UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
----------------------
FORM 10-QSB
(Mark One)
|X| QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the quarterly period ended March 31, 2005
|_| TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT
For the transition period from _____ to _____
COMMISSION FILE NUMBER 0-25675
PATRON SYSTEMS, INC.
(EXACT NAME OF SMALL BUSINESS ISSUER AS SPECIFIED IN ITS CHARTER)
DELAWARE 74-3055158
(STATE OR OTHER JURISDICTION OF (IRS EMPLOYER IDENTIFICATION NO.)
INCORPORATION OR ORGANIZATION)
500 N. MICHIGAN AVE, SUITE 300 60611
CHICAGO, IL
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
(312) 396-4031
(ISSUER'S TELEPHONE NUMBER)
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 Registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days. Yes |_| No |X|
State the number of shares outstanding of each of the issuer's classes of common
equity, as of the latest practicable date: 59,698,360 shares of common stock
outstanding as of July 29, 2005.
Transitional Small Business Disclosure Format (Check one): Yes |_| No |X|
PATRON SYSTEMS, INC.
FORM 10-QSB QUARTERLY REPORT
----------------------------------
TABLE OF CONTENTS
PART I - FINANCIAL INFORMATION PAGE
ITEM 1. FINANCIAL STATEMENTS............................................... 3
Condensed Consolidated Balance Sheet at March 31, 2005 (unaudited)........ 3
Condensed Consolidated Statements of Operations for the
Three Months Ended March 31, 2005 and 2004 (unaudited)............ 4
Condensed Consolidated Statement of Stockholders' (Deficiency)
Equity for the Three Months Ended March 31, 2005 (unaudited)...... 5
Condensed Consolidated Statements of Cash Flows for the
Three Months Ended March 31, 2005 and 2004 (unaudited)............ 6
Notes to Condensed Consolidated Financial Statements (unaudited)........... 7
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS............................... 26
ITEM 3. CONTROLS AND PROCEDURES............................................ 37
PART II - OTHER INFORMATION
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS........ 39
ITEM 6. EXHIBITS........................................................... 40
SIGNATURES................................................................. 42
FORWARD LOOKING STATEMENTS
The following discussion and explanations should be read in conjunction with the
financial statements and related notes contained elsewhere in this Form 10-QSB.
Certain statements made in this discussion are "forward-looking statements"
within the meaning of the Private Securities Litigation Reform Act of 1995.
Forward-looking statements can be identified by terminology such as "may",
"will", "should", "expects", "intends", "anticipates", "believes", "estimates",
"predicts", or "continue" or the negative of these terms or other comparable
terminology. Because forward-looking statements involve risks and uncertainties,
there are important factors that could cause actual results to differ materially
from those expressed or implied by these forward-looking statements. Although
Patron Systems believes that expectations reflected in the forward-looking
statements are reasonable, it cannot guarantee future results, performance or
achievements. Moreover, neither Patron Systems nor any other person assumes
responsibility for the accuracy and completeness of these forward-looking
statements. Patron Systems is under no duty to update any forward-looking
statements after the date of this report to conform such statements to actual
results.
2
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
PATRON SYSTEMS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEET
(unaudited)
ASSETS MARCH 31, 2005
------------
Current Assets:
Cash and cash equivalents ................................... $ 366,721
Restricted cash ............................................. 1,388,000
Accounts receivable, net .................................... 284,597
Other current assets ........................................ 76,260
------------
Total current assets ..................................... 2,115,578
Property and equipment, net ................................... 166,760
Deferred financing costs ...................................... 460,559
Intangible assets, net ........................................ 3,081,770
Goodwill ...................................................... 22,544,415
------------
Total assets ............................................. $ 28,369,082
============
LIABILITIES AND STOCKHOLDERS' DEFICIENCY
Current Liabilities
Accounts payable ............................................ $ 2,120,132
Accrued payroll and related expenses ........................ 3,203,699
Notes payable (to creditors of acquired business) ........... 2,640,000
Accrued interest ............................................ 1,139,219
Advances from stockholders .................................. 885,342
Demand notes payable ........................................ 695,000
Expense reimbursements due to officers and stockholders ..... 476,174
Consulting agreement payable ................................ 300,000
Deferred revenue ............................................ 235,034
Notes payable to officers and stockholders .................. 430,212
Other current liabilities ................................... 142,969
Bridge notes payable ........................................ 2,717,105
Acquisition notes payable ................................... 4,500,000
------------
Total current liabilities ................................ 19,484,886
Note payable - stock repurchase obligation .................... 1,738,667
------------
Total liabilities ........................................ 21,223,553
------------
Common stock subject to put right (2,000,000 shares) .......... 1,000,000
------------
Stockholders' Equity
Preferred stock, par value $0.01 per share,
75,000,000 shares authorized, none issued
and outstanding ........................................... --
Common stock, par value $0.01 per share,
150,000,000 shares authorized, 37,006,212
shares issued and outstanding as of March
31, 2005 (net of 2,000,000 shares subject
to put right) ............................................. 370,062
Additional paid-in capital .................................. 44,998,571
Common stock to be issued ................................... 5,189,400
Common stock repurchase obligation .......................... (1,300,000)
Deferred compensation ....................................... (966,833)
Accumulated deficit ......................................... (42,145,671)
------------
Total stockholders' equity ............................... 6,145,529
------------
Total liabilities and stockholders' equity ............... $ 28,369,082
============
See notes to condensed consolidated financial statements.
3
PATRON SYSTEMS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited)
THREE MONTHS ENDED
----------------------------
MARCH 31, MARCH 31,
2005 2004
------------ ------------
(DEVELOPMENT
STAGE)
Revenue ........................................ $ 48,860 $ --
------------ ------------
Cost of Sales
Cost of products/services .................... 31,004 --
Amortization of technology ................... 11,167 --
------------ ------------
Total cost of sales ........................ 42,171 --
------------ ------------
Gross profit ................................. 6,689 --
------------ ------------
Operating Expenses
Salaries and related expenses ................ 458,686 110,489
Consulting expense (non-employee stock based
compensation) ............................. 508,500 77,500
Professional fees ............................ 144,401 28,924
General and administrative ................... 244,244 270,994
Amortization of intangibles .................. 8,063 --
Stock based penalty under accomodation
agreement ................................. 369,000 255,000
Loss associated with settlement agreement .... -- 438,667
------------ ------------
Total operating expenses .................. 1,732,894 1,181,574
Operating loss ................................. (1,726,205) (1,181,574)
Interest income ................................ 19,250 19,250
Interest expense ............................... (496,840) (33,088)
------------ ------------
Loss before income taxes ....................... (2,203,795) (1,195,412)
Income taxes ................................. -- --
------------ ------------
Net loss ....................................... $ (2,203,795) (1,195,412)
============ ============
Net Loss Per Share - Basic and Diluted ......... $ (0.04) $ (0.03)
============ ============
Weighted Average Number of Shares Outstanding
- Basic and diluted ......................... 50,686,749 38,814,999
============ ============
See notes to condensed consolidated financial statements.
4
PATRON SYSTEMS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS' (DEFICIENCY) EQUITY (unaudited)
For the three months ended March 31, 2005
Additional Shares of Value of
Shares of Par Value Paid in Common Stock Common Stock
Common Stock Common Stock Capital to be Issued to be Issued
----------- ----------- ----------- ----------- -----------
Balance, December 31, 2004 (development stage) 37,006,212 $ 370,062 $28,973,711 5,951,648 $ 4,671,400
Common stock issued in purchase business
combinations
Complete Security Solutions, Inc. ............ -- -- 6,300,000 7,500,000 75,000
LucidLine, Inc. .............................. -- -- 3,696,000 4,400,000 44,000
Entelagent Software Corporation .............. -- -- 2,520,000 3,000,000 30,000
Common stock to be issued under accommodation
agreement as a penalty .................... -- -- -- 450,000 369,000
Amortization of deferred stock-based
compensation .............................. -- -- -- -- --
Issuance of warrants and bridge notes to
investors ................................. -- -- 1,043,860 -- --
Issuance of warrants issued as purchase
consideration ............................. -- -- 1,912,500 -- --
Issuance of warrants to transaction advisors . -- -- 255,000 -- --
Issuance of warrants to placement agent ...... -- -- 297,500 -- --
Net Loss ..................................... -- -- -- -- --
----------- ----------- ----------- ----------- -----------
Balance, March 31, 2005 ...................... 37,006,212 $ 370,062 $44,998,571 21,301,648 $ 5,189,400
=========== =========== =========== =========== ===========
COMMON STOCK
REPURCHASE DEFERRED ACCUMULATED
OBLIGATION COMPENSATION DEFICIT TOTAL
------------ ------------ ------------ ------------
Balance, December 31, 2004 (development stage) $ (1,300,000) $ (1,475,333) $(39,941,876) $ (8,702,036)
Common stock issued in purchase business
combinations
Complete Security Solutions, Inc. ............ -- -- -- 6,375,000
LucidLine, Inc. .............................. -- -- -- 3,740,000
Entelagent Software Corporation .............. -- -- -- 2,550,000
Common stock to be issued under accommodation
agreement as a penalty .................... -- -- -- 369,000
Amortization of deferred stock-based
compensation .............................. -- 508,500 -- 508,500
Issuance of warrants and bridge notes to
investors ................................. -- -- -- 1,043,860
Issuance of warrants issued as purchase
consideration ............................. -- -- -- 1,912,500
Issuance of warrants to transaction advisors . -- -- -- 255,000
Issuance of warrants to placement agent ...... -- -- -- 297,500
Net Loss ..................................... -- -- (2,203,795) (2,203,795)
------------ ------------ ------------ ------------
BALANCE, MARCH 31, 2005 ...................... $ (1,300,000) $ (966,833) $(42,145,671) $ 6,145,529
============ ============ ============ ============
5
PATRON SYSTEMS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
THREE MONTHS ENDED
----------------------------
MARCH 31, MARCH 31,
2005 2004
------------ ------------
(DEVELOPMENT
STAGE)
Cash Flows from Operating Activities
Net loss ................................................. $ (2,203,795) $ (1,195,412)
============ ============
Adjustments to reconcile net loss to net cash used
in operating activities:
Depreciation and amortization .......................... 19,525 --
Amortization of deferred compensation .................. 508,500 --
Accretion related to warrants issued for notes payable . 260,965 --
Amortization of deferred financing costs ............... 153,520 --
Common stock issued in lieu of cash for services ....... -- 77,500
Stock based penalty on accomodation agreement .......... 369,000 255,000
Costs of acquisitions not consummated .................. -- 438,667
Non-cash interest income ............................... (19,250) (19,250)
Changes in assets and liabilities:
Restriced cash escrowed to settle liabilities assumed (1,388,000) --
Prepaid expenses ..................................... 10,637 --
Accounts receivable .................................. (58,518) --
Other current assets ................................. 110,533 --
Accounts payable ..................................... (325,017) 20,181
Accrued interest ..................................... 94,827 33,088
Deferred revenue ..................................... 35,283 --
Expense reimbursements due to officers and
shareholders ...................................... (94,500) --
Accrued payroll and payroll related expenses ......... (72,250) 86,944
Other current liabilities ............................ 31,439 --
Other accrued expenses ............................... (3,413) --
------------ ------------
Total adjustments ........................................ (366,719) 892,130
============ ============
NET CASH USED IN OPERATING ACTIVITIES ...................... (2,570,514) (303,282)
============ ============
CASH FLOWS USED IN INVESTING ACTIVITIES
Cash payments in purchase business combinations .......... (847,633) --
Cash acquired in purchase business combinations .......... 416,397 --
Purchase of fixed assets ................................. (32,055) --
------------ ------------
NET CASH USED IN INVESTING ACTIVITIES ...................... (473,291) --
============ ============
CASH FLOWS FROM FINANCING ACTIVITIES
Expenses financed by (repaid to) officers and stockholders (225,000) 200,236
Advances from stockholders ............................... 500,000 --
Deferred financing costs ................................. (316,579) --
Proceed from issuance of common stock .................... -- 200,000
Proceeds from issuance of bridge notes ................... 3,500,000 --
Repayments of advances from shareholders ................. (93,796) (119,903)
------------ ------------
NET CASH PROVIDED BY FINANCING ACTIVITIES .................. 3,364,625 280,333
============ ============
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS ....... $ 320,820 $ (22,949)
CASH AND CASH EQUIVALENTS, beginning of period ............. $ 45,901 $ 22,957
------------ ------------
CASH AND CASH EQUIVALENTS, end of period ................... $ 366,721 $ 8
------------ ------------
Supplemental Disclosures of Cash Flow Information:
Issuance of note under stock repurchase obligation ....... $ -- $ 1,300,000
Obligation to repurchase 2,000,000 shares of common
stock subject to put right ............................ -- 1,000,000
Cash paid during the period for:
Interest ................................................. 214,428
Supplemental non-cash investing and financial activity
Current tangible assets acquired ......................... 417,525
Non-current tangible assets acquired ..................... 2,756,470
Current liabilities assumed with acquisitions ............ (8,606,548)
Non-current liabilities assumed with acquisitions ........ (439,126)
Intangible assets acquired ............................... 3,101,000
Goodwill recognized on purchase business combinations .... 22,544,415
Non-cash considerations .................................. (19,342,500)
Cash acquired in purchase business combinations .......... 416,397
------------
Cash paid to acquire businesses .......................... 847,633
============
See notes to condensed consolidated financial statements.
See notes to condensed consolidated financial statements.
6
PATRON SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
MARCH 31, 2005
NOTE A - BASIS OF INTERIM FINANCIAL STATEMENT PRESENTATION
The accompanying unaudited Condensed Consolidated Financial Statements of Patron
Systems, Inc. (the "Company," "Patron," "us," or "we") have been prepared in
accordance with accounting principles generally accepted in the United States
for interim financial information and the instructions to Form 10-QSB.
Accordingly, they do not include all the information and footnotes required by
accounting principles generally accepted in the United States for complete
financial statements. In the opinion of management all adjustments (which
include only normal recurring adjustments) necessary to present fairly the
financial position, results of operations and cash flows for all periods
presented have been made. The results of operations for the three-month period
ended March 31, 2005 is not necessarily indicative of the operating results that
may be expected for the entire year ending December 31, 2005.
NOTE B - THE COMPANY
ORGANIZATION AND DESCRIPTION OF BUSINESS
Patron Systems, Inc., ("Systems") is a Delaware corporation formed in April 2002
to provide comprehensive, end-to-end information security solutions to global
corporations and government institutions. Systems' founders intended to raise
capital on a private equity basis, but determined that it had a need for a
public company currency to achieve their growth plan.
Pursuant to an Amended and Restated Share Exchange Agreement dated October 11,
2002, Combined Professional Services ("CPS"), Systems and the stockholders of
Systems consummated a share exchange ("Share Exchange"), As a result of the
Share Exchange, the former stockholders of Systems became the majority
stockholders of CPS. Accordingly, Systems became the accounting acquirer of CPS
and the exchange was accounted for as a reverse merger and recapitalization of
Systems. CPS subsequently changed its name to Patron Systems, Inc. (the
"Company" or "Patron").
DEVELOPMENT STAGE OPERATIONS
In accordance with Statement of Financial Accounting Standard ("SFAS") No.7, the
Company was considered to be a development stage enterprise during the quarter
ended March 31, 2004, as its activities principally consisted of raising capital
and screening potential acquisition candidates in the information and homeland
security segments, As described in Note E, the Company consummated acquisitions
of three businesses that have developed technologies, customer bases and are
generating revenue. Accordingly, the Company is no longer considered to be a
development stage enterprise effective for the quarter ended March 31, 2005.
NOTE C - LIQUIDITY AND FINANCIAL CONDITION
The accompanying financial statements have been prepared assuming that the
Company will continue as a going concern. The Company incurred a net loss of
$2,203,795 for the three months ended March 31, 2005, which includes $877,500 of
non-cash charges for the fair value of common stock the Company issued as
penalties under certain registration rights agreements and amortization of
deferred compensation under a stock based compensation arrangement. In addition,
the Company used net cash flows in its operating activities of $2,570,514 during
the quarter ended March 31, 2005. The Company's working capital deficiency at
March 31, 2005 amounts to $17,369,308 and the Company is continuing to
experience shortages in working capital. The Company is also involved in
substantial litigation and is being investigated by the Securities and Exchange
Commission with respect to certain of its press releases and its use of form S-8
to register shares of common stock issued to certain consultants (Note N). The
Company cannot provide any assurance that the outcome of these matters will not
have a material adverse affect on its ability to sustain the business. These
matters raise substantial doubt about the Company's ability to continue as a
going concern. The accompanying financial statements do not include any
adjustments that may result from the outcome of this uncertainty.
