UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C 20549
FORM 10-QSB
|X| QUARTERLY REPORT UNDER SECTION 13 OR 15 (D) OF THE SECURITES
EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2006
COMMISSION FILE NUMBER: 0-21419
NETFABRIC HOLDINGS, INC.
(Exact Name of Small Business Issuer as Specified in Its Charter)
Delaware 76-0307819
(State or Other Jurisdiction of (I.R.S Employer Identification No.)
Incorporation or Organization)
Three Stewart Court
Denville, New Jersey, 07834
(Address of Principal Executive Offices)
(973)-887-2785
(Issuer's Telephone Number, Including Area Code)
Check whether the issuer (1) filed all reports required to be filed by Section
13 or 15 (d) of the Exchange Act during the past 12 months (or for such shorter
period that the registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days. Yes |X| No |_|
Indicate by a check mark whether the registrant is a shell company (as defined
in Rule 12b-2 of the Exchange Act).
Yes |_| No |X|
State the number of shares outstanding of each of the issuer's classes of common
equity, as of the latest practicable date: As of November 7, 2006, 74,773,883
shares of common stock, $.001 par value per share, of the issuer were
outstanding.
Transitional Small Business Disclosure Format (check one): Yes |_| No |X|
NETFABRIC HOLDINGS, INC.
INDEX
Page
----
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements (Unaudited)
Condensed Consolidated Balance Sheets 1
Condensed Consolidated Statements of Operations 2
Condensed Consolidated Statement of Stockholders'
Equity 3
Condensed Consolidated Statements of Cash Flows 4
Notes to Condensed Consolidated Financial Statements 5
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 21
Item 3. Controls and Procedures 27
PART II. OTHER INFORMATION 27
Item 1. Legal Proceedings 27
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 27
Item 3. Defaults Upon Senior Securities 27
Item 4. Submission of Matters to a Vote of Security Holders 27
Item 5. Other Information 27
Item 6. Exhibits 27
Signatures 28
NETFABRIC HOLDINGS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
SEPTEMBER 30, DECEMBER 31,
2006 2005
(UNAUDITED) (NOTE 2)
------------- ------------
ASSETS
CURRENT ASSETS:
Cash $ 62,605 $ 9,540
Trade accounts receivable, net 2,521,775 2,090,201
Due from related party -- 192,056
Prepaid expenses and other current assets 119,112 78,119
------------ -----------
Total current assets 2,703,492 2,369,916
Property and equipment, net 187,922 164,984
Goodwill 13,982,451 13,982,451
Other intangibles, net 934,706 1,099,717
Other assets 9,076 9,994
------------ -----------
TOTAL ASSETS $ 17,817,647 $17,627,062
============ ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Bridge loans, net of unamortized discount $ -- $ 441,125
Convertible debentures, net of unamortized discounts 520,729 366,666
Note payable to officer, net of unamortized discount -- 100,941
Loans and advances from officer and stockholders 52,639 202,639
Accounts payable and accrued liabilities 3,355,974 2,988,410
Accrued compensation 372,369 380,722
Deferred revenues and customer advances 629,857 66,019
Revolving note, net of unamortized discount 897,667 --
------------ -----------
Total current liabilities 5,829,235 4,546,522
------------ -----------
Derivative financial instruments -- 4,087,517
Convertible debentures, net of unamortized discount -- 612,059
Convertible note, net of unamortized discount 317,518 -
------------ -----------
Total liabilities 6,146,753 9,246,098
------------ -----------
COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS' EQUITY :
Common Stock, $.001 par value, 100,000,000 shares authorized, 74,893,883
and 62,44,357 shares issued, respectively and 74,773,883 and 62,44,357
outstanding, respectively 74,894 62,448
Additional paid-in capital 36,828,758 16,657,804
Deferred employee compensation (36,478)
Treasury stock, 120,000 shares (15,452)
Accumulated deficit (25,217,306) (8,302,810)
------------ -----------
Total stockholders' equity 11,670,894 8,380,964
------------ -----------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 17,817,647 $17,627,062
============ ===========
See Notes to Unaudited Condensed Consolidated Financial Statements.
