UNITED STATES
SECURITIES
AND EXCHANGE COMMISSION
Washington,
D.C. 20549
FORM 10-Q
QUARTERLY
REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT
OF 1934
For
the Quarter Ended September 30, 2010
Commission
File Number 001-33888
American
Defense Systems, Inc.
(Exact
Name of Registrant as Specified in Its Charter)
Delaware
|
|
83-0357690
|
(State
or Other Jurisdiction of Incorporation or
Organization)
|
|
(I.R.S.
Employer Identification No.)
|
230
Duffy Avenue
Hicksville,
NY 11801
(516)
390-5300
(Address
including zip code, and telephone number, including area code, of principal
executive offices)
Indicate
by check mark whether the registrant (1) has filed all reports required to
be filed by Section 13 or 15 (d) of the Securities Exchange Act of
1934 during the preceding 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
x
No
¨
Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate Web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this
chapter) during the preceding 12 months (or for such shorter period that the
registrant was required to submit and post such files). Yes
¨
No
¨
Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting
company. See definition of “accelerated filer,” “large accelerated filer”
and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
(Check one):
Large
Accelerated Filer
¨
|
|
Accelerated
Filer
¨
|
|
|
|
Non-Accelerated
Filer
¨
|
|
Smaller
Reporting Company
x
|
Indicate
by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act). Yes
¨
No
x
As of
November 15, 2010, 51,971,685 shares of common stock, par value $0.001 per
share, of the registrant were outstanding.
TABLE OF CONTENTS
PART I
— FINANCIAL INFORMATION
|
|
|
|
|
Item
1.
|
Condensed
Consolidated Financial Statements
|
3
|
|
Condensed
Consolidated Balance Sheets as of September 30, 2010 (Unaudited) and
December 31, 2009
|
3
|
|
Condensed
Consolidated Statements of Operations for the three and nine months ended
September 30, 2010 and 2009 (Unaudited)
|
5
|
|
Condensed
Consolidated Statements of Cash Flows for the nine months ended September
30, 2010 and 2009 (Unaudited)
|
6
|
|
Notes
to Condensed Consolidated Financial Statements
|
8
|
Item
2.
|
Management’s
Discussion and Analysis of Financial Condition and Results of
Operations
|
23
|
Item
3.
|
Quantitative
and Qualitative Disclosure About Market Risk
|
32
|
Item
4.
|
Controls
and Procedures
|
32
|
|
|
|
PART II
— OTHER INFORMATION
|
|
|
|
|
Item
1.
|
Legal
Proceedings
|
35
|
Item
1A.
|
Risk
Factors
|
35
|
Item
2.
|
Unregistered
Sales of Equity Securities and Use of Proceeds
|
45
|
Item
3.
|
Defaults
Upon Senior Securities
|
45
|
Item
4.
|
(Removed
and Reserved)
|
45
|
Item
5.
|
Other
Information
|
45
|
Item
6.
|
Exhibits
|
46
|
|
|
|
SIGNATURES
|
47
|
PART I
Item 1. Condensed Consolidated
Financial Statements
AMERICAN
DEFENSE SYSTEMS, INC. AND SUBSIDIARIES
CONDENSED
CONSOLIDATED BALANCE SHEETS
ASSETS
|
|
September 30,
2010
(Unaudited)
|
|
|
December 31,
2009 *
|
|
|
|
|
|
|
|
|
CURRENT
ASSETS
|
|
|
|
|
|
|
Cash
|
|
$
|
2,012,351
|
|
|
$
|
-
|
|
Accounts receivable, net of
allowance for doubtful accounts of $327,448 and $222,448 as of September
30, 2010 and December 31, 2009, respectively
|
|
|
2,059,895
|
|
|
|
2,288,666
|
|
Accounts receivable
factoring
|
|
|
441,314
|
|
|
|
199,876
|
|
Tax
receivable
|
|
|
333,258
|
|
|
|
108,741
|
|
Costs in excess of billings on
uncompleted contracts, net
|
|
|
2,937,325
|
|
|
|
7,762,836
|
|
Prepaid expenses and other current
assets
|
|
|
369,354
|
|
|
|
330,381
|
|
Deferred tax
assets
|
|
|
-
|
|
|
|
521
|
|
|
|
|
|
|
|
|
|
|
TOTAL CURRENT
ASSETS
|
|
|
8,153,497
|
|
|
|
10,691,021
|
|
|
|
|
|
|
|
|
|
|
Property and equipment,
net
|
|
|
2,436,074
|
|
|
|
3,078,724
|
|
Deferred financing costs,
net
|
|
|
636,636
|
|
|
|
1,547,551
|
|
Notes receivable,
net
|
|
|
400,000
|
|
|
|
400,000
|
|
Intangible
assets
|
|
|
634,450
|
|
|
|
606,000
|
|
Goodwill
|
|
|
812,500
|
|
|
|
660,000
|
|
Deposits
|
|
|
652,137
|
|
|
|
407,137
|
|
Other
assets
|
|
|
-
|
|
|
|
138,001
|
|
|
|
|
|
|
|
|
|
|
TOTAL
ASSETS
|
|
$
|
13,725,294
|
|
|
$
|
17,528,434
|
|
*
Condensed from audited financial statements
The
accompanying notes are an integral part of these condensed consolidated
financial statements.
AMERICAN
DEFENSE SYSTEMS, INC. AND SUBSIDIARIES
CONDENSED
CONSOLIDATED BALANCE SHEETS
LIABILITIES AND SHAREHOLDERS'
DEFICIENCY
|
|
September 30,
2010
(Unaudited)
|
|
|
December 31,
2009 *
|
|
|
|
|
|
|
|
|
CURRENT
LIABILITIES
|
|
|
|
|
|
|
Accounts
payable
|
|
$
|
4,834,541
|
|
|
$
|
6,695,712
|
|
Cash
overdraft
|
|
|
-
|
|
|
|
48,573
|
|
Accrued
expenses
|
|
|
426,292
|
|
|
|
498,795
|
|
Warrant
liability
|
|
|
9,915
|
|
|
|
35,413
|
|
|
|
|
|
|
|
|
|
|
TOTAL CURRENT
LIABILITIES
|
|
|
5,270,748
|
|
|
|
7,278,493
|
|
|
|
|
|
|
|
|
|
|
LONG TERM
LIABILITIES
|
|
|
|
|
|
|
|
|
Mandatory redeemable Series A
convertible preferred stock (cumulative), 15,000 shares authorized issued
and outstanding
|
|
|
13,966,268
|
|
|
|
12,429,832
|
|
Deferred
rent
|
|
|
198,243
|
|
|
|
-
|
|
Deferred tax
liability
|
|
|
-
|
|
|
|
521
|
|
|
|
|
|
|
|
|
|
|
TOTAL
LIABILITIES
|
|
|
19,435,259
|
|
|
|
19,708,846
|
|
|
|
|
|
|
|
|
|
|
COMMITMENTS AND
CONTINGENCIES
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
SHAREHOLDERS'
DEFICIENCY
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Common stock, $0.001 par value,
100,000,000 shares authorized, 51,971,685 and 46,611,457 shares issued and
outstanding as of September 30, 2010 and December 31, 2009,
respectively
|
|
|
51,971
|
|
|
|
46,611
|
|
Additional paid-in
capital
|
|
|
16,088,766
|
|
|
|
14,712,414
|
|
Accumulated
deficit
|
|
|
(21,850,702
|
)
|
|
|
(16,939,437
|
)
|
|
|
|
|
|
|
|
|
|
TOTAL SHAREHOLDERS'
DEFICIENCY
|
|
|
(5,709,965
|
)
|
|
|
(2,180,412
|
)
|
|
|
|
|
|
|
|
|
|
TOTAL LIABILITIES AND
SHAREHOLDERS' DEFICIENCY
|
|
$
|
13,725,294
|
|
|
$
|
17,528,434
|
|
*
Condensed from audited financial statements
The
accompanying notes are an integral part of these condensed consolidated
financial statements.
AMERICAN DEFENSE SYSTEMS, INC. AND
SUBSIDIARIES
CONDENSED
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
|
|
Three Months
Ended
|
|
|
Nine Months
Ended
|
|
|
|
September
30,
|
|
|
September
30,
|
|
|
|
2010
|
|
|
2009
|
|
|
2010
|
|
|
2009
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
CONTRACT REVENUES
EARNED
|
|
$
|
8,725,874
|
|
|
$
|
12,643,488
|
|
|
$
|
35,610,715
|
|
|
$
|
36,166,765
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
COST OF REVENUES EARNED (exclusive
of depreciation
shown separately
below)
|
|
|
4,653,974
|
|
|
|
9,999,606
|
|
|
|
24,243,958
|
|
|
|
24,112,580
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
GROSS
PROFIT
|
|
|
4,071,900
|
|
|
|
2,643,882
|
|
|
|
11,366,757
|
|
|
|
12,054,185
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
OPERATING
EXPENSES
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
General and administrative
expenses
|
|
|
1,357,833
|
|
|
|
1,939,163
|
|
|
|
4,729,578
|
|
|
|
5,143,716
|
|
General and administrative
salaries
|
|
|
870,384
|
|
|
|
1,051,214
|
|
|
|
2,687,891
|
|
|
|
3,146,617
|
|
Sales and
marketing
|
|
|
431,140
|
|
|
|
560,231
|
|
|
|
1,565,749
|
|
|
|
2,017,804
|
|
T2 expenses
|
|
|
206,511
|
|
|
|
154,766
|
|
|
|
629,838
|
|
|
|
392,438
|
|
Research and
development
|
|
|
274,750
|
|
|
|
117,268
|
|
|
|
548,464
|
|
|
|
320,495
|
|
Settlement of
litigation
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
|
|
63,441
|
|
Depreciation
|
|
|
290,868
|
|
|
|
278,264
|
|
|
|
870,120
|
|
|
|
797,676
|
|
Professional
fees
|
|
|
99,463
|
|
|
|
471,098
|
|
|
|
1,369,660
|
|
|
|
1,563,876
|
|
TOTAL OPERATING
EXPENSES
|
|
|
3,530,949
|
|
|
|
4,572,004
|
|
|
|
12,401,300
|
|
|
|
13,446,063
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
OPERATING INCOME
(LOSS)
|
|
|
540,951
|
|
|
|
(1,928,122
|
)
|
|
|
(1,034,543
|
)
|
|
|
(1,391,878
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
OTHER INCOME
(EXPENSE)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Unrealized loss on adjustment of
fair value Series A convertible preferred stock classified as a
liability
|
|
|
(50,594
|
)
|
|
|
(498,407
|
)
|
|
|
(923,609
|
)
|
|
|
(1,183,719
|
)
|
Unrealized gain (loss) on warrant
liability
|
|
|
15,923
|
|
|
|
10,674
|
|
|
|
25,498
|
|
|
|
(15,676
|
)
|
Loss on deemed extinguishment of
debt
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
|
|
(2,613,630
|
)
|
Other income
(expense)
|
|
|
-
|
|
|
|
(21,040
|
)
|
|
|
-
|
|
|
|
(33,770
|
)
|
Interest
expense
|
|
|
(434,621
|
)
|
|
|
(663,524
|
)
|
|
|
(1,585,111
|
)
|
|
|
(1,444,675
|
)
|
Interest expense - mandatorily
redeemable preferred stock dividends
|
|
|
(375,000
|
)
|
|
|
(450,000
|
)
|
|
|
(1,125,000
|
)
|
|
|
(1,200,000
|
)
|
Interest
income
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
|
|
8,859
|
|
Finance
charge
|
|
|
(91,930
|
)
|
|
|
(41,025
|
)
|
|
|
(268,793
|
)
|
|
|
(41,025
|
)
|
TOTAL OTHER INCOME
(EXPENSE)
|
|
|
(936,222
|
)
|
|
|
(1,663,322
|
)
|
|
|
(3,877,015
|
)
|
|
|
(6,523,636
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
LOSS BEFORE INCOME
TAXES
|
|
|
(395,271
|
)
|
|
|
(3,591,444
|
)
|
|
|
(4,911,558
|
)
|
|
|
(7,915,514
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
INCOME TAX
PROVISION
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
NET LOSS
|
|
$
|
(395,271
|
)
|
|
$
|
(3,591,444
|
)
|
|
$
|
(4,911,558
|
)
|
|
$
|
(7,915,514
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Weighted Average Shares
Outstanding (Basic and Diluted)
|
|
|
49,393,679
|
|
|
|
45,513,965
|
|
|
|
48,033,067
|
|
|
|
42,388,377
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
NET LOSS per Share - Basic and
Diluted
|
|
$
|
(0.01
|
)
|
|
$
|
(0.08
|
)
|
|
$
|
(0.10
|
)
|
|
$
|
(0.19
|
)
|
The
accompanying notes are an integral part of these condensed consolidated
financial statements.
AMERICAN
DEFENSE SYSTEMS, INC. AND SUBSIDIARIES
CONDENSED
CONSOLIDATED
STATEMENTS OF CASH
FLOWS
(Unaudited)
|
|
Nine Months Ended September
30,
|
|
|
|
2010
|
|
|
2009
|
|
|
|
|
|
|
|
|
CASH FLOWS FROM OPERATING
ACTIVITIES:
|
|
|
|
|
|
|
NET LOSS
|
|
$
|
(4,911,558
|
)
|
|
$
|
(7,915,514
|
)
|
Adjustments to reconcile net loss
to net cash provided by
operating
activities:
|
|
|
|
|
|
|
|
|
Change in costs in excess of
billings reserve
|
|
|
70,000
|
|
|
|
-
|
|
Loss on deemed extinguishment of
debt
|
|
|
-
|
|
|
|
2,613,630
|
|
Change in fair value associated
with preferred stock and warrants liabilities
|
|
|
898,111
|
|
|
|
1,199,395
|
|
Stock based compensation
expense
|
|
|
203,118
|
|
|
|
220,198
|
|
Amortization of deferred financing
costs
|
|
|
910,915
|
|
|
|
592,010
|
|
Amortization of discount on Series
A preferred stock
|
|
|
666,714
|
|
|
|
407,868
|
|
Depreciation and
amortization
|
|
|
870,120
|
|
|
|
797,676
|
|
Bad debt
expense
|
|
|
105,000
|
|
|
|
-
|
|
Deferred
rent
|
|
|
198,243
|
|
|
|
-
|
|
Stock issued for payment of
dividends on preferred stock
|
|
|
1,125,000
|
|
|
|
1,200,000
|
|
|
|
|
|
|
|
|
|
|
Changes in operating assets and
liabilities:
|
|
|
|
|
|
|
|
|
Accounts
receivable
|
|
|
123,771
|
|
|
|
(966,873
|
)
|
Accounts receivable
factoring
|
|
|
(241,438
|
)
|
|
|
(256,888
|
)
|
Tax
receivable
|
|
|
(224,517
|
)
|
|
|
-
|
|
Deposits and other
assets
|
|
|
(135,449
|
)
|
|
|
127,811
|
|
Cost in excess of billing on
uncompleted contracts
|
|
|
4,755,511
|
|
|
|
(2,914,789
|
)
|
Prepaid expenses and other current
assets
|
|
|
(38,973
|
)
|
|
|
93,499
|
|
Accounts payable and accrued
expenses
|
|
|
(2,086,174
|
)
|
|
|
6,358,429
|
|
Cash
overdraft
|
|
|
(48,573
|
)
|
|
|
-
|
|
NET CASH PROVIDED BY OPERATING
ACTIVITIES
|
|
|
2,239,821
|
|
|
|
1,556,452
|
|
|
|
|
|
|
|
|
|
|
CASH FLOWS FROM INVESTING
ACTIVITIES:
|
|
|
|
|
|
|
|
|
Purchase of
equipment
|
|
|
(227,470
|
)
|
|
|
(340,536
|
)
|
NET CASH USED IN INVESTING
ACTIVITIES
|
|
|
(227,470
|
)
|
|
|
(340,536
|
)
|
|
|
|
|
|
|
|
|
|
CASH FLOWS FROM FINANCING
ACTIVITIES:
|
|
|
|
|
|
|
|
|
Repayments of line of
credit
|
|
|
-
|
|
|
|
(76,832
|
)
|
Deferred offering
costs
|
|
|
-
|
|
|
|
(222,000
|
)
|
Deferred financing
costs
|
|
|
-
|
|
|
|
(1,184,160
|
)
|
NET CASH USED IN FINANCING
ACTIVITIES
|
|
|
-
|
|
|
|
(1,482,992
|
)
|
|
|
|
|
|
|
|
|
|
NET INCREASE (DECREASE) IN
CASH
|
|
|
2,012,351
|
|
|
|
(267,076
|
)
|
|
|
|
|
|
|
|
|
|
CASH AT BEGINNING OF
YEAR
|
|
|
-
|
|
|
|
374,457
|
|
CASH AT THE END OF
PERIOD
|
|
$
|
2,012,351
|
|
|
$
|
107,381
|
|
The
accompanying notes are an integral part of these condensed consolidated
financial statements.
AMERICAN
DEFENSE SYSTEMS, INC. AND SUBSIDIARIES
CONDENSED
CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)
(Unaudited)
|
|
Nine Months Ended September
30,
|
|
|
|
2010
|
|
|
2009
|
|
|
|
|
|
|
|
|
Supplemental disclosure of cash
flow information:
|
|
|
|
|
|
|
Cash paid during the period for
interest
|
|
$
|
-
|
|
|
$
|
33,770
|
|
Cash paid during the period for
taxes
|
|
$
|
-
|
|
|
$
|
-
|
|
|
|
|
|
|
|
|
|
|
Supplemental disclosure of
non-cash investing and financing activities:
|
|
|
|
|
|
|
|
|
Modification of the terms of the
Series A preferred stock
|
|
$
|
53,887
|
|
|
$
|
-
|
|
Contingent payment for APSG
acquisition
|
|
$
|
152,500
|
|
|
$
|
-
|
|
Stock issued in connection with
investor warrants
|
|
$
|
-
|
|
|
$
|
2,550,000
|
|
|
|
|
|
|
|
|
|
|
Cumulative effect of a change in
accounting principle on:
|
|
|
|
|
|
|
|
|
Warrants
|
|
$
|
-
|
|
|
$
|
165,777
|
|
Additional paid-in
capital
|
|
$
|
-
|
|
|
$
|
(837,954
|
)
|
Accumulated
deficit
|
|
$
|
-
|
|
|
$
|
672,179
|
|
The
accompanying notes are an integral part of these condensed consolidated
financial statements.
AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES
NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
1.
|
NATURE
OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING
POLICIES
|
Organization
American
Defense Systems, Inc. (the “Company” or “ADSI”) was incorporated under the laws
of the State of Delaware on December 6, 2002.
On May 1,
2003, the stockholder of A. J. Piscitelli & Associates, Inc. (“AJP”)
exchanged all of his issued and outstanding shares for shares of American
Defense Systems, Inc. The exchange was accounted for as a recapitalization of
the Company, wherein the stockholder retained all the outstanding stock of
American Defense Systems, Inc. At the time of the acquisition American Defense
Systems, Inc. was substantially inactive.
On
November 15, 2007, the Company entered into an Asset Purchase Agreement with
Tactical Applications Group (“TAG”), a North Carolina based sole proprietorship,
and its owner. TAG has a retail establishment located in
Jacksonville, North Carolina that supplies tactical equipment to military and
security personnel. As discussed more fully in Note 6, the operations
of TAG were discontinued on January 2, 2009.
In
January 2008, American Physical Security Group, LLC (“APSG”) was established as
a wholly owned subsidiary of the Company for the purposes of acquiring the
assets of American Anti-Ram, Inc., a manufacturer of crash tested vehicle
barricades. This acquisition represents a new product line for the
Company. APSG is located in North Carolina.