7
The Company expects to continue incurring losses for the foreseeable future due
to the inherent uncertainty that is related to establishing the commercial
feasibility of technological products and developing a presence in new markets.
The Company's ability to successfully integrate the acquired businesses
described in Note E is critical to the realization of its business plan. The
Company raised $4,000,000 of gross proceeds ($3,683,421 net proceeds after the
payment of certain transaction expenses) in two financing transactions,
including $500,000 that the Company received as an advance from a stockholder
during the three months ended March 31, 2005. The Company used $2,570,514 of
these proceeds to fund its operations (which includes a $1,388,000 escrow
deposit for the payment of liabilities assumed in business combinations), and
$473,291 in investing activities, which principally includes the cash component
of purchase business combinations that the Company consummated during the
quarter. In addition, the Company repaid an aggregate of $318,796 of certain
obligations due to certain officer/stockholders. Subsequent to March 31, 2005
the Company raised approximately $3,893,000 in additional gross funds in five
capital financing transactions. Net proceeds from these transaction amounted to
$3,587,840 which were used principally to fund operations.
The Company is currently in the process of attempting to raise additional
capital and has taken certain steps to conserve its liquidity while it continues
to integrate the acquired businesses. Although management believes that the
Company has access to capital resources, the Company has not secured any
commitments for additional financing at this time nor can the Company provide
any assurance that it will be successful in its efforts to raise additional
capital and/or successfully execute its business plan.
NOTE D - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of the Company and
its wholly-owned subsidiaries. All significant inter-company transactions have
been eliminated.
CASH AND CASH EQUIVALENTS
The Company considers all highly liquid securities purchased with original
maturities of three months or less to be cash equivalents.
REVENUE RECOGNITION
The Company derives revenues from the following sources: (1) sales of computer
software, which includes new software licenses and software updates and product
support revenues and (2) services, which include internet access, back-up,
retrieval and restoration services and professional consulting services.
The Company applies the revenue recognition principles set forth under AICPA
Statement of Position ("SOP") 97-2 "Software Revenue Recognition" and Securities
and Exchange Commission Staff Accounting Bulletin ("SAB") 104 "Revenue
Recognition" with respect to all of its revenue. Accordingly, the Company
records revenue when (i) persuasive evidence of an arrangement exists, (ii)
delivery has occurred, (iii) the vendor's fee is fixed or determinable, and (iv)
collectability is probable.
The Company generates revenues through sales of software licenses and annual
support subscription agreements, which include access to technical support and
software updates (if and when available). Software license revenues are
generated from licensing the rights to use products directly to end-users and
through third party service providers.
Revenues from software license agreements are generally recognized upon delivery
of software to the customer. All of the Company's software sales are supported
by a written contract or other evidence of sale transaction such as a customer
purchase order. These forms of evidence clearly indicate the selling price to
the customer, shipping terms, payment terms (generally 30 days) and refund
policy, if any. The selling prices of these products are fixed at the time the
sale is consummated.
8
Revenue from post contract customer support arrangements or undelivered elements
are deferred and recognized at the time of delivery or over the period in which
the services are performed based on vendor specific objective evidence of fair
value for such undelivered elements. Vendor specific objective evidence is
typically based on the price charged when an element is sold separately or, if
an element is not sold separately, on the price established by an authorized
level of management, if it is probable that the price, once established, will
not change before market introduction. The Company uses the residual method
prescribed in SOP 98-9 to allocate revenues to delivered elements once it has
established vendor-specific evidence for such undelivered elements.
The Company provides its internet access and back-up, retrieval and restoration
services under contractual arrangements with terms ranging from 1 year to 5
years. These contracts are billed monthly, in advance, based on the
contractually stated rates. At the inception of a contract, the Company may
activate the customer's account for a contractual fee that it amortizes over the
term of the contract in accordance with Emerging Issues Task Force Issue
("EITF") 00-21 "Revenue Arrangements with Multiple Deliverables." The Company's
standard contracts are automatically renewable by the customer unless terminated
on 30 days written notice. Early termination of the contract generally results
in an early termination fee equal to the lesser of six months of service or the
remaining term of the contract.
Professional consulting services are billed based on the number of hours of
consultant services provided and the hourly billing rates. The Company
recognizes revenue under these arrangements as the service is performed.
Revenue from the resale of third-party hardware and software is recognized upon
delivery provided there are no further obligations to install or modify the
hardware or software. Revenue from the sales of hardware/software is recorded at
the gross amount of the sale when the contract satisfies the requirements of
Emerging Issues Task Force ("EITF") 99-19.
ACCOUNTS RECEIVABLE
The Company adjusts its accounts receivable balances that it deems to be
uncollectible. The allowance for doubtful accounts is the Company's best
estimate of the amount of probable credit losses in the Company's existing
accounts receivable. The Company reviews its allowance for doubtful accounts on
a monthly basis and determines the allowance based on an analysis of its past
due accounts. All past due balances that are over 90 days are reviewed
individually for collectability. Account balances are charged off against the
allowance after all means of collection have been exhausted and the potential
for recovery is considered remote.
PROPERTY AND EQUIPMENT
Property and equipment is stated at cost. Depreciation is computed using the
straight-line method over the estimated useful lives of the assets. Maintenance
and repairs are charged to expense as incurred; cost of major additions and
betterments are capitalized. When property and equipment is sold or otherwise
disposed of, the cost and related accumulated depreciation are eliminated from
the accounts and any resulting gains or losses are reflected in the statement of
operations in the period of disposal
GOODWILL
SFAS 142, Goodwill and Other Intangible Assets, requires that goodwill be tested
for impairment at the reporting unit level (operating segment or one level below
an operating segment) on an annual basis (June 30th for the Company) and between
annual tests in certain circumstances. Application of the goodwill impairment
test requires judgment, including the identification of reporting units,
assigning assets and liabilities to reporting units, assigning goodwill to
reporting units, and determining the fair value. Significant judgments required
to estimate the fair value of reporting units include estimating future cash
flows, determining appropriate discount rates and other assumptions. Changes in
these estimates and assumptions could materially affect the determination of
fair value and/or goodwill impairment for each reporting unit. We have recorded
goodwill in connection with the Company's acquisitions described in Note E
amounting to $22,544,415. The Company has determined that no impairment charges
are necessary during the quarter ended March 31, 2005.
9
LONG LIVED ASSETS
The Company periodically reviews the carrying values of its long lived assets in
accordance with SFAS 144 "Long Lived Assets" when events or changes in
circumstances would indicate that it is more likely than not that their carrying
values may exceed their realizable value and record impairment charges when
necessary. The Company has determined that no impairment charges are necessary
during the quarter ended March 31, 2005.
STOCK OPTION PLANS
As permitted under SFAS No. 148 "Accounting for Stock-Based Compensation -
Transition and Disclosure," which amended SFAS No. 123 "Accounting for
Stock-Based Compensation," the Company has elected to continue to follow the
intrinsic value method in accounting for its stock-based compensation
arrangements as defined by Accounting Principles Board ("APB") Opinion No. 25
"Accounting for Stock Issued to Employees," and related interpretations
including Financial Accounting Standards Board ("FASB") Interpretation No. 44
"Accounting for Certain Transactions Involving Stock Compensation," an
interpretation of APB No. 25.
The following table summarizes the pro forma operating results of the Company
had compensation expense for stock options granted to employees been determined
in accordance with the fair market value based method prescribed by SFAS No.
123. The Company has presented the following disclosures in accordance with SFAS
No. 148.
Three Months ended March 31,
----------------------------
2005 2004
----------- -----------
Net Loss, as reported .......................... $(2,203,795) $(1,195,412)
(+)Stock-based compensation cost reflected
in the financial statements ................. -- --
(-)Stock-based employee compensation expense
under the fair value method ................ 185,278 204,444
----------- -----------
Pro-Forma Net Loss ............................. $(2,389,073) $(1,399,856)
=========== ===========
Pro-Forma Net Loss per Share-
Basic and Diluted, as reported ................. $ (0.04) $ (0.03)
=========== ===========
Basic and Diluted, pro-forma ................... $ (0.05) $ (0.04)
=========== ===========
Number of Shares, Basic and Diluted ............ 50,686,749 38,251,388
=========== ===========
NON-EMPLOYEE STOCK BASED COMPENSATION
The cost of stock based compensation awards issued to non-employees for services
are recorded at either the fair value of the services rendered or the
instruments issued in exchange for such services, whichever is more readily
determinable, using the measurement date guidelines enumerated in Emerging
Issues Task Force Issue ("EITF") 96-18, "Accounting for Equity Instruments That
Are Issued to Other Than Employees for Acquiring, or in Conjunction with
Selling, Goods or Services."
COMMON STOCK PURCHASE WARRANTS
The Company accounts for the issuance of common stock purchase warrants issued
with registration rights in accordance with the provisions of EITF 00-19
"Accounting for Derivative Financial Instruments Indexed to, and Potentially
Settled in, a Company's Own Stock."
Based on the provisions of EITF 00-19, the Company classifies as equity any
contracts that (i) require physical settlement or net-share settlement or (ii)
gives the company a choice of net-cash settlement or settlement in its own
shares (physical settlement or net-share settlement). The Company classifies as
assets or liabilities any contracts that (i) require net-cash settlement
(including a requirement to net cash settle the contract if an event occurs and
if that
10
event is outside the control of the company) (ii) give the counterparty a choice
of net-cash settlement or settlement in shares (physical settlement or net-share
settlement).
INCOME TAXES
The Company accounts for income taxes pursuant to SFAS No. 109, Accounting for
Income Taxes. Deferred taxes arise from temporary differences, primarily
attributable to the use of the cash method for tax purposes and accrual method
for book purposes and net operating loss carry-forwards. The Company records
valuation allowances for deferred tax assets when circumstances indicate it is
more likely than not that the Company will not realize the benefit of its
deferred tax assets.
NET LOSS PER SHARE
Basic net loss per common share is computed by dividing net loss by the
weighted-average number of common shares outstanding during the period. Diluted
net loss per common share also includes common stock equivalents outstanding
during the period if dilutive. Diluted net loss per common share has been
computed by dividing net loss by the weighted-average number of common shares
outstanding without an assumed increase in common shares outstanding for common
stock equivalents; as such common stock equivalents are anti-dilutive.
As a result of the consummation of the Share Exchange described in Note B, the
Company included 1,200,000 stock options with an exercise price of $.01 per
share that it issued to certain employees during 2002 in its calculation of
weighted-average number of common shares outstanding for all periods presented.
Net loss per common share excludes the following outstanding options, warrants
and convertible notes as their effect would be anti-dilutive:
MARCH 31,
------------------------------
2005 2004
---------- ----------
Options ................................ 7,125,000 5,200,000
Warrants ............................... 4,665,000 15,000
Convertible notes ...................... -- 120,462
---------- ----------
11,790,000 5,335,462
========== ==========
USE OF ESTIMATES IN PREPARING FINANCIAL STATEMENTS
In preparing financial statements in conformity with accounting principles
generally accepted in the United States of America, management is required to
make estimates and assumptions that affect the reported amounts of assets and
liabilities and the disclosure of contingent assets and liabilities at the date
of the financial statements and revenue and expenses during the reporting
period. Actual results could differ from those estimates.
FAIR VALUE OF FINANCIAL INSTRUMENTS
The carrying amounts reported in the balance sheet for cash, accounts
receivable, accounts payable accrued expenses, advances from stockholders and
all note obligations classified as current liabilities approximate their fair
values based on the short-term maturity of these instruments. The carrying
amounts of the Company's convertible and subordinated note obligations, stock
repurchase obligation and common stock subject to put right approximate fair
value as such instruments feature contractual interest rates that are consistent
with current market rates of interest or have effective yields that are
consistent with instruments of similar risk, when taken together with any equity
instruments concurrently issued to holders.
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In January 2003, Financial Accounting Standards Board ("FASB") issued FASB
Interpretation No. 46, "Consolidation of Variable Interest Entities" ("FIN 46").
This interpretation of Accounting Research Bulletin No. 51, "Consolidated
Financial Statements," provides guidance for identifying a controlling interest
in a variable interest entity ("VIE") established by means other than voting
interest. FIN 46 also required consolidation of a VIE
11
by an enterprise that holds such controlling interest. In December 2003, the
FASB completed its deliberations regarding the proposed modifications to FIN
No., 46 and issued Interpretation Number 46R, "Consolidation of Variable
Interest Entities - an Interpretation of ARB 51" ("FIN No. 46 R"). The decisions
reached included a deferral of the effective date and provisions for additional
scope exceptions for certain types of variable interests. Application of FIN No.
46R is required in financial statements of public entities that have interests
in VIEs or potential VIEs commonly referred to as special-purpose entities for
periods ending after December 15, 2003. Application by public issuers' entities
is required in all interim and annual financial statements for periods ending
after December 15, 2004. The adoption of this pronouncement did not have
material effect on the Company's financial statements.
In December 2004, the FASB issued SFAS No. 123R "Share Based Payment". This
statement is a revision of SFAS Statement No. 123, "Accounting for Stock-Based
Compensation" and supersedes APB Opinion No. 25, Accounting for Stock Issued to
Employees, and its related implementation guidance. SFAS 123R addresses all
forms of share based payment ("SBP") awards including shares issued under
employee stock purchase plans, stock options, restricted stock and stock
appreciation rights. Under SFAS 123R, SBP awards result in a cost that will be
measured at fair value on the awards' grant date, based on the estimated number
of awards that are expected to vest and will result in a charge to operations
for stock-based compensation expense. The charge will be reflected in the
Company's Statements of Operations during periods in which such charges are
recorded, but will not affect its Balance Sheets or Statements or Cash Flows.
SFAS 123R is effective for public entities that file as small business
issuers--as of the beginning of the first interim or annual reporting period of
the fiscal year that begins after December 15, 2005.
The Company is currently in the process of evaluating the effect that the
adoption of this pronouncement will have on its financial statements.
In December 2004, the FASB issued SFAS No. 153, "Exchanges of Non-monetary
Assets". SFAS 153 amends APB Opinion No. 29 to eliminate the exception for
non-monetary exchanges of similar productive assets and replaces it with a
general exception for exchanges of non-monetary assets that do not have
commercial substance. A non-monetary exchange has commercial substance if the
future cash flows of the entity are expected to change significantly as a result
of the exchange. The provisions of SFAS 153 are effective for non-monetary asset
exchanges occurring in fiscal periods beginning after June 15, 2005. Earlier
application is permitted for non-monetary asset exchanges occurring in fiscal
periods beginning after December 16, 2004. The provisions of this statement are
intended be applied prospectively. The adoption of this pronouncement is not
expected to have a material effect on the Company's financial statements.
EITF Issue No. 04-8, "The Effect of Contingently Convertible Instruments on
Diluted Earnings per Share." The EITF reached a consensus that contingently
convertible instruments, such as contingently convertible debt, contingently
convertible preferred stock, and other such securities should be included in
diluted earnings per share (if dilutive) regardless of whether the market price
trigger has been met. The consensus became effective for reporting periods
ending after December 15, 2004. The adoption of this pronouncement is not
expected to have material effect on the Company's financial statements.
NOTE E - BUSINESS COMBINATIONS
MERGER WITH COMPLETE SECURITY SOLUTIONS, INC.
On February 25, 2005, pursuant to the filing of an Agreement and Plan of Merger,
the Company's merger with Complete Security Solutions, Inc. ("CSSI") became
effective. The merger was consummated pursuant to a definitive Supplemental
Agreement and the Agreement and Plan of Merger, entered into as of February 24,
2005, each among the Company, CSSI Acquisition Co. I, Inc., a wholly-owned
subsidiary of the Company and CSSI. Pursuant to the terms of the Supplemental
Agreement and Agreement and Plan of Merger with CSSI, CSSI Acquisition Co. I,
Inc. merged with and into CSSI, with CSSI surviving the merger as a wholly-owned
subsidiary of the Company.
CSSI sells computer software that supports real-time secure collection, delivery
and sharing of field-based report information for public safety agencies. The
Company believes that CSSI's electronic forms technology provides law
enforcement and other justice agencies with secure, real-time access to field
reporting data for use inside a
12
department or in a multi-jurisdictional information sharing system. The Company
acquired CSSI because it believes that such technologies fit within its
strategic plan of building a business that addresses the urgency of homeland and
information security initiatives.
