (62,194) - ------------------------------------------------------------------------------------------- Net cash used in investing activities (28,623) (2,194) - ------------------------------------------------------------------------------------------- Financing activities: Proceeds from issuance of secured notes payable 12,320 180,000 Payments for capital lease obligations (6,405) (5,116) Proceeds from issuance of convertible debentures 2,175,000 1,507,000 Proceeds from issuance of common stock 50,440 120,350 Proceeds from exercise of common stock warrants and options 175,237 -- Proceeds from sale of accounts receivable 21,280 30,277 - ------------------------------------------------------------------------------------------- Net cash provided by financing activities 2,427,872 1,832,511 - ------------------------------------------------------------------------------------------- Net decrease in cash and cash equivalents 323,277 (55,445) Cash and cash equivalents, beginning of year 32,663 88,108 - ------------------------------------------------------------------------------------------- Cash and cash equivalents, end of year $ 355,940 $ 32,663 =========================================================================================== Supplemental Disclosure of Cash Flow Information: Cash payments for interest $ 17,220 $ 15,083 Convertible debentures, notes payable and accrued interest exchanged for common stock $ 1,757,628 $ 836,560 Debt discount $ 2,873,167 $ 1,763,816 - -------------------------------------------------------------------------------------------
See accompanying report of independent registered certified public accounting firm, summary of accounting policies and notes to consolidated financial statements. F-6 PATRIOT SCIENTIFIC CORPORATION SUMMARY OF ACCOUNTING POLICIES ORGANIZATION AND BUSINESS Patriot Scientific Corporation (the "Company") is engaged in the development, marketing, and sale of patented microprocessor technology and the sale of high-performance high-speed data communication products. The Company also owns innovative radar technology. The Company sold its antenna technology in August 1999. BASIS OF PRESENTATION AND CONSOLIDATION The consolidated financial statements have been prepared in accordance with generally accepted accounting principles and include the accounts of the Company, its majority owned subsidiaries, Metacomp, Inc. ("Metacomp") and Plasma Scientific Corporation. All material intercompany transactions and balances have been eliminated in consolidation. RECLASSIFICATIONS Certain reclassifications have been made to the 2003 financial statements in order for them to conform to the 2004 presentation. Such reclassifications have no impact on the Company's financial position or results of operations. FINANCIAL INSTRUMENTS AND CONCENTRATIONS OF CREDIT RISK Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of temporary cash investments and trade accounts receivable. When the Company has excess cash, the Company's cash equivalents are placed in high quality money market accounts with major financial institutions and high grade short-term commercial paper. The investment policy limits the Company's exposure to concentrations of credit risk. Money market accounts are federally insured; however, commercial paper is not insured. The Company has not experienced any losses in such accounts. Concentrations of credit risk with respect to accounts receivable are limited due to the wide variety of customers and markets which comprise the Company's customer base, as well as their dispersion across many different geographic areas. The Company routinely assesses the financial strength of its customers and, as a consequence, believes that its accounts receivable credit risk exposure is limited. Generally, the Company does not require collateral or other security to support customer receivables. The carrying value of financial instruments including cash, cash equivalents, accounts receivable, accounts payable and accrued liabilities approximate fair value because of the immediate or short-term maturity of these instruments. With respect to long-term debt, the carrying amounts approximate fair value due to the relative consistency in interest rates and the short term nature of the debt, with all debt maturing within two years of issuance. MARKETABLE SECURITIES As part of the sale of our gas plasma antenna technology we received restricted securities in a company that is traded on the OTC bulletin board. The securities can be traded under Rule 144 after July 2004. We reflect the value of those securities based on the closing price as of the end of our F-7 PATRIOT SCIENTIFIC CORPORATION SUMMARY OF ACCOUNTING POLICIES (CONTINUED) reporting period. Any unrealized gain or loss between reporting periods is reflected in our consolidated statement of operations as non-operating income or loss. PROPERTY, EQUIPMENT AND DEPRECIATION Property and equipment are stated at cost. Depreciation is computed over the estimated useful life of three to five years using the straight-line method. The Company follows the provisions of the Financial Accounting Standards Board ("FASB") Statement of Financial Accounting Standards ("SFAS") No. 144, "Accounting for the Impairment of Long-lived Assets." Long-lived assets and certain identifiable intangibles to be held and used by the Company are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. The Company continuously evaluates the recoverability of its long-lived assets based on estimated future cash flows and the estimated fair value of such long-lived assets, and provides for impairment if such undiscounted cash flows are insufficient to recover the carrying amount of the long-lived asset. PATENTS AND TRADEMARKS Patents and trademarks are carried at cost less accumulated amortization and are amortized over their estimated useful lives of four years. The carrying value of patents and trademarks is periodically reviewed and impairments, if any, are recognized when the expected future benefit to be derived from individual intangible assets is less than its carrying value determined based on the provisions of SFAS No. 144 as discussed above. REVENUE RECOGNITION We recognize revenue on the shipment to our customers of communication products, microprocessor integrated chips and evaluation boards. We also derive revenue from fees for the transfer of proven and reusable intellectual property components or the performance of engineering services. We enter into licensing agreements that will provide licensees the right to incorporate our intellectual property components in their products with terms and conditions that will vary by licensee. Generally, these payments will include a nonrefundable technology license fee, which will be payable upon the transfer of intellectual property, or a nonrefundable engineering service fee, which generally will be payable upon achievement of defined milestones. In addition, we anticipate these agreements will include royalty payments, which will be payable upon sale of a licensee's product, and maintenance and limited support fees. We will classify all revenue that involves the future sale of a licensee's products as royalty revenue. Royalty revenue will be generally recognized in the quarter in which a report is received from a licensee detailing the shipments of products incorporating our intellectual property components (i.e., in the quarter following the sale of licensed product by the licensee). We will classify all revenue that does not involve the future sale of a licensee's products, primarily license fees and engineering service fees and maintenance and support fees, as contract revenue. License fees will be recognized upon the execution of the license agreement and transfer of intellectual property, provided no further significant performance obligations exist and collectibility is deemed probable. Fees related to engineering services contracts, which will be performed on a best efforts basis and for which we will receive periodic milestone payments, will be recognized as revenue over the estimated development period, using a cost-based percentage of completion method. Annual maintenance and support fees, which will be F-8 PATRIOT SCIENTIFIC CORPORATION SUMMARY OF ACCOUNTING POLICIES (CONTINUED) renewable by the licensee, will be classified as contract revenue and will be amortized over the period of support, generally 12 months. RESEARCH AND DEVELOPMENT COSTS Research and development costs are expensed as incurred. ADVERTISING The Company expenses advertising costs as incurred. Advertising expenses were approximately none and $3,400 for the years ended May 31, 2004 and 2003. INCOME TAXES The Company accounts for income taxes under SFAS No. 109, "Accounting for Income Taxes". Deferred income taxes are recognized for the tax consequences in future years of differences between the tax basis of assets and liabilities and their financial reporting amounts at each year end based on enacted tax laws and statutory tax rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized. Income tax expense is the combination of the tax payable for the year and the change during the year in deferred tax assets and liabilities. NET LOSS PER SHARE The Company applies SFAS No. 128, "Earnings Per Share" for the calculation of "Basic" and "Diluted" earnings (loss) per share. Basic earnings (loss) per share includes no dilution and is computed by dividing income (loss) available to common stockholders by the weighted average number of common shares outstanding for the period. Diluted earnings (loss) per share reflect the potential dilution of securities that could share in the earnings (loss) of an entity. USE OF ESTIMATES The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. INVENTORIES Inventories consist of raw materials, work in process and finished goods and are valued at the weighted average cost method, which approximates cost on a first-in, first-out basis, not in excess of market value. As of May 31, 2004 and 2003 both inventory amounts were fully reserved. SALE OF ACCOUNTS RECEIVABLE The Company has adopted SFAS No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities" ("SFAS 140"). SFAS 140 provides consistent standards for distinguishing transfers of financial assets that are sales from transfers that are secured F-9 PATRIOT SCIENTIFIC CORPORATION SUMMARY OF ACCOUNTING POLICIES (CONTINUED) borrowings. A $400,000 factoring line established by the Company with a bank enables the Company to sell selected accounts receivable invoices to the bank with full recourse against the Company. These transactions qualify for a sale of assets since (1) the Company has transferred all of its right, title and interest in the selected accounts receivable invoices to the bank, (2) the bank may pledge, sell or transfer the selected accounts receivable invoices, and (3) the Company has no effective control over the selected accounts receivable invoices since it is not entitled to or obligated to repurchase or redeem the invoices before their maturity and it does not have the ability to unilaterally cause the bank to return the invoices. Under SFAS 140, after a transfer of financial assets, an entity recognizes the financial and servicing assets it controls and the liabilities it has incurred, derecognizes financial assets when control has been surrendered, and derecognizes liabilities when extinguished. During fiscal 2004 and 2003, the Company sold approximately $27,000 and $38,000, respectively, of its accounts receivable to a bank under a factoring agreement for approximately $21,000 and $30,000, respectively. Pursuant to the provisions of SFAS 140, the Company reflected the transaction as a sale of assets and established an accounts receivable from the bank for the retained amount less the costs of the transaction and less any anticipated future loss in the value of the retained asset. The retained amount is equal to 20% of the total accounts receivable invoice sold to the bank less 1% of the total invoice as an administrative fee and 1.75% per month of the total outstanding accounts receivable invoices as a finance fee. The estimated future loss reserve for each receivable included in the estimated value of the retained asset is based on the payment history of the accounts receivable customer. At May 31, 2004, there was no outstanding balance and $400,000 was available for future factoring of accounts receivable invoices. STOCK OPTIONS The Company applies Accounting Principles Board ("APB") Opinion 25, "Accounting for Stock Issued to Employees," and related Interpretations in accounting for all stock option plans. Under APB Opinion 25, compensation cost has been recognized for stock options granted to employees when the option price is less than the market price of the underlying common stock on the date of grant. SFAS No. 123, "Accounting for Stock-Based Compensation," and SFAS No. 148, "Accounting for Stock-Based Compensation-Transition and disclosure," require the Company to provide pro forma information regarding net income as if compensation cost for the Company's stock option plans had been determined in accordance with the fair value based method prescribed in SFAS No. 123. To provide the required pro forma information, the Company estimates the fair value of each stock option at the grant date by using the Black-Scholes option-pricing model. SFAS No. 148 also provides for alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. The Company has elected to continue to account for stock based compensation under APB No. 25. The Company applies SFAS No. 123 in valuing options granted to consultants and estimates the fair value of such options using the Black-Scholes option-pricing model. The fair value is recorded as consulting expense as services are provided. Options granted to consultants for which vesting is contingent based on future performance are measured at their then current fair value at each period end, until vested. F-10 PATRIOT SCIENTIFIC CORPORATION SUMMARY OF ACCOUNTING POLICIES (CONTINUED) Under the accounting provisions for SFAS No. 123, the Company's net loss per share would have been increased by the pro forma amounts indicated below: 2004 2003 - -------------------------------------------------------------------------------- Net loss as reported $(4,149,978) $(3,888,299) Compensation expense (152,074) (289,023) ----------- ----------- Net loss pro forma $(4,302,052) $(4,177,322) =========== =========== As reported per share Basic and diluted loss $ (0.03) $ (0.04) =========== =========== Pro forma per share Basic and diluted loss $ (0.03) $ (0.04) ----------- ----------- RECENT ACCOUNTING PRONOUNCEMENTS In April 2003, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standard ("SFAS") No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities." SFAS No. 149 amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives) and for hedging activities under SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." SFAS No. 149 requires that contracts with comparable characteristics be accounted for similarly. SFAS No. 149 is effective for contracts entered into or modified after June 30, 2003, and for hedging relationships designated after June 30, 2003. The adoption of this statement did not impact our financial position or results of operations. In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity." SFAS No. 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003, except for mandatorily redeemable financial instruments of nonpublic entities. The adoption of this statement did not impact our financial position or results of operations. F-11 PATRIOT SCIENTIFIC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. CONTINUED EXISTENCE AND MANAGEMENT'S PLAN Our consolidated financial statements are presented on the going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. Our ability to continue as a going concern is contingent upon our obtaining sufficient financing to sustain our operations. We incurred a net loss of $4,149,978 and $3,888,299 and negative cash flow from operations of $2,171,896 and $1,885,762 in the years ended May 31, 2004 and 2003. At May 31, 2004, we had cash and cash equivalents of $355,940. We have historically funded our operations primarily through the issuance of securities and debt financings. Cash and cash equivalents increased $323,277 during the year ended May 31, 2004. We estimate our current cash requirements to sustain our operations for the next twelve months through May 2005 to be $1.8 million. Since we are no longer supporting the communications product line, we are assuming that there will be no communications product revenue. We have issued 8% convertible debentures as our primary source of funding since 2002. At the option of the debenture holders, they may purchase additional debentures up to $1 million at any time during the two years following their purchase as long as the price of our common stock is in excess of $0.20 per share. During the year ended May 31, 2004, we obtained $2,175,000 from the issuance of convertible debentures, $50,440 from the sale of equity to several private investors, $183,270 from the exercise of warrants and $12,320 from short term notes entered into with a related party. If the optional amounts under the convertible debentures are not raised in sufficient amounts, then we may not have funds sufficient to meet our cash requirements. In such circumstances, we would need to secure additional debt and/or equity financings with individual or institutional investors. In addition, we would be required to make additional cost reductions if our cash requirements cannot be met from external sources. We expect that the $1.8 million requirement will be provided by: o additional debt and/or equity financings; o proceeds from the exercise of outstanding stock options and warrants; and o proceeds from revenue contracts and patent enforcement activities. In addition, we have formulated additional cost reduction plans which can be implemented if the required funds are not obtainable. As of May 31, 2004, we also have remaining $400,000 under an accounts receivable factoring agreement with our bank. We anticipate our future revenue to be derived primarily from the sale of licenses, royalties and the proceeds from litigation or settlements of patent infringement cases. To receive this revenue, we may require additional equipment, fabrication, components and supplies during the next twelve months to support potential customer requirements and further develop our technologies and to fund the expenses of protracted patent enforcement litigation. Product introductions such as those F-12 PATRIOT SCIENTIFIC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) currently underway for the Ignite I may require significant product launch, marketing personnel and other expenditures that cannot be currently estimated. Further, if expanded development is commenced or new generations of microprocessor technology are accelerated beyond current plans, additional expenditures we cannot currently estimate, may be required. It is possible therefore, that higher levels of expenditures may be required than we currently contemplate resulting from changes in development plans or as required to support new developments or commercialization activities or otherwise. If we are unable to obtain the necessary funds, we could be forced to substantially curtail or cease operations, which would have a material adverse effect on our business. Further, there can be no assurance that required funds, if available, will be available on attractive terms or that they will not have a significantly dilutive effect on our existing shareholders. As such, there is substantial doubt about our ability to continue as a going concern. The consolidated financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result from our possible inability to continue as a going concern. 2. PROPERTY AND EQUITMENT May 31, ------------------------- 2004 2003 ================================================================================ Computer equipment and software $1,660,707 $1,660,707 Furniture and fixtures 499,274 499,274 Laboratory equipment 205,594 205,594 ---------- ---------- 2,365,575 2,365,575 Less accumulated depreciation and amortization 2,297,186 2,212,045 ---------- ---------- Net property and equipment $ 68,389 $ 153,530 ================================================================================ Depreciation expense was $85,141 and $131,958 for the years ended May 31, 2004 and 2003 3. NOTE RECEIVABLE In June 2000, the Company entered into a three-year, $80,000 Secured Promissory Note Receivable with an individual who was, at the time of the issuance of the note, an executive officer of the Company. The note had an interest rate of 6% per annum with interest payments due semi-annually and the principal due at the maturity of the note. The individual pledged 100,000 shares of the Company's common stock that he held on the date of issuance as security for this note. In April 2003, the Company negotiated an early payment discount and the individual paid $60,000 to retire F-13 PATRIOT SCIENTIFIC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) this note. The balance of $20,000 was written off to bad debt expense during the year ended May 31, 2003. 4. SECURED NOTES PAYABLE We previously replaced and superceded a previously issued Secured Promissory Note with Swartz with an Amended Secured Promissory Note and Agreement with an effective date of October 9, 2001, an Addendum to Amended Secured Promissory Note dated March 12, 2002 and an Antidilution Agreement and Addendum to Warrants dated March 19, 2003. On March 23, 2004, the amended note, which had a principal balance of $635,276 plus accrued interest of $87,891, was exchanged for an 8% convertible debenture for $723,167 with a maturity date of March 23, 2006. As part of the consideration for entering into the original amended note, we agreed to issue warrants to Swartz related to each advance against the note. In connection with each advance, we issued to Swartz a warrant to purchase a number of shares of common stock equal to the amount of the advance multiplied by 8.25 at an initial exercise price equal to the lesser of (a) the factor of the average of the volume weighted average price per share, as defined by Bloomberg L.P., for each trading day in the period beginning on the date of the previous advance and ending on the trading day immediately preceding the date of the current advance multiplied by .70 or (b) the volume weighted average price per share minus $0.05. In addition, we were obligated under the addendum to the note to issue to Swartz warrants equal to 20% of the common stock issued between March 12, 2002 and April 1, 2003 and we are obligated under the antidilution agreement to issue to Swartz warrants equal to 30% of the common stock issued subsequent to April 1, 2003 to any parties other than Swartz. In addition, we agreed to extend the expiration date to December 31, 2006 on certain warrants that were to expire previous to December 31, 2006. In exchange for these concessions, Swartz agreed to extend the due date to March 1, 2004 on a note for $635,276 net of accrued interest and allowed us to unreserve 20,007,350 shares that had been reserved for the exercise of warrants for a period the sooner of 1) March 19, 2004, or 2) 90 days after the date on which our common stock exceeded $0.375 for 10 consecutive trading days. As of May 31, 2004 we issued warrants to purchase up to 28,286,208 shares of our common stock in accordance with the amended note agreements and antidilution agreement. The warrants issued were valued using the Black-Scholes pricing model based on the expected fair value at issuance and the estimated fair value was also recorded as debt discount. As part of the consideration for exchanging the note for an 8% convertible debenture, we agreed to extend the expiration dates on certain outstanding warrants to April 1, 2011. In January 2004, a note held by an affiliate for $200,353 plus accrued interest of $8,033 was partially used to exercise a warrant with the balance of $100,000 converted into four one year $25,000 notes due January 9, 2005 issued to four heirs of the estate over which the affiliate is a trustee. The interest rate on the four notes is 6% and the notes are secured by the assets of the company. F-14 PATRIOT SCIENTIFIC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 5. CONVERTIBLE DEBENTURES Overview. From April 23, 2002 through May 11, 2004, we sold an aggregate of $4,913,167 of convertible debentures, ranging from 8% to 12%, to a group of twenty-four investors. The convertible debentures entitle the debenture holder to convert the principal and unpaid accrued interest into our common stock for two years from the date of closing. Number of Shares Debentures May Be Converted Into. The debentures can be converted into a number of our common shares at conversion prices that initially equaled $0.0172 to $0.10289 per share. Resets of Conversion Price and Conversion Shares. A reset date occurs on each three month anniversary of the closing date of each debenture and on the date the registration statement becomes effective. If the volume weighted average price for our common stock for the ten days previous to the reset date is less than the conversion price in effect at the time of the reset date, then the number of common shares issuable to the selling shareholder on conversion will be increased. If the conversion price is reset, the debenture can be converted into a number of our common shares based on the following calculation: the amount of the debenture plus any unpaid accrued interest divided by the reset conversion price which shall equal the volume weighted average price for our common stock for the ten days previous to the reset date. Warrants. Concurrent with the issuance of the convertible debentures, we issued to the debenture holders warrants to purchase shares of our common stock. These warrants are exercisable for five years from the date of issuance at either initial negotiated exercise prices or prices equal to 115% of the volume weighted average price for our common stock for the ten days previous to the debenture date. The warrant exercise price is generally subject to being reset on each six month anniversary of its issuance, however, if the warrant holder elects to have the warrant shares registered, then the exercise price is fixed at the price in effect on the date of the election. Options to Purchase Additional Debentures. Subject to the price of our common stock being equal to or greater than $0.20 per share and a two year limitation, the debenture holders may purchase additional debentures equal to the value of their initial debentures. The price at which the optional additional debentures could be converted would initially equal 115% of the volume weighted average price for our common stock for the ten days previous to the date on which the optional additional debentures were closed. The optional additional debentures would carry the same warrant amounts and reset privileges as the initial debentures. Shareholder Approval. We may currently issue more than 20% of our outstanding shares under the convertible debentures. If we become listed on the NASDAQ Small Cap Market or NASDAQ National Market, then we must get shareholder approval to issue more than 20% of our outstanding shares. Since we are currently a bulletin board company, we do not need shareholder approval. Restrictive Covenants. For a period of 18 months from the date of the debentures, we are prohibited from certain transactions. These include the issuance of any debt or equity securities in a private transaction which are convertible or exercisable into shares of common stock at a price based on the F-15 PATRIOT SCIENTIFIC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) trading price of the common stock at any time after the initial issuance of such securities; the issuance of any debt or equity securities with a fixed conversion or exercise price subject to adjustment; and any private equity line type agreements without obtaining the debenture holders' prior written approval. Right of First Refusal. The debenture holders have a right of first refusal to purchase or participate in any equity securities offered by us in any private transaction which closes on or prior to the date that is two years after the issue date of each debenture. Registration Rights. Except for one debenture issued on March 23, 2004, we are responsible for registering the resale of the shares of our common stock which will be issued on the conversion of the debentures. As of May 31, 2004, there have been five registration statements (designated A through E). Security Interest. The convertible debentures are secured by our assets. The following tables present the status, as of May 31, 2004, of our convertible debentures:
Principal Conversion Prices Effective Shares Warrant Dates of Aggregate Balance ------------------- Registration Converted at Shares Series Issuance Principal at 5/31/04 Initial Reset Date May 31, 2004 Issued - ------ -------- --------- ---------- ------- ----- ---- ------------ ------ A 4/23/2002- $1,000,000 $ 25,000 $0.08616- $0.04190- 10/29/2002 23,441,662 12,859,175 6/10/2002 $0.10289 $0.04457 B 8/23/2002- $ 605,000 $ 107,500 $0.05126- $0.04381- 3/7/2003 11,620,528 11,234,835 1/24/2003 $0.0727 $0.04722 C 3/24/2002- $ 510,000 $ 10,000 $0.041- $0.041- 6/26/2003 10,179,007 9,377,943 6/9/2003 $0.065 $0.065 D 8/1/2003- $ 547,500 $ 55,000 $0.0172- $0.0172- 11/18/2003 23,792,725 22,455,355 10/21/2003 $0.048 $0.0477 E 12/1/2003- $1,527,500 $1,527,500 $0.0267- $0.0267- 6/7/2004 -- 30,395,392 5/11/2004 $0.10 $0.10 F 3/23/2004 $ 723,167 $ 723,167 $0.09 $0.09 Not Registered -- 8,035,192 ------------------------- ------------------------- Totals $4,913,167 $2,448,167 69,033,922 94,357,892
F-16 PATRIOT SCIENTIFIC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Convertible debentures issued since April 23, 2002 $ 4,913,167 Less amounts converted to common stock (2,465,000) ----------- 2,448,167 Less debt discount (2,075,146) ----------- Convertible debentures at May 31, 2004 373,021 Less current portion 145,320 ----------- Long term portion $ 227,701 =========== Maturity dates of outstanding convertible debentures June 10, 2004 $ 25,000 October 29, 2004 107,500 April 15, 2005 10,000 August 1, 2005 25,000 September 30, 2005 30,000 December 1, 2005 25,000 January 23, 2006 275,000 February 2, 2006 325,000 March 23, 2006 723,167 March 24, 2006 315,900 April 26, 2006 100,000 May 11, 2006 486,600 ----------- $ 2,448,167 =========== 6. STOCKHOLDERS' EQUITY (DEFICIT) During fiscal 2004, the Company's shareholders approved an increase in the authorized number of common shares from 200,000,000 to 400,000,000. PRIVATE STOCK OFFERINGS During fiscal 2004, 1,800,752 restricted shares of common stock were issued to a group of individual investors for $50,440 and 1,126,496 shares of common stock were issued to a vendor in satisfaction of $59,852 of trade accounts payable. During fiscal 2003, 3,765,266 restricted shares of common stock were issued to a group of individual investors for $120,350; 2,000,000 shares of common stock were issued to a consultant in exchange for services valued at $110,000; and 400,000 shares valued at $16,000 were issued to a former executive of the company as partial settlement of a legal action. The fair value (as determined by the quoted market price) for the consulting services and legal settlement were recorded as additional general and administrative expense during the year ended May 31, 2003. Also, during fiscal 2003, the Company issued 380,000 shares of common stock to a vendor in satisfaction of $22,800 of trade accounts payable. WARRANTS At May 31, 2004, the Company had warrants outstanding to purchase 121,349,420 shares of common stock at exercise prices ranging from $0.0172 to $0.65 per share expiring beginning in F-17 PATRIOT SCIENTIFIC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 2004 through 2011. During fiscal 2004, the Company issued warrants to purchase 73,436,127 shares of common stock at exercise prices ranging from $0.0172 to $0.10 per share and issued 11,079,175 shares of common stock on the exercise of warrants at exercise prices ranging from $0.0172 to $0.04 per share. At May 31, 2003, the Company had warrants outstanding to purchase 58,992,468 shares of common stock at exercise prices ranging from $0.033 to $1.12 per share expiring beginning in 2004 through 2008. During fiscal 2003, the Company issued warrants to purchase 35,005,013 shares of common stock at exercise prices ranging from $0.04 to $0.065 per share. The following table presents the outstanding warrants at May 31: 2004 2003 ----------- ---------- Issued in conjunction with Convertible debentures 83,278,716 31,164,260 Anti-dilution agreements 15,398,058 5,355,562 Equity lines of credit 18,765,369 18,765,369 Other 3,907,277 3,707,277 ----------- ---------- Total warrants outstanding 121,349,420 58,992,468 ----------- ---------- 1992 INCENTIVE STOCK OPTION PLAN ("ISO") The Company has an ISO Plan which expired March 20, 2002. The ISO Plan provided for grants to either full or part time employees, at the discretion of the board of directors, to purchase common stock of the Company at a price not less than the fair market value of the shares on the date of grant. In the case of a significant stockholder, the option price of the share could not be less than 110 percent of the fair market value of the share on the date of grant. Any options granted under the ISO Plan must be exercised within ten years of the date they were granted (five years in the case of a significant stockholder). At May 31, 2004, options to purchase up to 17,500 shares of common stock remained outstanding and will expire in July 2004. 1992 NON-STATUTORY STOCK OPTION PLAN("NSO") The Company has an NSO Plan which expired March 20, 2002. The NSO Plan provided, at the discretion of the board of directors, for grants to either full or part time employees, directors and consultants of the Company to purchase common stock of the Company at a price not less than the fair market value of the shares on the date of grant. Any options granted under the NSO Plan must be exercised within ten years of the date they were granted. At May 31, 2004, options to purchase up to 50,000 shares of common stock remained outstanding and will expire in 2005. F-18 PATRIOT SCIENTIFIC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 1996 STOCK OPTION PLAN Effective March 1996, the Company adopted the 1996 Stock Option Plan, which was amended by the Stockholders in December 1997, expiring March 24, 2006, reserving for issuance 4,000,000 shares of the Company's common stock. The 1996 Stock Option Plan provides, at the discretion of the board of directors, for grants to either full or part time employees, directors and consultants of the Company to purchase common stock of the Company at a price not less than the fair market value on the date of grant for incentive stock options or not less than 85% of the fair market value on the date of grant for non-qualified stock options. In the case of a significant stockholder, the option price of the share is not less than 110 percent of the fair market value of the shares on the date of grant. Any option granted under the 1996 Stock Option Plan must be exercised within ten years of the date they are granted (five years in the case of a significant stockholder). During the fiscal years ended May 31, 2004 and 2003, the Company granted options to purchase none and 340,500 shares of stock at market value. 2001 STOCK OPTION PLAN Effective February 2001, the Company adopted the 2001 Stock Option Plan, expiring February 21, 2011, reserving for issuance 3,000,000 shares of the Company's common stock. The 2001 Stock Option Plan provides, at the discretion of the board of directors, for grants to either full or part time employees, directors and consultants of the Company to purchase common stock of the Company at a price not less than the fair market value on the date of grant for incentive stock options or not less than 85% of the fair market value on the date of grant for non-qualified stock options. In the case of a significant stockholder, the option price of the share is not less than 110 percent of the fair market value of the shares on the date of grant. Any option granted under the 2001 Stock Option Plan must be exercised within ten years of the date they are granted (five years in the case of a significant stockholder). During the fiscal years ended May 31, 2004 and 2003, the Company granted options to purchase none and 875,000 shares of stock at market value. 2003 STOCK OPTION PLAN Effective July 2003, the Company adopted the 2003 Stock Option Plan, expiring July 2, 2013, reserving for issuance 6,000,000 shares of the Company's common stock. The 2003 Stock Option Plan provides, at the discretion of the board of directors, for grants to either full or part time employees, directors and consultants of the Company to purchase common stock of the Company at a price not less than the fair market value on the date of grant for incentive stock options or not less than 85% of the fair market value on the date of grant for non-qualified stock options. In the case of a significant stockholder, the option price of the share is not less than 110 percent of the fair market value of the shares on the date of grant. Any option granted under the 2003 Stock Option Plan must be exercised within ten years of the date they are granted (five years in the case of a significant stockholder). During the fiscal year ended May 31, 2004, the Company granted options to purchase 2,210,000 shares of stock at market value. F-19 PATRIOT SCIENTIFIC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SFAS No. 123, "Accounting for Stock-Based Compensation," requires the Company to provide pro forma information regarding net loss and net loss per share as if compensation costs for the Company's stock option plans and other stock awards had been determined in accordance with the fair value based method prescribed in SFAS No. 123. The Company estimates the fair value of each stock award at the grant date by using the Black-Scholes option-pricing model with the following weighted-average assumptions used for the two years ended May 31, 2004 and 2003, respectively: dividend yield of zero percent for both years; expected volatility of 107 to 127 and 100 to 120, risk-free interest rates of 2.1 to 3.9 and 2.3 to 4.3; and expected lives of 3 to 5 years for both years. A summary of the status of the Company's stock option plans and warrants as of May 31, 2004, 2003 and 2002 and changes during the years ending on those dates is presented below:
Options Warrants ------------------------- -------------------------- Weighted Weighted Average Average Exercise Exercise Shares Price Shares Price - --------------------------------------------------------------------------------------------------------------- Outstanding, June 1, 2002 4,249,739 $ 0.39 24,477,724 $ 0.11 =============================================================================================================== Granted 1,215,500 0.05 35,005,013 0.05 Cancelled (411,239) 0.81 (490,269) 0.30 Exercised 0 -- - --------------------------------------------------------------------------------------------------------------- Outstanding, May 31, 2003 5,054,000 $ 0.28 58,992,468 $ 0.06 =============================================================================================================== Granted 2,210,000 0.06 73,436,127 0.05 Cancelled (156,000) 0.13 -- Exercised (105,000) 0.05 (11,079,175) 0.03 - --------------------------------------------------------------------------------------------------------------- Outstanding, May 31, 2004 7,003,000 $ 0.21 121,349,420 $ 0.05 =============================================================================================================== - --------------------------------------------------------------------------------------------------------------- Exercisable, May 31, 2003 4,138,633 $ 0.29 57,992,468 $ 0.06 =============================================================================================================== Exercisable, May 31, 2004 5,904,434 $ 0.24 120,149,420 $ 0.05 =============================================================================================================== Weighted average fair value of options and warrants granted during the year ended May 31, 2003 $ 0.04 $ 0.05 Weighted average fair value of options and warrants granted during the year ended May 31, 2004 $ 0.05 $ 0.06 ===============================================================================================================
Included in the above table are certain options for which vesting is contingent based on various future performance measures. F-20 PATRIOT SCIENTIFIC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) The following table summarizes information about stock options and warrants outstanding at May 31, 2004:
Outstanding Exercisable ------------------------------------------------ --------------------------------- Weighted Average Weighted Weighted Range of Remaining Average Average Exercise Number Contractual Exercise Number Exercise Prices Outstanding Life Price Exercisable Price ========================================================================================================= Options $ 0.0345-0.059 2,380,000 4.24 $ 0.04 1,370,000 $ 0.05 0.07-0.09 1,365,500 2.96 0.08 1,526,934 0.08 0.11-0.1325 2,340,000 2.93 0.11 2,090,000 0.11 0.61-1.18 525,000 1.02 0.93 525,000 0.93 1.325 392,500 1.00 1.33 392,500 1.33 - --------------------------------------------------------------------------------------------------------- $ 0.0345-1.325 7,003,000 3.13 $ 0.21 5,904,434 $ 0.24 Warrants $ 0.0172-0.039 29,634,938 6.79 $ 0.03 29,634,938 $ 0.03 0.04-0.044 39,156,429 6.26 0.04 39,156,429 0.04 0.045-0.049 21,057,218 5.95 0.05 21,057,218 0.05 0.05-0.094 27,793,558 6.32 0.08 26,593,558 0.08 0.10-0.65 3,707,277 2.87 0.13 3,707,277 0.13 - --------------------------------------------------------------------------------------------------------- $ 0.0172-0.65 121,349,420 6.25 $ 0.05 120,149,420 $ 0.05
7. NET LOSS PER SHARE The Company has implemented Statement of Financial Accounting Standards ("SFAS") No. 128, "Earnings Per Share." SFAS No. 128 provides for the calculation of "Basic" and "Diluted" earnings per share ("EPS"). Basic EPS includes no dilution and is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution of securities that could share in the earnings of an entity. The Company's net losses for the periods presented cause the inclusion of potential common stock instruments outstanding to be antidilutive and, therefore, in accordance with SFAS No. 128, the Company is not required to present a diluted EPS. During the years ended May 31, 2004 and 2003, common stock options and warrants convertible or exercisable into approximately 128,352,420 and 64,046,468 shares of common stock were not included in diluted loss per share as the effect was antidilutive due to the Company recording losses in each of those years. F-21 PATRIOT SCIENTIFIC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 8. INCOME TAXES The net deferred tax asset recorded and its approximate tax effect consisted of the following: May 31, ------------------------------ 2004 2003 ================================================================================ Net operating loss carryforwards $12,873,000 $12,073,000 Purchased technology 371,000 420,000 Depreciation and amortization 1,434,000 1,607,000 Other, net 54,000 191,000 - ---------------------------------------------------------------- ------------- 14,732,000 14,291,000 Valuation allowance 14,732,000 14,291,000 - ---------------------------------------------------------------- ------------- Net deferred tax asset $ -- $ -- ================================================================ ============= A reconciliation of the income taxes at the federal statutory rate to the effective tax rate is as follows:
May 31, 2004 2003 ========================================================================================================= Federal income tax benefit computed at the Federal statutory rate $(1,411,000) $(1,322,000) State income tax benefit net of Federal benefit (242,000) (139,000) Other- permanent differences 1,212,000 521,000 Expiration of state net operating loss carryforwards -- 95,000 Change in valuation allowance 441,000 845,000 - --------------------------------------------------------------------------------------------------------- Income tax benefit $ -- $ -- =========================================================================================================
As of May 31, 2004 and 2003, valuation allowances equal to the net deferred tax asset recognized have been recorded, as management has not determined that it is more likely than not that the deferred tax asset will be realized. No current tax provision was recorded for fiscal 2004 and 2003 due to reported losses. The valuation allowance increased $441,000 for the year ended May 31, 2004 and $845,000 for the year ended May 31, 2003. At May 31, 2004, the Company has federal net operating loss carryforwards of approximately $34,290,000 that expire through 2023 and are subject to certain limitations under the Internal Revenue Code of 1986, as amended. As such, certain federal net operating loss carryforwards may expire unused. At May 31, 2004, the Company has state net operating loss carryforwards of approximately $20,244,000 that expire through 2011. The state of California suspended the utilization of net F-22 PATRIOT SCIENTIFIC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) operating losses for 2002 and 2003. 9. PROFIT-SHARING PLAN Effective July 1, 1993, the Company adopted a savings and profit-sharing plan that allows participants to make contributions by salary reduction pursuant to Section 401(k) of the Internal Revenue Code. At the Company's discretion, the Company may match contributions at 20% of the employee's contribution up to 6% of the employee's salary. The Company contributions are vested 20% per year beginning with the first year of service. The Company made no matching contribution in fiscal 2004 or 2003. 10. COMMITMENTS AND CONTINGENCIES LITIGATION In December 2003, the Company filed several lawsuits in United States District Courts against companies it contends are infringing on its patent number 5,809,336 entitled "High Performance Microprocessor Having Variable Speed Clock." The defendants and suits are as follows:
Defendant U.S. District Court Case Number - --------- ------------------- ----------- Sony Corporation of America Southern District of New York 03CV10142 Fujitsu Northern District of California C035787 Toshiba America, Inc. Southern District of New York 03CV10180 NEC USA, Inc. Eastern District of New York CV036432 Matsushita District of New Jersey 03CV06210