Interim
Review Reporting
The
accompanying interim unaudited condensed consolidated financial statements have
been prepared in accordance with generally accepted accounting principles for
interim financial information and with the instructions to Form 10-Q and Article
8 of Regulation S-X. Accordingly, they do not include all of the information and
footnotes required by generally accepted accounting principles for complete
financial statements. In the opinion of management, all adjustments (consisting
of normal recurring accruals) considered necessary for a fair presentation have
been included. Operating results for the three and nine month periods ended
September 30, 2010 are not necessarily indicative of the results that may be
expected for the year ending December 31, 2010. For further information, refer
to the financial statements and footnotes thereto included in the Company’s Form
10-K annual report for the year ended December 31, 2009 filed on April 15,
2010.
Nature
of Business
The
Company designs and supplies transparent and opaque armor solutions for both
military and commercial applications. Its primary customers are United States
government agencies and general contractors who have contracts with governmental
entities. These products, sold under Vista trademarks, are used in transport and
fighting vehicles, construction equipment, sea craft and various fixed
structures which require ballistic and blast attenuation.
The Company also provides engineering and consulting services,
develops and installs detention and security hardware, entry control and
monitoring systems, intrusion detection systems, and security glass. The Company
also supplies vehicle anti-ram barriers. Its primary customer for
these services and products are the detention and security
industry.
Principles
of Consolidation
The
consolidated financial statements include the accounts of American Defense
Systems, Inc. and its wholly-owned subsidiaries, AJP and APSG. All significant
intercompany accounts and transactions have been eliminated in
consolidation.
AMERICAN
DEFENSE SYSTEMS, INC. AND SUBSIDIARIES
NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Management
Liquidity Plans
As of
September 30, 2010, the Company had working capital of $2,882,749, an
accumulated deficit of $21,850,702, shareholders’ deficiency of $5,709,965 and
cash on hand of $2,012,351. The Company had net losses of $395,271
and $4,911,558 for the three and nine months ended September 30, 2010,
respectively. The Company has generated cash flows from operations for the
nine months ended September 30, 2010 and 2009. The Company is continuing to
implement cost cutting measures and is focusing all its efforts on securing new
sources of revenue. The Company believes that its current net
accounts receivable and cost in excess of billing together with its expected
cash flows from operations and its ability to sell accounts receivable under its
factoring agreement, will be sufficient to meet its anticipated cash
requirements for working capital at least through September 30, 2011. The Series
A convertible preferred stock (the “Series A Preferred”) had a mandatory
redemption date of December 31, 2010. On April 8, 2010, the Company entered into
a waiver agreement with the holders of its Series A Preferred (the “Series A
Holders”) which extended the maturity redemption date from December 31, 2010 to
April 1, 2011. On August 13, 2010, the Company entered into a waiver
agreement with the Series A Holders which extended the maturity redemption date
from April 1, 2011 to July 1, 2011. On November 12, 2010, the Company entered
into a waiver agreement with the Series A Holders which extended the maturity
date from July 1, 2011 to October 1, 2011.
The Company is currently
seeking to raise capital or obtain access to capital sufficient to permit the
Company to effect such redemption. If the Company is unable to timely raise
capital or obtain access to a credit facility or other source of funds
sufficient to fund such redemption, its cash flow could be adversely affected
and its business significantly harmed. In addition, restrictions imposed
pursuant to the General Corporation Law of the State of Delaware (the “DGCL”),
its state of incorporation, would prohibit the Company from satisfying such
redemption if the Company lacks sufficient surplus, as such term is defined
under the DGCL.
Reclassifications
Certain
amounts in the prior year financial statements have been reclassified for
comparative purposes to conform to the presentation in the current year
financial statements. These reclassifications had no effect on previously
reported income.
Use
of Estimates
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 accompanying
notes. Actual results could differ from those estimates.
Significant
estimates for all periods presented include cost in excess of billings,
allowance for doubtful accounts, liabilities associated with the Series A
Preferred and warrants, and valuation of deferred tax assets.
Subsequent
Events
The
Company has evaluated events that occurred subsequent to September 30, 2010
through the date these financial statements were issued. Management concluded
that no additional subsequent events required disclosure in these financial
statements except as discussed below.
On
October 15, 2010, the Company signed an amendment to its accounts receivable
purchase agreement with Republic Capital Access (“RCA”) which extended the term
during which it may offer and sell eligible accounts receivable to RCA from
October 15, 2010 to October 15, 2011.
On
November 12, 2010, the Company entered into a waiver agreement with the Series A
Holders which further extended the maturity date for mandatory redemption of all
outstanding Series A Preferred from July 1, 2011 to October 1,
2011.
AMERICAN
DEFENSE SYSTEMS, INC. AND SUBSIDIARIES
NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Revenue
and Cost Recognition
The
Company recognizes revenue in accordance with the provisions of Accounting
Standards Codification (“ASC”) 605, “Revenue Recognition”, which states that
revenue is realized and earned when all of the following criteria are
met:
(a)
persuasive evidence of the arrangement exists,
(b)
delivery has occurred or services have been rendered,
(c)
the seller’s price to the buyer is fixed and determinable, and
(d)
collectibility is reasonably assured.
The
Company recognizes revenue and reports profits from purchase orders filled under
master contracts when an order is complete. Purchase orders received under
master contracts may extend for periods in excess of one year. However, no
revenues, costs or profits are recognized in operations until the period of
completion of the order. An order is considered complete when all costs, except
insignificant items, have been incurred and the installation or product is
operating according to specification or the shipment has been accepted by the
customer. Provisions for estimated contract losses are made in the period that
such losses are determined. As of September 30, 2010 and December 31, 2009,
there were no such provisions made.
Contract
Revenue
Cost
in Excess of Billing
All costs
associated with uncompleted customer purchase orders under contract are recorded
on the balance sheet as a current asset called “Costs in Excess of Billings on
Uncompleted Contracts.” Such costs include direct material, direct labor, and
project-related overhead. Upon completion of a purchase order, costs are then
reclassified from the balance sheet to the statement of operations as costs of
revenue. A customer purchase order is considered complete when a satisfactory
inspection has occurred, resulting in customer acceptance and
delivery.
Concentrations
The
Company’s bank accounts are maintained in financial institutions. Deposits held
with banks may exceed the amount of insurance provided on such deposits.
Generally, these deposits may be redeemed upon demand and therefore bear minimal
risk.
The
Company received certain of its components from sole suppliers. The Company has
two suppliers that each
provide
greater than 10% of its supply needs. Additionally, the Company relies on a
limited number of contract manufacturers and suppliers to provide manufacturing
services for its products. The inability of any contract manufacturer or
supplier to fulfill supply requirements of the Company could materially impact
future operating results.
For the
three and nine months ended September 30, 2010, the Company derived 65% and 68%,
respectively, of its revenues from various U.S. government entities. For the
three and nine months ended September 30, 2009, the Company derived 60% and 75%,
respectively, of its revenues from various U.S. government
entities.
Allowance
for Doubtful Accounts
The
allowance for doubtful accounts reflects management’s best estimate of probable
losses inherent in the account receivable balance. Management determines the
allowance based on known troubled accounts, historical experience, and other
currently available evidence. Management performs on-going credit evaluations of
its customers and adjusts credit limits based upon payment history and the
customer’s current credit worthiness, as determined by the review of their
current credit information. Collections and payments from customers are
continuously monitored. While such bad debt expenses have historically been
within expectations and allowances established, the Company cannot guarantee
that it will continue to experience the same credit loss rates that it has in
the past. At September 30, 2010 and December 31, 2009, the allowance for
doubtful accounts was $327,448 and $222,448, respectively.
Loss per Share
Basic
loss per share is computed using the weighted-average number of common shares
outstanding during the period. Diluted net loss per share is computed using the
weighted-average number of common shares and excludes dilutive potential common
shares outstanding, as their effect is anti-dilutive. Dilutive potential common
shares would primarily consist of employee stock options, warrants and
convertible preferred stock.
AMERICAN
DEFENSE SYSTEMS, INC. AND SUBSIDIARIES
NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Securities
that could potentially dilute basic EPS in the future that were not included in
the computation of the diluted EPS because to do so would be anti-dilutive
consist of the following:
|
|
September
30
|
|
In Thousands
|
|
2010
|
|
|
2009
|
|
|
|
|
|
|
|
|
Warrants to purchase Common
Stock
|
|
|
675,001
|
|
|
|
1,448,681
|
|
|
|
|
|
|
|
|
|
|
Options to purchase Common
Stock
|
|
|
2,505,000
|
|
|
|
2,195,000
|
|
|
|
|
|
|
|
|
|
|
Series A Convertible Preferred
Stock
|
|
|
30,000,000
|
|
|
|
7,500,000
|
|
|
|
|
|
|
|
|
|
|
Total potential Common
Stock
|
|
|
33,180,001
|
|
|
|
11,143,681
|
|
Fair
Value of Financial Instruments
Fair
value of certain of the Company’s financial instruments including cash, accounts
receivable, note receivable, accrued compensation, and other accrued liabilities
approximate cost because of their short maturities. The Company measures and
reports fair value in accordance with ASC 820, “Fair Value Measurements and
Disclosure” which defines fair value, establishes a framework for measuring fair
value in accordance with generally accepted accounting principles, and expands
disclosures about fair value investments.
Fair
value, as defined in ASC 820, is the price that would be received to sell an
asset or paid to transfer a liability in an orderly transaction between market
participants at the measurement date. The fair value of an asset should reflect
its highest and best use by market participants, principal (or most
advantageous) markets, and an in-use or an in-exchange valuation premise. The
fair value of a liability should reflect the risk of nonperformance, which
includes, among other things, the Company’s credit risk.
Valuation
techniques are generally classified into three categories: the market approach;
the income approach; and the cost approach. The selection and application of one
or more of the techniques may require significant judgment and are primarily
dependent upon the characteristics of the asset or liability, and the quality
and availability of inputs. Valuation techniques used to measure fair value
under ASC 820 must maximize the use of observable inputs and minimize the use of
unobservable inputs. ASC 820 also provides fair value hierarchy for inputs and
resulting measurement as follows:
Level
1
Quoted
prices (unadjusted) in active markets that are accessible at the measurement
date for identical assets or liabilities;
Level
2
Quoted
prices for similar assets or liabilities in active markets; quoted prices for
identical or similar assets or liabilities in markets that are not active;
inputs other than quoted prices that are observable for the asset or liability;
and inputs that are derived principally from or corroborated by observable
market data for substantially the full term of the assets or liabilities;
and
Level 3
Unobservable
inputs for the asset or liability that are supported by little or no market
activity and that are significant to the fair values.
Fair
value measurements are required to be disclosed by the Level within the fair
value hierarchy in which the fair value measurements in their entirety fall.
Fair value measurements using significant unobservable inputs (in Level 3
measurements) are subject to expanded disclosure requirements including a
reconciliation of the beginning and ending balances, separately presenting
changes during the period attributable to total gains or losses for the period
(realized and unrealized), segregating those gains or losses included in
earnings, and a description of where those gains or losses included in earning
are reported in the statement of operations.
AMERICAN
DEFENSE SYSTEMS, INC. AND SUBSIDIARIES
NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
The
Company did not have any assets or liabilities categorized as Level 1 or Level 2
as of September 30, 2010.
The
following summarizes the Company’s assets and liabilities measured at fair value
as of September 30, 2010:
|
|
|
|
|
Fair Value Measurements at Reporting Date Using
|
|
|
|
|
|
|
Quoted Prices
in
Active Markets
for
Identical
|
|
|
Significant
Other
Observable
|
|
|
Significant
Unobservable
|
|
|
|
Balance as
of
|
|
|
Assets
|
|
|
Inputs
|
|
|
Inputs
|
|
Description
|
|
September 30,
2010
|
|
|
(Level 1)
|
|
|
(Level 2)
|
|
|
(Level 3)
|
|
Liabilities
|
|
|
|
|
|
|
|
|
|
|
|
|
Series A
Preferred
(1)
|
|
$
|
13,966,268
|
|
|
$
|
-
|
|
|
$
|
-
|
|
|
$
|
13,966,268
|
|
2005
Warrants
(1)
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
2006 Warrants
(1)
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
Placement Agent
Warrants
(1)
|
|
|
9,915
|
|
|
|
-
|
|
|
|
-
|
|
|
|
9,915
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
Liabilities
|
|
$
|
13,976,183
|
|
|
$
|
-
|
|
|
$
|
-
|
|
|
$
|
13,976,183
|
|
(1)
|
Methods
and significant inputs and assumptions are discussed in Note 5
below.
|
The
following is a reconciliation of the beginning and ending balances for the
Company’s liabilities measured at fair value on a recurring basis using
significant unobservable inputs (Level 3) for the nine months ended September
30, 2010:
|
|
Series A
Preferred
|
|
|
2005
Warrants
|
|
|
2006
Warrants
|
|
|
Placement
Agent
Warrants
|
|
|
Total
|
|
Balance – January 1,
2010
|
|
$
|
12,429,832
|
|
|
$
|
4,372
|
|
|
$
|
1,494
|
|
|
$
|
29,547
|
|
|
$
|
12,465,245
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Amortization of debt
discount
|
|
|
666,714
|
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
|
|
666,714
|
|
Change in fair
value
|
|
|
923,609
|
|
|
|
(4,372
|
)
|
|
|
(1,494
|
)
|
|
|
(19,632
|
)
|
|
|
898,111
|
|
Modification of
terms
|
|
|
(53,887
|
)
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
|
|
(53,887
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Balance – September 30,
2010
|
|
$
|
13,966,268
|
|
|
$
|
-
|
|
|
$
|
-
|
|
|
$
|
9,915
|
|
|
$
|
13,976,183
|
|
The
change in fair value recorded for Level 3 liabilities for the periods above are
reported in other income (expense) on the condensed consolidated statement of
operations.
AMERICAN
DEFENSE SYSTEMS, INC. AND SUBSIDIARIES
NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Recent
Accounting Pronouncements
In
June 2009, the Financial Accounting Standards Board (“FASB”) issued new
accounting guidance, under ASC Topic 810, which modifies how a company
determines when an entity that is insufficiently capitalized or is not
controlled through voting (or similar rights) should be consolidated. This
guidance clarified that the determination of whether a company is required to
consolidate an entity is based on, among other things, an entity’s purpose and
design and a company’s ability to direct the activities of the entity that most
significantly impact the entity’s economic performance. An ongoing reassessment
is required of whether a company is the primary beneficiary of a variable
interest entity. Additional disclosures are also required about a company’s
involvement in variable interest entities and any significant changes in risk
exposure due to that involvement. This guidance was effective as of the
beginning of each reporting entity’s first annual reporting period that began
after November 15, 2009, for interim periods within that first annual reporting
period, and for interim and annual reporting periods thereafter. The adoption of
this guidance did not have a material effect on the Company’s consolidated
financial position or results of operations.
In
October 2009, the FASB issued new accounting guidance, under ASC Topic 605,
on revenue recognition which addresses the accounting for multiple-deliverable
arrangements to enable vendors to account for products or services
(deliverables) separately rather than as a combined unit. Specifically, this
guidance amends the criteria for Subtopic 605-25,
Revenue Recognition-Multiple Element
Arrangements
, for separating consideration in multiple-deliverable
arrangements. This guidance establishes a selling price hierarchy for
determining the selling price of a deliverable, which is based on: (a)
vendor-specific objective evidence, (b) third-party evidence, or (c) estimates.
This guidance also eliminates the residual method of allocation and requires
that arrangement consideration be allocated at the inception of the arrangements
to all deliverables using the relative selling price method and also requires
expanded disclosures. This guidance is effective for all new or materially
modified arrangements entered into on or after January 1, 2011 with earlier
application permitted as of the beginning of a fiscal year. Full retrospective
application of the new guidance is optional. The adoption of this standard
will have an impact on the Company’s consolidated financial position and results
of operations for all multiple deliverable arrangements entered into or
materially modified in 2011.
In
January 2010, the FASB issued new accounting guidance, under ASC Topic 820, on
Fair Value Measurements and Disclosures, which requires new disclosures and
clarifies some existing disclosure requirements about fair value measurement.
Under the new guidance, a reporting entity should (a) disclose separately the
amounts of significant transfers in and out of Level 1 and Level 2 fair value
measurements and describe the reasons for the transfers, and (b) present
separately information about purchases, sales, issuances, and settlements in the
reconciliation for fair value measurements using significant unobservable
inputs. This guidance was effective for interim and annual reporting periods
beginning after December 15, 2009, except for the disclosures about purchases,
sales, issuances, and settlements in the roll forward of activity in Level 3
fair value measurements which are effective for fiscal years beginning after
December 15, 2010, and for interim periods within those fiscal years. The
adoption of the guidance effective for interim and annual reporting periods
beginning after December 15, 2009 did not have a material impact upon the
Company’s consolidated financial position or results of operations. The adoption
of the guidance effective for fiscal years beginning after December 15, 2010 is
not expected to have a material effect on the Company’s consolidated financial
position or results of operations.
In April
2010, the FASB issued ASU No. 2010-17,
Revenue Recognition - Milestone
Method (Topic 605): Milestone Method of Revenue Recognition
. This
standard provides guidance on defining a milestone and determining when it may
be appropriate to apply the milestone method of revenue recognition for research
or development transactions. Revenue that is contingent upon achievement of a
milestone can be recognized in the period in which the milestone is achieved
only if the milestone meets all criteria to be considered substantive.
Determining whether a milestone is substantive requires judgment that should be
made at the inception of the arrangement. To meet the definition of a
substantive milestone, the consideration earned by achieving the milestone
(1) would have to be commensurate with either the level of effort required
to achieve the milestone or the enhancement in the value of the item delivered,
(2) would have to relate solely to past performance, and (3) should be
reasonable relative to all deliverables and payment terms in the arrangement. No
bifurcation of an individual milestone is allowed and there can be more than one
milestone in an arrangement. The new standard was effective for interim and
annual periods beginning on or after June 15, 2010. The adoption of this
standard did not have any impact on the Company’s consolidated financial
position or results of operations.
In July
2010, the FASB issued ASU 2010-20,
Receivables (Topic 310): Disclosure
about the Credit Quality of Financial Receivables and the Allowance for Credit
Losses
, which amends ASC Topic 310 by requiring additional disclosures
about the credit quality of an entity’s financing receivables and its allowance
for credit losses on a disaggregated basis. The objective of enhancing these
disclosures is to improve financial statement users’ understanding of
(1) the nature of an entity’s credit risk associated with its financing
receivables and (2) the entity’s assessment of that risk in estimating its
allowance for credit losses as well as changes in the allowance and the reasons
for those changes. The guidance is effective for the first reporting period
ending on or after December 15, 2010. The adoption of this standard is not
expected to have a material impact on the Company’s consolidated financial
position and results of operations.
AMERICAN
DEFENSE SYSTEMS, INC. AND SUBSIDIARIES
NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
2.
|
COSTS
IN EXCESS OF BILLINGS (BILLINGS IN EXCESS OF COSTS) ON UNCOMPLETED
CONTRACTS AND ACCOUNTS RECEIVABLE
|
Costs in Excess of Billings
and Billing in Excess of Costs
The cost
in excess of billings on uncompleted purchase orders issued pursuant to
contracts reflects the accumulated costs incurred on purchase orders in
production but not completed. Upon completion, inspection and
acceptance by the customer, the purchase order is invoiced and the accumulated
costs are charged to the statement of operations as costs of revenues
earned. During the production cycle of the purchase order, should any
progress billings occur or any interim cash payments or advances be received,
such billings and/or receipts on uncompleted contracts are accumulated as
billings in excess of costs. The Company fully expects to collect net costs
incurred in excess of billing within twelve months and periodically
evaluates each purchase order and contract for potential disputes related to
overruns and uncollectable amounts.
Costs in
excess of billing on uncompleted contracts were $2,937,325 and
$7,762,836 as of September 30, 2010 and December 31, 2009,
respectively.
Backlog
The
estimated gross revenue on work to be performed on backlog was approximately
$31,000,000 as of September 30, 2010.
