NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
NOTE
1 - ORGANIZATION AND LINE OF BUSINESS
The
Company was incorporated under the name "Delivery Now Corp." in the State of
Delaware on October 3, 2000 for the purpose of providing delivery and messenger
services. On December 18, 2003, it discontinued the messenger delivery
service business in connection with the merger transaction described
below.
On
December 18, 2003, the Company consummated a merger agreement with CanOnline
Global Media, Inc., a Washington corporation ("CGMI"), pursuant to which CGMI
merged into the Company’s wholly-owned subsidiary, DLVN Acquisition Corp.
In connection with the reverse merger, on December 17, 2003, Delivery Now Corp.
changed its fiscal year end from September 30 to December 31 and changed its
name to NS8 Corporation ("NS8").
NS8,
CGMI
and CMC (collectively, the "Company") design and produce online business
communications and multimedia applications in the areas of streaming software,
digital media rights, data-content management, audio-video communications,
and
corporate collaboration systems.
NOTE
2 - GOING CONCERN
The
accompanying interim consolidated financial statements have been prepared in
conformity with accounting principles generally accepted in the United States
of
America (“GAAP”), which contemplate continuation of the Company as a going
concern. During the nine months ended September 30, 2007 and 2006, the Company
incurred net losses of $1,054,269 and $5,244,617, respectively, and had negative
cash flows from operations of $2,666,494 and $1,501,897, respectively. In
addition, the Company had a deficit accumulated during the development stage
of
$29,345,295 at September 30, 2007. These factors, among others, raise
substantial doubt about the Company's ability to continue as a going
concern.
Recovery
of the Company's assets is dependent upon future events, the outcome of which
is
indeterminable. Management plans to continue to provide for the Company's
capital needs during the year ending December 31, 2007 by issuing debt and
equity securities and by the continued development and commercialization of
its
products and services. The interim consolidated financial statements do not
include any adjustments relating to the recoverability and classification of
recorded asset amounts or amounts and classification of liabilities that might
be necessary should the Company be unable to continue in existence.
NOTE
3 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis
of Presentation of Financial Statements
The
accompanying unaudited interim consolidated financial statements have been
prepared by the Company in accordance with GAAP for interim financial
information. These principles are consistent in all material respects with
those
applied in the Company’s consolidated financial statements contained in the
Company’s annual report on Form 10-KSB for the fiscal year ended December 31,
2006, and pursuant to the instructions to Form 10-QSB and Item 310(b) of
Regulation S-B promulgated by the United States Securities and Exchange
Commission (“SEC”). Interim financial statements do not include all of the
information and footnotes required by GAAP for complete financial statements.
In
the opinion of management, the accompanying unaudited consolidated financial
statements contain all adjustments (all of which are of a normal recurring
nature, including the elimination of intercompany accounts) necessary to present
fairly the financial position, results of operations and cash flows of the
Company for the periods indicated. Interim results of operations are not
necessarily indicative of the results to be expected for the full year or any
other interim periods. These unaudited consolidated financial statements should
be read in conjunction with the financial statements and footnotes thereto
contained in the Company’s annual report on Form 10-KSB for the year ended
December 31, 2006.
Principles
of Consolidation
The
consolidated financial statements include the accounts of NS8 and its
wholly-owned subsidiaries, CGMI and CMC. All significant inter-company accounts
and transactions are eliminated in consolidation.
Development
Stage
Enterprise
The
Company is a development stage company as defined in Statement of Financial
Accounting Standards ("SFAS") No. 7, "Accounting and Reporting by Development
Stage Enterprises." The Company is devoting substantially all of its present
efforts to establishing a new business, and its planned principal operations
have not yet commenced. All losses accumulated since inception have been
considered as part of the Company's development stage activities.
Comprehensive
Loss
The
Company utilizes SFAS No. 130, "Reporting Comprehensive Income." This statement
establishes standards for reporting comprehensive loss and its components in
a
financial statement. Comprehensive loss, as defined, includes all changes in
equity (net assets) during a period from non-owner sources. The Company's
comprehensive loss includes foreign currency translation adjustments which
are
excluded from net income (loss) and are reported as a separate component of
shareholders' deficit as accumulated other comprehensive loss.
Accounting
for Derivative Instruments
In
connection with the issuance of certain convertible debentures in May and June
2004, November 2005 and April 2007 (see Note 8), the debentures provided for a
conversion of the debentures into shares of the Company's common stock at a
rate
which was determined to be variable. The Company determined that the variable
conversion feature was an embedded derivative instrument pursuant to SFAS No.
133, "Accounting for Derivative Instruments and Hedging Activities," as amended.
The accounting treatment of derivative financial instruments requires that
the
Company record the derivatives and related warrants at their fair values as
of
the inception date of the debenture agreements and at fair value as of each
subsequent balance sheet date. In addition, under the provisions of Emerging
Issues Task Force ("EITF") Issue No. 00-19, "Accounting for Derivative Financial
Instruments Indexed to, and Potentially Settled in, a Company's Own Stock,"
as a
result of entering into the debenture agreements, the Company was required
to
classify all other non-employee options and warrants as derivative liabilities
and record them at their fair values at each balance sheet date. Any change
in
fair value was recorded as non-operating, non-cash income or expense at each
balance sheet date. If the fair value of the derivatives was higher at the
subsequent balance sheet date, the Company recorded a non-operating, non-cash
charge. If the fair value of the derivatives was lower at the subsequent balance
sheet date, the Company recorded non-operating, non-cash income.
During
the three and nine months ended September 30, 2007, the Company recognized
other
income of $2,812,000 and $12,587,846, respectively, compared to other income
of
$2,463,443 and expense of $694,612 during the three and nine months ended
September 30, 2006, respectively, related to recording the derivative liability
at fair value. At September 30, 2007, the derivative liability balance was
$5,693,068.
Warrant-related
derivatives were valued using the Black-Scholes Option Pricing Model with the
following assumptions for the three and nine months ended September 30, 2007:
annual volatility of 230%, dividend yield of 0, and risk free interest rate
of
4.5% and 4.6%, respectively.