The Company is requesting the courts to enjoin the defendants from making use of our patent and are requesting damages for past infringements. In February, with the consent of the defendants and the Company, the above five actions were consolidated into the Fujitsu action in the Northern District of California under case number C035787. In February 2004, Intel Corporation filed a lawsuit against the Company in the United States District Court- Northern District of California, case number C040439, in which they are requesting a declaratory judgment that their microprocessors, used by the defendants in our consolidated suit, do not infringe the Company's patent. The Company filed a counterclaim against Intel contending that they also are infringing on its patent, and Intel asserted an affirmative defense that the Company's 5,809,336 patent is invalid. Also in February 2004, the Company filed a lawsuit in the United States District Court- Northern F-23 PATRIOT SCIENTIFIC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) District of California, case number C040618, against Charles H. Moore, Technology Properties Limited, and Daniel E. Leckrone. The Company is requesting the court to declare inventorship and ownership on each of its granted patents related to the suits discussed above and other unasserted claims of infringement Patriot believes it has. The Intel lawsuit has been stayed pending the results of the Moore lawsuit. OPERATING AND CAPITAL LEASES The Company is obligated under employment contracts with certain key employees to pay severance upon termination under certain defined conditions. Generally, unless relieved of their duties for cause, the executive officers are entitled to severance pay equal to two to four months of their then current monthly salary. In the case of a change in control, generally, the executive officers are entitled to severance pay equal to twelve months of their then current monthly salary unless they continue to work for the new controlling interest in the same function as previous to the change. The Company granted a lien and security interest in substantially all of its assets to the bank under the accounts receivable factoring line and to investors under its notes payable and convertible debentures. The Company has one capital lease at May 31, 2004. Future minimum lease payments are as follows: Year ending May 31, 2005 $ 9,562 2006 2,391 - -------------------------------------------------------------------------------- Total minimum lease payments 11,953 Amount representing interest 1,627 - -------------------------------------------------------------------------------- Present value of minimum lease payments 10,326 Total obligation 10,326 Less current portion (8,020) - -------------------------------------------------------------------------------- Long-term portion $ 2,306 ================================================================================ Capital leases included in fixed assets at May 31, 2004 and 2003, were $3,471 and $11,803, net of an allowance for depreciation of $21,524 and $13,192. Depreciation expense related to the capitalized lease was $8,332 and $8,332 for the years ended May 31, 2004 and 2003. F-24 PATRIOT SCIENTIFIC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) The Company has a non-cancellabe operating lease for its office and manufacturing facilities located in San Diego, California. Future minimum lease payments required under the operating lease are as follows: Years ending May 31, ================================================================================ Gross Sublease Net Payments Income Payments 2005 $135,454 $ 70,470 $ 64,984 2006 141,658 72,540 69,118 2007 23,782 12,150 11,632 Thereafter -- -- -- - -------------------------------------------------------------------------------- Total minimum lease payments $300,894 $155,160 $145,734 ================================================================================ Rent expense for fiscal 2004 and 2003 was $181,135 and $189,423, respectively. 11. SEGMENT INFORMATION EXPORT SALES The Company is engaged in one business segment, the development and marketing of microprocessor technology related products and licenses. Telecommunication products have reached the end of their life cycles and no longer provide any significant sales. During the fiscal years ended May 31, 2004 and 2003, the Company's product sales of high technology computer products and licenses were $13,615 and $31,340 and telecommunication products and licenses were $62,802 and $92,563. For the purpose of allocating revenues by geographic location, the Company uses the physical location of its customers as its basis. During the fiscal years ended May 31, 2004 and 2003, the Company's sales by geographic location consisted of the following: F-25 PATRIOT SCIENTIFIC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 2004 2003 ------------ ---------- Domestic sales $ 70,000 $113,000 Foreign sales: Europe 6,000 11,000 --------------------------- Total foreign sales 6,000 11,000 --------------------------- Total net product sales $ 76,000 $124,000 =========================== The Company has no foreign assets. SALES TO MAJOR CUSTOMERS During the fiscal years ended May 31, 2004 and 2003, revenues from significant customers consisted of the following: 2004 2003 ------------------- --------------------- Customer Sales Percent Sales Percent - -------- ----- ------- ----- ------- A $25,000 33.2% $ -- -- B 18,000 22.9% -- -- C 9,000 11.9% -- -- D -- -- 43,000 34.3% E -- -- 23,000 18.6% F -- -- 15,000 11.9% G -- -- 15,000 11.9% 12. RELATED PARTY TRANSACTIONS During fiscal year 2004, we sold services totaling $25,352 to a company owned by one of our officers. F-26 PATRIOT SCIENTIFIC CORPORATION CONSOLIDATED BALANCE SHEETS
November 30, May 31, 2004 2004 ------------ ------------ (Unaudited) ASSETS (Notes 4 and 5) Current assets: Cash and cash equivalents $ 172,736 $ 355,940 Marketable securities 10,427 22,646 Accounts receivable 3,593 1,225 Prepaid expenses 243,990 322,068 ------------ ------------ Total current assets 430,746 701,879 Property and equipment, net 45,256 68,389 Other assets 23,891 41,221 Patents and trademarks, net of accumulated amortization of $525,399 and $501,235 90,575 114,739 ------------ ------------ $ 590,468 $ 926,228 ============ ============ LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT) Current liabilities: Current portion of convertible debentures, net of debt discount of $2,093 and $27,180 (Note 5) $ 37,907 $ 145,320 Secured notes payable to shareholders (Note 4) 100,000 100,000 Accounts payable 101,349 134,600 Accrued liabilities 132,145 160,102 Current portion of capital lease obligation 6,541 8,020 ------------ ------------ Total current liabilities 377,942 548,042 Convertible debentures, net of debt discount of $1,372,907 and $2,047,966 (Note 5) 484,760 227,701 Long term portion of capital lease obligation -- 2,306 Stockholders' equity (deficit) (Notes 5 and 6) Preferred stock, $.00001 par value; 5,000,000 shares authorized none outstanding -- -- Common stock, $.00001 par value; 400,000,000 shares authorized; issued and outstanding 210,916,855 and 171,156,363 2,109 1,712 Additional paid-in capital 51,749,267 49,990,485 Accumulated deficit (52,023,610) (49,844,018) ------------ ------------ Total stockholders' equity (deficit) (272,234) 148,179 ------------ ------------ $ 590,468 $ 926,228 ============ ============
See accompanying summary of accounting policies and notes to unaudited consolidated financial statements. F-27 PATRIOT SCIENTIFIC CORPORATION CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)
Three Months Ended Six Months Ended -------------------------------- -------------------------------- November 30, November 30, November 30, November 30, 2004 2003 2004 2003 ------------- ------------- ------------- ------------- Net sales $ 18,748 $ 51,960 $ 21,298 $ 63,200 Cost of sales -- 4,259 -- 10,472 ------------- ------------- ------------- ------------- Gross profit 18,748 47,701 21,298 52,728 Operating expenses: Research and development 54,037 112,391 182,341 261,513 Selling, general and administrative 392,552 321,132 772,954 672,602 ------------- ------------- ------------- ------------- 446,589 433,523 955,295 934,115 ------------- ------------- ------------- ------------- Operating loss (427,841) (385,822) (933,997) (881,387) ------------- ------------- ------------- ------------- Other income (expenses): Unrealized gain (loss) on marketable securities 2,444 (23,234) (12,219) (23,234) Gain on sale of technology -- 75,500 -- 75,500 Other income 479 -- 47,752 -- Interest expense (648,223) (539,234) (1,281,128) (1,196,216) ------------- ------------- ------------- ------------- (645,300) (486,968) (1,245,595) (1,143,950) ------------- ------------- ------------- ------------- Net loss $ (1,073,141 $ (872,790) $ (2,179,592) $ (2,025,337) ============= ============= ============= ============= Basic and diluted loss per common share $ (0.01) $ (0.01) $ (0.01) $ (0.02) ============= ============= ============= ============= Weighted average number of common shares outstanding during the period (Note 1) 198,970,399 129,716,912 190,971,852 121,738,543 =========== =========== =========== ===========
See accompanying summary of accounting policies and notes to unaudited consolidated financial statements. F-28 PATRIOT SCIENTIFIC CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
Six Months Ended ---------------------------------------- November 30, 2004 November 30, 2003 ----------------- ----------------- Decrease in Cash and Cash Equivalents Operating activities: Net loss $(2,179,592) $(2,025,337) Adjustments to reconcile net loss to cash used in operating activities: Amortization and depreciation 47,297 67,726 Non-cash compensation 22,175 -- Non-cash interest expense related to convertible debentures, notes payable and warrants 1,192,563 1,118,584 Gain on sale of technology -- (75,500) Unrealized loss on marketable securities 12,219 23,234 Common stock issued for services 14,800 -- Changes in: Accounts receivable (2,368) (52,836) Prepaid expenses and other assets 95,408 3,443 Accounts payable and accrued liabilities (2,103) 81,211 -------------------------------------- Net cash used in operating activities (799,601) (859,475) -------------------------------------- Investing activities: Proceeds from sale of technolgy -- 7,500 Purchase of property, equipment and patents -- (22,195) -------------------------------------- Net cash used for investing activities -- (14,695) -------------------------------------- Financing activities: Proceeds from the issuance of short term notes payable -- 10,000 Proceeds from the issuance of convertible debentures 452,500 722,500 Proceeds from the issuance of common stock 3,250 47,040 Principal payments for capital lease obligations (3,785) (3,023) Proceeds from sales of accounts receivable -- 21,280 Proceeds from exercise of common stock warrants 164,432 50,100 -------------------------------------- Net cash provided by financing activities 616,397 847,897 -------------------------------------- Net increase (decrease) in cash and cash equivalents (183,204) (26,273) Cash and cash equivalents, beginning of period 355,940 32,663 -------------------------------------- Cash and cash equivalents, end of period $ 172,736 $ 6,390 ====================================== Supplemental Disclosure of Cash Flow Information: Cash payments for interest $ 2,226 $ 6,303 Convertible debentures, notes payable and accrued interest exchanged for common stock $ 1,062,104 $ 1,268,259 Debt discount $ 452,500 $ 622,500 ======================================
See accompanying summary of accounting policies and notes to unaudited consolidated financial statements. F-29 PATRIOT SCIENTIFIC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 1. BASIS OF PRESENTATION The consolidated financial statements of Patriot Scientific Corporation ("Patriot") presented herein have been prepared pursuant to the rules of the Securities and Exchange Commission for quarterly reports on Form 10-QSB and do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America. These statements should be read in conjunction with our audited consolidated financial statements and notes thereto included in Form 10-KSB for the year ended May 31, 2004. In the opinion of management, the interim consolidated financial statements reflect all adjustments of a normal recurring nature necessary for a fair statement of the results for interim periods. Operating results for the three month periods are not necessarily indicative of the results that may be expected for the year. LOSS PER SHARE We follow Statement of Financial Accounting Standards ("SFAS") No. 128, "Earnings per Share." Under SFAS No. 128, basic loss per share is calculated as loss available to common stockholders divided by the weighted average number of common shares outstanding. Diluted loss per share is calculated as net loss divided by the diluted weighted average number of common shares. The diluted weighted average number of common shares is calculated using the treasury stock method for common stock issuable pursuant to outstanding stock options and common stock warrants. Common stock options and warrants of 140,221,312 and 90,525,744 for the six months ended November 30, 2004 and 2003, respectively, were not included in diluted loss per share for the periods as the effect was antidilutive due to our recording losses in each of those periods. See Notes 5 and 7 for discussion of commitments to issue additional shares of common stock and warrants. STOCK OPTIONS The Company applies Accounting Principles Board ("APB") Opinion 25, "Accounting for Stock Issued to Employees," and related Interpretations in accounting for all stock option plans. Under APB Opinion 25, compensation cost has been recognized for stock options granted to employees when the option price is less than the market price of the underlying common stock on the date of grant. SFAS No. 123, "Accounting for Stock-Based Compensation," and SFAS No. 148, "Accounting for Stock-Based Compensation-Transition and disclosure," require the Company to provide pro forma information regarding net income as if compensation cost for the Company's stock option plans had been determined in accordance with the fair value based method prescribed in SFAS No. 123. To provide the required pro forma information, the Company estimates the fair value of each stock option at the grant date by using the Black-Scholes option-pricing model. SFAS No. 148 also F-30 PATRIOT SCIENTIFIC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) provides for alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. The Company has elected to continue to account for stock based compensation under APB No. 25. The Company applies SFAS No. 123 in valuing options granted to consultants and estimates the fair value of such options using the Black-Scholes option-pricing model. The fair value is recorded as consulting expense as services are provided. Options granted to consultants for which vesting is contingent based on future performance are measured at their then current fair value at each period end, until vested. Under the accounting provisions for SFAS No. 123, the Company's net loss per share would have been increased by the pro forma amounts indicated below:
Three Months Ended Six Months Ended ---------------------------- ----------------------------- November 30, November 30, November 30, November 30, 2004 2003 2004 2003 - --------------------------------------------------------- ----------------------------- Net loss as reported $(1,073,141) $ (872,790) $(2,179,592) $ 2,025,337) Compensation expense (10,110) (64,400) (12,993) (150,074) ----------- ----------- ----------- ----------- Net loss pro forma $(1,083,251) $ (937,190) $(2,192,585) $ 2,175,411) =========== =========== =========== =========== As reported per share Basic and diluted loss $ (0.01) $ (0.01) $ (0.01) $ (0.02) =========== =========== =========== =========== Pro forma per share Basic and diluted loss $ (0.01) $ (0.01) $ (0.01) $ (0.02) ----------- ----------- ----------- -----------
SALE OF ACCOUNTS RECEIVABLE We follow SFAS No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities," a replacement of SFAS No. 125. SFAS No. 140 provides consistent standards for distinguishing transfers of financial assets that are sales from transfers that are secured borrowings. A $400,000 factoring line we established with a bank enables us to sell selected accounts receivable invoices to the bank with full recourse against us. These transactions qualify for a sale of assets since (1) we have transferred all of our rights, title and interest in the selected accounts receivable invoices to the bank, (2) the bank may pledge, sell or transfer the selected accounts receivable invoices, and (3) we have no effective control over the selected accounts receivable invoices since we are not entitled to or obligated to repurchase or redeem the invoices before their maturity and we do not have the ability to unilaterally cause the bank to return the invoices. Under SFAS No.140, after a transfer of financial assets, an entity recognizes the financial and servicing assets it controls and the liabilities it has incurred, derecognizes financial assets when control has been surrendered, and derecognizes liabilities when extinguished. Pursuant to the provisions of SFAS No. 140, whenever we sell accounts receivable invoices to the bank, we reflect the transactions as sales of assets and establish a receivable from the bank for the retained amount less the costs of the transactions and less any anticipated future loss in the value of the F-31 PATRIOT SCIENTIFIC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) retained asset. The retained amount equals 20% of the total accounts receivable invoices sold to the bank less 1% of the total invoices as an administrative fee and 1.75% per month of the total outstanding accounts receivable invoices as a finance fee. The estimated future loss reserve for each receivable included in the estimated value of the retained asset is based on the payment history of the accounts receivable customer. At November 30, 2004, there were no accounts receivable invoices outstanding under the factoring line and $400,000 was available for future factoring of accounts receivable invoices. 2. RECENT ACCOUNTING PRONOUNCEMENTS In April 2003, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standard ("SFAS") No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities." SFAS No. 149 amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives) and for hedging activities under SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." SFAS No. 149 requires that contracts with comparable characteristics be accounted for similarly. SFAS No. 149 is effective for contracts entered into or modified after June 30, 2003, and for hedging relationships designated after June 30, 2003. The adoption of this statement did not impact our financial position or results of operations. In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity." SFAS No. 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003, except for mandatorily redeemable financial instruments of nonpublic entities. The adoption of this statement did not impact our financial position or results of operations. In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123R ("SFAS123R"), Share-Based Payment, an amendment of FASB Statements Nos. 123 and 95. SFAS 123R eliminates the ability to account for share-based compensation transaction using APB 25 and would require that such transactions be accounted for using a fair-value-based method and recognized as expenses in statement of operations. SFAS 123R allows the use of a modified version of prospective application, which requires that the fair value of new awards granted after the effective date of SFAS 123R, plus unvested awards at the date of adoption, be expensed over the applicable vesting period. The provisions of SFAS 123R will be effective for interim or annual reporting periods beginning after December 15, 2005 for the companies that file as small business issuers. The Company is currently evaluating the impact the implementation guidance and revisions included in SFAS 123R will have on its consolidated financial statements. F-32 PATRIOT SCIENTIFIC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 3. CONTINUED EXISTENCE AND MANAGEMENT'S PLAN Our consolidated financial statements are presented on the going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. Our ability to continue as a going concern is contingent upon our obtaining sufficient financing to sustain our operations. We incurred a net loss of $2,179,592, $4,149,978 and $3,888,299 and negative cash flow from operations of $799,601, $2,075,972 and $1,885,762 in the six months ended November 30, 2004 and the years ended May 31, 2004 and 2003, respectively. At November 30, 2004, we had working capital of $52,804 and cash and cash equivalents of $172,736. We have historically funded our operations primarily through the issuance of securities and debt financings. Cash and cash equivalents decreased $183,204 during the six months ended November 30, 2004. We estimate our current cash requirements to sustain our operations for the next twelve months through November 2005 to be $1.8 million. Since we are no longer supporting the communications product line, we are assuming that there will be no communications product revenue. We have issued 8% convertible debentures as our primary source of funding since 2002. At the option of the debenture holders, they may purchase additional debentures up to $1 million at any time during the two years following their purchase as long as the price of our common stock is in excess of $0.20 per share. During the first six months ended November 30, 2004, we obtained $452,500 from the issuance of 8% convertible debentures and $164,432 from the exercise of warrants. Subsequent to November 30, 2004, we obtained $25,000 from the issuance of 8% convertible debentures and $169,032 from the exercise of warrants. If exercise of warrants are not in sufficient amounts, then we may not have funds sufficient to meet our cash requirements. In such circumstances, we would need to secure additional debt and/or equity financings with individual or institutional investors. In addition, we would be required to make additional cost reductions if our cash requirements cannot be met from external sources. We expect that the $1.8 million requirement will be provided by: o additional debt and/or equity financings; o proceeds from the exercise of outstanding stock options and warrants; and o proceeds from revenue contracts and patent enforcement activities. In addition, we have formulated additional cost reduction plans which can be implemented if the required funds are not obtainable. As of November 30, 2004, we also have remaining $400,000 under an accounts receivable factoring agreement with our bank. We anticipate our future revenue to be derived primarily from the sale of licenses, royalties and the proceeds from litigation or settlements of patent infringement cases. To receive this revenue, we may require additional equipment, fabrication, components and supplies during the next twelve months to support potential customer requirements and further develop our technologies and to fund the expenses of protracted patent enforcement litigation. Product introductions such as those F-33 PATRIOT SCIENTIFIC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) currently underway for the Ignite microprocessor may require significant product launch, marketing personnel and other expenditures that cannot be currently estimated. Further, if expanded development is commenced or new generations of microprocessor technology are accelerated beyond current plans, additional expenditures we cannot currently estimate, may be required. It is possible therefore, that higher levels of expenditures may be required than we currently contemplate resulting from changes in development plans or as required to support new developments or commercialization activities or otherwise. If we are unable to obtain the necessary funds, we could be forced to substantially curtail or cease operations, which would have a material adverse effect on our business. Further, there can be no assurance that we will be able to timely receive shareholder approval to increase the number of authorized shares or that required funds, if available, will be available on attractive terms or that they will not have a significantly dilutive effect on our existing shareholders. As such, there is substantial doubt about our ability to continue as a going concern. The consolidated financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result from our possible inability to continue as a going concern. 4. SECURED NOTE PAYABLE In January 2004, a note held by an affiliate for $200,353 plus accrued interest of $8,033 was partially used to exercise a warrant with the balance of $100,000 converted into four one year $25,000 notes due September 1, 2005 issued to four heirs of the estate over which the affiliate is a trustee. The interest rate on the four notes is 6% and the notes are secured by the assets of the company. 5. CONVERTIBLE DEBENTURES Overview. From April 23, 2002 through November 18, 2004, we sold an aggregate of $5,365,667 of convertible debentures, ranging from 8% to 12%, to a group of twenty-four investors. The convertible debentures entitle the debenture holder to convert the principal and unpaid accrued interest into our common stock for two years from the date of closing. Number of Shares Debentures May Be Converted Into. The debentures can be converted into a number of our common shares at conversion prices that initially equaled $0.0167 to $0.10289 per share. Resets of Conversion Price and Conversion Shares. A reset date occurs on each three month anniversary of the closing date of each debenture and on the date the registration statement becomes effective. If the volume weighted average price for our common stock for the ten days previous to the reset date is less than the conversion price in effect at the time of the reset date, then the number of common shares issuable to the selling shareholder on conversion will be increased. If the conversion price is reset, the debenture can be converted into a number of our common shares based F-34 PATRIOT SCIENTIFIC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) on the following calculation: the amount of the debenture plus any unpaid accrued interest divided by the reset conversion price which shall equal the volume weighted average price for our common stock for the ten days previous to the reset date. Warrants. Concurrent with the issuance of the convertible debentures, we issued to the debenture holders warrants to purchase shares of our common stock. These warrants are exercisable for five to seven years from the date of issuance at either initial negotiated exercise prices or prices equal to 115% of the volume weighted average price for our common stock for the ten days previous to the debenture date. The warrant exercise price is generally subject to being reset on each six month anniversary of its issuance, however, if the warrant holder elects to have the warrant shares registered, then the exercise price is fixed at the price in effect on the date of the election. Options to Purchase Additional Debentures. Subject to the price of our common stock being equal to or greater than $0.20 per share and a two year limitation, the debenture holders may purchase additional debentures equal to the value of their initial debentures. The price at which the optional additional debentures could be converted would initially equal 115% of the volume weighted average price for our common stock for the ten days previous to the date on which the optional additional debentures were closed. The optional additional debentures would carry the same warrant amounts and reset privileges as the initial debentures. Shareholder Approval. We may currently issue more than 20% of our outstanding shares under the convertible debentures. If we become listed on the NASDAQ Small Cap Market or NASDAQ National Market, then we must get shareholder approval to issue more than 20% of our outstanding shares. Since we are currently a bulletin board company, we do not need shareholder approval. Restrictive Covenants. For a period of 18 months from the date of the debentures, we are prohibited from certain transactions. These include the issuance of any debt or equity securities in a private transaction which are convertible or exercisable into shares of common stock at a price based on the trading price of the common stock at any time after the initial issuance of such securities; the issuance of any debt or equity securities with a fixed conversion or exercise price subject to adjustment; and any private equity line type agreements without obtaining the debenture holders' prior written approval. Right of First Refusal. The debenture holders have a right of first refusal to purchase or participate in any equity securities offered by us in any private transaction which closes on or prior to the date that is two years after the issue date of each debenture. Registration Rights. Except for one debenture issued on March 23, 2004, we are responsible for registering the resale of the shares of our common stock which will be issued on the conversion of the debentures. As of November 30, 2004, there have been five registration statements (designated A through E). Debentures issued from September 28, 2004 through November 18, 2004 (designated G) have registration rights but have not been registered as of November 30, 2004. Security Interest. The convertible debentures are secured by our assets. F-35 PATRIOT SCIENTIFIC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) The following tables present the status, as of November 30, 2004, of our convertible debentures:
Principal Conversion Prices Effective Shares Warrant Dates of Aggregate Balance ------------------- Registration Converted at Shares Series Issuance Principal at 11/30/04 Initial Reset Date 11/30/04 Issued - ------ -------- --------- ----------- ------- ----- ---- ------------ ------ A 4/23/2002- 1,000,000 $ -- 0.08616- $0.04190- 10/29/2002 24,099,548 12,859,175 6/10/2002 0.10289 $0.04457 B 8/23/2002- 605,000 $ -- 0.05126- $0.03007- 3/7/2003 14,777,350 11,234,835 1/24/2003 0.0727 $0.04722 C 3/24/2003- 510,000 $ 10,000 0.041- $0.03968- 6/26/2003 10,179,007 9,377,943 6/9/2003 0.065 $0.06346 D 8/1/2003- 547,500 $ 30,000 0.0172- $0.0172- 11/18/2003 24,353,803 22,455,355 10/21/2003 0.048 $0.0477 E 12/1/2003- 1,527,500 $ 682,000 0.0267- $0.0267- 6/7/2004 26,880,016 30,395,392 5/11/2004 0.10 $0.04105 F 3/23/2004 723,167 $ 723,167 0.09 $0.0399 Not Registered -- 8,035,192 G 9/28/2004- 452,500 $ 452,500 0.0167- $0.0167- Not Registered -- 20,481,137 11/18/2004 0.04 $0.04 -------------------------- ---------------------------- Totals $5,365,667 $1,897,667 100,289,724 114,839,029
F-36 PATRIOT SCIENTIFIC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Convertible debentures issued since April 23, 2002 $ 5,365,667 Less amounts converted to common stock (3,468,000) ----------- 1,897,667 Less debt discount (1,375,000) ----------- Convertible debentures at November 30, 2004 522,667 Less current portion 37,907 ----------- Long term portion $ 484,760 =========== Maturity dates of outstanding convertible debentures April 15, 2005 $ 10,000 September 30, 2005 30,000 December 1, 2005 25,000 February 2, 2006 77,000 March 23, 2006 723,167 March 24, 2006 200,000 April 26, 2006 100,000 May 11, 2006 280,000 September 28, 2006 50,000 November 16, 2006 145,000 November 17, 2006 157,500 November 18, 2006 100,000 ----------- $ 1,897,667 ----------- 6. STOCKHOLDERS' DEFICIT The following table summarizes equity transactions during the six months ended November 30, 2004: Common Shares Dollars ----------- ----------- Balance June 1, 2004 171,156,363 $49,992,197 Sale of common stock 125,000 3,250 Exercise of common stock warrants 8,083,689 164,432 Stock issued on conversion of debentures and accrued interest 31,255,803 1,062,104 Stock issued for services 296,000 14,800 Non-cash compensation -- 22,175 Non-cash interest and debt discount related to warrants and debentures -- 492,418 ----------- ----------- Balance November 30, 2004 210,916,855 $51,751,376 =========== =========== F-37 PATRIOT SCIENTIFIC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) STOCK OPTIONS At November 30, 2004, we had 50,000 options outstanding pursuant to our 1992 NSO Stock Option Plan exercisable at $1.325 per share expiring in 2005; 1,948,000 options outstanding pursuant to our 1996 Stock Option Plan exercisable at a range of $0.0425 to $1.325 per share expiring beginning in 2005 through 2008; 2,230,000 options outstanding pursuant to our 2001 Stock Option Plan exercisable at a range of $0.0425 to $0.1275 per share expiring beginning in 2005 through 2008; and 2,205,000 options outstanding pursuant to our 2003 Stock Option Plan exercisable at a range of $0.0345 to $0.11 per share expiring in 2005 through 2009. Some of the options outstanding under these plans are not presently exercisable and are subject to meeting vesting criteria. WARRANTS At November 30, 2004, we had warrants outstanding exercisable into 133,788,312 common shares at exercise prices ranging from $0.0167 to $0.65 per share expiring beginning in 2006 through 2011. During the six months ended November 30, 2004, we issued warrants to purchase 21,282,581 shares of common stock which are subject to repricings at the six month anniversary of the issuance of the warrant; had investors exercise warrants to purchase 8,083,689 shares of our common stock; and cancelled warrants to purchase 760,000 shares of our common stock. For warrants issued in conjunction with the 8% convertible debentures, at each anniversary date the warrants will be repriced to the lesser of the initial exercise price or the volume weighted average price for our common stock for the ten days previous to the reset date. For warrants issued in conjunction with the equity lines of credit and snap shot warrants, at each anniversary date the warrants will be repriced to the lesser of the initial exercise price or 110% of the lowest closing bid price of our common stock for the five trading days ending on such six month anniversary date. During the six months ended November 30, 2004, warrants to purchase 41,188,105 shares of common stock with initial or reset exercise prices ranging from $0.0408 to $0.0938 have been repriced to exercise prices ranging from $0.0319 to $0.0451. During the six months ended November 30, 2004, we issued to Swartz snap shot warrants exercisable for five years into 801,444 common shares at an exercise price of $0.0672. The snap shot warrant was issued under an agreement with Swartz whereby we will issue to Swartz warrants to purchase common shares equal to 30% of any common stock or warrants we issue to parties other than Swartz or their affiliates after April 1, 2003. During the six months ended November 30, 2004, six warrant holders agreed to lock up agreements which allowed us to unreserve warrants exercisable into 18,606,452 shares of our common stock until the earlier of an increase in the authorized number of common shares or April 30, 2005. In exchange for this agreement, we agreed to extend their warrants by two years. F-38 PATRIOT SCIENTIFIC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) COMMON STOCK During the six months ended November 30, 2004, 296,000 shares of common stock were issued to a vendor in satisfaction of $14,800 of trade accounts payable and 125,000 shares of one-year restricted common stock were sold to one individual investor at a price of $0.026 per share for a total of $3,250. F-39
================================================================= ================================================================= Until the completion of the resale of the common stock included in this prospectus, all dealers that effect transactions in these securities, whether or not participating in this offering, may be The Resale of required to deliver a prospectus. This is in addition to the 47,832,555 Shares dealers' obligation to deliver a prospectus when acting as of underwriters and with respect to their unsold allotments or Common Stock subscriptions. Offered by Selling Shareholders Table of Contents Prospectus Summary .................................... 5 Risk Factors .......................................... 9 Plan of Distribution .................................. 16 Selling Shareholders .................................. 17 The Company ........................................... 18 PATRIOT SCIENTIFIC Use of Proceeds ....................................... 31 CORPORATION Litigation ............................................ 31 Management's Discussion and Analysis of Financial Condition ....................... 32 Changes in Accountants ................................ 47 Management ............................................ 48 Principal Shareholders ................................ 53 PROSPECTUS Certain Transactions .................................. 55 Trading Market and Related Matters 56 Description of Securities ............................. 57 Subject to Completion, January 31, 2005 Legal Matters ......................................... 58 Experts ............................................... 58 Index to Financial Statements ......................... F-1 ================================================================= =================================================================
PART II INFORMATION NOT REQUIRED IN PROSPECTUS ITEM 24. INDEMNIFICATION OF OFFICERS AND DIRECTORS. Pursuant to the Company's Certificate of Incorporation, and as permitted by Section 145 of the General Corporation Law of Delaware, the Company may indemnify its directors and officers under certain circumstances against reasonable expenses (including court costs and attorney's fees), judgments, penalties, fines, and amounts paid in settlement actually and reasonably incurred in connection with any action, suit or proceeding, whether civil, criminal, administrative or investigative, to which any of them is a party by reason of his being a director, officer, employee, or agent of the Company if it is determined that he acted in accordance with the applicable standard of conduct set forth in such statutory provisions. Thus, the indemnification provisions will protect officers and directors from liability only if the officer or director meets the applicable standard of conduct and the Company has the financial ability to honor the indemnity. ITEM 25. OTHER EXPENSES OF ISSUANCE AND DISTRIBUTION. Expenses payable in connection with the registration and distribution of the securities being registered hereunder, all of which will be borne by the Registrant, are as follows: Registration Fee - Securities and Exchange Commission ........ $ 512 Printing and Engraving ....................................... 1,000* Legal Fees and Expenses ...................................... 15,000* Accounting Fees .............................................. 15,000* Blue Sky Fees and Expenses ................................... 1,000* ------- Total ............................................... $32,512* * Estimated ITEM 26. RECENT SALES OF UNREGISTERED SECURITIES We offered and sold the following common stock, either for cash or in consideration of services rendered as indicated below, and common stock warrants without registration under the Securities Act of 1933, as amended, and exemption for such sales from registration under the Act is claimed in reliance upon the exemption provided by Section 4(2) thereof on the basis that such offers and sales were transactions not involving any public offering. Appropriate precautions against transfer have been taken, including the placing of a restrictive legend on all certificates evidencing such securities. All such sales were effected without the aid of underwriters, and no sales commissions were paid. II-1 Common Stock
Purchase Number of Aggregate Price Per Name Date of Sale Shares Purchase Price Share ---- ------------ ------ -------------- ----- Robert Crawford January 22, 2002 $ 400,000 $ 34,000 0.08 Cash William Crawford January 22, 2002 $ 400,000 $ 34,000 0.08 Cash iCapital January 25, 2002 $ 1,000,000 $ 90,000 0.09 Services Robert Crawford September 24, 2002 $ 1,000,000 $ 25,000 0.03 Cash REC Music Foundation September 24, 2002 $ 600,000 $ 15,000 0.03 Cash Donald Logo October 28, 2002 $ 166,000 $ 5,000 0.03 Cash Red Oak Inc. October 28, 2002 $ 166,000 $ 5,000 0.03 Cash Donald Logo December 6, 2002 $ 111,111 $ 5,000 0.04 Cash Red Oak Inc. December 6, 2002 $ 111,111 $ 5,000 0.04 Cash Don Riley December 9, 2002 $ 118,889 $ 5,350 0.04 Cash Greg Erickson December 16, 2002 $ 100,000 $ 5,000 0.05 Cash Dean Gullick December 19, 2002 $ 102,459 $ 5,000 0.05 Cash Robert Vincent December 19, 2002 $ 61,475 $ 3,000 0.05 Cash John Laws January 21, 2003 $ 98,039 $ 5,000 0.05 Cash REC Music Foundation February 3, 2003 $ 400,000 $ 12,000 0.03 Cash John Castellano February 3, 2003 $ 138,889 $ 5,000 0.04 Cash Lyle Armstrong February 7, 2003 $ 125,000 $ 4,500 0.04 Cash Lyle Armstrong February 13, 2003 $ 88,889 $ 3,000 0.03 Cash Red Oak Inc. February 13, 2003 $ 59,259 $ 2,000 0.03 Cash Orrin Noling February 24, 2003 $ 162,338 $ 5,000 0.03 Cash Michael Korbiak March 3, 2003 $ 155,807 $ 5,500 0.04 Cash Lyle Armstrong August 1, 2003 $ 44,118 $ 1,500 0.03 Cash Red Oak Inc. August 1, 2003 $ 44,118 $ 1,500 0.03 Cash Red Oak Inc. August 20, 2003 $ 100,000 $ 3,000 0.03 Cash REC Music Foundation August 26, 2003 $ 1,000,000 $ 25,000 0.03 Cash Red Oak Inc. September 16, 2003 $ 64,516 $ 2,000 0.03 Cash Dean Gullick September 23, 2003 $ 181,333 $ 5,440 0.03 Cash Lydon Inc. September 30, 2003 $ 67,667 $ 2,000 0.03 Cash Red Oak Inc. October 31, 2003 $ 100,000 $ 3,300 0.03 Cash Red Oak Inc. November 25, 2003 $ 100,000 $ 3,300 0.03 Cash Red Oak Inc. January 27, 2004 $ 100,000 $ 3,400 0.03 Cash Hawk Associates, Inc January 5, 2004 $ 700,000 $ 30,252 0.04 Services Hawk Associates, Inc February 3, 2004 $ 300,000 $ 14,800 0.05 Services Hawk Associates, Inc April 21, 2004 $ 126,496 $ 14,800 0.12 Services Hawk and Associates August 2, 2004 $ 296,000 $ 14,800 0.05 Services Red Oak Inc October 20, 2004 $ 125,000 $ 3,250 0.03 Cash Hawk and Associates January 10, 2005 $ 500,000 $ 44,000 0.09 Services
II-2 Warrants
Number of Initial Exercise Expiration Name Date of Issuance Shares Price Per Share Date - --------------------- -------------------- ---------- ----------------- ------------- Swartz Private Equity January 14, 2002 1,237,500 $ 0.05720 April 1, 2011 Swartz Private Equity January 28, 2002 825,000 $ 0.05390 April 1, 2011 Swartz Private Equity February 12, 2002 618,750 $ 0.04760 April 1, 2011 Swartz Private Equity February 15, 2002 206,250 $ 0.04510 April 1, 2011 Swartz Private Equity February 25, 2002 618,750 $ 0.04400 April 1, 2011 Swartz Private Equity March 12, 2002 1,650,000 $ 0.04840 April 1, 2011 Swartz Private Equity March 25, 2002 1,237,500 $ 0.03300 April 1, 2011 Lincoln Ventures April 23, 2002 2,514,809 $ 0.04685 April 1, 2011 Lincoln Ventures June 10, 2002 7,674,853 $ 0.06422 April 1, 2011 Charles Moore June 10, 2002 333,689 $ 0.06422 June 10, 2007 Victor Gabourel June 10, 2002 333,689 $ 0.06422 June 10, 2007 James Zolin June 10, 2002 333,689 $ 0.06422 June 10, 2007 Richard Daniels June 10, 2002 333,689 $ 0.06422 June 10, 2007 Swartz Private Equity July 1, 2002 635,318 $ 0.05400 April 1, 2011 Gloria Felcyn, TEE August 23, 2002 2,767,674 $ 0.04381 August 23, 2007 Swartz Private Equity October 1, 2002 1,294,013 $ 0.04000 April 1, 2011 Cliff Koerner October 29, 2002 448,732 $ 0.05126 October 29, 2007 Frederick Feck, Trustee October 29, 2002 560,915 $ 0.05126 October 29, 2007 Stan Caplan October 29, 2002 560,915 $ 0.05126 October 29, 2007 Dan Nunes October 29, 2002 280,458 $ 0.05126 October 29, 2007 Leo Correia October 29, 2002 280,458 $ 0.05126 October 29, 2007 Victor Gabourel October 29, 2002 560,915 $ 0.05126 October 29, 2007 Richard Daniels October 29, 2002 560,915 $ 0.05126 October 29, 2007 Cliff Koerner October 29, 2002 560,915 $ 0.05126 October 29, 2007 James Zolin October 29, 2002 224,366 $ 0.05126 October 29, 2007 Lincoln Ventures December 16, 2002 1,428,571 $ 0.06233 April 1, 2011 Swartz Private Equity January 1, 2003 2,804,719 $ 0.05400 April 1, 2011 Lincoln Ventures January 24, 2003 3,000,000 $ 0.05444 April 1, 2011 Lincoln Ventures March 24, 2003 3,963,414 $ 0.04100 April 1, 2011 Swartz Private Equity April 1, 2003 621,512 $ 0.04080 April 1, 2011 Lincoln Ventures April 15, 2003 222,222 $ 0.04500 April 1, 2011 Lincoln Ventures May 20, 2003 2,884,615 $ 0.06500 April 1, 2011 Lincoln Ventures June 9, 2003 2,307,692 $ 0.06500 April 1, 2011 Hawk Associates June 16, 2003 200,000 $ 0.06000 June 16, 2008 Swartz Private Equity July 1, 2003 193,333 $ 0.05720 April 1, 2011 James Zolin August 1, 2003 520,833 $ 0.04800 August 1, 2008 Victor Gabourel August 1, 2003 520,833 $ 0.04800 August 1, 2008 Richard Daniels August 1, 2003 520,833 $ 0.04800 August 1, 2008 Lincoln Ventures October 21, 2003 2,142,857 $ 0.03500 April 1, 2011
II-3
Number of Initial Exercise Expiration Name Date of Issuance Shares Price Per Share Date - --------------------- -------------------- ---------- ----------------- ------------- Swartz Private Equity October 1, 2003 1,557,653 $ 0.04360 April 1, 2011 Charles Merk December 1, 2003 641,026 $ 0.03900 December 1, 2008 Swartz Private Equity January 1, 2004 3,051,299 $ 0.04600 April 1, 2011 Lincoln Ventures LLC January 23, 2004 10,311,211 $ 0.02667 April 1, 2011 Stan Caplan February 2, 2004 375,000 $ 0.04000 February 2, 2009 Wayne Opperman February 2, 2004 1,250,000 $ 0.04000 February 2, 2009 James Gamble February 2, 2004 125,000 $ 0.04000 February 2, 2009 Steven Pratt February 2, 2004 250,000 $ 0.04000 February 2, 2009 Donald Opperman February 2, 2004 250,000 $ 0.04000 February 2, 2009 Gary Leikam February 2, 2004 125,000 $ 0.04000 February 2, 2009 Adnan Aladray February 2, 2004 250,000 $ 0.04000 February 2, 2009 Nazeah Aladray February 2, 2004 125,000 $ 0.04000 February 2, 2009 LaRiccia Trust February 2, 2004 250,000 $ 0.04000 February 2, 2009 James & Josephine Zolin February 2, 2004 750,000 $ 0.04000 February 2, 2009 James Zolin February 2, 2004 125,000 $ 0.04000 February 2, 2009 Victor Gabourel February 2, 2004 625,000 $ 0.04000 February 2, 2009 Ed Kashou February 2, 2004 500,000 $ 0.04000 February 2, 2009 Ed Kashou February 2, 2004 1,000,000 $ 0.04000 February 2, 2009 Dan Vincent February 2, 2004 125,000 $ 0.04000 February 2, 2009 Richard Daniels February 2, 2004 750,000 $ 0.04000 February 2, 2009 Stan Caplan February 2, 2004 750,000 $ 0.04000 February 2, 2009 Barbara Opperman February 2, 2004 250,000 $ 0.04000 February 2, 2009 Leo Correia February 2, 2004 250,000 $ 0.04000 February 2, 2009 Swartz Private Equity March 23, 2004 8,035,192 $ 0.09000 April 1, 2011 Lincoln Ventures LLC March 24, 2004 3,366,727 $ 0.09383 April 1, 2011 Swartz Private Equity April 1, 2004 5,240,211 $ 0.08090 April 1, 2009 Mt. Savage Productions April 26, 2004 1,000,000 $ 0.10000 April 26, 2009 Lincoln Ventures LLC May 11, 2004 6,951,428 $ 0.07000 April 1, 2011 Swartz Private Equity July 1, 2004 801,444 $ 0.06720 July 1, 2009 Wayne Opperman September 28, 2004 1,250,000 $ 0.04000 September 28, 2009 Wayne Opperman November 16, 2004 1,600,000 $ 0.02500 November 16, 2011 James & Josephine Zolin November 16, 2004 1,600,000 $ 0.02500 November 16, 2011 Victor Gabourel November 16, 2004 1,600,000 $ 0.02500 November 16, 2011 Richard Daniels November 16, 2004 1,000,000 $ 0.02500 November 16, 2011 Lincoln Ventures LLC November 17, 2004 9,431,137 $ 0.01670 April 1, 2011 Lincoln Ventures LLC November 18, 2004 4,000,000 $ 0.02500 April 1, 2011 Stan Caplan December 9, 2004 806,452 $ 0.03100 December 9, 2011 Daniel Nunes January 17, 2005 403,226 $ 0.03100 January 17, 2012
ITEM 27. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES. The Exhibits and Financial Statement Schedules to this Registration Statement are listed in the Exhibit Index commencing at page EX-1 hereof. II-4 ITEM 28. UNDERTAKINGS. The undersigned Registrant hereby undertakes the following: (1) To file, during any period in which offers or sales are being made, a post-effective amendment to this Registration Statement: (i) to include any prospectus required by Section 10(a)(3) of the Securities Act of 1933; (ii) to reflect in the prospectus any facts or events arising after the effective date of this Registration Statement (or the most recent post-effective amendment thereof) which, individually or in the aggregate, represent a fundamental change in the information in this Registration Statement; and (iii) to include any material information with respect to the plan of distribution not previously disclosed in this registration, or any material change to such information in the Registration Statement. (2) That, for the purpose of determining any liability under the Securities Act of 1933, each such post-effective amendment shall be deemed to be a new registration statement relating to the securities offered therein, and the offering of such securities at that time shall be deemed to be the initial bona fide offering thereof. (3) To remove from registration by means of a post-effective amendment to this Registration Statement any of the securities being registered which remain unsold at the termination of this offering. Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers or persons controlling the Registrant pursuant to the General Corporation Law of Delaware, the Certificate of Incorporation, or otherwise, the Registrant has been advised that, in the opinion of the Securities and Exchange Commission, such indemnification is against public policy as expressed in such Act, and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the Registrant of expenses incurred or paid by a director, officer or person controlling the Registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer or person controlling the Registrant in connection with any securities being registered, the Registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in such Act and will be governed by the final adjudication of such issue. II-5 SIGNATURES In accordance with the requirements of the Securities Act of 1933, the registrant certifies that it has reasonable grounds to believe that it meets all of the requirements of filing on Form SB-2 and authorized this registration statement to be signed on its behalf by the undersigned, in the City of San Diego, State of California, on January 31, 2005 PATRIOT SCIENTIFIC CORPORATION By: /s/ LOWELL W. GIFFHORN ------------------------------- Lowell W. Giffhorn Executive Vice President, Chief Financial Officer, Secretary and Director In accordance with the requirements of the Securities Act of 1933, this registration statement was signed by the following persons in the capacities and on the dates stated:
Signature Title Date --------- ----- ---- /s/JEFFREY E. WALLIN President and Chief Executive January 31, 2005 - -------------------- Officer Jeffrey E. Wallin /s/LOWELL W. GIFFHORN Chief Financial Officer, Principal January 31, 2005 - --------------------- Financial Officer, Principal Lowell W. Giffhorn Accounting Officer, Secretary and Director /s/DAVID POHL Director January 31, 2005 - ------------- David Pohl /s/CARLTON JOHNSON Director January 31, 2005 - -------------------------- Carlton Johnson /s/HELMUT FALK JR. Director January 31, 2005 - ------------------ Helmut Falk Jr. /s/GLORIA H. FELCYN Director January 31, 2005 - ------------------- Gloria H. Felcyn
II-6 SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM SB-2 Registration Statement Under The Securities Act of 1933 EXHIBITS PATRIOT SCIENTIFIC CORPORATION (Exact name of registrant as specified in its charter) II-7 PATRIOT SCIENTIFIC CORPORATION (a) Exhibits The following exhibits are included as part of this registration statement, except those exhibits marked (1), which have previously been filed with the Securities and Exchange Commission and are incorporated by reference to another registration statement, report or document. References to the "Company" in this Exhibit Index mean PATRIOT SCIENTIFIC CORPORATION, a Delaware corporation.