Accounts
Receivable
The
Company records accounts receivable related to its long-term contracts, based on
billings or on amounts due under the contractual terms. Accounts
receivable consist primarily of receivables from completed purchase orders and
progress billings on uncompleted contracts. Allowance for doubtful
accounts is based upon a review of outstanding receivables, historical
collection information, and existing economic conditions. Any amounts considered
recoverable under the customer’s surety bonds are treated as contingent gains
and recognized only when received.
Accounts
receivable throughout the year may decrease based on payments received, credits
for change orders, or back charges incurred. At September 30, 2010 and December
31, 2009, the Company had accounts receivable of $2,059,895 and $2,288,666,
respectively and an allowance for doubtful accounts of $327,448 and $222,448,
respectively. The Company recorded bad debt expense of $15,000 and
$105,000 for the three and nine months ended September 30, 2010, respectively.
No bad debt expense was recorded for the three or nine months ended September
30, 2009.
AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES
NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
3.
|
COMMITMENTS
AND CONTINGENCIES
|
Legal
Proceedings
The
Company is subject to various claims and contingencies in the ordinary course of
its business, including those related to litigation, business transactions,
employee-related matters, and others. When the Company is aware of a claim or
potential claim, it assesses the likelihood of any loss or exposure. If it is
probable that a loss will result and the amount of the loss can be reasonably
estimated, the Company will record a liability for the loss. The liability
recorded includes probable and estimable legal costs associated with the claim
or potential claim. If the loss is not probable or the amount of the loss cannot
be reasonably estimated, the Company discloses the claim if the likelihood of a
potential loss is reasonably possible and the amount involved could be material.
While there can be no assurances, the Company does not expect that any of its
pending legal proceedings will have a material financial impact on the Company’s
results.
On
February 29, 2008, Roy Elfers, a former employee commenced an action against the
Company for breach of contract arising from his termination of employment in the
Supreme Court of the State of New York, Nassau County. The Complaint seeks
damages of approximately $87,000. Discovery has been completed in this
action. On or about August 12, 2010, the Company filed a motion for
summary judgment to dismiss the complaint, and the motion is now fully
submitted. No trial date has been set. The Company believes
that meritorious defenses to the claims exist and the Company intends to
vigorously defend this action. The Company’s attorneys have advised
that it is too early to determine an outcome at this time.
On March
4, 2008, Thomas Cusack, the Company’s former General Counsel, commenced an
action with the United States Department of Labor, Occupational Safety and
Health and Safety Administration, alleging retaliation in contravention of the
Sarbanes-Oxley Act. Mr. Cusack seeks damages in excess of $3,000,000. On April
2, 2008, the Company filed a response to the charges. On March 7, 2008, Mr.
Cusack also commenced a second action against the Company for breach of contract
and related issues arising from his termination of employment in New York State
Supreme Court, Nassau County. On May 7, 2008, the Company served a
motion to dismiss the complaint, and on or about September 26, 2008, the Court
dismissed several claims (tortious interference with a contract, tortious
interference with economic opportunity, fraudulent inducement to enter into a
contract and breach of good faith and fair dealing). The remaining claims are
Mr. Cusack’s breach of contract claims and stock conversion claim. On or about
October 13, 2008, Mr. Cusack filed an amended complaint as to the remaining
claims, and on November 5, 2008, the Company filed an answer to the complaint
and filed counterclaims against Mr. Cusack for fraud and rescission. The parties
have completed discovery and depositions. On or about June 15, 2010, both
parties submitted motions for summary judgment and on August 19, 2010, the Court
granted Mr. Cusack’s motion as to his stock conversion claim. The Court also
narrowed the issues as to the breach of contract claim. On September
13, 2010, the Company filed an appeal of the Court’s decision. The judge has set
a trial date for the breach of contract claims and the stock valuation for
February 7, 2011. The Company believes that meritorious defenses to the claims
exist and the Company intends to vigorously defend this action. The
Company’s attorneys have advised that it is too early to determine an outcome at
this time.
AMERICAN DEFENSE SYSTEMS, INC. AND
SUBSIDIARIES
NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
4.
|
SHAREHOLDERS’
DEFICIENCY
|
The
following table summarizes the changes in shareholders' deficiency for
the nine months ended September 30, 2010:
Balance - January 1,
2010
|
|
$
|
(2,180,412
|
)
|
|
|
|
|
|
Stock based
compensation
|
|
|
203,118
|
|
|
|
|
|
|
Shares issued for payment of
dividends recorded as interest expense
|
|
|
1,125,000
|
|
|
|
|
|
|
Modification of Series A
convertible preferred stock
|
|
|
53,887
|
|
|
|
|
|
|
Net loss
|
|
|
(4,911,558
|
)
|
|
|
|
|
|
Balance - September 30,
2010
|
|
$
|
(5,709,965
|
)
|
Warrants
The
following is a summary of stock warrants outstanding at September 30,
2010:
|
|
Warrants
|
|
|
Weighted Average
Exercise Price
|
|
|
Weighted
Average
Remaining
Contractual
Lives
(in years)
|
|
Balance – January 1,
2010
|
|
|
1,448,681
|
|
|
$
|
1.47
|
|
|
|
1.75
|
|
Granted
|
|
|
-
|
|
|
|
n/a
|
|
|
|
-
|
|
Exercised
|
|
|
-
|
|
|
|
n/a
|
|
|
|
-
|
|
Cancelled, Forfeited or
expired
|
|
|
(773,680
|
)
|
|
|
1.00
|
|
|
|
-
|
|
Balance – September 30,
2010
|
|
|
675,001
|
|
|
$
|
2.00
|
|
|
|
2.44
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Exercisable – September 30,
2010
|
|
|
675,001
|
|
|
|
|
|
|
|
|
|
Stock Option Plan
The
Company accounts for all stock based compensation as an expense in the financial
statements and associated costs are measured at the fair value of the
award. The Company also recognizes the excess tax benefit related to
stock option exercises as financing cash inflows instead of operating
inflows. As a result, the Company’s net loss before taxes for the
nine months ended September 30, 2010 and 2009 included $203,118 and $220,198 of
stock based compensation, respectively, and $42,807 and $25,853, respectively,
for the three months ended September 30, 2010 and
2009. The stock based compensation expense is included
in general and administrative expense in the condensed consolidated
statements of operations. The Company has selected a
“with-and-without” approach regarding the accounting for the tax effects of
share-based compensation awards.
AMERICAN
DEFENSE SYSTEMS, INC. AND SUBSIDIARIES
NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
The
following is a summary of stock options outstanding at September 30,
2010:
|
|
Stock Options
|
|
|
Weighted-
Average
Exercise
Price
|
|
|
Aggregate
Intrinsic
Value
|
|
|
Weighted
Average
Remaining
Contractual
Life (In
years)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Outstanding, January 1,
2010
|
|
|
2,230,000
|
|
|
$
|
1.81
|
|
|
|
-
|
|
|
|
4.39
|
|
Granted
|
|
|
275,000
|
|
|
|
0.31
|
|
|
|
-
|
|
|
|
6.65
|
|
Exercised
|
|
|
-
|
|
|
|
n/a
|
|
|
|
n/a
|
|
|
|
n/a
|
|
Cancelled/forfeited
|
|
|
-
|
|
|
|
n/a
|
|
|
|
n/a
|
|
|
|
n/a
|
|
Outstanding, September 30,
2010
|
|
|
2,505,000
|
|
|
$
|
1.65
|
|
|
|
-
|
|
|
|
4.64
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Exercisable, September 30,
2010
|
|
|
937,000
|
|
|
$
|
1.81
|
|
|
|
|
|
|
|
4.33
|
|
As of September 30, 2010, there was a total of
$374,141 of unrecognized compensation arrangements granted under the Company’s
2007 Incentive Compensation Plan (the “2007 Plan”). The cost is expected to be
recognized through 2014.
On
January 25, 2010, the Company issued an option to purchase 100,000 shares of its
common stock to an officer as compensation under the 2007 Plan pursuant to
an amendment to the officer’s employment agreement. The exercise price for the
option is $0.40 per share and 40% of the option vested on the grant date and 20%
of the option vests annually thereafter with the first 20% vesting upon the
first anniversary of the grant date.
On July
31, 2010, the Company issued an option to purchase 175,000 shares of its common
stock to a consultant as compensation under the 2007 Plan. The exercise price
for the option is $0.26 per share and vests at the rate of 20% per year with the
first 20% vesting upon the first anniversary of the grant date.
The
Black-Scholes method option pricing model was used to estimate fair value as of
the date of grant using the following assumptions:
Risk-Free
rate
|
|
|
2.94% - 3.12
|
%
|
Expected
volatility
|
|
|
95.21% - 98.76
|
%
|
Forfeiture
rate
|
|
|
0
|
%
|
Expected
life
|
|
7
Years
|
|
Expected
dividends
|
|
|
0
|
%
|
Based on the assumptions noted above, the fair market value of
the options issued during the nine months ended September 30, 2010 was
$87,655.
Stock
Grants
On
January 1, 2010, the Company issued 125,000 shares of its common stock to the
Company’s non-employee directors as part of the director compensation under the
2007 Plan. The fair value on the date of grant was $50,000 based on the stock
price on the date of issuance.
On
January 19, 2010, the Company issued 75,000 shares of its common stock to an
employee as compensation under the 2007 Plan. The fair value on the
date of the grant was $28,500 based on the stock price on the date of
issuance.
On March
2, 2010, the Company issued 12,500 shares of its common stock to a consultant as
compensation for services rendered under the 2007 Plan. The fair
value on the date of the grant was $4,500 based on the stock price on the date
of issuance.
On May 7,
2010, the Company issued 17,361 shares of common stock to a consultant as
compensation for services rendered under the 2007 Plan. The fair value on
the date of grant was $5,729 based on the stock price on the date of
issuance.
On May
28, 2010, the Company issued 26,136 shares of common stock to a consultant as
compensation for services rendered under the 2007 Plan. The fair value on the
date of grant was $7,318 based on the stock price on the date of
issuance.
On August
24, 2010, the Company issued 75,000 shares of common stock to a consultant as
compensation for services rendered under the 2007 Plan. The fair
value on the date of grant was $16,500 based on the stock price on the date of
issuance.
AMERICAN
DEFENSE SYSTEMS, INC. AND SUBSIDIARIES
NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
On
September 1, 2010, the Company issued 19,231 shares of common stock to a
consultant as compensation for services rendered under the 2007
Plan. The fair value on the date of grant was $3,654 based on the
stock price on the date of issuance.
All of
these awards were fully vested on the date of grant. The Company recorded stock
based compensation of approximately $20,154 and $116,201 for the three and nine
months ended September 30, 2010, respectively, related to these
awards.
On March
31, 2010, the Company issued 1,035,000 shares of its common stock to the Series
A Holders as settlement of $375,000 of dividends pursuant to the terms of such
Series A Preferred. The Company recorded this payment of dividends as interest
expense for the three months ended March 31, 2010.
On June
30, 2010, the Company issued 1,455,000 shares of its common stock to the Series
A Holders as settlement of $375,000 of dividends pursuant to the terms of such
Series A Preferred. The Company recorded this payment of dividends as interest
expense for the three months ended June 30, 2010.
On
September 30, 2010, the Company issued 2,520,000 shares of its common stock to
the Series A Holders as settlement of $375,000 of dividends pursuant to the
terms of such Series A Preferred. The Company recorded this payment of dividends
as interest expense for the three months ended September 30, 2010.
5.
|
SERIES
A CONVERTIBLE PREFERRED STOCK AND WARRANT
LIABILITIES
|
Features
of the Series A Preferred and Warrants Liabilities
2005
Warrants
On June
30, 2005, in connection with the closing of its 2005 private placement offering,
the Company issued purchase warrants for up to 555,790 shares of common stock at
the exercise price of $1.10 per share and with the expiration date of June 30,
2010 (the “2005 Warrants”).
On August
16, 2005, the Company issued 50,000 shares of its common stock at an effective
price per share of $1.00 to one of the Company’s employees for accepting a job
offer. As a result of this issuance, in accordance with the terms of the 2005
Warrants agreements, the exercise price was adjusted to $1.00 per share and the
number of shares of common stock that would be acquired was adjusted to
576,587.
The 2005
Warrants expired on June 30, 2010 pursuant to their terms and there are no
outstanding 2005 Warrants.
2006
Warrants
On
October 24, 2006, in accordance with the terms and conditions of the Company’s
closing of its 2005 private placement offering, the Company issued purchase
warrants for up to 179,175 shares of common stock at the exercise price of $1.10
per share and with the expiration date of June 30, 2010 (the “2006
Warrants”).
On
February 8, 2007, the Company issued an aggregate of 260,000 shares of its
common stock at an effective price per share of $1.00 to certain of its
employees for services rendered. As a result of this issuance, in accordance
with the terms of the 2006 Warrants agreements, the exercise price was adjusted
to $1.00 per share and the number of shares of common stock that would be
acquired was adjusted to 197,093.
The 2006
Warrants expired on June 30, 2010 pursuant to their terms and there are no
outstanding 2006 Warrants.
Series A Preferred and Investor Warrants and
Placement Agent Warrants
The
Company entered into a Securities Purchase Agreement (“Purchase Agreement”) on
March 7, 2008 to sell shares of its Series A Preferred and
warrants to purchase shares of its common stock (“Investor Warrants”), and to
conditionally sell shares of the Company’s common stock, to the Series A
Holders. The Series A Holders purchased an aggregate of 15,000 shares of
Series A Preferred and Investor Warrants to purchase up to 3,750,000 shares
of common stock, and to conditionally purchase 100,000 shares of common stock.
The aggregate purchase price for the Series A Preferred and Investor
Warrants was $15,000,000 and the aggregate purchase price for the common stock
was $500,000. The Company completed the sale of the Series A
Preferred and Investor Warrants in two rounds, on March 7, 2008 and April
4, 2008, and the Company and the Series A Holders determined not to
complete the conditional sale of the 100,000 shares of common stock. The Series
A Holders are entitled to receive cumulative dividends, due at each subsequent
calendar quarter-end until maturity, at a rate of 9% if settled via cash or at a
rate of 10% if settled via shares (at the option of the Company) of the
Company’s common stock. The dividends rate is subject to increase in the event
of a “Triggering Event” under the Certificate of Designations, Preferences and
Rights of the Series A Preferred (the “Certificate of Designations”) and in the
event of an “Equity Condition Failure” under the Certificate of Designations,
settlement via shares would not be allowed for the remaining dividend
payments.
AMERICAN
DEFENSE SYSTEMS, INC. AND SUBSIDIARIES
NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
The
Series A Holders may convert shares of Series A Preferred, plus the amount of
accrued but unpaid dividends, into shares of the Company’s
common
stock at the conversion price of $0.50, as amended on April 8, 2010. The
Conversion Price is subject to certain adjustments upon
issuance
of certain securities, under the Certificate of Designation, with a lower
exercise price and/or with negative dilutive effect. The Series A Holders may
require the Company to redeem all or any portion of the outstanding shares of
Series A Preferred in cash, at the amount of 100% of the “Conversion Amount” or
110% of the “Conversion Amount”, upon a Triggering Event or Equity Condition
Failure.
The
Company may redeem all or any portion of the outstanding shares of Series A
Preferred in cash at the amount of (i) 100% of the “Conversion Amount” at any
time after either the two-year anniversary of the “Public Company Date”, if
certain other conditions are met, or the six-month anniversary of the “Qualified
Public Offering Date”, if certain other conditions are met under
the Certificate of Designations (ii) 110% of the Conversion Amount upon an
Equity Condition Failure or (iii) 115% of the Conversion Amount prior to any
“Fundamental Transaction” under the Certificate of Designations.
Pursuant to the terms of the Series A Preferred, the Company was
required to redeem, in cash, any outstanding shares of the Series A Preferred on
December 31, 2010. On April 8, 2010, the Company entered into a
waiver agreement with the Series A Holders which extended the maturity date for
the mandatory redemption of all outstanding Series A Preferred from December 31,
2010 to April 1, 2011. On August 13, 2010, the Company entered into a waiver
agreement with the Series A Holders which extended the maturity redemption date
from April 1, 2011 to July 1, 2011. On November 12, 2010, the Company
entered into a waiver agreement with the Series A Holders which extended the
maturity redemption date from July 1, 2011 to October 1, 2011.
Settlement
Agreement
In
connection with a Notice of Triggering Event Redemption received by the Company
on April 14, 2009, the Company entered into a Settlement Agreement, Waiver
and Amendment with the Series A Holders on May 22, 2009 (the “Settlement
Agreement”) pursuant to which, among other things, (i) the Series A
Holders waived any breach by the Company of certain financial covenants or its
obligation to timely pay dividends on the Series A Preferred for any period
through September 30, 2009 and waived any Equity Conditions Failure and any
Triggering Event otherwise arising from such breaches, (ii) the
Investor Warrants were amended to reduce the exercise price thereof from $2.40
per share to $0.01 per share, (iii) the Company issued the Series A Holders
an aggregate of 2,000,000 shares of the Company’s common stock (the “Settlement
Shares ”), in full satisfaction of the Company’s obligation to pay dividends
under the Certificate of Designations as of March 31, 2009, June 30,
2009 and September 30, 2009, and (iv) the Company agreed to redeem
$7,500,000 in stated value of the Series A Preferred by December 31,
2009 (the “December 2009 Redemption”). The Company agreed that, if it
fails to so redeem $7,500,000 in stated value of the Series A Preferred by
that date (a “Redemption Failure”), then, in lieu of any other remedies or
damages available to the Series A Holders (absent fraud), (i) the
redemption price payable by the Company will increase by an amount equal to 10%
of the stated value, (ii) the Company will use its best efforts to obtain
stockholder approval to reduce the Conversion Price of the Series A
Preferred from $2.00 to $0.50 (which would increase the number of shares of
common stock into which the Series A Preferred is convertible), and
(iii) the Company will expand the size of its board of directors by two,
will appoint two persons designated by the Series A Holders to fill the two
newly-created vacancies, and will use its best efforts to amend the Company’s
certificate of incorporation to grant the Series A Holders the right to
elect two persons to serve on the board.
Pursuant
to the terms of the Settlement Agreement, the Company entered into a
Registration Rights Agreement with the Series A Holders pursuant to which,
among other things, the Company agreed to file with the Securities and Exchange
Commission (“SEC”), by June 1, 2009, a registration statement covering the
resale of the Settlement Shares, and to use its best efforts to have such
registration statement declared effective as soon as practicable
thereafter. The Company further agreed with the Series A Holders to
include in such registration statement the shares of common stock issued upon
the exercise of the Investor Warrants in May and June 2009. A
registration statement was filed, and subsequently declared effective on
August 10, 2009.
Pursuant to the terms of the Settlement Agreement, each of the
Company’s directors and executive officers has entered into a Lock-Up Agreement,
pursuant to which each such person has agreed that, for so long as any shares of
Series A Preferred remain outstanding, he will not sell any shares of the
Company’s common stock owned by him as of May 22, 2009. Also pursuant to
the terms of the Settlement Agreement, the Company’s Chief Executive Officer,
President and Chairman, entered into an Irrevocable Proxy and Voting Agreement
with the Series A Holders (the “ Voting Agreement ”), pursuant to which the
Company’s CEO agreed, among other things, that if a Redemption Failure occurs he
will vote all shares of the Company’s voting stock owned by him in favor of
(i) reducing the Conversion Price of the Series A Preferred from $2.00
to $0.50 and (ii) amending the Company’s certificate of incorporation to
grant the Series A Holders the right to elect two persons to serve on the
board of directors (collectively, the “ Company Actions ”). The Company’s
CEO also appointed WCOF as his proxy to vote his shares of the Company’s voting
stock in favor of the Company Actions, and against approval of any opposing or
competing proposal, at any stockholder meeting or written consent of the
Company’s stockholders at which such matters are
considered.