Warrant-related
derivatives were valued using the Black-Scholes Option Pricing Model with the
following assumptions for the three and nine months ended September 30, 2006:
annual volatility of 236%, dividend yield of 0%, and risk free interest rate
of
4.8%.
Software
Development Costs
Pursuant
to the provisions of SFAS No. 86, "Accounting for the Costs of Computer Software
to Be Sold, Leased or Otherwise Marketed," the Company capitalizes the costs
associated with internally developed software and software purchased from third
parties if the related software product under development has reached
technological feasibility or if there are alternative future uses for the
purchased software. These costs are amortized on a product-by-product basis
typically over the estimated life of the software product using the greater
of
the ratio that current gross revenue for a product bears to the total of current
and anticipated future gross revenue for that product or the straight-line
method over the remaining estimated economic life of the product. At each
balance sheet date, the Company evaluates on a product-by-product basis the
unamortized capitalized cost of computer software compared to the net realizable
value of that product. The amount by which the unamortized capitalized cost
of a
computer software product exceeds its net realizable value is written
off.
Capitalization
of software development costs begins upon the establishment of technological
feasibility of its products. In the past, the Company did not capitalize any
software and development costs because they either did not meet SFAS No. 86
capitalization criteria or were immaterial. Beginning at the end of the first
quarter of 2006, the Company determined that certain of its software
applications reached technological feasibility. As a result, the Company
capitalized related software development costs incurred from this point until
September 30, 2007 totaling $273,423. The amortization of capitalized software
development costs began in the fourth quarter of 2006 using the straight-line
method over the estimated product life of 1.5 years. The Company recorded
$41,678 and $116,797 of amortization expense during the three and nine months
ended September 30, 2007, respectively.
Revenue
Recognition
The
Company recognizes revenue in accordance with GAAP that has been prescribed
for
the software industry under Statement of Position ("SOP") 97-2, "Software
Revenue Recognition," and with the guidelines of the SEC Staff Accounting
Bulletin (“SAB”) No. 101 as amended by SAB No. 104 "Revenue Recognition in
Financial Statements." Revenue recognition requirements in the software industry
are subject to change. The Company generally recognizes revenue when persuasive
evidence of an arrangement exists, the Company has delivered the product or
performed the service, the fee is fixed or determinable and collectibility
is
reasonably assured. However, determining whether and when some of these criteria
have been satisfied often involves assumptions and judgments that can have
a
significant impact on the timing and amount of revenue reported. When licenses
are sold together with maintenance and implementation services, license fees
are
recognized upon delivery of the product provided that: (1) the above criteria
have been met; (2) payment of the license fees is not dependent upon performance
of the consulting and implementation services; and (3) the services are not
essential to the functionality of the software. For arrangements where services
are essential to the functionality of the software, both the license and
services revenue are recognized in accordance with the provisions of SOP 81-1,
"Accounting for Performance of Construction-Type and Certain Production-Type
Contracts." Arrangements that allow the Company to make reasonably dependable
estimates relative to contract costs and the extent of progress toward
completion are accounted for using the percentage-of-completion method.
Arrangements that do not allow the Company to make reasonably dependable
estimates of costs and progress are accounted for using the completed-contract
method. Because the completed-contract method precludes recognition of
performance under the contract as the work progresses, it does not reflect
current financial performance when the contract extends beyond one accounting
period, and it therefore may result in uneven recognition of revenue, related
cost of revenues and gross margin.
Maintenance
and training services are generally recognized as the services are performed,
except in instances where services are included in an arrangement accounted
for
under SOP 81-1.
Revenues
from licensing the Company's software are generated from licensing agreements
primarily with Video-On-Demand ("VOD") distributors that generally pay a
per-unit royalty fee. Consequently, the Company recognizes revenue from these
licensing agreements on an as-earned basis, provided amounts are fixed or
determinable and collection is reasonably assured. The Company relies on working
relationships with these customers to reasonably and successfully estimate
current period volume in order to calculate the quarter end revenue
accruals.
If
the
Company changes any of these assumptions or judgments, it could cause a material
increase or decrease in the amount of revenue that the Company reports in a
particular period. Amounts for fees collected relating to arrangements where
revenue cannot be recognized are reflected on the Company's consolidated balance
sheet as deferred revenue and recognized when the applicable revenue recognition
criteria are satisfied.
Recoverability
of Deferred Costs
We
defer
costs on projects for service revenue. Deferred costs consist primarily of
direct and incremental costs to customize and install systems, as defined in
individual customer contracts, including costs to acquire hardware and software
from third parties and payroll costs for our employees and other third
parties.
We
recognize such costs in accordance with our revenue recognition policy by
contract. For revenue recognized under the completed contract method, costs
are
deferred until the products are delivered, or upon completion of services or,
where applicable, customer acceptance. For revenue recognized under the
percentage of completion method, costs are recognized as products are delivered
or services are provided in accordance with the percentage of completion
calculation. For revenue recognized ratably over the term of the contract,
costs
are recognized ratably over the term of the contract consistent with that for
the related revenue recognition. At each balance sheet date, we review deferred
costs, to ensure they are ultimately recoverable. Any anticipated losses on
uncompleted contracts are recognized when evidence indicates the estimated
total
cost of a contract exceeds its estimated total revenue.
Stock-Based
Compensation
On
January 1, 2006, the Company adopted SFAS No. 123 (revised 2004),
"Share-Based Payment," ("SFAS No. 123(R)") which establishes standards for
the
accounting of transactions in which an entity exchanges its equity instruments
for goods or services, primarily focuses on accounting for transactions where
an
entity obtains employee services in share-based payment transactions. SFAS
No.
123(R) requires a public entity to measure the cost of employee services
received in exchange for an award of equity instruments, including stock
options, based on the grant-date fair value of the award and to recognize it
as
compensation expense over the period the employee is required to provide service
in exchange for the award, usually the vesting period. In March 2005, the SEC
issued SAB No. 107, "Valuation of Share-Based Payment Arrangements for Public
Companies," ("SAB No. 107") relating to SFAS No. 123(R). The Company has applied
the provisions of SAB No. 107 in its adoption of SFAS No. 123(R).
