UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-QSB

 

x

QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

 

 

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2007

 

 

o

TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

 

FOR THE TRANSITION PERIOD FROM

TO

 

 

Commission File Number:  000-30063

 

ARTISTdirect, Inc.

(Exact name of small business issuer as specified in its charter)

 

Delaware

95-4760230

(State or other jurisdiction of

(I.R.S. Employer

incorporation or organization)

Identification Number)

 

 

1601 Cloverfield Boulevard, Suite 400 South

 

Santa Monica, California

90404

(Address of principal executive offices)

(Zip Code)

 

(310) 956-3300

 (Issuer’s telephone number, including area code)

 

Not applicable

(Former name, former address and former fiscal year, if changed since last report.)

 

 

Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter period that the issuer was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes  x   No  o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes  o   No  x

 

As of October 31, 2007, the Company had 10,333,127 shares of common stock, par value $0.01 per share, issued and outstanding.

 

Transitional Small Business Disclosure Format:  Yes  o   No  x

 

Documents incorporated by reference:  None.

 

 



 

ARTISTDIRECT, INC. AND SUBSIDIARIES

 

INDEX

 

 

 

Page No.

 

 

 

PART I. FINANCIAL INFORMATION

 

ITEM 1.

FINANCIAL STATEMENTS

 

 

CONDENSED CONSOLIDATED BALANCE SHEETS — SEPTEMBER 30, 2007 (UNAUDITED) AND DECEMBER 31, 2006

3

 

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED) —
THREE MONTHS AND NINE MONTHS ENDED SEPTEMBER 30, 2007 AND 2006

5

 

CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ DEFICIENCY (UNAUDITED) —
NINE MONTHS ENDED SEPTEMBER 30, 2007

6

 

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) — NINE MONTHS ENDED SEPTEMBER 30, 2007 AND 2006

7

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) —
THREE MONTHS AND NINE MONTHS ENDED SEPTEMBER 30, 2007 AND 2006

9

ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION

39

ITEM 3.

CONTROLS AND PROCEDURES

58

PART II. OTHER INFORMATION

59

ITEM 1.

LEGAL PROCEEDINGS

59

ITEM 2.

UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

59

ITEM 3.

DEFAULTS UPON SENIOR SECURITIES

59

ITEM 4.

SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

59

ITEM 5.

OTHER INFORMATION

59

ITEM 6.

EXHIBITS

59

SIGNATURES

60

 

1



 

In addition to historical information, this Quarterly Report on Form 10-QSB (“Quarterly Report”) for ARTISTdirect, Inc. (“ARTISTdirect” or the “Company”) contains “forward-looking” statements within the meaning of the United States Private Securities Litigation Reform Act of 1995, including statements that include the words “may,” “will,” “believes,” “expects,” “anticipates,” or similar expressions.  These forward-looking statements may include, among others, statements concerning the Company’s expectations regarding its business, growth prospects, revenue trends, operating costs, accounting, working capital requirements, competition, results of operations, financing needs and constraints, and other statements of expectations, beliefs, future plans and strategies, anticipated events or trends, and similar expressions concerning matters that are not historical facts.  The forward-looking statements in this Quarterly Report involve known and unknown risks, uncertainties and other factors that could cause the Company’s actual results, performance or achievements to differ materially from those expressed or implied by the forward-looking statements contained herein.

 

Each forward-looking statement should be read in context with, and with an understanding of, the various disclosures concerning the Company’s business made elsewhere in this Quarterly Report, as well as other public reports filed by the Company with the United States Securities and Exchange Commission.  Investors should not place undue reliance on any forward-looking statement as a prediction of actual results or developments.  Except as required by applicable law or regulation, the Company undertakes no obligation to update or revise any forward-looking statement contained in this Quarterly Report.

 

2


 

 


 

ARTISTdirect, Inc. and Subsidiaries

Condensed Consolidated Balance Sheets

(amounts in thousands, except for share data)

 

 

September 30,
2007

 

December 31,
 2006

 

 

 

(Unaudited)

 

 

 

Assets

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

6,360

 

$

5,602

 

Restricted cash

 

278

 

364

 

Accounts receivable, net of allowance for doubtful accounts
of $393 at September 30, 2007 and $421 at December 31,
2006

 

6,640

 

6,928

 

Income taxes refundable

 

330

 

 

Finished goods inventory

 

 

281

 

Prepaid expenses and other current assets

 

627

 

204

 

Total current assets

 

14,235

 

13,379

 

 

 

 

 

 

 

Property and equipment

 

4,362

 

4,197

 

Less accumulated depreciation and amortization

 

(2,322

)

(1,729

)

Property and equipment, net

 

2,040

 

2,468

 

 

 

 

 

 

 

Other assets:

 

 

 

 

 

Intangible assets:

 

 

 

 

 

Customer relationships, net

 

629

 

1,195

 

Proprietary technology, net

 

2,112

 

4,012

 

Non-competition agreements, net

 

481

 

728

 

Goodwill

 

31,085

 

31,085

 

Total intangible assets, net

 

34,307

 

37,020

 

Deferred financing costs, net

 

1,455

 

2,084

 

Deposits

 

20

 

21

 

Total other assets

 

35,782

 

39,125

 

 

 

$

52,057

 

$

54,972

 

 

(continued)

3



 

ARTISTdirect, Inc. and Subsidiaries

Condensed Consolidated Balance Sheets (continued)

(amounts in thousands, except for share data)

 

 

 

September 30,
2007

 

December 31,
2006

 

 

 

(Unaudited)

 

 

 

Liabilities and Stockholders’ Deficiency

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Accounts payable

 

$

1,406

 

$

1,832

 

Accrued expenses

 

2,882

 

1,575

 

Accrued interest payable

 

2,323

 

67

 

Deferred revenue

 

298

 

39

 

Income taxes payable

 

147

 

495

 

Liquidated damages payable under registration rights
agreements, net of advance payments of $500

 

2,558

 

3,777

 

Warrant liability

 

3,073

 

4,715

 

Derivative liability

 

11,300

 

18,356

 

Senior secured notes payable, net of discount of $766
and $1,110 at September 30, 2007 and December 31,
2006, respectively (in default)

 

12,541

 

12,197

 

Subordinated convertible notes payable, net of discount
of $4,554 and $6,516 at September 30, 2007 and
December 31, 2006, respectively (in default)

 

23,104

 

21,142

 

Total current liabilities

 

59,632

 

64,195

 

 

 

 

 

 

 

Long-term liabilities:

 

 

 

 

 

Deferred rent

 

189

 

199

 

Deferred income taxes payable

 

264

 

264

 

Total long-term liabilities

 

453

 

463

 

 

 

 

 

 

 

Commitments and contingencies

 

 

 

 

 

 

 

 

 

 

 

Stockholders’ deficiency:

 

 

 

 

 

Common stock, $0.01 par value -

 

 

 

 

 

Authorized – 60,000,000 shares

 

 

 

 

 

Issued and outstanding – 10,333,127 shares and
10,188,445 shares at September 30, 2007 and
December 31, 2006, respectively

 

103

 

102

 

Additional paid-in-capital

 

234,988

 

233,197

 

Accumulated deficit

 

(243,119

)

(242,985

)

Total stockholders’ deficiency

 

(8,028

)

(9,686

)

 

 

$

52,057

 

$

54,972

 

 

See accompanying notes to condensed consolidated financial statements.

 

 

4



 

ARTIST direct, Inc. and Subsidiaries

Condensed Consolidated Statements of Operations (Unaudited)

(amounts in thousands, except for share data)

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2007

 

2006

 

2007

 

2006

 

 

 

 

 

(Restated)

 

 

 

(Restated)

 

Net revenue:

 

 

 

 

 

 

 

 

 

E-commerce

 

$

337

 

$

663

 

$

1,340

 

$

1,917

 

Media

 

1,974

 

1,572

 

5,139

 

3,937

 

Anti-piracy and file-sharing marketing services

 

3,627

 

4,158

 

11,498

 

11,781

 

Total net revenue

 

5,938

 

6,393

 

17,977

 

17,635

 

Cost of revenue:

 

 

 

 

 

 

 

 

 

E-commerce

 

353

 

612

 

1,378

 

1,799

 

Media

 

969

 

709

 

2,562

 

2,110

 

Anti-piracy and file-sharing marketing services

 

2,414

 

2,040

 

6,928

 

5,617

 

Total cost of revenue

 

3,736

 

3,361

 

10,868

 

9,526

 

Gross profit

 

2,202

 

3,032

 

7,109

 

8,109

 

Operating expenses:

 

 

 

 

 

 

 

 

 

Sales and marketing

 

553

 

296

 

1,439

 

839

 

General and administrative, including stock-based compensation of $702 and $652 for the three months ended September 30, 2007 and 2006, respectively, and $1,690 and $1,736 for the nine months ended September 30, 2007 and 2006, respectively

 

2,982

 

2,107

 

8,490

 

6,896

 

Development and engineering

 

106

 

 

419

 

 

Write-off of fixed assets

 

 

 

97

 

 

Total operating costs

 

3,641

 

2,403

 

10,445

 

7,735

 

Income (loss) from operations

 

(1,439

)

629

 

(3,336

)

374

 

Other income (expense):

 

 

 

 

 

 

 

 

 

Interest income

 

59

 

45

 

160

 

76

 

Interest expense

 

(1,805

)

(1,472

)

(5,733

)

(4,411

)

Loss on foreign currency transactions

 

 

 

(14

)

 

Other income

 

 

10

 

 

63

 

Reduction in liquidated damages payable under registration rights agreements

 

 

 

719

 

 

Change in fair value of warrant liability

 

512

 

1,139

 

1,643

 

(1,818

)

Change in fair value of derivative liability

 

2,702

 

1,236

 

7,056

 

(2,765

)

Reduction in exercise price of warrants

 

 

 

 

(641

)

Amortization of deferred financing costs

 

(212

)

(212

)

(629

)

(646

)

Write-off of unamortized discount on debt and deferred financing costs resulting from principal payments on senior secured notes payable and conversion of subordinated convertible notes payable

 

 

 

 

(1,580

)

Income (loss) before income taxes

 

(183

)

1,375

 

(134

)

(11,348

)

Provision for income taxes

 

 

536

 

 

797

 

Net income (loss)

 

$

(183

)

$

839

 

$

(134

)

$

(12,145

)

 

 

 

 

 

 

 

 

 

 

Net income (loss) per common share:

 

 

 

 

 

 

 

 

 

Basic

 

$

(0.02

)

$

0.03

 

$

(0.01

)

$

(1.46

)

Diluted

 

$

(0.02

)

$

0.03

 

$

(0.01

)

$

(1.46

)

 

 

 

 

 

 

 

 

 

 

Weighted average common shares outstanding:

 

 

 

 

 

 

 

 

 

Basic

 

10,292,611

 

27,933,889

 

10,228,904

 

8,296,876

 

Diluted

 

10,292,611

 

30,543,558

 

10,228,904

 

8,296,876

 

 

See accompanying notes to condensed consolidated financial statements.

 

5



 

ARTISTdirect, Inc. and Subsidiaries

Condensed Consolidated Statement of Stockholders’ Deficiency (Unaudited)

(amounts in thousands, except for share data)

 

 

Common Stock

 

Additional
Paid-In

 

Accumulated

 

Total Stockholders’

 

 

 

Shares

 

Amount

 

Capital

 

Deficit

 

Deficiency

 

Balance at January 1, 2007

 

10,188,445

 

$

102

 

$

233,197

 

$

(242,985

)

$

(9,686

)

Fair value of stock options granted

 

 

 

1,633

 

 

1,633

 

Common stock issued for consulting services

 

17,307

 

 

57

 

 

57

 

Common stock issued upon exercise of stock options

 

127,375

 

1

 

101

 

 

102

 

Net loss

 

 

 

 

(134

)

(134

)

Balance at September 30, 2007

 

10,333,127

 

$

103

 

$

234,988

 

$

(243,119

)

$

(8,028

)

 

See accompanying notes to condensed consolidated financial statements.

 

6



 

ARTISTdirect, Inc. and Subsidiaries

Condensed Consolidated Statements of Cash Flows (Unaudited)

(amounts in thousands)

 

 

Nine Months Ended
September 30,

 

 

 

2007

 

2006

 

 

 

 

 

(Restated)

 

Cash flows from operating activities:

 

 

 

 

 

Net loss

 

$

(134

)

$

(12,145

)

Adjustments to reconcile net loss to net cash provided by operating activities:

 

 

 

 

 

Depreciation and amortization

 

6,371

 

6,229

 

Write-off of unamortized discount on debt and deferred financing costs resulting from principal payments on senior secured notes payable and conversion of subordinated convertible notes payable

 

 

1,580

 

Provision for doubtful accounts

 

10

 

(67

)

Stock-based compensation

 

1,690

 

1,736

 

Deferred income taxes

 

 

(1

)

Other

 

 

(88

)

Change in fair value of warrant liability

 

(1,643

)

1,818

 

Change in fair value of derivative liability

 

(7,056

)

2,765

 

Reduction in exercise price of warrants

 

 

641

 

Reduction in liquidated damages payable under registration rights agreements

 

(719

)

 

Write-off of fixed assets

 

97

 

 

Sub-total

 

(1,384

)

2,468

 

Changes in operating assets and liabilities:

 

 

 

 

 

(Increase) decrease in -

 

 

 

 

 

Accounts receivable

 

278

 

(2,342

)

Finished goods inventory

 

281

 

(40

)

Prepaid expenses and other current assets

 

(423

)

(183

)

Income taxes refundable

 

(330

)

828

 

Deposits

 

1

 

4

 

Increase (decrease) in -

 

 

 

 

 

Accounts payable

 

(426

)

109

 

Accrued expenses

 

1,307

 

(32

)

Accrued interest payable

 

2,256

 

(545

)

Deferred revenue

 

259

 

(321

)

Deferred rent

 

(10

)

200

 

Income taxes payable

 

(348

)

 

Liquidated damages payable under registration rights agreements

 

(500

)

 

Net cash provided by operating activities

 

961

 

146

 

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

Purchases of property and equipment

 

(391

)

(955

)

Net cash used in investing activities

 

(391

)

(955

)

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

Proceeds from exercise of stock options

 

102

 

71

 

Proceeds from exercise of warrants

 

 

5,212

 

Principal payments on senior secured notes payable

 

 

(1,693

)

(Increase) decrease in restricted cash

 

86

 

(4

)

Net cash provided by financing activities

 

188

 

3,586

 

 

 

 

 

 

 

Cash and cash equivalents:

 

 

 

 

 

Net increase

 

758

 

2,777

 

Balance at beginning of period

 

5,602

 

3,102

 

Balance at end of period

 

$

6,360

 

$

5,879

 

 

(continued)

 

7



 

ARTISTdirect, Inc. and Subsidiaries

Condensed Consolidated Statements of Cash Flows (Unaudited) (continued)

(amounts in thousands)

 

 

Nine Months Ended
September 30,

 

 

 

2007

 

2006

 

 

 

 

 

(Restated)

 

Supplemental disclosure of cash flow information:

 

 

 

 

 

Cash paid for -

 

 

 

 

 

Interest

 

$

1,139

 

$

2,585

 

Income taxes

 

$

678

 

$

 

 

 

 

 

 

 

Non-cash investing and financing activities:

 

 

 

 

 

Warrant liability transferred to additional paid-in capital as a result of exercise of warrants

 

$

 

$

9,311

 

Common stock issued upon conversion of subordinated convertible notes payable

 

$

 

$

3,275

 

Derivative liability transferred to additional paid-in capital as a result of conversions of subordinated convertible notes payable

 

$

 

$

3,915

 

 

See accompanying notes to condensed consolidated financial statements.