AMERICAN
DEFENSE SYSTEMS, INC. AND SUBSIDIARIES
NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
The
Company did not meet the December 2009 Redemption and has increased the size of
its board of directors by two and held a special meeting of shareholders on
April 8, 2010. At this special meeting, the shareholders approved the
amendments to the Company’s certificate of incorporation to (i) reduce the
Conversion Price of the Series A Preferred from $2.00 to $0.50 and (ii) grant
the Series A holders the right, voting as a separate class, to elect two persons
to serve on the Company’s board of directors. On April 8, 2010, the
Company entered into a waiver agreement with the Series A Holders which extended
the maturity date for the mandatory redemption of all outstanding Series A
Preferred from December 31, 2010 to April 1, 2011. On August 13, 2010, the
Company entered into a waiver agreement with the Series A
Holders
which further extended the maturity date for mandatory redemption of all
outstanding Series A Preferred from April 1, 2011 to July 1, 2011. On November
12, 2010, the Company entered into a waiver agreement with the Series A Holders
which further extended the maturity date for mandatory redemption of all
outstanding Series A Preferred from July 1, 2011 to October 1,
2011.
Investor
Warrants
In
connection with the sale of the Series A Preferred, Investor Warrants to
purchase up to 3,750,000 shares of common stock at $2.40 per share were issued
with an expiration date of April 11, 2011. The holders of the Investor Warrants
may require the Company to repurchase their warrants upon the occurrence of
certain defined events in the Investor Warrant agreement. As such the
Company recorded the Investor Warrants as a derivative at fair value at issuance
and subsequent reporting periods in accordance with ASC 815 “Derivatives and
Hedging”. Changes in the fair value from period to period are reported in the
statement of operations. In accordance with the Settlement
Agreement
entered into on May 22,
2009, the Investor Warrants were amended to reduce the exercise price from $2.40
to $0.01. The Investor Warrants were fully exercised on May 27, 2009, June
1, 2009, and June 8, 2009.
Placement Agent
Warrants
In
connection with the sale of the Series A Preferred and Investor Warrants,
the placement agent for such sale received warrants (the “Placement Agent
Warrants”) to purchase a total of 6% of the number of common stock issued in the
Series A Preferred financing or 675,001 shares at the exercise price of $2.00
per share and with the expiration date of March 7,
2013.
Accounting
for the Series A Preferred and Warrant Liabilities
2005 Warrants, 2006
Warrants, and Placement Agent Warrants
Upon
issuance, the 2005 Warrants, 2006 Warrants, and Placement Agent Warrants met the
requirements for equity classification set forth in Emerging Issues Task Force
(“EITF”) Issue 00-19,
Accounting for Derivative Financial
Instruments Indexed to, and Potentially Settled in a Company’s Own Stock
,
and Statement of Financial Accounting Standards (“SFAS”) No. 133, as codified in
ASC 815. However, effective January 1, 2009, the Company was required to analyze
its then outstanding financial instruments in accordance with EITF 07-5 as
codified in ASC 815-40. Based on the Company’s analysis, its 2005 Warrants, 2006
Warrants, and Placement Agent Warrants, include price protection provisions
whereby the exercise price could be adjusted upon certain financing transaction
at a lower price per share and could no longer be viewed as indexed to the
Company’s common stock. As a result, the 2005 Warrants, 2006 Warrants, and
Placement Agent Warrants are accounted for as “derivatives” under ASC 815 and
recorded as liabilities at fair value as of January 1, 2009 with changes in
subsequent period fair value recorded in the statement of operations.
Series A
Preferred
The
Series A Preferred is mandatorily redeemable on October
1, 2011 and convertible
into shares of common stock at a rate of 2,000 shares of common stock for each
share of Series A Preferred. As a result the Company elected to record the
hybrid instrument, preferred stock and conversion option together, at fair
value. Subsequent reporting period changes in fair value are to be reported in
the consolidated statement of operations.
The
proceeds from the issuance of the Series A Preferred and Investor Warrants,
net of direct costs including the fair value of warrants issued to placement
agent in connection with the transaction, were allocated to the instruments
based upon relative fair value upon issuance as these instruments must be
measured initially at fair value.
Therefore, after the initial
recording of the Series A Preferred based upon net proceeds received, the
carrying value of the Series A Preferred was adjusted to the fair value at
the date of issuance, with the difference recorded as a gain or
loss.
The
Settlement Agreement provides that $7,500,000 in stated value of the
Series A Preferred was to be redeemed at December 31, 2009. The
Company did not effect such redemption. As a result, in lieu of any other
remedies or damages available to Series A Holders, the redemption price payable
by the Company increased by an amount equal to 10% of the stated value, and the
Company amended its certificate of incorporation to (i) reduce the Conversion
Price of the Series A Preferred from $2.00 to $0.50 (which increased the number
of shares of its common stock into which the Series A Preferred is convertible)
and (ii) grant the Series A Holders, voting as a separate class, the right to
elect two persons to serve on its board of directors.
AMERICAN DEFENSE SYSTEMS, INC. AND
SUBSIDIARIES
NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Valuation
– Methodology and Significant Inputs Assumptions
Fair
values for the Company’s derivatives and financial instruments are estimated by
utilizing valuation models that consider current and expected stock prices,
volatility, dividends, market interest rates, forward yield curves and discount
rates. Such amounts and the recognition of
such
amounts are subject to significant estimates which may change in the future. The
methods and significant inputs and assumptions utilized in estimating the fair
value of the 2005 Warrants, 2006 Warrants, Placement Agent Warrants, and Series
A Preferred are discussed below. Each of the measurements is considered a Level
3 measurement as a result of at least one unobservable input.
2005 and 2006
Warrants
All 2005
and 2006 Warrants expired on June 30, 2010.
Placement Agent
Warrants
A
Black-Scholes-Merton option-pricing model was utilized to estimate the fair
value of the Placement Agent Warrants as of September 30, 2010. This model is
subject to the significant assumptions discussed below and requires the
following key inputs with respect to the Company and/or instrument:
Input
|
|
September 30,
2010
|
|
Quoted
Stock Price
|
|
$
|
0.16
|
|
Exercise
Price
|
|
$
|
2.00
|
|
Expected
Life (in years)
|
|
|
2.44
|
|
Stock
Volatility
|
|
|
98.16
|
%
|
Risk-Free
Rate
|
|
|
0.64
|
%
|
Dividend
Rate
|
|
|
0
|
%
|
Series A
Preferred
A
binomial lattice model was utilized to estimate the fair value of the Series A
Preferred as of September 30, 2010. The binomial model considers the key
features of the Series A Preferred, as noted above, and is subject to the
significant assumptions discussed below. First, a discrete simulation of the
Company’s stock price was conducted at each node and throughout the expected
life of the instrument. Second, an analysis of the higher position of a
conversion position, redemption position, or holding position (i.e. fair value
of the respective future nodes value discounted using the applicable discount
rate) was conducted relative to each node until a final fair value of the
instrument is conducted at the node representing the measurement date. This
model requires the following key inputs with respect to the Company and/or
instrument:
Input
|
|
September
30,
2010
|
|
Risk-Free
Rate
|
|
|
0.27
|
%
|
Expected
Volatility
|
|
|
85.02
|
%
|
Expected
Remaining Term until Maturity (in years)
|
|
0.75
|
|
Expected
Dividends
|
|
|
0.00
|
%
|
Strike
Price
|
|
$
|
0.50
|
|
Quoted
Stock Price
|
|
$
|
0.16
|
|
Effective
Discount Rate
|
|
|
24.00
|
%
|
The
following are significant assumptions utilized in developing the
inputs
|
|
Stock volatility was estimated by
considering (i) the annualized daily volatility of the Company’s stock
price during the historical period preceding the respective valuation
dates and measured over a period corresponding to the remaining life of
the instruments and (ii) the annualized daily volatility of comparable
companies’ stock price during the historical period preceding the
respective valuation dates and measured over a period corresponding to the
remaining life of the instrument. Historic prices of the Company and
comparable companies’ common stock were used to estimate volatility as the
Company did not have traded options as of the valuation
dates;
|
|
|
Based on the Company’s historical
operations and management’s expectations for the near future, the
Company’s stock was assumed to be a non-dividend-paying
stock;
|
AMERICAN
DEFENSE SYSTEMS, INC. AND SUBSIDIARIES
NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
|
|
Based on management’s
expectations for the near future, the Company is expected to settle the
future quarterly dividends due to the Series A Holders via
shares;
|
|
|
The
quoted market price of the Company’s stock was utilized in the valuations
because ASC 820-10 requires the use of quoted market prices, if available,
without considerations of blockage discounts (if the input is considered
as a Level 1 input). Because the stock is thinly traded, the quoted market
price may not reflect the market value of a large block of stock;
and
|
|
|
The
quoted market price of the Company’s stock as of measurement dates and
expected future stock prices were assumed to reflect the effect of
dilution upon conversion of the instruments to shares of common
stock.
|
The changes in fair value estimate between reporting periods
are related to the changes in the price of the Company’s common stock as of
the measurement dates, the expected volatility of the Company’s common stock
during the remaining term of the instrument, changes in the conversion price and
estimated discount rate.
On
January 2, 2009, the Company entered into an agreement with the prior owners of
TAG to sell certain assets and liabilities previously acquired from TAG back to
TAG. TAG was accounted for as a discontinued operation under
Generally Accepted Accounting Principles (“GAAP”), which requires the income
statement information be reformatted to separate the divested business from the
Company’s continuing operations.
There
were no discontinued operations related to TAG for the three or nine month
period ended September 30, 2010
and
2009.
In
accordance with the terms of the agreement, the original owners of TAG agreed to
repay $1,000,000 of the original $2,000,000 in consideration as
follows:
2009
|
|
$
|
100,000
|
|
2010
|
|
$
|
100,000
|
|
2011
|
|
$
|
200,000
|
|
2012
|
|
$
|
300,000
|
|
2013
|
|
$
|
300,000
|
|
Total
|
|
$
|
1,000,000
|
|
The
original owners of TAG have collateralized the note receivable with their
personal residence and the 250,000 shares issued to them on the date of
acquisition. These shares are being held by the Company in escrow
since January 2009 and will be returned upon final payment toward the note
receivable.
Due to
cash flow constraints, TAG is experiencing difficulty repaying the amounts due
to the Company.
The
Company and the original owners of TAG are currently in the process of
finalizing a re-negotiation of the contract with a new payment schedule starting
in 2011. The Company recorded a reserve on the note receivable of $575,000 as of
September 30, 2010 and December 31, 2009 of which $175,000 was included in
current assets and $400,000 is in long term assets. In addition, the Company
recorded a $575,000 loss from disposal of discontinued division for the year
ended December 31, 2009. The Company has included the entire amount as notes
receivable on its balance sheet, of which $400,000 is included within long term
assets.
Item 2. Management’s Discussion and
Analysis of Financial Condition and Results of Operations
The
following discussion and analysis of our financial condition and results of
operations should be read in conjunction with our consolidated financial
statements and related notes that appear elsewhere in this report and in our
annual report on Form 10-K for the year ended December 31,
2009.
Except
for statements of historical fact, certain information described in this report
contains “forward-looking statements” that involve substantial risks and
uncertainties. You can identify these statements by forward-looking words such
as “anticipate,” “believe,” “could,” “estimate,” “expect,” “intend,” “may,”
“should,” “project,” “will,” “would” or similar words. The statements that
contain these or similar words should be read carefully because these statements
discuss our future expectations, contain projections of our future results of
operations or of our financial position, or state other “forward-looking”
information. We believe that it is important to communicate our future
expectations to our investors. However, there may be events in the future that
we are not able accurately to predict or control. Further, we urge you to be
cautious of the forward-looking statements which are contained in this report
because they involve risks, uncertainties and other factors affecting our
operations, market growth, service and products. You should not place
undue reliance on any forward-looking statement, which speaks only as of the
date made. Our actual results could differ materially from those discussed in
the forward-looking statements. Factors that could cause or contribute to these
differences include those discussed below and elsewhere in this report,
particularly in “Risk Factors” in Item 1A of Part II.
Overview
We
are a defense and security products company engaged in three business areas:
customized transparent and opaque armor solutions for construction equipment,
and tactical and non-tactical transport vehicles used by the military;
architectural hardening and perimeter defense, such as bullet and blast
resistant transparent armor, walls and doors, as well as vehicle anti-ram
barriers such as bollards, steel gates and steel wedges that deploy out of the
ground; and tactical training products and services consisting of our live-fire
interactive T2 Tactical Training System (or T2) and our American Institute for
Defense and Tactical Studies.
We
primarily serve the defense market and our sales are highly concentrated within
the U.S. government. Our customers include various branches of the U.S. military
through the U.S. Department of Defense (or DoD) and to a much lesser extent
other U.S. government, law enforcement and correctional agencies as well as
private sector customers.
Our
recent historical revenues have been generated primarily from a limited number
of large contracts and a series of purchase orders from a single customer. To
continue expanding our business, we are seeking to broaden our customer base and
to diversify our product and service offerings. Our strategy to increase our
revenue, grow our company and increase stockholder value involves the following
key elements:
|
increase exposure to military
platforms in the U.S. and
internationally;
|
|
develop strategic alliances and
form strategic partnerships with original equipment manufacturers
(OEMs);
|
|
capitalize on increased homeland
security requirements and non-military
platforms;
|
|
focus on an advanced research and
development program to capitalize on increased demand for new armor
materials; and
|
|
pursue strategic
acquisitions.
|
We are pursuing each of these growth strategies simultaneously,
and believe one or more of them will result in additional revenue opportunities
within the next 12 months.
Sources
of Revenues
We derive
our revenues by fulfilling orders under master contracts awarded by branches of
the United States military, law enforcement and corrections agencies, private
companies involved in the defense market and other customer purchase orders.
Under these contracts and purchase orders, we provide customized transparent and
opaque armor products for transport and construction vehicles used by the
military, group protection kits and spare parts. We also derive revenues from
sales of our architectural hardening and perimeter defense products, which we
sometimes refer to as physical security products. To date, we have generated
nominal revenues from our T2 and other training solutions and we are evaluating
the continued offering of such training products and services and expect to
continue that process over the next several months.
Our
contract backlog as of September 30, 2010 was $31 million. We estimate that $7
million of contract backlog as of September 30, 2010 will be filled during the
remainder of 2010. Accordingly, in order to maintain our current revenue levels
and to generate revenue growth, we will need to win more contracts with the U.S.
government and other commercial entities, achieve significant penetration into
critical infrastructure and public safety protection markets, and successfully
further develop our relationships with OEMs and strategic partners.
Notwithstanding the anticipated significant troop reductions in
Afghanistan and Iraq, we expect that demand in those countries for armored
military construction vehicles will continue in order to repair significant war
damage and for nation-building purposes. In addition, we are exploring interest
in armored construction equipment in other countries with mine-infested
regions.
We
continue to aggressively bid on projects and are in preliminary talks with a
number of international firms to pursue long-term government and commercial
contracts, including with respect to Homeland Security. While no assurances can
be given that we will obtain a sufficient number of contracts or that any
contracts we do obtain will be of significant value or duration, we are
confident that we will continue to have the opportunity to bid on and win
contracts.
Cost
of Revenues and Operating Expenses
Cost of Revenues.
Cost of revenues consists of parts, direct labor and
overhead expense incurred for the fulfillment of orders under contract. These
costs are charged to expense upon completion and acceptance of an order. Costs
of revenue also includes the costs of prototyping and engineering, which are
expensed upon completion of an order as well. These costs are included as costs
of revenue because they are incurred to modify products based upon government
specifications and are reimbursable costs within the contract. These costs for
the production of goods under contract are expensed when they are complete. We
allocate overhead expenses such as employee benefits, computer supplies,
depreciation for computer equipment and office supplies based on personnel
assigned to the job. As a result, indirect overhead expenses are included in
cost of revenues and each operating expense category.
Sales and Marketing.
Expenses related to sales and marketing consist
primarily of compensation for our sales and marketing personnel, sales
commissions and incentives, trade shows and related travel. Sales and
marketing costs are charged to expense as incurred.
Research and Development.
Research and development expenses are incurred as we
perform ongoing evaluations of materials and processes for existing products, as
well as the development of new products and processes. Such expenses typically
include compensation and employee benefits of engineering and testing personnel,
materials, travel and costs associated with design and required testing
procedures associated with our product line. Research and development costs are
charged to expense as incurred.
General and Administrative.
General and administrative expenses consist of rent,
utilities, and other corporate expenses. We expect that during the remainder of
2010, general and administrative expenses will continue to decrease as compared
to 2009 due to a cost cutting initiative implemented at the end of 2009 and in
January 2010. For the nine months ended September 30, 2010, we have decreased
general and administrative expenses by approximately 8% compared to the same
period in 2009.
General and Administrative
Salaries.
General and administrative salaries expenses consist
of compensation and related expenses for executive, finance, accounting,
administrative, IT, and design and engineering personnel. We expect that during
the remainder of 2010, general and administrative salaries expenses will
continue to decrease as compared to 2009 due to a cost cutting initiative, which
includes a reduction in labor costs, implemented at the end of 2009 and in
January 2010. For the nine months ended September 30, 2010, we have decreased
general and administrative salaries expenses by approximately 13% compared to
the same period in 2009.
Critical Accounting Policies
Our
condensed consolidated financial statements are prepared in accordance with
accounting principles generally accepted in the United States. The preparation
of these consolidated financial statements requires us to make estimates and
assumptions that affect the reported amounts of assets, liabilities, revenues,
costs and expenses and related disclosures. On an ongoing basis, we evaluate our
estimates and assumptions. Our actual results may differ from these estimates
under different assumptions or conditions.
We
believe that of our significant accounting policies, which are described in
Note 1 to the consolidated financial statements included in our Annual
Report on Form 10-K for the year ended December 31, 2009, involve a greater
degree of judgment and complexity. Accordingly, these are the policies we
believe are the most critical to aid in fully understanding and evaluating our
consolidated financial condition and results of operations.
Revenue and Cost Recognition
.
We recognize revenue in accordance with the provisions
of Accounting Standards Codification (ASC) 605, “Revenue Recognition”, which
states that revenue is realized and earned when all of the following criteria
are met: (a) persuasive evidence of the arrangement exists, (b) delivery has
occurred or services have been rendered, (c) the seller’s price to the buyer is
fixed and determinable and (d) collectability is reasonably assured. Under this
provision, revenue is recognized upon delivery and acceptance of the
order.
We
recognize revenue and report profits from purchases orders filled under master
contracts when an order is complete. Purchase orders received under master
contracts may extend for periods in excess of one year. However, no revenues,
costs or profits are recognized in operations until the period of completion of
the order. An order is considered complete when all costs, except insignificant
items, have been incurred and the installation or product is operating according
to specification or the shipment has been accepted by the customer. Provisions
for estimated contract losses are made in the period that such losses are
determined. As of September 30, 2010 and December 31, 2009, there were no such
provisions made.
Stock-Based Compensation.
Stock based compensation consists of stock or options
issued to employees, directors and contractors for services rendered. We
accounted for the stock issued using the estimated current market price per
share at the date of issuance. Such cost was recorded as compensation in our
statement of operations at the date of issuance.
In
December 2007, we adopted our 2007 Incentive Compensation Plan pursuant to
which we have issued and intend to issue stock-based compensation from time to
time, in the form of stock, stock options and other equity based awards. Our
policy for accounting for such compensation in the form of stock options is as
follows:
We
account for stock based compensation in accordance with ASC 718
“Compensation–Stock Compensation”. In accordance with ASC 718,
we use the Black-Scholes option pricing model to measure the fair value of
our option awards. The Black-Scholes model requires the input of highly
subjective assumptions including volatility, expected term, risk-free interest
rate and dividend yield. In 2005, the SEC issued Staff Accounting Bulletin (SAB)
No. 107, as codified in ASC 718-10-599, which provides supplemental
implementation guidance for ASC 718.