SFAS
No.
123(R) requires companies to estimate the fair value of share-based payment
awards on the date of grant using an option-pricing model. The value of the
portion of the award that is ultimately expected to vest is recognized as
expense over the requisite service periods in the Company's consolidated
statement of operations.
Stock-based
compensation expense is based on the value of the portion of share-based payment
awards that is ultimately expected to vest during the period. Stock-based
compensation expense recognized in the Company's consolidated statements of
operations for the three and nine months ended September 30, 2006 included
compensation expense for share-based payment awards granted prior to, but not
yet vested as of December 31, 2005 based on the grant date fair value
estimated in accordance with the pro forma provisions of SFAS No. 123,
“Accounting For Stock-Based Compensation”, and compensation expense for the
share-based payment awards granted subsequent to December 31, 2005 based on
the grant date fair value estimated in accordance with the provisions of SFAS
No. 123(R). As stock-based compensation expense recognized in the consolidated
statements of operations is based on awards ultimately expected to vest, it
has
been reduced for estimated forfeitures. SFAS No. 123(R) requires forfeitures
to
be estimated at the time of grant and revised, if necessary, in subsequent
periods if actual forfeitures differ from those estimates. The estimated average
forfeiture rate for the three and nine months ended September 30, 2007 and
2006,
of approximately 3%, was based on historical forfeiture experience and estimated
future employee forfeitures. The estimated pricing term of option grants for
2007 and 2006 was five years.
SFAS
No.
123(R) requires the cash flows resulting from the tax benefits resulting from
tax deductions in excess of the compensation cost recognized for those options
to be classified as financing cash flows. There were no such tax benefits during
the three and nine months ended September 30, 2007 and 2006.
Net
Income (Loss) Per Common Share
The
Company utilizes SFAS No. 128, "Earnings per Share." Basic income (loss) per
share is computed using the weighted average number of common shares outstanding
during the period. Diluted income (loss) per share is computed using the
weighted average number of common and potentially dilutive shares outstanding
during the period. Potentially dilutive shares consist of the incremental common
shares issuable upon the exercise of stock options and warrants and conversion
of convertible debentures. Potentially dilutive shares are excluded from the
computation if their effect is antidilutive.
At
September 30, 2007 and 2006, the outstanding potentially dilutive common shares
totaled 1,102,596,951 and 194,970,076, respectively.
However,
as the Company incurred net losses for the nine months ended September 30,
2007
and 2006, none of the incremental shares outstanding during each of the periods
presented was included in the computation of diluted loss per share as they
were
antidilutive.
The
following table sets forth for the three months ended September 30,
2007 and 2006 the computation of basic and diluted net income per share,
including the reconciliation of the numerator and denominator used in the
calculation of basic and diluted net income per share:
|
|
|
Three
Months Ended September 30,
|
|
|
|
2007
|
|
|
2006
|
|
Basic
income per common share:
|
|
|
|
|
|
|
Net
income
|
|
$
|
1,671,485
|
|
|
$
|
870,743
|
|
|
|
|
|
|
Weighted-average
common shares outstanding, basic
|
|
|
206,175,897
|
|
|
|
110,954,980
|
|
|
|
|
|
|
Basic
income per common share
|
|
$
|
0.01
|
|
|
$
|
0.01
|
|
|
|
|
|
|
Diluted
income per common share:
|
|
|
|
|
|
|
|
|
Net
income
|
|
$
|
1,671,485
|
|
|
$
|
870,743
|
|
Convertible
notes interest expense (net of tax)
|
|
|
235,534
|
|
|
|
216,336
|
|
Adjusted
net income available to common stockholders
|
|
$
|
1,907,019
|
|
|
$
|
1,087,079
|
|
|
|
|
|
|
Weighted-average
common shares outstanding, basic
|
|
|
206,175,897
|
|
|
|
110,954,980
|
|
Effect
of dilutive securities:
|
|
|
|
|
|
|
|
|
Stock
options and warrants
|
|
|
-
|
|
|
|
12,632,994
|
|
Convertible
debentures
|
|
|
896,421,054
|
|
|
|
70,521,151
|
|
Contingent
shares
|
|
|
-
|
|
|
|
860,951
|
|
Weighted-average
common shares outstanding, diluted
|
|
|
1,102,596,951
|
|
|
|
194,970,076
|
|
|
|
|
|
|
Diluted
net income per common share
|
|
$
|
-
|
|
|
$
|
0.01
|
Foreign
Currency Translation
Assets
and liabilities in foreign currencies are translated at the exchange rate
prevailing at the balance sheet date. Revenues and expenses are translated
at
the exchange rate prevailing at the transaction date, and the resulting gains
and losses are reflected in the statements of operations. Gains and losses
arising from translation of a subsidiary's foreign currency financial statements
are shown as a component of shareholders' deficit as accumulated other
comprehensive income (loss).
Use
of Estimates
The
preparation of financial statements requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenue and expenses during the reporting
period. Significant estimates made by management include, among others,
collectibility of accounts receivable, the recoverability of property and
equipment, capitalized software development costs and valuation of stock-based
compensation, warrants, derivative liabilities and deferred taxes. Actual
results could differ from those estimates.
Concentrations
of Credit Risk
Financial
instruments which potentially subject the Company to concentrations of credit
risk consist of cash and accounts receivable. The Company places its cash with
high credit, quality financial institutions. At times, such cash may be in
excess of the Federal Deposit Insurance Corporation insurance limit of $100,000.
The Company has not experienced any losses in such accounts and believes it is
not exposed to any significant credit risk on cash.
For
the
three and nine months ended September 30, 2007 and 2006, 2 customers accounted
for approximately 100% of total revenues, respectively.
1
customer accounted for approximately 100% of accounts receivable at September
30, 2007.