 

8



 

ARTISTdirect, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

Three Months and Nine Months Ended September 30, 2007 and 2006 (2006 restated)

 

1. ORGANIZATION AND BUSINESS ACTIVITIES

 

ARTISTdirect, Inc., a Delaware corporation (“ADI”), was formed on October 6, 1999 upon its merger with ARTISTdirect, LLC. ARTISTdirect, LLC was organized as a California limited liability company and commenced operations on August 8, 1996. Unless the context indicates otherwise, ADI and its subsidiaries are referred to herein as the “Company”. The Company is headquartered in Santa Monica, California.

 

On July 28, 2005, the Company completed the acquisition of MediaDefender, Inc., a privately-held Delaware corporation (“MediaDefender”) (see Note 3). This transaction was accounted for as a purchase in accordance with SFAS No. 141, “Business Combinations”, and the operations of the two companies have been consolidated commencing August 1, 2005. MediaDefender is a leading provider of anti-piracy solutions in the Internet-piracy-protection (“IPP”) industry. During the year ended December 31, 2006, MediaDefender also began to offer file-sharing marketing services, wherein MediaDefender redirects, for a fee, specific peer-to-peer traffic on the Internet to designated client destinations.

 

The Company is a digital media entertainment company that is home to an online music network and, through its MediaDefender subsidiary, is a leading provider of anti-piracy solutions in the IPP industry. The ARTISTdirect Network (www.artistdirect.com) is a network of web-sites appealing to music fans, artists and marketing partners that offers multi-media content, music news and information, communities organized around shared music interests, music-related specialty commerce and digital music services.

 

Restatement of Financial Statements:

 

On December 20, 2006, the Company determined that it was necessary to restate the financial statements contained in its previously-filed Annual Report on Form 10-KSB/A for the fiscal year ended December 31, 2005 and Quarterly Reports on Form 10-QSB or Form 10-QSB/A for the quarterly periods ended September 30, 2005, March 31, 2006, June 30, 2006 and September 30, 2006 (collectively, the “Financial Statements”).  The determination was made by the Company’s Audit Committee following receipt by the Company of comments from the staff (the “Staff”) of the Securities and Exchange Commission (the “SEC”), and following consultation with the Company’s senior management, financial advisors and independent registered public accounting firm.

 

The Staff advised the Company to consider EITF 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock” (“EITF 00-19”), and, in light of the guidance set forth in EITF 00-19, to further evaluate the accounting treatment of certain embedded derivatives contained in the outstanding Sub-Debt Notes (as subsequently defined) issued by the Company in July 2005, as well as the accounting treatment of certain warrants issued to the Company’s lenders in July 2005, in conjunction with the financing of the acquisition of MediaDefender.  The Company filed the restated Financial Statements on April 19, 2007.  On May 11, 2007, the Staff provided additional comments to the Company regarding the Financial Statements, to which the Company subsequently responded. On June 11, 2007, the Staff advised the Company that it would have no further comments. The adjustments to the Financial Statements with respect to the restatements were non-cash in nature and were not caused by or related to any changes in the underlying operating performance of the Company’s business, including its revenues, operating costs and expenses, operating income or loss, operating cash flows or adjusted EBITDA.  However, such restatements had a material negative impact on the Company’s previously reported results of operations and earnings per share, current liabilities, net working capital and shareholders’ equity (deficiency). Additionally, as a result of the restatements, the Company triggered various events of default under its financing documents (see Note 4).

 

The Sub-Debt Notes contain reset, anti-dilution and change-in-control provisions that the Company has determined caused such debt instruments to be classified as “non-conventional” debt. Upon evaluation of such debt instruments under Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS No. 133”) and EITF 00-19, it was determined that the Company was required to bifurcate and value certain rights embedded in the Sub-Debt Notes on the date of issuance (including, specifically, the initial $1.55 per share fixed conversion feature, which was in excess of the $1.43 per share fair market value of the Company’s common stock on the date of issuance) and to classify such rights as either assets or liabilities. The fair value of these bifurcated derivatives, as determined by an independent valuation firm as of July 28, 2005, was calculated in accordance with SFAS No. 133 Implementation Issue No. B15, “Embedded Derivatives: Separate Accounting for Multiple Derivative Features Embedded in a Single Hybrid Instrument”, using a binomial lattice model, and utilized highly subjective and theoretical assumptions that can materially affect fair values from period to period.

 

9



 

The recognition of these derivative amounts did not have any impact on the Company’s revenues, operating expenses, income taxes or cash flows. The Company recorded an initial embedded derivative liability of $10,534,000, which was recorded as a discount to the $31,460,500 of convertible subordinated notes, and is being amortized over the term of the debt. The carrying value of the embedded derivative liability is being adjusted to reflect any material changes in such liability from the date of issuance to the end of each subsequent reporting period, with any such changes included in other income (expense) in the statement of operations. The Company has accounted for the registration rights penalties (see Note 4) in accordance with EITF 00-19-2, “Accounting for Registration Payment Arrangements” (“EITF 00-10-2”), which the Company adopted as of December 31, 2006, and Statement of Financial Accounting Standards No. 5, “Accounting for Contingencies”.

 

In addition to the adjustment for the embedded derivatives associated with the Sub-Debt Notes, the Company revised the initial valuation and subsequent changes to fair value of the warrants issued in conjunction with the Senior Financing and the Sub-Debt Financing (see Note 5).

 

A summary of the significant adjustments recorded to restate the financial statements as of and for the three months and nine months ended September 30, 2006 is presented below. The restatement did not have an impact on the Company’s cash flows for the three months and nine months ended September 30, 2006.

 

(a)   The initial fair value of the derivative liability was bifurcated from the Sub-Debt Notes and was recorded as a discount to the Sub-Debt Notes, and was amortized to interest expense over the life of the related debt.

 

(b)   The derivative liability was revalued at each quarter end, with the resulting change in fair value reflected in the statement of operations.

 

(c)   The initial fair value of the warrants issued in the Senior Financing and the Sub-Debt Financing was restated, resulting in revisions to deferred financing costs and debt discount amounts, and in the related amortization of such amounts to operations.

 

(d)   The warrants issued in conjunction with the Senior Financing and the Sub-Debt Financing were revalued at each quarter end, with the resulting change in fair value reflected in the statement of operations.

 

(e)   The pro rata portion of the restated warrant liability and the derivative liability associated with the conversion of the sub-debt into common stock was transferred to additional paid-in capital.

 

10



 

The following table presents the impact of the restatement on the effected balance sheet categories at September 30, 2006 (amounts in thousands):

 

 

 

As Previously
Reported

 

Restatement
Adjustments

 

Adjustment
Legend

 

As Restated

 

 

 

 

 

 

 

 

 

 

 

Deferred financing costs

 

$

2,139

 

$

166

 

(c)

 

$

2,305

 

Warrant liability

 

6,209

 

1,620

 

(c), (d)

 

7,829

 

Derivative liability

 

 

29,052

 

(a), (b)

 

29,052

 

Discount on senior secured notes payable

 

864

 

362

 

(c), (d)

 

1,226

 

Discount on subordinated convertible notes payable

 

540

 

6,673

 

(a), (b), (c)

 

7,213

 

Additional paid-in capital

 

225,348

 

6,724

 

(e)

 

232,072

 

Accumulated deficit

 

$

(220,045

)

$

(30,195

)

(a), (b), (c), (d)

 

$

(250,240

)

 

The following table presents the impact of the restatement on the statements of operations for the three months and nine months ended September 30, 2006 (amounts in thousands, except per share data):

 

 

 

 

 

Three Months Ended
September 30, 2006

 

Nine Months Ended
September 30, 2006

 

 

 

Adjustment
Legend

 

As Previously
Reported

 

Restatement
Adjustments

 

As Restated

 

As Previously
Reported

 

Restatement
Adjustments

 

As Restated

 

Income (loss) from operations

 

 

 

$

629

 

$

 

$

629

 

$

374

 

$

 

$

374

 

Interest income

 

 

 

45

 

 

45

 

76

 

 

 

76

 

Other income

 

 

 

10

 

 

10

 

63

 

 

63

 

Interest expense

 

(a), (c)

 

(825

)

(647

)

(1,472

)

(2,449

)

(1,962

)

(4,411

)

Amortization of deferred financing costs

 

(c)

 

(197

)

(15

)

(212

)

(600

)

(46

)

(646

)

Change in fair value of warrant liability

 

(c), (d)

 

887

 

252

 

1,139

 

(9,452

)

7,634

 

(1,818

)

Change in value of derivative liability

 

(a), (b)

 

 

1,236

 

1,236

 

 

(2,765

)

(2,765

)

Write-off of unamortized discount on debt and deferred financing costs due to conversion of subordinated convertible notes payable and principal payments on senior secured notes payable

 

(a), (c)

 

 

 

 

(537

)

(1,043

)

(1,580

)

Reduction in exercise price of warrants

 

(c), (d)

 

 

 

 

(797

)

156

 

(641

)

Income (loss) before income taxes

 

 

 

549

 

826

 

1,375

 

(13,322

)

1,974

 

(11,348

)

Provision for income taxes

 

 

 

(536

)

 

(536

)

(797

)

 

(797

)

Net income (loss)

 

 

 

$

13

 

$

826

 

$

839

 

$

(14,119

)

$

1,974

 

$

(12,145

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income (loss) per share – basic

 

 

 

$

0.00

 

 

 

$

0.03

 

$

(1.70

)

 

 

$

(1.46

)

Net income (loss) per share - diluted

 

 

 

$

0.00

 

 

 

$

0.03

 

$

(1.70

)

 

 

$

(1.46

)

 

Going Concern:

 

The accompanying consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America, which contemplate continuation of the Company as a going concern. As a result of the matters described herein, the Company’s independent registered public accounting firm, in its report on the Company’s 2006 consolidated financial statements, expressed substantial doubt about the Company’s ability to continue as a going concern. The consolidated financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or the amounts and classification of liabilities that could result from the outcome of this uncertainty.

 

As a result of communications with the Staff of the SEC in 2006, in particular regarding the application of accounting rules and interpretations related to embedded derivatives associated with the Company’s subordinated convertible notes payable issued in July 2005, the Company determined that it was necessary to restate previously issued financial statements. As a result, in December 2006, the Company was required to suspend the use of its then effective registration statement for the holders of its senior and subordinated indebtedness, which then triggered an event of default with respect to its registration rights agreements with the holders of such indebtedness. Accordingly, beginning January 18, 2007, the Company began to incur liquidated damages under its registration rights agreements aggregating approximately $540,000 per month, and the interest rate on its subordinated convertible notes payable increased from 4.0% per annum to 12.0% per annum, an increase of approximately $183,000 per month.

 

11



 

The adjustments to the financial statements with respect to the restatements were non-cash in nature and were not caused by or related to any changes in the underlying operating performance of the Company’s business, including revenues, operating costs and expenses, operating income or loss, income taxes, operating cash flows or adjusted EBITDA.  The fair value of these bifurcated derivatives of $10,534,000, as determined by an independent valuation firm, was calculated using a binomial lattice option-pricing model utilizing highly subjective and theoretical assumptions that can materially affect fair values from period to period. The recognition of these derivative amounts, initially recorded as a reduction to the related debt and being amortized to interest expense through the life of the debt, with the resulting changes in fair value of the liability being included as other income (expense) in the statement of operations each subsequent reporting period, did not have any impact on the Company’s revenues, operating expenses, income taxes or cash flows. However, such restatements had a material negative impact on the Company’s previously reported results of operations and earnings per share, current liabilities, net working capital and shareholders’ equity (deficiency).

 

During 2005 and 2006 and the nine months ended September 30, 2007, the Company’s consolidated operations generated sufficient cash flows from operations to enable the Company to fund its operating requirements and its originally scheduled (i.e., undefaulted) debt service obligations to both the senior and subordinated debt holders, and management currently anticipates that cash flows from operations will be adequate to fund operating and debt service requirements (based on the original terms as contemplated in the senior and subordinated loan agreements and excluding the registration penalty amounts) for the remainder of 2007 and generate operating cash flows in excess of pre-default amounts for at least the next twelve months.

 

Primarily as a result of the requirement to restate previously issued financial statements, which resulted in the recording of an embedded derivative liability, the reclassification of the senior and subordinated indebtedness to current liabilities, and the recording of estimated liquidated damages payable under registration rights agreements, the Company was not in compliance with certain of its financial covenants under both the Senior Financing and the Sub-Debt Financing at September 30, 2007 and December 31, 2006. Notwithstanding such developments, the Company believes that it would have been out of compliance with certain of its financial covenants at September 30, 2007.