Exhibit No. Document No. - ----------- -------- --- 2.0 PLAN OF ACQUISITION, REORGANIZATION, ARRANGEMENT, LIQUIDATION OR SUCCESSION. 2.1 Agreement to Exchange Technology for Stock in Patriot Scientific Corporation, (1) incorporated by reference to Exhibit 2.1 to Form 8-K dated August 10, 1989 2.2 Assets Purchase Agreement and Plan of Reorganization dated June 22, 1994, among (1) the Company, nanoTronics Corporation and Helmut Falk, incorporated by reference to Exhibit 10.4 to Form 8-K dated July 6, 1994 2.2.1 Amendment to Development Agreement dated April 23, 1996 between the Company and (1) Sierra Systems, incorporated by reference to Exhibit 2.2.1 to Pre-Effective Amendment No. 1 to Registration Statement on Form SB-2 dated April 29, 1996 2.3 Form of Exchange Offer dated December 4, 1996 between the Company and certain (1) shareholders of Metacomp, Inc. incorporated by reference to Exhibit 2.3 to Form 8-K dated January 9, 1997 2.4 Letter of Transmittal to Accompany Shares of Common Stock of Metacomp, Inc. (1) Tendered Pursuant to the Exchange Offer Dated December 4, 1996 incorporated by reference to Exhibit 2.4 to Form 8-K dated January 9, 1997 3.0 ARTICLES AND BYLAWS. 3.1 Original Articles of Incorporation of the Company's predecessor, Patriot Financial (1) Corporation, incorporated by reference to Exhibit 3.1 to registration statement on Form S-18, file no. 33-23143-FW 3.2 Articles of Amendment of Patriot Financial Corporation, as filed with the Colorado (1) Secretary of State on July 21, 1988, incorporated by reference to Exhibit 3.2 to registration statement on Form S-18, File No. 33-23143-FW 3.3 Certificate of Incorporation of the Company, as filed with the Delaware Secretary (1) of State on March 24, 1992, incorporated by reference to Exhibit 3.3 to Form 8-K dated May 12, 1992 3.3.1 Certificate of Amendment to the Certificate of Incorporation of the Company, as (1) filed with the Delaware Secretary of State on April 18, 1995, incorporated by reference to Exhibit 3.3.1 to Form 10-KSB for the fiscal year ended May 31, 1995 II-8 3.3.2 Certificate of Amendment to the Certificate of Incorporation of the Company, as (1) filed with the Delaware Secretary of State on June 19,1997, incorporated by reference to Exhibit 3.3.2 to Form 10-KSB for the fiscal year ended May 31, 1997 3.3.3 Certificate of Amendment to the Certificate of Incorporation of the Company, as (1) filed with the Delaware Secretary of State on April 28, 2000, incorporated by reference to Exhibit 3.3.3 to Registration Statement on Form S-3 dated May 5, 2000 3.3.4 Certificate of Amendment to the Certificate of Incorporation of the Company, as (1) filed with the Delaware Secretary of State on May 6, 2002, incorporated by reference to Exhibit 3.3.4 to Registration Statement on Form S-3 dated June 27, 2002 3.3.5 Certificate of Amendment to the Certificate of Incorporation of the Company, as (1) filed with the Delaware Secretary of State on October 16, 2003, incorporated by reference to Exhibit 3.3.5 to Registration Statement on Form SB-2 dated May 21, 2004+B96 3.4 Articles and Certificate of Merger of Patriot Financial Corporation into the (1) Company dated May 1, 1992, with Agreement and Plan of Merger attached thereto as Exhibit A, incorporated by reference to Exhibit 3.4 to Form 8-K dated May 12, 1992 3.5 Certificate of Merger issued by the Delaware Secretary of State on May 8, 1992, (1) incorporated by reference to Exhibit 3.5 to Form 8-K dated May 12, 1992 3.6 Certificate of Merger issued by the Colorado Secretary of State on May 12, 1992, (1) incorporated by reference to Exhibit 3.6 to Form 8-K dated May 12, 1992 3.7 Bylaws of the Company, incorporated by reference to Exhibit 3.7 to Form 8-K dated (1) May 12, 1992 4.0 INSTRUMENTS ESTABLISHING RIGHTS OF SECURITY HOLDERS. 4.1 Specimen common stock certificate, incorporated by reference to Exhibit 4.1 Form (1) 8-K dated May 12, 1992 4.2 Form of Stock Purchase Warrant (Labway Corporation) dated February 29, 1996, (1) exercisable to purchase 253,166 common shares at $1.58 per share until August 31, 1996, granted to investors in connection with an offering of securities made in reliance upon Regulation S, incorporated by reference to Exhibit 4.2 to Form 10-QSB for fiscal quarter ended February 29, 1996 4.3 Form of 6% Convertible Subordinated Promissory Note due September 30, 1998 (1) aggregating $1,500,000 to six investors incorporated by reference to Exhibit 4.3 to Form 10-QSB for fiscal quarter ended August 31, 1996 4.4 Form of 5% Convertible Term Debenture (CC Investments, LDC) due June 2, 1999 (1) aggregating $2,000,000 to two investors incorporated by reference to Exhibit 4.4 to Form 8-K dated June 16, 1997 II-9 4.5 Form of Stock Purchase Warrant (CC Investments, LDC) dated June 2, 1997 (1) exercisable to purchase an aggregate of 400,000 common shares at $1.69125 per share until June 2, 2002, granted to two investors in connection with the offering of securities in Exhibit 4.4 incorporated by reference to Exhibit 4.5 to Form 8-K dated June 16, 1997 4.6 Registration Rights Agreement dated June 2, 1997 by and among the Company and CC (1) Investments, LDC and the Matthew Fund, N.V. related to the registration of the common stock related to Exhibits 4.4 and 4.5 incorporated by reference to Exhibit 4.6 to Form 8-K dated June 16, 1997 4.7 Form of Warrant to Purchase Common Stock (Swartz Family Partnership, L.P.) dated (1) June 2, 1997 exercisable to purchase an aggregate of 211,733 common shares at $1.69125 per share until June 2, 2002, granted to a group of investors in connection with the offering of securities in Exhibit 4.4 incorporated by reference to Exhibit 4.7 to Form 8-K dated June 16, 1997 4.8 Registration Rights Agreement dated June 2, 1997 by and among the Company and (1) Swartz Investments, LLC related to the registration of the common stock related to Exhibit 4.7 incorporated by reference to Exhibit 4.8 to Form 8-K dated June 16, 1997 4.9 Form of 5% Convertible Term Debenture (CC Investments, LDC) due June 2, 1999 (1) aggregating $1,000,000 to two investors incorporated by reference to Exhibit 4.9 to Form 10-KSB for the fiscal year ended May 31, 1998 4.10 Form of Stock Purchase Warrant (CC Investments, LDC) dated November 24, 1997 (1) exercisable to purchase an aggregate of 200,000 common shares at $1.50 per share until June 2, 2002, granted to two investors in connection with the offering of securities described in Exhibit 4.9 incorporated by reference to Exhibit 4.10 to Form 10-KSB for the year ended May 31, 1998 4.11 Form of Warrant to Purchase Common Stock (Swartz Family Partnership, L.P.) dated (1) November 24, 1997 exercisable to purchase an aggregate of 105,867 common shares at $1.50 per share until June 2, 2002, granted to a group of investors in connection with the offering of securities described in Exhibit 4.9 incorporated by reference to Exhibit 4.11 to Form 10-KSB for the year ended May 31, 1998 4.12 Form of Warrant to Purchase Common Stock (Investor Communications Group, Inc.) (1) dated June 16, 1997 exercisable to purchase an aggregate of 130,000 common shares at prices ranging from $2.50 to $7.50 per share until June 15, 1999 incorporated by reference to Exhibit 4.12 to Form 10-KSB for the year ended May 31, 1998 4.13 Warrant to Purchase Common Stock issued to Spellcaster Telecommunications, Inc. (1) dated April 28, 1998 exercisable to purchase an aggregate of 100,000 common shares at $1.25 per share until April 28, 2000 incorporated by reference to Exhibit 4.13 to Form 10-KSB for the year ended May 31, 1998 II-10 4.14 Investment agreement dated February 24, 1999 by and between the Company and Swartz (1) Private Equity, LLC for a maximum aggregate amount of $5,000,000 incorporated by reference to Exhibit 4.14 to Form 10-QSB/A for the fiscal quarter ended November 30, 1998 4.15 Registration Rights Agreement dated February 24, 1999 by and between the Company (1) and Swartz Private Equity, LLC related to the registration of the common stock related to Exhibit 4.14 incorporated by reference to Exhibit 4.15 to Form 10-QSB/A for the fiscal quarter ended November 30, 1998 4.16 Form of Warrant to Purchase Common Stock (Swartz Private Equity, LLC) dated (1) February 24, 1999 exercisable to purchase common shares in connection with the offering of securities in Exhibit 4.14 incorporated by reference to Exhibit 4.16 to Form 10-QSB/A for the fiscal quarter ended November 30, 1998 4.17 Amended and Restated Investment Agreement dated July 12, 1999 by and between the (1) Company and Swartz Private Equity, LLC for a maximum aggregate amount of $5,000,000 incorporated by reference to Exhibit 4.17 to Pre-Effective Amendment No. 2 to Registration Statement on Form SB-2 dated July 14, 1999 4.18 Investment Agreement dated April 28, 2000 by and between the Company and Swartz (1) Private Equity, LLC for a maximum aggregate amount of $30,000,000 incorporated by reference to Exhibit 4.18 to Registration Statement on Form S-3 dated May 5, 2000 4.18.1 Waiver and Agreement dated September 24, 2001 amending the Investment Agreement (1) dated April 28, 2000 by and between the Company and Swartz Private Equity, LLC for a maximum aggregate amount of $30,000,000 incorporated by reference to Exhibit 4.18.1 to Registration Statement on Form S-1 dated October 11, 2001 4.19 2001 Stock Option Plan of the Company dated February 21, 2001 incorporated by (1) reference to Exhibit 4.19 to Registration Statement on Form S-8 dated March 26, 2001 4.20 Investment agreement dated September 17, 2001 by and between the Company and (1) Swartz Private Equity, LLC for a maximum aggregate amount of $25,000,000 incorporated by reference to Exhibit 4.20 to Registration Statement on Form S-1 dated October 11, 2001 4.21 Registration Rights Agreement dated September 17, 2001 by and between the Company (1) and Swartz Private Equity, LLC related to the registration of the common stock related to Exhibit 4.20 incorporated by reference to Exhibit 4.21to Registration Statement on Form S-1 dated October 11, 2001 4.22 Warrant to Purchase Common Stock dated September 17, 2001 exercisable to purchase (1) common shares in connection with the Offering of securities in Exhibit 4.20 incorporated by reference to Exhibit 4.22 to Registration Statement on Form S-1 dated October 11, 2001 4.23 Financial Consulting Services Agreement between the Company and M. Blaine Riley, (1) Randall Letcavage and Rosemary Nguyen incorporated by reference to Exhibit 4.23 to Registration Statement on Form S-8 dated January 22, 2002 II-11 4.24 Form of 8% Convertible Debenture (Lincoln Ventures, LLC) due June 10, 2004 (1) aggregating $1,000,000 to six investors incorporated by reference to Exhibit 4.24 to Registration Statement on Form S-3 dated June 27, 2002 4.25 Form of Stock Purchase Warrant (Lincoln Ventures, LLC) dated June 10, 2002 (1) exercisable to purchase an aggregate of 12,859,175 common shares at initial exercise prices ranging form $0.08616 to $0.10289 per share until June 10, 2007, granted to six investors in connection with the offering of securities described in Exhibit 4.24 incorporated by reference to Exhibit 4.25 to Registration Statement on Form S-3 dated June 27, 2002 4.26 Form of Registration Rights Agreement (Lincoln Ventures, LLC) dated June 10, 2002 (1) by and among the Company and six investors related to the registration of the common stock related to Exhibit 4.24 incorporated by reference to Exhibit 4.26 to Registration Statement on Form S-3 dated June 27, 2002 4.27 2003 Stock Option Plan of the Company dated July 2, 2003 incorporated by reference (1) to Exhibit 4.27 to Registration Statement on Form S-8 dated September 4, 2003 4.28 Form of 8% Convertible Debenture, Stock Purchase Warrant, Registration Rights (2) Agreement and Securities Purchase Agreement for financings entered into between September 28, 2004 and January 17, 2005 10.0 MATERIAL CONTRACTS. 10.1 1992 Incentive Stock Option Plan of the Company, incorporated by reference to (1) Exhibit 10.1 to Form 8-K dated May 12, 1992 10.1.1 Amendment to 1992 Incentive Stock Option Plan dated January 11, 1995, incorporated (1) by reference to Exhibit 10.1.1 to Form S-8 dated July 17, 1996 10.2 1992 Non-Statutory Stock Option Plan of the Company, incorporated by reference to (1) Exhibit 10.2 to Form 8-K dated May 12, 1992 10.2.1 Amendment to 1992 Non-Statutory Stock Option Plan dated January 11, 1995 (1) incorporated by reference to Exhibit 10.2.1 to Form 10-KSB for fiscal year ended May 31, 1996 10.3 Lease Agreement between the Company's subsidiary Metacomp, Inc. and Clar-O-Wood (1) Partnership, a California limited partnership dated April 11, 1991 as amended November 11, 1992 and November 2, 1995 incorporated by reference to Exhibit 10.3 to Form 10-KSB for fiscal year ended May 31, 1997 10.4 Stock Purchase Agreement dated November 29 and 30, 1995, between the Company and (1) SEA, Ltd., incorporated by reference to Exhibit 10.4 to Form 8-K dated December 11, 1995 10.4.1 Letter Amendment to Stock Purchase Agreement dated February 21, 1996, between the (1) Company and SEA, Ltd., incorporated by reference to Exhibit 10.4.1 to Form 10-QSB for fiscal quarter ended 2/29/96 II-12 10.5 1995 Employee Stock Compensation Plan of the Company, incorporated by reference to (1) Exhibit 10.5 to Form 10-QSB for fiscal quarter ended 11/30/95 10.6 Letter Stock and Warrant Agreement dated January 10, 1996 between the Company and (1) Robert E. Crawford, Jr., incorporated by reference to Exhibit 10.6 to Form 10-QSB for fiscal quarter ended February 29, 1996 10.7 Non-Exclusive Manufacturing and Line of Credit Agreement dated February 28, 1996, (1) between the Company and Labway Corporation, incorporated by reference to Exhibit 10.7 to Form 10-QSB for fiscal quarter ended February 29, 1996 10.8 Distribution and Representation Agreement dated February 28, 1996, between the (1) Company and Innoware, Inc., incorporated by reference to Exhibit 10.8 to Form 10-QSB for fiscal quarter ended February 29, 1996 10.9 Employment Agreement dated November 20, 1995 between the Company and Elwood G. (1) Norris, incorporated by reference to Exhibit 10.9 to Registration Statement on Form SB-2 dated March 18, 1996 10.9.1 First Amendment to Employment Agreement dated May 17, 1996 between the Company and (1) Elwood G. Norris, incorporated by reference to Exhibit 10.9.1 to Pre-Effective Amendment No. 2 to Registration Statement on Form SB-2 dated May 23, 1996 10.10 Employment Agreement dated November 20, 1995 between the Company and Robert (1) Putnam, incorporated by reference to Exhibit 10.10 to Registration Statement on Form SB-2 dated March 18, 1996 10.11 Sales Contractual Agreement dated March 19, 1996 between the Company and Evolve (1) Software, Inc., incorporated by reference to Exhibit 10.11 to Pre-Effective Amendment No. 1 to Registration Statement on Form SB-2 dated April 29, 1996 10.11.1 Two Year Stock Purchase Warrant dated March 19, 1996 Granted to Evolve Software, (1) Inc. Providing for the Purchase of up to 50,000 Common Shares at $2.85, incorporated by reference to Exhibit 10.11.1 to Pre-Effective Amendment No. 1 to Registration Statement on Form SB-2 dated April 29, 1996 10.12 Employment Agreement dated as of May 8, 1996 between the Company and Michael A. (1) Carenzo, including Schedule A - Stock Option Agreement, incorporated by reference to Exhibit 10.12 to Pre-Effective Amendment No. 2 to Registration Statement on Form SB-2 dated May 23, 1996 10.12.1 First Amendment to Employment Agreement dated as of May 8, 1996 between the (1) Company and Michael A. Carenzo dated September 23, 1996, incorporated by reference to Exhibit 10.12.1 to Form 10-KSB for the fiscal year ended May 31, 1997 10.13 1996 Stock Option Plan of the Company dated March 25, 1996 and approved by the (1) Shareholders on May 17, 1996, incorporated by reference to Exhibit 10.13 to Pre-Effective Amendment No. 2 to Registration Statement on Form SB-2 dated May 23, 1996 II-13 10.14 Sales Contractual Agreement dated June 20, 1996 between the Company and (1) Compunetics Incorporated incorporated by reference to Exhibit 10.14 to Form 10-KSB for fiscal year ended May 31, 1996 10.15 Sales Contractual Agreement dated July 31, 1996 between the Company and Premier (1) Technical Sales, Inc. incorporated by reference to Exhibit 10.15 to Form 10-KSB for fiscal year ended May 31, 1996 10.16 Employment Agreement dated January 1, 1997 between the Company and Norman J. (1) Dawson incorporated by reference to Exhibit 10.16 to Form 10-KSB for fiscal year ended May 31, 1997 10.17 Employment Agreement dated January 1, 1997 between the Company and Jayanta K. (1) Maitra incorporated by reference to Exhibit 10.17 to Form 10-KSB for fiscal year ended May 31, 1997 10.18 Technology License and Distribution Agreement dated June 23, 1997 between the (1) Company and Sun Microsystems, Inc. incorporated by reference to Exhibit 10.18 to Form 10-KSB for the fiscal year ended May 31, 1997 10.19 Employment Agreement dated March 23, 1998 between the Company and James T. Lunney (1) incorporated by reference to Exhibit 10.19 to Form 10-KSB for the fiscal year ended May 31, 1998 10.20 Employment Agreement dated July 28, 1997 between the Company and Phillip Morettini (1) incorporated by reference to Exhibit 10.20 to Form 10-KSB for the fiscal year ended May 31, 1998 10.21 Employment Agreement dated July 23, 1998 between the Company and Lowell W. (1) Giffhorn incorporated by reference to Exhibit 10.21 to Form 10-KSB for the fiscal year ended May 31, 1998 10.22 Secured Promissory Note dated June 12, 2000 between the Company and James T. (1) Lunney incorporated by reference to Exhibit 10.22 to Form 10-KSB for the fiscal year ended May 31, 2000 10.23 Purchase Agreement dated June 29, 2000 between the Company and 4S 37/38, LLC (1) incorporated by reference to Exhibit 10.23 to Form 10-KSB for the fiscal year ended May 31, 2000 10.24 Employment Agreement dated October 2, 2000 between the Company and Miklos B. (1) Korodi incorporated by reference to Exhibit 10.24 to Form 10-QSB for the fiscal quarter ended November 30, 2000 10.25 Employment Agreement dated December 1, 2000 between the Company and Richard G. (1) Blum incorporated by reference to Exhibit 10.25 to Form 10-QSB for the fiscal quarter ended November 30, 2000 10.26 Employment Agreement dated January 29, 2001 between the Company and Serge J. (1) Miller incorporated by reference to Exhibit 10.26 to Form 10-KSB for the fiscal year ended May 31, 2001 II-14 10.27 Lease Agreement dated February 23, 2001 between the Company and Arden Realty (1) Finance IV, LLC incorporated by reference to Exhibit 10.27 to Form 10-KSB for the fiscal year ended May 31, 2001 10.28 Employment Agreement dated January 1, 2001 between the Company and David H. Pohl (1) incorporated by reference to Exhibit 10.28 to Form 10-KSB for the fiscal year ended May 31, 2001 10.29 Employment Agreement dated April 26, 2001 between the Company and David H. Pohl (1) incorporated by reference to Exhibit 10.29 to Form 10-KSB for the fiscal year ended May 31, 2001 10.30 Employment Agreement dated November 17, 2001 between the Company and Lowell W. (1) Giffhorn incorporated by reference to Exhibit 10.30 to Registration Statement on Form S-3 dated June 27, 2002 10.31 Employment Agreement dated December 20, 2001 between the Company and Jayanta (1) Maitra incorporated by reference to Exhibit 10.31 to Registration Statement on Form S-3 dated June 27, 2002 10.32 Consulting Agreement dated March 7, 2002 between the Company and SDMC, Inc. (1) incorporated by reference to Exhibit 10.32 to Registration Statement on Form S-3 dated June 27, 2002 10.33 Employment Agreement dated January 2, 2004 between the Company and Jayanta Maitra (1) incorporated by reference to Exhibit 10.33 to Registration Statement on Form SB-2 dated May 21, 2004 10.34 Consulting Agreement dated March 18, 2004 between the Company and SDMC, Inc. (1) incorporated by reference to Exhibit 10.34 to Registration Statement on Form SB-2 dated May 21, 2004 10.35 Employment Agreement dated June 1, 2004 between the Company and Patrick Nunally (1) incorporated by reference to Exhibit 10.35 to Form 10-K for the fiscal year ended May 31, 2004 10.36 Amendment No. 1 to Employment Agreement dated July 12, 2004 between the Company (1) and Patrick Nunally 10.37 Employment Agreement dated September 1, 2004 between the Company and Lowell W. (2) Giffhorn 14.0 CODE OF ETHICS. 14.1 Code of Ethics for Senior Financial Officers incorporated by reference to Exhibit (1) 14.1 to Form 10-K for the fiscal year ended May 31, 2003 21.0 SUBSIDIARIES OF THE SMALL BUSINESS ISSUER. 21.1 Subsidiaries of the small business issuer incorporated by reference to Exhibit (1) 21.1 to Form 10-K for the fiscal year ended May 31, 2004 23.0 CONSENTS OF EXPERTS AND COUNSEL. II-15 23.1 Consent of Nation Smith Hermes Diamond, LLP independent registered certified (2) public accounting firm 99.0 ADDITIONAL EXHIBITS. 99.1 Form of ISO Plan Option (Gaspar) dated May 29, 1992, incorporated by reference to (1) Exhibit 28.2 to registration statement on Form SB-2, file no. 33-57858 99.2 Form of NSO Plan Option (Berlin) dated May 29, 1992, incorporated by reference to (1) Exhibit 28.3 to registration statement on Form SB-2, file no. 33-57858 99.3 Form of Incentive Stock Option Agreement to the Company's 1996 Stock Option Plan (1) (individual agreements differ as to number of shares, dates, prices and vesting), incorporated by reference to Pre-Effective Amendment No. 2 to Registration Statement on Form SB-2 dated May 23, 1996 99.4 Form of NonQualified Stock Option Agreement to the Company's 1996 Stock Option (1) Plan (individual agreement differ as to number of shares, date, prices and vesting), incorporated by reference to Pre-Effective Amendment No. 2 to Registration Statement on Form SB-2 dated May 23, 1996 99.5 Press Release of the Company dated November 4, 1996 incorporated by reference to (1) Exbibit 99.5 to Form 8-K dated January 9, 1997 99.6 Form of Incentive Stock Option Agreement to the Company's 2001 Stock Option Plan (1) incorporated by reference to Exhibit 99.6 to Registration Statement on Form S-8 filed March 26, 2001 99.7 Form of Non-Qualified Stock Option Agreement to the Company's 2001 Stock Option (1) Plan incorporated by reference to Exhibit 99.7 to Registration Statement on Form S-8 filed March 26, 2001 99.8 Form of Incentive Stock Option Agreement to the Company's 2003 Stock Option Plan (1) incorporated by reference to Exhibit 99.8 to Registration Statement on Form S-8 filed September 4, 2003 99.9 Form of Non-Qualified Stock Option Agreement to the Company's 2003 Stock Option (1) Plan incorporated by reference to Exhibit 99.9 to Registration Statement on Form S-8 filed September 4, 2003
- ---------- (1) Previously filed in indicated registration statement or report. (2) Exhibit filed herewith this Registration Statement on Form SB-2. (b) Reports on Form 8-K - A report on Form 8-K was filed on December 22, 2004, related to the resignation of a director and chairman of the board. II-16 All other schedules have been omitted because the information required to be set forth therein is not applicable or is shown in the Consolidated Financial Statements or the Notes thereto. II-17 EX-4.28 2 v011943_ex4-28.txt EXHIBIT 4.28 SECURITIES PURCHASE AGREEMENT SECURITIES PURCHASE AGREEMENT (this "AGREEMENT"), dated as of {{FundDate}}, by and among PATRIOT SCIENTIFIC CORPORATION, a Delaware corporation, ("COMPANY"), and {{FirstName}} {{LastName}}, an individual (the "BUYER"). WHEREAS: A. The Company and the Buyer are executing and delivering this Agreement in reliance upon the exemption from securities registration afforded by Rule 506 under Regulation D ("REGULATION D") as promulgated by the United States Securities and Exchange Commission (the "SEC") under the Securities Act of 1933, as amended (the "1933 ACT"); B. Buyer desires to purchase and the Company desires to issue and sell, upon the terms and conditions set forth in this Agreement (i) convertible debentures of the Company, in the form attached hereto as EXHIBIT "A", in the aggregate principal amount (the "ORIGINAL PRINCIPAL AMOUNT") of {{AmtSpell}}Thousand Dollars ({{DebDol}}) (together with any debenture(s) issued in replacement thereof or as a dividend thereon or otherwise with respect thereto in accordance with the terms thereof, the "DEBENTURES"), convertible into shares of common stock, $0.00001 par value per share, of the Company (the "COMMON STOCK"), upon the terms and subject to the limitations and conditions set forth in such Debentures and (ii) warrants (the "WARRANTS"), in the form attached hereto as EXHIBIT "B", to purchase {{NoWarrants}} shares (the "WARRANT AMOUNT") of Common Stock ; and C. Contemporaneous with the execution and delivery of this Agreement, the parties hereto are executing and delivering a Registration Rights Agreement, in the form attached hereto as EXHIBIT "C" (the "REGISTRATION RIGHTS AGREEMENT"), pursuant to which the Company has agreed to provide certain registration rights under the 1933 Act and the rules and regulations promulgated thereunder, and applicable state securities laws. NOW THEREFORE, the Company and the Buyer hereby agree as follows: 1. PURCHASE AND SALE OF DEBENTURES AND WARRANTS. (A) PURCHASE OF DEBENTURES AND WARRANTS. On the Closing Date (as defined below), the Company shall issue and sell to Buyer and Buyer agrees to purchase from the Company {{DebDol}} in principal amount (the "Original Principal Amount") of Debentures and an accompanying number of Warrants, in the form of EXHIBIT "B" attached, to purchase a number of shares equal to the Warrant Amount. 19 (B) FORM OF PAYMENT. On or before the Closing Date (as defined below), (i) Buyer shall pay the purchase price for the Debentures and the Warrants to be issued and sold to it at the Closing (as defined below) (the "PURCHASE PRICE") by wire transfer of immediately available funds to the Company, in accordance with the Company's written wiring instructions, against delivery of duly executed Debentures in the principal amount equal to the Purchase Price and the number of Warrants equal to the Warrant Amount, and (ii) the Company shall deliver such Debentures and Warrants duly executed on behalf of the Company, to such Buyer, against delivery of such Purchase Price. The Buyer agrees to provide a check for the Purchase Price on the date hereof. (C) CLOSING DATE. Subject to the satisfaction (or waiver) of the conditions thereto set forth in Section 6 and Section 7 below, the date and time of the issuance and sale of the Debentures and the Warrants pursuant to this Agreement (the "CLOSING DATE") shall be 4:00 PM Eastern Standard Time on {{FundDate}} or such other mutually agreed upon time. The closing of the transactions contemplated by this Agreement (the "CLOSING") shall occur on the Closing Date at the offices of the Buyer, or at such other location as may be agreed to by the parties. (D) BUYER'S OPTION TO PURCHASE ADDITIONAL DEBENTURES. The Buyer, at its option upon written notice ("Option Notice") to the Company given anytime during the two (2) year period immediately following the date hereof, may elect to purchase additional debentures (the "Additional Debentures") in one or more transactions totaling an aggregate of any amount less than or equal to the Original Principal Amount of Debentures originally purchased by Buyer, PROVIDED THAT the Buyer may not give an Option Notice on any date that the Market Price is less than $0.20. The closing of the purchase and sale of each Additional Debenture ("Additional Closing Date") shall occur within five (5) business days after the date that the Company first receives a copy of the applicable Option Notice. Each Additional Debenture shall be in the form of the Debenture annexed hereto as EXHIBIT "A," except that the "Initial Conversion Price," as defined therein, shall equal a negotiated price or 115% of the Market Price (as defined below) on the date of such closing. Each Additional Debenture shall be accompanied by a number of warrants ("Additional Warrants") equal to the original principal amount of the associated Additional Debenture, divided by the Market Price (as defined below) on the date of such closing. Each Additional Warrant shall be in the form of the Warrant annexed hereto as EXHIBIT "B," except that the initial "Exercise Price," as defined therein, shall equal a negotiated price or 115% of the Market Price (as defined below) on the date of such closing. 20 "MARKET PRICE," for any security as of any date, shall have the meaning ascribed to it in the Debentures. 2. BUYER'S REPRESENTATIONS AND WARRANTIES. Buyer represents and warrants to the Company solely as to such Buyer that: (A) INVESTMENT PURPOSE. As of the date hereof, the Buyer is purchasing the Debentures and the shares of Common Stock issuable upon conversion of or otherwise pursuant to the Debentures (including, without limitation, such additional shares of Common Stock as are issuable as a result of the events described in Sections 1.3 and 1.4 of the Debentures and Section 2 of the Registration Rights Agreement) (such shares of Common Stock being collectively referred to herein as the "CONVERSION SHARES") and the Warrants and the shares of Common Stock issuable upon exercise thereof (the "WARRANT SHARES" and, collectively with the Debentures, Warrants and Conversion Shares, the "SECURITIES") for its own account and not with a present view towards the public sale or distribution thereof, except pursuant to sales registered or exempted from registration under the 1933 Act; PROVIDED, HOWEVER, that by making the representations herein, the Buyer does not agree to hold any of the Securities for any minimum or other specific term and reserves the right to dispose of the Securities at any time in accordance with or pursuant to a registration statement or an exemption under the 1933 Act and applicable state securities laws. (B) ACCREDITED INVESTOR STATUS. The Buyer is not an "accredited investor" as that term is defined in Rule 501(a) of Regulation D (an "ACCREDITED INVESTOR"). The Buyer has received all documents and disclosures required under Rule 502(b) of Regulation D for private placements to a non-accredited investor under Rule 506 of the 1933 Act, including, without limitation, the following documents of the Company, each as filed with the SEC: (i) S-1 filed June 11, 2003; (ii) DEF 14A filed on September 17, 2003; (iii) 10-K filed on August 19, 2004; (iv) S-8 filed September 4, 2003; ; (v) 10-Q filed on April 21, 2003; (vi) S-1 filed on February 20, 2003; (vii) SB-2 filed May 21, 2004; (viii) 10-QSB filed on October 20, 2004, (ix)10-Q filed on January 21, 2004 and (x) 10Q filed April 8, 2004. (C) RELIANCE ON EXEMPTIONS. The Buyer understands that the Securities are being offered and sold to it in reliance upon specific exemptions from the registration requirements of United States federal and state securities laws and that the Company is relying upon the truth and accuracy of, and the Buyer's compliance with, the representations, warranties, agreements, acknowledgments and understandings of the Buyer set forth herein in order to determine the availability of such exemptions and the eligibility of the Buyer to acquire the Securities. (D) INFORMATION. The Buyer and its advisors, if any, have been furnished with all materials relating to the business, finances and operations of the Company and materials relating to the offer and sale of the Securities which have been requested by the Buyer or its advisors. The Buyer and its advisors, if any, have been afforded the opportunity to ask questions of the Company. Neither such inquiries nor any other due diligence investigation conducted by Buyer or any of its advisors or representatives shall modify, amend or affect Buyer's right to rely on the Company's representations and warranties contained in Section 3 below. The Buyer understands that its investment in the Securities involves a significant degree of risk. 21 (E) GOVERNMENTAL REVIEW. The Buyer understands that no United States federal or state agency or any other government or governmental agency has passed upon or made any recommendation or endorsement of the Securities. (F) TRANSFER OR RE-SALE. The Buyer understands that (i) except as provided in the Registration Rights Agreement, the sale or re-sale of the Securities has not been and is not being registered under the 1933 Act or any applicable state securities laws, and the Securities may not be transferred or resold unless (a) the Securities are sold pursuant to an effective registration statement under the 1933 Act, (b) the Buyer shall have delivered to the Company an opinion of counsel (which opinion shall be in form, substance and scope reasonably satisfactory to counsel to the Company) to the effect that the Securities to be sold or transferred may be sold or transferred pursuant to an exemption from such registration, (c) the Securities are sold or transferred to an "affiliate" (as defined in Rule 144 promulgated under the 1933 Act (or a successor rule) ("RULE 144") of the Buyer who agrees to sell or otherwise transfer the Securities only in accordance with this Section 2(f) and who is an Accredited Investor, or (d) the Securities are sold pursuant to Rule 144; and (ii) any sale of such Securities made in reliance on Rule 144 may be made only in accordance with the terms of said Rule and further, if said Rule is not applicable, any re-sale of such Securities under circumstances in which the seller (or the person through whom the sale is made) may be deemed to be an underwriter (as that term is defined in the 1933 Act) may require compliance with some other exemption under the 1933 Act or the rules and regulations of the SEC thereunder. Notwithstanding the foregoing or anything else contained herein to the contrary, the Securities may be pledged as collateral in connection with a BONA FIDE margin account or other lending arrangement. (G) LEGENDS. The Buyer understands that the Debentures and the Warrants and, until such time as the Conversion Shares and Warrant Shares have been registered under the 1933 Act as contemplated by the Registration Rights Agreement or otherwise may be sold pursuant to Rule 144 without any restriction as to the number of securities as of a particular date that can then be immediately sold, the Conversion Shares and Warrant Shares, may bear a restrictive legend in substantially the following form (and a stop-transfer order may be placed against transfer of the certificates for such Securities): 22 "The securities represented by this certificate have not been registered under the Securities Act of 1933, as amended, or applicable state securities laws. The securities may not be sold, transferred or assigned in the absence of an effective registration statement for the securities under said Act, or an opinion of counsel, in form, substance and scope reasonably satisfactory to counsel to the Company, that registration is not required under said Act or unless sold pursuant to Rule 144 under said Act." Upon the request of any holder and the surrender of certificates, the legend set forth above shall be removed and the Company shall issue a certificate without such legend to the holder of any Security upon which it is stamped, if (a) such Security is registered for sale under an effective registration statement filed under the 1933 Act or otherwise may be sold pursuant to Rule 144 without any restriction as to the number of securities as of a particular date that can then be immediately sold, or (b) such holder provides the Company with an opinion of counsel, in form, substance and scope reasonably satisfactory to counsel to the Company, to the effect that a public sale or transfer of such Security may be made without registration under the 1933 Act and such sale or transfer is effected or (c) such holder provides the Company with reasonable assurances that such Security can be sold pursuant to Rule 144. The Buyer agrees to sell all Securities, including those represented by a certificate(s) from which the legend has been removed, in compliance with applicable prospectus delivery requirements, if any. (H) [INTENTIONALLY LEFT BLANK] (I) RESIDENCY. The Buyer is a resident of the state of {{Residency}}. (J) KNOWLEDGE AND EXPERIENCE. Buyer has such knowledge and experience in financial and business matters that it is capable of evaluating the merits and risks of the investment in the Securities. 3. REPRESENTATIONS AND WARRANTIES OF THE COMPANY. The Company represents and warrants to Buyer that, except as set forth on the Company's disclosure schedules or any update thereto prior to the Closing Date: (A) ORGANIZATION AND QUALIFICATION. The Company and each of its Subsidiaries (as defined below), if any, is a corporation duly organized, validly existing and in good standing under the laws of the jurisdiction in which it is incorporated, with full power and authority (corporate and other) to own, lease, use and operate its properties and to carry on its business as and where now owned, leased, used, operated and conducted. SCHEDULE 3(A) sets forth a list of all of the Subsidiaries of the Company and the jurisdiction in which each is incorporated. The Company and each of its Subsidiaries is duly qualified as a foreign corporation to do business and is in good standing in every jurisdiction in which its ownership or use of property or the nature of the business conducted by it makes such qualification necessary except where the failure to be so qualified or in good standing would not have a Material Adverse Effect. "MATERIAL ADVERSE EFFECT" means any material adverse effect on (i) the Securities, (ii) the business, operations, assets, financial condition or prospects of the Company and its Subsidiaries, if any, taken as a whole, (iii) on the transactions contemplated hereby or by the agreements or instruments to be entered into in connection herewith or (iv) the authority or the ability of the Company to perform its obligation under this Agreement, the Registration Rights Agreement, the Debentures or the Warrants. "SUBSIDIARIES" means any corporation or other organization, whether incorporated or unincorporated, in which the Company owns, directly or indirectly, any equity or other ownership interest. 23 (B) AUTHORIZATION; ENFORCEMENT. (i) The Company has all requisite corporate power and authority to enter into and perform this Agreement, the Registration Rights Agreement, the Debentures and the Warrants and to consummate the transactions contemplated hereby and thereby and to issue the Securities, in accordance with the terms hereof and thereof, (ii) except as otherwise set forth in SCHEDULE 3(B), the execution and delivery of this Agreement, the Registration Rights Agreement, the Debentures and the Warrants by the Company and the consummation by it of the transactions contemplated hereby and thereby (including without limitation, the issuance of the Debentures and the Warrants and the issuance and reservation for issuance of the Conversion Shares issuable upon conversion of or otherwise pursuant to the Debentures and the Warrant Shares issuable upon exercise of or otherwise pursuant to the Warrants) have been duly authorized by the Company's Board of Directors and no further consent or authorization of the Company, its Board of Directors, or its stockholders is required, (iii) this Agreement has been duly executed and delivered by the Company, and (iv) this Agreement constitutes, and upon execution and delivery by the Company of the Registration Rights Agreement, the Debentures and the Warrants, each of such agreements and instruments will constitute, a legal, valid and binding obligation of the Company enforceable against the Company in accordance with its terms. (C) CAPITALIZATION. As of the date hereof, the authorized capital stock of the Company is as set forth on SCHEDULE 3(C). All of such outstanding shares of capital stock set forth in SCHEDULE 3(C) are, or upon issuance will be, duly authorized, validly issued, fully paid and nonassessable. No shares of capital stock of the Company are subject to preemptive rights or any other similar rights of the stockholders of the Company or any liens or encumbrances imposed through the actions or failure to act of the Company. Except as disclosed in SCHEDULE 3(C), as of the effective date of this Agreement, (i) there are no outstanding options, warrants, scrip, rights to subscribe 24 for, puts, calls, rights of first refusal, agreements, understandings, claims or other commitments or rights of any character whatsoever relating to, or securities or rights convertible into or exchangeable for any shares of capital stock of the Company or any of its Subsidiaries, or arrangements by which the Company or any of its Subsidiaries is or may become bound to issue additional shares of capital stock of the Company or any of its Subsidiaries, (ii) there are no agreements or arrangements under which the Company or any of its Subsidiaries is obligated to register the sale of any of its or their securities under the 1933 Act (except the Registration Rights Agreement) and (iii) there are no anti-dilution or price adjustment provisions contained in any security issued by the Company (or in any agreement providing rights to security holders) that will be triggered by the issuance of the Debentures, the Warrants, the Conversion Shares or Warrant Shares. The Company has furnished to the Buyer true and correct copies of the Company's Certificate of Incorporation as in effect on the date hereof ("CERTIFICATE OF INCORPORATION"), the Company's By-laws, as in effect on the date hereof (the "BY-LAWS"), and the terms of all securities convertible into or exercisable for Common Stock of the Company and the material rights of the holders thereof in respect thereto. In the event that the date of execution of this Agreement is not the Closing Date, the Company shall provide the Buyer with a written update of this representation signed by the Company's President and Chief Executive or Chief Financial Officer on behalf of the Company as of the Closing Date. (D) ISSUANCE OF SHARES. Upon issuance upon conversion of the Debentures and upon exercise of the Warrants in accordance with their respective terms, the Conversion Shares and Warrant Shares will be validly issued, fully paid and non-assessable, and free from all taxes, liens, claims and encumbrances and shall not be subject to preemptive rights or other similar rights of stockholders of the Company and will not impose personal liability upon the holder thereof. (E) ACKNOWLEDGMENT OF DILUTION. The Company understands and acknowledges the potentially dilutive effect to the Common Stock upon the issuance of the Conversion Shares upon conversion of or otherwise pursuant to the Debentures or upon issuance of the Warrant Shares upon exercise of or otherwise pursuant to the Warrants. The Company's directors and executive officers have studied and fully understand the nature of the Securities being sold hereunder. The Company further acknowledges that its obligation to issue Conversion Shares upon conversion of or otherwise pursuant to the Debentures and to issue Warrant Shares upon exercise of or otherwise pursuant to the Warrants in accordance with this Agreement, the Debentures and the Warrants is absolute and unconditional regardless of the dilutive effect that such issuance may have on the ownership interests of other stockholders of the Company. Taking the foregoing into account, the Company's Board of Directors has determined, in its good faith business judgment, that the issuance of the Securities hereunder and under the Debentures and the Warrants and the consummation of the transactions contemplated hereby and thereby are in the best interest of the Company and its stockholders. 