Recent
Accounting Pronouncements
In
February 2007, the Financial Accounting Standards Board (“FASB”) issued
SFAS No. 159, “The Fair Value Option for Financial Assets and Financial
Liabilities — Including an Amendment of FASB Statement No. 115.” SFAS
No. 159 permits entities to choose to measure many financial instruments
and certain other items at fair value. The objective is to improve financial
reporting by providing entities with the opportunity to mitigate volatility
in
reported earnings caused by measuring related assets and liabilities differently
without having to apply complex hedge accounting provisions. SFAS No. 159
also establishes presentation and disclosure requirements designed to facilitate
comparison between entities that choose different measurement attributes for
similar types of assets and liabilities. The Company will adopt SFAS
No. 159 in the first quarter of 2008, is still evaluating the effect, if
any, on its consolidated financial position and consolidated results of
operations and has not yet determined its impact.
In
July
2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in
Income Taxes--an interpretation of FASB Statement No. 109,” ("FIN
48"). FIN 48 clarifies the accounting for uncertainty in income taxes
recognized in the financial statements in accordance with FASB Statement No.
109, “Accounting for Income Taxes.” FIN 48 prescribes a recognition
threshold and measurement attribute for a tax position taken or expected to
be
taken in a tax return. FIN 48 also provides guidance on future
changes, classification, interest and penalties, accounting in interim periods,
disclosures and transition. FIN 48 is effective for fiscal years
beginning after December 15, 2006 and the Company adopted this standard
beginning January 1, 2007. Management believes that the adoption of
FIN 48 had no material impact on the financial statements.
NOTE
4 - ACCRUED EXPENSES
The
accrued expenses as of September 30, 2007 consisted of the
following:
|
|
|
September
30,
|
|
|
|
2007
|
|
|
|
|
|
Interest
on shareholder loans
|
|
$
|
225,261
|
|
Interest
on convertible debentures
|
|
|
875,049
|
|
Penalties
on convertible debentures (1)
|
|
|
969,092
|
|
Other
accrued expenses
|
|
|
18,665
|
|
Total
accrued expenses
|
|
$
|
2,088,067
|
(1) The
Company was required to file a registration statement, which was filed on
December 14, 2005, and have such registration statement declared effective
by no
later than February 27, 2006 (the "Effectiveness Deadline"). The registration
statement was not declared effective by the Effectiveness Deadline, and the
Company is liable to pay certain liquidated damages to the holders of
convertible debentures in the amount equal to 2% of the outstanding borrowings,
in cash or shares of the Company's common stock, at the note holder's option,
for each subsequent 30-day period after the Effectiveness Deadline. The required
registration statement was declared effective on February 14, 2007 and the
penalty ceased accruing. The Company has recorded interest expense related
to
accrued penalties of $969,092 for the period from March 1, 2006 through February
14, 2007, which is included in accrued expenses in the Company's consolidated
balance sheet.
See
Notes
6, 7 and 8 for details on interest expense recognized during the three and
nine
months ended September 30, 2007 and 2006.
NOTE
5 - ACCRUED MANAGEMENT FEES
On
September 30, 2006, certain individuals elected to defer the payment of the
outstanding management fees owed to them by the Company. The management fees
will be deferred to December 31, 2008 and such deferral does not restrict or
prevent the Company from repaying the management fees when and if sufficient
funds become available to the Company.
On
July
9, 2007, the Company implemented a debt reduction plan (“Debt Reduction Plan”)
whereby the management was able to convert up to 50% of the entire balance
of
their respective outstanding fees to common shares in the capital stock of
the
Company at a fixed price of $0.03 per common share until the end of July
2007. As a result of this plan, the Company converted $804,463 of
management fees into 26,815,480 common shares of the Company. The remaining
balance of outstanding management fees will continue to be treated as current
or
long-term obligations, depending on deferral terms of the related obligation,
and the Company plans to provide an option to continue to convert remaining
fee
balances into equity at the prevailing market price at the time the balance
of
their respective outstanding debts are converted into common shares of the
Company.
NOTE
6 - NOTES PAYABLE
On
July
9, 2007, the Company implemented the Debt Reduction Plan whereby
holders of loans were able to convert up to 50% of the entire balance of their
respective outstanding loans to common shares in the capital stock of the
Company at a fixed price of $0.03 per common share. As a result of this plan,
the loan holders converted the aggregate principal of $235,722 and $81,340
of
related accrued interest into 10,568,733 common shares of the Company. The
unconverted principal balance of $544,278 was combined with amounts due to
shareholders and directors.
NOTE
7 - RELATED PARTY TRANSACTIONS
Due
to shareholders and directors
Due
to
shareholders and directors at September 30, 2007 consisted of loans from various
shareholders and directors to finance the Company's operations. In connection
with the Debt Reduction Plan holders of loans converted $2,084,618 of their
respective outstanding loans and $237,708 of accrued interest, respectively,
to
77,410,867 common shares in the capital stock of the Company at a fixed price
of
$0.03 per common share. At September 30, 2007, the balance due amounted to
$2,822,602 and included the following:
|
·
|
Unsecured
promissory notes in the aggregate principal amount of $1,037,048.
All of
the notes bear interest at 6% per annum and are payable on demand.
During
the nine months ended September 30, 2007 the Company repaid $13,000
consisting of principal and related accrued interest on one of the
outstanding notes.
|
|
·
|
Unsecured
promissory notes in the aggregate principal amount of $764,619. All
of the
notes bear interest at 7% per annum, and are payable on
demand.
|
|
·
|
Unsecured
promissory note in the aggregate principal amount of $100,573. The
note
bears interest at 8% per annum, and is payable on
demand.
|
|
·
|
Unsecured
promissory notes in the aggregate principal amount of $920,362. All
of the
notes bear interest at 10% per annum, and are payable on demand.
Provided
that upon repayment of the $250,000 loan owed under the original
note
issued on March 11, 2004, the holder of the promissory note would
be
granted warrants to purchase 100,000 shares of the Company's common
stock
for gross proceeds of $100,000. The promissory note bears interest
at 10%
per annum, and the principal and any unpaid interest is due on demand.