 

As of September 30, 2007 and December 31, 2006, approximately $13,307,000 principal amount was outstanding with respect to the Senior Financing, and approximately $27,658,000 principal amount was outstanding with respect to the Sub-Debt Financing.  In addition, at September 30, 2007, approximately $775,000 and $1,783,000 was outstanding with respect to accrued registration delay penalties to the holders of the Senior Financing and the Sub-Debt Financing, respectively, and approximately $116,000 and $2,207,000 was outstanding with respect to accrued interest payable to the holders of the Senior Financing and the Sub-Debt Financing, respectively. The Company has not paid the registration delay penalties to either the holders of the Senior Notes or the Sub-Debt Notes, although it has made advance payments to the holders of the Senior Notes aggregating $500,000. As a result of the registration failure, the failure to pay the registration delay penalties and the various financial covenant and other breaches of the terms of the Senior Financing and the Sub-Debt Financing, multiple events of default exist under the Senior Financing and the Sub-Debt Financing. The terms of the Subordination Agreement among the Company and the creditor parties thereto (the “Subordination Agreement”) prevent the Company from making any cash payments to the Sub-Debt Note holders until the events of default under the Senior Financing are either cured or waived. Furthermore, upon the occurrence of an event of default, holders of at least 25% of the outstanding senior indebtedness may declare the outstanding principal and accrued interest on all senior notes immediately due and payable upon written notice to the Company, and each holder of outstanding subordinated indebtedness may only demand redemption of all or any portion of their respective notes under certain circumstances as described in the Subordination Agreement.

 

On October 16, 2007, the Company received an Event of Default Redemption Notice from the holders of approximately $2,693,000 principal amount of Sub-Debt Notes demanding that the Company redeem their Sub-Debt Notes. The Company believes and has advised these Sub-Debt Note holders that redemption (including the demand for redemption) is not permitted under the terms of the Subordination Agreement. On November 1, 2007, the Company received a copy of a letter to the Sub-Debt Note holders from Senior Note holders representing approximately 66% of the Senior Notes. The letter advised the Sub-Debt Note holders that the Subordination Agreement prohibits the Company from redeeming any Sub-Debt Notes and prohibits any Sub-Debt Note holder from pursuing any remedies. The letter further stated that the Senior Note holders were inclined to give the Company until November 30, 2007 to either cure the existing events of default or to pay off the obligations to the Senior Note holders in full, or the Senior Note holders expect they will likely begin to exercise additional remedies to obtain payment of their outstanding obligations. The Company does not have the capital resources necessary to cure the existing events of default, or to repay any accelerated indebtedness or redemption or penalty amounts.

 

All quarterly interest payments due on the outstanding senior and subordinated indebtedness were timely paid by the Company through December 2006. In addition, the quarterly interest payments due on the outstanding senior indebtedness in March 2007, June 2007 and September 2007 were timely paid.

 

12



 

Pursuant to the terms of the Subordination Agreement, interest on the outstanding subordinated convertible notes payable cannot be paid as a result of the existence of the events of default described herein.

 

Pursuant to a Forbearance and Consent Agreement with the investors in the Senior Financing, such investors agreed to forbear from the exercise of their rights and remedies under the Senior Financing documents as a result of the events of default with respect to the unavailability of the Company’s registration statement, as well as certain other events of default that existed or that could come into existence during the forbearance period, from April 17, 2007 through July 31, 2007, in exchange for aggregate cash payments of $500,000. The payments made by the Company under the Forbearance and Consent Agreement may be credited against the registration delay cash penalties or any other amounts ultimately determined to be due the investors in the Senior Financing. On July 6, 2007, the Company’s registration statement was declared effective by the SEC, thus making it available to the investors in the Senior Financing and Sub-Debt Financing. Although the Company and its representatives and advisors are in ongoing discussions with the investors in the Senior Financing and the investors in the Sub-Debt Financing as to a comprehensive resolution of the matters discussed herein, the Company cannot predict the ultimate outcome of such discussions.

 

On August 3, 2007, the Company entered into a Waiver and Forbearance Agreement with the holders of the Sub-Debt Financing pursuant to which the holders agreed to waive their right to charge the 12.0% default interest rate triggered by the Company’s defaults under the Subordinated Financing transaction documents and instead charge the 4.0% standard interest rate on the Sub-Debt Notes for the period from July 16, 2007 through August 31, 2007 (the “Forbearance Period”). The holders of the Sub-Debt Financing also agreed to forbear from exercising any of their other rights and remedies under the Sub-Debt Financing transaction documents during the Forbearance Period, upon the terms and conditions in the Waiver and Forbearance Agreement. Effective September 1, 2007, the interest rate returned to the 12.0% default interest rate.

 

The registration delay penalties and ongoing default interest charges are continuing to have a significant and material negative impact on the Company’s operations and cash flows. The Company and its representatives and advisors are in ongoing discussions with the holders of its senior and subordinated debt obligations to obtain a waiver of and amendment to certain of the financing documents with respect to the events of default, the impact of the restatements, the payment of cash penalties and default interest, and various related matters. The Company is exploring various alternatives to resolve the defaults under its senior and secured debt obligations, but is unable to predict the outcome of such negotiations. To the extent that the Company is unable to restructure its senior and subordinated debt obligations in a satisfactory manner and/or the lenders begin to exercise additional remedies to enforce their rights, the Company will not have sufficient cash resources to maintain its operations. In such event, the Company may be required to consider a formal or informal restructuring or reorganization, including a filing under Chapter 11 of the United States Bankruptcy Code.

 

2. BASIS OF PRESENTATION

 

Principles of Consolidation:

 

The accompanying condensed financial statements include the consolidated accounts of ADI and its wholly-owned subsidiaries. All intercompany accounts and transactions have been eliminated for all periods presented.

 

Interim Financial Information:

 

The interim condensed consolidated financial statements are unaudited, but in the opinion of management of the Company, contain all adjustments, which include normal recurring adjustments, necessary to present fairly the financial position at September 30, 2007, the results of operations for the three months and nine months ended September 30, 2007 and 2006, and the cash flows for the nine months ended September 30, 2007 and 2006. The condensed consolidated balance sheet as of December 31, 2006 is derived from the Company’s audited financial statements as of that date.

 

Certain information and footnote disclosures normally included in financial statements that have been presented in accordance with generally accepted accounting principles have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission with respect to interim financial statements, although management of the Company believes that the disclosures contained in these financial statements are adequate to make the information presented therein not misleading. For further information, refer to the consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-KSB for the fiscal year ended December 31, 2006, as filed with the Securities and Exchange Commission.

 

13



 

The Company’s results of operations for the three months and nine months ended September 30, 2007 are not necessarily indicative of the results of operations to be expected for the full fiscal year ending December 31, 2007.

 

Estimates:

 

In preparing financial statements in conformity with generally accepted accounting principles, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Some of the more significant estimates include the allowance for bad debts, impairment of intangible assets and long-lived assets, stock-based compensation, the valuation allowance on deferred tax assets and the change in fair value of the warrant liability and derivative liability. Actual results could differ materially from those estimates.

 

Development and Engineering Costs:

 

Development and engineering costs, which are presented as a separate line item in the statement of operations in 2007, consist primarily of third-party development costs and payroll and related expenses for in-house development costs incurred in the design and production of the Company’s content and services, including revisions to the Company’s web-site. These costs are charged to operations as incurred. During the three months and nine months ended September 30, 2006, these costs, which were not material, were included in cost of revenue.

 

Reclassification:

 

Certain amounts have been reclassified from their presentation in 2006 to conform to the current year’s presentation. Such reclassifications did not have any effect on income (loss) from operations, net income (loss), or operating cash flows.

 

Net Income (Loss) Per Common Share:

 

The Company calculates net income (loss) per common share in accordance with Statement of Financial Accounting Standards No. 128, “Earnings Per Share” (“SFAS No. 128”), and EITF 03-6, “Participating Securities and the Two-Class Method under FASB Statement No. 128” (“EITF 03-6”). EITF 03-6 clarifies the use of the “two-class” method of calculating earnings per share as originally prescribed in SFAS No. 128 and provides guidance on how to determine whether a security should be considered a “participating security”.

 

The Company has determined that the convertible subordinated notes payable are a participating security, as each note holder is entitled to receive any dividends paid and distributions made to the common stockholders as if the note had been converted into common stock on the record date. The participatory shares are included in the weighted average shares outstanding as of the beginning of each period in calculating the basic weighted average shares outstanding.

 

Under the two-class method, basic income (loss) per common share is computed by dividing net income (loss) applicable to common stockholders by the weighted-average number of common shares outstanding for the reporting period. Diluted income (loss) per common share is computed using the more dilutive of the “two-class” method or the “if-converted” method. Net losses are not allocable to the holders of the subordinated convertible notes payable. Diluted income (loss) per share gives effect to all potentially dilutive securities, including stock options, senior and sub-debt warrants, and convertible subordinated notes payable, unless their effect is anti-dilutive.

 

The calculation of diluted weighted average common shares outstanding for the three months and nine months ended September 30, 2007 and 2006 is based on the average of the closing price of the Company’s common stock during each respective period. The calculation of diluted income (loss) per share for the three months ended September 30, 2007 and the nine months ended September 30, 2007 and 2006 excluded the effect from the conversion of subordinated convertible notes payable and the exercise of stock options and senior and sub-debt warrants since their effect would have been anti-dilutive. The calculation of diluted income per share for the three months ended September 30, 2006 included the impact from dilutive stock options and senior and sub-debt warrants, but excluded the effect from the conversion of subordinated convertible notes payable, as well as stock options and warrants representing 585,149 shares and 433,333 shares, respectively, since their effect would have been anti-dilutive.

 

Issued but unvested shares of common stock are excluded from the calculation of basic earnings per share, but are included in the calculation of diluted earnings per share, to the extent that they are not anti-dilutive.

 

14



 

 

 

Three Months Ended September 30,

 

Nine Months Ended September 30,

 

 

 

2007

 

2006

 

2007

 

2006

 

 

 

 

 

(Restated)

 

 

 

(Restated)

 

 

 

 

 

 

 

 

 

 

 

Numerator:

 

 

 

 

 

 

 

 

 

Net income (loss), as reported

 

$

(183

)

$

839

 

$

(134

)

$

(12,145

)

 

 

 

 

 

 

 

 

 

 

Allocation of net income (loss), as reported:

 

 

 

 

 

 

 

 

 

Basic:

 

 

 

 

 

 

 

 

 

Net income (loss) applicable to common stockholders

 

$

(183

)

$

300

 

$

(134

)

$

(12,145

)

Net income (loss) applicable to convertible sub-debt note holders

 

 

539

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income (loss), as reported

 

$

(183

)

$

839

 

$

(134

)

$

(12,145

)

 

 

 

 

 

 

 

 

 

 

Diluted:

 

 

 

 

 

 

 

 

 

Net income (loss) applicable to common stockholders

 

$

(183

)

$

347

 

$

(134

)

$

(12,145

)

Net income (loss) applicable to convertible sub-debt note holders

 

 

492

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income (loss), as reported

 

$

(183

)

$

839

 

$

(134

)

$

(12,145

)

 

 

 

 

 

 

 

 

 

 

Denominator:

 

 

 

 

 

 

 

 

 

Weighted average common shares outstanding

 

10,292,611

 

9,998,869

 

10,228,904

 

8,296,876

 

Weighted average common shares attributable to subordinated notes

 

 

17,935,020

 

 

 

Weighted average common shares used in calculating basic net income (loss) per common share

 

10,292,611

 

27,933,889

 

10,228,904

 

8,296,876

 

 

 

 

 

 

 

 

 

 

 

Weighted average common shares issuable upon exercise of outstanding stock options, based on the treasury stock method

 

 

2,609,669

 

 

 

Weighted average common shares issuable upon exercise of sub-debt warrants, based on the treasury stock method

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Weighted average common shares used in computing diluted net income (loss) per common share

 

10,292,611

 

30,543,558

 

10,228,904

 

8,296,876

 

 

 

 

 

 

 

 

 

 

 

Calculation of net income (loss) per common share:

 

 

 

 

 

 

 

 

 

Basic:

 

 

 

 

 

 

 

 

 

Net income (loss) applicable to common stockholders

 

$

(183

)

$

839

 

$

(134

)

$

(12,145

)

 

 

 

 

 

 

 

 

 

 

Weighted average common shares used in calculating basic net income (loss) per common share

 

10,292,611

 

27,933,889

 

10,228,904

 

8,296,876

 

 

 

 

 

 

 

 

 

 

 

Net income (loss) applicable to common stockholders

 

$

(0.02

)

$

0.03

 

$

(0.01

)

$

(1.46

)

 

 

 

 

 

 

 

 

 

 

Diluted:

 

 

 

 

 

 

 

 

 

Net income (loss) applicable to common stockholders

 

$

(183

)

$

839

 

$

(134

)

$

(12,145

)

 

 

 

 

 

 

 

 

 

 

Weighted average common shares used in calculating diluted net income (loss) per common share

 

10,292,611

 

30,543,558

 

10,228,904

 

8,296,876

 

 

 

 

 

 

 

 

 

 

 

Net income (loss) applicable to common stockholders

 

$

(0.02

)

$

0.03

 

$

(0.01

)

$

(1.46

)

 

15



 

Stock-Based Compensation:

 

Effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment” (“SFAS No. 123R”), a revision to SFAS No. 123, “Accounting for Stock-Based Compensation”. SFAS No. 123R requires that the Company measure the cost of employee services received in exchange for equity awards based on the grant date fair value of the awards, with the cost to be recognized as compensation expense in the Company’s financial statements over the vesting period of the awards. Accordingly, the Company recognizes compensation cost for equity-based compensation for all new or modified grants issued after December 31, 2005. In addition, commencing January 1, 2006, the Company recognized the unvested portion of the grant date fair value of awards issued prior to adoption of SFAS No. 123R based on the fair values previously calculated for disclosure purposes over the remaining vesting period of the outstanding stock options and warrants.

 

The Company accounts for stock option and warrant grants issued and vesting to non-employees in accordance with EITF No. 96-18, “Accounting for Equity Instruments that are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services”, and EITF 00-18, “Accounting Recognition for Certain Transactions involving Equity Instruments Granted to Other Than Employees”, whereas the value of the stock compensation is based upon the measurement date as determined at either (a) the date at which a performance commitment is reached or (b) at the date at which the necessary performance to earn the equity instruments is complete.

 

During the three months and nine months ended September 30, 2007, the Company recorded $580,000 and $1,354,000, respectively, and during the three months and nine months ended September 30, 2006, the Company recorded $587,000 and $1,616,000, respectively, as a charge to operations to recognize the unvested portion of the grant date fair value of awards issued prior to the adoption of SFAS No. 123R.