25 (F) NO CONFLICTS. The execution, delivery and performance of this Agreement, the Registration Rights Agreement, the Debentures and the Warrants by the Company and the consummation by the Company of the transactions contemplated hereby and thereby (including, without limitation, the issuance and reservation for issuance of the Conversion Shares and Warrant Shares) will not (i) except as otherwise set forth in SCHEDULE 3(F), conflict with or result in a violation of any provision of the Certificate of Incorporation or By-laws or (ii) violate or conflict with, or result in a breach of any provision of, or constitute a default (or an event which with notice or lapse of time or both would become a default) under, or give to others any rights of termination, amendment, acceleration or cancellation of, any agreement, indenture, patent, patent license or instrument to which the Company or any of its Subsidiaries is a party, or (iii) result in a violation of any law, rule, regulation, order, judgment or decree (including federal and state securities laws and regulations and regulations of any self-regulatory organizations to which the Company or its securities are subject) applicable to the Company or any of its Subsidiaries or by which any property or asset of the Company or any of its Subsidiaries is bound or affected (except, in the case of clauses (i), (ii) and (iii) above, for such conflicts, defaults, terminations, amendments, accelerations, cancellations and violations as would not, individually or in the aggregate, have a Material Adverse Effect). Neither the Company nor any of its Subsidiaries is in violation of its Certificate of Incorporation, By-laws or other organizational documents and neither the Company nor any of its Subsidiaries is in default (and no event has occurred which with notice or lapse of time or both could put the Company or any of its Subsidiaries in default) under, and neither the Company nor any of its Subsidiaries has taken any action or failed to take any action that would give to others any rights of termination, amendment, acceleration or cancellation of, any agreement, indenture or instrument to which the Company or any of its Subsidiaries is a party or by which any property or assets of the Company or any of its Subsidiaries is bound or affected, except for possible defaults as would not, individually or in the aggregate, have a Material Adverse Effect. The businesses of the Company and its Subsidiaries, if any, are not being conducted, and shall not be conducted so long as a Buyer owns any of the Securities, in violation of any law, ordinance or regulation of any governmental entity the violation of which would have a Material Adverse Effect. Except as disclosed in SCHEDULE 3(F) and as specifically contemplated by this Agreement and as required under the 1933 Act and any applicable state securities laws, the Company is not required to obtain any consent, authorization or order of, or make any filing or registration with, any court, governmental agency, regulatory agency, self regulatory organization or stock market or any third party in order for it to execute, deliver or perform any of its obligations under this Agreement, the Registration Rights Agreement, the Debentures or the Warrants in accordance with the terms hereof or thereof or to issue and sell the Debentures and Warrants in accordance with the terms hereof and to issue the Conversion Shares upon conversion of or otherwise pursuant to the Debentures and the Warrant Shares upon exercise of or otherwise pursuant to the Warrants. Except as disclosed in SCHEDULE 3(F), all consents, authorizations, orders, filings and registrations which the Company is required to obtain pursuant to the preceding sentence have been obtained or effected on or prior to the date hereof. The Company is not in violation of the listing requirements of the OTC-BB and does not reasonably anticipate that the Common Stock will be delisted by the OTC-BB in the foreseeable future. The Company and its Subsidiaries are unaware of any facts or circumstances which might give rise to any of the foregoing. 26 (G) SEC DOCUMENTS; FINANCIAL STATEMENTS. Since at least January 1, 2001, the Company has timely filed all reports, schedules, forms, statements and other documents required to be filed by it with the SEC pursuant to the reporting requirements of the Securities Exchange Act of 1934, as amended (the "1934 ACT") (all of the foregoing filed prior to the date hereof and since at least January 1, 2001 and all exhibits included therein and financial statements and schedules thereto and documents (other than exhibits to such documents) incorporated by reference therein, being hereinafter referred to herein as the "SEC DOCUMENTS"). The Company has delivered to Buyer true and complete copies of the SEC Documents, except for such exhibits and incorporated documents. As of their respective dates, the SEC Documents complied in all material respects with the requirements of the 1934 Act and the rules and regulations of the SEC promulgated thereunder applicable to the SEC Documents, and none of the SEC Documents, at the time they were filed with the SEC, contained any untrue statement of a material fact or omitted to state a material fact required to be stated therein or necessary in order to make the statements therein, in light of the circumstances under which they were made, not misleading. None of the statements made in any such SEC Documents is, or has been, required to be amended or updated under applicable law (except for such statements as have been amended or updated in subsequent filings prior to the date hereof). As of their respective dates, the financial statements of the Company included in the SEC Documents complied as to form in all material respects with applicable accounting requirements and the published rules and regulations of the SEC with respect thereto. Such financial statements have been prepared in accordance with United States generally accepted accounting principles, consistently applied, during the periods involved (except (i) as may be otherwise indicated in such financial statements or the notes thereto, or (ii) in the case of unaudited interim statements, to the extent they may not include footnotes or may be condensed or summary statements) and fairly present in all material respects the consolidated financial position of the Company and its consolidated Subsidiaries as of the dates thereof and the consolidated results of their operations and cash flows for the periods then ended (subject, in the case of unaudited statements, to normal year-end audit adjustments). Except as set forth in the financial statements of the Company included in the SEC Documents, the Company has no liabilities, contingent or otherwise, other than (i) liabilities incurred in the ordinary course of business subsequent to November 30, 2001 and (ii) obligations under contracts and commitments incurred in the ordinary course of business and not required under generally accepted accounting principles to be reflected in such financial statements, which, individually or in the aggregate, are not material to the financial condition or operating results of the Company. 27 (H) ABSENCE OF CERTAIN CHANGES. Except for losses incurred in the ordinary course of business that have been publicly disclosed prior to the date hereof or as set forth on SCHEDULE 3(H) hereof, since November 30, 2001, there has been no material adverse change and no material adverse development in the assets, liabilities, business, properties, operations, financial condition, results of operations or prospects of the Company or any of its Subsidiaries. For purposes of this Section 3(h), the terms "material adverse change" and "material adverse development" shall exclude continuing losses that are consistent with the Company's historical losses. (I) ABSENCE OF LITIGATION. Except as disclosed in SCHEDULE 3(I)(A), to the knowledge of the Company or any of its subsidiaries, there is no action, suit, claim, proceeding, inquiry or investigation before or by any court, public board, government agency, self-regulatory organization or body pending or, to the knowledge of the Company or any of its Subsidiaries, threatened against or affecting the Company or any of its Subsidiaries, or their officers or directors in their capacity as such, that would have a Material Adverse Effect. SCHEDULE 3(I)(B) contains a complete list and summary description of any known pending or threatened proceeding against or affecting the Company or any of its Subsidiaries, without regard to whether it, if adversely decided, would have a Material Adverse Effect. The Company and its Subsidiaries are unaware of any facts or circumstances which might give rise to any of the foregoing. (J) PATENTS, COPYRIGHTS, ETC. All of the Company's material patents, patent applications, patent rights, inventions, know-how, trade secrets, trademarks, trademark applications, service marks, service names, trade names and copyrights ("INTELLECTUAL PROPERTY") are set forth in Schedule A to the Debenture. The Company and each of its Subsidiaries owns or possesses the requisite licenses or rights to use all Intellectual Property necessary to enable it to conduct its business as now operated, including but not limited to the intellectual property set forth in Schedule A to the Debenture (and, except as otherwise set forth in SCHEDULE 3(J) hereof, to the best of the Company's knowledge, as presently contemplated to be operated in the future), except for such licenses or rights the failure of which to own or possess would not, individually or in the aggregate, have a Material Adverse Effect; there is no claim or action by any person pertaining to, or proceeding pending, or to the Company's knowledge threatened, which challenges the right of the Company or of a Subsidiary with respect to any Intellectual Property necessary to enable it to conduct its business as now operated (and, except as otherwise set forth in SCHEDULE 3(J) hereof, to the best of the Company's knowledge, as presently contemplated to be operated in the future), except for actions or claims which, if adversely decided, would not have a Material Adverse Effect; to the best of the Company's knowledge, the Company's or its Subsidiaries' current and intended products, services and processes do not infringe on any Intellectual Property or other rights held by any person, and the Company is unaware of any facts or circumstances which might give rise to any of the foregoing. The Company and each of its Subsidiaries have taken reasonable security measures to protect the secrecy, confidentiality and value of their Intellectual Property. The Company has liens on its Intellectual Property as detailed in SCHEDULE 3(J) hereof. 28 (K) NO MATERIALLY ADVERSE CONTRACTS, ETC. Neither the Company nor any of its Subsidiaries is subject to any charter, corporate or other legal restriction, or any judgment, decree, order, rule or regulation which in the judgment of the Company's officers has or is reasonably likely in the future to have a Material Adverse Effect. Neither the Company nor any of its Subsidiaries is a party to any contract or agreement which in the judgment of the Company's officers has or is reasonably likely to have a Material Adverse Effect. (L) TAX STATUS. Except as set forth on SCHEDULE 3(L), the Company and each of its Subsidiaries has made or filed all federal, state and foreign income and all other tax returns, reports and declarations required by any jurisdiction to which it is subject (unless and only to the extent that the Company and each of its Subsidiaries has set aside on its books provisions reasonably adequate for the payment of all unpaid and unreported taxes) and has paid all taxes and other governmental assessments and charges that are material in amount, shown or determined to be due on such returns, reports and declarations, except those being contested in good faith and has set aside on its books provisions reasonably adequate for the payment of all taxes for periods subsequent to the periods to which such returns, reports or declarations apply. There are no unpaid taxes in any material amount claimed to be due by the taxing authority of any jurisdiction, and the officers of the Company know of no basis for any such claim. The Company has not executed a waiver with respect to the statute of limitations relating to the assessment or collection of any foreign, federal, state or local tax. Except as set forth on SCHEDULE 3(L), none of the Company's tax returns is presently being audited by any taxing authority. (M) CERTAIN TRANSACTIONS. Except as set forth on SCHEDULE 3(M) and except for arm's length transactions pursuant to which the Company or any of its Subsidiaries makes payments in the ordinary course of business upon terms no less favorable than the Company or any of its Subsidiaries could obtain from third parties and other than the grant of stock options disclosed on SCHEDULE 3(C), none of the officers, directors, or employees of the Company is presently a party to any transaction with the Company or any of its Subsidiaries (other than for services as employees, officers and directors), including any contract, agreement or other arrangement providing for the furnishing of services to or by, providing for rental of real or personal property to or from, or otherwise requiring payments to or from any officer, director or such employee or, to the knowledge of the Company, any corporation, partnership, trust or other entity in which any officer, director, or any such employee has a substantial interest or is an officer, director, trustee or partner. 29 (N) DISCLOSURE. All information relating to or concerning the Company or any of its Subsidiaries set forth in this Agreement and provided to the Buyer pursuant to Section 2(d) hereof and otherwise in connection with the transactions contemplated hereby is true and correct in all material respects and the Company has not omitted to state any material fact necessary in order to make the statements made herein or therein, in light of the circumstances under which they were made, not misleading. No event or circumstance has occurred or exists with respect to the Company or any of its Subsidiaries or its or their business, properties, prospects, operations or financial conditions, which has not been publicly announced or disclosed but under applicable law, rule or regulation, requires public disclosure or announcement by the Company (assuming for this purpose that the Company's reports filed under the 1934 Act are being incorporated into an effective registration statement filed by the Company under the 1933 Act). (O) ACKNOWLEDGMENT REGARDING BUYER'S PURCHASE OF SECURITIES. The Company acknowledges and agrees that the Buyer is acting solely in the capacity of arm's length purchaser with respect to this Agreement and the transactions contemplated hereby. The Company further acknowledges that Buyer is not acting as a financial advisor or fiduciary of the Company (or in any similar capacity) with respect to this Agreement and the transactions contemplated hereby and that any statement made by Buyer or any of its respective representatives or agents in connection with this Agreement and the transactions contemplated hereby is not advice or a recommendation and is merely incidental to the Buyer's purchase of the Securities and has not been relied upon by the Company, its officers or directors in any way. The Company further represents to Buyer that the Company's decision to enter into this Agreement has been based solely on the independent evaluation of the Company and its representatives. (P) NO INTEGRATED OFFERING. Neither the Company, nor any of its affiliates, nor any person acting on its or their behalf, has directly or indirectly made any offers or sales of any security or solicited any offers to buy any security under circumstances that would require registration under the 1933 Act of the issuance of the Securities to the Buyer. The issuance of the Securities to the Buyer will not be integrated with any other issuance of the Company's securities (past, current or future) for purposes of any stockholder approval provisions applicable to the Company or its securities. (Q) NO BROKERS. The Company has taken no action which would give rise to any claim by any person for brokerage commissions, finder's fees or similar payments relating to this Agreement or the transactions contemplated hereby. (R) PERMITS; COMPLIANCE. The Company and each of its Subsidiaries is in possession of all franchises, grants, authorizations, licenses, permits, easements, variances, exemptions, consents, certificates, approvals and orders necessary to own, lease and operate its properties and to carry on its business as it is now being conducted (collectively, the "COMPANY PERMITS"), except where the failure to so possess any such Company Permits would not have a Material Adverse Effect, and there is no action pending or, to the knowledge of the Company, threatened regarding suspension or cancellation of any of the Company Permits. To the best of the Company's knowledge, neither the Company nor any of its Subsidiaries is in conflict with, or in default or violation of, any of the Company Permits, except for any such conflicts, defaults or violations which, individually or in the aggregate, would not reasonably be expected to have a Material Adverse Effect. Since December 31, 2001, neither the Company nor any of its Subsidiaries has received any notification with respect to possible conflicts, defaults or violations of applicable laws, except for notices relating to possible conflicts, defaults or violations, which conflicts, defaults or violations would not have a Material Adverse Effect. 30 (S) ENVIRONMENTAL MATTERS. (i) Except as set forth in SCHEDULE 3(S), there are, to the Company's knowledge, with respect to the Company or any of its Subsidiaries or any predecessor of the Company, no past or present violations of Environmental Laws (as defined below), releases of any material into the environment, actions, activities, circumstances, conditions, events, incidents, or contractual obligations which may give rise to any common law environmental liability or any liability under the Comprehensive Environmental Response, Compensation and Liability Act of 1980 or similar federal, state, local or foreign laws and neither the Company nor any of its Subsidiaries has received any notice with respect to any of the foregoing, nor is any action pending or, to the Company's knowledge, threatened in connection with any of the foregoing. The term "ENVIRONMENTAL LAWS" means all federal, state, local or foreign laws relating to pollution or protection of human health or the environment (including, without limitation, ambient air, surface water, groundwater, land surface or subsurface strata), including, without limitation, laws relating to emissions, discharges, releases or threatened releases of chemicals, pollutants contaminants, or toxic or hazardous substances or wastes (collectively, "HAZARDOUS MATERIALS") into the environment, or otherwise relating to the manufacture, processing, distribution, use, treatment, storage, disposal, transport or handling of Hazardous Materials, as well as all authorizations, codes, decrees, demands or demand letters, injunctions, judgments, licenses, notices or notice letters, orders, permits, plans or regulations issued, entered, promulgated or approved thereunder. (ii) Other than those that are or were stored, used or disposed of in compliance with applicable law, no Hazardous Materials are contained on or about any real property currently owned, leased or used by the Company or any of its Subsidiaries, and no Hazardous Materials were released on or about any real property previously owned, leased or used by the Company or any of its Subsidiaries during the period the property was owned, leased or used by the Company or any of its Subsidiaries, except in the normal course of the Company's or any of its Subsidiaries' business. 31 (iii) Except as set forth in SCHEDULE 3(S), there are no underground storage tanks on or under any real property owned, leased or used by the Company or any of its Subsidiaries that are not in compliance with applicable law. (T) TITLE TO PROPERTY. The Company and its Subsidiaries have good and marketable title in fee simple to all real property and good and marketable title to all personal property owned by them which is material to the business of the Company and its Subsidiaries, in each case free and clear of all liens, encumbrances and defects except such as are described in SCHEDULE 3(T) or such as would not have a Material Adverse Effect. Any real property and facilities held under lease by the Company and its Subsidiaries are held by them under valid, subsisting and enforceable leases with such exceptions as would not have a Material Adverse Effect. (U) INSURANCE. The Company and each of its Subsidiaries are insured by insurers of recognized financial responsibility against such losses and risks and in such amounts as management of the Company believes to be prudent and customary in the businesses in which the Company and its Subsidiaries are engaged. Neither the Company nor any such Subsidiary has any reason to believe that it will not be able to renew its existing insurance coverage as and when such coverage expires or to obtain similar coverage from similar insurers as may be necessary to continue its business at a cost that would not have a Material Adverse Effect. (V) INTERNAL ACCOUNTING CONTROLS. The Company and each of its Subsidiaries maintain a system of internal accounting controls sufficient, in the judgment of the Company's board of directors, to provide reasonable assurance that (i) transactions are executed in accordance with management's general or specific authorizations, (ii) transactions are recorded as necessary to permit preparation of financial statements in conformity with generally accepted accounting principles and to maintain asset accountability, (iii) access to assets is permitted only in accordance with management's general or specific authorization and (iv) the recorded accountability for assets is compared with the existing assets at reasonable intervals and appropriate action is taken with respect to any differences. (W) FOREIGN CORRUPT PRACTICES. Neither the Company, nor any of its Subsidiaries, nor any director, officer, agent, employee or other person acting on behalf of the Company or any Subsidiary has, in the course of his actions for, or on behalf of, the Company, used any corporate funds for any unlawful contribution, gift, entertainment or other unlawful expenses relating to political activity; made any direct or indirect unlawful payment to any foreign or domestic government official or employee from corporate funds; violated or is in violation of any provision of the U.S. Foreign Corrupt Practices Act of 1977; or made any bribe, rebate, payoff, influence payment, kickback or other unlawful payment to any foreign or domestic government official or employee. 32 (X) SOLVENCY. The Company (both before and after giving effect to the transactions contemplated by this Agreement) is solvent (I.E., its assets have a fair market value in excess of the amount required to pay its probable liabilities on its existing debts as they become absolute and matured) and currently the Company has no information that would lead it to reasonably conclude that the Company would not have the ability to, nor does it intend to take any action that would impair its ability to, pay its debts from time to time incurred in connection therewith as such debts mature. Except as disclosed in SCHEDULE 3(X), the Company did not receive a qualified opinion from its auditors with respect to its most recent fiscal year end and does not anticipate or know of any basis upon which its auditors might issue a qualified opinion in respect of its current fiscal year. (Y) NO INVESTMENT COMPANY. The Company is not, and upon the issuance and sale of the Securities as contemplated by this Agreement will not be an "investment company" required to be registered under the Investment Company Act of 1940 (an "INVESTMENT COMPANY"). The Company is not controlled by an Investment Company. (Z) NON-ACCREDITED INVESTOR DISCLOSURES. The Company has provided to the Buyer all documents and disclosures required under Rule 502(b) of Regulation D for private placements to a non-accredited investor under Rule 506 of the 1933 Act. 4. COVENANTS. (A) BEST EFFORTS. The parties shall use their best efforts to satisfy timely each of the conditions described in Section 6 and 7 of this Agreement. (B) FORM D; BLUE SKY LAWS. The Company agrees to file a Form D with respect to the Securities as required under Regulation D and to provide a copy thereof to Buyer promptly after such filing. The Company shall, on or before the Closing Date, take such action as the Company shall reasonably determine is necessary to qualify the Securities for sale to the Buyer at the Closing pursuant to this Agreement under applicable securities or "blue sky" laws of the states of the United States (or to obtain an exemption from such qualification), and shall provide evidence of any such action so taken to Buyer on or prior to the Closing Date. 33 (C) REPORTING STATUS; ELIGIBILITY TO USE FORM S-1. The Company's Common Stock is registered under Section 12(g) of the 1934 Act. So long as any Buyer beneficially owns any of the Securities, the Company shall timely file all reports required to be filed with the SEC pursuant to the 1934 Act, and the Company shall not terminate its status as an issuer required to file reports under the 1934 Act even if the 1934 Act or the rules and regulations thereunder would permit such termination. The Company currently meets, and will take all necessary action to continue to meet, the "registrant eligibility" requirements set forth in the general instructions to Form S-1 for registration of the resale of the securities purchased hereunder. (D) USE OF PROCEEDS. The Company shall use the proceeds from the sale of the Debentures and the Warrants in the manner set forth in SCHEDULE 4(D) attached hereto and made a part hereof and shall not use such proceeds in a manner inconsistent with the provisions of Article II of the Debentures. (E) [INTENTIONALLY LEFT BLANK]. (F) [INTENTIONALLY LEFT BLANK]. (G) FINANCIAL INFORMATION. The Company agrees to send the following reports to Buyer until Buyer transfers, assigns, or sells all of the Securities: (i) within ten (10) days after the filing with the SEC, a copy of its Annual Report on Form 10-K, its Quarterly Reports on Form 10-Q and any Current Reports on Form 8-K; (ii) within one (1) day after release, copies of all press releases issued by the Company or any of its Subsidiaries; and (iii) contemporaneously with the making available or giving to the stockholders of the Company, copies of any notices or other information the Company makes available or gives to such stockholders. (H) RESERVATION OF SHARES. The Company covenants that it will initially reserve (the "INITIAL SHARE RESERVATION") from its authorized and unissued Common Stock a number of shares of Common Stock equal to at least one hundred and ten percent (110%) the Original Principal Amount of the Debenture, divided by the Conversion Price in effect on the date of the Initial Share Reservation, free from preemptive rights, to provide for the issuance of Common Stock upon the conversion of the Debenture and shall initially reserve an additional number of shares equal to the Warrant Amount, free from preemptive rights, to provide for the issuance of Common Stock upon the exercise of the Warrants. The Company further covenants that, beginning on the date of the Initial Share Reservation (the "CONVERSION BEGINNING DATE"), and continuing throughout the period the conversion right exists, the Company shall at all times have authorized, and reserved (the "ONGOING SHARE RESERVATION REQUIREMENT") for the purpose of issuance, a sufficient number of shares of 34 Common Stock to provide for the full conversion or exercise of the outstanding Debentures and Warrants and issuance of the Conversion Shares and Warrant Shares in connection therewith (based on the Conversion Price (as defined in the Debentures) in effect from time to time and the Exercise Price of the Warrants in effect from time to time). The Company shall not reduce the number of shares of Common Stock reserved for issuance upon conversion of or otherwise pursuant to the Debentures and exercise of or otherwise pursuant to the Warrants without the consent of Buyer. The Company shall use its best efforts at all times to maintain the number of shares of Common Stock so reserved for issuance at no less than one hundred and ten percent (110%) the number that is then actually issuable upon full conversion of the Debentures (based on the Conversion Price (as defined in the Debentures) in effect from time to time) and full exercise of the Warrants (based on the Exercise Price of the Warrants in effect from time to time). If at any time the number of shares of Common Stock authorized and reserved for issuance is below the number of Conversion Shares issued and issuable upon conversion of or otherwise pursuant to the Debentures (based on the Conversion Price (as defined in the Debentures) in effect from time to time) and Warrant Shares issued or issuable upon exercise of or otherwise pursuant to the Warrants (based on the Exercise Price of the Warrants in effect from time to time), the Company will promptly take all corporate action necessary to authorize and reserve a sufficient number of shares, including, without limitation, calling a special meeting of stockholders to authorize additional shares to meet the Company's obligations under this Section 4(h), in the case of an insufficient number of authorized shares, and using its best efforts to obtain stockholder approval of an increase in such authorized number of shares. (I) LISTING. The Company shall use its best efforts to promptly secure the listing of the Conversion Shares and Warrant Shares upon each national securities exchange or automated quotation system, if any, upon which shares of Common Stock are then listed (subject to official notice of issuance) and, so long as any Buyer owns any of the Securities, shall maintain, so long as any other shares of Common Stock shall be so listed, such listing of all Conversion Shares from time to time issuable upon conversion of or otherwise pursuant to the Debentures and all Warrant Shares from time to time issuable upon exercise of or otherwise pursuant to the Warrants. The Company will use its best efforts to obtain and, so long as any Buyer owns any of the Securities, maintain the listing and trading of its Common Stock on the OTC-BB, the Nasdaq National Market (the "NNM"), the Nasdaq SmallCap Market (the "NASDAQ SMALLCAP"), the New York Stock Exchange ("NYSE"), or the American Stock Exchange ("AMEX") and will comply in all respects with the Company's reporting, filing and other obligations under the bylaws or rules of the National Association of Securities Dealers ("NASD") and such exchanges, as applicable. The Company shall promptly provide to Buyer copies of any notices it receives from the OTC-BB and any other exchanges or quotation systems on which the Common Stock is then listed regarding the continued eligibility of the Common Stock for listing on such exchanges and quotation systems. 35 (J) CORPORATE EXISTENCE. So long as a Buyer beneficially owns any Debentures or Warrants, the Company shall maintain its corporate existence and shall not merge, consolidate or sell all or substantially all of the Company's assets, except in the event of a merger or consolidation or sale of all or substantially all of the Company's assets, where the (i) the successor or acquiring entity and, if an entity different from the successor or acquiring entity, the entity whose securities into which the Debentures shall become convertible pursuant to Section 1.5(b) of the Debentures, in such transaction assumes the Company's obligations hereunder and under the agreements and instruments entered into in connection herewith (including the Debentures and the Warrants) and (ii) the entity whose securities into which the Debentures shall become convertible pursuant to Section 1.5(b) of the Debentures is a publicly traded corporation whose Common Stock is listed for trading on the NNM, NASDAQ SmallCap, NYSE or AMEX. (K) NO INTEGRATION. The Company shall not make any offers or sales of any security (other than the Securities) under circumstances that would require registration of the Securities being offered or sold hereunder under the 1933 Act or cause the offering of the Securities to be integrated with any other offering of securities by the Company for the purpose of any stockholder approval provision applicable to the Company or its securities. (L) LIMITATION ON SALE OR DISPOSITION OF INTELLECTUAL PROPERTY. So long as the Company shall have any obligation under the Debenture or so long as any of the Warrants remain outstanding, the Corporation shall not sell, convey, dispose of, spin off or assign any or all of its Intellectual Property (including but not limited to the Intellectual Property set forth in Schedule A to the Debenture), or the rights to receive proceeds from patent infringement litigation or other litigation related to such intellectual property (collectively, the "INTELLECTUAL PROPERTY RIGHTS"), in each case without Buyer's written consent, provided that the Company may, without the Buyer's Written Consent, enter into one or more licensing agreements with respect to its Intellectual Property so long as such agreements are not with any affiliate (as such term is defined in Rule 501(b) of Regulation D) of the Company or with any relative of, or entity controlled by, or any entity 10% or more of which is owned by, any officer, director, employee or former employee of the Company, provided, further, that the Company shall not be subject to the restrictions of this Section 4(l) if the cash consideration received by the Company in exchange for such Intellectual Property Rights exceeds $ {AMOUNT} million. The Company will provide at closing duly executed board resolutions attesting to the above limitations on the disposition of the Company's intellectual property. (M) [INTENTIONALLY LEFT BLANK]. (N) IRREVOCBLE TRANSFER AGENT INSTRUCTIONS. Within ten (10) business days after the Closing Date, the Company agrees to deliver to Buyer the Irrevocable Transfer Agent Instructions (as defined below), in form and substance satisfactory to the Buyer, which instructions shall be acknowledged in writing by the Company's Transfer Agent. 36 5. TRANSFER AGENT INSTRUCTIONS. The Company shall issue irrevocable instructions to its transfer agent to issue certificates, registered in the name of Buyer or its nominee, for the Conversion Shares and Warrant Shares in such amounts as specified from time to time by Buyer to the Company upon conversion of the Debentures or exercise of the Warrants in accordance with the terms thereof (the "IRREVOCABLE TRANSFER AGENT INSTRUCTIONS"). Prior to registration of the Conversion Shares and Warrant Shares under the 1933 Act or the date on which the Conversion Shares and Warrant Shares may be sold pursuant to Rule 144 without any restriction as to the number of securities as of a particular date that can then be immediately sold, all such certificates shall bear the restrictive legend specified in Section 2(g) of this Agreement. The Company warrants that no instruction other than the Irrevocable Transfer Agent Instructions referred to in this Section 5, and stop transfer instructions to give effect to Section 2(f) hereof (in the case of the Conversion Shares and Warrant Shares, prior to registration of the Conversion Shares and Warrant Shares under the 1933 Act or the date on which the Conversion Shares and Warrant Shares may be sold pursuant to Rule 144 without any restriction as to the number of securities as of a particular date that can then be immediately sold), will be given by the Company to its transfer agent and that the Securities shall otherwise be freely transferable on the books and records of the Company as and to the extent provided in this Agreement and the Registration Rights Agreement. Nothing in this Section shall affect in any way the Buyer's obligations and agreement set forth in Section 2(g) hereof to comply with all applicable prospectus delivery requirements, if any, upon re-sale of the Securities. If a Buyer provides the Company with (i) an opinion of counsel in form, substance and scope customary for opinions in comparable transactions, to the effect that a public sale or transfer of such Securities may be made without registration under the 1933 Act and such sale or transfer is effected or (ii) the Buyer provides reasonable assurances that the Securities can be sold pursuant to Rule 144, the Company shall permit the transfer, and, in the case of the Conversion Shares and Warrant Shares, promptly instruct its transfer agent to issue one or more certificates, free from any restrictive legend, in such name and in such denominations as specified by such Buyer. 6. CONDITIONS TO THE COMPANY'S OBLIGATION TO SELL. The obligation of the Company hereunder to issue and sell the Debentures and Warrants to a Buyer at the Closing is subject to the satisfaction, at or before the Closing Date, of each of the following conditions thereto, provided that these conditions are for the Company's sole benefit and may be waived by the Company at any time in its sole discretion: 37 (a) The Buyer shall have executed this Agreement and the Registration Rights Agreement, and delivered the same to the Company. (b) The Buyer shall have delivered the Purchase Price in accordance with Section 1(b) above. (c) The representations and warranties of the Buyer shall be true and correct in all material respects as of the date when made and as of the Closing Date as though made at that time (except for representations and warranties that speak as of a specific date, which representations and warranties shall be true and correct as of such date), and the Buyer shall have performed, satisfied and complied in all material respects with the covenants, agreements and conditions required by this Agreement to be performed, satisfied or complied with by the Buyer at or prior to the Closing Date. (d) No litigation, statute, rule, regulation, executive order, decree, ruling or injunction shall have been enacted, entered, promulgated or endorsed by or in any court or governmental authority of competent jurisdiction or any self-regulatory organization having authority over the matters contemplated hereby which prohibits the consummation of any of the transactions contemplated by this Agreement. 7. CONDITIONS TO BUYER'S OBLIGATION TO PURCHASE. The obligation of Buyer hereunder to purchase the Debentures and Warrants at the Closing is subject to the satisfaction, at or before the Closing Date, of each of the following conditions, provided that these conditions are for such Buyer's sole benefit and may be waived by such Buyer at any time in its sole discretion: (a) The Company shall have executed this Agreement and the Registration Rights Agreement, and delivered the same to the Buyer. (b) The Company shall have delivered to such Buyer duly executed Debentures (in such denominations as the Buyer shall request) and Warrants in accordance with Section 1(b) above. (c) [Intentionally Left Blank]. (d) The representations and warranties of the Company contained in this Agreement, as modified by the Exhibits and Schedules hereto, shall be true and correct in all material respects as of the date when made and as of the Closing Date as though made at such time (except for representations and warranties that speak as of a specific date, which representations and warranties shall be true and correct as of such date) and the Company shall have performed, satisfied and complied in all material respects with the covenants, agreements and conditions required by this Agreement to be performed, satisfied or complied with by the Company at or prior to the Closing Date. The Buyer shall have received a certificate or certificates, executed by the President and Chief Executive Officer of the Company, dated as of the Closing Date, to the foregoing effect and as to such other matters as may be reasonably requested by such Buyer including, but not limited to certificates with respect to the Company's Certificate of Incorporation, By-laws and Board of Directors' resolutions relating to the transactions contemplated hereby. 38 (e) No litigation, statute, rule, regulation, executive order, decree, ruling or injunction shall have been enacted, entered, promulgated or endorsed by or in any court or governmental authority of competent jurisdiction or any self-regulatory organization having authority over the matters contemplated hereby which prohibits the consummation of any of the transactions contemplated by this Agreement. (f) Trading in the Common Stock on the OTC-BB shall not have been suspended by the SEC or the Nasdaq and, within two (2) business days of the Closing, the Company will make application to the OTC-BB, if legally required by Nasdaq, to have the Conversion Shares and the Warrant Shares authorized for quotation. (g) The Buyer shall have received an opinion of the Company's counsel, dated as of the Closing Date, in form, scope and substance reasonably satisfactory to the Buyer and in substantially the same form as EXHIBIT "D" attached hereto. (h) The Buyer shall have received an officer's certificate described in Section 3(c) above, dated as of the Closing Date. 8. GOVERNING LAW; MISCELLANEOUS. (A) GOVERNING LAW; ARBITRATION. This Agreement shall be governed by and construed in accordance with the internal laws of the State of New York. Any controversy or claim arising out of or related to this Debenture or the breach thereof, shall be settled by binding arbitration in New York, NY in accordance with the Expedited Procedures (Rules 53-57) of the Commercial Arbitration Rules of the American Arbitration Association ("AAA"). A proceeding shall be commenced upon written demand by the Company or Buyer to the other. The arbitrator(s) shall enter a judgment by default against any party, which fails or refuses to appear in any properly noticed arbitration proceeding. The proceeding shall be conducted by one (1) arbitrator, unless the amount alleged to be in dispute exceeds two hundred fifty thousand dollars ($250,000), in which case three (3) arbitrators shall preside. The arbitrator(s) will be chosen by the parties from a list provided by the AAA, and if the parties are unable to agree within ten (10) days, the AAA shall select the arbitrator(s). The arbitrators must be experts in securities law and financial transactions. The arbitrators shall assess costs and expenses of the arbitration, including all attorneys' and experts' fees, as the arbitrators believe is appropriate in light of the merits of the parties' respective positions in the issues in dispute. Each party submits irrevocably to the jurisdiction of any state court sitting in New York, NY or to the United States District Court sitting in New York for purposes of enforcement of any discovery order, judgment or award in connection with such arbitration. The award of the arbitrator(s) shall be final and binding upon the parties and may be enforced in any court having jurisdiction. The arbitration shall be held in such place as set by the arbitrator(s) in accordance with Rule 55. With respect to any arbitration proceeding in accordance with this section, the prevailing party's reasonable attorney's fees and expenses shall be borne by the non-prevailing party. 39 Although the parties, as expressed above, agree that all claims, including claims that are equitable in nature, for example specific performance, shall initially be prosecuted in the binding arbitration procedure outlined above, if the arbitration panel dismisses or otherwise fails to entertain any or all of the equitable claims asserted by reason of the fact that it lacks jurisdiction, power and/or authority to consider such claims and/or direct the remedy requested, then, in only that event, will the parties have the right to initiate litigation respecting such equitable claims or remedies. The forum for such equitable relief shall be in either a state or federal court sitting in New York, NY. Each party waives any right to a trial by jury, assuming such right exists in an equitable proceeding, and irrevocably submits to the jurisdiction of said New York court. New York law shall govern both the proceeding as well as the interpretation and construction of this Agreement and the transaction as a whole. (B) COUNTERPARTS; SIGNATURES BY FACSIMILE. This Agreement may be executed in one or more counterparts, all of which shall be considered one and the same agreement and shall become effective when counterparts have been signed by each party and delivered to the other party. This Agreement, once executed by a party, may be delivered to the other party hereto by facsimile transmission of a copy of this Agreement bearing the signature of the party so delivering this Agreement. (C) HEADINGS. The headings of this Agreement are for convenience of reference and shall not form part of, or affect the interpretation of, this Agreement. (D) SEVERABILITY. If any provision of this Agreement shall be invalid or unenforceable in any jurisdiction, such invalidity or unenforceability shall not affect the validity or enforceability of the remainder of this Agreement or the validity or enforceability of this Agreement in any other jurisdiction. (E) ENTIRE AGREEMENT; AMENDMENTS. This Agreement and the instruments referenced herein contain the entire understanding of the parties with respect to the matters covered herein and therein and, except as specifically set forth herein or therein, neither the Company nor the Buyer makes any representation, warranty, covenant or undertaking with respect to such matters. No provision of this Agreement may be waived or amended other than by an instrument in writing signed by the party to be charged with enforcement. 