1
NETFABRIC HOLDINGS, INC. AND SUBSIDIARIES
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
THREE MONTHS THREE MONTHS NINE MONTHS NINE MONTHS
ENDED ENDED ENDED ENDED
SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30,
2006 2005 2006 2005
(UNAUDITED) (UNAUDITED) (UNAUDITED) (UNAUDITED)
------------- ------------- ------------- -------------
Revenues $ 4,553,403 $ 5,210,697 $ 12,951,807 $ 7,484,026
----------- ----------- ------------ -----------
OPERATING EXPENSES:
Direct employee compensation and
consultant expenses 3,489,443 3,786,914 9,684,601 5,564,989
Selling, general and administrative expenses 1,247,345 1,765,223 4,081,025 2,895,774
Non-cash charge for dispute settlements -- -- 9,492,070 --
In process research and development 1,200,000 1,200,000
Non-cash charge for share based compensation 202,174 -- 444,192 --
Depreciation and amortization 81,367 14,290 223,794 20,360
----------- ----------- ------------ -----------
Total operating expenses 6,220,329 5,566,427 25,125,682 8,481,123
----------- ----------- ------------ -----------
Loss from operations (1,666,926) (355,730) (12,173,875) (997,097)
OTHER INCOME / (EXPENSE):
Amortization of debt discounts and debt
issuance costs (364,144) (443,988) (2,600,572) (808,357)
Interest and bank charges (60,901) (29,309) (228,809) (52,783)
Gain on derivative financial instruments -- -- 336,352 --
Debt extinguishment costs (27,104) -- (1,773,181) --
----------- ----------- ------------ -----------
Total other income / (expense) (452,149) (473,297) (4,266,210) (861,140)
----------- ----------- ------------ -----------
Loss before provision for income taxes (2,119,075) (829,027) (16,440,085) (1,858,237)
Provision for income taxes -- -- -- --
----------- ----------- ------------ -----------
LOSS FROM CONTINUING OPERATIONS (2,119,075) (829,027) (16,440,085) (1,858,237)
----------- ----------- ------------ -----------
DISCONTINUED OPERATIONS:
Loss from operations of discontinued segment -- (485,090) (474,411) (1,609,911)
----------- ----------- ------------ -----------
NET LOSS $(2,119,075) $(1,314,117) $(16,914,496) $(3,468,148)
=========== =========== ============ ===========
Net loss from continuing operations
per common share, basic and diluted $ (0.03) $ (0.01) $ (0.25) $ (0.04)
=========== =========== ============ ===========
Net loss from discontinued operations
per common share, basic and diluted $ -- $ (0.01) $ (0.01) $ (0.03)
=========== =========== ============ ===========
Net loss per common share, basic and
diluted $ (0.03) $ (0.02) $ (0.26) $ (0.07)
=========== =========== ============ ===========
Weighted average number of shares
outstanding, basic and diluted 70,601,600 62,767,581 65,749,547 49,420,164
=========== =========== ============ ===========
See Notes to Unaudited Condensed Consolidated Financial Statements.
2
NETFABRIC HOLDINGS INC. AND SUBSIDIARIES
UNAUDITED CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
COMMON STOCK ADDITIONAL
--------------------- PAID-IN DEFERRED
SHARES PAR VALUE CAPITAL COMPENSATION
---------- --------- ----------- ------------
Balances at December 31, 2005 62,448,357 $62,448 $16,657,804 $(36,478)
Issuance of common shares in connection
with settlement of payables 60,526 61 57,439
Value of contributions from shareholder
in connection with settlement
of disputes -- -- 9,492,070
Employee share-based compensation -- -- 338,689
Reclassification of deferred employee
stock option compensation -- -- (36,478) 36,478
Allocation of value to beneficial
conversion feature in connection with
issuance of convertible note -- -- 511,577
Issuance of options and warrants in
connection with debt financing -- -- 1,432,743
Reissuance of warrants in connection
with debt extinguishment -- -- 372,353
Reclassification of derivative
financial instrument relating to
beneficial conversion feature -- -- 804,307
Reclassification of derivative
financial instrument relating to
warrants -- -- 2,946,858
Settlement of bridge loans with common
stock 2,500,000 2,500 1,622,500
Conversion of convertible debenture
issued to officer with common stock 500,000 500 129,500
Issuance of shares in connection with
extension of convertible debenture to
officer 100,000 100 29,900
Allocation of value to beneficial
conversion feature issued in
connection with issuance of
convertible debenture -- -- 322,755
Allocation of value for warrants issued
in connection with convertible
debentures -- -- 90,739
Allocation of value for common shares
issued in connection with convertible
debentures 525,000 525 164,510
Allocation of value for warrants issued
in connection with extension
of convertible debentures -- -- 115,908
Allocation of value of common shares
issued in connection with extension
of convertible debentures 350,000 350 55,992
Issuance of common shares for services 160,000 160 10,874
Rescission of shares previously issued
for services 15,452
Issuance of warrants for services -- -- 51,516
Issuance of shares for acquisition of
assets 8,250,000 8,250 1,641,750
Net loss
---------- ------- ----------- --------
BALANCES AT SEPTEMBER 30, 2006 (UNAUDITED) 74,893,883 74,894 36,828,758 --
========== ======= =========== ========
TREASURY STOCK
---------------- TOTAL
ACCUMULATED AMOUNT STOCKHOLDERS'
DEFICIT SHARES AT COST EQUITY