 

At September 30, 2007, the unvested portion of the grant date fair value of awards issued prior to adoption of SFAS No. 123R on January 1, 2006 (excluding milestone–vested options), based on the fair values previously calculated, will be charged to operations over the remaining vesting period of the outstanding options as follows (amounts are in thousands):

 

 

Years Ending December 31,

 

 

 

2007 (three months)

 

$

323

 

2008

 

883

 

2009

 

26

 

Total

 

$

1,232

 

 

For the past several years and in accordance with established public company accounting practice, the Company has consistently utilized the Black-Scholes option-pricing model to calculate the fair value of stock options and warrants issued as compensation, primarily to management, employees and directors. The Black-Scholes option-pricing model is a widely-accepted method of valuation that public companies typically utilize to calculate the fair value of options and warrants that they issue in such circumstances.

 

In calculating the Black-Scholes value of stock options and warrants issued, the Company uses the full term of the option, an appropriate risk-free interest rate (generally from 4% to 5%), and a 0% dividend yield.

 

The Company utilizes the daily closing stock prices of its common stock as quoted on the OTC Bulletin Board to calculate the expected volatility used in the Black-Scholes option-pricing model. Since the Company’s business operations and capital structure changed dramatically on July 28, 2005 as a result of the acquisition of MediaDefender and the related financing transactions, the Company has utilized daily closing stock prices from August 1, 2005 through each subsequent quarter end to generate a volatility factor for use in calculating the fair value of options and warrants issued during each respective period. By utilizing daily trading data related to the period of time that reflects the Company’s current business operations, the Company believes that this methodology generates volatility factors that more accurately reflect, as well as adjust for, normal market fluctuations in the Company’s common stock over an extended period of time. This methodology has generated volatility factors ranging from approximately 163% to 100% during 2005, 2006 and 2007. These volatility factors have generally trended downward during 2006 and 2007.

 

Derivative Financial Instruments:

 

Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS No. 133”), requires all derivatives to be recorded on the balance sheet at fair value.  When multiple derivatives (both assets and liabilities) exist within a financial instrument, they are bundled together as a single hybrid compound instrument in accordance with SFAS No. 133 Implementation Issue No. B15, “Embedded Derivatives:  Separate Accounting for Multiple Derivative Features Embedded in a Single Hybrid Instrument”.

 

16



 

The calculation of the fair value of derivatives utilizes highly subjective and theoretical assumptions that can materially affect fair values from period to period. The change in the fair value of the derivatives from period to period is recorded in other income (expense) in the statement of operations. As a result, the Company’s financial statements are impacted quarterly based on factors such as the price of the Company’s common stock and the principal amount of Sub-Debt Notes converted into common stock. Consequently, the Company’s results of operations and financial position may vary from quarter to quarter based on factors other than those directly associated with the Company’s operating revenues and expenses. The recognition of these derivative amounts does not have any impact on cash flows.

 

EITF 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock (“EITF 00-19”), requires freestanding contracts that are settled in a company’s own stock, including common stock warrants, to be designated as an equity instrument, an asset or a liability.  When the ability to physically or net-share settle a conversion option or the exercise of freestanding options or warrants is deemed to be not within the control of the Company, the embedded conversion option or freestanding options or warrants may be required to be accounted for as a derivative liability. Under the provisions of EITF 00-19, a contract designated as an asset or a liability must be carried at fair value on a company’s balance sheet, with any changes in fair value recorded in a company’s results of operations.

 

The Company has accounted for registration rights penalties in accordance with EITF 00-19-2, “Accounting for Registration Payment Arrangements”, which the Company adopted as of December 31, 2006, and Statement of Financial Accounting Standards No. 5, “Accounting for Contingencies”.

 

The Company accounts for derivatives, including the embedded derivatives associated with the Sub-Debt Notes and the warrants issued in conjunction with the Senior Financing and the Sub-Debt Financing, at fair value, adjusted at the end of each reporting period to reflect any material changes, with any such changes included in other income (expense) in the statement of operations.

 

At the date of the conversion of Sub-Debt Notes into common stock or the principal repayment of Senior Notes, the pro rata portion of the related unamortized discount on debt and deferred financing costs is charged to operations and included in other income (expense). At the date of exercise of any of the warrants, or the conversion of Sub-Debt Notes into common stock, the pro rata portion of the fair value of the related warrant liability and/or embedded derivative liability is transferred to additional paid-in capital.

 

Foreign Currency Transactions:

 

The Company’s reporting currency and functional currency is the United States dollar. The Company periodically receives payments for services in Canadian dollars and British pounds, which are translated into United States dollars using the exchange rate in effect at the date of payment. Gains or losses resulting from foreign currency transactions, to the extent material, are included in other income (expense) in the statement of operations.

 


Change in Estimate:

 

At June 30, 2007, the Company evaluated the useful life of certain of its computer equipment and determined to reduce the depreciation period from 7 years to 5 years. The effect of this change in estimate was to increase depreciation expense by approximately $124,000 and $248,000 for the three months and nine months ended September 30, 2007, respectively. The Company estimates that this change in estimate will increase depreciation expense by a total of approximately $371,000 in 2007 and $168,000 in 2008 in excess of the amounts that would have been recorded as depreciation expense originally.

 

Adoption of New Accounting Policies:

 

In December 2006, the FASB issued FSP EITF 00-19-2, “ Accounting for Registration Payment Arrangements” (“EITF 00-19-2”), which addresses an issuer’s accounting for registration payment arrangements. EITF 00-19-2 specifies that the contingent obligation to make future payments or otherwise transfer consideration under a registration payment arrangement, whether issued as a separate agreement or included as a provision of a financial instrument or other agreement, should be separately recognized and measured in accordance with SFAS No. 5, “ Accounting for Contingencies” . EITF 00-19-2 further clarifies that a financial instrument subject to a registration payment arrangement should be accounted for in accordance with other applicable generally accepted accounting principles without regard to the contingent obligation to transfer consideration pursuant to the registration payment arrangement. EITF 00-19-2 is effective immediately for registration payment arrangements and the financial instruments subject to those arrangements that are entered into or modified subsequent to the date of issuance of EITF 00-19-2.

 

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For registration payment arrangements and financial instruments subject to those arrangements that were entered into prior to the issuance of EITF 00-19-2, EITF 00-19-2 is effective for financial statements issued for fiscal years beginning after December 15, 2006, and interim periods within those fiscal years. Early adoption of EITF 00-19-2 for interim or annual periods for which financial statements or interim reports have not been issued is permitted. The Company chose to early adopt EITF 00-19-2 effective December 31, 2006 (see Note 4).

 

In June 2006, the Emerging Issues Task Force (“EITF”) reached a consensus on EITF Issue 06-3, “How Taxes Collected From Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That Is, Gross versus Net Presentation)” (“EITF 06-3”). The scope of EITF 06-3 includes any tax assessed by a governmental authority that is directly imposed on a revenue-producing transaction between a seller and a customer, and provides that a company may adopt a policy of presenting taxes either on a gross basis - that is, including the taxes within revenue - or on a net basis. For any such taxes that are reported on a gross basis, a company should disclose the amounts of those taxes for each period for which an income statement is presented if those amounts are significant. The Company collects various state sales taxes that fall under the scope of EITF 06-3 on goods that it sells in its e-commerce business segment and is accounting for and reporting such taxes on a net basis. EITF 06-3 is effective for financial reports for interim periods and annual reporting periods beginning after December 15, 2006. The Company adopted EITF 06-3 effective January 1, 2007. The adoption of EITF 06-3 did not have a material effect on the Company’s financial statements.

 

Effective January 1, 2007, the Company adopted FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109, Accounting for Income Taxes” (“FIN 48”). FIN 48 addresses the determination of whether tax benefits claimed or expected to be claimed on a tax return should be recorded in the financial statements. Under FIN 48, the Company may recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position should be measured based on the largest benefit that has a greater than fifty percent likelihood of being realized upon ultimate settlement. FIN 48 also provides guidance on de-recognition, classification, interest and penalties on income taxes, accounting in interim periods and requires increased disclosures. The adoption of the provisions of FIN 48 did not have a material effect on the Company’s financial statements. As of September 30, 2007, no liability for unrecognized tax benefits was required to be recorded.

 

The Company files income tax returns in the U.S. federal jurisdiction and various states. The Company is subject to U.S. federal or state income tax examinations by tax authorities for years after 2002 (see Note 9).

 

The Company’s policy is to record interest and penalties on uncertain tax provisions as income tax expense.

 

Recent Accounting Pronouncements:

 

In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS No. 159”), which provides companies with an option to report selected financial assets and liabilities at fair value.  SFAS No. 159’s objective is to reduce both complexity in accounting for financial instruments and the volatility in earnings caused by measuring related assets and liabilities differently. Generally accepted accounting principles have required different measurement attributes for different assets and liabilities that can create artificial volatility in earnings. SFAS No. 159 helps to mitigate this type of accounting-induced volatility by enabling companies to report related assets and liabilities at fair value, which would likely reduce the need for companies to comply with detailed rules for hedge accounting. SFAS No. 159 also establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types of assets and liabilities. SFAS No. 159 requires companies to provide additional information that will help investors and other users of financial statements to more easily understand the effect of the company’s choice to use fair value on its earnings. SFAS No. 159 also requires companies to display the fair value of those assets and liabilities for which the company has chosen to use fair value on the face of the balance sheet.  SFAS No. 159 does not eliminate disclosure requirements included in other accounting standards, including requirements for disclosures about fair value measurements included in SFAS No. 157 and SFAS No. 107. SFAS No. 159 is effective as of the beginning of a company’s first fiscal year beginning after November 15, 2007.  Early adoption is permitted as of the beginning of the previous fiscal year provided that the company makes that choice in the first 120 days of that fiscal year and also elects to apply the provisions of SFAS No. 157. The Company is currently assessing the potential effect of SFAS No. 159 on its financial statements.

 

In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (“SFAS No. 157”), which establishes a formal framework for measuring fair value under Generally Accepted Accounting Principles (“GAAP”). SFAS No. 157 defines and codifies the many definitions of fair value included among various other authoritative literature, clarifies and, in some instances, expands on the guidance for implementing fair value measurements, and increases the level of disclosure required for fair value measurements. Although SFAS No. 157 applies to and amends the provisions of existing FASB and American Institute of Certified Public Accountants (“AICPA”) pronouncements, it does not, of itself, require any new fair value measurements, nor does it establish valuation standards.

 

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SFAS No. 157 applies to all other accounting pronouncements requiring or permitting fair value measurements, except for:  SFAS No. 123R, share-based payment and related pronouncements, the practicability exceptions to fair value determinations allowed by various other authoritative pronouncements, and AICPA Statements of Position 97-2 and 98-9 that deal with software revenue recognition. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and to interim periods within those fiscal years. The Company is currently assessing the potential effect of SFAS No. 157 on its financial statements.

 

Other than the foregoing, management does not believe that any other recently issued, but not yet effective, accounting standards, if currently adopted, would have a material effect on the Company’s consolidated financial statements.

 

3. ACQUISITION OF MEDIADEFENDER, INC.

 

On July 28, 2005, the Company consummated the acquisition of MediaDefender, Inc., a privately-held Delaware corporation (“MediaDefender”), pursuant to the terms of an Agreement and Plan of Merger (the “Merger Agreement”) entered into by and among the Company, ARTISTdirect Merger Sub, Inc., a Delaware corporation and wholly-owned subsidiary of the Company (“Merger Sub”), and MediaDefender. Under the terms of the Merger Agreement, Merger Sub merged with and into MediaDefender, the separate corporate existence of Merger Sub ceased and MediaDefender survived as a wholly-owned subsidiary of the Company. The stockholders of MediaDefender received aggregate consideration of $42,500,000 in cash, subject to certain holdbacks and adjustments described in the Merger Agreement

 

MediaDefender is a leading provider of anti-piracy solutions in the Internet-piracy-protection (“IPP”) industry. During the year ended December 31, 2006, MediaDefender also began to offer file-sharing marketing services, wherein MediaDefender redirects, for a fee, specific peer-to-peer traffic on the Internet to designated client destinations.

 

In order to fund the acquisition of MediaDefender, the Company completed a $15,000,000 senior secured debt transaction and a $30,000,000 convertible subordinated debt transaction, as described at Note 4.

 

In accordance with the Merger Agreement, the Company acknowledged the terms of Employment Agreements entered into on July 28, 2005 by MediaDefender with each of Randy Saaf and Octavio Herrera, confirming the terms of their employment. Mr. Saaf and Mr. Herrera each earn a base salary of no less than $350,000 per annum during the initial term of the agreements, which continue until December 31, 2008, and are also entitled to receive performance bonuses of up to $350,000 if MediaDefender achieves operating earnings before interest, taxes, depreciation and amortization (calculated using the same accounting methods and policies as MediaDefender has historically used) exceeding $7,000,000 and $7,500,000 in fiscal 2007 and 2008, respectively. Mr. Saaf and Mr. Herrera are each entitled to receive twelve months of severance pay at the rate of 100% of their monthly salary and the pro rata portion of the performance bonus referenced above if they are terminated “without cause”. In addition, the Company granted stock options to purchase 200,000 shares of common stock to each of Mr. Saaf and Mr. Herrera, exercisable at $3.00 per share for a period of five years and vesting quarterly over a period of three and one-half years.

 

The Company also acknowledged the terms of Non-Competition Agreements entered into on July 28, 2005 by MediaDefender and Mr. Saaf and Mr. Herrera. The Non-Competition Agreements prohibit Mr. Saaf and Mr. Herrera from (i) engaging in certain competitive business activities, (ii) soliciting customers of MediaDefender or the Company, (iii) soliciting existing employees of MediaDefender or the Company and (iv) disclosing any confidential information regarding MediaDefender or the Company. Each agreement has a term of four years and shall continue to remain in force and effect in the event the above-referenced Employment Agreements are terminated prior to the end of the four-year term of the Non-Competition Agreements. In consideration, Mr. Saaf and Mr. Herrera were each entitled to a cash payment of $525,000 from MediaDefender on December 31, 2006 (which payments were timely made). As a result of these agreements, effective July 28, 2005, the Company recorded an asset of $1,050,000 for the non-competition agreements and a related liability of $1,050,000 for the guaranteed payments to MediaDefender management. The $1,050,000 allocated to non-competition agreements is being amortized over the life of the employment agreements.

 

Mr. Saaf and Mr. Herrera each invested $2,250,000 in the convertible subordinated debt transaction entered into to fund the acquisition of MediaDefender on the same terms and conditions as the other investors in such financing (see Note 4).