Upon exercise, each warrant entitles the holder to purchase one share
of
the Company's common stock at $1.00 per share, and expires two years
from
the date of issuance. The fair value of the warrants of $51,587,
as
calculated using the Black-Scholes option pricing model, was recorded
as a
debt discount and was recognized as interest expense during 2004
and 2005
year end. In addition, under the provisions of EITF Issue No. 00-19,
the
fair value of the warrants was recorded as a derivative liability
in the
accompanying interim consolidated balance sheet (see Note
3).
|
Interest
expense on amounts due to shareholders and directors was $45,375 and $80,976
for
the three months ended September 30, 2007 and 2006, respectively, and $235,373
and $204,922 for the nine months ended September 30, 2007 and 2006,
respectively. Accrued interest on the notes was $225,261 at September 30, 2007
and is included in accrued expenses in the accompanying interim consolidated
balance sheet (see Note 4).
NOTE
8 - CONVERTIBLE DEBENTURES
2004
Debentures
During
May and June 2004, the Company issued two secured convertible debentures ("2004
Debentures") in the amount of $750,000 each to one investment company, Cornell
Capital Partners, LP ("Cornell Capital"), for a total of $1,500,000. The 2004
Debentures are secured by all of the assets of the Company. On July 20, 2007,
the Company negotiated an extension of the original maturity dates
of May 19, 2007 and June 25, 2007 to July 19, 2008.
As
a result of this
extension, the
interest on converted debentures was increased to 14%
from the original 5.0% per annum. There was no related expense in
connection with the modification of the interest rate.
The
secured debentures are convertible into the Company's common stock at the
holder's option any time up to maturity at a conversion price equal to the
lower
of:
|
·
|
120%
of the closing bid price of the common stock as of the closing date,
or
|
|
·
|
80%
of the lowest closing bid price of the common stock during the five
trading days immediately preceding the conversion
date.
|
At
maturity, the Company has the option to either pay the holder the outstanding
principal balance and accrued interest or to convert the debentures into shares
of common stock at a conversion price similar to the terms described above.
The
Company has the right to redeem the debentures upon three business days notice
for 120% of the amount redeemed. Upon such redemption, the holder shall receive
warrants equal to 50,000 shares of common stock for each $100,000 redeemed
on a
pro rata basis.
Each
warrant entitles the holder to purchase one share of the Company's common stock
at an exercise price equal to 120% of the closing bid price of the common stock
on the closing date. The warrants have "piggy-back" and demand registration
rights and shall survive for two years from the closing date. If the Company
elects to redeem a portion or all of the debentures prior to maturity the amount
allocated to the warrants as a debt discount will be calculated and recognized
as an expense at that time. In connection with the issuance of the 2004
Debentures, the Company recorded a debt discount of $428,571, consisting of
an
embedded put option, which was recorded as a derivative liability upon issuance
of the 2004 Debentures. The Company amortized the discount using the
effective interest method through June 2007. The derivative liability will
be
recorded as additional paid-in capital upon conversion or repayment of the
debentures.
On
September 30, 2007, the outstanding principal balance of the 2004 Debentures
was
$850,100. The Company recognized interest expense of $0 and $27,109 in the
accompanying interim consolidated statements of operations for the three months
ended September 30, 2007 and 2006, and $31,341 and $69,309 for the nine months
ended September 30, 2007 and 2006, respectively, related to the amortization
of
the debt discount. As of September 30, 2007 the discount has been amortized
in
full.
The
fair
value of the remaining derivative liability related to the embedded put option
is $242,885 at September 30, 2007 and is included in the accompanying interim
consolidated balance sheet.
2005
Debentures
On
November 14, 2005, the Company issued two new convertible debentures to Cornell
Capital. One debenture replaced previously issued promissory notes in the amount
of $1,863,430, which represented unconverted principal of $1,600,000, plus
accrued interest. The second debenture was for $500,000, which was new
financing, less fees and expenses payable to Cornell Capital. On December 8,
2005, the Company issued a third debenture to Cornell Capital in the amount
of
$500,000 which also represented new financing for the Company, less fees and
expenses in the amount of $145,000 which was included in the debt discount.
The
last secured convertible debenture in the principal amount of $300,000, less
fees and expenses of $30,000, which was included in the debt discount, was
closed on September 28, 2006. These debentures will collectively be referred
to
as the "2005 Debentures." The 2005 Debentures carry an interest rate of 10%
per
annum, mature on November 14, 2008, except for $300,000 which matures on
September 28, 2009, and are secured by all of the assets of the
Company.
The
secured debentures are convertible into Company’s common stock at the holder’s
option any time up to maturity at a conversion price equal to the lower
of:
|
·
|
90%
of the average of the three lowest volume weighted daily average
prices of
the Company's common stock for the 30 days prior to the conversion
date.
|
The
Company has also issued warrants to Cornell Capital to purchase 5,000,000 shares
of common stock at an exercise price of $0.075 per share, 10,000,000 shares
of
common stock at an exercise price of $0.06 per share and 10,000,000 shares
of
common stock at an exercise price of $0.05 per share. The warrants were valued
at $2,250,000 on the date of grant using the Black-Scholes option pricing model
and are included in derivative liability (see Note 3) at fair value in the
accompanying interim consolidated balance sheet. On July 20, 2007, as a result
of maturity date extension on the 2004 Debentures, the exercise price on the
25,000,000 warrants was re-priced to $0.02. The value of this warrant
modification, as determined using the Black-Scholes valuation model, was $0,
and
accordingly no additional expense was recognized in the statement of
operations.
The
amendment of the promissory notes into the 2005 Debentures represents a
modification of terms of the promissory notes. Pursuant to EITF No. 96-19,
"Debtors' Accounting for a Modification or Exchange of Debt Instruments," and
EITF Issue No. 05-7, "Accounting for Modifications to Conversion Options
Embedded in Debt Instruments and Related Issues," the Company accounted for
this
modification as an extinguishment of debt and the issuance of new debt.
Accordingly, during the year ended December 31, 2005, the Company recorded
a
loss on extinguishment of debt of $2,250,000 related to the value of the
warrants issued in connection with the 2005 Debentures.
In
connection with the issuance of the 2005 Debentures, the Company recorded an
aggregate debt discount of $1,619,000, consisting of an embedded put option,
which was recorded as a derivative liability upon note issuance. The Company
is
amortizing the discount using the effective interest method through November
2008. The derivative liability will be recorded as additional paid-in capital
upon conversion or repayment of the 2005 Debentures.