------------ ------- ------- -------------
Balances at December 31, 2005 $ (8,302,810) $ 8,380,964
Issuance of common shares in connection
with settlement of payables 57,500
Value of contributions from shareholder
in connection with settlement
of disputes 9,492,070
Employee share-based compensation 338,689
Reclassification of deferred employee
stock option compensation --
Allocation of value to beneficial
conversion feature in connection with
issuance of convertible note 511,577
Issuance of options and warrants in
connection with debt financing 1,432,743
Reissuance of warrants in connection
with debt extinguishment 372,353
Reclassification of derivative
financial instrument relating to
beneficial conversion feature 804,307
Reclassification of derivative
financial instrument relating to
warrants 2,946,858
Settlement of bridge loans with common
stock 1,625,000
Conversion of convertible debenture
issued to officer with common stock 130,000
Issuance of shares in connection with
extension of convertible debenture to
officer 30,000
Allocation of value to beneficial
conversion feature issued in
connection with issuance of
convertible debenture 322,755
Allocation of value for warrants issued
in connection with convertible
debentures 90,739
Allocation of value for common shares
issued in connection with convertible
debentures 165,035
Allocation of value for warrants issued
in connection with extension
of convertible debentures 115,908
Allocation of value of common shares
issued in connection with extension
of convertible debentures 56,342
Issuance of common shares for services 11,034
Rescission of shares previously issued
for services (120,000) (15,452) --
Issuance of warrants for services 51,516
Issuance of shares for acquisition of
assets 1,650,000
Net loss (16,914,496) (16,914,496)
------------ -------- ------- ------------
BALANCES AT SEPTEMBER 30, 2006 (UNAUDITED) (25,217,306) (120,000) (15,452) 11,670,894
============ ======== ======= ============
3
NETFABRIC HOLDINGS, INC. AND SUBSIDIARIES
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
Nine Months Nine Months
Ended Ended
September 30, September 30,
2006 2005
(unaudited) (unaudited)
------------- -------------
OPERATING ACTIVITIES
Net loss $(16,914,496) $(3,468,148)
Loss from discontinued operations 474,411 1,609,911
Adjustments to reconcile net loss to net cash used in
operating activities:
Non-cash charge for common stock issued for rent 37,500
Non-cash charge for interest expense 22,500 --
Non-cash charge for settlement of disputes 9,492,070 --
Non-cash charge in connection with settlement of debt 1,152,104
Non-cash charge for in process research and development 1,200,000
Non-cash charge for reissuance of warrants in connection
with debt extinguishment 372,353 --
Non-cash charge for amortization
of employee deferred compensation -- 26,768
Non-cash charge for share based compensation 444,192 15,469
Non-cash charge for shares issued in connection with
prospective financing transaction 350,000
Non-cash gain on derivative financial instrument (336,352) --
Amortization of debt discounts 2,582,274 792,436
Amortization of debt issuance costs 18,298 15,921
Depreciation and amortization 223,794 20,360
Changes in operating assets and liabilities:
Inventory -- 17,025
Trade accounts receivable (431,574) (232,916)
Due from related party 192,056 (23,593)
Prepaid expenses and other current assets (84,046) (48,015)
Other assets -- 27,584
Accounts payable and accrued liabilities 404,761 1,048,151
Accrued compensation (8,353) 36,012
Deferred revenues and advances 563,838 (675,455)
------------ -----------
Net cash used in continuing operations (632,170) (450,990)
Net cash used in discontinued operations (454,344) (1,558,014)
------------ -----------
Net cash used in operating activities (1,086,514) (2,009,004)
------------ -----------
INVESTING ACTIVITIES
Direct acquisition costs of UCA Services -- (187,000)
Net cash acquired in technology licensing transaction 450,000
Purchases of property and equipment (98,471) (113,935)
------------ -----------
Net cash provided by (used in) investing activities 351,529 (300,935)
------------ -----------
FINANCING ACTIVITIES
Proceeds from issuance of common stock -- 1,000,000
Loans and advances from stockholders and officers 20,000 320,000
Repayment of note to employee (200,000) --
Convertible debentures issued 650,000 100,000
Repayments of convertible debenture (100,000)
Repayments of bridge loans (500,000) --
Proceeds (repayment) of convertible debentures (1,658,160) 849,000
Proceeds from issuance of revolving note, net 1,336,407 --
Proceeds from issuance of convertible note, net 1,430,500 --
Debt issuance costs (20,697) (25,545)
Repayment of loans from officer and director (170,000) --
------------ -----------
Net cash provided by financing activities 788,050 2,243,455
------------ -----------
Net decrease in cash 53,065 (66,484)
Cash at beginning of period 9,540 67,719
------------ -----------
Cash at end of period $ 62,605 $ 1,235
============ ===========
Supplemental cash flow information:
Cash paid for interest expense $ 182,000 $ 12,500
============ ===========
Cash paid for income taxes $ -- $ --
============ ===========
See Notes to Unaudited Condensed Consolidated Financial Statements.