 

Upon the closing of the transaction, the Company issued 1,109,032 shares of common stock and a seven-year warrant to purchase 114,985 shares of common stock with an exercise price of $1.55 per share to WNT07 Holdings, LLC (“WNT07”).

 

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The managers of WNT07 are Eric Pulier and Teymour Boutros-Ghali, both of whom were at the time of the issuance of the consideration and currently are members of the Company’s Board of Directors. The shares and warrants were issued as consideration for services provided by Mr. Pulier and Mr. Boutros-Ghali as consultants to the Company in connection with the acquisition of MediaDefender. The consideration issued to WNT07 was approved by the disinterested members of the Company’s Board of Directors. The shares and warrants were issued in reliance upon exemptions from registration pursuant to Section 4(2) under the Securities Act and Rule 506 promulgated thereunder. The shares of common stock were valued at $1,585,916 ($1.43 per share) and the warrants were valued at $83,939, based on a valuation report prepared by an independent valuation firm. The aggregate value of $1,669,855 was allocated $333,971 (20%) to a covenant not to compete (as described below) and $1,335,884 (80%) to the costs that the Company incurred to acquire MediaDefender, based on management’s estimate of the relative values, as confirmed by the independent valuation firm.

 

On July 28, 2005, the Company entered into a Non-Competition Agreement with WNT07, Eric Pulier and Teymour Boutros-Ghali (collectively, the “Advisors”). The Non-Competition Agreement prohibits any of the Advisors (i) from engaging in certain competitive business activities and (ii) from soliciting existing employees of the Company or its subsidiaries. The covenants not to complete or solicit expire on the earlier of April 1, 2007 or the date of termination of Advisor’s services with the Company. The amount allocated to the covenant not to compete was amortized in full through April 1, 2007.

 

4.           FINANCING TRANSACTIONS WITH RESPECT TO MEDIADEFENDER, INC. ACQUISITION (CURRENTLY IN DEFAULT)

 

In conjunction with the acquisition of MediaDefender on July 28, 2005 (see Note 3), the Company completed a $15,000,000 senior secured debt transaction (the “Senior Financing”) and a $30,000,000 convertible subordinated debt transaction (the “Sub-Debt Financing”).

 

The Senior Financing was completed in accordance with the terms set forth in the Note and Warrant Purchase Agreement entered into on July 28, 2005 by the Company, each of the investors indicated on the schedule of buyers attached thereto and U.S. Bank National Association as Collateral Agent (the “Note Purchase Agreement”). Pursuant to the terms of the Note Purchase Agreement, each investor received a note with a term of three years and eleven months that bears interest at the rate of 11.25% per annum (each a “Senior Note”), payable quarterly, with any unpaid principal and accrued interest due and payable at maturity. Termination and payment of the Senior Notes by the Company prior to maturity does not result in a prepayment fee. As collateral for the $15,000,000 Senior Financing, the investors received a first priority security interest in all existing and future assets of the Company and its subsidiaries, tangible and intangible, including, but not limited to, cash and cash equivalents, accounts receivable, inventories, other current assets, furniture, fixtures and equipment and intellectual property.

 

In addition, not later than ninety days after the close of each fiscal year, the Company is obligated to apply 60% of its excess cash flow, as defined in the Note Purchase Agreement (the “Annual Cash Sweep”), to prepay the principal amount of the Senior Notes. At December 31, 2006, there was no amount payable for the 2006 Annual Cash Sweep.

 

The Senior Financing investors also received five-year warrants to purchase an aggregate of 3,250,000 shares of the Company’s common stock at an exercise price of $2.00 per share (collectively, the “Senior Warrants”). The Senior Warrants were valued at $1,982,500 based on a valuation report prepared by an independent valuation firm utilizing the Black-Scholes option-pricing model, and were recorded as a discount to the $15,000,000 of senior secured debt, and are being amortized to interest expense over the term of the debt.

 

The Senior Warrants were subject to certain anti-dilution and price reset provisions, as well certain registration rights obligations requiring the Company to file and maintain effective a registration statement with the SEC covering the shares of common stock underlying such warrants, which, if not complied with, subjects the Company to a cash penalty of 1.5% of the Senior Financing per thirty-day period. Accordingly, in accordance with EITF 00-19, the fair value of the Senior Warrants was recorded as warrant liability in the Company’s balance sheet at July 28, 2005, and is being adjusted to reflect any material changes in such liability from the date of issuance to the end of each subsequent reporting period, with any such changes included in other income (expense) in the statement of operations.

 

The Sub-Debt Financing was completed in accordance with the terms set forth in the Securities Purchase Agreement entered into on July 28, 2005 by the Company and each of the investors indicated on the schedule of buyers attached thereto (the “Securities Purchase Agreement”). Pursuant to the terms of the Securities Purchase Agreement, each investor received a convertible subordinated note with a term of four years that bears interest at the rate of 4.0% per annum (each a “Sub-Debt Note”), with any unpaid principal and accrued interest due and payable at maturity.

 

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The interest rate increases to 12.0% per annum during any period in which the Company is in default of its obligations under the Sub-Debt Note. Commencing September 30, 2006, interest is payable quarterly in cash or shares of common stock, at the option of the Company. Each Sub-Debt Note had an initial conversion price of $1.55 per share, and was subject to certain anti-dilution, reset and change-of-control provisions. In addition, each Sub-Debt Note is subject to mandatory conversion by the Company in the event certain trading price targets for the Company’s common stock are met.

 

The Sub-Debt Notes contain specific provisions that expressly prohibit the Company from issuing shares to a Sub-Debt Note holder if, after the conversion, such Sub-Debt Note holder would exceed the respective limit called for in their Sub-Debt Note, either 4.99% or 9.99%, of the Company’s outstanding common shares.

 

Following effectiveness of a registration statement filed by the Company for the securities issued in the Sub-Debt Financing, two times within any twelve-month period, the Company has the right to require the holder of each Sub-Debt Note to convert all or a portion equal to not less than 25% of the note conversion amount (limited to 50% of the note conversion amount if pursuant to clause (a) below) into shares of the Company’s common stock in the event that (a) the closing sale price of the Company’s common stock equals or exceeds $2.32 per share for each of any fifteen consecutive trading days, with a minimum trading volume of 200,000 shares of common stock on each such trading day, (b) the closing sale price of the Company’s common stock equals or exceeds $3.10 per share on each trading day during the fifteen consecutive trading day period, with a minimum trading volume of 200,000 shares of common stock on each such trading day, subject in both cases to appropriate adjustments for stock splits, stock dividends, stock combinations and other similar transactions after the issuance date, or (c) completion of an equity financing (including the issuance of securities convertible into equity securities, or long-term debt securities issued as a unit with equity securities, of the Company) at a price per share of not less than $2.50 generating aggregate gross proceeds of at least $20,000,000 from outside third party investors.

 

The holders of the Sub-Debt Notes are entitled to receive any dividends paid or distributions made to the holders of common stock to the same extent as if such holders had converted their Sub-Debt Notes into common stock (without regard to any limitations on conversion) and had held such shares of common stock on the record date for such dividend or distribution, with such payment to be made concurrently with the payment of the dividend or distribution to the holders of common stock.

 

The Sub-Debt Financing investors also received five-year warrants to purchase an aggregate of 1,596,774 shares of common stock at an exercise price of $1.55 per share, subject to certain anti-dilution and price reset provisions (collectively, the “Sub-Debt Warrants”). The Sub-Debt Warrants were valued at $1,133,710 based on a valuation report prepared by an independent valuation firm utilizing the Black-Scholes option-pricing model, and were recorded as a discount to the $30,000,000 of convertible subordinated debt, and are being amortized to interest expense over the term of the debt.

 

In conjunction with the aforementioned financing transactions, a Subordination Agreement dated July 28, 2005 was entered into between the Company, the Senior Financing investors, and the Sub-Debt Financing investors pursuant to which the Sub-Debt Financing investors agreed to subordinate their rights to the investors in the Senior Financing in the event of a default under the Senior Financing transaction documents and on certain other terms and conditions described therein.

 

Legal fees paid or reimbursed by the Company for services provided by the respective legal counsels for the lenders were recorded as a charge to deferred financing costs and are being amortized over the terms of the related debt.

 

Pursuant to the terms of the Note Purchase Agreement and the Securities Purchase Agreement, the Company was required to amend its Certificate of Incorporation to increase the number of authorized shares of common stock from 15,000,000 shares to 60,000,000 shares. The Company obtained the requisite approvals of the Board of Directors and stockholders and filed a Certificate of Amendment to the Certificate of Incorporation with the Delaware Secretary of State on November 7, 2005 to effect the increase in the authorized shares of common stock.

 

If all of the securities issued in the Senior Financing and the Sub-Debt Financing are converted or exercised into shares of the Company’s common stock in accordance with their respective terms, it will result in significant dilution to the Company’s existing stockholders and a possible change in control of the Company. If all of the Company’s outstanding equity-based instruments are converted or exercised into shares of the Company’s common stock in accordance with their respective terms, including those issued in conjunction with the acquisition of MediaDefender, there would be a total of approximately 38,000,000 shares of the Company’s common stock issued and outstanding.

 

The securities issued by the Company in the Senior Financing and the Sub-Debt Financing were offered and sold in reliance upon exemptions from registration pursuant to Section 4(2) under the Securities Act of 1933, as amended (the “Securities Act”), and Rule 506 promulgated thereunder. Each of the investors qualified as an “accredited investor,” as specified in Rule 501 under the Securities Act.

 

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The Sub-Debt Notes and the Sub-Debt Warrants were subject to certain registration rights obligations requiring the Company to file and maintain effective a registration statement with the SEC covering the shares of common stock underlying such warrants, which, if not complied with, subjects the Company to a cash penalty of 1.0% of the Sub-Debt Financing per thirty-day period. Accordingly, in accordance with EITF 00-19, the fair value of the Sub-Debt Warrants was recorded as warrant liability in the Company’s balance sheet at July 28, 2005, and is being adjusted to reflect any material changes in such liability from the date of issuance to the end of each subsequent reporting period, with any such changes included in other income (expense) in the statement of operations.

 

The Sub-Debt Notes contain reset, anti-dilution and change-in-control provisions that the Company has determined caused such debt instruments to be classified as “non-conventional” debt. Upon evaluation of such debt instruments under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS No. 133”), and EITF 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock” (“EITF 00-19”), it was determined that the Company was required to bifurcate and value certain rights embedded in the Sub-Debt Notes on the date of issuance (including, specifically, the initial $1.55 per share fixed conversion feature, which was in excess of the $1.43 per share fair market value of the Company’s common stock on the date of issuance) and to classify such rights as either assets or liabilities. The fair value of these bifurcated derivatives as of July 28, 2005, as determined by an independent valuation firm, was calculated in accordance with SFAS No. 133 Implementation Issue No. B15, “Embedded Derivatives:  Separate Accounting for Multiple Derivative Features Embedded in a Single Hybrid Instrument”, using a binomial lattice model utilizing highly subjective and theoretical assumptions that can materially affect fair values from period to period. The recognition of these derivative amounts did not have any impact on the Company’s revenues, operating expenses or cash flows. The Company recorded an initial embedded derivative liability of $10,534,000, which was recorded as a discount to the $31,460,500 of convertible subordinated notes, and is being amortized over the term of the debt. The carrying value of the embedded derivative liability is being adjusted to reflect any material changes in such liability from the date of issuance to the end of each subsequent reporting period, with any such changes included in other income (expense) in the statement of operations. The Company has accounted for registration rights penalties in accordance with EITF 00-19-2, “Accounting for Registration Payment Arrangements”, which the Company adopted as of December 31, 2006, and SFAS No. 5, “Accounting for Contingencies”.

 

The Sub-Debt Notes contain several embedded derivative features (both assets and liabilities) that have been accounted for at fair value. The various embedded derivative features of the Sub-Debt Notes have been valued at the date of inception of the Sub-Debt Financing and at the end of each reporting period thereafter. The material derivative features include:  (1) the standard conversion feature of the debentures, (2) a limitation on the conversion by the holder, and (3) the Company’s right to force conversion. An independent valuation firm valued the embedded derivative features and determined that, except for the above-noted features, the remaining derivative attributes (both assets and liabilities) were immaterial, both individually and in the aggregate, and effectively offset each other. The value of the embedded derivatives were bifurcated from the Sub-Debt Notes and recorded as derivative liability, with the initial amount recorded as discount on the related Sub-Debt Notes. This discount is being amortized to interest expense over the life of the Sub-Debt Notes.

 

The Company determined that the warrants issued in conjunction with the Senior Financing and the Sub-Debt Financing created derivative liabilities in accordance with EITF 00-19 because share settlement of these financial instruments was not within the control of the Company, since the Company could not conclude that it had sufficient authorized but unissued common shares available to satisfy its potential share obligations under the warrant agreements. The Company reached this conclusion because:  (1) the Company has an obligation to file a registration statement with the SEC to register the common stock underlying warrants, and to have such registration statement declared effective, and to maintain effective such registration statement, or to pay penalties in the form of liquidated damages for each thirty-day period that such registration statement is not effective, (2) the warrants contained dilution protection features, with no limit or cap on the number of shares that could be issued by the Company pursuant to such provisions, and (3) the warrants contained certain price reset features. Because the warrants contain certain anti-dilution and price reset provisions, as well as have registration rights, the fair value of the warrants was accounted for as a derivative and presented as warrant liability.

 

Pursuant to the terms of a letter agreement, dated July 15, 2005, by and between the Company and Broadband Capital Management LLC (“Broadband”), effective July 28, 2005, the Company issued to Broadband a Sub-Debt Note in the amount of $1,460,500 (in addition to the $30,000,000 referred to above) and five-year warrants to purchase 1,516,935 shares of common stock with an exercise price of $1.55 per share. The notes and warrants issued to Broadband or its affiliates were issued on the same terms and conditions granted to the other Sub-Debt Financing investors. The securities were issued as partial consideration for Broadband’s services as the Company’s placement agent in the Sub-Debt Financing and the Senior Financing. The securities were issued in reliance upon exemptions from registration pursuant to Section 4(2) under the Securities Act and Rule 506 promulgated thereunder. The Broadband warrants were valued at $1,077,024 based on a valuation report prepared by an independent valuation firm utilizing the Black-Scholes option-pricing model.