On
September 30, 2007, the outstanding principal balance of the 2005 Debentures
was
$2,820,441, less the remaining debt discount of $578,243. The Company recognized
interest expense of $124,111 and $199,716 in the accompanying consolidated
statements of operations for the three months ended September 30, 2007 and
2006,
and $417,850 and $449,716 for the nine months ended September 30, 2007 and
2006,
respectively, related to the amortization of the debt discount.
The
fair
value of the remaining derivative liability related to the embedded put option
is $1,449,039 at September 30, 2007 and is included in the accompanying interim
consolidated balance sheet.
2007
Debentures
On
April
16, 2007, the Company entered into a capital financing with Cornell Capital
Partners, L.P. to fund the Company’s ongoing operations and commercialization of
its products and services. The Company plans to sell up to $3.3 million of
secured convertible debentures, which will be funded on multiple closings dates.
During the nine months ended September 30, 2007, the Company closed new
debentures for the gross proceeds of $2,450,000, less fees and expenses of
$300,000, which were included in other assets and are being amortized over
the
related debenture maturity life of 3 years. The 2007 Debentures bear interest
at
the rate of 14% per annum and are secured by all of the assets of the
Company. $1,650,000 of the aggregate principal of new debentures matures on
April 16, 2010, $400,000 matures on July 12, 2010 and $400,000 matures on August
24, 2010. These debentures will collectively be referred to as the "2007
Debentures."
The
2007
Debentures are convertible into the Company’s common stock at the holder’s
option any time up to maturity at a conversion price equal to the lower
of:
|
·
|
80%
of the average of the lowest volume weighted daily average prices
of the
Company's common stock for the 30 days prior to the conversion
date.
|
The
Company also issued warrants to Cornell Capital to purchase 250,000,000 shares
of common stock at an exercise price of $0.02 per share. The warrants were
valued at $10,000,000, of which $1,100,000 was recorded as debt discount, on
the
date of grant using the Black-Scholes option pricing model and is included
in
derivative liability (see Note 3) at fair value in the accompanying interim
consolidated balance sheet. The Company is amortizing the discount using the
effective interest method through April 2010.
In
connection with the issuance of the 2007 Debentures, the Company recorded an
aggregate interest expense of $1,100,000, consisting of an embedded put option,
which was recorded as a derivative liability upon note issuance. The derivative
liability will be recorded as additional paid-in capital upon conversion or
repayment of the 2007 Debentures.
On
September 30, 2007, the outstanding principal balance of the 2007 Debentures
was
$2,450,000, less the remaining debt discount of $921,250. The Company recognized
interest expense of $93,704 and $178,750 in the accompanying consolidated
statements of operations for the three and nine months ended September 30,
2007,
related to the amortization of the debt discount. The fair value of the
remaining derivative liability related to the embedded put option is $1,100,000
at September 30, 2007 and is included in the accompanying interim consolidated
balance sheet.
Interest
expense on the principal balance of 2004, 2005 and 2007 Debentures was $174,741
and $85,426 for the three months ended September 30, 2007 and 2006,
respectively, and $391,834 and $253,906 for the nine months ended September
30,
2007 and 2006, respectively. Accrued interest on the convertible debentures
was
$875,049 at September 30, 2007 and is included in accrued expenses in the
accompanying consolidated balance sheet (see Note 4).
NOTE
9 - COMMITMENTS AND CONTINGENCIES
Litigation
On
March
20, 2007, Maximum Ventures, Inc. (“MVI”) commenced a legal action against the
Company and asserts causes of action for breach of contract and quantum
meruit. The action arises from a purported breach of a settlement
agreement entered into between the Company and MVI whereby the Company allegedly
agreed to issue 1,721,902 shares of its common stock to MVI and to have such
stock registered. MVI claims that the Company failed to timely issue the
stock and did not have same registered. MVI seeks in excess of $100,000 in
damages in this action.
On
May 3,
2007, the Company answered the Complaint, denying the material allegations
contained therein. This action is in its early stages and the parties are
presently engaged in discovery. The Company intends to vigorously defend
this action.
The
Company may become involved in other legal proceedings and claims which arise
in
the normal course of business. Management is not aware of any such matter will
have a material effect on the Company's consolidated financial position or
results of operations.
Indemnities
and Guarantees
During
the normal course of business, the Company has made certain indemnities and
guarantees under which it may be required to make payments in relation to
certain transactions. The Company indemnifies its directors, officers, employees
and agents to the maximum extent permitted under the laws of the State of
Delaware. These indemnities include certain agreements with the Company's
officers under which the Company may be required to indemnify such person for
liabilities arising out of their employment relationship. In connection with
its
facility leases, the Company has indemnified its lessors for certain claims
arising from the use of the facilities. The duration of these indemnities and
guarantees varies and, in certain cases, is indefinite. The majority of these
indemnities and guarantees do not provide for any limitation of the maximum
potential future payments the Company could be obligated to make. Historically,
the Company has not been obligated to make significant payments for these
obligations and no liabilities have been recorded for these indemnities and
guarantees in the accompanying consolidated balance sheet.
NOTE
10 - SHAREHOLDERS' DEFICIT
Preferred
Stock
The
Company has 5,000,000 authorized shares of non-voting preferred stock with
a
$0.0001 par value. The preferred stock may be issued in series, from time to
time, with such designations, rights, preferences, and limitations as the Board
of Directors may determine by resolution. The Company did not have any preferred
stock issued and outstanding at September 30, 2007.
Common
Stock
On
July
10, 2007 the Company increased its authorized share capital to 5,000,000,000.
Included in the Company's issued and outstanding shares of common stock are
1,276,436 shares issued in connection with the reverse acquisition (see Note
1)
that have not been exchanged for shares of the Company.
On
June
28, 2007, the Company’s Board of Directors rewarded current and certain past
employees by gifting to each of the employees 100,000 free trading common shares
of the Company with a par value of $0.0001 per share. The total shares awarded
to the employees amounted to 2,100,000. As of September 30, 2007, the shares
have not been issued due to certain administrative matters, but have been
included as issued but not outstanding in the accompanying interim consolidated
balance sheet. The shares were valued at $42,000 based on the fair value at
the
measurement date and recorded as compensation expense.