In connection with the CSSI merger, the Company issued 7,500,000 shares of
common stock in exchange for the outstanding shares of the common stock of CSSI,
and subordinated promissory notes in the aggregate principal amount of
$4,500,000 (the "Subordinated Notes") and warrants to purchase 2,250,000 shares
of common stock ("Purchase Warrants") in exchange for the outstanding shares of
the preferred stock of CSSI. The Purchase Warrants have a term of 5 years and an
exercise price of $0.70 per share. The Subordinated Notes and Purchase Warrants
were issued to Apex Investment Fund V, L.P., The Northwestern Mutual Life
Insurance Company, and Advanced Equities Venture Partners I, L.P.
The Subordinated Notes issued to the holders of the outstanding preferred stock
of CSSI have an initial term of 120 days (due on June 25, 2005), with the
Company's option to extend the term for an additional 60 days to August 24,
2005. The Subordinated Notes are interest free and automatically convert into
the securities offered by the Company at the first closing of a subsequent
financing for the Company, for such number of offered securities as could be
purchased for the principal amount being converted. If the Subordinated Notes
are not paid in full on or before the extended maturity date, each noteholder
will be issued a warrant (the "Penalty Warrant") entitling the holder to
purchase 3.84 shares of common stock for each $1.00 of principal amount then
outstanding. The Penalty Warrants issuable in connection with the non-payment of
the Subordinated Notes may only be exercised by a holder's delivery of its
subordinated promissory note in payment of the exercise price, the delivery of
which will result in the full satisfaction of all amounts of principal and
interest due and payable under such Subordinated Note. As described in Note P,
the Company did not repay the Subordinated Notes on their original maturity date
of June 25, 2005.
The Company has agreed to register the resale of the 7,500,000 shares of common
stock issued to the holders of the outstanding common stock of CSSI and the
2,250,000 shares of common stock issuable upon the exercise of the warrants
issued to the holders of the outstanding preferred stock of CSSI at such time as
the Company next files a registration statement with the Securities and Exchange
Commission ("SEC") on a best efforts basis.
MERGER WITH LUCIDLINE, INC.
On February 25, 2005, pursuant to the filing of an Agreement and Plan of Merger,
the Company's merger with LucidLine, Inc. ("LucidLine") became effective. The
merger was consummated pursuant to a definitive Supplemental Agreement and the
Agreement and Plan of Merger entered into as of February 24, 2005, each among
the Company, LL Acquisition I Corp., a wholly-owned subsidiary of the Company
and LucidLine. Pursuant to the terms of the Supplemental Agreement and Agreement
and Plan of Merger with LucidLine, LL Acquisition I Corp. merged with and into
LucidLine, with LucidLine surviving the merger as a wholly-owned subsidiary of
the Company.
LucidLine provides high-speed Internet access, synchronized remote back-up,
retrieval, and restoration services to small and mid-size businesses. The
Company acquired LucidLine because it believes that LucidLine's information
protection technologies fit within its strategic plan of building a business
that addresses the urgency of homeland and information security initiatives.
In connection with the LucidLine merger, the Company issued 4,400,000 shares of
common stock and $200,000 of cash, in exchange for all of the outstanding shares
of LucidLine's common stock. The Company has agreed to register the resale of
the shares of common stock issued to the holders of the outstanding common stock
of LucidLine at such time as the Company next files a registration statement
with the SEC on a best efforts basis.
MERGER WITH ENTELAGENT SOFTWARE CORP.
On November 24, 2002, Patron, ESC Acquisition, Inc., a California corporation
and wholly-owned subsidiary of Patron ("Entelagent Mergerco"), and Entelagent
Software Corp., a California corporation ("Entelagent"), entered into an
Agreement and Plan of Merger, (the "Entelagent Merger Agreement") whereby
Entelagent Mergerco would be merged with and into Entelagent with Entelagent
surviving as a wholly owned subsidiary of Patron (the
13
"Entelagent Merger"). Patron, Entelagent Mergerco and Entelagent also
concurrently entered into a Supplemental Agreement (the "Entelagent Supplemental
Agreement").
On February 24, 2005, Patron entered into a definitive Amended and Restated
Supplemental Agreement pursuant to which Entelagent Mergerco would merge with
and into Entelagent, with Entelagent surviving the merger as a wholly-owned
subsidiary of Patron. The Amended and Restated Supplemental Agreement amended
and restated the Entelagent Supplemental Agreement.
On March 30, 2005, pursuant to the filing of an Amended and Restated Agreement
and Plan of Merger, Patron's merger with Entelagent became effective. The
Amended and Restated Agreement and Plan of Merger amended and restated the
Entelagent Merger Agreement.
Entelagent provides flexible and scalable real-time content-aware email
monitoring and post-event review of e-mail messages and their attachments as
well as infrastructure for knowledge management of archived e-mail messages and
attachments in all media. Entelagent's e-mail content monitoring technology
addresses the need for comprehensive internal security measures to safeguard
company intellectual capital. The Company acquired Entelagent because it
believes that Entelagent's information surveillance and protection technologies
fit within its strategic plan of building a business that addresses the urgency
of homeland and information security initiatives.
In connection with the Entelagent Merger, Patron issued 3,000,000 shares of
Patron's common stock in exchange for all of the outstanding shares of the
capital stock of Entelagent. Patron has agreed to register the resale of the
3,000,000 shares of common stock issued to the holders of the outstanding
capital stock of Entelagent at such time as Patron next files a registration
statement with the SEC on a best efforts basis. In addition, pursuant to the
terms of the Amended and Restated Supplemental Agreement, Patron also agreed to
(i) issue to certain officers, directors, stockholders and creditors of
Entelagent, in consideration of amounts owed by Entelagent to such parties,
promissory notes in the aggregate principal amount of $2,640,000, with interest
payable thereon at a rate of 8% per annum and maturing one year after the
completion of the merger and (ii) pay $1,388,000 in outstanding liabilities of
Entelagent from the net proceeds of the Interim Bridge Financing I completed on
February 28, 2005. Accordingly, the Company placed $1,388,000 of the proceeds it
received from the Interim Bridge Financing I financing transaction in an escrow
account to be specifically used for the payment of such liabilities. Such funds
are presented as restricted cash in the accompanying balance sheet at March 31,
2005.
Prior to the completion of the business combinations, CSSI made an aggregate of
$2,600,000 in loans and advances to Patron, Entelagent and LucidLine. The loans
and advances, which remained outstanding subsequent to the completion of the
transactions, have been eliminated in the Company's consolidated financial
statements.
BUSINESS COMBINATION ACCOUNTING
The Company accounted for its acquisitions of CSSI, LucidLine and Entelagent
using the purchase method of accounting prescribed under SFAS 141 "Business
Combinations." Under the purchase method, the acquiring enterprise records any
purchase consideration issued to the sellers of the acquired business at their
fair values. The aggregate of the fair value of the purchase consideration plus
any direct transaction expenses incurred by the acquiring enterprise is
allocated to the assets acquired (including any separately identifiable
intangibles) and liabilities assumed based on their fair values at the date of
acquisition. The excess of cost of the acquired entities over the fair values of
assets acquired and liabilities assumed was recorded as goodwill. The results of
operations for each of the acquired companies following the dates of each
business combination is included in the Company consolidated results of
operations for the quarter ended March 31, 2005.
The Company evaluated each of the aforementioned transactions to identify the
acquiring entity as required under SFAS 141 for business combinations effected
through an exchange of equity interests. Based on such evaluation the Company
determined that it was the acquiring entity in each transaction (and
cumulatively for all transactions) as (1) the larger portion of the relative
voting rights in the Company after each combination was retained by its
previously existing stockholders, (2) the previously existing stockholders,
through their retention of a majority of voting rights, retained the ability to
elect or appoint a voting majority of the governing body of the combined entity,
and (3) under the terms of the exchange of equity securities, the Company paid a
premium over the market value of the equity securities of the other combining
entities.
14
The following table provides a breakdown of the purchase price including the
fair value of purchase consideration issued to the sellers of the acquired
business and direct transaction expenses incurred by the Company in connection
with consummating these transactions:
COMPLETE
SECURITY ENTELAGENT
SOLUTIONS LUCIDLINE, SOFTWARE
INC. INC. CORPORATION TOTAL
----------- ----------- ----------- -----------
Cash ........................ $ -- $ 200,000 $ -- $ 200,000
Common Stock ................ 6,375,000 3,740,000 2,550,000 12,665,000
Subordinated promissory notes 4,500,000 -- -- 4,500,000
Common stock warrants ....... 1,912,500 -- -- 1,912,500
Transaction expenses ........ 398,128 154,611 359,894 912,633
----------- ----------- ----------- -----------
Total Purchase Price ..... $13,185,628 $ 4,094,611 $ 2,909,894 $20,190,133
=========== =========== =========== ===========
The fair value of common stock issued to the sellers as purchase consideration
was determined in accordance with the provisions of EITF 99-12 "Determination of
the Measurement Date for the Market Price of Acquirer Securities Issued in a
Purchase Business Combination." The fair value of subordinated notes issued to
the sellers as purchase consideration is considered to be equal to their
principal amounts due to the short-term maturity of those instruments. The
Company calculated the fair value of common stock purchase warrants issued to
the sellers as purchase consideration using the Black-Scholes option-pricing
model.
Transaction expenses, which include legal fees and transaction advisory services
directly related to the acquisitions amount to $912,633. Such fees include
$657,633 paid in cash and $255,000 for the fair value of 300,000 common stock
purchase warrants issued to Laidlaw & Company in its capacity as a transaction
advisor.
PRELIMINARY PURCHASE PRICE ALLOCATION
Under business combination accounting, the total preliminary purchase price was
allocated to CSSI's and LucidLine's net tangible and identifiable intangible
assets based on their estimated fair values as of February 25, 2005. The total
preliminary purchase price allocation for Entelagent's net tangible and
identifiable intangible assets was based on their estimated fair values as of
March 30, 2005. The preliminary allocation of the purchase price for these three
acquisitions is set forth below. The excess of the purchase price over the net
tangible and identifiable intangible assets was recorded as goodwill.
15
COMPLETE
SECURITY ENTELAGENT
SOLUTIONS LUCIDLINE, SOFTWARE
INC. INC. CORPORATION TOTAL
------------ ------------ ------------ ------------
Fair value of tangible assets:
Cash .............................. $ 399,636 $ 9,563 $ 7,198 $ 416,397
Accounts receivable ............... 118,225 22,936 84,918 226,079
Employee receivables .............. 111,773 2,000 27,500 141,273
Other current assets .............. 43,857 326 5,990 50,173
------------ ------------ ------------ ------------
Total current assets .............. 673,491 34,825 125,606 833,922
Property and Equipment ............ 62,000 61,000 12,000 135,000
Advances to prospective affiliates 2,621,470 -- -- 2,621,470
------------ ------------ ------------ ------------
Total tangible assets ............ 3,356,961 95,825 137,606 3,590,392
Liabilities assumed: .............. --
Accounts payable .................. (128,854) (32,473) (355,416) (516,743)
Advances from prospective affiliate -- (829,032) (2,363,359) (3,192,391)
Accrued expenses
and other current liabilities .. (357,391) -- (4,540,023) (4,897,414)
------------ ------------ ------------ ------------
Total current liabilities ......... (486,245) (861,505) (7,258,798) (8,606,548)
Long term liabilities ............. -- (93,796) (345,330) (439,126)
------------ ------------ ------------ ------------
Total liabilities assumed ......... (486,245) (955,301) (7,604,128) (9,045,674)
------------ ------------ ------------ ------------
Net tangible assets acquired
(liabilities assumed) ........... 2,870,716 (859,476) (7,466,522) (5,455,282)
Value of excess allocated to:
Developed technology .............. 670,000 -- 1,900,000 2,570,000
Customer relationships ............ 180,000 -- -- 180,000
Trademarks and tradenames ......... 55,000 -- 106,000 161,000
In-process research and
development ................... 190,000 -- -- 190,000
Goodwill .......................... 9,219,912 4,954,087 8,370,416 22,544,415
------------ ------------ ------------ ------------
$ 13,185,628 $ 4,094,611 $ 2,909,894 $ 20,190,133
============ ============ ============ ============
The purchase price allocation is preliminary, based on management's estimates
and a valuation study performed by an independent outside appraisal firm that
has not yet been finalized. The Company considered its intention for future use
of the acquired assets, analyses of the historical financial performance of each
of the acquired businesses and estimates of future performance of each acquired
businesses' products and services. The Company's final determination of the
purchase price allocation could result in changes to the amounts reflected in
its preliminary estimate. The Company is in the process of finalizing the
information required to file its Form 8-K with the Securities and Exchange
Commission and will do so as soon as practicable.
PROFORMA FINANCIAL INFORMATION
The unaudited financial information in the table below summarizes the combined
results of operations of the Company and CSSI, LucidLine and Entelagent, on a
proforma basis, as if the companies had been combined as of the beginning of
each of the periods presented.
The unaudited proforma financial information for the three months ended March
31, 2005 combines the historical results for Patron for the three months ended
March 31, 2005and the historical results for CSSI and LucidLine for the period
from January 1, 2005 to February 24, 2005 and the historical results for
Entelagent for the period from January 1, 2005 to March 20, 2005. The unaudited
proforma financial results for the three months ended March 31, 2004 combines
the historical results for Patron for this period with the historical results
for CSSI, Entelagent and LucidLine for the three months ended March 31, 2004.
16
THREE MONTHS ENDED MARCH 31,
2005 2004
----------- -----------
Total revenues ................................... $ 207,829 $ 215,038
Net loss ......................................... (4,635,653) (2,010,132)
Pro forma net loss per share, basic and diluted .. $ (0.08) $ (0.04)
The proforma financial information is presented for informational purposes only
and is not indicative of the results of operations that would have been achieved
if the acquisitions of these three companies had taken place at the beginning of
each of the periods presented
NOTE F - OTHER CURRENT ASSETS
Other current assets consist of the following:
MARCH 31,
2005
---------
Prepaid expenses ............................ $ 39,530
Employee advances ........................... 30,740
Deposits .................................... 5,990
---------
$ 76,260
=========
NOTE G - PROPERTY AND EQUIPMENT
MARCH 31,
2005
---------
Computers ................................... $ 142,155
Furniture and Fixtures ...................... 24,900
---------
sub-total ............................... 167,055
less: accumulated depreciation .............. (295)
---------
Property and equipment, net ............. $ 166,760
=========
Depreciation expense for the three months ended March 31, 2005 was $295.
NOTE H - DEFERRED FINANCING COSTS
Deferred financing costs, which amount to $614,079, include cash fees of
$316,579 and $297,500 representing the fair value of 350,000 common stock
purchase warrants issued to Laidlaw & Company (UK) Ltd. in their capacity as the
placement agent in the $3,500,000 Interim Bridge Financing I (Note J) in
February 2005. The fair value of the warrants was determined using the
Black-Scholes option-pricing model.
The deferred financing costs are being amortized over the minimum term of the
debt instrument issued through the financing which is 120 days. Amortization
expense amounted to $153,520 for the three months ended March 31, 2005 and is
included as a component of interest expense in the accompanying statement of
operations.
NOTE I - INTANGIBLE ASSETS
The components of intangible assets as of March 31, 2005 are set forth in the
following table:
17
NET BOOK ESTIMATED
PRELIMINARY ACCUMULATED VALUE AT USEFUL
FAIR VALUE AMORTIZATION 3/31/2005 LIFE
---------- ---------- ---------- ----------
Trademarks and tradenames ......... $ 161,000 $ 1,146 $ 159,854 4 years
Developed technology .............. 2,570,000 11,167 2,558,833 5 years
Customer relationships ............ 180,000 3,750 176,250 4 years
In-process research and development 190,000 3,167 186,833 5 years
---------- ---------- ----------
$3,101,000 $ 19,230 $3,081,770
========== ========== ==========
The Company classifies amortization of developed technology as a component of
cost of sales.
AMORTIZATION OF INTANGIBLE ASSETS
The amortization of intangible assets will result in the following expense by
year:
INTANGIBLE
YEARS ENDED DECEMBER 31, AMORTIZATION
----------------------- -------------
2005 $ 497,167
2006 637,250
2007 637,250
2008 637,250
2009 568,417
2010 123,667
NOTE J - NOTES PAYABLE
BRIDGE NOTES
On February 28, 2005, the Company completed a $3.5 million financing (the
"Interim Bridge Financing I") through the issuance of 10% Senior Convertible
Promissory Notes (the "Bridge Notes") and warrants to purchase up to 1,750,000
shares of the Company's common stock. The warrants have a term of 5 years and an
exercise price of $0.70 per share. On February 28, 2005, the warrants had a fair
value of $1,837,500 based on a closing price of $1.05 per share. Prior to
maturity, the Bridge Notes may be converted into the securities issuable at the
first closing of a subsequent financing by the Company, for such number of
offered securities as could be purchased for the principal amount being
converted. The Bridge Notes have an initial term of 120 days (due on June 28,
2005), bear interest at a contractual rate of 10% per annum and feature an
option to extend the term for an additional 60 days to August 27, 2005. As
described in Note P, the Company did not repay the Bridge Notes on the original
maturity date of June 28, 2005.