Because
we have only recently become a public entity, we have a limited trading
history. The expected term of an award is based on the “simplified” method
allowed by ASC 718-10-599, whereby the expected term is equal to the period of
time between the vesting date and the end of the contractual term of the award.
The risk-free interest rate is based on the rate on U.S. Treasury zero coupon
issues with maturities consistent with the estimated expected term of the
awards. We have not paid and do not anticipate paying a dividend on our common
stock in the foreseeable future and accordingly, use an expected dividend yield
of zero. Changes in these assumptions can affect the estimated fair value of
options granted and the related compensation expense which may significantly
impact our results of operations in future periods.
Stock-based
compensation expense recognized will be based on the estimated portion of the
awards that are expected to vest. We will apply estimated forfeiture rates based
on analyses of historical data, including termination patterns and other
factors.
We
recognized $203,118 and $220,198 in stock compensation expense for the nine
months ended September 30, 2010 and 2009, respectively, and $42,807 and $25,853
for the three months ended September 30, 2010 and 2009,
respectively.
Fair Value
Measurements
. We have adopted the provisions of ASC 820,
“Fair Value Measurements and Disclosures”. ASC 820 defines fair value,
establishes a framework for measuring fair value in accordance with generally
accepted accounting principles and expands disclosures about fair value
investments.
Fair
value, as defined in ASC 820, is the price that would be received to sell an
asset or paid to transfer a liability in an orderly transaction between market
participants at the measurement date. The fair value of an asset should reflect
its highest and best use by market participants, whether using an in-use or an
in-exchange valuation premise. The fair value of a liability should reflect the
risk of nonperformance, which includes, among other things, our credit
risk.
Valuation
techniques are generally classified into three categories: the market approach;
the income approach; and the cost approach. The selection and application of one
or more of the techniques may require significant judgment and are primarily
dependent upon the characteristics of the asset or liability, the principal (or
most advantageous) market in which participants would transact for the asset or
liability, and the quality and availability of inputs. Inputs to valuation
techniques are classified as either observable or unobservable within the
following hierarchy:
|
Level 1 Inputs: These
inputs come from quoted prices (unadjusted) in active markets for
identical assets or
liabilities.
|
|
Level 2 Inputs: These
inputs are other than quoted prices that are observable, for an asset or
liability. This includes: quoted prices for similar assets or liabilities
in active markets; quoted prices for identical or similar assets or
liabilities in markets that are not active; and inputs that are derived
principally from or corroborated by observable market data by correlation
or other means.
|
|
Level 3 Inputs: These are
unobservable inputs for the asset or liability which require our own
assumptions.
|
Series A Convertible Preferred Stock, Investor Warrants and
Placement Agent Warrants
Series A Convertible Preferred
Stock.
The Series A Convertible Preferred Stock (or Series A
Preferred) is redeemable on October 1, 2011 (as extended from December 31, 2010
to April 1, 2011 pursuant to a waiver agreement with the Series A Holders dated
April 8, 2010, further extended from April 1, 2011 to July 1, 2011
pursuant to a waiver agreement with the Series A Holders dated August 13, 2010
and further extended from July 1, 2011 to October 1, 2011 pursuant to a waiver
agreement with the Series A Holders dated November 12, 2010) and
convertible into shares of common stock at a rate of 2,000 shares of common
stock for each share of Series A Preferred subject to adjustment should we issue
future common stock at a lesser price. As a result we elected to record the
hybrid instrument, preferred stock and conversion option together, at fair
value. Subsequent reporting period changes in fair value are to be
reported in the statement of operations.
The
proceeds from the issuance of the Series A Preferred and accompanying
common stock warrants (or Investor Warrants), net of direct costs including the
fair value of warrants issued to a placement agent in connection with the
transaction, must be allocated to the instruments based upon relative fair value
upon issuance as they must be measured initially at fair value. Therefore, after
the initial recording of the Series A Preferred based upon net proceeds
received, the carrying value of the Series A Preferred must be adjusted to
the fair value at the date of issuance, with the difference recorded as a gain
or loss. On March 7, 2008, the date of initial issuance, we recorded a
derivative liability of $9.8 million. On April 4, 2008, the date of the
second issuance, we recorded a derivative liability of $3.6 million. The
fair value of the Series A Preferred was adjusted as of September 30, 2010,
resulting in a loss of $50,594 and $923,609 for the three and nine months then
ended, respectively. As of September 30, 2010, the adjusted fair value of the
Series A Preferred is $13,966,268.
Derivative
Warrants
Investor
Warrants.
The Investor Warrants met the criteria
under ASC 815 “Derivatives and Hedging”. Under ASC 815, the warrants
were recorded at fair value upon the date of issuance, with changes in the value
fair value recognized as a gain or loss as they occur. On March 7, 2008,
the date of initial issuance, we recorded a derivative liability of $1.1
million. On April 4, 2008, the date of the second issuance, we recorded a
derivative liability of $0.4 million.
On
May 22, 2009, we entered into a Settlement Agreement, Waiver and Amendment
(or Settlement Agreement) with the holders of the Series A Preferred (or
Series A Holders) pursuant to which, among other things, the Investor Warrants
were amended to reduce the exercise price thereof from $2.40 per share to $0.01
per share. The warrants were exercised in full during May and June
2009 and the Investor Warrant liability was accordingly reclassified to
Additional Paid-In Capital.
For
additional information, see “Liquidity and Capital Resources - Series A
Convertible Preferred Stock” below.
Placement Agent Warrants
The
warrants issued to the placement agent with respect to the sale of the
Series A Preferred and Investor Warrants (or Placement Agent Warrants) were
accounted for as a transaction cost associated with the issuance of the
Series A Preferred. The Placement Agent Warrants are recorded at fair value
at the date of issuance. Under EITF 00-19 “Accounting for Derivative
Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own
Stock”, as codified in ASC 815, we satisfy the criteria for classification of
the Placement Agent Warrants as equity on the date of issuance. We have recorded
the corresponding amount recorded as a deferred financing cost since the
Series A Preferred and Investor Warrants are classified as liabilities and
are amortized as additional financing costs over the term of the
Series A Preferred using the interest method. At the date of each issuance,
we recorded $1.0 million and $0.4 million in deferred financing costs. Effective
January 1, 2009, we were required to analyze these instruments in accordance
with EITF 07-5 as codified in ASC 815-40. Based on our analysis, the Placement
Agent Warrants include price protection provisions whereby the exercise price
could be adjusted upon certain financing transaction at a lower price per share
and could no longer be viewed as indexed to our common stock. As a result, we
accounted for these warrants as a “derivative” under ASC 815 and
recorded as liabilities at fair value on January 1, 2009 of $91,743. The fair
value of these warrants is $9,915 as of September 30, 2010. A gain of
$15,923 and $19,632 was recorded on the change in fair value in the statement of
operations for the three and nine months ended September 30, 2010,
respectively.
2005
Warrants and 2006 Warrants
Upon
issuance, warrants issued in connection with the closing of the Company’s
private placement offering in 2005 and 2006 (or the 2005 Warrants and 2006
Warrants) met the requirements for equity classification set forth in EITF Issue
00-19, “Accounting for Derivative Financial Instruments Indexed to, and
Potentially Settled in a Company’s Own Stock”, and SFAS No. 133 as codified in
ASC 815. However, effective January 1, 2009, we were required to analyze these
instruments in accordance with EITF 07-5 as codified in ASC 815-40. Based on our
analysis, the 2005 Warrants and 2006 Warrants include price protection
provisions whereby the exercise price could be adjusted upon certain financing
transaction at a lower price per share and could no longer be viewed as indexed
to our common stock. As a result, the 2005 Warrants and 2006 Warrants were
accounted for as “derivatives” under ASC and recorded as liabilities at fair
value on January 1, 2009 of $74,032. The fair value of these warrants was $0 as
of September 30, 2010. A gain of $0 and $5,866 was recorded on the change in
fair value in the statement of operations for the three and nine months ended
September 30, 2010, respectively. The 2005 Warrants and the 2006 Warrants
expired on June 30, 2010 without being exercised.
Consolidated Results of Operations
The
following discussion should be read in conjunction with the information set
forth in the condensed consolidated financial statements and the related notes
thereto appearing elsewhere in this report.
Comparison
of the Three Months Ended September 30, 2010 and 2009
Revenues.
Revenues for
the three months ended September 30, 2010 were $8.7 million, a decrease of $3.9
million, or 31.0%, as compared to revenues of $12.6 million in the comparable
period in 2009. This decrease was due primarily to a slow-down in
government orders. For the three months ended September 30, 2010 and 2009,
the revenues for our physical security product business were $1.2
million.
Cost of Revenues.
Cost
of revenues for the three months ended September 30, 2010 was $4.7 million, a
decrease of $5.3 million, or 53.0%, over cost of revenues of $10.0 million in
the comparable period in 2009. This decrease resulted primarily from
contract billings of $3.3 million that were under audit by the government as of
June 30, 2010 and were recognized as revenue upon approval during the quarter
ended September 30, 2010. The total contract was for $6.2 million of which $2.9
million of revenue and related cost of sales was recorded during the quarter
ended June 30, 2010.
Gross Profit
.
Gross profits for the three months ended September 30, 2010 and 2009 were $4.1
million and $2.6 million, respectively. Gross profit margin was 46.7% and 20.9%
for three months ended September 30, 2010 and 2009, respectively. The
increase in gross profit margin resulted primarily from contract billings of
$3.3 million that were under audit by the government as of June 30, 2010 and
were recognized as revenue upon approval during the quarter ended September 30,
2010. The total contract was for $6.2 million of which $2.9 million of revenue
and related cost of sales was recorded during the quarter ended June 30,
2010.
Sales and Marketing Expenses.
Sales and marketing expenses for the three months ended September
30, 2010 and 2009 were $431,140 and $560,231, respectively, representing a
decrease of $129,091, or 23.0%. The decrease was due primarily to
a decrease in trade show expenses and related expenses from selling and
marketing, and the cost cutting initiative we implemented at the end of 2009 and
in January 2010.
T2 Expenses.
T2
expenses for the three months ended September 30, 2010 and 2009 were $206,511
and $154,766, respectively, representing an increase of $51,745, or
33.4%. The increase was due primarily to an increase in T2 salary
expense resulting from the increase in the number of T2
employees.
Research and Development
Expenses.
Research and development expenses for the three
months ended September 30, 2010 and 2009 were $274,750 and $117,268,
respectively. The increase of $157,482 or 134.3% from 2009 to 2010 was
primarily the result of additional testing of our Crew Protection Kits (CPKs),
improvements of existing products, continued work on our products in
development, and expenses related to earmarks to be billed to the
government.
General and Administrative
Expenses.
General and administrative expenses for the three
months ended September 30, 2010 and 2009 were $1.4 million and $1.9 million,
respectively. The decrease of $0.5 million or 26.3% was due primarily to the
cost cutting initiative we implemented at the end of 2009 and in January
2010.
General and Administrative Salaries
Expense.
General and administrative salaries expenses for the
three months ended September 30, 2010 and 2009 were $870,384 and $1,051,214,
respectively. The decrease of $180,830 or 17.2% was due primarily to the
cost cutting initiative we implemented at the end of 2009 and in January 2010.
Depreciation Expense.
Depreciation expense was $290,868 and $278,264 for the three months ended
September 30, 2010 and 2009, respectively, an increase of $12,604, or
4.5%.
Professional Fees.
Professional fees for the three months ended September 30, 2010 and 2009 were
$99,463 and $471,098, respectively. The decrease of $371,635 or 78.9% was due
primarily to a shift from the reliance on outside legal counsel to in-house
legal counsel.
Other (Income) and Expense.
Our Series A Preferred is recorded at fair value with changes in
fair value recorded in the statement of operations. Changes in the price
of our common stock as well as other valuation assumptions affect the fair
value. We
experienced
a loss on adjustment of fair value with respect to our Series A Preferred
of $50,594 and $498,407 for the three months ended September 30, 2010 and 2009,
respectively. In addition, we incurred interest expense associated with
the amortization of the deferred financing costs and discount on the
Series A Preferred of $432,994 and $588,765 for the three months ended
September 30, 2010 and 2009, respectively.
Comparison
of the Nine Months Ended September 30, 2010 and 2009
Revenues.
Revenues for
the nine months ended September 30, 2010 were $35.6 million, a decrease
of $0.6 million, or 1.7%, over revenues of $36.2 million in the comparable
period in 2009. Revenues were relatively flat despite a slow-down in
government defense spending. For the nine months ended September 30, 2010 the
revenues for our physical security product business were $8.3 million, an
increase of $5.0 million or 151.5% over revenues of $3.3 million for the
nine months ended September 30, 2009.
Cost of Revenues.
Cost
of revenues for the nine months ended September 30, 2010 was $24.2 million, a
decrease of $0.1 million, or 0.4%, over cost of revenues of $24.1 million in the
comparable period in 2009.
Gross Profit
.
Gross profits for the nine months ended September 30, 2010 and 2009 were
approximately $11.4 million and $12.1 million, respectively. Gross profit
margin was 31.9% and 33.3% for the nine months ended September 30, 2010 and
2009.
Sales and Marketing Expenses.
Sales and marketing expenses for the nine months ended September 30,
2010 and 2009 were $1.6 million and $2.0 million, respectively, representing a
decrease of $0.4 million, or 20.0%. The decrease was due primarily to
a decrease in trade show expenses and related expenses from selling and
marketing, and the cost cutting initiative we implemented at the end of 2009 and
in January 2010.
T2 Expenses.
T2
expenses for the nine months ended September 30, 2010 and 2009 were $629,838 and
$392,438, respectively, representing an increase of $237,400, or
60.5%. The increase was due primarily to an increase in T2 salary
expense resulting from the increase in the number of T2
employees.
Research and Development
Expenses.
Research and development expenses for the nine
months ended September 30, 2010 and 2009 were $548,464 and $320,495,
respectively. The increase of $227,969 or 71.1% from 2009 to 2010 was
primarily the result of additional testing of our CPKs, improvements of existing
products, continued work on our products in development, and expenses related to
earmarks to be billed to the government.
General and Administrative
Expenses.
General and administrative expenses for the nine
months ended September 30, 2010 and 2009 were $4.7 million and $5.1 million,
respectively. The decrease of $0.4 million, or 7.8%, was due primarily to
the cost cutting initiative we implemented at the end of 2009 and in January
2010.
General and Administrative Salaries
Expense.
General and administrative salaries expenses for the
nine months ended September 30, 2010 and 2009 were $2.7 million and $3.1
million, respectively. The decrease of $0.4 million or 12.9% was due
primarily to the cost cutting initiative we implemented at the end of 2009 and
in January 2010.
Depreciation Expense.
Depreciation expense was $870,120 and $797,676 for the nine months ended
September 30, 2010 and 2009, respectively, an increase of $72,444, or
9.1%.
Professional Fees.
Professional fees for the nine months ended September 30, 2010 and 2009 were
$1.4 million and $1.6 million, respectively. The decrease of $0.2 million, or
12.5%, was due primarily to a shift from the reliance on outside legal counsel
to in-house legal counsel.
Other (Income) and Expense.
Our Series A Preferred is recorded at fair value with changes in
fair value recorded in the statement of operations. Changes in the price
of our common stock as well as other valuation assumptions affect the fair
values. We experienced a loss on adjustment of fair value with respect to our
Series A Preferred of $0.9 million and $1.2 million for the nine months
ended September 30, 2010 and 2009, respectively. In addition, we incurred
interest expense associated with the amortization of the deferred financing
costs and discount on the Series A Preferred of $1.6 million and $1.4
million for the nine months ended September 30, 2010 and 2009, respectively. As
a result of the modification of the terms of our Series A Preferred pursuant to
the May 22, 2009 Settlement Agreement, we recorded a loss of $2.6 million on
deemed extinguishment of debt for the nine months ended September 30,
2009.
Liquidity
and Capital Resources
The
primary sources of our liquidity during the nine months ended September 30, 2010
have come from operations. As of September 30, 2010, our principal sources
of liquidity were net accounts receivable of $2.1 million and costs in
excess of billings of $2.9 million.
We
believe that our current net accounts receivable and costs in excess of billings
together with our expected cash flows from operations and our ability to sell
accounts receivable to Republic Capital Access (RCA) will be sufficient to meet
our anticipated cash requirements for working capital and capital expenditures
at least through September 30, 2011. The Series A Preferred is redeemable on
October 1, 2011, as extended from December 31, 2010 to April 1, 2011, pursuant
to a waiver agreement with the Series A Holders dated April 8, 2010, further
extended from April 1, 2011 to July 1, 2011 pursuant to a waiver agreement with
the Series A Holders dated August 13, 2010 and further extended from July 1,
2011 to October 1, 2011 pursuant to a waiver agreement with the Series A Holders
dated November 12 , 2010). We are currently seeking to raise capital or obtain
access to capital sufficient to permit us to effect such redemption. If we are
unable to timely raise capital or obtain access to a credit facility or other
source of funds sufficient to fund such redemption, our cash flow could be
adversely affected and our business significantly harmed. In addition,
restrictions imposed pursuant to the General Corporation Law of the State of
Delaware (the “DGCL”), our state of incorporation, would prohibit us from
satisfying such redemption if we lack sufficient surplus, as such term is
defined under the DGCL.
Net Cash Provided By Operating
Activities.
Net cash provided by operating activities was
$2,239,821 for the nine months ended September 30, 2010 compared to $1,556,452
for the nine months ended September 30, 2009. Net cash provided by
operating activities during the nine months ended September 30, 2010 consisted
primarily of changes in our operating assets and liabilities
of $2,104,158, including changes in accounts receivable, cost in excess of
billing, prepaid expenses and other current assets, and accounts payable and
accrued expenses. The decreases in accounts receivable and costs in excess
of billing of $123,771 and $4,755,511, respectively, reflect a decrease in
receivables from increased collections and a decrease in costs incurred on
projects in process as of September 30, 2010. Net cash provided by
operating activities during the nine months ended September 30, 2009 consisted
primarily of changes in our operating assets and liabilities including
accounts receivable, cost in excess of billing, prepaid expenses and other
current assets, and accounts payable and accrued expenses. The increases
in accounts receivable and costs in excess of billing of $966,873 and
$2,914,789, respectively, reflect the increases in projects in process as of
September 30, 2009.
As of December 31, 2009, we had a net operating loss carry
forward of $9.3 million available to reduce future taxable
income. The taxable income generated in future periods will be offset
by net operating loss carry forward and result in no current tax
liability. We have a full valuation allowance against our deferred
tax assets as our management concluded that it was more likely than not that we
would not realize the benefit of our deferred tax assets by generating
sufficient taxable income in future years. We expect to continue to
provide a full valuation allowance until, or unless, we can sustain a level of
profitability that demonstrates our ability to utilize these
assets.
Net Cash Used In Investing
Activities.
Net
cash used in investing activities for the nine months ended September 30, 2010
and 2009 was $227,470 and $340,536, respectively, and consisted of purchases of
general and computer equipment, and leasehold improvements.
Net Cash Used In Financing
Activities.
Net
cash used in financing activities for the nine months ended September
30, 2010 and 2009 was $0 and $1,482,992, respectively. Net cash used
in financing activities during 2009 consisted of repayments of line
of credit, deferred offering costs and deferred financing costs.
Accounts
Receivable Purchase Agreement
In
July 2009, we entered into an accounts receivable purchase agreement with RCA,
which was amended in October 2009. Under the purchase agreement, we can sell
eligible accounts receivables to RCA. Eligible accounts receivable, subject to
the full definition of such term in the purchase agreement, generally are our
receivables under prime government contracts.