On
July
9, 2007, the Company implemented a debt reduction plan whereby holders of
unsecured debt were able to convert up to 50% of the entire balance of
their respective outstanding debts to common shares in the capital stock of
the
Company at a fixed price of $0.03 per common share until the end of July
2007. As of September 30, 2007, the balance of unsecured debt
converted to common stock amounted to $3,443,851 and the Company issued
114,795,080 restricted common shares upon conversion.
Warrants
and Common Stock for Consulting Services
On
April
11, 2007, the Company entered into a one year consulting agreement with Mr.
George O’Leary, the President of SKS Consulting of South Florida Corp. (“SKS”).
Pursuant to the terms of the Company’s consulting agreement with SKS, SKS will
be paid $1,500 per day for services actually performed, with up to two weeks
committed to the Company per month. The Company will also issue to SKS on a
monthly basis 100,000 restricted shares of Company common stock, and a five-year
warrant to purchase an additional 100,000 shares of Company common stock at
$0.02 per share. SKS can earn an additional five-year warrant to purchase up
to
500,000 shares with an exercise price of $0.04 per share, upon achievement
of
the following milestones: (i) warrant to purchase 125,000 shares after
successful organizational restructuring by May 31, 2007, (ii) warrant to
purchase 125,000 shares for completing a short term financing by May 31, 2007,
(iii) warrant to purchase 125,000 shares after the Company operates at monthly
breakeven by December 31, 2007, and (iv) warrant to purchase 125,000 shares
after the Company’s stock price reaches $0.06 per share for a consecutive 30-day
period.
As
of the
date of filing of this report, neither the warrants nor the common stock have
been issued to SKS due to administrative matters and the Company has accrued
a
consulting expense of $20,917 and $51,834, representing the fair value of the
stock and warrants earned during the three months ended September 30, 2007.
The
shares of the Company’s common stock were valued at $12,000 and have been
included as issued but not outstanding in the accompanying interim consolidated
balance sheet.
Warrants
re-pricing
On
July
20, 2007 the Company's board of directors re-priced certain warrants. The value
of this warrant
modification, as determined using
the Black-Scholes valuation model, was
$0 (which is the difference between the value
of the original warrants immediately prior to
the modification and the value of the extended warrants). In
connection with this modification, the warrant holders provided an extension
of
the maturity date on 2004 Debentures (see Note 8).
Stock-Based
Compensation
2001
Stock Option Plan
The
Company adopted its 2001 stock option plan (the "2001 Plan") on June 29, 2001.
The 2001 Plan provides for the grant of options intended to qualify as
"incentive stock options," options that are not intended to so qualify or
"non-statutory stock options" and stock appreciation rights. The total number
of
shares of common stock reserved for issuance under the 2001 Plan is 5,000,000,
subject to adjustment in the event of a stock split, stock dividend,
recapitalization or similar capital change, plus an indeterminate number of
shares of common stock issuable upon the exercise of "reload options" described
below. The Company has not yet granted any options or stock appreciation rights
under the 2001 Plan.
2004
Stock Option Plan
The
Company adopted its 2004 stock option plan (the "2004 Plan") on February 4,
2004. The 2004 Plan provides for the grant of "non-statutory stock options."
The
total number of shares of common stock reserved for issuance under the 2004
Plan
is 30,000,000, subject to adjustment in the event of a stock split, stock
dividend, recapitalization or similar capital change.
In
March
2005, the 2004 Plan was amended to clarify the continuous employment
requirements of the vesting schedule of the Company's stock options and to
provide for a standardized stock option exercise form to be used by optionees
wishing to exercise vested stock options. If no vesting schedule is specified
at
the time of the grant, the options vest in full over the course of two years
from the date of grant as follows: 25% vest nine months from the date of grant
and 75% vest pro rata monthly over eighteen months.
A
summary
of option activity as of September 30, 2007 and changes during the nine months
ended September 30, 2007 is presented below:
|
|
|
|
|
|
|
|
|
Weighted
|
|
|
|
|
|
|
|
|
|
Weighted
|
|
|
Average
|
|
|
|
|
|
|
|
|
|
Average
|
|
|
Remaining
|
|
|
Aggregate
|
|
|
|
|
|
|
Exercise
|
|
|
Contractual
|
|
|
Intrinsic
|
|
|
|
Options
|
|
|
Price
|
|
|
Life
|
|
|
Value
|
|
Outstanding
at January 1, 2007
|
|
|
30,498,352
|
|
|
$
|
0.22
|
|
|
|
2.8
|
|
|
|
-
|
|
Granted
|
|
|
3,600,000
|
|
|
|
0.02
|
|
|
|
-
|
|
|
|
-
|
|
Exercised
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
Forfeited
or expired
|
|
|
(272,500
|
)
|
|
|
0.23
|
|
|
|
-
|
|
|
|
-
|
|
Outstanding
at September 30, 2007
|
|
|
33,825,852
|
|
|
$
|
0.19
|
|
|
|
2.8
|
|
|
$
|
-
|
|
Exercisable
|
|
|
31,725,852
|
|
|
$
|
0.20
|
|
|
|
2.8
|
|
|
$
|
-
|
|
Vested
or expected to vest
|
|
|
33,762,852
|
|
|
$
|
0.19
|
|
|
|
2.8
|
|
|
$
|
-
|
The
fair
value of stock options granted in 2007 and 2006 was derived using the
Black-Scholes stock option pricing model. Expected volatility is based on
historical volatility of the Company’s stock over a period equal to the expected
term. The Company uses historical exercise data to estimate the expected term
that represents the period of time that options granted to employees are
expected to be outstanding. The risk-free rate is based on the U.S. Treasury
yield curve in effect at the time of grant that covers the expected term of
the
stock options. The following table shows the average assumptions used in the
pricing model during the following periods:
|
|
|
Three
Months Ended September 30,
|
|
|
Nine
Months Ended September 30,
|
|
|
|
|
2007
|
|
|
2006
|
|
|
2007
|
|
|
2006
|
|
|
Expected
lives in years
|
|
|
5
|
|
|
|
5
|
|
|
|
5
|
|
|
|
5
|
|
|
Risk
free interest rates
|
|
|
4.5
|
%
|
|
|
4.8
|
%
|
|
|
4.6
|
%
|
|
|
4.8
|
%
|
|
Volatility
|
|
|
230
|
%
|
|
|
236
|
%
|
|
|
230
|
%
|
|
|
236
|
%
|
|
Dividend
yield
|
|
|
0
|
%
|
|
|
0
|
%
|
|
|
0
|
%
|
|
|
0
|
%
|
T
he
Company
recognized compensation expense of $21,000 and $205,464 for the three months
ended September 30, 2007 and 2006, and $63,600 and $644,798 for the nine
months ended September 30, 2007 and 2006, respectively, which is included in
general and administrative expenses in the accompanying consolidated statement
of operations. The unrecognized compensation cost at September 30, 2007 was
$8,400.