In accordance with Accounting Principles Board Opinion No. 14, the Company
allocated $2,456,140 of the proceeds to the Bridge Notes and $1,043,860 of
proceeds to the warrants. The difference between the carrying amount of the
Bridge Notes and their contractual redemption amount is being accreted as
interest expense to June 28, 2005, their earliest date of redemption. Accretion
of the aforementioned discount amounted to $260,965 for the three months ended
March 31, 2005 and is included as a component of interest expense in the
accompanying statement of operations. Contractual interest expense on the Bridge
Notes, which amounted to $29,167 for the three months ended March 31, 2005 is
also included as a component of interest expense in the accompanying statement
of operations
In the event that the Company chooses to extend the contractual maturity date of
the Bridge Notes for an additional 60 days to August 28, 2005, the contractual
interest rate will increase to 12% per annum, and the Company will be required
to issue warrants (the "Bridge Extension Warrants") to purchase such number of
shares of common stock equal to 1/2 of a share for each $1.00 of principal
amount outstanding. The Bridge Extension Warrants have a term of 5 years and an
exercise price of $0.70 per share.
If the Bridge Notes are not paid in full on or before the extended maturity
date, each noteholder will be issued a warrant ("Bridge Penalty Warrant")
entitling the holder to purchase 3.84 shares of common stock for each $1.00 of
principal amount then outstanding. The Bridge Penalty Warrants may only be
exercised by a holder's delivery of its Bridge Note in payment of the exercise
price, the delivery of which will result in the full satisfaction of all amounts
of principal and interest due and payable under such Bridge Note. The Company
has agreed to file with the SEC a registration statement for the resale of the
restricted shares of the Company's common stock issuable upon exercise of all of
the warrants issued in this transaction, on a best efforts basis.
The Company sold these securities to thirty-three accredited investors
introduced by Laidlaw & Company (UK) Ltd. ("Laidlaw"), which is the placement
agent in the Interim Bridge Financing I. As described in Note H, the Company
incurred $614,070 of fees in connection with this transaction including $297,500
for the fair value of warrants to purchase up to 350,000 shares of the Company's
common stock (the "Placement Agent Warrants") at an exercise price of $0.70 per
share.
18
The issuance and sale of the securities issued in connection with the Interim
Bridge Financing I were exempt from the registration and prospectus delivery
requirements of the Securities Act, pursuant to Section 4(2) of the Securities
Act as transactions not involving any public offering.
DEMAND NOTES PAYABLE
Through December 31, 2004, the Company borrowed an aggregate amount of $695,000
from four unrelated parties. These notes are payable on demand and bear interest
at the rate of 10% per annum. Interest expense on these notes amounted to
$17,375 and $17,375 for the three months ended March 31, 2005 and 2004,
respectively.
NOTE K - RELATED PARTY TRANSACTIONS
ADVANCES FROM STOCKHOLDERS
Certain stockholders have made working capital advances to the Company, the
unpaid balance of which amounts to $430,212 at March 31, 2005. These amounts,
which are non-interest bearing, are payable on demand.
On March 31, 2005, the Company received $500,000 in financing from Apex
Investment Fund V, LP ("Apex"), one of the selling shareholders of CSSI and a
current stockholder of the Company. In consideration of this financing from
Apex, the parties have mutually agreed that the terms of this loan will be
identical to the terms that are being offered to the investors in the Interim
Bridge Financing II, described in Note P. The Company has finalized terms and is
currently in the process of finalizing definitive agreements and notes with
respect to the terms the additional bridge financing. Accordingly, the Company
has classified the advance from Apex as a demand loan pending the completion of
the agreements and notes.
EXPENSE REIMBURSEMENTS DUE TO OFFICERS AND STOCKHOLDERS
Certain stockholders and officers of the Company have paid expenses on the
Company's behalf since its inception, of which $476,174 remains outstanding at
March 31, 2005. The amounts payable to such officers and stockholders are due on
demand.
NOTES PAYABLE TO OFFICERS AND STOCKHOLDERS
Notes payable to officers and stockholders bear interest at 10% and are due on
demand. Interest expense on these notes amounted to $6,438 for the three months
ended March 31, 2005.
NOTE L - COMMON STOCK REPURCHASE OBLIGATION AND PUT RIGHT
On June 6, 2005, the Company entered into a settlement of certain claims brought
by Patrick J. Allin, the Company's former Chief Executive Officer and a former
member of the Company's Board of Directors, against the Company. This settlement
is described more fully in Note P below.
Pursuant to the Settlement Agreement and Mutual Release, the Company, among
other things, agreed to purchase from Mr. Allin and The Allin Dynastic Trust two
million (2,000,000) shares (the "Remainder Shares") through a cash payment from
the proceeds of a follow-on-financing by the Company, at a price per share equal
to the lesser of (a) $.50 per share or (b) 90% of the issue price or conversion
price, as the case may be, of the security issued in a follow-on-financing,
provided however that in the event that 90% of the issue price or conversion
price, as the case may be, of the security issued in the follow-on-financing is
less than $.50 per share, Mr. Allin and/or The Allin Dynastic Trust may, at
their option, refuse to sell any or all of the Remainder Shares to the Company.
For the Remainder Shares, the Company recorded $1,000,000 for the intrinsic
value of the 2 million shares of common stock subject to Mr. Allin's put right.
The Company also reduced the number of shares issued and outstanding by 2
million shares as of February 21, 2004. However, the Company did not remove
these shares from the number of shares issued and outstanding for the purposes
of computing Net Loss per Share on the Statements of Operations. In the event
the stock issued in the Company's proposed follow-on financing is issued at less
than $0.50
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per share and Mr. Allin refuses to sell the Remainder Shares to the Company,
this amount will be eliminated on the books of the Company.
NOTE M - ACCOMMODATION AGREEMENT
In November 2002, the Company entered into a financing arrangement with a third
party financial institution (the "Lender"), pursuant to which the Company would
borrow $950,000 under a note to be collateralized by the pledge of 950,000
shares of registered stock from five different stockholders. In connection with
this arrangement, the Company executed a series of Accommodation Agreements with
these stockholders wherein each stockholder pledged their shares in return for
the right to receive on or before November 17, 2003 the return of the pledged
shares, or replacement shares in the event of foreclosure, and one additional
share of common stock for every four shares pledged as compensation. The Company
also agreed to use "best efforts" to register these shares with the US
Securities and Exchange Commission 12 months from the date of issue.
In December 2002, the Company received approximately $450,000 of proceeds under
the note and provided the Lender the pledged shares. Since that date, no
additional proceeds were provided by the Lender and repeated attempts were made
by the Company to secure the additional proceeds. The Company has effectively
accounted for the Lender's failure to fund the facility and return the pledged
shares as a foreclosure on the loan collateral. Accordingly, the Company
recorded a $1,047,728 loss during the year ended December 31, 2002.
On March 13, 2003, the Company issued 1,200,000 replacement shares with an
aggregate fair value of $3,708,000 to the stockholders who pledged their shares
under the Accommodation Agreements. Accordingly, the Company recorded an
additional loss of $2,210,272 during the year ended December 31, 2003 for the
difference between the loss the Company recorded upon the Lender's foreclosure
of the collateral and the aggregate fair value of the replacement shares.
In addition, the Accommodation Agreements provided for the Company to pay a
penalty in the event of its failure to cause the replacement shares to be
registered on or before March 31, 2003. As a result, the Company has accrued a
penalty of 450,000 shares per quarter, which penalty amounted to $369,000 and
$255,000 in the quarters ended March 31, 2005 and 2004, respectively.
NOTE N - COMMITMENTS AND CONTINGENCIES
LEGAL PROCEEDINGS
Sherleigh Associates Inc. Profit Sharing Plan ("Sherleigh") filed a complaint
against the Company, Patrick Allin, former Chief Executive Officer of the
Company, and Robert E. Yaw, the Company's non-executive Chairman, on February 3,
2004, in the United States District Court for the Southern District of New York
(the "Court") alleging common law fraud. The complaint alleged that Sherleigh
was fraudulently induced into purchasing 1,000,000 shares of Company common
stock in reliance upon certain of the Company's press releases and allegedly
false statements by Mr. Allin and Mr. Yaw, concerning the Company's plans to
acquire two target companies, TrustWave Corporation (currently a strategic
partner of the Company) and Entelagent (a current subsidiary of the Company),
and its financing arrangements regarding those acquisitions. Sherleigh seeks
rescission of its purchase agreement and return of its $2,000,000 purchase price
or compensatory damages to be proven at trial. Mr. Allin recently entered into a
settlement agreement with Sherleigh and is requesting that the Court include in
its dismissal order a finding that the settlement is reasonable and a
prohibition against any claims by the Company or Mr. Yaw against Mr. Allin for
contribution or indemnification with respect to Sherleigh's claims. The Company
has opposed Mr. Allin's request. The issue has been fully briefed but the Court
has not yet issued any ruling on Mr. Allin's request. Discovery has been
completed, but no trial date has been set by the Court. The Company believes the
Plaintiff's claims are without merit and intends to continue to defend against
them through trial, if necessary. The amount of loss, if any, with respect to
the claim cannot be predicted or quantified at this time and, therefore, no
amounts have been recorded on the books of the Company.
Cook Associates, Inc. ("Cook Associates") filed a complaint against us in the
Circuit Court of Cook County, Illinois, on October 7, 2004, alleging breach of
contract. Cook Associates alleges that the Company contracted with Cook
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Associates to provide certain executive search services and advice regarding
potential mergers and acquisitions pursuant to Cook Associates' standard fees
policy to which the Company allegedly agreed. Cook Associates maintains that it
provided those services to the Company and is seeking approximately $528,081 in
damages. The Company believes it has valid defenses to the claims. Nonetheless,
the Company believes it is in its best interests to reach a reasonable
resolution to this matter and to avoid costly litigation. Accordingly, the
Company is currently in negotiations with Cook and believes it will reach a
reasonable settlement of all claims and potential claims without any material
adverse effects.
In December of 2004, Patrick Allin, former Chief Executive Officer informed the
Company of his intent to assert several claims against the Company for (1) sums
allegedly owed under his employment agreement with the Company, in the aggregate
amount of approximately $2,173,234, (2) indemnification from the Company in the
amount of $850,000 for the value of the shares tendered by him to Sherleigh in
connection with his settlement of that action, (3) the Company's alleged failure
to remove restrictive legends from a total of 6,500,000 shares of the Company's
common stock owned by him and the Allin Dynastic Trust, an affiliated entity,
and (4) amounts payable to him under the terms of demand notes in the amount of
$146,000 plus accrued interest. On June 6, 2005, the Company settled these
claims as described below in Note P - Subsequent Events. As a result of the
settlement, the Company accrued for certain liabilities and an additional
reserve for the stock the Company agreed to repurchase from him.
In April of 2005, Richard L. Linting, a former President of the Company's
Professional Services Group, filed a complaint against the Company and Robert E.
Yaw, II, the Company's non-executive Chairman, in the Circuit Court of Cook
County, Illinois alleging breach of his purported employment contract and
seeking sums allegedly owed under the employment contract in the amount of
$1,321,809, plus court costs and fees. The Company believes it has valid
defenses to the claims. Nonetheless, the Company has been working to settle this
claim with Mr. Linting and believes, based on discussions with legal counsel,
Mr. Linting will settle this matter for amounts of cash and stock approximately
equal to amounts already accrued on the Company's books as of the date of his
termination.
In December of 2004, Marie Graul, former Chief Financial Officer, informed the
Company of her intention to assert a claim against the Company for sums
allegedly owed under her employment agreement with the Company. The Company
believes it has valid defenses to the claims. Although the Company has been
working to settle this claim with Ms. Graul, the Company believes this claim
will enter arbitration proceedings. For Ms. Graul, the Company has recorded
accrued, but unpaid, salary of $95,139 from the start of her employment through
the date of termination, or July 17, 2003. In addition, Ms. Graul's employment
agreement specifies that if her agreement was terminated for any reason before
January 1, 2004, she would be entitled to a bonus of 25% of her base salary, or
$62,500. Therefore, the Company believes the total accrued, but unpaid payroll
due to Ms. Graul under the terms of her employment agreement is $157,639. Any
additional amounts the Company may owe Ms. Graul as a result of the arbitration
proceedings are not estimable at this time.
While the Company believes its has defenses to the claims noted above,
notwithstanding the fact that the Company intends to vigorously defend these
actions, there can be no assurance the Company will be successful in its defense
of any of these claims. In the event the Company is required to pay damages in
connection with any one or more of the claims asserted in these actions, such
payment could have a material adverse effect on the Company's business and
operations.
SEC INVESTIGATION
Pursuant to Section 20(a) of the Securities Act and Section 21(a) of the
Securities Exchange Act, the staff of the SEC (the "Staff"), issued an order (In
the Matter of Patron Systems, Inc. - Order Directing a Private Investigation and
Designating Officers to Take Testimony (C-03739-A, February 12, 2004)) (the
"Order") that a private investigation (the "SEC Investigation") be made to
determine whether certain actions of, among others, the Company, certain of its
officers and directors and others violated Section 5(a) and 5(c) of the
Securities Act and/or Section 10 and Rule 10b-5 promulgated under the Exchange
Act. Generally, the Order provides, among other things, that the Staff is
investigating (i) the legality of two (2) separate Registration Statements filed
by the Company on Form S-8, filed on December 20, 2002 and on April 2, 2003, as
amended on April 9, 2003 (collectively, the "Registration Statements"), covering
the resale of, in the aggregate, 4,375,000 shares of common stock issued to
various consultants of the Company, and (ii) whether in connection with the
purchase or sale of shares of common
21
stock, certain officers and directors of the Company and others (a) sold common
stock in violation of Section 5 of the Securities Act and/or, (b) made
misrepresentations and/or omissions of material facts and/or employed fraudulent
devices in connection with such purchases and/or sales relating to certain of
the Company's press releases regarding, among other items, proposed mergers and
acquisitions that were never consummated. If the SEC brings an action against
the Company, it could result in, among other items, a civil injunctive order or
an administrative cease-and-desist order being entered against the Company, in
addition to the imposition of a significant civil penalty. Moreover, the SEC
Investigation and/or a subsequent SEC action could affect adversely the
Company's ability to have its common stock become listed on a stock exchange
and/or quoted on the NASD Bulletin Board or NASDAQ, the Company being able to
sell its securities and/or have its securities registered with the SEC and/or in
various states and/or the Company's ability to implement its business plan. To
date, the Company's legal counsel representing the Company in such matters has
indicated that the SEC Investigation is ongoing and the Staff has not indicated
whether it will or will not recommend that the SEC bring an enforcement action
against the Company, its officers, directors and/or others.
NOTE O - STOCKHOLDERS' EQUITY
ISSUANCE OF COMMON STOCK AS PURCHASE CONSIDERATION
On February 25, 2005 the Company committed to issue an aggregate of 11,900,000
shares of its common stock with an aggregate fair value of $10,115,000 as
purchase consideration to the sellers of CSSI and LucidLine (Note E). On
February 28, 2005, the Company committed to issue an additional 3,000,000 shares
of its common stock with an aggregate fair value of $2,550,000 as purchase
consideration to the sellers of Entelagent (Note E). The aforementioned
transactions are presented as common stock to be issued in the accompanying
balance sheet and statements of stockholders' (deficiency) equity at March 31,
2005.
ISSUANCE OF COMMON STOCK PURCHASE WARRANTS
On February 25, 2005, the Company issued 2,250,000 common stock purchase
warrants with a term of 5 years and an exercise price of $0.70 per share as a
portion of purchase consideration associated with the acquisition of the
preferred stock of CSSI (Note E). The aggregate fair value of these warrants
amounted to $1,912,500.
On February 28, the Company issued warrants to purchase up to 1,750,000 shares
of its common stock to the Bridge Notes investors described in Note I.
Additionally, the Company issued 350,000 common stock purchase warrants with an
aggregate fair value of $297,500 to the Placement Agent in the Interim Bridge
Financing I transaction.
Finally, the Company also issued warrants for 300,000 shares at a $0.70 per
share exercise price to Laidlaw & Company and/or its designees in connection
with the receipt of acquisition related services for the Entelagent, LucidLine
and CSSI mergers (Note E). The aggregate fair value of these warrants amounted
to $255,000.