 

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The aggregate value of the Sub-Debt Note, the warrants and additional cash payments to Broadband aggregating $299,500 were charged to deferred financing costs and are being amortized to other expense over the term of the debt. The securities issued to Broadband were accounted for in a manner consistent with the accounting for the Sub-Debt Notes and Sub-Debt Warrants as described above.

 

Pursuant to the terms of a letter agreement, dated June 21, 2005, by and between the Company and Libra FE, LP (“Libra”), effective July 28, 2005, the Company issued to Libra a seven-year warrant to purchase 237,500 shares of its common stock with an exercise price of $2.00 per share upon the closing of the Senior Financing (the “Libra Warrant”). The Libra Warrant was issued as partial consideration for Libra’s services as the Company’s placement agent in the Senior Financing described above. The Company entered into a Registration Rights Agreement with Libra on July 28, 2005 (the “Libra Registration Rights Agreement”), pursuant to which the Company will include the shares underlying the Libra Warrant in the registration statement covering the securities issued in the Senior Financing and the Sub-Debt Financing described above. The Libra Warrant was issued in reliance upon exemptions from registration pursuant to Section 4(2) under the Securities Act and Rule 506 promulgated thereunder. The Libra Warrant was valued at $175,750 based on a valuation report prepared by an independent valuation firm utilizing the Black-Scholes option-pricing model. The aggregate value of the Libra Warrant and additional payments to Libra of $450,997 were charged to deferred financing costs and are being amortized to other expense over the term of the debt.

 

The Libra Warrant was subject to certain registration rights requiring the Company to file and maintain effective a registration statement with the SEC covering the shares of common stock underlying such warrant, which if not complied with could subject the Company to a cash penalty of $5,000 per thirty-day period.  In accordance with EITF 00-19, the fair value of the Libra Warrant was recorded as warrant liability at July 28, 2005, and was being adjusted to reflect any material changes in such liability from the date of issuance to the end of each subsequent reporting period, with any such changes included in other income (expense) in the statement of operations. Effective April 19, 2006, the Libra Warrant was exercised on a cashless basis at $2.00 per share, resulting in the issuance of 123,864 shares of common stock.

 

At the date of exercise of any of the Senior Warrants, the Sub-Debt Warrants or the Libra Warrant, or the conversion of Sub-Debt Notes into common stock, the pro rata fair value of the related warrant liability and/or embedded derivative liability is transferred to additional paid-in capital.

 

Pursuant to the Senior Financing and Sub-Debt Financing documents, the Company is required to comply on a quarterly basis with certain financial covenants, including minimum working capital, maximum capital expenditures, minimum leverage ratio, minimum EBITDA and minimum fixed charge coverage ratio. These financial covenants are identical in the Senior Financing and the Sub-Debt Financing documents.

 

Due to the accounting classification of the warrants issued in conjunction with the Senior Financing and the Sub-Debt Financing as a current liability in accordance with SFAS No. 133 and EITF 00-19, the Company was not in compliance with certain of these financial covenants at December 31, 2005.

 

On April 7, 2006, the lenders provided waivers with respect to such past events of default under the Senior Notes and amended their loan documents such that the warrant liability and any change thereto in future periods will not affect future covenant and excess cash flow calculations. In consideration thereof, the Company offered to temporarily reduce the exercise price of the 3,250,000 warrants held by the investors in the Senior Financing from $2.00 to $1.85 per share through April 30, 2006, and agreed to permanently reduce the exercise price of the 1,596,744 warrants held by the investors in the Sub-Debt Financing from $1.55 to $1.43 per share on certain terms and conditions.  Any exercise of the aforementioned warrants at the reduced exercise price was required to be for cash only.  The conversion price of the Sub-Debt Notes of $1.55 per share was not affected.  The Company also entered into similar agreements, as applicable, and provided identical temporary and permanent reductions to warrant exercise prices, with Broadband Capital Management LLC (1,516,935 warrants originally exercisable at $1.55 per share) and Libra FE, LP (237,500 warrants originally exercisable at $2.00 per share).  The Company also agreed to utilize 25% of the net proceeds from the exercise of the warrants held by the investors in the Senior Financing to reduce the respective principal balances on the Senior Notes payable held by such exercising investors, and to pay any related unpaid accrued interest on such principal payments. The aforementioned waivers did not extend to the embedded derivative liabilities associated with the Sub-Debt.

 

Effective April 27, 2006, certain of the investors in the Senior Financing exercised their warrants to purchase 2,816,667 shares of common stock at $1.85 per share, resulting in the issuance of 2,816,667 shares of common stock in exchange for cash proceeds of $5,212,000, of which $1,303,000 was used to reduce the respective principal balances on the Senior Notes payable held by such exercising investors. There was no conversion of subordinated convertible notes payable during April 2006 in relation to this transaction.

 

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As a result of the $0.15 warrant exercise price reduction offered to the investors in the Senior Financing in April 2006, the Company recorded a charge to operations during the nine months ended September 30, 2006 for the aggregate fair value of such exercise price reductions of $423,000 relating to the warrants held and exercised by the Senior Financing investors in April 2006. The Company provided this consideration primarily in exchange for a waiver of and amendment to certain of the financial covenants contained in the loan agreements entered into in conjunction with the July 2005 acquisition of MediaDefender. The amount charged to operations was calculated by multiplying the $0.15 reduction, which represented the fair value of the consideration transferred, by the number of warrants that elected to accept the Company’s offer and exercise, as follows:  $0.15 x 2,816,667 = $423,000. This charge to operations was presented as reduction in exercise price of warrants and was included in other income (expense) in the statement of operations.

 

As a result of the $0.12 warrant exercise price reduction provided to the investors in the Sub-Debt Financing in April 2006, the Company recorded a charge to operations during the nine months ended September 30, 2006 for the aggregate fair value of such exercise price reductions of $218,000 relating to the warrants held by the investors in the Sub-Debt Financing in April 2006. The Company provided this consideration in exchange for a waiver of and amendment to certain of the financial covenants contained in the loan agreements entered into in conjunction with the July 2005 acquisition of MediaDefender. This amount was calculated by determining the difference between the fair value of the warrants held by the investors in the Sub-Debt Financing, based on a comparison of updated Black-Scholes calculations using the original $1.55 exercise price and the reduced $1.43 exercise price. The Company utilized revised Black-Scholes input metrics to reflect updated changes, in particular to estimated life and volatility. The result was that the Black-Scholes value of the Sub-Debt warrants was $3.54, based on the original $1.55 exercise price, as compared to a Black-Scholes value of $3.61, based on the reduced exercise price of $1.43. The amount charged to operations was calculated by multiplying the $0.07 difference ($3.61 - $3.54), which represented the fair value of the consideration transferred, by the number of warrants affected, as follows:  $0.07 x 3,113,709 = $218,000. This charge to operations was presented as reduction in exercise price of warrants and was included in other income (expense) in the statement of operations.

 

On November 7, 2006, the Company entered into a waiver (the “Sub-Debt Waiver”) with the holders of the Sub-Debt Notes.  A provision of the Sub-Debt Notes contains a negative covenant pertaining to the Company’s Consolidated Fixed Charge Coverage Ratio (as such term is defined in the Sub-Debt Notes), which is to be calculated on a quarterly basis (the “Fixed Charge Covenant”).  The Fixed Charge Covenant as originally drafted did not contemplate that the first cash payment of accrued interest was not due and payable to the holders of the Sub-Debt Notes until September 30, 2006 (the “First Interest Payment”), an approximate fourteen-month period from the original issuance date of the Sub-Debt Notes.  As a result of the Company timely making the First Interest Payment of $1,307,000, the Company was forced to breach the Fixed Charge Covenant.  The holders of the Sub-Debt Notes agreed to waive this event of default under the Sub-Debt Notes that may have been triggered due to a breach of the Fixed Charge Covenant resulting from the First Interest Payment.

 

On November 7, 2006, the Company also entered into a waiver (the “Senior Waiver”) with the purchasers of the Senior Notes originally issued by the Company.  The Note Purchase Agreement contains the same Fixed Charge Covenant that is contained in the Sub-Debt Notes (the “Senior Fixed Charge Covenant”).  As a result of the Company timely making the First Interest Payment of $1,307,000, the Company was forced to breach the Senior Fixed Charge Covenant.  The holders of the Senior Notes agreed to waive the event of default under the Note Purchase Agreement that may have been triggered due to a breach of the Senior Fixed Charge Covenant resulting from the First Interest Payment.

 

The financing documents governing the terms and conditions of the senior and subordinated indebtedness required the Company to maintain an effective registration statement covering the resale of shares of common stock underlying the various securities issued by the Company to each holder. A resale registration statement on Form SB-2, as amended, was declared effective by the SEC on December 9, 2005.  The Company subsequently filed Post-Effective Amendment No. 1 to the registration statement on Form SB-2, which was declared effective by the SEC on May 1, 2006, and Post-Effective Amendment No. 2 to the registration statement on Form SB-2, which was declared effective by the SEC on July 6, 2007.  As a result of the determination to restate previously issued financial statements (see Note 1), the Form SB-2 was not available for use by the holders between December 21, 2006 and July 6, 2007.

 

The financing documents specify that an event of default of the senior and subordinated indebtedness is triggered if a resale registration statement is unavailable for use by the holders for a period of more than ten consecutive trading days after the expiration of an allowable ten-day grace period.  The Company invoked its use of the ten-day allowable grace period on December 21, 2006, which expired on December 31, 2006.  The Company delivered notice to holders of its outstanding senior and subordinated indebtedness that, as of January 18, 2007, an event of default had been triggered under their respective senior and subordinated financing documents.

 

24



 

As of January 18, 2007, the Form SB-2 remained unavailable for use by the holders, and it continued to be unavailable for use until July 6, 2007, when Amendment No. 2 to the registration statement on Form SB-2 was declared effective by the SEC.  Accordingly, at December 31, 2006, March 31, 2007 and June 30, 2007, the registration statement covering the resale of shares of common stock underlying the various securities issued by the Company to each holder of the senior and subordinated indebtedness was not effective. As a result, an event of default, among others, with respect to the senior and subordinated indebtedness was triggered by the unavailability of the Form SB-2 to the holders between December 21, 2006 and July 6, 2007. The financing documents provide that while the Form SB-2 remains unavailable for use, holders of senior indebtedness are entitled to a cash penalty equal to 1.5% of the original Senior Financing, on a pro rata basis, and the holders of subordinated indebtedness are entitled to a cash penalty equal to 1.0% of the original Sub-Debt Financing, on a pro rata basis.  These cash penalties are due and payable by the Company at the end of each thirty-day period while the Form SB-2 remains unavailable.  The first cash penalty payment was due on January 30, 2007, and monthly thereafter.

 

In accordance with EITF 00-19-2, which the Company adopted as of December 31, 2006, and SFAS No. 5, the Company accrued seven months liquidated damages (through mid-August 2007) under the registration rights agreements aggregating approximately $3,777,000 as a charge to operations at December 31, 2006, which was reduced by $719,000 at June 30, 2007 as a result of the Company’s registration statement being declared effective on July 6, 2007, which was earlier than originally estimated, and by an aggregate of $500,000 of advance payments made to the holders of the Senior Financing during the nine months ended September 30, 2007 for liquidated damages under the registration rights agreement. Accordingly, liquidated damages payable under registration rights agreements were $2,558,000 at September 30, 2007 and $3,777,000 at December 31, 2006, and were reflected as a current liability at such dates. The Company believes that the amount of the liquidated damages accrued reflects the undiscounted maximum potential amount of liquidated damages payable to the holders of the Senior Financing and the Sub-Debt Financing since the underlying shares become generally available for resale under an effective registration statement on July 6, 2007

 

Since the registration rights component of the derivative liabilities was not material through September 30, 2006, there was no cumulative-effect adjustment recorded as a result of the transition rules with respect to the adoption of EITF-00-19-2 at December 31, 2006. The Company will continue to review the status of the registration statement and adjust the accrued liquidated damages under the registration rights agreements at each quarter end to the extent necessary.

 

A summary of the registration penalty accrual at September 30, 2007 and December 31, 2006 is presented below.

 

 

 

September 30,

 

December 31,

 

 

 

2007

 

2006

 

 

 

 

 

 

 

Senior secured notes payable

 

$

775,000

 

$

1,575,000

 

Subordinated convertible notes payable

 

1,783,000

 

2,202,000

 

Total registration penalty accrual

 

$

2,558,000

 

$

3,777,000

 

 

As of September 30, 2007 and December 31, 2006, approximately $13,307,000 principal amount was outstanding with respect to the Senior Financing, and approximately $27,658,000 principal amount was outstanding with respect to the Sub-Debt Financing.  In addition, at September 30, 2007, approximately $775,000 and $1,783,000 was outstanding with respect to accrued registration delay penalties to the holders of the Senior Financing and the Sub-Debt Financing, respectively, and approximately $116,000 and $2,207,000 was outstanding with respect to accrued interest payable to the holders of the Senior Financing and the Sub-Debt Financing, respectively. The Company has not paid the registration delay penalties to either the holders of the Senior Notes or the Sub-Debt Notes, although it has made advance payments to the holders of the Senior Notes aggregating $500,000. As a result of the registration failure, the failure to pay the registration delay penalties and the various financial covenant and other breaches of the terms of the Senior Financing and the Sub-Debt Financing, multiple events of default exist under the Senior Financing and the Sub-Debt Financing. The terms of the Subordination Agreement among the Company and the creditor parties thereto (the “Subordination Agreement”) prevent the Company from making any cash payments to the Sub-Debt Note holders until the events of default under the Senior Financing are either cured or waived. Furthermore, upon the occurrence of an event of default, holders of at least 25% of the outstanding senior indebtedness may declare the outstanding principal and accrued interest on all senior notes immediately due and payable upon written notice to the Company, and each holder of outstanding subordinated indebtedness may only demand redemption of all or any portion of their respective notes under certain circumstances as described in the Subordination Agreement.

 

25



 

On October 16, 2007, the Company received an Event of Default Redemption Notice from the holders of approximately $2,693,000 principal amount of Sub-Debt Notes demanding that the Company redeem their Sub-Debt Notes. The Company believes and has advised these Sub-Debt Note holders that redemption (including the demand for redemption) is not permitted under the terms of the Subordination Agreement. On November 1, 2007, the Company received a copy of a letter to the Sub-Debt Note holders from Senior Note holders representing approximately 66% of the Senior Notes. The letter advised the Sub-Debt Note holders that the Subordination Agreement prohibits the Company from redeeming any Sub-Debt Notes and prohibits any Sub-Debt Note holder from pursuing any remedies. The letter further stated that the Senior Note holders were inclined to give the Company until November 30, 2007 to either cure the existing events of default or to pay off the obligations to the Senior Note holders in full, or the Senior Note holders expect they will likely begin to exercise additional remedies to obtain payment of their outstanding obligations. The Company does not have the capital resources necessary to cure the existing events of default, or to repay any accelerated indebtedness or redemption or penalty amounts.