Accuracy
of Fair Value Estimates
The
Company develops its assumptions based on the Black-Scholes model. The Company
is responsible for determining the assumptions used in estimating the fair
value
of share-based payment awards. Its determination of fair value of share-based
payment awards on the date of grant using an option-pricing model is affected
by
the Company's stock price as well as assumptions regarding a number of highly
complex and subjective variables. These variables include, but are not limited
to the Company's expected stock price volatility over the term of the awards,
and actual and projected employee stock option exercise behaviors.
Because
the Company's employee stock options have certain characteristics that are
significantly different from traded options, and because changes in the
subjective assumptions can materially affect the estimated value, in
management's opinion, the existing valuation models may not provide an accurate
measure of the fair value of the Company's employee stock options. Although
the
fair value of employee stock options and restricted stock awards is determined
in accordance with SFAS No. 123(R) and SAB No. 107 using an option-pricing
model, that value may not be indicative of the fair value observed in a willing
buyer/willing seller market transaction.
NOTE
11 - SUBSEQUENT EVENTS
Convertible
Debenture
On
October 29, 2007, the Company closed an additional convertible debenture with
Cornell Capital for the total principal amount of $400,000, less fees and
expenses of $40,000. The new debenture is part of the "2007 Debentures", as
described in Note 8, bears interest at the rate of 14% per annum, matures on
October 29, 2010, and is secured by all of the assets of the
Company.
Conversion
of Shareholder Loans and Management Fees
On October
10, 2007, the Company issued 1,812,740 restricted common shares upon
conversion of the 50% balance of unsecured debt for the aggregate amount of
$54,382. The conversion was made under the debt reduction plan, as discussed
in
Note 5, 6 and 7. As of November 14, 2007, the balance of unsecured debt
converted to common stock amounted to $3,498,234 and the Company issued
116,607,820 common shares upon conversion.
The
remaining balance of outstanding loans will continue to be treated as short
or
long-term debt, depending on the maturity of the respective debt, and the
Company plans to provide an option to those loan holders to continue to convert
their remaining loan balances into equity at the prevailing market price at
the
time the balance of their respective outstanding loans are converted into common
shares of the Company.
Common
Stock
On
October 3, and 8, 2007 the Company received conversion notices from Cornell
Capital in the aggregate principal amount of $104,000, which represent
conversions under the terms of 2005 Debenture Agreement. Upon the execution
of
the conversion notice the Company issued 22,608,696 free-trading shares of
the Company’s stock to Cornell Capital at a conversion price of $0.0046 per
share.
Contracts
On
October 19, 2007, the Company entered into an employment agreement with James
C.
Forbes with respect to the terms and conditions of his employment as Chief
Executive Officer. On the same date Mr. Forbes was elected as a member of the
Board of Directors of the Company. These appointments took effect on October
29,
2007. Pursuant to the terms of the Executive Employment Agreement made between
Mr. Forbes and the Company, the Company shall pay Mr. Forbes a base salary
of
$200,000 per year. Mr. Forbes will also be eligible to receive a
quarterly incentive bonus of up to $12,500 each quarter and an annual incentive
bonus of up to $50,000 each year. The bonus is payable in respect of
his services to the Company based on the achievement of revenue, operating
profit, and operating metric objectives as determined by the Board of Directors
of the Company. In addition, Mr. Forbes will receive a monthly $750
transportation allowance and a one time commencement bonus of $20,000 paid
in
quarterly installments. On October 29, 2007, the Company granted Mr.
Forbes an initial option to purchase 5,000,000 shares of Company common stock
at
an exercise price of $0.02 per share with a contractual life of four years
and
the options vest and become exercisable at the rate of 1,250,000 per year during
the four year period. In addition, if the Company exceeds its
performance milestones during its first year of operations under Mr. Forbes
tenure as CEO as determined by the Board of the Company, then the Company will
grant Mr. Forbes an option to purchase an additional 5,000,000 shares (subject
to appropriate capitalization adjustments) of the Company’s common stock at an
exercise price of Two Cents ($0.02) per share with a contractual life of four
years (the “
Performance Option
”). The Performance Option will be
granted within two (2) weeks of the Company’s filing of its Annual Report on
Form 10-K for the applicable fiscal year. The Performance Option will
vest and be exercisable at the rate of 1,250,000 per year at the end of each
year of the four year period.
On
October 1, 2007, the Company entered into a public relations agreement with
AGORACOM Investor Relations Corp. ("AGORACOM") based in Toronto, Canada.
AGORACOM specializes in introducing and positioning small-cap companies to
appropriate communities of investors and will provide shareholders and the
investment community with a communications link to NS8's ongoing corporate
activities as the Company executes its business plan. Upon the execution of
the
agreement, NS8 will issue to AGORACOM a warrant to purchase 250,000
registered shares of common stock. The warrants are exercisable until October
1,
2010 at a price of $0.006 per share. The warrants will vest in equal quarterly
amounts and stages over the next 12 months. However, AGORACOM has
elected not to exercise any such options until after the first 12 months of
service. AGORACOM will only have the right to exercise vested options
early if NS8 is acquired or experiences a material change in control during
the
first 12 months of service.