All of the aforementioned warrants are reflected as an increase to additional
paid-in capital in the accompanying balance sheet and statements of
stockholders' (deficiency) equity at March 31, 2005.
ISSUANCE OF COMMON STOCK AS PENALTY UNDER AN ACCOMMODATION AGREEMENT
The Accommodation Agreements (Note M) provided for a penalty in the event the
Company failed to register the replacement shares on or before March 31, 2003.
The replacement shares were not registered on or before March 31, 2003. As a
result, the Company has accrued a penalty of 450,000 shares per quarter for the
five stockholders, in the aggregate. The Company recorded charges of $369,000
and $255,000, for the periods ended March 31, 2005 and 2004, respectively. The
Company intends to include the replacement and penalty shares in a registration
statement to be filed in 2005, at which time the penalty will cease to accrue.
The penalty shares are presented as common stock to be issued in the
accompanying balance sheet and statements of stockholders' (deficiency) equity
at March 31, 2005.
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NOTE P - SUBSEQUENT EVENTS
ADDITIONAL BRIDGE FINANCING RECEIVED FROM APEX INVESTMENT FUND V, LP AND THE
NORTHWESTERN MUTUAL LIFE INSURANCE COMPANY
On April 15, 2005, Patron received an additional $200,000 from Apex. Then, on
May 2, 2005, Patron received $200,000 from Apex. Finally, on June 15, 2005,
Patron received $750,000 from Apex.
On July 1, 2005, Patron received an additional $200,000 from The Northwestern
Mutual Life Insurance Company ("Northwestern").
In consideration of this financing from Apex and Northwestern, the parties have
mutually agreed that Apex and Northwestern will be offered the same terms as
investors in the Interim Bridge Financing II, described above. This mutual
agreement was entered into on a verbal basis. As of the date of this filing, the
Company has finalized terms and is currently in the process of finalizing
definitive agreements and notes with respect to the additional bridge financing.
SETTLEMENT WITH PATRICK J. ALLIN, FORMER CHIEF EXECUTIVE OFFICER
On June 6, 2005, the Company entered into a settlement of certain claims brought
by Patrick J. Allin, the Company's former Chief Executive Officer and a former
member of the Company's Board of Directors, against the Company. Pursuant to the
Settlement Agreement and Mutual Release dated June 2, 2005, among the Company,
Mr. Allin and The Allin Dynastic Trust, the Company agreed to pay to Mr. Allin,
in settlement of Mr. Allin's claims, an aggregate payment of One Million One
Hundred Fifty Thousand Dollars ($1,150,000) payable as follows: (i) Two Hundred
Thousand Dollars ($200,000) paid upon execution of the Settlement Agreement and
Mutual Release and (ii) Nine Hundred Fifty Thousand Dollars ($950,000) payable
in cash and/or a promissory note upon the consummation of a follow-on-financing
by the Company. The parties also agreed to release all claims existing as of the
date of the Settlement Agreement and Mutual Release. The Settlement Agreement
and Mutual Release terminates by its terms if the Company does not consummate a
follow-on-financing by August 15, 2005. The Company has fully reserved for the
amount at February 21, 2004. The Company had already accrued an aggregate of
$927,167 in amounts repayable to Mr. Allin at February 21, 2004. The difference
between the amounts already accrued and the cash settlement amount of $216,507
is included in General and Administrative expense in the three months ending
March 31, 2004 in the accompanying statement of operations.
Pursuant to the Settlement Agreement and Mutual Release, the Company also agreed
to purchase from Mr. Allin and The Allin Dynastic Trust an aggregate of four
million (4,000,000) shares of the Company's common stock as follows: (i) two
million (2,000,000) shares (the "Initial Shares") through the issuance of
promissory notes in the aggregate principal amount of One Million Six Hundred
Thousand Dollars ($1,600,000) and (ii) two million (2,000,000) shares (the
"Remainder Shares") through a cash payment from the proceeds of a
follow-on-financing by the Company, at a price per share equal to the lesser of
(a) $.50 per share or (b) 90% of the issue price or conversion price, as the
case may be, of the security issued in a follow-on-financing, provided however
that in the event that 90% of the issue price or conversion price, as the case
may be, of the security issued in the follow-on-financing is less than $.50 per
share, Mr. Allin and/or The Allin Dynastic Trust may, at their option, refuse to
sell any or all of the Remainder Shares to the Company. The Initial Shares are
to be held in escrow pursuant to a mutually agreed upon Escrow Agreement to be
subsequently entered into between the parties. Each of Mr. Allin and The Allin
Dynastic Trust have agreed to lock-up their shares until the shorter of (y) the
six month period subsequent to the consummation of a follow-on-financing and (z)
the date on which the next registration statement filed by the Company becomes
effective.
The promissory notes issued to purchase the Initial Shares bear interest at an
annual rate of 8%, with interest payments due and payable on the last day of
August, November, February and May during the term of the promissory notes, with
a maturity date of June 30, 2006. In addition, if the Company defaults on
certain terms under the promissory notes, and such default remains uncured for
five days, all payments under the promissory notes accelerate and the Company
agrees to confess to a judgment against the Company in a court of the promissory
note holder's choosing in Cook County, Illinois. In the alternative, the holders
of the promissory notes may demand that
23
the shares purchased by the promissory notes be returned in fulfillment of all
obligations remaining under such promissory notes.
As a result of this agreement to repurchase shares of common stock from Mr.
Allin and The Allin Dynastic Trust, the Company has applied hindsight to record
certain liabilities and adjustments to equity. On February 21, 2004, for the
first 2 million shares, the Company recorded a note payable to Mr. Allin
amounting to $1,738,667, representing $1,600,000 in principal and $138,667
interest payable quarterly from June 6, 2005 to June 6, 2006. On June 6, 2005,
the closing price of our common stock was $0.65, representing a stock buy-back
commitment based on the fair value of the 2 million shares of common stock of
$1,300,000. The remaining $438,667 was recorded as a litigation loss.
For the Remainder Shares, the Company recorded $1,000,000 for the intrinsic
value of the 2 million shares of common stock subject to Mr. Allin's put right.
The Company also reduced the number of shares issued and outstanding by 2
million shares as of February 21, 2004. However, the Company did not remove
these shares from the number of shares issued and outstanding for the purposes
of computing Net Loss per Share on our Statements of Operations.
In the event the stock issued in the Company's proposed follow-on financing is
issued at less than $0.50 per share and Mr. Allin refuses to sell the Remainder
Shares to the Company, this amount will be eliminated on the books of the
Company.
INTERIM BRIDGE FINANCING II
On June 6, 2005, the Company completed a new $2,543,000 financing (the "Interim
Bridge Financing II") through the issuance of (i) 10% Junior Convertible
Promissory Notes and (ii) warrants to purchase up to 1,271,500 shares of common
stock. The warrants have a term of 5 years and an exercise price of $0.60 per
share. On June 6, 2005, the warrants had a fair value of $826,475 based on a
closing price of $0.65 per share. Prior to maturity, the Junior Convertible
Promissory Notes may be converted into the securities offered by the Company at
the first closing of a subsequent financing for the Company, for such number of
offered securities as could be purchased for the principal amount being
converted. The Junior Convertible Promissory Notes have an initial term of 120
days, with an option for the Company to extend the term for an additional 60
days, and pay interest at a rate of 10% per annum. Upon the extension of the
maturity date of the Junior Convertible Promissory Notes, the associated
interest payable will be increased to 12% per annum, and the Company will be
required to issue warrants to purchase such number of shares of the Company's
common stock equal to one-half of a share for each $1.00 of principal amount
outstanding. The warrants issuable upon extension of the maturity date of the
Junior Convertible Promissory notes will have a term of 5 years and an exercise
price of $0.60 per share. In addition, if the Junior Convertible Promissory
Notes are not paid in full on or before the extended maturity date, each
noteholder will be issued a warrant entitling the holder to purchase 3.84 shares
of the Company's common stock for each $1.00 of principal amount then
outstanding. The warrants issuable in connection with the non-payment of the
Junior Convertible Promissory Notes may only be exercised by a holder's delivery
of its Junior Convertible Promissory Note in payment of the exercise price, the
delivery of which will result in the full satisfaction of all amounts of
principal and interest due and payable under such Junior Convertible Promissory
Note. The Company has agreed to file with the Securities and Exchange Commission
a registration statement for the resale of the restricted shares of its common
stock issuable upon exercise of the Warrants on a best efforts basis.
The Company sold these securities to seven accredited investors introduced by
Laidlaw & Company (UK) Ltd. ("Laidlaw"). Laidlaw acted as a broker in the
Interim Bridge Financing II. For its services as a broker, the Company paid
Laidlaw a cash fee of $305,160, including the reimbursement of costs, and issued
to Laidlaw and/or its designees warrants to purchase up to 152,580 shares of the
Company's common stock at an exercise price of $0.60 per share.
The issuance and sale of the securities issued or issuable in connection with
the Interim Bridge Financing II were exempt from the registration and prospectus
delivery requirements of the Securities Act of 1933, as amended (the "Securities
Act") pursuant to Section 4(2) of the Securities Act as transactions not
involving any public offering.
24
EXTENSION OF ACQUISITION AND BRIDGE NOTE MATURITY DATES
On February 28, 2005, the Company completed a $3.5 million financing (the
"Interim Bridge Financing I") through the issuance of 10% Senior Convertible
Promissory Notes (the "Bridge Notes") and warrants to purchase up to 1,750,000
shares of the Company's common stock (Note H). The Bridge Notes have an initial
term of 120 days (due on June 28, 2005), bear interest at a contractual rate of
10% per annum and feature an option to extend the term for an additional 60 days
to August 27, 2005. The Bridge Notes were not repaid as of June 28, 2005 and the
option to extend the term for an additional 60 days was exercised.
On February 25, 2005, Subordinated Notes were issued to the holders of the
outstanding preferred stock of CSSI (Note E). These notes have an initial term
of 120 days (due on June 25, 2005), with the Company's option to extend the term
for an additional 60 days to August 24, 2005. The Subordinated Notes are
interest free and automatically convert into the securities offered by the
Company at the first closing of a subsequent financing for the Company, for such
number of offered securities as could be purchased for the principal amount
being converted. The Subordinated Notes were not redeemed as of June 25, 2005
and the option to extend the term for an additional 60 days was exercised.
SETTLEMENT WITH COOK ASSOCIATES, INC.
On June 29, 2005, the Company entered into a settlement with Cook Associates to
settle all claims and potential claims related to the lawsuit that had been
filed by Cook Associates against the Company. Under the terms of the settlement,
Cook Associates agreed to dismiss its lawsuit and associated claim for $528,081
in damages and the Company agreed to remove any and all conditions/restrictions
that would prevent the 600,000 shares of Company common stock owned by Cook
Associates from being freely traded.
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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
PATRON SYSTEMS, INC. AND SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
MARCH 31, 2005
The following discussion and analysis should be read in conjunction with the
Annual Report on Form 10-KSB, including the consolidated financial statements,
and the related notes thereto, for the years ended December 31, 2004, 2003 and
2002 of Patron Systems, Inc. and subsidiaries (collectively referred to as
"Patron," the "Company," "we," "us," or "our"). Except for historical
information contained herein, the matters discussed below are forward-looking
statements made pursuant to the safe harbor provisions of the Private Securities
Litigation Reform Act of 1995. Such statements involve risks and uncertainties,
including, but not limited to, economic, governmental, political, competitive
and technological factors affecting our operations, markets, products, prices
and other factors discussed elsewhere in this report and other reports filed by
us with the SEC. These factors may cause results to differ materially from the
statements made in this report or otherwise made by or on our behalf.
OVERVIEW
On February 25, 2005, we consummated the acquisitions of Complete Security
Solutions, Inc. and LucidLine, Inc. pursuant to the filings of Agreements and
Plans of Merger with the Secretaries of State of the States of Delaware and
Illinois, respectively. On February 28, 2005, Patron Systems, Inc. consummated a
private placement with accredited investors in the amount of $3.5 million. On
March 30, 2005, we consummated the acquisition of Entelagent Software Corp.
pursuant to the filing of an Agreement and Plan of Merger with the Secretary of
State of the State of California. On March 31, 2005, we borrowed $500,000 from a
shareholder, Apex Investment Fund V, LP. Subsequent to March 31, 2005 we raised
approximately $3,893,000 in additional gross funds in five capital financing
transactions. Net proceeds from these transaction amounted to $3,587,840 which
were used principally to fund operations. We discuss these transactions in
further detail in this report.
Our acquisitions have allowed us to develop a platform for trusted security
services and next generation integrated security products, which we intend to
deliver to global corporations and government institutions. We intend to work
with organizations to ensure that global enterprises implement information
security policies, procedures and products that result in "trusted" information
environments.
We currently offer software solutions that fit into overall corporate compliance
and data protection initiatives by automatically finding, archiving and applying
persistent protection to sensitive data - beyond authentication - whenever,
wherever and however sensitive data is shared, accessed and stored. Additionally
we offer software solutions that support real-time secure collection, delivery
and sharing of field-based report information. This software allows law
enforcement and public-safety agencies to have real-time access to field
reporting data for use inside a department or in a multi-jurisdictional
information sharing system.
We also offer a range of services to corporate and government entities utilizing
fiber optics and data replication technologies to provide secure robust off-site
data backup, recovery, restoration, and retrieval services coupled with
high-speed data communication turnkey solutions. Our secure and scalable
high-speed data communication solutions facilitate seamless instantaneous backup
of mission critical business data and enable immediate access to data and
real-time restoration of critical business functionality in the event of a
crisis or disaster. Additionally, we offer our clients a comprehensive Risk and
Vulnerability Assessment (RAVA) evaluation service. This service provides
security and business impact assessments, which evaluate an organization's
compliance with both Homeland Security and NTSA standards.
Furthermore, we intend to address the homeland security requirements that are
being imposed on state, county and municipal governments. The Company believes
that we offer state, county and municipal governments a unique
26
group of product and service offerings focused on their specific homeland
security information infrastructure issues. This is accomplished by utilizing
the full range of our capabilities for evaluating and assessing information
infrastructure risks and vulnerabilities, combined with our experience in
designing, implementing and managing large, secure information infrastructure
systems. Also contributing is our extensive experience in implementing
real-time, secure data collection and the multi-jurisdictional sharing of law
enforcement and public-safety information combined with our experience in
developing and deploying software solutions which provide secure data and
content delivery and management.
CRITICAL ACCOUNTING POLICIES
The preparation of financial statements and related disclosures in conformity
with accounting principles generally accepted in the United States requires
management to make estimates and assumptions that affect the amounts reported in
the Condensed Consolidated Financial Statements and Notes thereto. Our
application of accounting policies affects these estimates and assumptions.
Actual results could differ from these estimates under different assumptions or
conditions.
BASIS OF PRESENTATION
In accordance with Statement of Financial Accounting Standard ("SFAS") No.7, we
considered our business to be a development stage enterprise through December
31, 2004, as our activities principally consisted of raising capital and
screening potential acquisition candidates in the information and homeland
security segments, During the quarter ended March 31, 2005, we effected business
combinations with CSSI, LucidLine and Entelagent. Each of the acquired
businesses has developed technologies, customer bases and generates revenue.
Accordingly, we no longer consider our business to be a development stage
enterprise effective for the quarter ended March 31, 2005.
REVENUE RECOGNITION
We derive revenues from the following sources: (1) sales of computer software,
which includes new software licenses and software updates and product support
revenues and (2) services, which include internet access, back-up, retrieval and
restoration services and professional consulting services.
We apply the revenue recognition principles set forth under AICPA Statement of
Position ("SOP") 97-2 "Software Revenue Recognition" and Securities and Exchange
Commission Staff Accounting Bulletin ("SAB") 104 "Revenue Recognition" with
respect to all of its revenue. Accordingly, we record revenue when (i)
persuasive evidence of an arrangement exists, (ii) delivery has occurred, (iii)
the vendor's fee is fixed or determinable, and (iv) collectability is probable.
We generate revenues through sales of software licenses and annual support
subscription agreements which include access to technical support and software
updates (if and when available). Software license revenues are generated from
licensing the rights to use our products directly to end-users and through third
party service providers.
Revenues from software license agreements are generally recognized upon delivery
of software to the customer. All of our software sales are supported by a
written contract or other evidence of sale transaction such as a customer
purchase order. These forms of evidence clearly indicate the selling price to
the customer, shipping terms, payment terms (generally 30 days) and refund
policy, if any. The selling prices of these products are fixed at the time the
sale is consummated.