40 (F) NOTICES. Any notices required or permitted to be given under the terms of this Agreement shall be sent by certified or registered mail (return receipt requested) or delivered personally or by courier (including a recognized overnight delivery service) or by facsimile and shall be effective five days after being placed in the mail, if mailed by regular United States mail, or upon receipt, if delivered personally or by courier (including a recognized overnight delivery service) or by facsimile, in each case addressed to a party. The addresses for such communications shall be: If to the Company: To the address set forth immediately below such Company's name on the signature pages hereto. With copy to: Otto E. Sorensen, Esq. LUCE, FORWARD, HAMILTON AND SCRIPPS, LLP 600 West Broadway, Suite 2600 San Diego, CA 92191 Tel (619) 699-2534 Fax (619) 232-8311 If to a Buyer: To the address set forth immediately below such Buyer's name on the signature pages hereto. Each party shall provide notice to the other party of any change in address. (G) SUCCESSORS AND ASSIGNS. This Agreement shall be binding upon and inure to the benefit of the parties and their successors and assigns. Neither the Company nor any Buyer shall assign this Agreement or any rights or obligations hereunder without the prior written consent of the other. Notwithstanding the foregoing, subject to Section 2(f), Buyer may assign its rights hereunder to any person that purchases Securities in a private transaction from a Buyer or to any of its "affiliates," as that term is defined under the 1934 Act, without the consent of the Company; PROVIDED, HOWEVER, that prior to any assignment of its rights hereunder to a person (other than an affiliate) that purchases any Debentures or Warrants from such Buyer in a private transaction such Buyer shall provide the Company with written notice of its intention to sell some or all of the Debentures or Warrants, which notice shall disclose the proposed purchase price for such Debentures or Warrants, and the Company shall have the option, during the ten (10) business day period following such notice, to purchase all, but not less than all, of such Debentures and/or Warrants at the proposed purchase price, after which period the Buyer shall be free to sell the Debentures and/or Warrants to a third party at such proposed purchase price. 41 (H) THIRD PARTY BENEFICIARIES. This Agreement is intended for the benefit of the parties hereto and their respective permitted successors and assigns, and is not for the benefit of, nor may any provision hereof be enforced by, any other person. (I) SURVIVAL. The covenants, agreements, representations and warranties of the parties hereto contained in this Agreement shall survive the closing hereunder for a period of two (2) years notwithstanding any due diligence investigation conducted by or on behalf of the Buyer. (J) INDEMNIFICATION. The Company (the "INDEMNIFYING PARTY") agrees to indemnify and hold harmless the Buyer and all its officers, directors, employees, agents, members and managers (the "INDEMNIFIED PARTY") for loss or damage arising as a result of or related to any breach or alleged breach by the Company of any of its representations, warranties and covenants set forth in Sections 3 and 4 hereof or any of its covenants and obligations under this Agreement or the Registration Rights Agreement, including advancement of expenses as they are incurred with respect to claims by third parties. Promptly after receipt of notice of the commencement of any action against an Indemnified Party, such Indemnified Party shall notify the Indemnifying Party in writing of the commencement thereof and the basis hereunder upon which a claim for indemnification is asserted, but the failure to do so shall not relieve the Indemnifying Party of its obligations hereunder except to the extent the Indemnifying Party is materially prejudiced by such failure. In the event of the commencement of any such action, the Indemnifying Party shall be entitled to participate therein and to assume the defense thereof with counsel satisfactory to the Indemnified Party, and, after notice from the Indemnifying Party to the Indemnified Party of its election so to assume the defense thereof, the Indemnifying Party shall not be liable to the Indemnified Party hereunder for any legal expenses (including attorneys' fees) subsequently incurred by such Indemnified Party in connection with the defense thereof other than reasonable costs of investigation and of liaison with counsel so selected, provided, however, that, if the defendants in any such action include both the Indemnified Party and the Indemnifying Party and the Indemnified Party shall have reasonably concluded that there may be reasonable defenses available to it which are different from or additional to those available to the Indemnifying Party or if the interests of the Indemnified Party reasonably may be deemed to conflict with the interests of the Indemnifying Party, the Indemnified Party shall have the right to select one separate counsel and to assume such legal defenses and otherwise to participate in the defense of such action, with the reasonable expenses and fees of such separate counsel and other expenses related to such participation to be reimbursed by the Indemnifying Party as incurred. 42 As to cases in which the Indemnifying Party has assumed and is providing the defense for the Indemnified Party, the control of such defense shall be vested in the Indemnifying Party; provided that the consent of the Indemnified Party shall be required prior to any settlement of such case or action, which consent shall not be unreasonably withheld. As to any action, the party which is controlling such action shall provide to the other party reasonable information (including reasonable advance notice of all proceedings and depositions in respect thereto) regarding the conduct of the action and the right to attend all proceedings and depositions in respect thereto through its agents and attorneys, and the right to discuss the action with counsel for the party controlling such action. (K) PUBLICITY. The Company and the Buyer shall have the right to review a reasonable period of time before issuance of any press releases, filings with the SEC, NASD or any stock exchange or interdealer quotation system, or any other public statements with respect to the transactions contemplated hereby; PROVIDED, HOWEVER, that the Company shall be entitled, without the prior approval of the Buyer, to make any press release or public filings with respect to such transactions as is required by applicable law and regulations (although the Buyer shall be consulted by the Company in connection with any such press release prior to its release and shall be provided with a copy thereof and be given an opportunity to comment thereon). (L) FURTHER ASSURANCES. Each party shall do and perform, or cause to be done and performed, all such further acts and things, and shall execute and deliver all such other agreements, certificates, instruments and documents, as the other party may reasonably request in order to carry out the intent and accomplish the purposes of this Agreement and the consummation of the transactions contemplated hereby. (M) NO STRICT CONSTRUCTION. The language used in this Agreement will be deemed to be the language chosen by the parties to express their mutual intent, and no rules of strict construction will be applied against any party. (N) REMEDIES. The Company acknowledges that a breach by it of its obligations hereunder will cause irreparable harm to Buyer, by vitiating the intent and purpose of the transactions contemplated hereby. Accordingly, the Company acknowledges that the remedy at law for a breach of its obligations under this Agreement will be inadequate and agrees, in the event of a breach or threatened breach by the Company of the provisions of this Agreement, that Buyer shall be entitled, in addition to all other available remedies in law or in equity, to an injunction or injunctions to prevent or cure any breaches of the provisions of this Agreement and to enforce specifically the terms and provisions of this Agreement, without the necessity of showing economic loss and without any bond or other security being required. (O) NO ORAL AMENDMENTS. There shall be no oral modifications or amendments to this Agreement. This Agreement may be modified or amended only in writing. 43 IN WITNESS WHEREOF, the undersigned Buyer and the Company have caused this Agreement to be duly executed as of the {{ExecDay}} day of November, 2004. - ------------------------------------------------------------------------------- PATRIOT SCIENTIFIC CORPORATION By: ________________________ Lowell W. Giffhorn, CFO By: _____________________ {{FirstName}} {{LastName}} By: ________________________ Jeffrey E. Wallin, Pres. & CEO ADDRESS: ADDRESS: {{Address1}} PATRIOT SCIENTIFIC CORPORATION {{City}}, {{State}} {{PostalCode}} 10989 Via Frontera Telephone: {{HomePhone}} San Diego, CA 92127 Facsimile: {{Fax}} Telephone: (858) 674-5000 FACSIMILE: (858) 674-5005 - ------------------------------------------------------------------------------- 44 THE SECURITIES REPRESENTED BY THIS CERTIFICATE HAVE NOT BEEN REGISTERED UNDER THE SECURITIES ACT OF 1933, AS AMENDED (THE"ACT") OR APPLICABLE STATE SECURITIES LAWS. SUCH SECURITIES MAY NOT BE SOLD, TRANSFERRED OR ASSIGNED IN THE ABSENCE OF AN EFFECTIVE REGISTRATION STATEMENT FOR THE SECURITIES UNDER SAID ACT, OR AN OPINION OF COUNSEL IN FORM, SUBSTANCE AND SCOPE REASONABLY SATISFACTORY TO COUNSEL TO THE BORROWER THAT REGISTRATION IS NOT REQUIRED UNDER SAID ACT OR UNLESS SOLD PURSUANT TO RULE 144 UNDER SAID ACT. CONVERTIBLE DEBENTURE FOR VALUE RECEIVED, PATRIOT SCIENTIFIC CORPORATION, a Delaware corporation (hereinafter called the "BORROWER" or "COMPANY"), hereby promises to pay to the order of {{FirstName}} {{LastName}}, an individual, or registered assigns (the "HOLDER") the sum of {{AmtSpell}} Thousand Dollars ({{DebDol}}), on {{MatDate}} (the "MATURITY DATE"), and to pay interest on the unpaid principal balance hereof at the rate of eight percent (8%) per annum from {{FundDate}} (the "ISSUE DATE") until the same becomes due and payable, whether at maturity or upon acceleration or otherwise. Any amount of principal or interest on this Convertible Debenture ("the Debenture") which is not paid when due shall bear interest at the rate of fifteen percent (15%) per annum from the due date thereof until the same is paid ("DEFAULT INTEREST"). Interest shall commence accruing on the Issue Date, shall be computed on the basis of a 365-day year and the actual number of days elapsed and shall be payable monthly, in cash or, to the extent not yet paid, at maturity or upon acceleration in accordance with the terms hereof. All payments due hereunder (to the extent not converted into Common Stock, par value $0.00001 per share, of the Borrower (the "COMMON STOCK") in accordance with the terms hereof) shall be made in lawful money of the United States of America provided that, to the extent that any accrued interest has not been paid when due, at the option of the Holder, in whole or in part, such accrued and unpaid interest may, upon written notice to the Borrower, be added to the principal amount of this Debenture, in which event interest shall accrue thereon in accordance with the terms of this Debenture and such additional principal amount shall be convertible into Common Stock in accordance with the terms of this Debenture. All payments shall be made at such address as the Holder shall hereafter give to the Borrower by written notice made in accordance with the provisions of this Debenture. Whenever any amount expressed to be due by the terms of this Debenture is due on any day which is not a business day, the same shall instead be due on the next succeeding day which is a business day. Except as otherwise expressly provided herein, this Debenture may not be prepaid by the Borrower. As used in this Debenture, the term "business day" shall mean any day other than a Saturday, Sunday or a day on which commercial banks in the City of New York, New York are authorized or required by law or executive order to remain closed. Each capitalized term used herein, and not otherwise defined, shall have the meaning ascribed thereto in that certain Securities Purchase Agreement, dated {{FundDate}}, pursuant to which this Debenture was originally issued (the "PURCHASE AGREEMENT"). For purposes hereof, the term "Debentures" shall be deemed to refer to this Debenture, all other convertible debentures issued pursuant to the Purchase Agreement and all convertible debentures issued in replacement hereof or thereof or otherwise with respect hereto or thereto. The following terms shall apply to this Debenture: ARTICLE I. CONVERSION RIGHTS 1.1 CONVERSION RIGHT. (A) CONVERSION TIMING AND AMOUNT. Subject to the limitations on conversion contained herein, the Holder shall have the right from time to time, and at any time on or after the Conversion Beginning Date and on or prior to the earlier of (i) the Maturity Date and (ii) the date of payment of the Default Amount (as defined in Article III) pursuant to Article III or Section 1.6 hereof, to convert all or any part of the outstanding and unpaid principal amount of this Debenture into fully paid and non-assessable shares of Common Stock, as such Common Stock exists on the Issue Date, or any shares of capital stock or other securities of the Borrower into which such Common Stock shall hereafter be changed or reclassified, at the Conversion Price (as defined in Section 1.2 below) determined as provided herein (a "CONVERSION"); (B) LIMITATION ON CONVERSION. Notwithstanding the above, in no event shall the Holder be entitled to convert any portion of this Debenture in excess of that portion of this Debenture upon conversion of which the sum of (1) the number of shares of Common Stock beneficially owned by the Holder and any applicable affiliates (other than shares of Common Stock which may be deemed beneficially owned through the ownership of the unconverted portion of the Debentures, the unexercised Warrants or the unexercised or unconverted portion of any other security of the Borrower subject to a limitation on conversion or exercise analogous to the limitations contained herein) and (2) the number of shares of Common Stock issuable upon the conversion of the portion of this Debenture with respect to which the determination of this proviso is being made, would result in beneficial ownership by the Holder and its affiliates of more than 4.99% of the outstanding shares of Common Stock (the "4.99% LIMITATION"). For purposes of the proviso to the immediately preceding sentence, (i) beneficial ownership shall be determined by the Holder in accordance with Section 13(d) of the Exchange Act and Regulations 13D-G thereunder, except as otherwise provided in clause (1) of such proviso to the immediately preceding sentence, and PROVIDED THAT the 4.99% Limitation shall be conclusively satisfied if the applicable Notice of Conversion includes a signed representation by the Holder that the issuance of the shares in such Notice of Conversion will not violate the 4.99% Limitation, and the Company shall not be entitled to require additional documentation of such satisfaction. The parties agree that, in the event that the Company receives any tender offer or any offer to enter into a merger with another entity whereby the Company shall not be the surviving entity (an "Offer"), then "4.99%" shall be automatically revised immediately after such offer to read "9.99%" each place it occurs in the first paragraph of this Section 1(b) above. Notwithstanding the above, Holder shall retain the option to either exercise or not exercise its option(s) to acquire Common Stock pursuant to the terms hereof after an Offer. 2 (C) CALCULATION OF CONVERSION AMOUNT. The number of shares of Common Stock to be issued upon each conversion of this Debenture shall be determined by dividing the Conversion Amount (as defined herein) by the applicable Conversion Price. The term "CONVERSION AMOUNT" means, with respect to any conversion of this Debenture, the sum of (1) the principal amount of this Debenture to be converted in such conversion, PLUS (2) all accrued and unpaid interest thereon for the period beginning on the Issue Date and ending on the Conversion Date (as defined in Section 1.4 hereof), PLUS (3) Default Interest, if any, on the amounts referred to in the immediately preceding clauses (1) and/or (2), PLUS (4) at the Holder's option, any amounts owed to the Holder pursuant to Sections 1.3 and 1.4 hereof or pursuant to Section 2 of that certain Registration Rights Agreement, dated as of {{FundDate}}, executed in connection with the initial issuance of this Debenture and the other Debentures issued on the Issue Date (the "REGISTRATION RIGHTS AGREEMENT"). 1.2 CONVERSION PRICE. (A) INITIAL CONVERSION PRICE. Subject to the provisions of Section 1.5 below, the "CONVERSION PRICE" shall initially equal {{ConvPrice}} (the "INITIAL CONVERSION PRICE"), which represents either a negotiated price or one hundred and fifteen percent (115%) of the Market Price, as defined herein, determined on the date of this Debenture (subject to equitable adjustments for stock splits, stock dividends or rights offerings by the Borrower relating to the Borrower's securities or the securities of any subsidiary of the Borrower, combinations, recapitalization, reclassifications, extraordinary distributions and similar events). (B) RESETS OF CONVERSION PRICE. In the event that the Market Price determined on any Reset Date (as defined herein) (each, a "RESET DATE MARKET PRICE") is less than the lesser of (i) the Initial Conversion Price or (ii) the lowest Reset Date Market Price for any prior Reset Date (if any)(the lesser of (i) and (ii) immediately above being referred to herein as the "ADJUSTED CONVERSION PRICE"), then the Conversion Price shall, beginning on the Trading Day next following the applicable Reset Date and at all times thereafter (unless later reset under the terms of this Debenture), equal the Adjusted Conversion Price for that Reset Date, PROVIDED, HOWEVER, that (x) if the Registration Statement (as defined in the Registration Rights Agreement) required to be filed pursuant to Section 2(a) of the Registration Rights Agreement has not been declared effective by the SEC prior to January 1, 2005 or (y) after January 1, 2005, such Registration Statement after its initial effectiveness lapses (a "LAPSE") in effect or sales of all of the Registrable Securities (as defined in the Registration Rights Agreement) otherwise cannot be made thereunder, whether by reason of the Borrower's failure or inability to amend or supplement the prospectus (the "PROSPECTUS") included therein in accordance with the Registration Rights Agreement or otherwise, after such Registration Statement becomes effective (including, without limitation, during an Allowed Delay (as defined in Section 3(f) of the Registration Statement)(the date beginning on the first date of a Lapse and ending on the date on which the Holder is first notified in writing by the Borrower's counsel that sales of all of the Registrable Securities may again be made under the Prospectus shall be referred to as a "LAPSE PERIOD"), then the Conversion Price shall be reset to equal the lesser of (i) the Conversion Price then in effect, or (ii) (a) in the case of an event described in clause (x) of this proviso, the lowest Market Price on any day during the period beginning on January 1, 2005 and ending on the date on which the Registration Statement is declared effective, or (b) in the case of an event described in clause (y) of this proviso, the lowest Market Price during the applicable Lapse Period. The Conversion Price (whether by reference to the Initial Conversion Price or an Adjusted Conversion Price) shall be subject to adjustment pursuant to the provisions of Section 1.5. 3 (C) CERTAIN DEFINITIONS. For purposes hereof: The "VOLUME WEIGHTED AVERAGE PRICE" for any security as of any date means the volume weighted average sale price on the Over the Counter Electronic Bulletin Board (the "OTC-BB") as reported by, or as calculated based upon data reported by, Bloomberg Financial Markets or an equivalent, reliable reporting service mutually acceptable to and hereafter designated by holders of a majority in interest of the Debentures and the Borrower ("BLOOMBERG") or, if the OTC-BB is not the principal trading market for such security, the volume weighted average sale price of such security on the principal securities exchange or trading market where such security is listed or traded as reported by Bloomberg, or, if no volume weighted average sale price is reported for such security, then the last closing trade price of such security as reported by Bloomberg, or, if no last closing trade price is reported for such security by Bloomberg, the average of the bid prices of any market makers for such security that are listed in the "pink sheets" by the National Quotation Bureau, Inc. If the volume weighted average price cannot be calculated for such security on such date in the manner provided above, the volume weighted average price shall be the fair market value as mutually determined by the Borrower and the holders of a majority in interest of the Debentures being converted for which the calculation of the volume weighted average price is required in order to determine the Conversion Price of such Debentures. "TRADING DAY" shall mean any day on which the Common Sock is traded for any period on the OTC-BB, or on the principal securities exchange or other securities market on which the Common Stock is then being traded. "RESET DATE" shall mean each three (3) month anniversary of the Issue Date hereof throughout the term of this Debenture, and, in addition shall mean the date that a registration statement covering the resale of shares of Common Stock issuable upon conversion of this Debenture is declared effective. "MARKET PRICE," as of any date, means (i) the Volume Weighted Average Price (as defined herein) of the Company's Common Stock during the ten (10) consecutive trading day period immediately preceding the date in question. "CLOSING PRICE," as of any date, means the last sale price of the Common Stock on the OTC BB as reported by Bloomberg or, or, if the OTC-BB is not the principal trading market for such security, the last sale price of such security on the principal securities exchange or trading market where such security is listed or traded as reported by Bloomberg, Inc., or if no last sale price of such security is available on the OTC-BB for such security or in any of the foregoing manners, the average of the bid prices of any market makers for such security that are listed in the "pink sheets" by the National Quotation Bureau, Inc. If the Closing Price cannot be calculated for such security on such date in the manner provided above, the Closing Price shall be the fair market value as mutually determined by the Borrower and the Holder. 4 1.3 RESERVATION OF SHARES. (A) INCREASE AND MAINTENANCE OF AUTHORIZED AND RESERVED AMOUNT. The Borrower covenants that it will initially reserve (the "INITIAL SHARE RESERVATION") from its authorized and unissued Common Stock a number of shares of Common Stock equal to at least two times the initial principal amount of this Debenture, divided by Conversion Price in effect on the date of the Initial Share Reservation, free from preemptive rights, to provide for the issuance of Common Stock upon the conversion of this Debenture. Borrower further covenants that, beginning on the date of the Initial Share Reservation (the "CONVERSION BEGINNING DATE"), and continuing throughout the period the conversion right exists, the Borrower will reserve from its authorized and unissued Common Stock a sufficient number of shares (the "RESERVED AMOUNT"), free from preemptive rights, to provide for the issuance of Common Stock upon the full conversion of this Debenture. The Reserved Amount shall be increased from time to time in accordance with the Borrower's obligations pursuant to Section 4(h) of the Purchase Agreement. The Borrower represents that upon issuance, such shares will be duly and validly issued, fully paid and non-assessable. In addition, if the Borrower shall issue any securities or make any change to its capital structure which would change the number of shares of Common Stock into which the Debentures shall be convertible at the then applicable Conversion Price, the Borrower shall at the same time make proper provision so that thereafter there shall be a sufficient number of shares of Common Stock authorized and reserved, free from preemptive rights, for conversion of the outstanding Debentures. (B) INSTRUCTIONS TO TRANSFER AGENT. The Borrower (i) acknowledges that it has irrevocably instructed its transfer agent to issue certificates for the Common Stock issuable upon conversion of this Debenture and (ii) agrees that its issuance of this Debenture shall constitute full authority to its officers and agents who are charged with the duty of executing stock certificates to execute and issue the necessary certificates for shares of Common Stock in accordance with the terms and conditions of this Debenture. (C) CONVERSION FAILURE. If, at any time a Holder of this Debenture submits a Notice of Conversion, and the Borrower does not have sufficient authorized but unissued shares of Common Stock available to effect such conversion in accordance with the provisions of this Article I (a "CONVERSION FAILURE"), subject to Section 5.8, the Borrower shall issue to the Holder all of the shares of Common Stock which are then available to effect such conversion. The portion of this Debenture which the Holder included in its Notice of Conversion and which exceeds the amount which is then convertible into available shares of Common Stock (the "EXCESS AMOUNT") shall, notwithstanding anything to the contrary contained herein, not be convertible into Common Stock in accordance with the terms hereof until (and at the Holder's option at any time after) the date additional shares of Common Stock are authorized and duly reserved for issuance by the Borrower to permit such conversion. The Borrower shall pay to the Holder payments ("CONVERSION FAILURE PAYMENTS") for a Conversion Failure in a dollar amount equal to: 5 (A) a number of shares equal to the total outstanding principal amount plus accrued but unpaid interest of the Debenture at the time of the applicable Notice of Conversion, divided by the lowest Conversion Price in effect during the period beginning on and including the date of the Conversion Failure and ending on the date (the "AUTHORIZATION DATE") that the Borrower authorizes a sufficient number of shares of Common Stock to effect conversion of the full outstanding principal balance of this Debenture (a "CONVERSION FAILURE PERIOD"), multiplied by (B) the difference of: (x) the highest Closing Price per share for the Company's Common Stock for any trading day during the applicable Conversion Failure Period, minus (y) the lowest Conversion Price per share in effect at any time during the Conversion Failure Period. The Borrower shall use its best efforts to authorize a sufficient number of shares of Common Stock as soon as practicable following the earlier of (i) such time that the Holder notifies the Borrower or that the Borrower otherwise becomes aware that there are or likely will be insufficient authorized and unissued shares to allow full conversion of outstanding amount of this Debenture and (ii) a Conversion Failure. The Borrower shall send notice to the Holder of the authorization of additional shares of Common Stock, the Authorization Date and the amount of the Holder's accrued Conversion Failure Payments. (D) PAYMENT OF ACCRUED CONVERSION FAILURE PAYMENTS. The accrued Conversion Failure Payments for each Conversion Failure Period shall be paid in cash on or before the fifth (5th) day following the last business day of the applicable Conversion Failure Period in which they have accrued, PROVIDED that, at the option of the Holder (by written notice to the Borrower), such payments shall be added to the principal amount of this Debenture, in which event interest shall accrue thereon in accordance with the terms of this Debenture and such additional principal amount shall be convertible into Common Stock in accordance with the terms of this Debenture. Nothing herein shall limit the Holder's right to pursue actual damages (to the extent in excess of the Conversion Failure Payments) for the Borrower's failure to maintain a sufficient number of authorized shares of Common Stock, and the Holder shall have the right to pursue all remedies available at law or in equity (including a decree of specific performance and/or injunctive relief). Notwithstanding the above, if a particular Conversion Failure results in an Event of Default pursuant to Section 3.2, then the Conversion Failure Payment, for that Conversion Failure only, shall be considered to have been satisfied upon payment to the Holder of the Default Amount, in full, payable in accordance with Article III. 1.4 METHOD OF CONVERSION. (A) MECHANICS OF CONVERSION. Subject to Section 1.1 and the other provisions of this Debenture, this Debenture may be converted by the Holder in whole or in part at any time and from time to time after the Issue Date, by (A) submitting to the Borrower a duly executed notice of conversion in the form attached hereto as Exhibit A ("NOTICE OF CONVERSION") by facsimile dispatched prior to Midnight, New York City time (the "CONVERSION NOTICE DEADLINE") on the date specified therein on the Conversion Date (as defined herein) (or by other means resulting in, or reasonably expected to result in, written notice to the Borrower on the date specified therein as the Conversion Date) to the office of the Borrower; which notice shall specify the principal amount of this Debenture to be converted, the applicable Conversion Price, and the number of shares of Common Stock issuable upon such conversion; and (B) subject to Section 1.4(b), surrendering this Debenture at the principal office of the Borrower. 6 (B) SURRENDER OF DEBENTURE UPON CONVERSION. Notwithstanding anything to the contrary set forth herein, upon conversion of this Debenture in accordance with the terms hereof, the Holder shall not be required to physically surrender this Debenture to the Borrower unless the entire unpaid principal amount of this Debenture is so converted. The Holder and the Borrower shall maintain records showing the principal amount so converted and the dates of such conversions or shall use such other method, reasonably satisfactory to the Holder and the Borrower, so as not to require physical surrender of this Debenture upon each such conversion. In the event of any dispute or discrepancy, such records of the Borrower shall be controlling and determinative in the absence of manifest error. Notwithstanding the foregoing, if any portion of this Debenture is converted as aforesaid, the Holder may not transfer this Debenture unless the Holder first physically surrenders this Debenture to the Borrower, whereupon the Borrower will forthwith issue and deliver upon the order of the Holder a new Debenture of like tenor, registered as the Holder (upon payment by the Holder of any applicable transfer taxes) may request, representing in the aggregate the remaining unpaid principal amount of this Debenture. The Holder and any assignee, by acceptance of this Debenture, acknowledge and agree that, by reason of the provisions of this paragraph, following conversion of a portion of this Debenture, the unpaid and unconverted principal amount of this Debenture represented by this Debenture may be less than the amount stated on the face hereof. (C) PAYMENT OF TAXES. The Borrower shall not be required to pay any tax which may be payable in respect of any transfer involved in the issue and delivery of shares of Common Stock or other securities or property on conversion of this Debenture in a name other than that of the Holder (or in street name), and the Borrower shall not be required to issue or deliver any such shares or other securities or property unless and until the person or persons (other than the Holder or the custodian in whose street name such shares are to be held for the Holder's account) requesting the issuance thereof shall have paid to the Borrower the amount of any such tax or shall have established to the satisfaction of the Borrower that such tax has been paid. (D) LOST OR STOLEN DEBENTURES. Upon receipt by the Borrower of evidence of the loss, theft, destruction or mutilation of this Debenture, and (in the case of loss, theft or destruction) of indemnity reasonably satisfactory to the Borrower, and upon surrender and cancellation of this Debenture, if mutilated, the Borrower shall execute and deliver a new Debenture of like tenor and date. 7 (E) DELIVERY OF COMMON STOCK UPON CONVERSION. Upon submission of a Notice of Conversion, the Borrower shall, within three business days after the Conversion Date (the "DELIVERY PERIOD"), issue and deliver (or cause its Transfer Agent so to issue and deliver) in accordance with the terms hereof and the Purchase Agreement to or upon the order of the Holder that number of shares of Common Stock for the portion of this Debenture converted as shall be determined in accordance herewith. (F) DELIVERY FAILURE. In addition to any other remedies available to the Holder, including actual damages and/or equitable relief, in the event that the Borrower fails to deliver to the Holder Common Stock (a "DELIVERY FAILURE") issuable upon conversion of this Debenture pursuant to the Notice of Conversion by the date that is a two-day grace period following the Delivery Period, the Borrower shall pay to the Holder an amount ("DELIVERY FAILURE PAYMENTS") for a Delivery Failure in a dollar amount equal to: (A) a number of shares equal to the total outstanding principal amount and any accrued but unpaid interest of the Debentures at the time of the applicable Notice of Conversion, divided by the lowest Conversion Price in effect during the period beginning on and including the date of the Delivery Failure and ending on the date (the "DELIVERY DATE") that the Borrower delivers to the Holder all of the Common Stock issuable upon conversion of this Debenture pursuant to the Notice of Conversion (a "DELVERY FAILURE PERIOD"), multiplied by (B) the difference of: (x) the highest Closing Price per share for the Company's Common Stock for any trading day during the applicable Delivery Failure Period, minus (y) the lowest Conversion Price per share in effect at any time during the applicable Delivery Failure Period. (G) PAYMENT OF ACCRUED DELIVERY FAILURE PAYMENTS. The accrued Delivery Failure Payments for each Delivery Failure Period shall be paid in cash on or before the fifth (5th) day following the last business day of the Delivery Failure Period in which they have accrued, PROVIDED that, at the option of the Holder (by written notice to the Borrower), such payments shall be added to the principal amount of this Debenture, in which event interest shall accrue thereon in accordance with the terms of this Debenture and such additional principal amount shall be convertible into Common Stock in accordance with the terms of this Debenture; PROVIDED, HOWEVER, in the event of a failure by the Borrower to deliver shares upon conversion as a result of a Conversion Failure, the Holder shall not be entitled to receive Delivery Failure Payments but shall be entitled to receive Conversion Failure Payments in accordance with Section 1.3. Notwithstanding the above, if a particular Delivery Failure results in an Event of Default pursuant to Section 3.2, then the Delivery Failure Payment, for that Delivery Failure only, shall be considered to have been satisfied upon payment to the Holder of the Default Amount, in full, payable in accordance with Article III. 8 (H) DELIVERY OF ELECTRONIC SHARES. In lieu of delivering physical certificates representing the Common Stock issuable upon conversion, provided the Borrower's Transfer Agent is participating in the Depository Trust Company ("DTC") Fast Automated Securities Transfer ("FAST") program, upon written request of the Holder and its compliance with the provisions contained in Section 1.1 and in this Section 1.4, the Borrower shall use its best efforts to cause its Transfer Agent to electronically transmit the Common Stock issuable upon conversion to the Holder by crediting the account of the Holder's Prime Broker with DTC through its Deposit Withdrawal Agent Commission ("DWAC") system. The time periods for delivery and penalties described in the immediately preceding paragraph shall apply to the electronic transmittals described herein. (I) OBLIGATION OF BORROWER TO DELIVER COMMON STOCK. Upon receipt by the Borrower of a Notice of Conversion, the Holder shall be deemed to be the holder of record of the Common Stock issuable upon such conversion, the outstanding principal amount and the amount of accrued and unpaid interest on this Debenture shall be reduced to reflect such conversion, and, unless the Borrower defaults on its obligations hereunder, all rights with respect to the portion of this Debenture being so converted shall forthwith terminate except the right to receive the Common Stock or other securities, cash or other assets, as herein provided, on such conversion. If the Holder shall have given a Notice of Conversion as provided herein, the Borrower's obligation to issue and deliver the certificates for Common Stock shall be absolute and unconditional, irrespective of the absence of any action by the Holder to enforce the same, any waiver or consent with respect to any provision thereof, the recovery of any judgment against any person or any action to enforce the same, any failure or delay in the enforcement of any other obligation of the Borrower to the holder of record, or any setoff, counterclaim, recoupment, limitation or termination, or any breach or alleged breach by the Holder of any obligation to the Borrower, and irrespective of any other circumstance which might otherwise limit such obligation of the Borrower to the Holder in connection with such conversion. (J) NO FRACTIONAL SHARES. If any conversion of this Debenture would result in a fractional share of Common Stock or the right to acquire a fractional share of Common Stock, such fractional share shall be disregarded and the number of shares of Common Stock issuable upon conversion of this Debenture shall be the next higher number of shares. (K) CONVERSION DATE. The "CONVERSION DATE" shall be the date specified in the Notice of Conversion, provided that the Notice of Conversion is submitted by facsimile (or by other means resulting in, or reasonably expected to result in, written notice) to the Borrower or its Transfer Agent before Midnight, New York City time, on the date so specified, otherwise the Conversion Date shall be the first business day after the date so specified (provided that the Notice of Conversion is actually received by the Borrower or its Transfer Agent on such business day). The person or persons entitled to receive the shares of Common Stock issuable upon conversion shall be treated for all purposes as the record holder or holders of such securities as of the Conversion Date and all rights with respect to this Debenture (or portion thereof) surrendered shall forthwith terminate except the rights set forth in Sections 1.4(f) and Section 1.7 hereof. 9 1.5 EFFECT OF CERTAIN EVENTS. (A) EFFECT OF MERGER, CONSOLIDATION, ETC. At the option of the Holder, the sale, conveyance or disposition of all or substantially all of the assets of the Borrower, the effectuation by the Borrower of a transaction or series of related transactions in which more than 50% of the voting power of the Borrower is disposed of, or the consolidation, merger or other business combination of the Borrower with or into any other Person (as defined herein) or Persons when the Borrower is not the survivor shall, at the Holder's option, either: (i) be deemed to be an Event of Default (as defined in Article III) pursuant to which the Borrower shall be required to pay to the Holder upon the consummation of and as a condition to such transaction an amount equal to the Default Amount (as defined in Article III) or (ii) be treated pursuant to Section 1.5(b) hereof. "PERSON" shall mean any individual, corporation, limited liability company, partnership, association, trust or other entity or organization. (B) ADJUSTMENT DUE TO MERGER, CONSOLIDATION, ETC. If, at any time when this Debenture is issued and outstanding and prior to conversion of all of the Debentures, there shall be any merger, consolidation, exchange of shares, recapitalization, reorganization, or other similar event, as a result of which shares of Common Stock of the Borrower shall be changed into the same or a different number of shares of another class or classes of stock or securities of the Borrower or another entity, or in case of any sale or conveyance of all or substantially all of the assets of the Borrower other than in connection with a plan of complete liquidation of the Borrower (each, a "CHANGE OF CONTROL TRANSACTION"), then the Holder of this Debenture shall thereafter have the right to receive upon conversion of this Debenture, upon the basis and upon the terms and conditions specified herein and in lieu of the shares of Common Stock immediately theretofore issuable upon conversion, such stock, securities or assets which the Holder would have been entitled to receive in such transaction had this Debenture been converted in full immediately prior to such transaction (without regard to any limitations on conversion set forth herein, including but not limited to without regard to the 4.99% Limitation), and in any such case appropriate provisions shall be made with respect to the rights and interests of the Holder of this Debenture to the end that the provisions hereof (including, without limitation, provisions for adjustment of the Conversion Price and of the number of shares issuable upon conversion of the Debenture) shall thereafter be applicable, as nearly as may be practicable in relation to any securities or assets thereafter deliverable upon the conversion hereof. The Borrower shall not effect any transaction described in this Section 1.5(b) unless (a) it first gives, to the extent practicable, thirty (30) days prior written notice (but in any event at least fifteen (15) business days prior written notice) of the record date of the special meeting of shareholders to approve, or if there is no such record date, the consummation of, such merger, consolidation, exchange of shares, recapitalization, reorganization or other similar event or sale of assets (during which time the Holder shall be entitled to convert this Debenture) and (b) the resulting successor or acquiring entity (if not the Borrower) and, if an entity different from the successor or acquiring entity, the entity whose capital stock or assets the holders of Common Stock are entitled to receive as a result of such Change of Control Transaction, assumes by written instrument the obligations of this Debenture, including this Section 1.5(b). The above provisions shall similarly apply to successive consolidations, mergers, sales, transfers or share exchanges. 10 (C) ADJUSTMENT DUE TO DISTRIBUTION. If the Borrower shall declare or make any distribution of its assets (or rights to acquire its assets) to holders of Common Stock as a dividend, stock repurchase, by way of return of capital or otherwise (including any dividend or distribution to the Borrower's shareholders in cash or shares (or rights to acquire shares) of capital stock of a subsidiary (i.e., a spin-off) (a "DISTRIBUTION"), then the Holder of this Debenture shall be entitled, upon any conversion of this Debenture after the date of record for determining shareholders entitled to such Distribution, to receive the amount of such assets which would have been payable to the Holder with respect to the shares of Common Stock issuable upon such conversion had such Holder been the holder of such shares of Common Stock on the record date for the determination of shareholders entitled to such Distribution. (D) PURCHASE RIGHTS. If, at any time when any Debentures are issued and outstanding, the Borrower issues any convertible securities or rights to purchase stock, warrants, securities or other property (the "PURCHASE RIGHTS") pro rata to the record holders of any class of Common Stock, then the Holder of this Debenture will be entitled to acquire, upon the terms applicable to such Purchase Rights, the aggregate Purchase Rights which such Holder could have acquired if such Holder had held the number of shares of Common Stock acquirable upon complete conversion of this Debenture (without regard to any limitations on conversion contained herein) immediately before the date on which a record is taken for the grant, issuance or sale of such Purchase Rights or, if no such record is taken, the date as of which the record holders of Common Stock are to be determined for the grant, issue or sale of such Purchase Rights. (E) ADDITIONAL ADJUSTMENTS TO CONVERSION PRICE. The Conversion Price shall be subject to adjustment from time to time as provided in this Section 1.5(e). (i) ADJUSTMENT OF CONVERSION PRICE. If, and whenever on or after the date of issuance of this Debenture, the Borrower issues or sells any shares of Common Stock for no consideration or for a consideration per share less than the Conversion Price then in effect, or issues any convertible securities, warrants (other than those issuable to the Holder), options (including but not limited to employee stock options), equity line type offerings or other underwritten offerings, or any other type of security that is convertible or exchangeable into common stock at a rate or price that is less than the Conversion Price then in effect, or carries with it the right to receive additional shares of Common Stock at a later date, such that the average price per share for such shares of Common Stock is less than the Conversion Price then in effect, then the Conversion Price shall immediately be reduced to equal the price per share of such other Common Stock, options, or other securities. (ii) SUBDIVISION OR COMBINATION OF COMMON STOCK. If the Borrower at any time subdivides (by any stock split, stock dividend, recapitalization, reorganization, reclassification or otherwise) the shares of Common Stock acquirable hereunder into a greater number of shares, then, after the date of record for effecting such subdivision, the Conversion Price in effect immediately prior to such subdivision will be proportionately reduced. If the Borrower at any time combines (by reverse stock split, recapitalization, reorganization, reclassification or otherwise) the shares of Common Stock acquirable hereunder into a smaller number of shares, then, after the date of record for effecting such combination, the Conversion Price in effect immediately prior to such combination will be proportionately increased. 