Under
the terms of the purchase agreement, we may offer eligible accounts receivable
to RCA and if RCA purchases such receivables, we will receive an initial upfront
payment equal to 90% of the receivable. Following RCA’s receipt of payment from
our customer for such receivable, they will pay to us the remaining 10% of the
receivable less its fees. In addition to a discount factor fee and an initial
enrollment fee, we are required to pay RCA a program access fee equal to a
stated percentage of the sold receivable, a quarterly program access fee if the
average daily amount of the sold receivables is less than $2.25 million and
RCA’s initial expenses in negotiating the purchase agreement and other expenses
in certain specified situations. The purchase agreement also provides that in
the event, but only to the extent, that the conveyance of receivables by us is
characterized by a court or other governmental authority as a loan rather than a
sale, we shall be deemed to have granted RCA effective as of the date of the
first purchase under the purchase agreement, a security interest in all of our
right, title and interest in, to and under all of the receivables sold by us to
RCA, whether now or hereafter owned, existing or arising.
The
initial term of the purchase agreement was to end on December 31, 2009 with
annual renewals, unless earlier terminated by either of the parties. Pursuant to
the October 2009 amendment, the term during which we may offer and sell eligible
accounts receivable to RCA was extended from December 31, 2009 to October 15,
2010, and the discount factor rate was reduced from 0.524% to 0.4075%. Pursuant
to an October 2010 amendment, the term during which we may offer and sell
eligible accounts receivable to RCA was further extended from October 15, 2010
to October 15, 2011. As of September 30, 2010, RCA holds $4.4 million of
accounts receivable for which RCA has not received payment from our
customers.
Series
A Convertible Preferred Stock
In
March and April 2008, we sold shares of our Series A Preferred and Investor
Warrants. We received aggregate gross proceeds of $15.0 million, before fees and
expenses of the placement agent in the transaction and other
expenses.
In
connection with our application to list our common stock on the NYSE Amex, we
entered into a Consent and Agreement (or Consent Agreement) on May 23, 2008 with
the Series A Holders whereby the Series A Holders agreed to limit the number of
shares of common stock issuable upon conversion of, or as dividends on, the
Series A Preferred and upon the exercise of the Investor Warrants without
approval of our common stockholders (which stockholder approval was received on
December 12, 2008). In return, among other things, we agreed for the fiscal year
ending December 31, 2008 (A) to achieve (i) revenues equal to or exceeding
$50,000,000 and (ii) consolidated EBITDA equal to or exceeding $13,500,000, and
(B) to publicly disclose and disseminate, and to certify to the Series A
Holders, our operating results for such period, no later than February 15, 2009
(we collectively refer to these as the Financial Covenants). Under the Consent
Agreement, the breach of the Financial Covenants were each deemed a ‘‘Triggering
Event’’ under the Certificate of Designations, Preferences and Rights of the
Series A Convertible Preferred Stock (or Certificate of Designations), which
would give the Series A Holders the right to require us to redeem all or a
portion of their Series A Preferred shares at a price per share calculated under
the Certificate of Designations.
We
did not satisfy the terms of the Financial Covenants and in April 2009 we
received a Notice of Triggering Event Redemption from the holder of 94% of our
Series A Preferred. The notice demanded the full redemption of such holder’s
Series A Preferred as a consequence of the Financial Covenants breach, and
demanded payment of accrued dividends on the Series A Preferred and legal fees
and expenses incurred in connection with negotiations concerning the breach of
the Financial Covenants.
On
May 22, 2009, we entered into the Settlement Agreement pursuant to which, among
other things, (i) the Series A Holders waived any breach by us of the Financial
Covenants or our obligation to timely pay dividends on the Series A Preferred
for any period through September 30, 2009, and waived any ‘‘Equity Conditions
Failure’’ and any ‘‘Triggering Event’’ under the certificate of designations of
the Series A Preferred otherwise arising from such breaches, (ii) the Investor
Warrants were amended to reduce their exercise price from $2.40 per share to
$0.01 per share, (iii) we issued the Series A Holders an aggregate of 2,000,000
shares of our common stock (or Settlement Shares), in full satisfaction of our
obligation to pay dividends under the Certificate of Designations as of March
31, 2009, June 30, 2009 and September 30, 2009, and (iv) we agreed to redeem
$7.5 million in stated value of the Series A Preferred by December 31, 2009. We
agreed that, if we fail to so redeem $7.5 million in stated value of the Series
A Preferred by that date (a Redemption Failure), then, in lieu of any other
remedies or damages available to the Series A Holders (absent fraud), (i) the
redemption price payable by us will increase by an amount equal to 10% of the
stated value, (ii) we will use our best efforts to obtain stockholder approval
to reduce the Conversion Price of the Series A Preferred from $2.00 to $0.50
(which would increase the number of shares of common stock into which the Series
A Preferred is convertible), and (iii) we will expand the size of our board of
directors by two, will appoint two persons designated by the Series A Holders to
fill the two newly-created vacancies, and will use our best efforts to amend our
certificate of incorporation to grant the Series A Holders the right to elect
two persons to serve on the board (or Series A Directors).
Pursuant
to the terms of the Settlement Agreement, we also entered into a Registration
Rights Agreement with the Series A Holders, in which we agreed to file with the
SEC, by June 1, 2009, a registration statement covering the resale of the
Settlement Shares, and to use our best efforts to have such registration
statement declared effective as soon as practicable thereafter. We further
agreed with the Series A Holders to include in such registration statement the
shares of common stock issued upon the exercise of the Investor Warrants. A
registration statement was filed, and subsequently declared effective on August
10, 2009.
Also
pursuant to the terms of the Settlement Agreement, each of our directors and
executive officers entered into a Lock-Up Agreement, pursuant to which each such
person agreed that, for so long as any shares of Series A Preferred remain
outstanding, he will not sell any shares of our common stock owned by him as of
May 22, 2009.
Also
pursuant to the terms of the Settlement Agreement, on May 22, 2009 our Chief
Executive Officer, President and Chairman, entered into an Irrevocable Proxy and
Voting Agreement with the Series A Holders, pursuant to which he agreed, among
other things, that if a Redemption Failure occurs he will vote all shares of
voting stock owned by him in favor of (i) reducing the Conversion Price of the
Series A Preferred from $2.00 to $0.50 and (ii) amending our certificate of
incorporation to grant the Series A Holders the right to elect two persons to
serve on the board of directors (collectively referred to as the Company
Actions). Our Chief Executive Officer also appointed one of the Series A Holders
as his proxy to vote his shares of voting stock in favor of the Company Actions,
and against approval of any opposing or competing proposal, at any stockholder
meeting or written consent of our stockholders at which such matters are
considered.
The
Settlement Agreement provides that if as of December 1, 2009, we do not
reasonably believe that we can fund the required redemption on or before
December 31, 2009, we need to take actions required to obtain the stockholder
approval for an amendment to our certificate of incorporation necessary for
reducing the Conversion Price and granting the Series A Holders the right to
elect two directors designated by such preferred stockholder (or Series A
Directors), including, without limitation, (i) calling a meeting of our
stockholders to consider such amendment; (ii) submitting to the SEC a
preliminary proxy statement for such meeting of stockholders; and (iii) upon
receipt of the requisite stockholder approval, filing the amendment to our
certificate of incorporation.
We were
unable to effect the redemption of the $7.5 million in stated value of the
Series A Preferred by December 31, 2009 and we have accordingly increased the
number of directors constituting our board of directors by two and held a
special meeting of our stockholders on April 8, 2010. At this special meeting,
the stockholders approved the amendments to our certificate of incorporation to
reduce the Conversion Price of the Series A Preferred from $2.00 to $0.50 and
provide for the ability of the Series A Holders to elect the Series A Directors.
Additionally, we amended the certificate of incorporation as of April 9, 2010.
Based on the reduction of the Conversion Price of the Series A Preferred, the
number of our common stock into which the Series A Preferred is convertible into
increased from 7.5 million to 30.0 million. Notwithstanding the Settlement
Agreement and compliance with the remedies described above for the failure to
redeem the $7.5 million in stated value of the Series A Preferred by December
31, 2009, the terms of the Series A Preferred provided that we are to redeem any
such preferred stock outstanding on the Maturity Date, December 31, 2010, as
such term is further defined in the Certificate of Designations (such redemption
provision hereinafter referred to as the Mandatory Redemption
Provision).
On April
8, 2010, we entered into a waiver agreement with the Series A Holders, pursuant
to which the Series A Holders agreed to extend the Maturity Date from December
31, 2010 to April 1, 2011, on August 13, 2010, we entered into a waiver
agreement with the Series A Holders which further extended the Maturity Date to
July 1, 2011 and on November 12, 2010, we entered into a waiver agreement with
the Series A Holders which further extended the Maturity Date to October 1,
2011 (the period from December 31, 2010 to October 1, 2011 is
referred to as the Extension Period). Pursuant to the waiver agreements, during
the Extension Period, (i) the Series A Holders agreed to waive any right to the
redemption of the Series A Preferred under the Mandatory Redemption Provision
until the last day of the Extension Period and (ii) our failure to comply with
the Mandatory Redemption Provision prior to the last day of the Extension Period
shall be deemed not to be a breach of such provision or the terms and conditions
of, or applicable to, the Series A Preferred. We currently are seeking to raise
capital or obtain access to capital sufficient to permit us to effect the
mandatory redemption.
The terms
of the Series A Preferred were amended to reduce its Conversion Price from $2.00
to $0.50 and extend the Maturity Date from December 31, 2010 to April 1, 2011,
July 1, 2011 and October 1, 2011. We evaluated these modifications in
order to determine if the modifications were cause for the application of
extinguishment accounting. Extinguishment accounting is to be applied
if there has been a substantial modification of debt instrument terms. The
modifications would be considered substantial under the guidance of ASC
470-50-40-10, if:
(1)
The change in the present value of future cash flows is at least 10% or
if;
(2)
The change in the fair value of the conversion option is at least 10% of the
carrying amount of the preferred stock.
Based
on our analysis, neither the extension of the maturity date nor the reduction of
the Conversion Price qualifies the modification as substantial. Thus,
extinguishment accounting should not be applied to the transaction. Since the
fair value of the embedded conversion option increased as a result of the
modification, the increase to the fair value of the embedded conversion option
reduces the carrying amount of the debt instrument and increases paid-in capital
in accordance with ASC 470-50-40-15.
Item 3. Quantitative and
Qualitative Disclosure About Market Risk
We are a
smaller reporting company as defined by Rule 12b-2 of the Securities
Exchange Act of 1934 (or Exchange Act) and are not required to provide the
information required under this Item 3.
Item 4. Controls and
Procedures
Evaluation
of Disclosure Controls and Procedures
Disclosure
controls and procedures, as defined in Rules 13(a)-15(e) and 15(d)-15(e) under
the Exchange Act, are controls and other procedures that are designed to ensure
that information required to be disclosed in reports filed or submitted under
the Exchange Act is recorded, processed, summarized, and reported, within the
time periods specified by the rules and forms promulgated by the SEC. Disclosure
controls and procedures include, without limitation, controls and procedures
designed to ensure that such information is accumulated and communicated to
management, including our Chief Executive Officer and Chief Financial Officer,
as appropriate, to allow timely decisions regarding required disclosure. As a
result of our evaluation, our Chief Executive Officer and Chief Financial
Officer concluded that our disclosure controls and procedures were not effective
as of September 30, 2010 because of the material weaknesses set forth
below.
The
following is a summary of our material weaknesses as of September 30,
2010:
Financial
Reporting
Due to a
lack of adequate systems, processes, and resources with sufficient GAAP
knowledge, experience, and training, we did not maintain effective controls over
the period-end financial close and reporting processes as of September 30, 2010.
Due to the actual and potential effect on financial statement balances and
disclosures, the resulting restatement of our prior year financial statements
and the importance of the financial closing and reporting processes, we
concluded that, in the aggregate, these deficiencies in internal controls over
the period-end financial close and reporting process constituted a material
weakness in internal control over financial reporting. The specific deficiencies
contributing to this material weakness were as follows:
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•
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Inadequate
policies and procedures
. We did not design,
establish, and maintain effective documented GAAP-compliant financial
accounting policies and procedures, nor a formalized process for
determining, documenting, communicating, implementing, monitoring, and
updating accounting policies and procedures, including policies and
procedures related to significant, complex, and non-routine
transactions.
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•
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Inadequate
GAAP expertise
. We did not have
individuals with adequate GAAP knowledge in specific complex areas and
non-routine transactions such as preferred stock, warrants, discontinued
operations, costs related to registration, acquisitions, and
financing.
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•
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Equity
Compensation
. We did not maintain
adequate policies and procedures to ensure effective controls over the
administration, accounting, and disclosure for stock-based compensation
sufficient to prevent a material misstatement of related compensation
expense. Specifically, the following deficiencies in our granting,
administration, and accounting for awards were
identified:
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º
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Inaccurate
accounting and disclosure
. We did not maintain
adequate procedures or effective controls over accounting, communication,
and disclosure of compensation expense related to awards. Specifically, we
lacked a process of financial and administrative oversight over the
stock-based compensation
process.
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º
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Inadequate
administration of awards
. We did not maintain
effective controls as it related to the reconciliation of grants to source
data.
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Insufficient
tracking of employee data
. We did not maintain
adequate procedures or effective controls over tracking awards that
ultimately impacted the timely accounting for compensation
expense.
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General
Computing Controls
We did
not maintain adequate general computing control policies and procedures. The
following individual material weaknesses were identified:
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•
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Inadequate
system access controls.
System access
controls over our accounting information system were not in place to
appropriately prohibit or limit user access in areas including journal
entries, invoice processing, and master-file
maintenance.
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•
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Inadequate
general computing controls.
Overall general user
and system administration were inadequate in the following areas where
procedures were in place but not formalized or
documented;
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Backup and
recovery of financial data
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Systems
development and change
management
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Our
efforts to improve our internal controls are ongoing and focused on expanding
our organizational capabilities to improve our control environment and on
implementing process changes to strengthen our internal control and monitoring
activities.
As part
of our ongoing remedial efforts, we have, among other things:
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•
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expanded our accounting policy
and controls organization by creating and filling a new position with GAAP
expertise around specific
topics;
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engaged external subject matter
experts to:
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advise on accounting for and
disclosure of stock-based compensation related matters, including
providing additional ASC 718 training and accounting
assistance;
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develop and implement formal
remediation plans;
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develop, implement and/or enhance
accounting and finance-related policies and procedures, including end-user
computing;
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•
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initiated a project to review our
key financial systems security processes and responsibilities to
appropriately design automated controls that adequately segregate job
responsibilities;
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communicated to all employees the
importance of adhering to IT system access segregation and change request
protocols, to prevent unauthorized changes and improper accesses from
recurring;
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We
believe that the foregoing actions will improve our internal control over
financial reporting, as well as our disclosure controls and procedures. We
intend to perform such procedures and commit such resources as necessary to
continue to allow us to overcome or mitigate these material weaknesses such that
we can make timely and accurate quarterly and annual financial filings until
such time as those material weaknesses are fully addressed and
remediated.
Changes
in Internal Controls
There
were no changes in our internal controls over financial reporting during the
quarter ended September 30, 2010 that have materially affected, or are
reasonably likely to affect, our internal control over financial
reporting.
Limitations
on the Effectiveness of Controls
Our
management, including our Chief Executive Officer and Chief Financial Officer,
does not expect that our disclosure controls and internal controls will prevent
all errors and all fraud. A control system, no matter how well conceived and
operated, can provide only reasonable, not absolute, assurance that the
objectives of the control system are met. Further, the design of a control
system must reflect the fact that there are resource constraints, and the
benefits of controls must be considered relative to their costs. Because of the
inherent limitations in all control systems, no evaluation of controls can
provide absolute assurance that all control issues and instances of fraud, if
any, with our company have been detected. These inherent limitations include the
realities that judgments in decision-making can be faulty and that breakdowns
can occur because of simple error or mistake. Additionally, controls can be
circumvented by the individual acts of some persons, by collusion of two or more
people or by management override of the controls.
The
design of any system of controls also is based in part upon certain assumptions
about the likelihood of future events, and there can be no assurance that any
design will succeed in achieving its stated goals under all potential future
conditions; over time, a control may become inadequate because of changes in
conditions or the degree of compliance with the policies or procedures may
deteriorate. Because of the inherent limitations in a cost-effective control
system, misstatements due to error or fraud may occur and may not be
detected.
PART
II
Item
1. Legal Proceedings
On
February 29, 2008, Roy Elfers, a former employee commenced an action against us
for breach of contract arising from his termination of employment in the Supreme
Court of the State of New York, Nassau County. The Complaint seeks
damages of approximately $87,000. Discovery has been completed in this action.
On or about August 12, 2010, we filed a motion for summary judgment to dismiss
the complaint, and the motion is now fully submitted. No trial date has been
set. We believe meritorious defenses to the claims exist and we intend to
vigorously defend this action.
On March
4, 2008, Thomas Cusack, our former General Counsel, commenced an action with the
United States Department of Labor, Occupational Safety and Health and Safety
Administration, alleging retaliation in contravention of the Sarbanes-Oxley
Act. Mr. Cusack seeks damages in excess of
$3,000,000. On April 2, 2008, we filed a response to the charges. On
March 7, 2008, Mr. Cusack also commenced a second action against us for
breach of contract and related issues arising from his termination of employment
in New York State Supreme Court, Nassau County. On May 7, 2008, we
served a motion to dismiss the complaint, and on or about September 26, 2008,
the Court dismissed several claims (tortious interference with a contract,
tortious interference with economic opportunity, fraudulent inducement to enter
into a contract and breach of good faith and fair dealing). The
remaining claims are Mr. Cusack's breach of contract claims and stock
conversion claim. On or about October 13, 2008, Mr. Cusack filed
an amended complaint as to the remaining claims, and on November 5, 2008, we
filed an answer to the complaint and filed counterclaims against Mr. Cusack
for fraud and rescission. The parties have completed discovery and
depositions. On or about June 15, 2010, both parties submitted
motions for summary judgment and on August 19, 2010, the Court granted Mr.
Cusack’s motion as to his stock conversion claim. The Court also narrowed the
issues as to the breach of contract claim. On September 13, 2010, we
filed an appeal of the Court’s decision. The judge has set a trial date for the
breach of contract claims and the stock valuation for February 7, 2011. We
believe meritorious defenses to the claims exist and we intend to vigorously
defend this action.
Item
1A. Risk Factors
Our
business, industry and common stock are subject to numerous risks and
uncertainties. The discussion below sets forth all of such risks and
uncertainties that we have identified as material, but are not the only risks
and uncertainties facing us. Any of the following risks, if realized,
could materially and adversely affect our revenues, operating results,
profitability, financial condition, prospects for future growth and overall
business, as well as the value of our common stock. Our business is
also subject to general risks and uncertainties that affect many other
companies, such as overall U.S. and non-U.S. economic and industry conditions,
including a global economic slowdown, geopolitical events, changes in laws or
accounting rules, fluctuations in interest and exchange rates, terrorism,
international conflicts, major health concerns, natural disasters or other
disruptions of expected economic and business conditions. Additional risks and
uncertainties not currently known to us or that we currently believe are
immaterial also may impair our business operations and liquidity.
Risks
Relating to Our Company
We
depend on the U.S. Government for a substantial amount of our sales and if we do
not continue to experience demand for our products within the U.S. Government,
our business may fail. Moreover, our growth in the last few years has been
attributable in large part to U.S. wartime spending in support of troop
deployments in Iraq and Afghanistan. If such troop levels are reduced, our
business may be harmed.
We
primarily serve the defense market and our sales are highly concentrated within
the U.S. government. Customers for our products include the U.S. Department of
Defense, including the U.S. Marine Corps and U.S. Army Tank Automotive and
Armaments Command (TACOM), and the U.S. Department of Homeland Security.
Government tax revenues and budgetary constraints, which fluctuate from time to
time, can affect budgetary allocations for these customers. Many government
agencies have in the past experienced budget deficits that have led to decreased
spending in defense, law enforcement and other military and security areas. Our
results of operations may be subject to substantial period-to-period
fluctuations because of these and other factors affecting military, law
enforcement and other governmental spending.