Revenue from post contract customer support arrangements or undelivered elements
are deferred and recognized at the time of delivery or over the period in which
the services are performed based on vendor specific objective evidence of fair
value for such undelivered elements. Vendor specific objective evidence is
typically based on the price charged when an element is sold separately or, if
an element is not sold separately, on the price established by an authorized
level of management, if it is probable that the price, once established, will
not change before market introduction. We use the residual method prescribed in
SOP 98-9 to allocate revenues to delivered elements once it has established
vendor-specific evidence for such undelivered elements.
27
We provide internet access and back-up, retrieval and restoration services under
contractual arrangements with terms ranging from 1 year to 5 years. These
contracts are billed monthly, in advance, based on the contractually stated
rates. At the inception of a contract, we may activate the customer's account
for a contractual fee that it amortizes over the term of the contract in
accordance with Emerging Issues Task Force Issue ("EITF") 00-21 "Revenue
Arrangements with Multiple Deliverables." Our standard contracts are
automatically renewable by the customer unless terminated on 30 days written
notice. Early termination of the contract generally results in an early
termination fee equal to the lesser of six months of service or the remaining
term of the contract.
Professional consulting services are billed based the number of hours of
consultant services provided and the hourly billing rates. We recognize revenue
under these arrangements as the service is performed.
Revenue from the resale of third-party hardware and software is recognized upon
delivery provided there are no further obligations to install or modify the
hardware or software. Revenue from the sales of hardware/software is recorded at
the gross amount of the sale when the contract satisfies the requirements of
Emerging Issues Task Force ("EITF") 99-19.
BUSINESS COMBINATIONS
In accordance with business combination accounting, we allocate the purchase
price of acquired companies to the tangible and intangible assets acquired,
liabilities assumed, as well as in-process research and development based on
their estimated fair values. We have engaged a third-party appraisal firm to
assist management in determining the fair values of certain assets acquired and
liabilities assumed. Such a valuation requires management to make significant
estimates and assumptions, especially with respect to intangible assets.
Management makes estimates of fair value based upon assumptions believed to be
reasonable. These estimates are based on historical experience and information
obtained from the management of the acquired companies. Critical estimates in
valuing certain of the intangible assets include but are not limited to: future
expected cash flows from license sales, maintenance agreements, customer
contracts and acquired developed technologies; expected costs to develop the
in-process research and development into commercially viable products; the
acquired company's brand awareness and market position, as well as assumptions
about the period of time the acquired brand will continue to be used in the
combined company's product portfolio; and discount rates. These estimates are
inherently uncertain and unpredictable. Assumptions may be incomplete or
inaccurate, and unanticipated events and circumstances may occur which may
affect the accuracy or validity of such assumptions, estimates or actual
results.
GOODWILL AND INTANGIBLE ASSETS
We account for Goodwill and Intangible Assets in accordance with SFAS No. 141,
"Business Combinations" and SFAS No. 142, "Goodwill and Other Intangible
Assets." Under SFAS No. 142, goodwill and intangibles that are deemed to have
indefinite lives are no longer amortized but, instead, are to be reviewed at
least annually for impairment. Intangible assets continue to be amortized over
their estimated useful lives.
INCOME TAXES
We account for income taxes pursuant to Statement of Financial Accounting
Standards (SFAS) No. 109, Accounting for Income Taxes. Deferred taxes arise from
temporary differences, primarily attributable to the use of the cash method for
tax purposes and accrual method for book purposes and net operating loss
carry-forwards.
NET LOSS PER SHARE
Basic net loss per common share is computed by dividing net loss by the
weighted-average number of common shares outstanding during the period. Diluted
net loss per common share also includes common stock equivalents outstanding
during the period if dilutive. Diluted net loss per common share has been
computed by dividing net loss by the weighted-average number of common shares
outstanding without an assumed increase in common shares outstanding for common
stock equivalents; as such common stock equivalents are anti-dilutive.
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STOCK OPTION PLANS
As permitted under SFAS No. 148 "Accounting for Stock-Based Compensation -
Transition and Disclosure," which amended SFAS No. 123 "Accounting for
Stock-Based Compensation," we have elected to continue to follow the intrinsic
value method in accounting for our stock-based compensation arrangements as
defined by Accounting Principles Board ("APB") Opinion No. 25 "Accounting for
Stock Issued to Employees," and related interpretations including Financial
Accounting Standards Board ("FASB") Interpretation No. 44 "Accounting for
Certain Transactions Involving Stock Compensation," an interpretation of APB No.
25.
NON-EMPLOYEE STOCK BASED COMPENSATION
We record the cost of stock based compensation awards that we have issued to
non-employees for services at either the fair value of the services rendered or
the instruments issued in exchange for such services, whichever is more readily
determinable, using the measurement date guidelines enumerated in Emerging
Issues Task Force Issue ("EITF") 96-18, "Accounting for Equity Instruments That
Are Issued to Other Than Employees for Acquiring, or in Conjunction with
Selling, Goods or Services."
RESULTS OF OPERATIONS
THREE MONTHS ENDED MARCH 31, 2005 COMPARED TO THE THREE MONTHS ENDED MARCH 31,
2004.
For the three months ended March 31, 2005, our consolidated revenues amounted to
$48,860 compared to $0 for the three months ended March 31, 2004. The increase
is the result of business combinations that we consummated with CSSI and
LucidLine in February 2005 and Entelagent in March 2005.
Cost of Sales for the three months ended March 31, 2005 amounted to $42,171
compared to $0 for the three months ended March 31, 2004. Cost of sales during
the three months ended March 31, 2005 includes $11,167 associated with the
amortization of developed technology that we acquired from CSSI and Entelagent.
Operating expenses amounted to $1,732,894 for the three months ended March 31,
as compared to $1,181,574 for the three months ended March 31, 2004, an increase
of $551,320. The increase includes $348,179 for salaries associated with an
increase in the number of employees from acquired businesses, $431,000 for the
amortization of a stock based compensation arrangement that we entered into
during the year ended December 31, 2004 (for corporate finance advisory
services), $115,477 for legal and professional fees that we incurred principally
in connection with bringing the Company into compliance with its Securities and
Exchange Commission reporting obligations, $8,063 for deprecation and
amortization of acquired assets and $114,000 for the fair value of common stock
we are obligated to issued under a penalty provision of an Accommodation
Agreement. The increases were partially offset by a $26,750 reduction in general
and administrative expenses and $439,000 representing a charge we recorded in
2004 in connection with the settlement of litigation with a former
officer/stockholder.
Our consolidated loss from operations for the three months ended March 31, 2005
amounted to $1,726,205 compared to a loss of $1,181,574 for the same period in
2004. Our loss increased as a result of the increase and decreases in our
revenues and operating expenses discussed above.
Interest expense during the three months ended March 31, 2005 amounted to
$496,840 for the three months ended March 31, 2005 as compared to $33,088 for
the three months ended March 31, 2004. The $463,752 increase is directly related
to our issuances of notes and increased borrowings that we made to finance our
acquisitions of CSSI, LucidLine and Entelagent and fund our working capital
needs. Interest income, which amounted to $19,250 during each of the three
months ended March 31, 2005 and 2004 represents interest earned from loans that
we made to Entelagent prior to our acquisition of that business on March 30,
2005.
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LIQUIDITY AND CAPITAL RESOURCES
We incurred a net loss of $2,203,795 for the three months ended March 31, 2005,
which includes $877,500 of non-cash charges for the fair value of common stock
we issued as penalties under certain registration rights agreements and
amortization of deferred compensation under a stock based compensation
arrangement. In addition, we used net cash flows in our operating activities of
$2,570,514 during the quarter ended March 31, 2005. Our working capital
deficiency at March 31, 2005 amounts to $17,369,308 and we are continuing to
experience shortages in working capital. We are also involved in substantial
litigation and are being investigated by the Securities and Exchange Commission
with respect to certain of our press releases and our use of form S-8 to
register shares of common stock that we issued to certain consultants in prior
periods. We cannot provide any assurance that the outcome of these matters will
not have a material adverse affect on our ability to sustain the business. Our
independent registered public accounting firm has expressed doubt about our
ability to continue as a going concern
We expect to continue incurring losses for the foreseeable future due to the
inherent uncertainty that is related to establishing the commercial feasibility
of technological products and developing a presence in new markets. Our ability
to successfully integrate acquired businesses is critical to the realization of
our business plan. We raised $4,000,000 of gross proceeds ($3,683,421 net
proceeds after the payment of certain transaction expenses) in two financing
transactions, including $500,000 that we received as an advance from a
stockholder during the three months ended March 31, 2005. We used $2,570,514 of
these proceeds to fund our operations (which includes a $1,388,000 escrow
deposit for the payment of liabilities we assumed in business combinations), and
$473,291 in investing activities, which principally includes the cash component
of purchase business combinations that we consummated during the quarter. We
also repaid an aggregate of $318,793 of certain obligations due to certain
officer/stockholders. Subsequent to March 31, 2005, we raised approximately
$3,893,000 in additional gross funds in five capital financing transactions. Net
proceeds from these transaction amounted to $3,587,840 which were used
principally to fund operations.
We are currently in the process of attempting to raise additional capital and
have taken certain steps to conserve our liquidity while we continue to
integrate the acquired businesses. Although we believe that we have access to
capital resources, we have not secured any commitments for additional financing
at this time nor can we provide any assurance that we will be successful in our
efforts to raise additional capital and/or successfully execute our business
plan.
OFF-BALANCE SHEET ARRANGEMENTS
At March 31, 2005, we did not have any relationships with unconsolidated
entities or financial partnerships, such as entities often referred to as
structured finance, variable interest or special purpose entities, which would
have been established for the purpose of facilitating off-balance sheet
arrangements or other contractually narrow or limited purposes. As such, we are
not exposed to any financing, liquidity, market or credit risk that could arise
if we had engaged in such relationships.
CAUTIONARY STATEMENTS AND RISK FACTORS
The risks noted below and elsewhere in this report and in other documents we
file with the SEC are risks and uncertainties that could cause our actual
results to differ materially from the results contemplated by the
forward-looking statements contained in this report and other public statements
we make.
RISKS RELATED TO OUR COMMON STOCK
THERE IS DOUBT ABOUT OUR ABILITY TO CONTINUE AS A GOING CONCERN.
We currently have a number of obligations that we are unable to meet without
generating additional revenues or raising additional capital. If we cannot
generate additional revenues or raise additional capital in the near future, we
may become insolvent. As of March 31, 2005, our cash balance was $366,721 and we
had a working capital deficit of $17,369,308. This raises substantial doubt
about our ability to continue as a going concern. Historically, we have funded
our capital requirements with debt and equity financing. Our ability to obtain
additional equity or debt
30
financing depends on a number of factors including our financial performance and
the overall conditions in our industry. If we are not able to raise additional
financing or if such financing is not available on acceptable terms, we may
liquidate assets, seek or be forced into bankruptcy, and/or continue operations
but suffer material harm to our operations and financial condition. These
measures could have a material adverse affect on our ability to continue as a
going concern.
INVESTORS MAY NOT BE ABLE TO ADEQUATELY EVALUATE OUR BUSINESS AND PROSPECTS DUE
TO OUR LIMITED OPERATING HISTORY, LACK OF REVENUES AND LACK OF PRODUCT
OFFERINGS.
We are at an early stage of executing our business plan and have no history of
offering information security capabilities. Combined Professional Services was
incorporated in Nevada in 1995 and Patron Systems was incorporated in Delaware
in 2002. We have not had significant business operations since inception. As a
result of our limited history, it may be difficult to plan operating expenses or
forecast our revenues accurately. Our assumptions about customer or network
requirements may be wrong. The revenue and income potential of these products is
unproven, and the markets addressed by these products are volatile. If such
products are not successful, our actual operating results could be below our
expectations and the expectations of investors and market analysts, which would
likely cause the price of our common stock to decline.
We have generated no revenue from operations as of December 31, 2004 and rely on
financing generated from our capital raising activities to fund the
implementation of our business plan. We have incurred operating and net losses
and negative cash flows from operations since our inception. As of March 31,
2005, we had an accumulated deficit of approximately $42 million. We may
continue to incur operating and net losses, due in part to implementing our
acquisitions strategy, engaging in financing activities and expansion of our
personnel and our business development capabilities. We will continue to seek
financing for the acquisition of other acquisition targets that we may identify
in the future. We continue to believe that we will secure financing in the near
future, but there can be no assurance of our success. If we are unable to obtain
the necessary funding, it will materially adversely affect our ability to
execute our business plan and to continue our operations.
In addition, we may not be able to achieve or maintain profitability, and, even
if we do achieve profitability, the level of any profitability cannot be
predicted and may vary significantly from quarter to quarter.
THERE CAN BE NO GUARANTY THAT A MARKET WILL DEVELOP FOR THE PRODUCTS WE INTEND
TO OFFER.
We currently have a limited offering of products. We intend to acquire products
through the acquisition of existing businesses. There is no guarantee, however,
that a market will develop for Internet security solutions of the type we intend
to offer. We cannot predict the size of the market for Internet security
solutions, the rate at which the market will grow, or whether our target
customers will accept our acquired products.
OUR OPERATING RESULTS MAY FLUCTUATE SIGNIFICANTLY, WHICH MAY RESULT IN
VOLATILITY OR HAVE AN ADVERSE EFFECT ON THE MARKET PRICE OF OUR COMMON STOCK.
The market prices of the securities of technology-related companies have
historically been volatile and may continue to be volatile. Thus, the market
price of our common stock is likely to be subject to wide fluctuations. If our
revenues do not grow or grow more slowly than we anticipate, if operating or
capital expenditures exceed our expectations and cannot be reduced
appropriately, or if some other event adversely affects us, the market price of
our common stock could decline. Only a small public market currently exists for
our common stock and the number of shares eligible for sale in the public market
is currently very limited, but is expected to increase. Sales of substantial
shares in the future would depress the price of our common stock. In addition,
we currently do not receive any stock market research coverage by any recognized
stock market research or trading firm and our shares are not traded on any
national securities exchange. A larger and more active market for our common
stock may not develop.
Because of our limited operations history and lack of assets and revenues to
date, our common stock is believed to be currently trading on speculation that
we will be successful in implementing our acquisition and growth strategies.
There can be no assurance that such success will be achieved. The failure to
implement our acquisitions and growth strategies would likely adversely affect
the market price of our common stock. In addition, if the market for
31
technology-related stocks or the stock market in general experiences a continued
or greater loss in investor confidence or otherwise fails, the market price of
our common stock could decline for reasons unrelated to our business, results of
operations and financial condition. The market price of our common stock also
might decline in reaction to events that affect other companies in our industry
even if these events do not directly affect us. General political or economic
conditions, such as an outbreak of war, a recession or interest rate or currency
rate fluctuations, could also cause the market price of our common stock to
decline. Our common stock has experienced, and is likely to continue to
experience, these fluctuations in price, regardless of our performance.
WE ARE CURRENTLY SUBJECT TO AN SEC INVESTIGATION.
Pursuant to Section 20(a) of the Securities Act and Section 21(a) of the
Securities Exchange Act of 1934, as amended (the "Exchange Act"), the staff of
the SEC (the "Staff"), issued an order (In the Matter of Patron Systems, Inc. -
Order Directing a Private Investigation and Designating Officers to Take
Testimony (C-03739-A, February 12, 2004)) (the "Order") that a private
investigation (the "SEC Investigation") be made to determine whether certain of
our actions, among others, certain of its officers and directors and others (as
described below) violated Section 5(a) and 5(c) of the Securities Act and/or
Section 10 and Rule 10b-5 promulgated under the Exchange Act. Generally, the
Order provides, among other things, that the Staff is investigating (i) the
legality of two (2) separate Registration Statements filed by us on Form S-8,
filed on December 20, 2002 and on April 2, 2003, as amended on April 9, 2003
(collectively, the "Registration Statements"), covering the resale of, in the
aggregate, 4,375,000 shares of common stock issued to various of our
consultants, and (ii) whether in connection with the purchase or sale of shares
of common stock, certain of our officers, directors and others (a) sold common
stock in violation of Section 5 of the Securities Act and/or, (b) made
misrepresentations and/or omissions of material facts and/or employed fraudulent
devices in connection with such purchases and/or sales relating to certain of
our press releases regarding, among other items, proposed mergers and
acquisitions that were never consummated. If the SEC brings an action against
us, it could result in, among other items, a civil injunctive order or an
administrative cease-and-desist order being entered against us, in addition to
the imposition of a significant civil penalty. Moreover, the SEC Investigation
and/or a subsequent SEC action could affect adversely our ability to have our
common stock listed on a stock exchange and/or quoted on the NASD Bulletin Board
or NASDAQ, our ability to sell our securities and/or have our securities
registered with the SEC and/or in various states and/or our ability to implement
its business plan. To date, our legal counsel representing us in such matters
has indicated that the SEC Investigation is ongoing and the Staff has not
indicated whether it will or will not recommend that the SEC bring an
enforcement action against us, our officers, directors and/or others.