11 (F) NOTICE OF ADJUSTMENTS. Upon the occurrence of each adjustment or readjustment of the Conversion Price as a result of the events described in this Section 1.5, the Borrower, at its expense, shall promptly compute such adjustment or readjustment and prepare and furnish to the Holder of a certificate setting forth such adjustment or readjustment and showing in detail the facts upon which such adjustment or readjustment is based. The Borrower shall, upon the written request at any time of the Holder, furnish to such Holder a like certificate setting forth (i) such adjustment or readjustment, (ii) the Conversion Price at the time in effect and (iii) the number of shares of Common Stock and the amount, if any, of other securities or property which at the time would be received upon conversion of the Debenture. 1.6 [INTENTIONALLY LEFT BLANK]. 1.7 STATUS AS SHAREHOLDER. Upon submission of a Notice of Conversion by a Holder, (i) the shares covered thereby (other than the shares, if any, which cannot be issued because their issuance would exceed such Holder's allocated portion of the Reserved Amount) shall be deemed converted into shares of Common Stock and (ii) the Holder's rights as a Holder of such converted portion of this Debenture shall cease and terminate, excepting only the right to receive certificates for such shares of Common Stock and to any remedies provided herein or otherwise available at law or in equity to such Holder because of a failure by the Borrower to comply with the terms of this Debenture. Notwithstanding the foregoing, if a Holder has not received certificates for all shares of Common Stock prior to the tenth (10th) business day after the expiration of the deadline with respect to a conversion of any portion of this Debenture for any reason, then (unless the Holder otherwise elects to retain its status as a holder of Common Stock by so notifying the Borrower) the Holder shall regain the rights of a Holder of this Debenture with respect to such unconverted portions of this Debenture and the Borrower shall, as soon as practicable, return such unconverted Debenture to the Holder or, if the Debenture has not been surrendered, adjust its records to reflect that such portion of this Debenture has not been converted. In all cases, the Holder shall retain all of its rights and remedies (including, without limitation, the right to receive Conversion Failure Payments pursuant to Section 1.3 to the extent required thereby for such Conversion Failure and any subsequent Conversion Failure) for the Borrower's failure to convert this Debenture. ARTICLE II. CERTAIN COVENANTS 2.1 DISTRIBUTIONS ON CAPITAL STOCK. So long as the Borrower shall have any obligation under this Debenture, the Borrower shall not, without the Holder's written consent, (a) pay, declare or set apart for such payment, any dividend or other distribution (whether in cash, property or other securities) on shares of capital stock other than dividends on shares of Common Stock solely in the form of additional shares of Common Stock or (b) directly or indirectly or through any subsidiary make any other payment or distribution in respect of its capital stock. 12 2.2 RESTRICTION ON STOCK REPURCHASES. So long as the Borrower shall have any obligation under this Debenture, the Borrower shall not, without the Holder's written consent, redeem, repurchase or otherwise acquire (whether for cash or in exchange for property or other securities or otherwise) in any one transaction or series of related transactions any shares of capital stock of the Borrower or any warrants, rights or options to purchase or acquire any such shares, except for any such repurchases made by the Borrower in connection with the termination of employment of any of its employees, PROVIDED that such repurchases are (i) made at no greater than the Market Price of such shares of capital stock and (ii) approved by a majority of the Borrower's disinterested directors. 2.3 BORROWINGS. So long as the Borrower shall have any obligation under this Debenture, the Borrower shall not, without the Holder's written consent, create, incur, assume or suffer to exist any liability for borrowed money, except (a) borrowings in existence or committed on the date hereof and of which the Borrower has informed the Holder in writing prior to the date hereof, (b) indebtedness to trade creditors incurred in the ordinary course of business, (c) borrowings, the proceeds of which shall be used to repay this Debenture, or (d) asset-based borrowings involving accounts receivable or inventory financing or leaseholds. 2.3 ADVANCES AND LOANS. So long as the Borrower shall have any obligation under this Debenture, the Borrower shall not, without the Holder's written consent, lend money, give credit or make advances to any person, firm, joint venture or corporation, including, without limitation, officers, directors, employees, subsidiaries and affiliates of the Borrower, except loans, credits or advances (a) in existence or committed on the date hereof and which the Borrower has informed the Holder in writing prior to the date hereof, (b) made in the ordinary course of business, as determined by a majority of the Borrower's disinterested directors or (c) relating to (i) the recruitment or retention of employees or (ii) transactions with joint venture partners or subsidiaries, provided that such loans, credits or advances referred to in (i) and (ii) are approved by a majority of the Borrower's disinterested directors. 2.4 CONTINGENT LIABILITIES. So long as the Borrower shall have any obligation under this Debenture, the Company shall not without the Holder's written consent, assume, guarantee, endorse, contingently agree to purchase or otherwise become liable upon the obligation of any person, firm, partnership, joint venture or corporation, except by the endorsement of negotiable instruments for deposit or collection and except assumptions, guarantees, endorsements and contingencies (a) in existence or committed on the date hereof and which the Borrower has informed the Holder in writing prior to the date hereof, (b) made in the ordinary course of business, as determined by a majority of the Borrower's disinterested directors or (c) relating to (i) the recruitment or retention of employees or (ii) transactions with joint venture partners or subsidiaries, provided that such assumptions, guarantees, endorsements and contingencies referred to in (i) and (ii) are approved by a majority of the Borrower's disinterested directors. 13 ARTICLE III. EVENTS OF DEFAULT Each of the following events shall be considered to be an "EVENT OF DEFAULT", unless waived by the Holder: 3.1 FAILURE TO PAY PRINCIPAL OR INTEREST. The Borrower fails to pay the principal hereof or interest thereon when due on this Debenture, whether at maturity, upon mandatory prepayment, upon acceleration or otherwise; 3.2 CONVERSION AND THE SHARES. The Borrower (a) fails to issue shares of Common Stock to the Holder upon exercise by the Holder of the conversion rights of the Holder in accordance with the terms of this Debenture (for a period of at least sixty (60) days, if such failure is a Conversion Failure solely as a result of a shortage of authorized shares and the Borrower is using its best efforts to authorize a sufficient number of shares of Common Stock as soon as practicable or for a period of at least thirty (30) days if such failure is a Delivery Failure under Section 1.4(f) and is not as a result of a shortage of authorized shares), (b) at any time, the Company announces or states in writing that it will not honor its obligations to issue shares of Common Stock to the Holder upon exercise by the Holder of the conversion rights of the Holder in accordance with the terms of this Debenture, (c) fails to transfer or cause its transfer agent to transfer (electronically or in certificated form) any certificate for shares of Common Stock issued to the Holder upon conversion of this Debenture as and when required by this Debenture or the Registration Rights Agreement, or (d) fails to remove any restrictive legend (or to withdraw any stop transfer instructions in respect thereof) on any certificate for any shares of Common Stock issued to the Holder upon conversion of this Debenture as and when required by this Debenture, the Purchase Agreement or the Registration Rights Agreement (or makes any announcement or written statement that it does not intend to honor the obligations described in this paragraph) and any such failure shall continue uncured (or any announcement or written statement not to honor its obligations shall not be rescinded in writing) for ten (10) days after the Borrower shall have been notified thereof in writing by the Holder; 3.3 FAILURE TO EFFECT REGISTRATION. The Borrower fails to file with the Securities and Exchange Commission on or before January 1, 2005 the Registration Statement(s) (as defined in the Registration Rights Agreement) required to be filed pursuant to Section 2(a) of the Registration Rights Agreement, or fails to obtain effectiveness with the Securities and Exchange Commission prior to March 1, 2005 of the Registration Statement(s) (as defined in the Registration Rights Agreement) required to be filed pursuant to Section 2(a) of the Registration Rights Agreement, or fails to obtain the effectiveness of any additional Registration Statement (required to be filed pursuant to Section 3(b) of the Registration Rights Agreement) within 60 days after the Registration Trigger Date (as defined in the Registration Rights Agreement), or as promptly as practicable in the event the Company is required to increase its authorized shares, or any such Registration Statement, after its initial effectiveness and during the Registration Period (as defined in the Registration Rights Agreement), lapses in effect or sales of all of the Registrable Securities (as defined in the Registration Rights Agreement) cannot otherwise be made thereunder (whether by reason of the Borrower's failure to amend or supplement the prospectus included therein in accordance with the Registration Rights Agreement, the Borrower's failure to file and obtain effectiveness with the SEC of an additional Registration Statement required pursuant to Section 3(b) of the Registration Rights Agreement or otherwise) for more than twenty (20) consecutive days or sixty (60) days in any twelve month period after such Registration Statement becomes effective; 14 3.4 BREACH OF COVENANTS. The Borrower breaches any material covenant or other material term or condition contained in Article II hereof or in Sections 1.3, 1.4 or 1.5 of this Debenture, or Sections 4(b), 4(c), 4(d), 4(e), 4(h), 4(i), 4(j), 4(k), 4(l), 4(m) or 5 of the Purchase Agreement and such breach continues for a period of ten (10) business days after written notice thereof to the Borrower from the Holder; 3.5 BREACH OF REPRESENTATIONS AND WARRANTIES. Any representation or warranty of the Borrower made herein or in any agreement, statement or certificate given in writing pursuant hereto (including, without limitation, pursuant to the Purchase Agreement and the Registration Rights Agreement), shall be false or misleading in any material respect when made and the breach of which has a material adverse effect on the rights of the Holder with respect to this Debenture, the Purchase Agreement or the Registration Rights Agreement; 3.6 RECEIVER OR TRUSTEE. The Borrower or any subsidiary of the Borrower shall make an assignment for the benefit of creditors, or apply for or consent to the appointment of a receiver or trustee for it or for a substantial part of its property or business, or such a receiver or trustee shall otherwise be appointed; 3.7 JUDGMENTS. Any money judgment, writ or similar process shall be entered or filed by a court against the Borrower or any subsidiary of the Borrower or any of its property or other assets for more than $1,000,000, and shall remain unvacated, unbonded or unstayed for a period of twenty (20) days unless otherwise consented to by the Holder, which consent will not be unreasonably withheld; 3.8 BANKRUPTCY. Bankruptcy, insolvency, reorganization or liquidation proceedings or other proceedings for relief under any bankruptcy law or any law for the relief of debtors shall be instituted by or against the Borrower or any "significant subsidiary" (as defined in Rule 1-02(w) of Regulation S-X promulgated under the 1933 Act) of the Borrower; 3.9 DELISTING OF COMMON STOCK. The Borrower shall fail to maintain the listing of the Common Stock on at least one of the NNM, the Nasdaq Small Cap, the NYSE, OTC-BB or the AMEX; 3.10 DEFAULT UNDER OTHER DEBENTURES. An Event of Default has occurred and is continuing under any of the other Debentures issued pursuant to the Purchase Agreement or under any of the warrants ("WARRANTS") issued pursuant to the Purchase Agreement; 15 3.11 FAILURE TO AUTHORIZE AND RESERVE COMMON STOCK. The Borrower shall fail to authorize and reserve, and maintain authorized and reserved, shares of Common Stock as required under Section 1.3 hereof; or 3.12 ACCEPTANCE OF A TENDER OFFER BY THE BORROWER. The Borrower shall accept a tender offer ("TENDER OFFER") from any person or entity to acquire fifty percent (50%) or more of the Borrower's shares of Common Stock. If any Events of Default shall occur then, unless waived by the Holder, upon the occurrence and during the continuation of any Event of Default specified in Section 3.1, 3.2, 3.3, 3.4, 3.5, 3.7, 3.9, 3.10, 3.11 or 3.12, at the option of the Holder, such option exercisable through the delivery of written notice to the Borrower by such Holders (the "DEFAULT NOTICE"), or upon the occurrence of an Event of Default specified in Section 3.6 or 3.8, the Debentures shall become immediately due and payable and the Borrower shall pay to the Holder, in full satisfaction of its obligations hereunder, an amount equal to the greater of: (i) 115% TIMES the SUM of (w) the then outstanding principal amount of this Debenture, PLUS (x) all accrued and unpaid interest thereon for the period beginning on the Issue Date and ending on the date of payment of the Default Amount (the "DEFAULT PAYMENT DATE"), PLUS (y) Default Interest, if any, on the amounts referred to in clauses (w) and/or (x), PLUS (z) any amounts owed to the Holder pursuant to Section 2(c) of the Registration Rights Agreement (the then outstanding principal amount of this Debenture to the date of payment PLUS the amounts referred to in clauses (x), (y) and (z) shall collectively be known as the "DEFAULT SUM"), or (ii) the Parity Value of the Default Sum to be prepaid, where "PARITY VALUE" means (a) the highest number of shares of Common Stock issuable upon conversion of such Default Sum in accordance with Article I (without giving any effect to any limitation on conversion of the Debenture contained herein, including but not limited to the 4.99% Limitation) calculated as follows: the Default Sum divided by the lowest Conversion Price in effect at any time after the Holder delivers a Default Notice to the Borrower, through the date that the Borrower pays the Default Amount, MULTIPLIED BY 16 (b) the highest Closing Price (as defined herein) for the Common Stock during the period beginning on the date of first occurrence of the Event of Default (provided that, with respect to a Conversion Failure or Delivery Failure that has resulted in an Event of Default under this Article III, such period shall begin on the date of the applicable Notice of Conversion) and ending one day prior to the Default Payment Date. The greater of (i) and (ii) immediately above is referred to herein as the "DEFAULT AMOUNT". The Conversion Price shall continue to be reset and adjusted in accordance with the terms of this Debenture notwithstanding a Default, up until the Default Amount is paid to the Holder in full. The Default Amount, together with all other amounts payable hereunder, shall immediately become due and payable, all without demand, presentment or notice, all of which hereby are expressly waived, together with all costs, including, without limitation, legal fees and expenses, of collection, and the Holder shall be entitled to exercise all other rights and remedies available at law or in equity. If the Borrower fails to pay the Default Amount within five (5) business days of written notice that such amount is due and payable (the "Default Amount Due Date"), then the Holder shall have the right at any time, so long as the Borrower remains in default (and so long and to the extent that there are sufficient authorized shares), to require the Borrower, upon written notice (which may be given one or more times, from time to time anytime after the Default Amount Due Date), to immediately issue, in lieu of all or any specified portion (the "Specified Portion") of the unpaid portion (the "Unpaid Portion") of the Default Amount, a number of shares (the "Default Shares") of Common Stock of the Borrower, subject to the 9.99% Limitation, equal to the Specified Portion of the Default Amount divided by the Conversion Price in effect on the date such shares are issued to the Holder, PROVIDED THAT, the Holder may require that such payment of shares be made in one or more installments at such time and in such amounts as Holder chooses. The Holder shall not be entitled to receive Default Shares on a given date if and to the extent that such issuance would cause the 9.99% Amount, as defined below, to be exceeded (the "9.99% LIMITATION"). If and to the extent that the issuance of Default Shares with respect to a given Specified Portion would result in the a violation of the 9.99% Limitation, then that particular Specified Portion shall be automatically reduced to a value that would cause the number of Default Shares to be issued to equal the 9.99% Amount, and the amount of such reduction shall be added back to the Unpaid Portion of the Default Amount. For purposes hereof, "9.99% Amount" shall mean a number of Default Shares to be issued with respect to a particular Specified Portion of the Default Amount which would, when aggregated with all other shares of Common Stock held by the Holder and its affiliates at the time of such issuance, result in beneficial ownership by the Holder and its affiliates of exactly 9.99% of the outstanding shares of Common Stock of the Borrower, with beneficial ownership being determined in accordance with Section 13(d) of the Securities Exchange Act of 1934, as amended (the "EXCHANGE ACT"), and Regulations 13D-G thereunder, PROVIDED THAT the 9.99% Limitation shall be conclusively satisfied if the Holder provides a signed representation that the issuance of the applicable shares will not violate the 9.99% Limitation, and the Company shall not be entitled to require additional documentation of such satisfaction. 17 ARTICLE IV. COLLATERALIZATION As security for the repayment of the principal, all accrued and unpaid interest and all other payments that are or become due pursuant to this Debenture, the Borrower does hereby grant, pledge, transfer, sell, assign, convey and deliver to the Holder, and do grant to the Holder a security interest in, all of the right, title and interest of such Borrower, in, to and under the following (hereinafter collectively referred to as the "Collateral"): All of the Borrower's patents, trademarks and other intellectual property, including but not limited to those set forth on Schedule A annexed hereto (collectively, the "INTELLECTUAL PROPERTY"). Except as otherwise set forth on Schedule B annexed hereto, the Borrower hereby represents that the Holder has a senior lien on the Collateral, and agrees not to grant any liens on the Collateral that are either senior to, or in parity with, the Holder's lien. The Borrower agrees to take all necessary actions to assist the Holder in perfecting the Holder's lien on each piece of Collateral within fifteen (15) days of the date hereof, including but not limiting to signing and delivering the appropriate forms. ARTICLE V. MISCELLANEOUS 5.1 FAILURE OR INDULGENCE NOT WAIVER. No failure or delay on the part of the Holder in the exercise of any power, right or privilege hereunder shall operate as a waiver thereof, nor shall any single or partial exercise of any such power, right or privilege preclude other or further exercise thereof or of any other right, power or privileges. All rights and remedies existing hereunder are cumulative to, and not exclusive of, any rights or remedies otherwise available. 5.2 NOTICES. Any notice herein required or permitted to be given shall be in writing and may be personally served or delivered by courier or sent by United States mail and shall be deemed to have been given upon receipt if personally served (which shall include telephone line facsimile transmission) or sent by courier or five (5) days after being deposited in the United States mail, certified, with postage pre-paid and properly addressed, if sent by mail. For the purposes hereof, the address of the Holder shall be as shown on the records of the Borrower; and the address of the Borrower shall be PATRIOT SCIENTIFIC CORPORATION, 10989 Via Frontera, San Diego, CA 92127, Telephone: (858) 674-5000, Facsimile: (858) 674-5005. Both the Holder and the Borrower may change the address for service by service of written notice to the other as herein provided. 5.3 AMENDMENTS. Except as otherwise expressly provided herein, this Debenture and any provision hereof may only be amended by an instrument in writing signed by the Borrower and the Holder. The term "Debenture" and all reference thereto, as used throughout this instrument, shall mean this instrument as originally executed, or if later amended or supplemented, then as so amended or supplemented. 18 5.4 ASSIGNABILITY. This Debenture shall be binding upon the Borrower and its successors and assigns, and shall inure to be the benefit of the Holder and its successors and assigns. 5.5 COST OF COLLECTION. If default is made in the payment of this Debenture, the Borrower shall pay the Holder hereof costs of collection, including reasonable attorneys' fees. 5.6 GOVERNING LAW; ARBITRATION. This Debenture shall be governed by and construed in accordance with the internal laws of the State of New York. Any controversy or claim arising out of or related to this Debenture or the breach thereof, shall be settled by binding arbitration in New York, NY in accordance with the Expedited Procedures (Rules 53-57) of the Commercial Arbitration Rules of the American Arbitration Association ("AAA"). A proceeding shall be commenced upon written demand by Company or the Holder to the other. The arbitrator(s) shall enter a judgment by default against any party, which fails or refuses to appear in any properly noticed arbitration proceeding. The proceeding shall be conducted by one (1) arbitrator, unless the amount alleged to be in dispute exceeds two hundred fifty thousand dollars ($250,000), in which case three (3) arbitrators shall preside. The arbitrator(s) will be chosen by the parties from a list provided by the AAA, and if they are unable to agree within ten (10) days, the AAA shall select the arbitrator(s). The arbitrators must be experts in securities law and financial transactions. The arbitrators shall assess costs and expenses of the arbitration, including all attorneys' and experts' fees, as the arbitrators believe is appropriate in light of the merits of the parties' respective positions in the issues in dispute. Each party submits irrevocably to the jurisdiction of any state court sitting in New York, NY or to the United States District Court sitting in New York for purposes of enforcement of any discovery order, judgment or award in connection with such arbitration. The award of the arbitrator(s) shall be final and binding upon the parties and may be enforced in any court having jurisdiction. The arbitration shall be held in such place as set by the arbitrator(s) in accordance with Rule 55. With respect to any arbitration proceeding in accordance with this section, the prevailing party's reasonable attorney's fees and expenses shall be borne by the non-prevailing party. Although the parties, as expressed above, agree that all claims, including claims that are equitable in nature, for example specific performance, shall initially be prosecuted in the binding arbitration procedure outlined above, if the arbitration panel dismisses or otherwise fails to entertain any or all of the equitable claims asserted by reason of the fact that it lacks jurisdiction, power and/or authority to consider such claims and/or direct the remedy requested, then, in only that event, will the parties have the right to initiate litigation respecting such equitable claims or remedies. The forum for such equitable relief shall be in either a state or federal court sitting in New York, NY. Each party waives any right to a trial by jury, assuming such right exists in an equitable proceeding, and irrevocably submits to the jurisdiction of said New York court. New York law shall govern both the proceeding as well as the interpretation and construction of the Debenture and the transaction as a whole. 5.7 CERTAIN AMOUNTS. Whenever pursuant to this Debenture the Borrower is required to pay an amount in excess of the outstanding principal amount (or the portion thereof 19 required to be paid at that time) plus accrued and unpaid interest plus Default Interest on such interest, the Borrower and the Holder agree that the actual damages to the Holder from the receipt of cash payment on this Debenture may be difficult to determine and the amount to be so paid by the Borrower represents stipulated damages and not a penalty and is intended to compensate the Holder in part for loss of the opportunity to convert this Debenture and to earn a return from the sale of shares of Common Stock acquired upon conversion of this Debenture at a price in excess of the price paid for such shares pursuant to this Debenture. The Borrower and the Holder hereby agree that such amount of stipulated damages is not plainly disproportionate to the possible loss to the Holder from the receipt of a cash payment without the opportunity to convert this Debenture into shares of Common Stock. 5.8 ALLOCATIONS OF AND RESERVED AMOUNT. The Reserved Amount shall be allocated pro rata among the holders of Debentures based on the principal amount of such Debentures issued to the Holder. Each increase to the Reserved Amount shall be allocated pro rata among the holders of Debentures based on the principal amount of such Debentures held by the Holder at the time of the increase in the Reserved Amount. In the event a Holder shall sell or otherwise transfer any of such Holder's Debentures, each transferee shall be allocated a pro rata portion of such transferor's Reserved Amount. Any portion of the Reserved Amount which remains allocated to any person or entity which does not hold any Debentures shall be allocated to the remaining Holders of Debentures, pro rata based on the principal amount of such Debentures then held by such Holders. 5.9 DAMAGES SHARES. The shares of Common Stock that may be issuable to the Holder pursuant to Sections 1.3 and 1.4 hereof and pursuant to Section 2 of the Registration Rights Agreement ("DAMAGES SHARES") shall be treated as Common Stock issuable upon conversion of this Debenture for all purposes hereof and shall be subject to all of the limitations and afforded all of the rights of the other shares of Common Stock issuable hereunder, including without limitation, the right to be included in the Registration Statement filed pursuant to the Registration Rights Agreement. For purposes of calculating interest payable on the outstanding principal amount hereof, except as otherwise provided herein, amounts convertible into Damages Shares ("DAMAGES AMOUNTS") shall not bear interest but must be converted prior to the conversion of any outstanding principal amount hereof, until the outstanding Damages Amounts is zero. 5.10 DENOMINATIONS. At the request of the Holder, upon surrender of this Debenture, the Borrower shall promptly issue new Debentures in the aggregate outstanding principal amount hereof, in the form hereof, in such denominations as the Holder shall request. 5.11 PURCHASE AGREEMENT. By its acceptance of this Debenture, the Holder agrees to be bound by the applicable terms of the Purchase Agreement. 5.12 NOTICE OF CORPORATE EVENTS. Except as otherwise provided in this Debenture, the Holder of this Debenture shall have no rights as a Holder of Common Stock unless and only to the extent that it converts this Debenture into Common Stock. The Borrower shall provide the Holder with prior notification of any meeting of the Borrower's shareholders (and copies of proxy materials and other information sent to shareholders). In the event of any taking by the 20 Borrower of a record of its shareholders for the purpose of determining shareholders who are entitled to receive payment of any dividend or other distribution, any right to subscribe for, purchase or otherwise acquire (including by way of merger, consolidation, reclassification or recapitalization) any share of any class or any other securities or property, or to receive any other right, or for the purpose of determining shareholders who are entitled to vote in connection with any proposed sale, lease or conveyance of all or substantially all of the assets of the Borrower or any proposed liquidation, dissolution or winding up of the Borrower, the Borrower shall mail a notice to the Holder, at least twenty (20) days prior to the record date specified therein (or thirty (30) days prior to the consummation of the transaction or event, whichever is earlier), of the date on which any such record is to be taken for the purpose of such dividend, distribution, right or other event, and a brief statement regarding the amount and character of such dividend, distribution, right or other event to the extent known at such time. The Borrower shall make a public announcement of any event requiring notification to the Holder hereunder substantially simultaneously with the notification to the Holder in accordance with the terms of this Section 5.12. 5.13 REMEDIES. The Borrower acknowledges that a breach by it of its obligations hereunder will cause irreparable harm to the Holder, by vitiating the intent and purpose of the transaction contemplated hereby. Accordingly, the Borrower acknowledges that the remedy at law for a breach of its obligations under this Debenture will be inadequate and agrees, in the event of a breach or threatened breach by the Borrower of the provisions of this Debenture, that the Holder shall be entitled, in addition to all other available remedies at law or in equity, to an injunction or injunctions restraining, preventing or curing any breach of this Debenture and to enforce specifically the terms and provisions thereof, without the necessity of showing economic loss and without any bond or other security being required. IN WITNESS WHEREOF, Borrower has caused this Debenture to be signed in its name by its duly authorized officer this {{ExecDay}} day of November, 2004. BORROWER: PATRIOT SCIENTIFIC CORPORATION By:_____________________________ Lowell W. Giffhorn, Exec. V.P. and CFO By: _____________________________ Jeffrey E. Wallin, Pres. and CEO 21 EXHIBIT A NOTICE OF CONVERSION (To be Executed by the Registered Holder in order to Convert the Debentures) The undersigned hereby irrevocably elects to convert $__________ principal amount of the Debenture (defined herein) into shares of common stock, par value $____ per share ("Common Stock"), of PATRIOT SCIENTIFIC CORPORATION, a Delaware corporation (the "BORROWER") according to the conditions of the convertible debentures of the Borrower dated as of {{FundDate}} (the "DEBENTURES"), as of the date written below. If securities are to be issued in the name of a person other than the undersigned, the undersigned will pay all transfer taxes payable with respect thereto and is delivering herewith such certificates. No fee will be charged to the Holder for any conversion, except for transfer taxes, if any. The Borrower shall electronically transmit the Common Stock issuable pursuant to this Notice of Conversion to the account of the undersigned or its nominee with DTC through its Deposit Withdrawal Agent Commission system ("DWAC TRANSFER"). Name of DTC Prime Broker:______________________________ Account Number:________________________________________ In lieu of receiving shares of Common Stock issuable pursuant to this Notice of Conversion by way of a DWAC Transfer, the undersigned hereby requests that the Borrower issue a certificate or certificates for the number of shares of Common Stock set forth above (which numbers are based on the Holder's calculation attached hereto) in the name(s) specified immediately below or, if additional space is necessary, on an attachment hereto: Name: _________________________________________________ Address: _______________________________________________ The undersigned represents and warrants that all offers and sales by the undersigned of the securities issuable to the undersigned upon conversion of the Debentures shall be made pursuant to registration of the securities under the Securities Act of 1933, as amended (the "ACT"), or pursuant to an exemption from registration under the Act. Date of Conversion:_______________________________ Applicable Conversion Price:________________________ Number of Shares of Common ______________________ Stock to be Issued Pursuant to (i): ____________________ Conversion of the Debentures:_______________________ 22 (ii) Conversion of Conversion Failure Payments, Delivery Failure Payments and/or payments pursuant to Section 2(c) of the Registration Rights Agreement: __________________________ Signature: __________________________________________________ Name: _______________________________________________________ Address: ____________________________________________________ Subject to Section 1.4(b) of the Debenture(s), the Borrower is not required to issue shares of Common Stock until the original Debenture(s) (or evidence of loss, theft or destruction thereof) to be converted are received by the Borrower or its Transfer Agent. The Borrower shall issue and deliver shares of Common Stock to an overnight courier not later than two business days following receipt of the original Debenture(s) to be converted, and shall make payments pursuant to the Debentures for the number of business days such issuance and delivery is late. 23 REGISTRATION RIGHTS AGREEMENT REGISTRATION RIGHTS AGREEMENT (this "Agreement"), dated as of {{FundDate}}, by and between PATRIOT SCIENTIFIC CORPORATION, a Delaware corporation (the "Company"), and {{FirstName}} {{LastName}}, an individaul. WHEREAS: A. In connection with the Securities Purchase Agreement by and among the parties hereto of even date herewith (the "Securities Purchase Agreement"), the Company has agreed, upon the terms and subject to the conditions contained therein, to issue and sell to the Buyer (i) convertible debentures (the "Debentures") that are convertible into shares of the Company's common stock, par value $0.00001 per share (the "Common Stock"), upon the terms and subject to the limitations and conditions set forth in such Debentures and (ii) warrants (the "Warrants") to purchase {{NoWarrants}} shares of Common Stock, upon the terms and conditions and subject to the limitations and conditions set forth in the Warrants dated {{FundDate}}; and B. To induce the Buyer to execute and deliver the Securities Purchase Agreement, the Company has agreed to provide certain registration rights under the Securities Act of 1933, as amended, and the rules and regulations thereunder, or any similar successor statute (collectively, the "1933 Act"), and applicable state securities laws; NOW, THEREFORE, In consideration of the premises and the mutual covenants contained herein and other good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, the Company and the Buyer hereby agree as follows: 1. DEFINITIONS. a. As used in this Agreement, the following terms shall have the following meanings: (i) "BUYER" means {{FirstName}} {{LastName}}, and any transferee or assignee who agrees to become bound by the provisions of this Agreement in accordance with Section 9 hereof. (ii) "REGISTER," "REGISTERED," and "REGISTRATION" refer to a registration effected by preparing and filing a Registration Statement or Statements in compliance with the 1933 Act and pursuant to Rule 415 under the 1933 Act or any successor rule providing for offering securities on a continuous basis ("RULE 415"), and the declaration or ordering of effectiveness of such Registration Statement by the United States Securities and Exchange Commission (the "SEC"). 24 (iii) "REGISTRABLE SECURITIES" means (a) the shares of Common Stock (the "Conversion Shares") issued or issuable upon conversion of or otherwise pursuant to the Debentures (including, without limitation, any shares issued or issuable pursuant to Sections 1.3 and 1.4 of the Debentures and Section 2 herein) (b) any shares of Common Stock (the "Warrant Shares") issued or issuable upon exercise of or otherwise pursuant to the Warrants and (c) any shares of capital stock issued or issuable as a dividend on or in exchange for or otherwise with respect to any of the foregoing. (iv) "REGISTRATION STATEMENT(S)" means a registration statement(s) of the Company under the 1933 Act. b. Capitalized terms used herein and not otherwise defined herein shall have the respective meanings set forth in the Securities Purchase Agreement. 2. REGISTRATION. A. MANDATORY REGISTRATION. The Company shall prepare, and, on or prior to January 1, 2005 (the "FILING DATE") file with the SEC a Registration Statement on Form S-3 (or, if Form S-3 is not then available, on such form of Registration Statement as is then available to effect a registration of the Registrable Securities, subject to the consent of the Buyer, which consent will not be unreasonably withheld) covering the resale of the Registrable Securities, which Registration Statement, to the extent allowable under the 1933 Act and the rules and regulations promulgated thereunder (including Rule 416), shall state that such Registration Statement also covers such indeterminate number of additional shares of Common Stock as may become issuable upon conversion of or otherwise pursuant to the Debentures and exercise of or otherwise pursuant to the Warrants to prevent dilution resulting from stock splits, stock dividends or similar transactions. The number of shares of Common Stock initially included in such Registration Statement shall be no less than one and one-half (1.5) times the aggregate number of Conversion Shares that are then issuable upon conversion of or otherwise pursuant to the Debentures (based on the Conversion Price (as defined in the Debentures) then in effect) and the aggregate number of Warrant Shares that are then issuable upon exercise of or otherwise pursuant to the Warrants, without regard to any limitation on the Buyer's ability to convert the Debentures or exercise the Warrants. The Company acknowledges that the number of shares initially included in the Registration Statement represents a good faith estimate of the maximum number of shares issuable upon conversion of or otherwise pursuant to the Debentures and exercise of or otherwise pursuant to the Warrants. The Registration Statement (and each amendment or supplement thereto, and each request for acceleration of effectiveness thereof) shall be provided to (and subject to the approval of) the Buyer and its counsel prior to its filing or other submission. B. [INTENTIONALLY OMITTED]. C. PAYMENTS BY THE COMPANY. The Company shall use its best efforts to obtain effectiveness of the Registration Statement as soon as practicable, but in any event not later than March 1, 2005 (the "REGISTRATION DEADLINE"). If (i) the Registration Statement covering the Registrable Securities required to be filed by the Company pursuant to 2 Section 2(a) hereof is not declared effective by the SEC by the Registration Deadline, or (ii) after the Registration Statement has been declared effective by the SEC, sales of all of the Registrable Securities cannot be made pursuant to the Registration Statement, or (iii) the Common Stock is not listed or included for quotation on the Over the Counter Electronic Bulletin Board (the "OTC-BB"), the Nasdaq National Market ("NNM"), the Nasdaq Small Cap Market ("NASDAQ SMALL CAP"), the New York Stock Exchange (the "NYSE") or the American Stock Exchange (the "AMEX"), then the Company will make payments to the Buyer in such amounts and at such times as shall be determined pursuant to this Section 2(c) as partial relief for the damages to the Buyer by reason of any such delay in or reduction of its ability to sell the Registrable Securities (which remedy shall not be exclusive of any other remedies available at law or in equity). The Company shall pay to each holder of the Debentures or Registrable Securities an amount equal to the then outstanding principal amount of the Debentures (and, in the case of holders of Registrable Securities, the principal amount of Debentures from which such Registrable Securities were converted or the aggregate exercise price paid for such Registrable Securities upon exercise of the Warrants) ("OUTSTANDING PRINCIPAL AMOUNT") multiplied by the Applicable Percentage (as defined below) times the number of months (prorated for partial months) after the Registration Deadline and prior to the date the Registration Statement is declared effective by the SEC; The term "APPLICABLE PERCENTAGE" means 2.0 hundredths (.02). (For example, if the Registration Statement becomes effective one (1) month after the Registration Deadline, the Company would pay $20,000 for each $1,000,000 of Outstanding Principal Amount. If thereafter, sales of all of the Registrable Securities could not be made pursuant to the Registration Statement for an additional period of one (1) month, the Company would pay an additional $20,000 for each $1,000,000 Outstanding Principal Amount. Such amounts shall be paid in cash within five (5) days after the end of each period that gives rise to such obligation, PROVIDED that, if any such period extends for more than thirty (30) days, interim payments shall be made for each such thirty (30) day period, PROVIDED, FURTHER, that, if such amounts are not paid within the period specified, at the Buyer's option, such amounts may be added to the Conversion Amount (as defined in the Debentures) of the Debentures and thereafter be convertible into Common Stock at the "CONVERSION PRICE" (as defined in the Debentures) in accordance with the terms of the Debentures. Any shares of Common Stock issued upon conversion of such amounts shall be Registrable Securities. Nothing herein shall limit the Buyer's right to pursue damages for the failure to timely obtain effectiveness of the Registration Statement by the Registration Deadline or to thereafter maintain the effectiveness of the Registration Statement as required pursuant to this Agreement or to maintain the listing of the Common Stock; D. PIGGY-BACK REGISTRATIONS. If at any time prior to the expiration of the Registration Period (as hereinafter defined) the Company shall determine to file with the SEC a Registration Statement relating to an offering for its own account or the account of others under the 1933 Act of any of its equity securities (other than on Form S-4 or Form S-8 or their then equivalents relating to equity securities to be issued solely in connection with any acquisition of any entity or business or equity securities issuable in connection with stock option or other employee benefit plans), the Company shall send to Buyer written notice of such determination and, if within fifteen (15) days after the effective date of such notice, the Buyer shall so request in writing, the Company shall include in such Registration Statement all or any part of the Registrable Securities the Buyer requests to be registered, except that if, in connection with any underwritten public offering for the account of the Company, the managing underwriter(s) thereof shall impose a limitation on the number of shares of Common Stock which may be included in the Registration Statement because, in such underwriter(s)' judgment, marketing or other factors dictate such limitation is necessary to facilitate public distribution, then the Company shall be obligated to include in such Registration Statement only such limited portion of the Registrable Securities with respect to which the Buyer has requested inclusion hereunder as the underwriter shall permit; 3 PROVIDED, HOWEVER, that the Company shall not exclude any Registrable Securities unless the Company has first excluded all outstanding securities, the holders of which are not entitled by contract to inclusion of such securities in such Registration Statement or are not entitled to pro rata inclusion with the Registrable Securities; and PROVIDED, FURTHER, HOWEVER, that, after giving effect to the immediately preceding proviso, any exclusion of Registrable Securities shall be made pro rata with holders of other securities having the contractual right to include such securities in the Registration Statement other than holders of securities entitled to inclusion of their securities in such Registration Statement by reason of demand registration rights. No right to registration of Registrable Securities under this Section 2(d) shall be construed to limit any registration required under Section 2(a) hereof. If an offering in connection with which the Buyer is entitled to registration under this Section 2(d) is an underwritten offering, then the Buyer shall, unless otherwise agreed by the Company, offer and sell such Registrable Securities in an underwritten offering using the same underwriter or underwriters and, subject to the provisions of this Agreement, on the same terms and conditions as other shares of Common Stock included in such underwritten offering. Notwithstanding anything to the contrary set forth herein, the registration rights of the Buyer pursuant to this Section 2(d) shall only be available in the event the Company fails to timely file, obtain effectiveness or maintain effectiveness of any Registration Statement to be filed pursuant to Section 2(a) in accordance with the terms of this Agreement. E. ELIGIBILITY FOR FORM SB-2. The Company represents and warrants that it meets the registrant eligibility and transaction requirements for the use of Form SB-2 for registration of the sale by the Buyer of the Registrable Securities and the Company shall file all reports required to be filed by the Company with the SEC in a timely manner so as to maintain such eligibility for the use of Form SB-2. 