U.S. defense spending historically has been cyclical. Defense
budgets have received their strongest support when perceived threats to national
security raise the level of concern over the country’s safety, such as in Iraq
and Afghanistan. As these threats subside, spending on the military tends to
decrease. Accordingly, while U.S. Department of Defense funding has grown
rapidly over the past few years, there is no assurance that this trend will
continue. Rising budget deficits, the cost of the war on terror and increasing
costs for domestic programs continue to put pressure on all areas of
discretionary spending, and the federal government has signaled that this
pressure will most likely impact the defense budget. A decrease in U.S.
government defense spending, including as a result of planned significant U.S.
troop level reductions in Iraq or Afghanistan, or changes in spending allocation
could result in our government contracts being reduced, delayed or terminated.
Reductions in our government contracts, unless offset by other military and
commercial opportunities, could adversely affect our ability to sustain and grow
our future sales and earnings.
Our
revenues historically have been concentrated in a small number of contracts
obtained through the U.S. Department of Defense and the loss of, or reduction in
estimated revenue under, any of these contracts, or the inability to contract
further with the U.S. Department of Defense could significantly reduce our
revenues and harm our business.
Our
revenues historically have been generated by a small number of contracts. During
the three and nine months ended September 30, 2010, three contracts with U.S.
Department of Defense organizations represented approximately 65% and 68%,
respectively, of our revenue. While we believe we have satisfied and continue to
satisfy the terms of these contracts, there can be no assurance that we will
continue to receive orders under such contracts. Our government customers
generally have the right to cancel any contract, or ongoing or planned orders
under any contract, at any time. If any of our significant contracts were
canceled, or our customers reduce their orders under any of these contracts, or
we were unable to contract further with the U.S. Department of Defense, our
revenues could significantly decrease and our business could be severely
harmed.
We
are required to redeem any outstanding Series A Preferred, of which $15.0
million in stated value is outstanding, as of October 1, 2011. If we do not
generate, raise or obtain access to funds sufficient to redeem our Series A
Preferred or if we fail to redeem such Preferred Stock, our cash flow could be
adversely affected and our business significantly harmed.
On May
22, 2009, we entered into a Settlement Agreement, Waiver and Amendment with the
holders of our Series A Preferred, pursuant to which, among other things, we
have agreed to redeem $7,500,000 in stated value of Series A Preferred by
December 31, 2009. We did not effect such redemption. As a result, in lieu of
any other remedies or damages available to the holders of our Series A
Preferred, the redemption price payable by us increased by an amount equal to
10% of the stated value, and we amended our certificate of incorporation to (i)
reduce the conversion price of the Series A Preferred from $2.00 to $0.50 (which
increased the number of shares of our common stock into which the Series A
Preferred is convertible) and (ii) grant the holders of Series A Preferred,
voting as a separate class, the right to elect two persons to serve on our board
of directors.
We
currently have outstanding $15.0 million in stated value of our Series A
Preferred. The terms of such stock provide that we are to redeem any such stock
outstanding as of October 1, 2011.We are seeking to raise capital or obtain
access to funds sufficient to timely redeem our Series A Preferred. If we are
not successful and we do not timely redeem the Series A Preferred , our cash
flow could be adversely affected and our business significantly harmed. For
additional information, please refer to Part I, Item 2. Management’s Discussion
and Analysis of Financial Condition and Results of
Operations — Liquidity and Capital Resources — Series A
Convertible Preferred Stock.
We
are required to comply with complex laws and regulations relating to the
procurement, administration and performance of U.S. government contracts, and
the cost of compliance with these laws and regulations, and penalties and
sanctions for any non-compliance could adversely affect our
business.
We are
required to comply with laws and regulations relating to the administration and
performance of U.S. government contracts, which affect how we do business with
our customers and impose added costs on our business. Among the more significant
laws and regulations affecting our business are the following:
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The Federal Acquisition
Regulations: Along with agency regulations supplemental to the Federal
Acquisition Regulations, comprehensively regulate the formation,
administration and performance of federal government
contracts;
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The Truth in Negotiations Act:
Requires certification and disclosure of all cost and pricing data in
connection with contract
negotiations;
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The Cost Accounting Standards and
Cost Principles: Imposes accounting requirements that govern our right to
reimbursement under certain cost-based federal government contracts;
and
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Laws, regulations and executive
orders restricting the use and dissemination of information classified for
national security purposes and the export of certain products and
technical data. We engage in international work falling under the
jurisdiction of U.S. export control laws. Failure to comply with these
control regimes can lead to severe penalties, both civil and criminal, and
can include debarment from contracting with the U.S.
government.
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Our contracting agency customers periodically review our
performance under and compliance with the terms of our federal government
contracts. We also routinely perform internal reviews. As a result of these
reviews, we may learn that we are not in compliance with all of the terms of our
contracts. If a government review or investigation uncovers improper or illegal
activities, we may be subject to civil or criminal penalties or administrative
sanctions, including:
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Termination
of contracts;
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Cost
associated with triggering of price reduction
clauses;
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Suspension
or debarment from doing business with federal government
agencies.
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If we
fail to comply with these laws and regulations, we may also suffer harm to our
reputation, which could impair our ability to win awards of contracts in the
future or receive renewals of existing contracts. If we are subject to civil and
criminal penalties and administrative sanctions or suffer harm to our
reputation, our current business, future prospects, financial condition, and/or
operating results could be materially harmed. In addition, we are subject to the
industrial security regulations, protocols, and procedures of the U.S.
Government as set forth in the National Industrial Security Program Operating
Manual (NISPOM), which are designed to protect and safeguard classified
information from unauthorized release to individuals and organizations not
possessing a security clearance or the requisite level of clearance necessary to
access that information. Accordingly, any failure to adhere to the requirements
of the NISPOM could expose us to severe legal and administrative consequences,
including, but not limited to, our suspension or debarment from government
contracts, the revocation of our clearance, and the termination of our
government contracts, the occurrence of any of which could substantially harm
our existing business and preclude us from competing for or receiving future
government contracts.
Government
contracts are usually awarded through a competitive bidding process that entails
risks not present in the acquisition of commercial contracts and may result in
our inability to win new contract awards, which would materially adversely
affect our business prospects and results of operations.
A
significant portion of our contracts and task orders with the U.S. government is
awarded through a competitive bidding process. We expect that much of the
business we seek in the foreseeable future will continue to be awarded through
competitive bidding. Budgetary pressures and changes in the procurement process
have caused many government customers to increasingly purchase goods and
services through indefinite delivery/indefinite quantity (IDIQ) contracts,
General Services Administration (GSA) schedule contracts and other
government-wide acquisition contracts (GWACs). These contracts, some of which
are awarded to multiple contractors, have increased competition and pricing
pressure, requiring us to make sustained post-award efforts to realize revenue
under each such contract. Competitive bidding presents a number of risks,
including without limitation:
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the need to bid on programs in
advance of the completion of their design, which may result in unforeseen
technological difficulties and cost
overruns;
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the substantial cost and
managerial time and effort that we may spend to prepare bids and proposals
for contracts that may not be awarded to
us;
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the need to estimate accurately
the resources and cost structure that will be required to service any
contract we are awarded; and
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the expense and delay that may
arise if our or our partners’ competitors protest or challenge contract
awards made to us or our partners pursuant to competitive bidding, and the
risk that any such protest or challenge could result in the resubmission
of bids on modified specifications, or in the termination, reduction or
modification of the awarded
contract.
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If we are
unable to consistently win new contract awards over any extended period, our
business and prospects will be adversely affected, and that could cause our
actual results to be adversely affected. In addition, upon the expiration of a
contract, if the customer requires further services of the type provided by the
contract, there is frequently a competitive rebidding process. There can be no
assurance that we will win any particular bid, or that we will be able to
replace business lost upon expiration or completion of a contract, and the
termination or non-renewal of any of our significant contracts would cause our
actual results to be adversely affected.
The
U.S. government may reform its procurement or other practices in a manner
adverse to us.
Because
we derive a significant portion of our revenues from contracts with the U.S.
government or its agencies, we believe that the success and development of our
business will depend on our continued successful participation in federal
contracting programs. The current administration has signed a Memorandum for the
Heads of Executive Departments and Agencies on Government Contracting, which
orders significant changes to government contracting, including the review of
existing federal contracts to eliminate waste and the issuance of
government-wide guidance to implement reforms aimed at cutting wasteful spending
and fraud. The federal procurement reform called for in the Memorandum requires
the heads of several federal agencies to develop and issue guidance on review of
existing government contracts and authorizes that any contracts identified as
wasteful or otherwise inefficient be modified or cancelled. If any of our
contracts were to be modified or cancelled, our actual results could be
adversely affected and we can give no assurance that we would be able to procure
new U.S. Government contracts to offset the revenues lost as a result of any
modification or cancellation of our contracts. In addition, there may be
substantial costs or management time required to respond to government review of
any of our current contracts, which could delay or otherwise adversely affect
our ability to compete for or perform contracts. Further, if the ordered reform
of the U.S. Government’s procurement practices involves the adoption of new
cost-accounting standards or the requirement that competitors submit bids or
perform work through teaming arrangements, that could be costly to satisfy or
could impair our ability to obtain new contracts. The reform may also involve
the adoption of new contracting methods to GSA or other government-wide
contracts, or new standards for contract awards intended to achieve certain
socio-economic or other policy objectives, such as establishing new set-aside
programs for small or minority-owned businesses. In addition, the U.S.
government may face restrictions from other new legislation or regulations, as
well as pressure from government employees and their unions, on the nature and
amount of services the U.S. government may obtain from private contractors.
These changes could impair our ability to obtain new contracts. Any new
contracting methods could be costly or administratively difficult for us to
implement and, as a result, could harm our operating results.
Our
contracts with the U.S. government and its agencies are subject to audits and
cost adjustments. Unfavorable government audits could force us to adjust
previously reported operating results, could affect future operating results and
could subject us to a variety of penalties and sanctions.
U.S.
government agencies, including the Defense Contract Audit Agency (DCAA),
routinely audit and investigate government contracts and government contractors’
incurred costs, administrative processes and systems. Certain of these agencies,
including the DCAA, review our performance on contracts, pricing practices, cost
structure and compliance with applicable laws, regulations and standards. They
also review the adequacy of our internal control systems and policies, including
our purchase, property, estimation, compensation and management information
systems. Any costs found to be improperly allocated to a specific contract will
not be reimbursed, and any such costs already reimbursed must be refunded.
Moreover, if any of the administrative processes and systems are found not to
comply with government requirements, we may be subjected to increased government
scrutiny and approval that could delay or otherwise adversely affect our ability
to compete for or perform contracts. Therefore, an unfavorable outcome of an
audit by the DCAA or another government agency could cause actual results to be
adversely affected and differ materially from those anticipated. If a government
investigation uncovers improper or illegal activities, we may be subject to
civil and criminal penalties and administrative sanctions, including termination
of contracts, forfeitures of profits, suspension of payments, fines and
suspension or debarment from doing business with the U.S. government. In
addition, we could suffer serious reputational harm if allegations of
impropriety were made against us. Each of these events could cause our actual
results to be adversely affected.
A portion of our business depends upon obtaining and maintaining
required security clearances, and our failure to do so could result in
termination of certain of our contracts or cause us to be unable to bid or
re-bid on certain contracts.
Obtaining
and maintaining personal security clearances for employees involves a lengthy
process, and it can be difficult to identify, recruit and retain employees who
already hold security clearances. If our employees are unable to obtain or
retain security clearances, or if such employees who hold security clearances
terminate their employment with us, the customer whose work requires cleared
employees could terminate their contract with us or decide not to exercise
available options, or to not renew it. To the extent we are not able to engage
employees with the required security clearances for a particular contract, we
may not be able to bid on or win new contracts, or effectively re-bid on
expiring contracts, which could adversely affect our business.
A
facility security clearance (FCL) is an administrative determination by the
Defense Security Service (DSS), a U.S. Department of Defense component, that a
particular contractor facility has the requisite level of security, procedures,
and safeguards to handle classified information requirements for access to
classified information. Our ability to obtain and maintain FCLs has a direct
impact on our ability to compete for and perform U.S. government contracts, the
performance of which requires access to classified information. Our inability to
so obtain or maintain any FCL level could result in the termination, non-renewal
or our inability to obtain certain U.S. government contracts, which would reduce
our revenues and harm our business.
We
may not realize the full amount of revenues reflected in our backlog, which
could harm our operations and significantly reduce our future
revenues.
There can
be no assurances that our backlog estimates will result in actual revenues in
any particular fiscal period because our customers may modify or terminate
projects and contracts and may decide not to exercise contract options. We
define backlog as the future revenue we expect to receive from our contracts. We
include potential orders expected to be awarded under IDIQ contracts. Our
revenue estimates for a particular contract are based, to a large extent, on the
amount of revenue we have recently recognized on that contract, our experience
in utilizing capacity on similar types of contracts, and our professional
judgment. Our revenue estimate for a contract included in backlog can be lower
than the revenue that would result from our customers utilizing all remaining
contract capacity. Our backlog includes estimates of revenues the receipt of
which require future government appropriation, option exercise by our clients
and/or is subject to contract modification or termination. At September 30,
2010, our backlog was approximately $31 million; $7 million of which we estimate
will be realized during the remainder of 2010. These estimates are based on our
experience under such contracts and similar contracts, and we believe such
estimates to be reasonable. However, we believe that the receipt of revenues
reflected in our backlog estimate for the following twelve months will generally
be more certain than our backlog estimate for periods thereafter. If we do not
realize a substantial amount of our backlog, our operations could be harmed and
our future revenues could be significantly reduced.
U.S.
government contracts often contain provisions that are typically not found in
commercial contracts and that are unfavorable to us, which could adversely
affect our business.
U.S.
government contracts contain provisions and are subject to laws and regulations
that give the U.S. government rights and remedies not typically found in
commercial contracts, including without limitation, allowing the U.S. government
to:
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terminate existing contracts for
convenience, as well as for
default;
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establish limitations on future
services that can be offered to prospective customers based on conflict of
interest regulations;
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reduce or modify contracts or
subcontracts;
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decline to make orders under
existing contracts;
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cancel multi-year contracts and
related orders if funds for contract performance for any subsequent year
become unavailable;
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decline to exercise an option to
renew a multi-year contract;
and
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claim intellectual property
rights in products provided by
us.
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The ownership, control or influence of our company by foreigners
could result in the termination, non-renewal of or our inability to obtain
certain U.S. government contracts, which would reduce our revenues and harm our
business.
We are
subject to industrial security regulations of the U.S. Department of Defense and
other federal agencies that are designed to safeguard against unauthorized
access by foreigners and others to classified and other sensitive information.
If we were to come under foreign ownership, control or influence, our clearances
could be revoked and our U.S. government customers could terminate, or decide
not to renew, our contracts, and such a situation could also impair our ability
to obtain new contracts and subcontracts. Any such actions would reduce our
revenues and harm our business.
We
depend on our suppliers and two, in particular, each currently provide us with
more than 10% of our supply needs. If we cannot obtain certain components for
our products or we lose any of our key suppliers, we would have to develop
alternative designs that could increase our costs or delay our
operations.
We depend
upon a number of suppliers for components of our products. Two of these
suppliers, Action Group, Inc. and Industrial Door Contractors, Inc., each
accounted for more than 10% of our total purchases during the nine months ended
September 30, 2010. There is an inherent risk that certain components of our
products will be unavailable for prompt delivery or, in some cases,
discontinued. We have only limited control over any third-party manufacturer as
to quality controls, timeliness of production, deliveries and various other
factors. Should the availability of certain components be compromised through
the loss of, or impairment of the relationship with, any of our three key
suppliers or otherwise, it could force us to develop alternative designs using
other components, which could add to the cost of goods sold and compromise
delivery commitments. If we are unable to obtain components in a timely manner,
at an acceptable cost, or at all, we would need to select new suppliers, and
redesign or reconstruct processes we use to build our transparent and opaque
armored products. We may not be able to manufacture one or more of our products
for a period of time, which could materially adversely affect our business,
results from operations and financial condition.
If
we fail to keep pace with the ever-changing market of security-related defense
products, our revenues and financial condition will be negatively
affected.
The
security-related defense product market is rapidly changing, with evolving
industry standards. Our future success will depend in part upon our ability to
introduce new products, designs, technologies and features to meet changing
customer requirements and emerging industry standards; however, there can be no
assurance that we will successfully introduce new products or features to our
existing products or develop new products that will achieve market acceptance.
Any delay or failure of these products to achieve market acceptance would
adversely affect our business. In addition, there can be no assurance that
products or technologies developed by others will not render our products or
technologies non-competitive or obsolete. Should we fail to keep pace with the
ever-changing nature of the security-related defense product market, our
revenues and financial condition will be negatively affected.
We
believe that, in order to remain competitive in the future, we will need to
continue to invest financial resources to develop new and adapt or modify our
existing offerings and technologies, including through internal research and
development, acquisitions and joint ventures or other teaming arrangements.
These expenditures could divert our attention and resources from other projects,
and we cannot be sure that these expenditures will ultimately lead to the timely
development of new offerings and technologies. Due to the design complexity of
our products, we may in the future experience delays in completing the
development and introduction of new products. Any delays could result in
increased costs of development or deflect resources from other projects. In
addition, there can be no assurance that the market for our offerings will
develop or continue to expand as we currently anticipate. The failure of our
technology to gain market acceptance could significantly reduce our revenues and
harm our business. Furthermore, we cannot be sure that our competitors will not
develop competing technologies which gain market acceptance in advance of our
products.
We may be subject to personal liability claims for our products
and if our insurance is not sufficient to cover such claims, our expenses may
increase substantially.
Our
products are used in applications where the failure to use our products properly
or their malfunction could result in bodily injury or death, and we may be
subject to personal liability claims. Although we currently maintain general
liability insurance which includes $1 million of product liability coverage, our
insurance may not be adequate to cover such claims. As a result, a significant
lawsuit could adversely affect our business. We may be exposed to liability for
personal injury or property damage claims relating to the use of our products.
Any future claim against us for personal injury or property damage could
materially adversely affect our business, financial condition, and results of
operations and result in negative publicity. We currently maintain insurance for
this type of liability as well as seek Support Antiterrorism by Fostering
Effective Technologies Act of 2002 (also known as the SAFETY Act) certification
for our products where we deem appropriate. However, although we maintain
insurance coverage, we may experience legal claims outside of our insurance
coverage, or in excess of our insurance coverage, or that insurance will not
cover. Even if we are not found liable, the costs of defending a lawsuit can be
high.
We
are subject to substantial competition.
We are
subject to significant competition that could harm our ability to win business
and increase the price pressure on our products. We face strong competition from
a wide variety of firms, including large, multinational, defense and aerospace
firms. Most of our competitors have considerably greater financial, marketing
and technological resources than we do, which may make it difficult to win new
contracts and we may not be able to compete successfully. Certain competitors
operate larger facilities and have longer operating histories and presence in
key markets, greater name recognition and larger customer bases. As a result,
these competitors may be able to adapt more quickly to new or emerging
technologies and changes in customer requirements. They may also be able to
devote greater resources to the promotion and sale of their products. Moreover,
we may not have sufficient resources to undertake the continuing research and
development necessary to remain competitive.
We
must comply with environmental regulations or we may have to pay expensive
penalties or clean-up costs.
We are
subject to federal, state, local and foreign laws, and regulations regarding
protection of the environment, including air, water, and soil. Our manufacturing
business involves the use, handling, storage, discharge and disposal of,
hazardous or toxic substances or wastes to manufacture our products. We must
comply with certain requirements for the use, management, handling, and disposal
of these materials. If we are found responsible for any hazardous contamination,
we may have to pay expensive fines or penalties or perform costly clean-up. Even
if we are charged, and later found not responsible, for such contamination or
clean-up, the cost of defending the charges could be high. Authorities may also
force us to suspend production, alter our manufacturing processes, or stop
operations if we do not comply with these laws and regulations.