 

All quarterly interest payments due on the outstanding senior and subordinated indebtedness were timely paid by the Company through December 2006. In addition, the quarterly interest payments due on the outstanding senior indebtedness in March 2007, June 2007 and September 2007 were timely paid. Pursuant to the terms of the Subordination Agreement, interest on the outstanding subordinated convertible notes payable cannot be paid as a result of the existence of the events of default described herein.

 

A summary of accrued interest payable at September 30, 2007 and December 31, 2006 is presented below.

 

 

 

September 30,

 

December 31,

 

 

 

2007

 

2006

 

 

 

 

 

 

 

Senior secured notes payable

 

$

62,000

 

$

67,000

 

Subordinated convertible notes payable

 

2,095,000

 

 

Liquidated damages payable under registration rights agreements with respect to:

 

 

 

 

 

Senior secured notes payable

 

54,000

 

 

Subordinated convertible notes payable

 

112,000

 

 

Total accrued interest payable

 

$

2,323,000

 

$

67,000

 

 

Pursuant to a Forbearance and Consent Agreement with the investors in the Senior Financing, such investors agreed to forbear from the exercise of their rights and remedies under the Senior Financing documents as a result of the events of default with respect to the unavailability of the Company’s registration statement, as well as certain other events of default that existed or that could come into existence during the forbearance period, from April 17, 2007 through July 31, 2007, in exchange for aggregate cash payments of $500,000. The payments made by the Company under the Forbearance and Consent Agreement may be credited against the registration delay cash penalties or any other amounts ultimately determined to be due the investors in the Senior Financing. On July 6, 2007, the Company’s registration statement was declared effective by the SEC, thus making it available to the investors in the Senior Financing and Sub-Debt Financing. Although the Company and its representatives and advisors are in ongoing discussions with the investors in the Senior Financing and the investors in the Sub-Debt Financing as to a comprehensive resolution of the matters discussed herein, the Company cannot predict the ultimate outcome of such discussions.

 

On August 3, 2007, the Company entered into a Waiver and Forbearance Agreement with the holders of the Sub-Debt Financing pursuant to which the holders agreed to waive their right to charge the 12.0% default interest rate triggered by the Company’s defaults under the Subordinated Financing transaction documents and instead charge the 4.0% standard interest rate on the Sub-Debt Notes for the period from July 16, 2007 through August 31, 2007 (the “Forbearance Period”). The holders of the Sub-Debt Financing also agreed to forbear from exercising any of their other rights and remedies under the Sub-Debt Financing transaction documents during the Forbearance Period, upon the terms and conditions in the Waiver and Forbearance Agreement. Effective September 1, 2007, the interest rate returned to the 12.0% default interest rate.

 

The Forbearance and Consent Agreement that the Company entered into with the investors in the Senior Financing did not impact the investors in the Sub-Debt Financing. Since the Subordination Agreement (as described above) limits the rights of the investors in the Sub-Debt Financing, the Company has not paid any interest or penalties to the investors in the Sub-Debt Financing in 2007.

 

Primarily as a result of the requirement to restate previously issued financial statements, which resulted in the recording of an embedded derivative liability, the reclassification of the senior and subordinated indebtedness to current liabilities, and the recording of estimated liquidated damages payable under registration rights agreements, the Company was not in compliance with certain of its financial covenants under both the Senior Financing and the Sub-Debt Financing at September 30, 2007 and December 31, 2006.

 

26



 

Notwithstanding such developments, the Company believes that it would have been out of compliance with certain of its financial covenants at September 30, 2007.

 

The registration delay penalties and ongoing default interest charges are continuing to have a significant and material negative impact on the Company’s operations and cash flows. The Company and its representatives and advisors are in ongoing discussions with the holders of its senior and subordinated debt obligations to obtain a waiver of and amendment to certain of the financing documents with respect to the events of default, the impact of the restatements, the payment of cash penalties and default interest, and various related matters. The Company is exploring various alternatives to resolve the defaults under its senior and secured debt obligations, but is unable to predict the outcome of such negotiations. To the extent that the Company is unable to restructure its senior and subordinated debt obligations in a satisfactory manner and/or the lenders begin to exercise additional remedies to enforce their rights, the Company will not have sufficient cash resources to maintain its operations. In such event, the Company may be required to consider a formal or informal restructuring or reorganization, including a filing under Chapter 11 of the United States Bankruptcy Code.

 

5.           DERIVATIVE FINANCIAL INSTRUMENTS

 

In conjunction with the financing for the acquisition of MediaDefender on July 28, 2005 (see Notes 3 and 4), the Company completed a $15,000,000 senior secured debt transaction (the “Senior Financing”) and a $30,000,000 convertible subordinated debt transaction (the “Sub-Debt Financing”). The Company also issued various warrants in conjunction with such financings.

 

The Sub-Debt Notes contain multiple embedded derivative features (both assets and liabilities) that have been accounted for at fair value as a compound embedded derivative. The compound embedded derivative associated with the Sub-Debt Notes has been valued at the date of inception of the Sub-Debt Financing and at the end of each reporting period thereafter. The compound embedded derivative includes the following material features:  (1) the standard conversion feature of the debentures, (2) a limitation on the conversion by the holder, and (3) the Company’s right to force conversion.

 

An independent valuation firm valued the various derivative features in the compound embedded derivative and determined that, except for the above-noted features, the remaining derivative attributes (both assets and liabilities) were immaterial, both individually and in the aggregate, and they effectively offset one another. The value of the compound embedded derivative that includes the above-noted features was bifurcated from the Sub-Debt Notes and recorded as derivative liability. This initial amount was recorded as a discount on the related Sub-Debt Notes. This discount is being amortized to interest expense over the life of the Sub-Debt Notes.

 

The Company, with the assistance of an independent valuation firm, calculated the fair value of the compound embedded derivative associated with the Sub-Debt Notes in accordance with SFAS No. 133 Implementation Issue No. B15, “Embedded Derivatives:  Separate Accounting for Multiple Derivative Features Embedded in a Single Hybrid Instrument”, which requires that when multiple derivatives (both assets and liabilities) exist within a financial instrument, they are bundled together as a single hybrid compound instrument. The calculation model utilized a complex, customized, binomial lattice model suitable for the valuation of path-dependent American options. The model uses the risk neutral binomial methodology to simulate the scenarios and stock price paths. The model also uses backward dynamic programming to value the payoffs at each node considering all the embedded options simultaneously.

 

27



 

The valuation model used the following assumptions for the original valuation and for each succeeding quarterly valuation:

 

 

 

2005

 

2006

 

2007

 

Embedded derivatives

 

7/28

 

9/30

 

12/31

 

3/31

 

6/30

 

9/30

 

12/31

 

3/31

 

6/30

 

9/30

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Initial fair value of common stock

 

$

1.43

 

 

 

 

 

 

 

 

 

 

Fair value of common stock at each subsequent reporting period end

 

 

$

2.50

 

$

3.30

 

$

4.50

 

$

3.50

 

$

3.25

 

$

2.35

 

$

1.90

 

$

2.00

 

$

1.80

 

Conversion price

 

$

1.55

 

$

1.55

 

$

1.55

 

$

1.55

 

$

1.55

 

$

1.55

 

$

1.55

 

$

1.55

 

$

1.55

 

$

1.55

 

Terminal time period in months

 

48

 

46

 

43

 

40

 

37

 

34

 

31

 

28

 

25

 

22

 

Expected return

 

4.04

%

4.18

%

4.35

%

4.82

%

5.10

%

4.59

%

4.69

%

4.58

%

4.87

%

3.97

%

Initial volatility factor

 

55

%

 

 

 

 

 

 

 

 

 

Volatility factor for each subsequent reporting period

 

 

54

%

59

%

56

%

63

%

63

%

53

%

60

%

56

%

63

%

Triggering events to forced conversion:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Event 1 - stock price equal or above

 

$

2.32

 

$

2.32

 

$

2.32

 

$

2.32

 

$

2.32

 

$

2.32

 

$

2.32

 

$

2.32

 

$

2.32

 

$

2.32

 

Event 2 - daily share trading volume equal or above

 

200,000

 

200,000

 

200,000

 

200,000

 

200,000

 

200,000

 

200,000

 

200,000

 

200,000

 

200,000

 

Lack of liquidity discount for the limitation on conversion

 

20

%

20

%

20

%

20

%

20

%

20

%

20

%

20

%

20

%

20

%

 

The Company determined that the warrants issued in conjunction with the Senior Financing and the Sub-Debt Financing created derivative liabilities in accordance with EITF 00-19 because share settlement of these financial instruments was not within the control of the Company, since the Company could not conclude that it had sufficient authorized but unissued common shares available to satisfy its potential share obligations under the warrant agreements. The Company reached this conclusion because:  (1) the Company has an obligation to file a registration statement with the SEC to register the common stock underlying warrants, and to have such registration statement declared effective, and to maintain effective such registration statement, or to pay penalties in the form of liquidated damages for each thirty-day period that such registration statement is not effective, (2) the warrants contained dilution protection features, with no limit or cap on the number of shares that could be issued by the Company pursuant to such provisions, and (3) the warrants contained certain price reset features. Because the warrants contain certain anti-dilution and price reset provisions, as well as have registration rights, the fair value of the warrants was accounted for as a derivative and presented as warrant liability.

 

The Company calculated the fair value of the various warrants using the Black-Scholes option-pricing model, using the volatility factor determined by the independent valuation firm. The valuation model used the following assumptions for the original valuation and for each succeeding quarterly valuation:

 

 

 

2005

 

2006

 

2007

 

Warrant liability

 

7/28

 

9/30

 

12/31

 

3/31

 

6/30

 

9/30

 

12/31

 

3/31

 

6/30

 

9/30

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Initial fair value of common stock

 

$

1.43

 

 

 

 

 

 

 

 

 

 

Fair value of common stock at each subsequent reporting period end

 

 

$

2.50

 

$

3.30

 

$

4.50

 

$

3.50

 

$

3.25

 

$

2.35

 

$

1.90

 

$

2.00

 

$

1.80

 

Exercise price:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Senior warrants

 

$

2.00

 

$

2.00

 

$

2.00

 

$

2.00

 

$

2.00

 

$

2.00

 

$

2.00

 

$

2.00

 

$

2.00

 

$

2.00

 

Sub-debt warrants

 

$

1.55

 

$

1.55

 

$

1.55

 

$

1.55

 

$

1.43

 

$

1.43

 

$

1.43

 

$

1.43

 

$

1.43

 

$

1.55

 

Libra warrants

 

$

2.00

 

$

2.00

 

$

2.00

 

$

2.00

 

 

 

 

 

 

 

Time period in months:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Senior warrants

 

60

 

58

 

55

 

52

 

49

 

46

 

43

 

40

 

37

 

34

 

Sub-debt warrants

 

60

 

58

 

55

 

52

 

49

 

46

 

43

 

40

 

37

 

34

 

Libra warrants

 

84

 

82

 

79

 

76

 

 

 

 

 

 

 

Expected return

 

4.04

%

4.18

%

4.35

%

4.82

%

5.10

%

4.59

%

4.69

%

4.58

%

4.87

%

3.97

%

Initial volatility factor

 

55

%

 

 

 

 

 

 

 

 

 

Volatility factor for each subsequent reporting period

 

 

54

%

59

%

56

%

63

%

63

%

53

%

60

%

56

%

63

%

 

The Company’s Sub-Debt Notes contain compound embedded derivatives (as described above) that required that they be bifurcated from the debt host instrument at the date of issuance and valued. The calculation of the fair value of the compound embedded derivatives required the use of a more sophisticated valuation model than a Black-Scholes option-pricing model. Accordingly, the Company retained an independent valuation firm to calculate the fair value of the compound embedded derivatives, and the changes in fair value at each subsequent period end.

 

28



 

The Company, with the assistance of the independent valuation firm, calculated the fair value of the compound embedded derivatives associated with the Sub-Debt Notes in accordance with SFAS No. 133 Implementation Issue No. B15, “Embedded Derivatives:  Separate Accounting for Multiple Derivative Features Embedded in a Single Hybrid Instrument”, by utilizing a complex, customized, binomial lattice model suitable in the valuation of path-dependent American options. This model utilized subjective and theoretical assumptions that can materially affect fair values from period to period.

 

The independent valuation firm concluded that the Company’s historical pattern of stock prices as of July 28, 2005, and for some time thereafter, would not provide a sufficient indication of the long-term expected volatility of the Company’s stock going forward for purposes of the calculation of the fair value of the compound embedded derivatives, due to the significant changes in the business operations and capital structure of the Company on July 28, 2005 as a result of the acquisition of MediaDefender and the related financing transactions. Accordingly, the Company’s independent valuation firm based its calculation of the Company’s expected stock price volatilities on the volatility factors of similar public companies. The independent valuation firm identified four companies that were similar to the Company in terms of industry, market capitalization, stock price and profitability:  Easylink Services Corporation; Forgent Networks, Inc.; Inforte Corp.; and Think Partnership, Inc. Using historical stock returns data for a period of one year, the independent valuation firm calculated the volatilities of these companies at the various reporting dates. The expected volatilities for the Company as of the reporting dates were calculated based on the average of the volatilities of these comparable companies. The resulting volatilities were then used to calculate the fair value, and the changes in fair value, of the Company’s compound embedded derivative liabilities at each period end. The Company also utilized these volatilities to calculate the fair value, and the changes in fair value, of the Company’s warrant derivative liabilities at each period end.

 

Paragraph A32 of SFAS No. 123R lists factors to consider in estimating expected volatility. The independent valuation firm retained by the Company to value the compound embedded derivatives contained in the Sub-Debt Notes determined that the appropriate methodology to calculate volatility with respect to the Company’s compound embedded derivatives was to consider the Company as similar to a newly public company without a trading history because of the significant transformative changes resulting from the acquisition and financing of the MediaDefender transaction on July 28, 2005. With reference to newly public companies, section (c) of paragraph A32 of SFAS No. 123R suggests that the expected volatility of similar entities be considered. The independent valuation firm arrived at this determination due to the Company’s acquisition of MediaDefender on July 28, 2005 and the related equity-based financing transactions that provided the capital to fund the acquisition.