THE CONCENTRATION OF OUR CAPITAL STOCK OWNERSHIP WITH INSIDERS IS LIKELY TO
LIMIT THE ABILITY OF OTHER STOCKHOLDERS TO INFLUENCE CORPORATE MATTERS.
As of June 24, 2005, the executive officers, directors and entities affiliated
with any of them together beneficially own approximately 29.56% of our
outstanding common stock. As a result, these stockholders may be able to
exercise control over matters requiring approval by our stockholders, including
the election of directors and approval of significant corporate transactions.
This concentration of ownership might also have the effect of delaying or
preventing a change in our control that might be viewed as beneficial by other
stockholders.
FUTURE SALES OF SHARES BY EXISTING STOCKHOLDERS COULD CAUSE OUR STOCK PRICE TO
DECLINE.
If our existing or future stockholders sell, or are perceived to sell,
substantial amounts of our common stock in the public market, the market price
of our common stock could decline. As of June 24, 2005, there are 55,796,712
shares of common stock outstanding, of which all but 39,234,580 shares are held
by directors, executive officers and other affiliates, the sale of which are
subject to volume limitations under Rule 144, various vesting agreements and our
quarterly and other "blackout" periods. Furthermore, shares subject to
outstanding options and warrants and shares reserved for future issuance under
our stock option plan will become eligible for sale in the public market to the
extent permitted by the provisions of various vesting agreements, the lock-up
agreements and Rule 144 under the Securities Act.
THE UNPREDICTABILITY OF AN ACQUIRED COMPANY'S QUARTERLY RESULTS MAY CAUSE THE
TRADING PRICE OF OUR COMMON STOCK TO DECLINE.
32
The quarterly revenues and operating results of companies we may acquire will
likely continue to vary in the future due to a number of factors, many of which
are outside of our control. Any of these factors could cause the price of our
common stock to decline. The primary factors that may affect future revenues and
future operating results include the following:
o the demand for our subsidiaries' current product offerings and
our future products;
o the length of sales cycles;
o the timing of recognizing revenues;
o new product introductions by us or our competitors;
o changes in our pricing policies or the pricing policies of our
competitors;
o variations in sales channels, product costs or mix of products
sold;
o our ability to develop, introduce and ship in a timely manner
new products and product enhancements that meet customer
requirements;
o our ability to obtain sufficient supplies of sole or limited
source components for our products;
o variations in the prices of the components we purchase;
o our ability to attain and maintain production volumes and
quality levels for our products at reasonable prices at our
third-party manufacturers;
o our ability to manage our customer base and credit risk and to
collect our accounts receivable; and
o the financial strength of our value-added resellers and
distributors.
Our operating expenses are largely based on anticipated revenues and a high
percentage of our expenses are, and will continue to be, fixed in the short
term. As a result, lower than anticipated revenues for any reason could cause
significant variations in our operating results from quarter to quarter and,
because of our rapidly growing operating expenses, could result in substantial
operating losses.
OUR COMMON STOCK IS SUBJECT TO THE SEC'S PENNY STOCK RULES. THEREFORE,
BROKER-DEALERS MAY EXPERIENCE DIFFICULTY IN COMPLETING CUSTOMER TRANSACTIONS AND
TRADING ACTIVITY IN OUR SECURITIES MAY BE ADVERSELY AFFECTED.
If at any time a company has net tangible assets of $5,000,000 or less and the
common stock has a market price per share of less than $5.00, transactions in
the common stock may be subject to the "penny stock" rules promulgated under the
Exchange Act. Under these rules, broker-dealers who recommend such securities to
persons other than institutional accredited investors must:
o make a special written suitability determination for the
purchaser;
o receive the purchaser's written agreement to a transaction
prior to sale;
o provide the purchaser with risk disclosure documents which
identify certain risks associated with investing in "penny
stocks" and which describe the market for these "penny stocks"
as well as a purchaser's legal remedies; and
o obtain a signed and dated acknowledgment from the purchaser
demonstrating that the purchaser has actually received the
required risk disclosure document before a transaction in a
"penny stock" can be completed.
If our common stock becomes subject to these rules, broker-dealers may find it
difficult to effectuate customer transactions and trading activity in our
securities may be adversely affected. As a result, the market price of our
securities may be depressed, and stockholders may find it more difficult to sell
their shares of our common stock.
RISKS RELATED TO OUR BUSINESS
WE MAY BE UNABLE TO SUCCESSFULLY INTEGRATE ACQUIRED BUSINESSES.
Our business plan is dependent upon the acquisition and integration of companies
that have previously operated independently. The process of integrating could
cause an interruption of, or loss of momentum in, the activities of our business
and the loss of key personnel. The diversion of management's attention and any
delays or difficulties encountered in connection with our integration of
acquired operations could have an adverse effect on our business, results of
operations, financial condition or prospects.
33
WE CURRENTLY DO NOT HAVE SUFFICIENT REVENUES TO SUPPORT OUR BUSINESS ACTIVITIES
AND IF OPERATING LOSSES CONTINUE, WILL BE REQUIRED TO OBTAIN ADDITIONAL CAPITAL
THROUGH FINANCINGS WHICH WE MAY NOT BE ABLE TO SECURE.
To achieve our intended growth, we will require substantial additional capital.
We have encountered difficulty and delays in raising capital to date and the
market environment for development stage companies, like ours, remains
particularly challenging. There can be no assurance that funds will be available
when needed or on acceptable terms. Technology companies in general have
experienced difficulty in recent years in accessing capital. Inability to obtain
additional financing may require us to delay, scale back or eliminate certain of
our growth plans which could have a material and adverse effect on our business,
financial condition or results of operations or to cease operations. Even if we
are able to obtain additional financing, such financing could be structured as
equity financing that would dilute the ownership percentage of any investor in
our securities.
DOWNTURNS IN THE INTERNET INFRASTRUCTURE, NETWORK SECURITY AND RELATED MARKETS
MAY DECREASE OUR REVENUES AND MARGINS.
The market for our current products and other products we intend to offer
depends on economic conditions affecting the broader Internet infrastructure,
network security and related markets. Downturns in these markets may cause
enterprises and carriers to delay or cancel security projects, reduce their
overall or security-specific information technology budgets or reduce or cancel
orders for our current products and other products we intend to offer. In this
environment, customers such as distributors, value-added resellers and carriers
may experience financial difficulty, cease operations and fail to budget or
reduce budgets for the purchase of our current products or other products we
intend to offer. This, in turn, may lead to longer sales cycles, delays in
purchase decisions, payment and collection, and may also result in price
pressures, causing us to realize lower revenues, gross margins and operating
margins. In addition, general economic uncertainty caused by potential
hostilities involving the United States, terrorist activities, the decline in
specific markets such as the service provider market in the United States, and
the general decline in capital spending in the information technology sector
make it difficult to predict changes in the purchase and network requirements of
our potential customers and the markets we intend to serve. We believe that, in
light of these events, some businesses may curtail or eliminate capital spending
on information technology. A decline in capital spending in the markets we
intend to serve may adversely affect our future revenues, gross margins and
operating margins and make it necessary for us to gain significant market share
from our future competitors in order to achieve our financial goals and achieve
profitability.
COMPETITION MAY DECREASE OUR PROJECTED REVENUES, MARKET SHARE AND MARGINS.
The market for network security products is highly competitive, and we expect
competition to intensify in the future. Competitors may gain market share and
introduce new competitive products for the same markets and customers we intend
to serve with our products. These products may have better performance, lower
prices and broader acceptance than the products we currently offer or intend to
offer.
Many of our potential competitors have longer operating histories, greater name
recognition, large customer bases and significantly greater financial,
technical, sales, marketing and other resources than we have. In addition, some
of our potential competitors currently combine their products with other
companies' networking and security products. These potential competitors also
often combine their sales and marketing efforts. Such activities may result in
reduced prices, lower gross and operating margins and longer sales cycles for
the products we currently offer and intend to offer. If any of our larger
potential competitors were to commit greater technical, sales, marketing and
other resources to the markets we intend to serve, or reduce prices for their
products over a sustained period of time, our ability to successfully sell the
products we intend to offer, increase revenue or meet our or market analysts
expectations could be adversely affected.
FAILURE TO ADDRESS EVOLVING STANDARDS IN THE NETWORK SECURITY INDUSTRY AND
SUCCESSFULLY DEVELOP AND INTRODUCE NEW PRODUCTS OR PRODUCT ENHANCEMENTS WOULD
CAUSE OUR REVENUES TO DECLINE.
The market for network security products is characterized by rapid technological
change, frequent new product introductions, changes in customer requirements and
evolving industry standards. We expect to introduce our products and
enhancements to existing products to address current and evolving customer
requirements and broader networking trends and vulnerabilities. We also expect
to develop products with strategic partners and incorporate
34
third-party advanced security capabilities into our intended product offerings.
Some of these products and enhancements may require us to develop new hardware
architectures that involve complex and time-consuming processes. In developing
and introducing our intended product offerings, we have made, and will continue
to make, assumptions with respect to which features, security standards and
performance criteria will be required by our potential customers. If we
implement features, security standards and performance criteria that are
different from those required by our potential customers, market acceptance of
our intended product offerings may be significantly reduced or delayed, which
would harm our ability to penetrate existing or new markets.
Furthermore, we may not be able to develop new products or product enhancements
in a timely manner, or at all. Any failure to develop or introduce these new
products and product enhancements might cause our existing products to be less
competitive, may adversely affect our ability to sell solutions to address large
customer deployments and, as a consequence, our revenues may be adversely
affected. In addition, the introduction of products embodying new technologies
could render existing products we intend to offer obsolete, which would have a
direct, adverse effect on our market share and revenues. Any failure of our
future products or product enhancements to achieve market acceptance could cause
our revenues to decline and our operating results to be below our expectations
and the expectations of investors and market analysts, which would likely cause
the price of our common stock to decline.
WE HAVE MATERIAL WEAKNESSES IN OUR FINANCIAL SYSTEMS, INTERNAL CONTROLS AND
OPERATIONS THAT COULD HAVE A MATERIAL ADVERSE EFFECT ON OUR OPERATIONS,
FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
Our ability to sell our intended product offerings and implement our business
plan successfully in a volatile and growing market requires effective management
and financial systems and a system of financial processes and controls. Our
Chief Executive Officer and Acting Chief Financial Officer evaluated the
effectiveness of our disclosure controls and procedures in accordance with
Exchange Act Rules 13a-15 or 15d-15 and identified material weaknesses in our
internal control relating to, among other things, our limited segregation of
duties, ability to identify and record complex transactions including capital
financing transactions and business combinations and timely file our tax
returns. The identification of these material weaknesses has led our Chief
Executive Officer and Acting Chief Financial Officer to conclude that our
disclosure controls and procedures are currently not adequate to enable us to
record, process, summarize and report information required to be included in our
periodic SEC filings within the required time period.
We have limited management resources to date and are still establishing our
management and financial systems. Growth, to the extent it occurs, is likely to
place a considerable strain on our management resources, systems, processes and
controls. To address these issues, we will need to continue to improve our
financial and managerial controls, reporting systems and procedures, and will
need to continue to expand, train and manage our work force worldwide. If we are
unable to maintain an adequate level of financial processes and controls, we may
not be able to accurately report our financial performance on a timely basis and
our business and stock price would be harmed.
IF OUR FUTURE PRODUCTS DO NOT INTEROPERATE WITH OUR END CUSTOMERS' NETWORKS,
INSTALLATIONS WOULD BE DELAYED OR CANCELLED, WHICH COULD SIGNIFICANTLY REDUCE
OUR ANTICIPATED REVENUES.
Future products will be designed to interface with our end customers' existing
networks, each of which have different specifications and utilize multiple
protocol standards. Many end customers' networks contain multiple generations of
products that have been added over time as these networks have grown and
evolved. Our future products must interoperate with all of the products within
these networks as well as with future products that might be added to these
networks in order to meet end customers' requirements. If we find errors in the
existing software used in our end customers' networks, we may elect to modify
our software to fix or overcome these errors so that our products will
interoperate and scale with their existing software and hardware. If our future
products do not interoperate with those within our end customers' networks,
installations could be delayed or orders for our products could be cancelled,
which could significantly reduce our anticipated revenues.
AS A PUBLIC COMPANY, WE MAY INCUR INCREASED COSTS AS A RESULT OF RECENTLY
ENACTED AND PROPOSED CHANGES IN LAWS AND REGULATIONS RELATING TO CORPORATE
GOVERNANCE MATTERS AND PUBLIC DISCLOSURE.
Recently enacted and proposed changes in the laws and regulations affecting
public companies, including the provisions of the Sarbanes-Oxley Act of 2002 and
rules adopted or proposed by the SEC will result in increased
35
costs for us as we evaluate the implications of these laws, regulations and
standards and respond to their requirements. These laws and regulations could
make it more difficult or more costly for us to obtain certain types of
insurance, including director and officer liability insurance, and we may be
forced to accept reduced policy limits and coverage or incur substantially
higher costs to obtain the same or similar coverage. The impact of these events
could also make it more difficult for us to attract and retain qualified persons
to serve on our board of directors, board committees or as executive officers.
We cannot estimate the amount or timing of additional costs we may incur as a
result of these laws and regulations.
WE WILL DEPEND ON OUR KEY PERSONNEL TO MANAGE OUR BUSINESS EFFECTIVELY IN A
RAPIDLY CHANGING MARKET, AND IF WE ARE UNABLE TO HIRE ADDITIONAL PERSONNEL OR
RETAIN EXISTING PERSONNEL, OUR ABILITY TO EXECUTE OUR BUSINESS STRATEGY WOULD BE
IMPAIRED.
Our future success depends upon the continued services of our executive
officers. The loss of the services of any of our key employees, the inability to
attract or retain qualified personnel in the future, or delays in hiring
required personnel, could delay the development and introduction of, and
negatively impact our ability to sell, our intended product offerings.
WE MIGHT HAVE TO DEFEND LAWSUITS OR PAY DAMAGES IN CONNECTION WITH ANY ALLEGED
OR ACTUAL FAILURE OF OUR PRODUCTS AND SERVICES.
Because our intended product offerings and services provide and monitor network
security and may protect valuable information, we could face claims for product
liability, tort or breach of warranty. Anyone who circumvents our security
measures could misappropriate the confidential information or other property of
end customers using our products, or interrupt their operations. If that
happens, affected end customers or others may sue us. Defending a lawsuit,
regardless of its merit, could be costly and could divert management attention.
Our business liability insurance coverage may be inadequate or future coverage
may be unavailable on acceptable terms or at all.
WE COULD BECOME SUBJECT TO LITIGATION REGARDING INTELLECTUAL PROPERTY RIGHTS
THAT COULD BE COSTLY AND RESULT IN THE LOSS OF SIGNIFICANT RIGHTS.
In recent years, there has been significant litigation in the United States
involving patents and other intellectual property rights. We may become a party
to litigation in the future to protect our intellectual property or as a result
of an alleged infringement of another party's intellectual property. Claims for
alleged infringement and any resulting lawsuit, if successful, could subject us
to significant liability for damages and invalidation of our proprietary rights.
These lawsuits, regardless of their success, would likely be time-consuming and
expensive to resolve and would divert management time and attention. Any
potential intellectual property litigation could also force us to do one or more
of the following:
o stop or delay selling, incorporating or using products that
use the challenged intellectual property; and/or
o obtain from the owner of the infringed intellectual property
right a license to sell or use the relevant technology, which
license might not be available on reasonable terms or at all;
or redesign the products that use that technology.
If we are forced to take any of these actions, our business might be seriously
harmed. Our insurance may not cover potential claims of this type or may not be
adequate to indemnify us for all liability that could be imposed.
THE INABILITY TO OBTAIN ANY THIRD-PARTY LICENSE REQUIRED TO DEVELOP NEW PRODUCTS
AND PRODUCT ENHANCEMENTS COULD REQUIRE US TO OBTAIN SUBSTITUTE TECHNOLOGY OF
LOWER QUALITY OR PERFORMANCE STANDARDS OR AT GREATER COST, WHICH COULD SERIOUSLY
HARM OUR BUSINESS, FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
From time to time, we may be required to license technology from third parties
to develop new products or product enhancements. Third-party licenses may not be
available to us on commercially reasonable terms or at all. The inability to
obtain any third-party license required to develop new products or product
enhancements could require us to obtain substitute technology of lower quality
or performance standards or at greater cost, which could seriously harm our
business, financial condition and results of operations.