3. OBLIGATIONS OF THE COMPANY. In connection with the registration of the Registrable Securities, the Company shall have the following obligations: a. The Company shall prepare promptly, and file with the SEC as soon as practicable after the date of the Closing under the Securities Purchase Agreement (the "CLOSING DATE") (but no later than the Filing Date), a Registration Statement with respect to the number of Registrable Securities provided in Section 2(a), and thereafter use its best efforts to 4 cause such Registration Statement relating to Registrable Securities to become effective as soon as possible after such filing (but in no event later than the Registration Deadline), and keep the Registration Statement effective pursuant to Rule 415 at all times until such date as is the earlier of (i) the date on which all of the Registrable Securities have been sold and (ii) the date on which the Registrable Securities (in the opinion of counsel to the Buyer) may be immediately sold to the public without registration or restriction (including without limitation as to volume by each holder thereof) under the 1933 Act (the "REGISTRATION PERIOD"), which Registration Statement (including any amendments or supplements thereto and prospectuses contained therein) shall not contain any untrue statement of a material fact or omit to state a material fact required to be stated therein, or necessary to make the statements therein not misleading. b. The Company shall prepare and file with the SEC such amendments (including post-effective amendments) and supplements to the Registration Statements and the prospectus used in connection with the Registration Statements as may be necessary to keep the Registration Statements effective at all times during the Registration Period, and, during such period, comply with the provisions of the 1933 Act with respect to the disposition of all Registrable Securities of the Company covered by the Registration Statements until such time as all of such Registrable Securities have been disposed of in accordance with the intended methods of disposition by the seller or sellers thereof as set forth in the Registration Statements. In the event that on any Trading Day (as defined in the Debentures) (the "REGISTRATION TRIGGER DATE") the number of shares available under a Registration Statement filed pursuant to this Agreement is insufficient to cover all of the Registrable Securities issued or issuable upon conversion of or otherwise pursuant to the Debentures (based on the Conversion Price (as defined in the Debentures) then in effect) and exercise of or otherwise pursuant to the Warrants, in each case without giving effect to any limitations on the Buyer' ability to convert the Debentures or exercise the Warrants, the Company shall amend the Registration Statement, or file a new Registration Statement (on the short form available therefore, if applicable), or both, so as to cover one hundred fifty percent (150%) of all of the Registrable Securities so issued or issuable (without giving effect to any limitations on conversion contained in the Debentures or exercise contained in the Warrants) as of the Registration Trigger Date, in each case, as soon as practicable, but in any event within twenty (20) business days after the necessity therefore arises (based on the market price of the Common Stock and other relevant factors on which the Company reasonably elects to rely), provided, however that the Company shall have a sufficient number of authorized and unissued shares. In the event the Company does not have a sufficient number of authorized and unissued shares, the Company shall use its best efforts to obtain all necessary shareholder approvals and to make all necessary filings to increase its authorized shares as promptly as practicable and, within twenty (20) business days after the necessary increase in its authorized shares shall become effective, amend the Registration Statement or file a new Registration Statement as set forth above. The Company shall use its best efforts to cause such amendment and/or new Registration Statement to become effective as soon as practicable following the filing thereof, but in any event within sixty (60) days of the Registration Trigger Date or as promptly as practicable in the event the Company is required to increase its authorized shares. The provisions of Section 2(c) above shall be applicable with respect to the Company's obligations under this Section 3(b). 5 c. The Company shall furnish to the Buyer and its legal counsel (i) promptly after the same is prepared and publicly distributed, filed with the SEC, or received by the Company, one copy of each Registration Statement and any amendment thereto, each preliminary prospectus and prospectus and each amendment or supplement thereto, and, in the case of the Registration Statement referred to in Section 2(a), each letter written by or on behalf of the Company to the SEC or the staff of the SEC, and each item of correspondence from the SEC or the staff of the SEC, in each case relating to such Registration Statement (other than any portion of any thereof which contains information for which the Company has sought confidential treatment), and (ii) such number of copies of a prospectus, including a preliminary prospectus, and all amendments and supplements thereto and such other documents as the Buyer may reasonably request in order to facilitate the disposition of the Registrable Securities owned by the Buyer. The Company will immediately notify the Buyer by facsimile of the effectiveness of each Registration Statement or any post-effective amendment. The Company will promptly respond to any and all comments received from the SEC, with a view towards causing each Registration Statement or any amendment thereto to be declared effective by the SEC as soon as practicable and shall file an acceleration request as soon as practicable, but no later than three (3) business days (the "ACCELERATION REQUEST DEADLINE"), following the resolution or clearance of all SEC comments or, if applicable, following notification by the SEC that any such Registration Statement or any amendment thereto will not be subject to review. d. The Company shall use reasonable efforts to (i) register and qualify the Registrable Securities covered by the Registration Statements under such other securities or "blue sky" laws of such jurisdictions in the United States as the Buyer, (ii) prepare and file in those jurisdictions such amendments (including post-effective amendments) and supplements to such registrations and qualifications as may be necessary to maintain the effectiveness thereof during the Registration Period, (iii) take such other actions as may be necessary to maintain such registrations and qualifications in effect at all times during the Registration Period, and (iv) take all other actions reasonably necessary or advisable to qualify the Registrable Securities for sale in such jurisdictions; e. [INTENTIONALLY OMITTED] f. As promptly as practicable after becoming aware of such event, the Company shall notify the Buyer of the happening of any event, of which the Company has knowledge, as a result of which the prospectus included in any Registration Statement, as then in effect, includes an untrue statement of a material fact or omits to state a material fact required to be stated therein or necessary to make the statements therein not misleading, and use its best efforts promptly to prepare a supplement or amendment to any Registration Statement to correct such untrue statement or omission, and deliver such number of copies of such supplement or amendment to the Buyer as the Buyer may reasonably request; provided that, for not more than twenty (20) consecutive days (or a total of not more than sixty (60) days in any twelve (12) month period), the Company may delay the disclosure of material non-public information concerning the Company (as well as prospectus or Registration Statement updating) the disclosure of which at the time is not, in the good faith opinion of the Company, 6 in the best interests of the Company (an "ALLOWED DELAY"); provided, further, that the Company shall promptly (i) notify the Buyer in writing of the existence of (but in no event, without the prior written consent of the Buyer, shall the Company disclose to the Buyer any of the facts or circumstances regarding) material non-public information giving rise to an Allowed Delay and (ii) advise the Buyer in writing to cease all sales under such Registration Statement until the end of the Allowed Delay, provided the above actions are consistent with the requirements of the 1933 Act and/or 1934 Act or other applicable law. Upon expiration of the Allowed Delay, the Company shall again be bound by the first sentence of this Section 3(f) with respect to the information giving rise thereto. g. The Company shall use its best efforts to prevent the issuance of any stop order or other suspension of effectiveness of any Registration Statement, and, if such an order is issued, to obtain the withdrawal of such order at the earliest possible moment and to notify the Buyer who holds Registrable Securities being sold (or, in the event of an underwritten offering, the managing underwriters) of the issuance of such order and the resolution thereof. h. The Company shall permit a single firm of counsel designated by the Buyer to review such Registration Statement and all amendments and supplements thereto (as well as all requests for acceleration or effectiveness thereof) a reasonable period of time prior to their filing with the SEC (not less than three (3) business days but not more then five (5) business days) and not file any document in a form to which such counsel reasonably objects and will not request acceleration of such Registration Statement without prior notice to such counsel. i. The Company shall make generally available to its security holders as soon as practicable, but not later than ninety (90) days after the close of the period covered thereby, an earnings statement (in form complying with the provisions of Rule 158 under the 1933 Act) covering a twelve-month period beginning not later than the first day of the Company's fiscal quarter next following the effective date of the Registration Statement. j. At the request of the Buyer participating in an underwritten offering pursuant to Section 2(d), the Company shall furnish, on the date that Registrable Securities are delivered to an underwriter for sale in connection with any Registration Statement pursuant to Section 2(d), (i) an opinion, dated as of such date, from counsel representing the Company for purposes of such Registration Statement, in form, scope and substance as is customarily given in an underwritten public offering, addressed to the underwriters, if any, and the Buyer and (ii) a letter, dated such date, from the Company's independent certified public accountants in form and substance as is customarily given by independent certified public accountants to underwriters in an underwritten public offering, addressed to the underwriters, if any, and the Buyer. k. The Company shall make available for inspection by (i) the Buyer, and (ii) one firm of attorneys and one firm of accountants or other agents retained by the Buyer (collectively, the "INSPECTORS") all pertinent financial and other records, and pertinent corporate documents and properties of the Company (collectively, the "RECORDS"), as shall be reasonably deemed necessary by each Inspector to enable each Inspector to exercise its due diligence responsibility, and cause the Company's officers, directors and employees to supply all information which any Inspector may reasonably request for purposes of such due diligence; 7 PROVIDED, HOWEVER, that each Inspector shall hold in confidence and shall not make any disclosure (except to the Buyer) of any Record or other information which the Company determines in good faith to be confidential, and of which determination the Inspectors are so notified, unless (a) the disclosure of such Records is necessary to avoid or correct a misstatement or omission in any Registration Statement, (b) the release of such Records is ordered pursuant to a subpoena or other order from a court or government body of competent jurisdiction, or (c) the information in such Records has been made generally available to the public other than by disclosure in violation of this or any other agreement. The Company shall not be required to disclose any confidential information in such Records to any Inspector until and unless such Inspector shall have entered into confidentiality agreements (in form and substance satisfactory to the Company) with the Company with respect thereto, substantially in the form of this Section 3(k). The Buyer agrees that it shall, upon learning that disclosure of such Records is sought in or by a court or governmental body of competent jurisdiction or through other means, give prompt notice to the Company and allow the Company, at its expense, to undertake appropriate action to prevent disclosure of, or to obtain a protective order for, the Records deemed confidential. Nothing herein (or in any other confidentiality agreement between the Company and the Buyer) shall be deemed to limit the Buyer's ability to sell Registrable Securities in a manner which is otherwise consistent with applicable laws and regulations. l. The Company shall hold in confidence and not make any disclosure of information concerning the Buyer provided to the Company unless (i) disclosure of such information is necessary to comply with federal or state securities laws, (ii) the disclosure of such information is necessary to avoid or correct a misstatement or omission in any Registration Statement, (iii) the release of such information is ordered pursuant to a subpoena or other order from a court or governmental body of competent jurisdiction, or (iv) such information has been made generally available to the public other than by disclosure in violation of this or any other agreement. The Company agrees that it shall, upon learning that disclosure of such information concerning the Buyer is sought in or by a court or governmental body of competent jurisdiction or through other means, give prompt notice to the Buyer prior to making such disclosure, and allow the Buyer, at its expense, to undertake appropriate action to prevent disclosure of, or to obtain a protective order for, such information. m. The Company shall use its best efforts to (i) cause all the Registrable Securities covered by the Registration Statement to be listed on each national securities exchange on which securities of the same class or series issued by the Company are then listed, if any, if the listing of such Registrable Securities is then permitted under the rules of such exchange, or (ii) to the extent the securities of the same class or series are not then listed on a national securities exchange, secure the designation and quotation, of all the Registrable Securities covered by the Registration Statement on the NNM or, if not eligible for the NNM on the Nasdaq Small Cap or, if not eligible for the Nasdaq Small Cap, on the Over the Counter electronic bulletin board and, without limiting the generality of the foregoing, to arrange for at least two market makers to register with the National Association of Securities Dealers, Inc. ("NASD") as such with respect to such Registrable Securities. 8 n. The Company shall provide a transfer agent and registrar, which may be a single entity, for the Registrable Securities not later than the effective date of the Registration Statement. o. The Company shall cooperate with the Buyer who holds Registrable Securities being offered and the managing underwriter or underwriters, if any, to facilitate the timely preparation and delivery of certificates (not bearing any restrictive legends) representing Registrable Securities to be offered pursuant to such Registration Statement and enable such certificates to be in such denominations or amounts, as the case may be, as the managing underwriter or underwriters, if any, or the Buyer may reasonably request and registered in such names as the managing underwriter or underwriters, if any, or the Buyer may request, and, within three (3) business days after a Registration Statement which includes Registrable Securities is ordered effective by the SEC, the Company shall deliver, and shall cause legal counsel selected by the Company to deliver, to the transfer agent for the Registrable Securities (with copies to the Buyer) an appropriate instruction and an opinion of such counsel in the form required by the transfer agent in order to issue the Registrable Securities free of restrictive legends. p. At the request of the holders of a majority-in-interest of the Registrable Securities, the Company shall prepare and file with the SEC such amendments (including post-effective amendments) and supplements to a Registration Statement and any prospectus used in connection with the Registration Statement as may be necessary in order to change the plan of distribution set forth in such Registration Statement. q. The Company shall not, and shall not agree to, allow the holders of any securities of the Company to include any of their securities in any Registration Statement under Section 2(a) hereof or any amendment or supplement thereto under Section 3(b) hereof without the consent of the holders of a majority-in-interest of the Registrable Securities. In addition, the Company shall not offer any securities for its own account or the account of others in any Registration Statement under Section 2(a) hereof or any amendment or supplement thereto under Section 3(b) hereof without the consent of the holders of a majority-in-interest of the Registrable Securities. r. The Company shall take all other reasonable actions necessary to expedite and facilitate disposition by the Buyer of Registrable Securities pursuant to a Registration Statement. s. The Company shall comply with all applicable laws related to a Registration Statement and offering and sale of securities and all applicable rules and regulations of governmental authorities in connection therewith (including without limitation the 1933 Act and the 1934 Act and the rules and regulations promulgated by the SEC). 9 4. OBLIGATIONS OF THE BUYER. In connection with the registration of the Registrable Securities, the Buyer shall have the following obligations: a. It shall be a condition precedent to the obligations of the Company to complete the registration pursuant to this Agreement with respect to the Registrable Securities of the Buyer that the Buyer shall furnish to the Company such information regarding itself, the Registrable Securities held by it and the intended method of disposition of the Registrable Securities held by it as shall be reasonably required to effect the registration of such Registrable Securities and shall execute such documents in connection with such registration as the Company may reasonably request. At least three (3) business days prior to the first anticipated filing date of the Registration Statement, the Company shall notify the Buyer of the information the Company requires from each the Buyer. b. The Buyer, by the Buyer's acceptance of the Registrable Securities, agrees to cooperate with the Company as reasonably requested by the Company in connection with the preparation and filing of the Registration Statements hereunder, unless the Buyer has notified the Company in writing of the Buyer's election to exclude all of the Buyer's Registrable Securities from the Registration Statements. c. In the event of an underwritten offering pursuant to Section 2(d) in which any Registrable Securities are to be included, the Buyer agrees to enter into and perform the Buyer's obligations under an underwriting agreement, in usual and customary form, including, without limitation, customary indemnification and contribution obligations, with the managing underwriter of such offering and take such other actions as are reasonably required in order to expedite or facilitate the disposition of the Registrable Securities, unless the Buyer has notified the Company in writing of the Buyer's election to exclude all of the Buyer's Registrable Securities from such Registration Statement. d. The Buyer agrees that, upon receipt of any notice from the Company of the happening of any event of the kind described in Section 3(f) or 3(g), the Buyer will immediately discontinue disposition of Registrable Securities pursuant to the Registration Statement covering such Registrable Securities until the Buyer's receipt of the copies of the supplemented or amended prospectus contemplated by Section 3(f) or 3(g) and, if so directed by the Company, the Buyer shall deliver to the Company (at the expense of the Company) or destroy (and deliver to the Company a certificate of destruction) all copies in the Buyer's possession, of the prospectus covering such Registrable Securities current at the time of receipt of such notice. e. No Buyer may participate in any underwritten registration hereunder unless the Buyer (i) agrees to sell the Buyer's Registrable Securities on the basis provided in any underwriting arrangements in usual and customary form entered into by the Company, (ii) completes and executes all questionnaires, powers of attorney, indemnities, underwriting agreements and other documents reasonably required under the terms of such underwriting arrangements, and (iii) agrees to pay its pro rata share of all underwriting discounts and commissions and any expenses in excess of those payable by the Company pursuant to Section 5 below. 10 5. EXPENSES OF REGISTRATION. All reasonable expenses, other than underwriting discounts and commissions, incurred in connection with registrations, filings or qualifications pursuant to Sections 2 and 3, including, without limitation, all registration, listing and qualification fees, printers and accounting fees, the fees and disbursements of counsel for the Company, and the reasonable fees and disbursements of one counsel selected by the Buyer pursuant to Sections 2(b) and 3(h) hereof shall be borne by the Company. 6. INDEMNIFICATION. In the event any Registrable Securities are included in a Registration Statement under this Agreement: a. To the extent permitted by law, the Company will indemnify, hold harmless and defend (i) the Buyer, (ii) the directors, officers, partners, managers, members, employees, agents and each person who controls any Buyer within the meaning of the 1933 Act or the Securities Exchange Act of 1934, as amended (the "1934 ACT"), if any, (iii) any underwriter (as defined in the 1933 Act) for the Buyer in connection with an underwritten offering pursuant to Section 2(d) hereof, and (iv) the directors, officers, partners, employees and each person who controls any such underwriter within the meaning of the 1933 Act or the 1934 Act, if any (each, an "INDEMNIFIED PERSON"), against any joint or several losses, claims, damages, liabilities or expenses (collectively, together with actions, proceedings or inquiries by any regulatory or self-regulatory organization, whether commenced or threatened, in respect thereof, "CLAIMS") to which any of them may become subject insofar as such Claims arise out of or are based upon: (i) any untrue statement or alleged untrue statement of a material fact in a Registration Statement or the omission or alleged omission to state therein a material fact required to be stated or necessary to make the statements therein not misleading; (ii) any untrue statement or alleged untrue statement of a material fact contained in any preliminary prospectus if used prior to the effective date of such Registration Statement, or contained in the final prospectus (as amended or supplemented, if the Company files any amendment thereof or supplement thereto with the SEC) or the omission or alleged omission to state therein any material fact necessary to make the statements made therein, in light of the circumstances under which the statements therein were made, not misleading; or (iii) any violation or alleged violation by the Company of the 1933 Act, the 1934 Act, any other law, including, without limitation, any state securities law, or any rule or regulation thereunder relating to the offer or sale of the Registrable Securities (the matters in the foregoing clauses (i) through (iii) being, collectively, "VIOLATIONS"). Subject to the restrictions set forth in Section 6(c) with respect to the number of legal counsel, the Company shall reimburse the Indemnified Person, promptly as such expenses are incurred and are due and payable, for any reasonable legal fees or other reasonable expenses incurred by them in connection with investigating or defending any such Claim. Notwithstanding anything to the contrary contained herein, the indemnification agreement contained in this Section 6(a): (i) shall not apply to a Claim arising out of or based upon a Violation which occurs in reliance upon and in conformity with information furnished in writing to the Company by any Indemnified Person or underwriter for such Indemnified Person expressly for use in connection with the preparation of such Registration Statement or any such amendment thereof or supplement thereto; (ii) shall not apply to amounts paid in settlement of any Claim if such settlement is effected without the prior written consent of the Company, which consent shall not be unreasonably withheld; and (iii) with respect to any preliminary prospectus, shall not inure to the benefit of any Indemnified Person if the untrue statement or omission of material fact contained in the preliminary prospectus was corrected on a timely basis in the prospectus, as then amended or supplemented, such corrected prospectus was timely made available by the Company pursuant to Section 3(c) hereof, and the Indemnified Person was promptly advised in writing not to use the incorrect prospectus prior to the use giving rise to a Violation and such Indemnified Person, notwithstanding such advice, used it. Such indemnity shall remain in full force and effect regardless of any investigation made by or on behalf of the Indemnified Person and shall survive the transfer of the Registrable Securities by the Buyer pursuant to Section 9. 11 b. [Intentionally Omitted]. c. Promptly after receipt by an Indemnified Person under this Section 6 of notice of the commencement of any action (including any governmental action), such Indemnified Person shall, if Claim in respect thereof is to be made against any the Company under this Section 6, deliver to the Company a written notice of the commencement thereof, and the Company shall have the right to participate in, and, to the extent the Company so desires, to assume control of the defense thereof with counsel mutually satisfactory to the Company and the Indemnified Person, as the case may be. PROVIDED, HOWEVER, that an Indemnified Person shall have the right to retain its own counsel with the fees and expenses to be paid by the Company, if, in the reasonable opinion of counsel retained by the Company, the representation by such counsel of the Indemnified Person and the Company would be inappropriate due to actual or potential differing interests between such Indemnified Person and any other party represented by such counsel in such proceeding. The Company shall pay for only one separate legal counsel for the Indemnified Persons, and such legal counsel shall be selected by Buyer, if the Buyer is entitled to indemnification hereunder. The failure to deliver written notice to the Company within a reasonable time of the commencement of any such action shall not relieve the Company of any liability to the Indemnified Person under this Section 6, except to the extent that the Company is actually prejudiced in its ability to defend such action. The indemnification required by this Section 6 shall be made by periodic payments of the amount thereof during the course of the investigation or defense, as such expense, loss, damage or liability is incurred and is due and payable. 7. CONTRIBUTION. To the extent any indemnification by the Company is prohibited or limited by law, the Company agrees to make the maximum contribution with respect to any amounts for which it would otherwise be liable under Section 6 to the fullest extent permitted by law. 8. REPORTS UNDER THE 1934 ACT. With a view to making available to the Buyer the benefits of Rule144 promulgated under the 1933 Act or any other similar rule or regulation of the SEC that may at any time permit the Buyer to sell securities of the Company to the public without registration ("RULE 144"), the Company agrees to: 12 a. make and keep public information available, as those terms are understood and defined in Rule 144; b. file with the SEC in a timely manner all reports and other documents required of the Company under the 1933 Act and the 1934 Act so long as the Company remains subject to such requirements (it being understood that nothing herein shall limit the Company's obligations under Section 4(c) of the Securities Purchase Agreement) and the filing of such reports and other documents is required for the applicable provisions of Rule 144; and c. furnish to the Buyer so long as the Buyer owns Registrable Securities, promptly upon request, (i) a written statement by the Company that it has complied with the reporting requirements of Rule 144, the 1933 Act and the 1934 Act, (ii) a copy of the most recent annual or quarterly report of the Company and such other reports and documents so filed by the Company, and (iii) such other information as may be reasonably requested to permit the Buyers to sell such securities pursuant to Rule 144 without registration. 9. ASSIGNMENT OF REGISTRATION RIGHTS. The rights under this Agreement shall be automatically assignable by the Buyers to any transferee of all or any portion of Registrable Securities if: (i) the Buyer agrees in writing with the transferee or assignee to assign such rights, and a copy of such agreement is furnished to the Company within a reasonable time after such assignment, (ii) the Company is, within a reasonable time after such transfer or assignment, furnished with written notice of (a) the name and address of such transferee or assignee, and (b) the securities with respect to which such registration rights are being transferred or assigned, (iii) following such transfer or assignment, the further disposition of such securities by the transferee or assignee is restricted under the 1933 Act and applicable state securities laws, (iv) at or before the time the Company receives the written notice contemplated by clause (ii) of this sentence, the transferee or assignee agrees in writing with the Company to be bound by all of the provisions contained herein, and (v) such transfer shall have been made in accordance with the applicable requirements of the Securities Purchase Agreement. 10. AMENDMENT OF REGISTRATION RIGHTS. Provisions of this Agreement may be amended and the observance thereof may be waived (either generally or in a particular instance and either retroactively or prospectively), only with written consent of the Company, the Buyer (to the extent such Buyer still owns Registrable Securities) and Buyers who hold a majority interest of the Registrable Securities. Any amendment or waiver effected in accordance with this Section 10 shall be binding upon the Buyer and the Company. 11. MISCELLANEOUS. a. A person or entity is deemed to be a holder of Registrable Securities whenever such person or entity owns of record such Registrable Securities. If the Company receives conflicting instructions, notices or elections from two or more persons or entities with respect to the same Registrable Securities, the Company shall act upon the basis of instructions, notice or election received from the registered owner of such Registrable Securities. 13 b. Any notices required or permitted to be given under the terms hereof shall be sent by certified or registered mail (return receipt requested) or delivered personally or by courier (including a recognized overnight delivery service) or by facsimile and shall be effective five days after being placed in the mail, if mailed by regular United States mail, or upon receipt, if delivered personally or by courier (including a recognized overnight delivery service) or by facsimile, in each case addressed to a party. The addresses for such communications shall be: If to the Company: To the address set forth immediately below such Company's name on the signature pages hereto. With copy to: Otto Sorensen, Esq. LUCE, FORWARD, HAMILTON AND SCRIPPS, LLP 600 West Broadway, Suite 2600 San Diego, CA 92191 Tel (619) 699-2534 Fax (619) 232-8311 If to a Buyer: To the address set forth immediately below such Buyer's name on the signature pages hereto. Each party shall provide notice to the other party of any change in address. c. Failure of any party to exercise any right or remedy under this Agreement or otherwise, or delay by a party in exercising such right or remedy, shall not operate as a waiver thereof. d. This Agreement shall be governed by and construed in accordance with the internal laws of the State of New York. Any controversy or claim arising out of or related to this Debenture or the breach thereof, shall be settled by binding arbitration in New York, NY in accordance with the Expedited Procedures (Rules 53-57) of the Commercial Arbitration Rules of the American Arbitration Association ("AAA"). A proceeding shall be commenced upon written demand by Company or the Buyer to the other. The arbitrator(s) shall enter a judgment by default against any party, which fails or refuses to appear in any properly noticed arbitration proceeding. The proceeding shall be conducted by one (1) arbitrator, unless the amount alleged to be in dispute exceeds two hundred fifty thousand dollars ($250,000), in which case three (3) arbitrators shall preside. The arbitrator(s) will be chosen by the parties from a list provided by the AAA, and if they are unable to agree within ten (10) days, the AAA shall select the arbitrator(s). The arbitrators must be experts in securities law and financial transactions. The arbitrators shall assess costs and expenses of the arbitration, including all attorneys' and experts' fees, as the arbitrators believe is appropriate in light of the merits of the parties' respective positions in the issues in dispute. Each party submits irrevocably to the jurisdiction of any state court sitting in New York, NY or to the United States District Court sitting in New York for purposes of enforcement of any discovery order, judgment or award in connection with such arbitration. The award of the arbitrator(s) shall be final and binding upon the parties and may be enforced in any court having jurisdiction. The arbitration shall be held in such place as set by the arbitrator(s) in accordance with Rule 55. With respect to any arbitration proceeding in accordance with this section, the prevailing party's reasonable attorney's fees and expenses shall be borne by the non-prevailing party. 14 Although the parties, as expressed above, agree that all claims, including claims that are equitable in nature, for example specific performance, shall initially be prosecuted in the binding arbitration procedure outlined above, if the arbitration panel dismisses or otherwise fails to entertain any or all of the equitable claims asserted by reason of the fact that it lacks jurisdiction, power and/or authority to consider such claims and/or direct the remedy requested, then, in only that event, will the parties have the right to initiate litigation respecting such equitable claims or remedies. The forum for such equitable relief shall be in either a state or federal court sitting in New York, NY. Each party waives any right to a trial by jury, assuming such right exists in an equitable proceeding, and irrevocably submits to the jurisdiction of said New York court. New York law shall govern both the proceeding as well as the interpretation and construction of the Debenture and the transaction as a whole. e. This Agreement and the Securities Purchase Agreement (including all schedules and exhibits thereto) constitute the entire agreement among the parties hereto with respect to the subject matter hereof and thereof. There are no restrictions, promises, warranties or undertakings, other than those set forth or referred to herein and therein. This Agreement and the Securities Purchase Agreement supersede all prior agreements and understandings among the parties hereto with respect to the subject matter hereof and thereof. f. Subject to the requirements of Section 9 hereof, this Agreement shall inure to the benefit of and be binding upon the successors and assigns of each of the parties hereto. g. The headings in this Agreement are for convenience of reference only and shall not limit or otherwise affect the meaning hereof. h. This Agreement may be executed in two or more counterparts, each of which shall be deemed an original but all of which shall constitute one and the same agreement. This Agreement, once executed by a party, may be delivered to the other party hereto by facsimile transmission of a copy of this Agreement bearing the signature of the party so delivering this Agreement. i. Each party shall do and perform, or cause to be done and performed, all such further acts and things, and shall execute and deliver all such other agreements, certificates, instruments and documents, as the other party may reasonably request in order to carry out the intent and accomplish the purposes of this Agreement and the consummation of the transactions contemplated hereby. j. Except as otherwise provided herein, all consents and other determinations to be made by the Buyer pursuant to this Agreement shall be made by Buyers holding a majority of the Registrable Securities, determined as if the all of the Debentures then outstanding have been converted into for Registrable Securities. 15 k. The Company acknowledges that a breach by it of its obligations hereunder will cause irreparable harm to the Buyer by vitiating the intent and purpose of the transactions contemplated hereby. Accordingly, the Company acknowledges that the remedy at law for breach of its obligations hereunder will be inadequate and agrees, in the event of a breach or threatened breach by the Company of any of the provisions hereunder, that the Buyer shall be entitled, in addition to all other available remedies in law or in equity, to an injunction or injunctions to prevent or cure breaches of the provisions of this Agreement and to enforce specifically the terms and provisions hereof, without the necessity of showing economic loss and without any bond or other security being required. l. The language used in this Agreement will be deemed to be the language chosen by the parties to express their mutual intent, and no rules of strict construction will be applied against any party. m. In the event that any provision of this Agreement is invalid or unenforceable under any applicable statute or rule of law, then such provision shall be deemed inoperative to the extent that it may conflict therewith and shall be deemed modified to conform with such statute or rule of law. Any provision hereof which may prove invalid or unenforceable under any law shall not affect the validity or enforceability of any other provision hereof. n. The initial number of Registrable Securities included in any Registration Statement and each increase to the number of Registrable Securities included therein shall be allocated pro rata among the Buyers based on the number of Registrable Securities held by the Buyer at the time of such establishment or increase, as the case may be. In the event an Buyer shall sell or otherwise transfer any of such holder's Registrable Securities, each transferee shall be allocated a pro rata portion of the number of Registrable Securities included in a Registration Statement for such transferor. Any shares of Common Stock included on a Registration Statement and which remain allocated to any person or entity which does not hold any Registrable Securities shall be allocated to the remaining Buyers, pro rata based on the number of shares of Registrable Securities then held by the Buyers. For the avoidance of doubt, the number of Registrable Securities held by an Buyer shall be determined as if all the Debentures and Warrants then outstanding and held by an Buyer were converted into or exercised for Registrable Securities. [INTENTIONALLY LEFY BLANK]. 16 o. There shall be no oral modifications or amendments to this Agreement. This Agreement may be modified or amended only in writing. IN WITNESS WHEREOF, the undersigned Buyer and the Company have caused this Agreement to be duly executed as of the {{ExecDay}} day of November, 2004. - ------------------------------------------------------------------------------- PATRIOT SCIENTIFIC CORPORATION By: ________________________ Lowell W. Giffhorn, CFO By: ______________________ {{FirstName}} {{LastName}} By: ________________________ Jeffrey E. Wallin, Pres. and CEO ADDRESS: ADDRESS: {{Address1}} PATRIOT SCIENTIFIC CORPORATION {{City}}, {{State}} {{PostalCode}} 10989 Via Frontera Telephone: {{HomePhone}} San Diego, CA 92127 Facsimile: {{Fax}} Telephone: (858) 674-5000 FACSIMILE: (858) 674-5005 - ------------------------------------------------------------------------------- 17 THIS WARRANT AND THE SECURITIES ISSUABLE UPON EXERCISE HEREOF HAVE NOT BEEN REGISTERED UNDER THE SECURITIES ACT OF 1933, AS AMENDED (THE "SECURITIES ACT"), OR ANY STATE SECURITIES LAW, AND MAY NOT BE SOLD, TRANSFERRED, ASSIGNED, PLEDGED, HYPOTHECATED OR OTHERWISE DISPOSED OF OR EXERCISED UNLESS (i) A REGISTRATION STATEMENT UNDER THE SECURITIES ACT AND APPLICABLE STATE SECURITIES LAWS SHALL HAVE BECOME EFFECTIVE WITH REGARD THERETO, OR (ii) AN EXEMPTION FROM REGISTRATION UNDER THE SECURITIES ACT AND APPLICABLE STATE SECURITIES LAWS IS AVAILABLE IN CONNECTION WITH SUCH OFFER, SALE OR TRANSFER. AN INVESTMENT IN THESE SECURITIES INVOLVES A HIGH DEGREE OF RISK. HOLDERS MUST RELY ON THEIR OWN ANALYSIS OF THE INVESTMENT AND ASSESSMENT OF THE RISKS INVOLVED. Warrant to Purchase {{NoWarrants}} shares Warrant Number ____ - -------------- WARRANT TO PURCHASE COMMON STOCK OF PATRIOT SCIENTIFIC CORP. THIS CERTIFIES that {{FirstName}} {{LastName}} or any subsequent holder hereof ("Holder") has the right to purchase from Patriot Scientific Corp., a Delaware corporation (the "Company"), up to {{NoWarrants}} fully paid and nonassessable shares, of the Company's common stock, $0.00001 par value per share ("Common Stock"), subject to adjustment as provided herein, at a price equal to the Exercise Price as defined in Section 3 below, at any time beginning on the Date of Issuance (defined below) and ending at 5:00 p.m., New York, New York time, on the date that is seven (7) years after the Date of Issuance (the "Exercise Period"). Holder agrees with the Company that this Warrant to Purchase Common Stock of the Company (this "Warrant" or this "Agreement") is issued and all rights hereunder shall be held subject to all of the conditions, limitations and provisions set forth herein. 