 

6.   MEDIADEFENDER SECURITY BREACH

 

During the weekend of September 15 and 16, 2007, MediaDefender experienced an unlawful online security breach by hackers, which resulted in approximately 6,000 e-mails, as well as access to other confidential information and data, for the period from mid-December 2006 through September 10, 2007 being stolen and posted at numerous web-sites on the Internet. These e-mails contained confidential information and communications covering a wide variety of internal issues, including personal data, customer data and pricing information, and other sensitive information. This matter has been referred to the appropriate federal, state and local law enforcement organizations and an investigation is ongoing. An internal investigation of this matter is continuing, as a result of which the Company has revised various procedures and policies and enhanced its online and Internet security protocols. The Company does not believe that this breach has any impact on the Company’s accounting and financial controls or reporting systems.

 

As a result of this development, MediaDefender recorded approximately $600,000 for service credits to customers, which were recorded as a reduction to revenues during the three months ended September 30, 2007. This amount was determined based on various factors, including discussions with customers, and is subject to adjustment in future periods based on additional information. MediaDefender also recorded approximately $225,000 of legal, consulting and other direct costs related to the breach during the three months ended September 30, 2007.

 

7.   GOODWILL

 

Goodwill at September 30, 2007 and December 31, 2006 was $31,085,000, which was recorded in conjunction with the acquisition of MediaDefender in July 2005 (see Note 3).  In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets”, an intangible asset that is not subject to amortization such as goodwill shall be tested for impairment at least on an annual basis, and more often under certain circumstances, and written down when impaired.  An interim impairment test is required if an event occurs or conditions change that would more likely than not reduce the fair value of the reporting unit below its carrying value. The first step of the impairment test consists of a comparison of the total fair value of each reporting unit to the reporting unit’s net assets on the date of the test.

 

29



 

If the fair value is in excess of the net assets, there is no indication of impairment and thus no need to perform the second step of the impairment test.

 

During the three months ended September 30, 2007, the Company performed its second annual impairment test relating to the acquisition of MediaDefender and determined that there was no indication of impairment.

 

The Company does not currently believe that there is a long-term impact on Media Defender due to the security breach described at Note 6. However, due to the fluid nature of the situation as it relates to the status of MediaDefender’s customer relationships and future business prospects, this assessment could change. Accordingly, the Company intends to perform another impairment test at December 31, 2007.

 

8.   RELATED PARTY TRANSACTIONS

 

Effective as of January 1, 2006, the Company entered into a one-year consulting agreement with Eric Pulier, a director of the Company, through WNT Consulting Group, a California limited liability company wholly-owned by Mr. Pulier (“WNT”). The consulting agreement was approved by the disinterested members of the Company’s Board of Directors. Effective January 12, 2007, the parties mutually agreed to terminate this consulting agreement, which had automatically renewed for a second one-year term through December 31, 2007.  Under the terms of the original consulting agreement, Mr. Pulier received a base fee of $10,000 per month, certain other mandatory payments, and was also eligible to receive cash bonuses on the achievement of certain specified milestones.  Mr. Pulier had also agreed to waive all stock options and other stock-based compensation granted to outside members of the Company’s Board of Directors during the term of his original consulting agreement. The termination agreement provided for a one-time cash payment to Mr. Pulier (through WNT) in the amount of $100,000 (which was paid in January 2007), in consideration for the termination of the consulting agreement and an acknowledgement and complete release of any and all claims related to unpaid compensation, bonus amounts or other out-of-pocket expenses (in cash or otherwise) that may have been owed by the Company as of January 12, 2007. The termination agreement was approved by the Compensation Committee of the Company’s Board of Directors. Mr. Pulier will continue to serve as a member of the Company’s Board of Directors.

 

On January 12, 2007, the Company entered into a new consulting agreement with Mr. Pulier (through WNT).  During the term of the new consulting agreement, which commenced January 12, 2007 and continues in effect until any party provides ten days prior written notice to the other parties of its intention to terminate, Mr. Pulier will provide non-exclusive consulting and advisory services to the Company outside of the ordinary course of his services as a member of the Board of Directors.  In consideration, Mr. Pulier (through WNT) is entitled to receive hourly compensation at the rate of $500 per hour.  Any consulting request made by the Company must be approved in advance by all parties prior to commencement of services.  The new consulting agreement was approved by the Compensation Committee of the Company’s Board of Directors. During the three months and nine months ended September 30, 2007, Mr. Pulier (through WNT) did not earn any fees under the new consulting agreement.

 

Effective August 31, 2007, Robert N. Weingarten, the Chief Financial Officer and Secretary of the Company resigned from all positions he held with the Company.  The Company and Mr. Weingarten entered into a Separation Agreement and Release dated August 31, 2007, whereas the Company and Mr. Weingarten mutually agreed to terminate their employment relationship as of August 31, 2007 and the parties released each other from any and all claims. As a result of this resignation, the Company and Mr. Weingarten entered into an Agreement for Consulting Services (the “Consulting Agreement”) dated August 31, 2007 whereas Mr. Weingarten will be retained as a consultant for a twelve-month period, unless sooner terminated pursuant to the terms of the Consulting Agreement, and shall be paid a base consulting fee of $16,250 per month.

 

In addition, the Company and Mr. Weingarten entered into an Omnibus Stock Option Amendment Agreement (the “Option Agreement”) dated August 31, 2007 whereas the Company agreed to amend certain provisions of stock options previously granted to Mr. Weingarten (see Note 9). Mr. Weingarten will be allowed to exercise the 120,000 stock options granted to him in 2004 until the original expiration date of March 29, 2011 without regard to his resignation from the Company. Pursuant to the Option Agreement, the vesting of time-vesting options to acquire 275,000 shares shall be accelerated provided he does not breach the Consulting Agreement such that the remaining unvested time-vesting options became fully vested and exercisable as of August 31, 2007.  The vesting of the performance-vesting options to acquire 275,000 shares shall occur only upon the closing of a sale, merger or other “change of control” transaction at a price above $3.10 per share occurring prior to August 31, 2008 provided he does not breach the Consulting Agreement.  In addition, Mr. Weingarten will be able to exercise the time-vesting options and the performance-vesting options, if vested, until August 5, 2010, without regard to his resignation provided he does not breach the Consulting Agreement.

 

30



 

During the three months and nine months ended September 30, 2007, the Company incurred legal fees of $3,000 and $6,000, respectively, to Davis Shapiro Lewit & Hayes, LLP, a law firm in which Fred Davis, a director of the Company, is a partner. During the three months and nine months ended September 30, 2006, the Company incurred legal fees to such law firm of $61,000 and $63,000, respectively.

 

9.   EQUITY-BASED TRANSACTIONS

 

On May 6, 2005, the Company issued to a consultant a stock option to purchase an aggregate of 22,000 shares of the Company’s common stock pursuant to the Company’s 1999 Employee Stock Option Plan exercisable for a period of five years at $1.00 per share, the market price on the date of the grant, pursuant to a short-term consulting agreement. The option was subject to milestones, one of which was partially attained during the nine months ended September 30, 2006, as a result of which options for 10,000 shares vested during such period. The fair value of the vested portion of this option, calculated pursuant to the Black-Scholes option-pricing model, of $35,000 was charged to operations during the nine months ended September 30, 2006.

 

During the nine months ended September 30, 2006, the Company issued 84,287 shares of common stock upon the exercise of stock options previously issued to employees and consultants, and received cash proceeds of approximately $71,000.

 

During the nine months ended September 30, 2006, the Company issued 2,112,902 shares of common stock upon the conversion of $3,275,000 of subordinated convertible notes payable.  As a result, $1,580,000 was charged to operations during the nine months ended September 30, 2006, consisting of related deferred financing costs of $349,000, debt discount costs related to warrants of $292,000, and debt discount costs related to embedded derivatives of $939,999. There were no conversions during the three months ended September 30, 2006.

 

Effective April 7, 2006, the Company entered into various agreements with the investors in its Senior Financing and Sub-Debt Financing (see Note 4) to amend their respective registration rights agreements and to amend and waive certain financial covenants.  In consideration thereof, the Company offered to temporarily reduce the exercise price of the 3,250,000 warrants held by the investors in the Senior Financing from $2.00 to $1.85 per share through April 30, 2006, and agreed to permanently reduce the exercise price of the 1,596,744 warrants held by the investors in the Sub-Debt Financing from $1.55 to $1.43 per share on certain terms and conditions.  Any exercise of the aforementioned warrants at the reduced exercise price was required to be for cash only.  The conversion price of the Sub-Debt Notes of $1.55 per share was not affected.  The Company also entered into similar agreements, as applicable, and provided identical temporary and permanent reductions to warrant exercise prices, with Broadband Capital Management LLC (1,516,935 warrants originally exercisable at $1.55 per share) and Libra FE, LP (237,500 warrants originally exercisable at $2.00 per share).  The Company also agreed to utilize 25% of the net proceeds from the exercise of the warrants held by the investors in the Senior Financing to reduce the respective principal balances on the Senior Notes payable held by such exercising investors, and to pay any related unpaid accrued interest on such principal payments.

 

Effective April 27, 2006, certain of the investors in the Senior Financing exercised their warrants to purchase 2,816,667 shares of common stock at $1.85 per share, resulting in the issuance of 2,816,667 shares of common stock in exchange for cash proceeds of $5,212,000, of which $1,303,000 was used to reduce the respective principal balances on the Senior Notes payable held by such exercising investors (see Note 4).

 

Effective April 19, 2006, the Libra Warrant was exercised on a cashless basis at $2.00 per share, resulting in the issuance of 123,864 shares of common stock (see Note 4).

 

As a result of the exercise by the warrant holders of certain of the Senior Warrant Shares and of the Libra Warrant Shares during April 2006, $9,311,000 of the warrant liability at March 31, 2006 was transferred to additional paid-in capital during the nine months ended September 30, 2006.

 

As a result of the aforementioned warrant exercise price reductions, the Company recorded a charge to operations during the nine months ended September 30, 2006 for the aggregate fair value of such exercise price reductions of $641,000, consisting of $218,000 relating to the warrants held by the investors in the Sub-Debt Financing and $423,000 relating to the warrants held by the investors in the Senior Financing (see Note 4).

 

Information with respect to common stock and stock options issued pursuant to consulting agreements during the three months and nine months ended September 30, 2007 is provided at Note 8.

 

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As a result of the resignation of the Company’s former Chief Financial Officer effective August 31, 2007 (see Note 8), the Company agreed to amend certain provisions of stock options previously granted to the former Chief Financial Officer, including the accelerated vesting of certain options. The Company recorded the fair value of these amendments, calculated pursuant to the Black-Scholes option-pricing model, of $215,000 as a charge to operations during the three months and nine months ended September 30, 2007. The assumptions used in the Black-Scholes option-pricing model to calculate the fair value of the amendments to the options were as follows: 

 

Stock price on date of grant

 

$3.00

 

Risk-free interest rate

 

5.0

%

Volatility

 

146.3

%

Dividend yield

 

0

%

Weighted average expected life (years)

 

5

 

Weighted average fair value of option

 

$2.81

 

 

2006 Equity Incentive Plan:

 

During the three months and nine months ended September 30, 2007, the Company issued 5,769 shares and 17,307 shares of common stock, respectively, pursuant to a consulting agreement (see Note 10), and options to purchase 15,000 shares and 470,000 shares of common stock, respectively, including options to purchase 0 and 350,000 shares to management, respectively, as discussed below.

 

Effective February 2, 2007, the Company issued to Rene L. Rousselet, the Company’s Corporate Controller and Chief Accounting Officer, a stock option to purchase 50,000 shares of common stock exercisable through February 2, 2012 at $1.50 per share, the fair market value on the date of grant. The stock option vests and becomes exercisable in equal installments on March 31, 2007, June 30, 2007, September 30, 2007 and December 31, 2007. The fair value of the stock option, determined pursuant to the Black-Scholes option-pricing model, was $60,000, of which $15,000 and $45,000 were charged to operations during the three months and nine months ended September 30, 2007, respectively.

 

Effective February 2, 2007, the Company issued to its newly-appointed Vice President of Worldwide Sales, a stock option to purchase 300,000 shares of common stock exercisable through February 2, 2012 at $1.50 per share, the fair market value on the date of grant. The option with respect to 175,000 shares vests in seven equal quarterly installments on June 30, 2007, September 30, 2007, December 31, 2007, March 31, 2008, June 30, 2008, September 30, 2008 and December 31, 2008, and the option with respect to 125,000 shares vests on the achievement of performance targets to be mutually determined by the parties. The fair value of the time-vested portion of this stock option, determined pursuant to the Black-Scholes option-pricing model, was $208,000, of which $30,000 and $60,000 were charged to operations during the three months and nine months ended September 30, 2007.

 

Effective June 29, 2007, the Company issued to its six non-officer directors stock options to purchase an aggregate of 80,000 shares exercisable through June 29, 2012 at $2.00 per share, the fair market value on the date of grant. The options vested 50% on June 30, 2007 and 25% each on September 30, 2007 and December 31, 2007. The fair value of these stock options, determined pursuant to the Black-Scholes option-pricing model, was $130,000, of which $32,500 and $97,500 were charged to operations during the three months and nine months ended September 30, 2007.

 

The assumptions used in the Black-Scholes option-pricing model to calculate the fair value of the aforementioned options were as follows: 

 

Stock price on date of grant

 

$1.50 – $2.00

 

Risk-free interest rate

 

4.84 – 4.88

%

Volatility

 

1.065 – 1.116

%

Dividend yield

 

0

%

Weighted average expected life (years)

 

5

 

Weighted average fair value of option

 

$1.19 – $1.62

 

 

32



 

 

A summary of stock option activity under the 2006 Equity Incentive Plan during the nine months ended September 30, 2007 is as follows:

 

 

 

Options Outstanding

 

 

 

Number
of Shares

 

Weighted
Average
Exercise Price

 

 

 

 

 

 

 

Options outstanding at December 31, 2006

 

126,551

 

$

3.20

 

Granted

 

480,000

 

$

1.63

 

Exercised

 

 

 

 

Canceled/Expired

 

 

 

 

Options outstanding at September 30, 2007