We
may not be able to adequately safeguard our intellectual property rights and
trade secrets from unauthorized use, and we may become subject to claims that we
infringe on others’ intellectual property rights.
We rely
on a combination of trade secrets, trademarks, and other intellectual property
laws, nondisclosure agreements and other protective measures to preserve our
proprietary rights to our products and production processes.
We
currently have five utility and one provisional U.S. pending patent
applications. We do not know whether any of our pending patent applications will
result in the issuance of patents or whether the examination process will
require us to narrow our claims. We have not emphasized, and do not presently
intend to emphasize, patents as a source of significant competitive advantage;
however, if we are issued patents we intend to seek to enforce them as
commercially appropriate.
These
measures afford only limited protection and may not preclude competitors from
developing products or processes similar or superior to ours. Moreover, the laws
of certain foreign countries do not protect intellectual property rights to the
same extent as the laws of the United States, and we may face other obstacles to
enforcing our intellectual property rights outside the United States including
the ability to enforce judgments, the possibility of conflicting judgments among
courts and tribunals in different jurisdictions and locating, hiring and
supervising local counsel in such other countries.
Although we implement protective measures and intend to defend
our proprietary rights, these efforts may not be successful. From time to time,
we may litigate within the United States or abroad to enforce our licensed
patents, to protect our trade secrets and know-how or to determine the
enforceability, scope and validity of our proprietary rights and the proprietary
rights of others. Enforcing or defending our proprietary rights could be
expensive, require management’s attention and might not bring us timely or
effective relief.
Furthermore,
third parties may assert that our products or processes infringe their patent or
other intellectual property rights. Our patents, if granted, may be challenged,
invalidated or circumvented. Although there are no pending or threatened
intellectual property lawsuits against us, we may face litigation or
infringement claims in the future. Infringement claims could result in
substantial costs and diversion of our resources even if we ultimately prevail.
A third party claiming infringement may also obtain an injunction or other
equitable relief, which could effectively block the distribution or sale of
allegedly infringing products. Although we may seek licenses from third parties
covering intellectual property that we are allegedly infringing, we may not be
able to obtain any such licenses on acceptable terms, if at
all.
We
depend on management and other key personnel and we may not be able to execute
our business plan without their services.
Our
success and our business strategy depend in large part on our ability to attract
and retain key management and operating personnel. Such individuals are in high
demand and are often subject to competing employment offers. We depend to a
large extent on the abilities and continued participation of our executive
officers and other key employees. We presently maintain “key man” insurance on
Anthony Piscitelli, our President and Chief Executive Officer. We believe that,
as our activities increase and change in character, additional experienced
personnel will be required to implement our business plan. Competition for such
personnel is intense and we may not be able to hire them when required, or have
the ability to retain them.
We
may partner with foreign entities, and domestic entities with foreign contacts,
which may affect our business plans by increasing our costs.
We
recognize that there may be opportunities for increased product sales in both
the domestic and global defense markets. We have recently initiated plans to
strategically team with foreign entities as well as domestic entities with
foreign business contacts in order to better compete for both domestic and
foreign military contracts. In order to implement these plans, we may incur
substantial costs which may include additional research and development,
prototyping, hiring personnel with specialized skills, implementing and
maintaining technology control plans, technical data export licenses,
production, product integration, marketing, warehousing, finance charges,
licensing, tariffs, transportation and other costs. In the event that working
with foreign entities and/or domestic entities with foreign business contacts
proves to be unsuccessful, this strategy may ineffectively use our resources
which may affect our profitability and the costs associated with such work may
preclude us from pursuing alternative opportunities.
We
are presently classified as a small business and the loss of our small business
status may adversely affect our ability to compete for government
contracts.
We are
presently classified as a small business as determined by the Small Business
Administration based upon the North American Industry Classification Systems
(NAICS) industry and product specific codes which are regulated in the United
States by the Small Business Administration. While we do not presently derive a
substantial portion of our business from contracts which are set-aside for small
businesses, we are able to bid on small business set-aside contracts as well as
contracts which are open to non-small business entities. It is also possible
that we may become more reliant upon small business set-aside contracts. Our
continuing growth may cause us to lose our designation as a small business, and
additionally, as the NAICS codes are periodically revised, it is possible that
we may lose our status as a small business and may sustain an adverse impact on
our current competitive advantage. The loss of small business status could
adversely impact our ability to compete for government contracts, maintain
eligibility for special small business programs and limit our ability to partner
with other business entities which are seeking to team with small business
entities as may be required under a specific contract.
We
intend to pursue international sales opportunities which may require export
licenses and controls and result in the commitment of significant resources and
capital.
In order
to pursue international sales opportunities, we have initiated a program to
obtain product classifications, commodity jurisdictions, licenses, and
technology control plans, technical data export licenses and export related
programs. Due to our diverse products, it is possible that some products may be
subject to classification under the United States State Department International
Traffic in Arms Regulations (ITAR). In the event that a product is classified as
an ITAR-controlled item, we will be required to obtain an ITAR export license.
While we believe that we will be able to obtain such licenses, the denial of
required licenses and/or the delay in obtaining such licenses may have a
significant adverse impact on our ability to sell products internationally.
Alternatively, our products may be subject to classification under the United
States Commerce Department’s Export Administration Regulations (EAR). We also
anticipate that we may be required to comply with international regulations,
tariffs and controls and we intend to work closely with experienced freight
forwarders and advisors. We anticipate that an internal compliance program for
international sales will require the commitment of significant resources and
capital.
Increases
in our international sales may expose us to unique and potentially greater risks
than are presented in our domestic business, which could negatively impact our
results of operations and financial condition.
If our
international sales grow, we may be exposed to certain unique and potentially
greater risks than are presented in our domestic business. International
business is sensitive to changes in the budgets and priorities of international
customers, which may be driven by potentially volatile worldwide economic
conditions, regional and local economic and political factors, as well as U.S.
foreign policy. International sales will also expose us to local government
laws, regulations and procurement regimes which may differ from U.S. Government
regulation, including import-export control, exchange control, investment and
repatriation of earnings, as well as to varying currency and other economic
risks. International contracts may also require the use of foreign
representatives and consultants or may require us to commit to financial support
obligations, known as offsets, and provide for penalties if we fail to meet such
requirements. As a result of these and other factors, we could experience award
and funding delays on international projects or could incur losses on such
projects, which could negatively impact our results of operations and financial
condition.
We
have made, and expect to continue to make, strategic acquisitions and
investments, and these activities involve risks and uncertainties.
In
pursuing our business strategies, we continually review, evaluate and consider
potential investments and acquisitions. In evaluating such transactions, we are
required to make difficult judgments regarding the value of business
opportunities, technologies and other assets, and the risks and cost of
potential liabilities. Furthermore, acquisitions and investments involve certain
other risks and uncertainties, including the difficulty in integrating
newly-acquired businesses, the challenges in achieving strategic objectives and
other benefits expected from acquisitions or investments, the diversion of our
attention and resources from our operations and other initiatives, the potential
impairment of acquired assets and the potential loss of key employees of the
acquired businesses.
The
outcome of litigation in which we have been named as a defendant is
unpredictable and an adverse decision in any such matter could have a material
adverse effect on our financial position or results of operations.
We are
defendants in a number of litigation matters. These matters may divert financial
and management resources that would otherwise be used to benefit our operations.
Although we believe that we have meritorious defenses to the claims made in the
litigation matters to which we have been named a party and intend to contest
each lawsuit vigorously, no assurances can be given that the results of these
matters will be favorable to us. An adverse resolution or outcome of any of
these lawsuits, claims, demands or investigations could have a negative impact
on our financial condition, results of operations and liquidity. Please see Part
II, Item 1, Legal Proceedings.
Unanticipated
changes in our tax provisions or exposure to additional income tax liabilities
could affect our profitability.
We are
subject to income taxes in the United States. In the ordinary course of our
business, there are many transactions and calculations where the ultimate tax
determination is uncertain. Furthermore, changes in domestic or foreign income
tax laws and regulations, or their interpretation, could result in higher or
lower income tax rates assessed or changes in the taxability of certain sales or
the deductibility of certain expenses, thereby affecting our income tax expense
and profitability. Although we believe our tax estimates are reasonable, the
final determination of tax audits could be materially different from our
historical income tax provisions and accruals. Additionally, changes in the
geographic mix of our sales could also impact our tax liabilities and affect our
income tax expense and profitability.
Risks
Relating to Our Common Stock
If
we fail to maintain an effective system of internal controls over financial
reporting, we may not be able to report accurately our financial results. This
could have a material adverse effect on our share price.
Effective
internal controls are necessary for us to provide accurate financial reports. We
completed documenting and testing our internal control procedures to satisfy the
requirements of Section 404 of the Sarbanes Oxley Act of 2002 and the related
rules of the SEC, which require, among other things, our management to assess
annually the effectiveness of our internal control over financial reporting and
our independent registered public accounting firm to issue a report on that
assessment.
As a
result of the material weaknesses identified during the course of our evaluation
of our controls and procedures, our Chief Executive Officer and Chief Financial
Officer have concluded that our disclosure controls and procedures were not
effective to ensure that the information required to be disclosed by us in the
reports that we file or submit under the Exchange Act was recorded, processed,
summarized and reported within the time periods specified in the SEC’s rules and
forms and that such information required to be disclosed is accumulated and
communicated to management, including our Chief Executive Officer and Chief
Financial Officer, to allow timely decisions regarding required disclosure. We
identified material weaknesses in our period-end financial close processes and
general computing controls. To address these material weaknesses, we intend to
engage outside experts to provide counsel and guidance in areas where we cannot
economically maintain the required expertise internally.
There can
be no assurance that we will maintain adequate controls over our financial
processes and reporting in the future or that those controls will be adequate in
all cases to uncover inaccurate or misleading financial information that could
be reported by members of management. If our controls failed to identify any
misreporting of financial information or our management or independent
registered public accounting firm were to conclude in their reports that our
internal control over financial reporting was not effective, investors could
lose confidence in our reported financial information and the trading price of
our shares could drop significantly. In addition, we could be subject to
sanctions or investigations by the stock exchange upon which our common stock
may be listed, the SEC or other regulatory authorities, which would require
additional financial and management resources.
Volatility
of our stock price could adversely affect stockholders.
The
market price of our common stock could fluctuate significantly as a result
of:
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quarterly variations in our
operating results;
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cyclical nature of defense
spending;
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changes in the market’s
expectations about our operating
results;
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our operating results failing to
meet the expectation of securities analysts or investors in a particular
period;
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changes in financial estimates
and recommendations by securities analysts concerning our company or the
defense industry in general;
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operating and stock price
performance of other companies that investors deem comparable to
us;
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news reports relating to trends
in our markets;
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changes in laws and regulations
affecting our business;
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material announcements by us or
our competitors;
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sales of substantial amounts of
common stock by our directors, executive officers or significant
stockholders or the perception that such sales could
occur;
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general economic and political
conditions such as recessions and acts of war or terrorism;
and
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other matters discussed in the
Risk Factors.
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Fluctuations
in the price of our common stock could contribute to the loss of all or part of
an investor’s investment in our company.
We
do not intend to pay dividends on our common stock and consequently your only
opportunity to achieve a return on your investment is if the price of common
stock appreciates.
We do not
plan to declare dividends on our common stock in the foreseeable future. Any
payment of cash dividends will depend upon our financial condition, capital
requirements, earnings and other factors deemed relevant by our board of
directors. Agreements governing future indebtedness will likely contain similar
restrictions on our ability to pay cash dividends. Consequently, your only
opportunity to achieve a return on your investment in the common stock of our
company will be if the market price of our common stock appreciates and you sell
your common stock at a profit.
In
addition, under the Certificate of Designations for our Series A Preferred, an
affirmative vote at a meeting duly called or the written consent without a
meeting of the holders of such Series A Preferred representing at least a
majority of the then outstanding shares of the Series A Preferred is required
for us to pay dividends or any other distribution on our common
stock.
Provisions
in our certificate of incorporation and bylaws or Delaware law might discourage,
delay or prevent a change of control of our company or changes in our management
and, therefore, depress the trading price of our stock.
Our
certificate of incorporation and bylaws contain provisions that could depress
the trading price of our common stock by acting to discourage, delay or prevent
a change in control of our company or changes in our management that the
stockholders of our company may deem advantageous. These
provisions:
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establish a classified board of
directors so that not all members of our board of directors are elected at
one time;
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provide that directors may only
be removed “for cause” and only with the approval of 66 2⁄3 percent of our
stockholders;
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provide that only our board of
directors can fill vacancies on the board of
directors;
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require super-majority voting to
amend our bylaws or specified provisions in our certificate of
incorporation;
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authorize the issuance of “blank
check” preferred stock that our board of directors could issue to increase
the number of outstanding shares and to discourage a takeover
attempt;
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limit the ability of our
stockholders to call special meetings of
stockholders;
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prohibit common stockholder
action by written consent, which requires all common stockholder actions
to be taken at a meeting of our
stockholders;
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provide that the board of
directors is expressly authorized to adopt, amend, or repeal our bylaws,
subject to the rights of our stockholders to do the same by super-majority
vote of stockholders; and
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establish advance notice
requirements for nominations for election to our board of directors or for
proposing matters that can be acted upon by stockholders at stockholder
meetings.
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In
addition, Section 203 of the DGCL may discourage, delay or prevent a change in
control of our company.
These and
other provisions contained in our amended and restated certificate of
incorporation and bylaws could delay or discourage transactions involving an
actual or potential change in control of us or our management, including
transactions in which our stockholders might otherwise receive a premium for
their shares over then current prices, and may limit the ability of stockholders
to remove our current management or approve transactions that our stockholders
may deem to be in their best interests and, therefore, could adversely affect
the price of our common stock.
Shares
of stock issuable pursuant to our stock options, warrant and Series A Preferred
may adversely affect the market price of our common stock.
As of
November 15, 2010, we had outstanding stock options to purchase an aggregate of
2,505,000 shares of common stock under our 2007 Incentive Compensation Plan of
which 937,000 were exercisable and warrants to purchase an aggregate of 675,001
shares of common stock. In addition, we have 1,864,003 shares of common stock
reserved for issuance under our 2007 Incentive Compensation Plan and 30,000,000
shares reserved for issuance upon the conversion of our Series A
Preferred. Our outstanding warrants and Series A Preferred also
contain provisions that increase, subject to limited exceptions, the number of
shares of common stock that may be acquired upon the conversion or exercise of
such securities in the event we issue (or are deemed to have issued) shares of
our common stock at a per share price that is less than their then existing
exercise price, in the case of the warrants, and Conversion Price, in the case
of the Series A Preferred. The exercise of the stock options and
warrants would further reduce a stockholder’s percentage voting and ownership
interest. Further, the stock options and warrants are likely to be exercised
when our common stock is trading at a price that is higher than the exercise
price of these options and warrants, and we would be able to obtain a higher
price for our common stock than we will receive under such options and warrants.
The exercise, or potential exercise, of these options and warrants or conversion
of our Series A Preferred could adversely affect the market price of our common
stock and adversely affect the terms on which we could obtain additional
financing.
Future sales, or the availability for sale, of our
common stock may cause our stock price to decline.
We have
registered shares of our common stock that are subject to outstanding stock
options, or reserved for issuance under our 2007 Incentive Compensation Plan,
which shares can generally be freely sold in the public market upon issuance.
Pursuant to a settlement with the holders of our Series A Preferred in May 2009,
we also have registered the resale of up to 5,695,505 shares of our common
stock and expect to register additional shares of our common stock
acquired by such preferred stockholders as dividends on the Series A
Preferred. Sales, or the availability for sale, of substantial
amounts of our common stock in the public market could adversely affect the
market price of our common stock and could materially impair our future ability
to raise capital through offerings of our common stock.
The
continued listing of our common stock on the NYSE Amex is subject to compliance
with their continued listing requirements. While we have not received any notice
of intent to delist our common stock, we have received notice that the price of
our common stock would need to increase in order to be in compliance with NYSE
Amex listing standards. If our common stock were to be delisted, the ability of
investors in our common stock to make transactions in such stock would be
limited.
Our
common stock is listed on the NYSE Amex, a national securities exchange.
Continued listing of our common stock on the NYSE Amex requires us to meet
continued listing requirements set forth in the NYSE Amex’s Company Guide. These
requirements include both quantitative and qualitative standards. While we have
not received any notice of intent to delist our common stock, investors should
be aware that if the NYSE Amex were to delist our common stock from quotation on
its exchange, this would limit investors’ ability to make transactions in our
common stock.
In
October 2010 we received a notice from the NYSE Amex advising us that the price
of our common stock would need to increase in order to be in compliance with
continued listing standards. The NYSE Amex requested that we either affect a
reverse stock split or advise them of other pending or planned action to address
our stock price within a reasonable amount of time. We have responded to the
NYSE Amex with an action plan.
Item
2. Unregistered Sales of Equity
Securities and Use of Proceeds
As of
September 30, 2010, we issued an aggregate of 2,520,000 shares of our common
stock to the holders of our Series A Preferred as dividends pursuant to the
Certificate of Designations, Preferences and Rights of Series A Preferred. We
relied on the exemption provided by Section 4(2) of the Securities Act of 1933
and Regulation D promulgated thereunder.
Item
3. Defaults Upon Senior
Securities
None.
Item
4. (Removed and
Reserved)
Item
5. Other
Information
None.
Exhibit
Number
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Exhibit
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3.1
(1)
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Third
Amended and Restated Certificate of Incorporation.
|
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3.2
(2)
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Amended
and Restated Bylaws.
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3.3
(3)
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First
Amendment to Third Amended and Restated Certificate of
Incorporation.
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3.4
(4)
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First
Amendment to Amended and Restated Bylaws.
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31.1*
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|
Certification
of Chairman and Chief Executive Officer pursuant to Rule 13a-14(a) and
Rule 15d-14(a), promulgated under the Securities Exchange Act of 1934, as
amended.
|
|
|
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31.2*
|
|
Certification
of Chief Financial Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a),
promulgated under the Securities Act of 1934, as
amended.
|
|
|
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32.1*
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Certification
of Chairman and Chief Executive Officer and Chief Financial Officer
pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of
the Sarbanes-Oxley Act of
2002.
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*
Filed herewith.
(1)
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Previously
filed as an Exhibit to Amendment No. 3 to the Form 10, filed on April 22,
2008.
|
(2)
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Previously
filed as an Exhibit to Amendment No. 1 to the Form 10, filed on March 21,
2008.
|
(3)
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Previously
filed as an Exhibit to the Current Report on Form 8-K, filed on April 15,
2010.
|
(4)
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Previously
filed as an Exhibit to the Current Report on Form 8-K, filed on January
28, 2010.
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SIGNATURES
Pursuant
to the requirements of the Securities Exchange Act of 1934, the registrant has
duly caused this report to be signed on its behalf by the undersigned thereunto
duly authorized.
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AMERICAN
DEFENSE SYSTEMS, INC.
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Date:
November 17, 2010
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By:
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/s/ Gary Sidorsky
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Chief
Financial Officer
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Index to
Exhibits
Exhibit
Number
|
|
Exhibit
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|
|
|
31.1
|
|
Certification
of Chairman and Chief Executive Officer pursuant to Rule 13a-14(a) and
Rule 15d-14(a), promulgated under the Securities Exchange Act of 1934, as
amended.
|
|
|
|
31.2
|
|
Certification
of Chief Financial Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a),
promulgated under the Securities Act of 1934, as
amended.
|
|
|
|
32.1
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|
Certification
of Chairman and Chief Executive Officer and Chief Financial Officer
pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of
the Sarbanes-Oxley Act of
2002.
|
Eagle Broadband (AMEX:EAG)
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Eagle Broadband (AMEX:EAG)
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