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GOVERNMENTAL REGULATIONS AFFECTING THE IMPORT OR EXPORT OF PRODUCTS COULD
NEGATIVELY AFFECT OUR REVENUES.
Governmental regulation of imports or exports or failure to obtain required
export approval of our encryption technologies could harm our international and
domestic sales. The United States and various foreign governments have imposed
controls, export license requirements and restrictions on the import or export
of some technologies, especially encryption technology. In addition, from time
to time, governmental agencies have proposed additional regulation of encryption
technology, such as requiring the escrow and governmental recovery of private
encryption keys.
In particular, in light of recent terrorist activity, governments could enact
additional regulation or restrictions on the use, import or export of encryption
technology. Additional regulation of encryption technology could delay or
prevent the acceptance and use of encryption products and public networks for
secure communications. This might decrease demand for our intended product
offerings and services. In addition, some foreign competitors are subject to
less stringent controls on exporting their encryption technologies. As a result,
they may be able to compete more effectively than we can in the domestic and
international network security market.
MANAGEMENT COULD INVEST OR SPEND OUR CASH OR CASH EQUIVALENTS AND INVESTMENTS IN
WAYS THAT MIGHT NOT ENHANCE OUR RESULTS OF OPERATIONS OR MARKET SHARE.
We have made no specific allocations of our cash or cash equivalents and
investments. Consequently, management will retain a significant amount of
discretion over the application of our cash or cash equivalents and investments
and could spend the proceeds in ways that do not improve our operating results
or increase our market share. In addition, these proceeds may not be invested to
yield a favorable rate of return.
ITEM 3. CONTROLS AND PROCEDURES
Members of our management, including our Chief Executive Officer and Acting
Chief Financial Officer, have evaluated the effectiveness of our disclosure
controls and procedures, as defined by paragraph (e) of Exchange Act Rules
13(a)-15 or 15(d)-15. Based on that evaluation and the material weakness
described below, our Chief Executive Officer and Acting Chief Financial Officer
concluded that our disclosure controls and procedures were not adequate to
enable us to record, process, summarize and report information required to be
included in our periodic SEC filings within the required time period.
DISCLOSURE CONTROLS AND INTERNAL CONTROLS
Disclosure controls are procedures that are designed with the objective of
ensuring that information required to be disclosed in our reports filed under
the Securities Exchange Act of 1934, as amended, such as this Report, is
recorded, processed, summarized and reported within the time periods specified
in the SEC's rules and forms. Disclosure controls are also designed with the
objective of ensuring that such information is accumulated and communicated to
our management, including our Chief Executive Officer and Senior Vice President,
Finance and Administration, as appropriate, to allow timely decisions regarding
required disclosure. Internal controls are procedures which are designed with
the objective of providing reasonable assurance that our transactions are
properly authorized, recorded and reported and our assets are safeguarded
against unauthorized or improper use, to permit the preparation of our financial
statements in conformity with generally accepted accounting principles.
Our company is not an "accelerated filer" (as defined in the Securities Exchange
Act) and is not required to deliver management's report on control over our
financial reporting until our fiscal year ended December 31, 2006. Nevertheless,
we identified certain matters that would constitute material weaknesses (as
defined under the Public Company Accounting Oversight Board Auditing Standard
No. 2) in our internal controls over financial reporting.
We have identified deficiencies in our system of internal controls, which are
considered to be material weaknesses. These material weaknesses have led us to
conclude that we currently have an inadequate structure with respect to our
financial reporting systems. Until March of 2005, we had no central corporate
accounting department. Each of our subsidiaries separately maintained its own
books and records and independently controlled its cash disbursements and cash
receipts. The decentralized nature of our accounting system limits the
effectiveness of our
37
internal control procedures and our ability to detect potential misstatements
and incorrect accounting and financial reporting. The subsidiary accounting
departments do not have the sophistication to critically evaluate and implement
new accounting pronouncements, and stock based transactions for options,
warrants and common stock, At times these transactions were not recorded
properly and required additional procedures and review and we were required to
record adjustments proposed by our independent registered public accounting
firm.
Certain of the material weaknesses we identified relate to our limited
segregation of duties. Segregation of duties within our company is limited due
to the fact that we have not had (until recently) any full-time employees since
February 10, 2004 and, until the completion of business combination during the
quarter ended Maecg 31, 2005, our Company's affairs have been managed by our
non-executive Chairman and Sole Director Robert E, Yaw, II. In addition, our
financial records up until that time were maintained by a former employee who
had been providing these services to us on a consulting basis. This condition
constituted a material weakness in our financial reporting system and a system
of internal controls that has affected our ability to timely close our books on
a quarterly and annual basis.
The second material weakness we identified is in our ability to implement the
requirements of complex accounting pronouncements. We have had difficulty with
ensuring that the accounting for our equity-based transactions is accurate and
complete. Since April 30, 2002 (Inception), we have consummated a series of
complex equity transactions involving the application of highly specialized
accounting principles. The equity based transactions that we have had difficulty
with specifically relate to stock to be issued under consulting agreements, the
penalty shares to be issued in connection with the Accommodation Agreements, and
the common stock to be repurchased in connection with the Allin Settlement
Agreement. We also experienced difficulty with applying the requirements of SFAS
141 "Business Combinations" and related pronouncement as it relates to our
acquisitions of CSSI, LucidLine and Entelagent. Although we believe that certain
of these events are unique and that our equity based transactions in the future
are likely to be substantially reduced, we are evaluating certain corrective
measures to provide us with the structure we need at such times that we may
engage in equity based transactions and consummate additional business
combinations in the future.
The third material weakness we identified is in our ability to implement a tax
reporting structure to file, on a timely basis, Federal and state tax returns.
This material weakness is primarily due to our limited segregation of duties.
Through our acquisitions of CSSI, LucidLine and Entelagent, we have
significantly increased the number of employees working for us and intend to
implement a tax reporting structure to address this deficiency.
We believe these material weaknesses resulted from continued working capital
deficiencies and a failure to generate cash flows from operations. Immediately
following our acquisitions, we appointed a Chief Executive Officer/Acting Chief
Financial Officer who is principally responsible for overseeing our financial
affairs. In addition, we increased our number of employees with our acquisitions
of Entelagent, LucidLine and CSSI and have begun the process of screening
candidates for key positions in our finance department. We believe that the
expansion of our operations and increase in the number of employees will enable
us to take corrective measures once we finish evaluating our existing
capabilities and our available resources to take such corrective measures.
Additionally, we expect to hire a Chief Financial Officer with public company
experience within the next twelve months and relieve our Chief Executive Officer
of his current Acting Chief Financial Officer duties.
We believe that any such risks are partially mitigated by the fact that we had
minimal assets and activities during our most recent reporting periods,
recordkeeping and authorization function were not being performed by the same
individual and the non-executive Chairman reviewed and approved all of our
transactions. However, we acknowledge that additional control procedures are
necessary to ensure that our transactions are properly recorded and that our
assets are appropriately safeguarded.
INTERNAL CONTROL OVER FINANCIAL REPORTING
There were no changes in our internal control over financial reporting or in
other factors identified in connection with the evaluation required by paragraph
(d) of Exchange Act Rules 13(a)-15 or 15(d)-15 that occurred during the quarter
ended March 31, 2005 or the four quarters ended December 31, 2004 that have
materially affected, or are reasonably likely to materially affect, our internal
control over financial reporting.
38
PART II - OTHER INFORMATION
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
The following unregistered equity securities have been issued by us during the
period from January 1, 2005 to March 31, 2005:
TITLE AND AMOUNT OF SECURITIES NAME OF NAME OR CLASS OF
GRANTED/EXERCISE PRICE IF PRINCIPAL PERSONS WHO RECEIVED CONSIDERATION
DATE OF GRANT APPLICABLE UNDERWRITER SECURITIES RECEIVED
------------- ------------------------------ ----------- -------------------- -------------
February 4,400,000/COMMON STOCK NONE STOCKHOLDERS OF $0.00(1)
2005 LUCIDLINE, INC.
February 7,500,000/COMMON STOCK NONE STOCKHOLDERS OF $0.00(2)
2005 COMPLETE SECURITY
SOLUTIONS, INC.
March 2005 3,000,000/COMMON STOCK NONE STOCKHOLDERS OF $0.00(3)
ENTELAGENT SOFTWARE
CORP.
1. On February 25, 2005, we agreed to issue 4,400,000 shares of common
stock to the stockholders of our subsidiary, LucidLine, Inc. in
consideration of our merger with LucidLine, Inc.
2. On February 25, 2005, we agreed to issue 7,500,000 shares of common
stock to the stockholders of Complete Security Solutions, Inc. in
consideration of our merger with Complete Security Solutions, Inc.
3. On March 30, 2005, we agreed to issue 3,000,000 shares of common stock
to the stockholders of Entelagent Software Corp. in consideration of
our merger with Entelagent Software Corp.
The following unregistered derivative securities (options and warrants) have
been issued by us during the period from January 1, 2005 to March 31, 2005:
TITLE AND AMOUNT OF SECURITIES NAME OF NAME OR CLASS OF
GRANTED/EXERCISE PRICE IF PRINCIPAL PERSONS WHO RECEIVED CONSIDERATION
DATE OF GRANT APPLICABLE UNDERWRITER SECURITIES RECEIVED
------------- ------------------------------ ----------- -------------------- -------------
February 2005 2,250,000/Common Stock Purchase None Series A Preferred $0.00(1)
Warrants Stockholders of
Complete Security
Solutions, Inc.
February 2005 1,750,000/Common Stock Purchase None 33 Accredited Investors $0.00(2)
Warrants in Interim Bridge
Financing I
February 2005 650,000/Common Stock Purchase None Laidlaw & Company (UK) $0.00(3)
Warrants Ltd.
1. On February 25, 2005, we agreed to issue warrants to purchase up to
2,250,000 shares of our common stock to the Series A Preferred
stockholders of Complete Security Solutions, Inc. in consideration of
our merger with Complete Security Solutions, Inc. The warrants have a
term of 5 years and an exercise price of $0.70 per share.
2. On February 28, 2005, we issued warrants to purchase up to 1,750,000
shares of our common stock to 33 accredited investors who invested in
our Interim Bridge Financing I. The warrants have a term of 5 years and
an exercise price of $0.70 per share.
3. On February 28, 2005, we issued warrants to purchase up to 650,000
shares of our common stock to Laidlaw & Company (UK) Ltd. In connection
with services rendered to us as the placement agent for Interim Bridge
Financing I and financial services related to the acquisitions of
Entelagent, CSSI and LucidLine. The warrants have a term of 5 years and
an exercise price of $0.70 per share.
The above unregistered securities were issued pursuant to an exemption from the
registration requirements of the Securities Act under Section 4(2) of the
Securities Act.
39
ITEM 6. EXHIBITS
EXHIBIT
NUMBER DESCRIPTION OF EXHIBIT
------- -----------------------------------------------------------------
2.1 Amended and Restated Supplemental Agreement dated as of February
24, 2005, by and among Patron Systems, Inc., ESC Acquisition,
Inc. and Entelagent Software Corp. (incorporated by reference to
Exhibit 10.1 to the Current Report on Form 8-K filed March 2,
2005).
2.2 Supplemental Agreement dated February 24, 2005, by and among
Patron Systems, Inc., LL Acquisition I Corp. and LucidLine, Inc.
(incorporated by reference to Exhibit 10.2 to the Current Report
on Form 8-K filed March 2, 2005).
2.3 Agreement and Plan of Merger dated February 24, 2005, by and
among Patron Systems, Inc., LL Acquisition I Corp. and LucidLine,
Inc. (incorporated by reference to Exhibit 10.3 to the Current
Report on Form 8-K filed March 2, 2005).
2.4 Supplemental Agreement dated February 24, 2005, among Patron
Systems, Inc., CSSI Acquisition Co. I, Inc. and Complete Security
Solutions, Inc. (incorporated by reference to Exhibit 10.5 to the
Current Report on Form 8-K filed March 2, 2005).
2.5 Agreement and Plan of Merger dated February 24, 2005, among
Patron Systems, Inc., CSSI Acquisition Co. I, Inc. and Complete
Security Solutions, Inc. (incorporated by reference to Exhibit
10.6 to the Current Report on Form 8-K filed March 2, 2005).
2.6 Amended and Restated Agreement and Plan of Merger dated March 30,
2005, by and among Patron Systems Inc., ESC Acquisition, Inc. and
Entelagent Software Corp. (incorporated by reference to Exhibit
10.1 to the Current Report on Form 8-K filed April 5, 2005).
10.1 Registration Rights Agreement dated February 24, 2005, among
Patron Systems, Inc. and each of the former LucidLine, Inc.
shareholders signatory thereto (incorporated by reference to
Exhibit 10.4 to the Current Report on Form 8-K filed March 2,
2005).
10.2 Registration Rights Agreement dated February 24, 2005, among
Patron Systems, Inc. and each of the former Complete Security
Solutions, Inc. stockholders signatory thereto (incorporated by
reference to Exhibit 10.7 to the Current Report on Form 8-K filed
March 2, 2005).
10.3 Form of Subordinated Promissory Note issued to the former
preferred stockholders of Complete Security Solutions, Inc.
(incorporated by reference to Exhibit 10.8 to the Current Report
on Form 8-K filed March 2, 2005).
10.4 Form of Common Stock Purchase Warrant issued by Patron Systems,
Inc. in favor of the former preferred stockholders of Complete
Security Solutions, Inc. (incorporated by reference to Exhibit
10.9 to the Current Report on Form 8-K filed March 2, 2005).
10.5 Subscription Agreement dated February 28, 2005, among Patron
Systems, Inc. and each of the investors listed on the signature
pages thereto (incorporated by reference to Exhibit 10.10 to the
Current Report on Form 8-K filed March 2, 2005).
10.6 Registration Rights Agreement dated February 28, 2005, among
Patron Systems, Inc. and each of the investors in the Bridge
Financing listed on the signature pages thereto (incorporated by
reference to Exhibit 10.11 to the Current Report on Form 8-K
filed March 2, 2005).
10.7 Form of 10% Senior Convertible Promissory Note (incorporated by
reference to Exhibit 10.12 to the Current Report on Form 8-K
filed March 2, 2005).
40
EXHIBIT
NUMBER DESCRIPTION OF EXHIBIT
------- -----------------------------------------------------------------
10.8 Form of Common Stock Purchase Warrant issued by Patron Systems,
Inc. in favor of investors in the Bridge Financing (incorporated
by reference to Exhibit 10.13 to the Current Report on Form 8-K
filed March 2, 2005).
10.9 Registration Rights Agreement dated February 28, 2005, among
Patron Systems, Inc. and Laidlaw & Company (UK) Ltd.
(incorporated by reference to Exhibit 10.14 to the Current Report
on Form 8-K filed March 2, 2005).
10.10 Form of Common Stock Purchase Warrant issued by Patron Systems,
Inc. in favor of Laidlaw & Company (UK) Ltd. in connection with
placement agent services (incorporated by reference to Exhibit
10.15 to the Current Report on Form 8-K filed March 2, 2005).
10.11 Form of Common Stock Purchase Warrant issued by Patron Systems,
Inc. in favor of Laidlaw & Company (UK) Ltd in connection with
advisory services (incorporated by reference to Exhibit 10.16 to
the Current Report on Form 8-K filed March 2, 2005).
10.12 Registration Rights Agreement dated March 30, 2005, among Patron
Systems, Inc. and each of the former Entelagent Software Corp.
shareholders signatory thereto (incorporated by reference to
Exhibit 10.2 to the Current Report on Form 8-K filed April 5,
2005).
10.13 Form of Promissory Note issued to certain creditors of Entelagent
Software Corp. (incorporated by reference to Exhibit 10.3 to the
Current Report on Form 8-K filed April 5, 2005).
31.1 Certification of principal executive officer and acting principal
financial officer pursuant to Section 302 of the Sarbanes-Oxley
Act of 2002.
32.1 Certification Pursuant to 18 U.S.C. Section 1350. as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
41
SIGNATURES
In accordance with the requirements of the Exchange Act, the registrant caused
this report to be signed on its behalf by the undersigned, thereunto duly
authorized.
Date: August 2, 2005 PATRON SYSTEMS, INC.
--------------------
(Registrant)
/s/ Robert Cross
-----------------------------------------
By: Robert Cross
Its: Chief Executive Officer and
42