4
NETFABRIC HOLDINGS INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1. NATURE OF BUSINESS AND MANAGEMENT'S PLANS
NetFabric Holdings, Inc. ("Holdings" or the "Company") (formerly known as
Houston Operating Company, Inc.) was incorporated under the laws of the State of
Delaware on August 31, 1989. On December 9, 2004, Holdings entered into an
Exchange Agreement (the "Acquisition Agreement" or "Share Exchange") with all of
the stockholders of NetFabric Corporation ("NetFabric") whereby Holdings
acquired all of the issued and outstanding capital stock of NetFabric and
NetFabric became a wholly-owned subsidiary of Holdings. This transaction was
treated as a reverse merger, and a capital transaction, equivalent to the
issuance of stock by NetFabric for Holdings' net assets and accordingly, the
historical financial statements prior to December 9, 2004 are those of
NetFabric. (Holdings and its subsidiaries are collectively referred to as
"Holdings").
NetFabric, a Delaware corporation incorporated on December 17, 2002, began
operations in July 2003. NetFabric developed and marketed Voice Over Internet
Protocol ("VoIP") appliances that simplified the integration of standard
telephone systems with an IP infrastructure. On May 5, 2006, the Company
announced its decision to exit from the hardware-based VoIP communications
product line (including resale of transport services) that is targeted at small
to mid-sized businesses ("SMB's"). In accordance with Statement of Financial
Accounting Standards No. 144 "Accounting for the Impairment or Disposal of
Long-Lived Assets", ("SFAS No. 144"), the Company has presented the results of
operations from its VoIP business segment as discontinued operations in the
accompanying condensed consolidated balance sheets, statements of operations and
statements of cash flows (Note 3).
On May 20, 2005, Holdings entered into and closed on a share exchange agreement
("Exchange Agreement"), whereby Holdings acquired all of the issued and
outstanding shares of UCA Services, Inc., a New Jersey company ("UCA Services")
from its shareholders in exchange for the issuance of 24,096,154 shares of
common stock of Holdings (See Note 5). Holdings emerged from the development
stage upon the acquisition of UCA Services.
UCA Services is an information technology ("IT") services company that serves
the information needs of a wide range of Fortune 500 and SMB clients in the
financial markets industry as well as the pharmaceutical, health care and
hospitality sectors. UCA Services delivers a broad range of IT services in the
practice areas of infrastructure builds and maintenance, application development
and maintenance, managed services and professional services.
MANAGEMENT'S PLANS
The accompanying condensed consolidated financial statements have been prepared
on a going concern basis. As shown in the accompanying condensed consolidated
financial statements, the Company has incurred accumulated losses totaling
$25,217,306 and a working capital deficit of $3,125,743 at September 30, 2006.
These factors, among others, indicate there is substantial doubt that the
Company may be unable to continue as a going concern. The condensed consolidated
financial statements do not include any adjustments that might result from the
outcome of this uncertainty.
Management recognizes that the Company's continuation as a going concern is
dependent upon its ability to generate sufficient cash flow to allow the Company
to continue the development of its business plans and satisfy its current and
long-term obligations on a timely basis. The Company believes that it will be
able to complete the necessary steps in order to meet its cash requirements for
the next 12 months and continue its business development efforts. Management's
plans in this regard include, but are not limited to, the following:
o Settlement of liabilities with the Company's common stock.
o Current discussions and negotiations with a number of additional financing
alternatives, one or more of which management believes it will be able to
successfully close to provide necessary working capital. There is no assurance
that the Company will be successful in completing a financing (Note 12).