1. Date of Issuance and Term. This Warrant shall be deemed to be issued on {{FundDate}} ("Date of Issuance"). The term of this Warrant is seven (7) years from the Date of Issuance. Notwithstanding anything to the contrary herein, the applicable portion of this Warrant shall not be exercisable during any time that, and only to the extent that, the number of shares of Common Stock to be issued to Holder upon such exercise, when added to the number of shares of Common Stock, if any, that the Holder otherwise beneficially owns (outside of this Warrant, and not including any other warrants having a provision substantially similar to this paragraph) at the time of such exercise, would exceed 4.99% of the number of shares of Common Stock then outstanding, as determined in accordance with Section 13(d) of the Exchange Act (the "4.99% Limitation"). The 4.99% Limitation shall be conclusively satisfied if the applicable Exercise Notice includes a signed representation by the Holder that the issuance of the shares in such Exercise Notice will not violate the 4.99% Limitation, and the Company shall not be entitled to require additional documentation of such satisfaction. 18 Notwithstanding the above, in the event that the Company receives any tender offer or any offer to enter into a merger with another entity whereby the Company shall not be the surviving entity (an "Offer"), then "4.99%" shall be automatically revised immediately after such offer to read "9.99%" each place it occurs in this Section 1. Notwithstanding the above, Holder shall retain the option to either exercise or not exercise its option(s) to acquire Common Stock pursuant to the terms hereof after an Offer, and, in the event of a cash exercise following a tender offer, the Exercise Price per share that would otherwise be due shall instead be offset against the tender price per share to be received by the Holder, provided, however, that in the event a tender offer is not completed, Holder shall promptly pay to the Company the Exercise Price that would have been due at the time the Warrant was exercised. 2. Exercise. (a) Manner of Exercise. During the Exercise Period, this Warrant may be exercised as to all or any lesser number of full shares of Common Stock covered hereby (the "Warrant Shares") upon surrender of this Warrant, with the Exercise Form attached hereto as Exhibit A (the "Exercise Form") duly completed and executed, together with the full Exercise Price (as defined below) for each share of Common Stock as to which this Warrant is exercised, at the office of the Company, Patriot Scientific Corporation, Attn: Lowell W. Giffhorn, CFO; 10989 Via Frontera, San Diego, CA 92127; Telephone: (858) 674-5000, Facsimile: (858) 674-5005 or at such other office or agency as the Company may designate in writing, by overnight mail, with an advance copy of the Exercise Form sent to the Company and its Transfer Agent by facsimile (such surrender and payment of the Exercise Price hereinafter called the "Exercise of this Warrant"). (b) Date of Exercise. The "Date of Exercise" of the Warrant shall be defined as the date that the advance copy of the completed and executed Exercise Form is sent by facsimile to the Company, provided that the original Warrant and Exercise Form are received by the Company as soon as practicable thereafter. Alternatively, the Date of Exercise shall be defined as the date the original Exercise Form is received by the Company, if Holder has not sent advance notice by facsimile. The Company shall not be required to deliver the shares of Common Stock to the Holder until the requirements of Section 2(a) above are satisfied. (c) Cancellation of Warrant. This Warrant shall be canceled upon the Exercise of this Warrant, and, as soon as practical after the Date of Exercise, Holder shall be entitled to receive Common Stock for the number of shares purchased upon such Exercise of this Warrant, and if this Warrant is not exercised in full, Holder shall be entitled to receive a new Warrant (containing terms identical to this Warrant) representing any unexercised portion of this Warrant in addition to such Common Stock. 19 (d) Holder of Record. Each person in whose name any Warrant for shares of Common Stock is issued shall, for all purposes, be deemed to be the Holder of record of such shares on the Date of Exercise of this Warrant, irrespective of the date of delivery of the Common Stock purchased upon the Exercise of this Warrant. Nothing in this Warrant shall be construed as conferring upon Holder any rights as a stockholder of the Company. 3. Payment of Warrant Exercise Price. The Exercise Price ("Exercise Price") shall initially equal {{WarrPrice}} per share (the "Initial Exercise Price") or, if the Date of Exercise is more than six (6) months after the Date of Issuance, the lesser of (i) the Initial Exercise Price or (ii) the "Lowest Reset Price," as that term is defined below. The Company shall calculate a "Reset Price" on each six-month anniversary date of the Date of Issuance which shall equal the Market Price (as defined below) on such six-month anniversary date of the Date of Issuance. The "Lowest Reset Price" shall equal the lowest Reset Price determined on any six-month anniversary date of the Date of Issuance preceding the Date of Exercise, taking into account, as appropriate, any adjustments made pursuant to Section 5 hereof. Payment of the Exercise Price may be made by either of the following, or a combination thereof, at the election of Holder: (i) Cash Exercise: cash, bank or cashiers check or wire transfer; or (ii) Cashless Exercise: surrender of this Warrant at the principal office of the Company together with notice of cashless election, in which event the Company shall issue Holder a number of shares of Common Stock computed using the following formula: X = Y (A-B)/A where: X = the number of shares of Common Stock to be issued to Holder. Y = the number of shares of Common Stock for which this Warrant is being exercised. A = the Market Price of one (1) share of Common Stock (for purposes of this Section 3(ii), where "MARKET PRICE," as of any date, means the Volume Weighted Average Price (as defined herein) of the Company's Common Stock during the ten (10) consecutive trading day period immediately preceding the date in question. As used herein, the "VOLUME WEIGHTED AVERAGE PRICE" for any security as of any date means the volume weighted average sale price on the Over the Counter Electronic Bulletin Board (the "OTC-BB") as reported by, or based upon data reported by, Bloomberg Financial Markets or an equivalent, reliable reporting service mutually acceptable to and hereafter designated by holders of a majority in interest of the Warrants and the Company ("BLOOMBERG") or, if the OTC-BB is not the principal trading market for such security, the volume weighted average sale price of such security on the principal securities exchange or trading market where such security is listed or traded as reported by Bloomberg, or, if no volume weighted average sale price is reported for such security, then the last closing trade price of such security as reported by Bloomberg, or, if no last closing trade price is reported for such security by Bloomberg, the average of the bid prices of any market makers for such security that are listed in the "pink sheets" by the National Quotation Bureau, Inc. If the Volume Weighted Average Price cannot be calculated for such security on such date in the manner provided above, the volume weighted average price shall be the fair market value as mutually determined by the Company and the holders of a majority in interest of the Warrants being exercised for which the calculation of the volume weighted average price is required in order to determine the Exercise Price of such Warrants. "TRADING DAY" shall mean any day on which the Common Sock is traded for any period on the OTC-BB, or on the principal securities exchange or other securities market on which the Common Stock is then being traded. B = the Exercise Price. For purposes of Rule 144 and sub-section (d)(3)(ii) thereof, it is intended, understood and acknowledged that the Common Stock issuable upon exercise of this Warrant in a cashless exercise transaction shall be deemed to have been acquired at the time this Warrant was issued. Moreover, it is intended, understood and acknowledged that the holding period for the Common Stock issuable upon exercise of this Warrant in a cashless exercise transaction shall be deemed to have commenced on the date this Warrant was issued. 4. Transfer and Registration. (a) Transfer Rights. Subject to the provisions of Section 8 of this Warrant, this Warrant may be transferred on the books of the Company, in whole or in part, in person or by attorney, upon surrender of this Warrant properly completed and endorsed. This Warrant shall be canceled upon such surrender and, as soon as practicable thereafter, the person to whom such transfer is made shall be entitled to receive a new Warrant or Warrants as to the portion of this Warrant transferred, and Holder shall be entitled to receive a new Warrant as to the portion hereof retained. (b) Registrable Securities. The Common Stock issuable upon the exercise of this Warrant has registration rights pursuant to that certain Registration Rights Agreements between the Company and {{FirstName}} {{LastName}} dated {{FundDate}}. 5. Anti-Dilution Adjustments. (a) Stock Dividend. If the Company shall at any time declare a dividend payable in shares of Common Stock, then Holder, upon Exercise of this Warrant after the record date for the determination of holders of Common Stock entitled to receive such dividend, shall be entitled to receive upon Exercise of this Warrant, in addition to the number of shares of Common Stock as to which this Warrant is exercised, such additional shares of Common Stock as such Holder would have received had this Warrant been exercised immediately prior to such record date and the Exercise Price will be proportionately adjusted. (b) Recapitalization or Reclassification. If the Company shall at any time effect a recapitalization, reclassification or other similar transaction of such character that the shares of Common Stock shall be changed into or become exchangeable for a larger or smaller number of shares, then upon the effective date thereof, the number of shares of Common Stock which Holder shall be entitled to purchase upon Exercise of this Warrant shall be increased or decreased, as the case may be, in direct proportion to the increase or decrease in the number of shares of Common Stock by reason of such recapitalization, reclassification or similar transaction, and the Exercise Price shall be, in the case of an increase in the number of shares, proportionally decreased and, in the case of decrease in the number of shares, proportionally increased. The Company shall give Holder the same notice it provides to holders of Common Stock of any transaction described in this Section 5(b). (c) Distributions. If the Company shall at any time distribute for no consideration to holders of Common Stock cash, evidences of indebtedness or other securities or assets (other than cash dividends or distributions payable out of earned surplus or net profits for the current or preceding years) then, in any such case, Holder shall be entitled to receive, upon Exercise of this Warrant, with respect to each share of Common Stock issuable upon such exercise, the amount of cash or evidences of indebtedness or other securities or assets which Holder would have been entitled to receive with respect to each such share of Common Stock as a result of the happening of such event had this Warrant been exercised immediately prior to the record date or other date fixing shareholders to be affected by such event (the "Determination Date"). (d) Notice of Consolidation or Merger. In the event of a merger, consolidation, exchange of shares, recapitalization, reorganization, or other similar event, as a result of which shares of Common Stock shall be changed into the same or a different number of shares of the same or another class or classes of stock or securities or other assets of the Company or another entity or there is a sale of all or substantially all the Company's assets (a "Corporate Change"), then this Warrant shall be exerciseable into such class and type of securities or other assets as Holder would have received had Holder exercised this Warrant immediately prior to such Corporate Change; provided, however, that Company may not affect any Corporate Change unless it first shall have given thirty (30) days notice to Holder hereof of any Corporate Change. (e) Exercise Price Adjusted. As used in this Warrant, the term "Exercise Price" shall mean the purchase price per share specified in Section 3 of this Warrant, until the occurrence of an event stated in subsection (a), (b) or (c) of this Section 5, and thereafter shall mean said price as adjusted from time to time in accordance with the provisions of said subsection. No such adjustment under this Section 5 shall be made unless such adjustment would change the Exercise Price at the time by $.01 or more; provided, however, that all adjustments not so made shall be deferred and made when the aggregate thereof would change the Exercise Price at the time by $.01 or more. No adjustment made pursuant to any provision of this Section 5 shall have the net effect of increasing the Exercise Price in relation to the split adjusted and distribution adjusted price of the Common Stock. The number of shares of Common Stock subject hereto shall increase proportionately with each decrease in the Exercise Price. (f) Adjustments: Additional Shares, Securities or Assets. In the event that at any time, as a result of an adjustment made pursuant to this Section 5, Holder shall, upon Exercise of this Warrant, become entitled to receive shares and/or other securities or assets (other than Common Stock) then, wherever appropriate, all references herein to shares of Common Stock shall be deemed to refer to and include such shares and/or other securities or assets; and thereafter the number of such shares and/or other securities or assets shall be subject to adjustment from time to time in a manner and upon terms as nearly equivalent as practicable to the provisions of this Section 5. 6. Fractional Interests. No fractional shares or scrip representing fractional shares shall be issuable upon the Exercise of this Warrant, but on Exercise of this Warrant, Holder may purchase only a whole number of shares of Common Stock. If, on Exercise of this Warrant, Holder would be entitled to a fractional share of Common Stock or a right to acquire a fractional share of Common Stock, such fractional share shall be disregarded and the number of shares of Common Stock issuable upon exercise shall be the next higher number of shares. 7. Reservation of Shares. From and after June 1, 2002, the Company shall at all times reserve for issuance such number of authorized and unissued shares of Common Stock (or other securities substituted therefor as herein above provided) as shall be sufficient for the Exercise of this Warrant and payment of the Exercise Price. If at any time the number of shares of Common Stock authorized and reserved for issuance is below the number of shares sufficient for the Exercise of this Warrant and payment of the Exercise Price (based on the Exercise Price in effect from time to time), the Company will promptly take all corporate action necessary to authorize and reserve a sufficient number of shares, including, without limitation, calling a special meeting of stockholders to authorize additional shares to meet the Company's obligations under this Section 7, in the case of an insufficient number of authorized shares, and using its best efforts to obtain stockholder approval of an increase in such authorized number of shares. The Company covenants and agrees that upon the Exercise of this Warrant, all shares of Common Stock issuable upon such exercise shall be duly and validly issued, fully paid, nonassessable and not subject to preemptive rights, rights of first refusal or similar rights of any person or entity. 8. Restrictions on Transfer. (a) Registration or Exemption Required. This Warrant has been issued in a transaction exempt from the registration requirements of the Act by virtue of Regulation D and exempt from state registration under applicable state laws. The Warrant and the Common Stock issuable upon the Exercise of this Warrant may not be pledged, transferred, sold or assigned except pursuant to an effective registration statement or an exemption to the registration requirements of the Act and applicable state laws. (b) Assignment. If Holder can provide the Company with reasonably satisfactory evidence that the conditions of (a) above regarding registration or exemption have been satisfied, Holder may sell, transfer, assign, pledge or otherwise dispose of this Warrant, in whole or in part. Holder shall deliver a written notice to Company, substantially in the form of the Assignment attached hereto as Exhibit B, indicating the person or persons to whom the Warrant shall be assigned and the respective number of warrants to be assigned to each assignee. The Company shall effect the assignment within ten (10) days, and shall deliver to the assignee(s) designated by Holder a Warrant or Warrants of like tenor and terms for the appropriate number of shares. 9. Benefits of this Warrant. Nothing in this Warrant shall be construed to confer upon any person other than the Company and Holder any legal or equitable right, remedy or claim under this Warrant and this Warrant shall be for the sole and exclusive benefit of the Company and Holder. 10. Arbitration; Governing Law. This Agreement shall be governed by and construed in accordance with the laws of the State of New York applicable to agreements made in and wholly to be performed in that jurisdiction, except for matters arising under the Act or the Securities Exchange Act of 1934, which matters shall be construed and interpreted in accordance with such laws. Any controversy or claim arising out of or related to the this Agreement or the breach thereof, shall be settled by binding arbitration in New York, New York in accordance with the Expedited Procedures (Rules 53-57) of the Commercial Arbitration Rules of the American Arbitration Association ("AAA"). A proceeding shall be commenced upon written demand by Company or any Lender to the other. The arbitrator(s) shall enter a judgment by default against any party, which fails or refuses to appear in any properly noticed arbitration proceeding. The proceeding shall be conducted by one (1) arbitrator, unless the amount alleged to be in dispute exceeds two hundred fifty thousand dollars ($250,000), in which case three (3) arbitrators shall preside. The arbitrator(s) will be chosen by the parties from a list provided by the AAA, and if they are unable to agree within ten (10) days, the AAA shall select the arbitrator(s). The arbitrators must be experts in securities law and financial transactions. The arbitrators shall assess costs and expenses of the arbitration, including all attorneys' and experts' fees, as the arbitrators believe is appropriate in light of the merits of the parties' respective positions in the issues in dispute. Each party submits irrevocably to the jurisdiction of any state court sitting in New York, New York or to the United States District Court sitting in New York for purposes of enforcement of any discovery order, judgment or award in connection with such arbitration. The award of the arbitrator(s) shall be final and binding upon the parties and may be enforced in any court having jurisdiction. The arbitration shall be held in such place as set by the arbitrator(s) in accordance with Rule 55. With respect to any arbitration proceeding in accordance with this section, the prevailing party's reasonable attorney's fees and expenses shall be borne by the non-prevailing party. Although the parties, as expressed above, agree that all claims, including claims that are equitable in nature, for example specific performance, shall initially be prosecuted in the binding arbitration procedure outlined above, if the arbitration panel dismisses or otherwise fails to entertain any or all of the equitable claims asserted by reason of the fact that it lacks jurisdiction, power and/or authority to consider such claims and/or direct the remedy requested, then, in only that event, will the parties have the right to initiate litigation respecting such equitable claims or remedies. The forum for such equitable relief shall be in either a state or federal court sitting in New York, New York. Each party waives any right to a trial by jury, assuming such right exists in an equitable proceeding, and irrevocably submits to the jurisdiction of said New York court. New York law shall govern both the proceeding as well as the interpretation and construction of this Agreement and the transaction as a whole. 11. Loss of Warrant. Upon receipt by the Company of evidence of the loss, theft, destruction or mutilation of this Warrant, and (in the case of loss, theft or destruction) of indemnity or security reasonably satisfactory to the Company, and upon surrender and cancellation of this Warrant, if mutilated, the Company shall execute and deliver a new Warrant of like tenor and date. 12. Notice or Demands. Notices or demands pursuant to this Warrant to be given or made by Holder to or on the Company shall be sufficiently given or made if sent by certified or registered mail, return receipt requested, postage prepaid, and addressed, until another address is designated in writing by the Company, to the address set forth in Section 2(a) above. Notices or demands pursuant to this Warrant to be given or made by the Company to or on Holder shall be sufficiently given or made if sent by certified or registered mail, return receipt requested, postage prepaid, and addressed, to the address of Holder set forth in the Company's records, until another address is designated in writing by Holder. IN WITNESS WHEREOF, the undersigned has executed this Warrant as of the {{ExecDay}} day of November, 2004. PATRIOT SCIENTIFIC CORP. By: ______________________________________ LOWELL W. GIFFHORN, CHIEF FINANCIAL OFFICER By: _________________________________________ JEFFREY E. WALLIN, PRES. AND CEO EXHIBIT A EXERCISE FORM FOR WARRANT TO: PATRIOT SCIENTIFIC CORP. The undersigned hereby irrevocably exercises the right to purchase ____________ of the shares of Common Stock (the "Common Stock") of Patriot Scientific Corp., a Delaware corporation (the "Company"), evidenced by the attached warrant (the "Warrant"), and herewith makes payment of the exercise price with respect to such shares in full, all in accordance with the conditions and provisions of said Warrant. 1. The undersigned agrees not to offer, sell, transfer or otherwise dispose of any of the Common Stock obtained on exercise of the Warrant, except in accordance with the provisions of Section 8(a) of the Warrant. 2. The undersigned requests that stock certificates for such shares be issued free of any restrictive legend, if appropriate, and a warrant representing any unexercised portion hereof be issued, pursuant to the Warrant in the name of the undersigned and delivered to the undersigned at the address set forth below: Dated: - -------------------------------------------------------------------------------- Signature - -------------------------------------------------------------------------------- Print Name - -------------------------------------------------------------------------------- Address - -------------------------------------------------------------------------------- NOTICE The signature to the foregoing Exercise Form must correspond to the name as written upon the face of the attached Warrant in every particular, without alteration or enlargement or any change whatsoever. - -------------------------------------------------------------------------------- EXHIBIT B ASSIGNMENT (To be executed by the registered holder desiring to transfer the Warrant) FOR VALUE RECEIVED, the undersigned holder of the attached warrant (the "Warrant") hereby sells, assigns and transfers unto the person or persons below named the right to purchase _______ shares of the Common Stock of Patriot Scientific Corp., evidenced by the attached Warrant and does hereby irrevocably constitute and appoint _______________________ attorney to transfer the said Warrant on the books of the Company, with full power of substitution in the premises. Dated: ------------------------------ ------------------------------------ Signature Fill in for new registration of Warrant: ------------------------------------ Name ------------------------------------ Address ------------------------------------ Please print name and address of assignee (including zip code number) - ---------------------------------------------------------- NOTICE The signature to the foregoing Assignment must correspond to the name as written upon the face of the attached Warrant in every particular, without alteration or enlargement or any change whatsoever. EX-5.1 3 v011943_ex5-1.txt EXHIBIT 5.1 (Luce, Forward, Hamilton & Scripps LLP Letterhead) January 31, 2005 Patriot Scientific Corporation 10989 Via Frontera San Diego, CA 92127 Re: Registration Statement on Form SB-2 for 47,832,555 Shares of Common Stock Ladies and Gentlemen: We have acted as your counsel in connection with the preparation of a Registration Statement on Form SB-2 (the "Registration Statement") filed with the Securities and Exchange Commission to register 47,832,555 shares of common stock, $.00001 par value per share (the "Shares"), of Patriot Scientific Corporation, a Delaware corporation (the "Company"), to be sold by the selling stockholders set forth in the Registration Statement. For purposes of rendering this opinion, we have made such legal and factual examinations as we have deemed necessary under the circumstances and, as part of such examination, we have examined, among other things, originals and copies, certified or otherwise, identified to our satisfaction, of such documents, corporate records and other instruments as we have deemed necessary or appropriate. For the purposes of such examination, we have assumed the genuineness of all signatures on original documents and the conformity to original documents of all copies submitted to us. On the basis of and in reliance upon the foregoing examination and assumptions, we are of the opinion that assuming the Registration Statement shall have become effective pursuant to the provisions of the Securities Act of 1933, as amended, the Shares, when issued in accordance with the Registration Statement, will be validly issued, fully paid and nonassessable. We hereby consent to the filing of this opinion as an Exhibit to the Registration Statement and to the reference to this firm under the caption "Legal Matters" in the prospectus included in the Registration Statement. Very truly yours, /s/ Luce, Forward, Hamilton & Scripps LLP LUCE, FORWARD, HAMILTON & SCRIPPS LLP EX-10.37 4 v011943_ex10-37.txt EXHIBIT 10.37 EMPLOYMENT AGREEMENT This EMPLOYMENT AGREEMENT ("Agreement") is effective as of September 1, 2004 by and between PATRIOT SCIENTIFIC CORPORATION, a Delaware Corporation (the "Company"), and LOWELL GIFFHORN (the "Employee"). The parties agree as follows: 1. Term of Employment. The Company hereby agrees to employ the Employee and the Employee hereby agrees to accept employment as Executive Vice President and Chief Financial Officer (CFO) of the Company for a one year period commencing September 1, 2004, or for such shorter period as may be mutually agreed by the Company and the Employee (the "Employment Period'), subject to the terms and conditions of this Agreement. In his capacity as CFO of the Company, Employee will be responsible for the general duties associated with his title including, but not limited to management of the financial affairs, investor relations, and/or such other management duties on behalf of the Company as may be assigned to him from time to time by the Chief Executive Officer ("CEO") of the Company. The Employee agrees that, during the Employment Period, he will serve the Company faithfully and to the best of his abilities, devoting substantially all his time, energy and skill to the activities of the Company and the promotion of its interests. The Employee agrees not to work for or participate in any business that competes in any manner with the business of the Company during his employment with the Company, including after hours, or on weekends, or during vacation time, even if only organizational assistance or limited consultation is involved. 2. Compensation and Benefit Plans. (a) The Employee shall receive a base salary during the Employment Period which shall be payable in installments at such times as other employees are paid but in any case at least monthly as follows: The Employee shall receive a gross base salary of not less than twelve thousand dollars ($12,000) per month for his services as CFO. The base salary may be subject to other upward adjustments as may be recommended by the CEO of the Company to the Board of Directors of the Company (the "Board") and as shall be approved by the Board and Compensation Committee. (b) The Employee may receive, at the sole discretion of the Board of Directors of the Company, an Annual Incentive Bonus up to 50% of the total yearly base compensation for the applicable year (the "Annual Incentive Bonus"). The Annual Incentive Bonus payment will be based upon mutually agreed upon objectives and levels of performance, if any, and shall otherwise be at the discretion of the Board of Directors. (c) The Employee shall be eligible to participate in all employee benefit programs, if any, maintained by the Company, including, but not limited to, group life insurance, medical, dental, retirement and pension plans, any deferred compensation profit sharing plans, 401(k) savings plan, and other such fringe benefits as are or may be available from time to time to senior Employees of the Company, including without limitation a car allowance of $400 per month. The Company reserves the right to modify or eliminate such fringe benefits on a prospective basis, at any time, effective upon 60 days notice to Employee. During the Employment Period, the Employee shall accrue vacation at the rate of 4 weeks per annum. (d) The Company will pay or reimburse the Employee during the Employment Period for all expenses normally reimbursed by the Company and reasonably incurred by the Employee in furtherance of his duties hereunder including but not limited to, expenses of entertainment, travel, meals, hotel accommodations and the like upon the submission by the Employee of vouchers or an itemized list thereof and as may be required in order to permit such payments as proper deductions for the Company under the Internal Revenue Code of 1986 and the rules and regulations adopted pursuant thereto now or hereafter in effect. Any and all business expenses exceeding $100.00 shall be pre-approved by the CEO of the Company. 3. Stock Options. (a) The Employee is hereby granted an option to purchase 300,000 shares of the Company's common stock with an exercise price of the average of the closing bid and asking price ($.038) as of August 31, 2004. These shares will be fully vested as of September 1, 2004. (b) The Company shall grant to the Employee an option to purchase 125,000 shares of the Company's common stock on August 31, 2005 at an exercise price of the average of the closing bid and ask price as of August 31, 2005 and fully vested as of August 31, 2005. (c) The Company shall grant to the Employee an option to purchase 125,000 shares of the Company's common stock on September 1, 2006 at an exercise price of the average of the closing bid and ask price as of August 31, 2006 and fully vested as of August 31, 2006. 4. Termination of Employment. (a) Termination for Cause by Company. The Company may terminate Employee's employment immediately at any time for good cause, including, but not limited to: (a) acts or omissions constituting gross negligence, recklessness, gross misconduct, dishonesty or an act of moral turpitude on the part of Employee; (b) Employee's material breach of this Agreement or any other confidentiality agreement between the Company and Employee; (c) Employee's conviction or entry of a plea of nolo contendere for fraud, misappropriation or embezzlement, or any felony or crime of moral turpitude; (d) Employee's breach of fiduciary duty toward the Company; (e) Employee's inability to perform all of the essential functions and duties of Employee's position, with or without reasonable accommodation; (f) Employee's death; (g) improper actions taken to impair the Company's duly held licenses; (h) a determination or request by an appropriate regulatory authority that the Employee be removed or disqualified from acting as an officer of the Company; (i) Employee's failure to satisfactorily perform his duties to the Company, provided that Employee fails to cure any such failure within 30 days after written notice from the Company of such failure, provided further, however, that such right to cure shall not apply to any repetition of the same failure previously cured hereunder; or (j) Employee's violation of any material rule, regulation or policy of the Company that may be established and made known to the Company's employees from time to time. In the event Employee's employment is terminated in accordance with this subparagraph 4.(a), Employee shall be entitled to receive only the Base Salary then in effect, prorated to the date of termination, and any benefits and expense reimbursements to which Employee is entitled by virtue of his prior employment with the Company through the date of termination (collectively referred to as "Standard Entitlements."). All other company obligations to Employee pursuant to this Agreement will become automatically terminated and completely extinguished. Executive will not be entitled to receive any severance payment or any part thereof. (b) Termination Without Cause By The Company. If the Employee's employment is terminated for other than cause by the Company, then the Employee is entitled to severance payments equal to four (4) months of the then current base salary payable in a lump sum payment. providing Employee executes a full general release, releasing all claims, known or unknown, that Employee may have against the Company arising out of or any way related to Employee's employment or termination of employment with the Company. In such event, the Employee shall have the right to continue coverage in accordance with COBRA, at his expense, under group life insurance, medical, and dental healthcare plans of the Company by paying the applicable group premium(s) as if the Employee were still employed. (c) Voluntary Resignation By Employee. Employee may voluntarily resign Employee's position with the Company, at any time, on thirty (30) days advance written notice. The Company reserves the right, exercisable in its sole discretion, to pay Employee his Base Salary and the value of other contractual benefits provided herein, on a pro rata basis in lieu of the required noticed. In the event of Employee's resignation, Employee will be entitled to receive the Standard Entitlements to the date of resignation and no other amount for the remaining term of this Agreement, if any. All other company obligations to Employee pursuant to this Agreement will become automatically terminated and completely extinguished. Employee will not be entitled to receive any severance payment. (d) Change of Control. If within six (6) months of a Change in Control, as that term is defined herein, Employee refuses to accept or voluntarily resigns from a position other than a Qualified Position, as that term is defined herein, Employee shall receive severance compensation equal to twelve (12) months of the then current base salary payable in a lump sum payment providing Employee executes a full general release, releasing all claims, known or unknown, that Employee may have against the Company arising out of or any way related to Employee's employment or termination of employment with the Company. A "Change in Control" means the acquisition, directly or indirectly, of more than 40% of the outstanding shares of any class of voting securities of the Company by one person or one entity that is not an existing shareholder as of the date of this Agreement, or a merger, consolidation or sale of all or substantially all of the assets of the Company, such that the individuals constituting the Board of the Company immediately prior to such period shall cease to constitute a majority of the Board, unless the election of each director who was not a director prior thereto was approved by vote of at least two-thirds of the directors then in office who were directors prior to such period. Notwithstanding the foregoing, an acquisition of the requisite percentage of voting securities in connection with a public offering of securities by the Company for the primary purpose of providing capital resources to the Company shall not be considered a "Change in Control" for purposes of this paragraph. "Qualified Position" is an Employee officer position with the entity surviving the Change in Control with substantially the same responsibilities as those held by the Employee on the date of the Change in Control as determined by the Company's compensation committee in its sole discretion. Also, notwithstanding the foregoing, if the Company determines that the amounts payable to Employee under this Agreement, cause such payments to be treated as excess parachute payments within the meaning of Section 280G of the Internal Revenue Code, the Company shall reduce the amount payable to Employee under this Section 4(d) to an amount that will not subject Employee to the imposition of tax under Section 4999 of the Internal Revenue Code; provided, however, that this provision shall apply only to payments to be made under this employment agreement and Employee by the Company. 5. Trade Secrets of the Company, Patents and Inventions. Employee agrees to read, sign and abide by the Company's Proprietary Information and Inventions Agreement which is attached as Exhibit 1 and incorporated herein by reference. 6. Severability. In the event that any provisions or portion of this Agreement shall be determined to be invalid or unenforceable for any reason, in whole or in part, the remaining provisions of this Agreement shall be unaffected thereby and shall remain in full force and effect to the fullest extent permitted by law. 7. Assignment. The rights of the Company (but not its obligations) under this Agreement may, without the consent of the Employee, be assigned by the Company to any parent, subsidiary, or a successor of the Company; provided that such parent, subsidiary or successor acknowledges in writing that it is also bound by the terms and obligations of this Agreement. Except as provided for in Section 9 hereunder the Employee may not assign all or any of his rights, duties or obligations hereunder without the prior written consent of the Company. 8. Survival of Certain Provisions. The covenants and agreements set forth in Paragraph 5 through 18 of this Agreement shall survive termination of the Employee's employment and/or this Agreement, and shall remain in full force and effect regardless of the cause of such termination. 9. Beneficiaries: References. The Employee shall be entitled to select (and change) a beneficiary or beneficiaries to receive any accrued compensation or benefit payable, if any, following the Employee's death, and may change such election, in either case, by giving the Company written notice thereof. In the event of the Employee's death or a judicial determination of his incompetence, reference in this Agreement shall be deemed, where appropriate, to refer to the Employee's beneficiary, estate, committee, conservator or other legal representative. 10. Notices. All notices, requests, demands and other communications shall be in writing and shall be defined to have been duly given if delivered or if mailed by registered mail, postage prepaid; (a) If to the Employee, addressed to him at the following address as may be changed in writing from time to time: Lowell Giffhorn 10875 Kemah Lane San Diego, CA 92131 (b) If to the Company, addressed to: CEO Patriot Scientific Corporation 10989 Via Frontera San Diego, CA 92127 or to such other address as any party may request by notice given as aforesaid to the other parties hereto. 11. Titles and Headings. Titles and headings to paragraphs hereof are for the purposes of references only and shall in no way limit, define or otherwise effect the provisions hereof 12. Governing Law. This Agreement is being executed and delivered and is intended to be performed in the State of California, and shall be governed by and construed in accordance with the laws of the State of California. 13. Agreement to Arbitrate. Employee and Company agree to arbitrate any controversy, claim or dispute between them arising out of or in any way related to this Agreement, the employment relationship between them, and any disputes upon termination of employment in accordance with the Arbitration Agreement attached hereto as Exhibit "2" and incorporated by this reference as though fully set forth herein. 14. Counterparts. This Agreement shall be executed simultaneously in two or more counterparts, each of which shall be deemed an original, but all of which together shall constitute one and the same instrument. It shall not be necessary in making proof of this Agreement to produce or account for more than one original counterpart. 15. Entire Agreement. This Agreement, including the Exhibits attached hereto, contains the entire agreement of the parties hereto and may be modified or amended only by a written instrument executed by the parties hereto. This Agreement supersedes any previous oral or written communications, representations, understandings or agreements with Employer or any officer or agent thereof through the date the Agreement is executed by the parties. Employee understands that no representative of the Company has been authorized to enter into any agreement or commitment with Employee which is inconsistent in any way with the terms of this Agreement. 16. Good Faith. Each of the parties hereto agrees that he or it shall act in good faith in all actions taken under this Agreement. 17. Waiver. No waiver of any of the provisions of this Agreement shall be deemed to be or shall constitute a waiver of any other provision of the Agreement, whether or not similar, nor shall any waiver constitute a continuing waiver. No waiver of any provision of this Agreement shall be binding upon the parties hereto unless it is executed in writing by the party making the waiver. 18. Interpretation; Construction. The headings set forth in this Agreement are for convenience only and shall not be used in interpreting this Agreement. This Agreement has been drafted by legal counsel representing the Company, but Employee has participated in the negotiation of its terms. Furthermore, Employee acknowledges that Employee has had an opportunity to have it reviewed by legal counsel, if desired, and, therefore, the normal rule of construction to the effect that any ambiguities are to be resolved against the drafting party shall not be employed in the interpretation of this Agreement. IN WITNESS WHEREOF, the parties hereto have executed the Agreement as of the day and year first above written. PATRIOT SCIENTIFIC CORPORATION By: /S/ J.E. WALLIN ------------------------ J.E. Wallin, CEO Employee: By: /S/ LOWELL GIFFHORN ------------------- Lowell Giffhorn EX-23.1 5 v011943_ex23-1.txt EXHIBIT 23.1 CONSENT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS Patriot Scientific Corporation San Diego, California We hereby consent to the use in the Prospectus constituting a part of this Registration Statement of our report dated July 8, 2004, relating to the consolidated financial statements of Patriot Scientific Corporation, which are contained in that Prospectus. Our report contains an explanatory paragraph regarding the Company's ability to continue as a going concern. We also consent to the reference to us under the caption "Experts" in the Prospectus. /s/ Nation Smith Hermes Diamond - -------------------------------- San Diego, California January 31, 2005 -----END PRIVACY-ENHANCED MESSAGE-----