In order to execute its business plan and achieve its objectives for the near
future, management believes it will require approximately $2,000,000 over the
next twelve months for working capital. A significant component of this is for
satisfying the Company's obligations as they become due, both borrowings and
vendor payables. Accordingly, the Company needs to raise additional financing
and generate cash flows from its operations. Should additional cash flows not be
available, management believes that the Company would have the ability to
restructure its operations and if necessary initiate significant reductions in
expenses. In addition, the Company will have to negotiate with its lenders to
extend the repayment dates of its indebtedness. There can be no assurance,
however, that the Company will be able to successfully restructure its
operations or debt obligations in the event it fails to obtain additional
financing.
5
NETFABRIC HOLDINGS INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
NOTE 2. BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND
PRACTICES
BASIS OF PRESENTATION / INTERIM FINANCIAL STATEMENTS
The accompanying unaudited condensed consolidated financial statements have been
prepared pursuant to the rules and regulations of the Securities and Exchange
Commission ("SEC"). Certain information and footnote disclosures normally
included in financial statements prepared in accordance with accounting
principles generally accepted in the United States of America have been omitted
pursuant to such rules and regulations. However the Company believes that the
disclosures are adequate to make the information presented not misleading. The
financial statements reflect all adjustments (consisting only of normal
recurring adjustments) that are, in the opinion of management, necessary for a
fair presentation of the Company's financial position and results of operations.
The operating results for the three and nine months ended September 30, 2006 and
2005 are not necessarily indicative of the results to be expected for any other
interim period or any future year. The accompanying unaudited condensed
consolidated financial statements should be read in conjunction with the
Company's December 31, 2005 consolidated financial statements, including the
notes thereto, which are included in the Company's Annual Report on Form 10-KSB
for the fiscal year ended December 31, 2005 filed on April 17, 2006.
RECLASSIFICATIONS
Certain reclassifications have been made in the prior period consolidated
financial statements to conform to the current period presentation.
As a result of the Company's decision to exit the VoIP hardware business,
previously reported financial statements have been reclassified as discontinued
operations to conform to the current period presentation.
ESTIMATES
The preparation of the condensed consolidated financial statements in conformity
with accounting principles generally accepted in the United States of America
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 condensed consolidated financial statements and
the reported amounts of revenues and expenses during the reporting period. The
accounting estimates that require management's most difficult and subjective
judgments include provisions for bad debts, depreciable/amortizable lives,
impairment of long-lived assets, accounting for goodwill and other intangible
assets, the fair value of the Company's common stock, the fair value of options
and warrants issued for services, the allocation of proceeds from certain
financings to equity instruments and the computation of other reserves. Because
of the uncertainty inherent in such estimates, actual results may differ from
these estimates.
REVENUE RECOGNITION
The Company derives revenue principally from professional services. In
accordance with SEC Staff Accounting Bulletin No. 104, "Revenue Recognition,"
revenue is recognized when persuasive evidence of an arrangement exists,
delivery has occurred, the fee is fixed and determinable, collectibility is
reasonably assured, contractual obligations have been satisfied, and title and
risk of loss have been transferred to the customer.
UCA Services derives revenue primarily from professional services, managed IT
services, application development services and from business process management
services. Arrangements with customers for services are generally on a time and
material basis or fixed-price, fixed-timeframe. Revenue on time-and-material
contracts is recognized as the related services are performed. Revenue from
fixed-price, fixed-timeframe service contracts are recognized ratably over the
term of the contract. When the Company receives cash advances from customers in
advance of the service period, amounts are reported as advances from customers
until the commencement of the service period. Billings and collections in excess
of revenue recognized are classified as deferred revenue.
ALLOWANCE FOR DOUBTFUL ACCOUNTS
The Company maintains allowances for doubtful accounts for estimated losses
resulting from the inability of its customers to make required payments. These
estimated losses are based upon historical bad debts, specific customer
creditworthiness and current economic trends. If the financial condition of a
customer deteriorates, resulting in the customer's inability to make payments
within approved credit terms, additional allowances may be required. The Company
performs credit evaluations of its customers' financial condition on a regular
basis, and has not experienced any material bad debt losses to date.
6
NETFABRIC HOLDINGS INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
LONG-LIVED ASSETS
Long-lived assets, including property and equipment and intangible assets with
finite lives, are monitored and reviewed for impairment in value whenever events
or changes in circumstances indicate that the carrying amount of any such asset
may not be recoverable. The determination of recoverability is based on an
estimate of undiscounted cash flows expected to result from the use of an asset
and its eventual disposition. The estimated cash flows are based upon, among
other things, certain assumptions about expected future operating performance,
growth rates and other factors. Estimates of undiscounted cash flows may differ
from actual cash flows due to factors such as technological changes, economic
conditions, and changes in the Company's business model or operating
performance. If the sum of the undiscounted cash flows (excluding interest) is
below the carrying value, an impairment loss is recognized, measured as the
amount by which the carrying value exceeds the fair value of the asset.
CONCENTRATIONS OF CREDIT RISK
Financial instruments that potentially subject the Company to concentrations of
credit risk consist primarily of cash and accounts receivable. The Company
reduces credit risk by placing its cash with major financial institutions with
high credit ratings. At times, such amounts may exceed federally insured limits.
The Company reduces credit risk related to accounts receivable by routinely
assessing the financial strength of its customers and maintaining an appropriate
allowance for doubtful accounts.
The Company's services have been provided primarily to a limited number of
clients located worldwide in a variety of industries. The Company had revenues
from two clients representing 48% (38%, and 10%, respectively) of revenues
during the three months ended September 30, 2006. The Company had revenues from
three clients representing 54% (33%, 11% and 10%, respectively) of revenues
during the nine months ended September 30, 2006.
The Company generally does not require its clients to provide collateral.
Additionally, the Company is subject to a concentration of credit risk with
respect to its accounts receivable. The Company had one client accounting for
34.2% of total gross accounts receivable as of September 30, 2006.
GOODWILL
Goodwill represents the Company's allocation of the cost to acquire UCA Services
in excess of the fair value of net assets acquired. The purchase price and its
allocation, to reflect the fair values of identifiable assets acquired and
liabilities assumed, have been based upon management's evaluation, including
independent valuation.
Under SFAS No. 142 "Goodwill and Other Intangible Assets" ("SFAS No. 142"),
goodwill is not amortized but is reviewed for impairment annually. The Company
performs its annual goodwill impairment testing, by reportable segment, in the
second quarter of each year, or more frequently if events or changes in
circumstances indicate that goodwill may be impaired. Application of the
goodwill impairment test requires significant judgments including estimation of
future cash flows, which are dependent on internal forecasts, estimation of the
long-term rate of growth for UCA Services, the useful life over which cash flows
will occur, and determination of UCA Services' cost of capital. Changes in these
estimates and assumptions could materially affect the determination of fair
value and/or conclusions on goodwill impairment for UCA Services.
OTHER INTANGIBLES
Other intangible assets with finite lives are accounted for under the provisions
of SFAS No. 142. These intangible assets arise from business combinations and
consist of customer relationships and restricted covenants related to employment
agreements that are amortized, on a straight-line basis, over periods of up to
six years. The Company follows the impairment provisions and disclosure
requirements of SFAS No. 142. Accordingly these intangible assets are reviewed
for impairment whenever events or changes in circumstances indicate that the
carrying amount may not be recoverable.
FAIR VALUE OF FINANCIAL INSTRUMENTS
The fair values of the Company's assets and liabilities that qualify as
financial instruments under statement of financial accounting standards ("SFAS")
No. 107 "Disclosure about Fair Value of Financial Instruments" approximate their
carrying amounts presented in the balance sheets at September 30, 2006 and
December 31, 2005.
7
NETFABRIC HOLDINGS INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
The Company accounts for derivative instruments in accordance with SFAS No. 133
"Accounting for Derivative Instruments and Hedging Activities," as amended,
("SFAS No. 133") which establishes accounting and reporting standards for
derivative instruments and hedging activities, including certain derivative
instruments imbedded in other financial instruments or contracts and requires
recognition of all derivatives on the balance sheet at fair value. Accounting
for the changes in the fair value of the derivative instruments depends on
whether the derivatives qualify as hedge relationships and the types of the
relationships designated are based on the exposures hedged. Changes in the fair
value of derivative instruments which are not designated as hedges are
recognized in earnings as other income (loss).
The Company has issued financial instruments which have required a determination
of the fair value of certain related derivatives, where quoted market prices
were not published or readily available at the date of issuance. The Company
bases its fair value determinations on an evaluation of the facts and
circumstances and valuation techniques that require judgments and estimates.
SHARE-BASED COMPENSATION EXPENSE
On January 1, 2006, the Company adopted Statement of Financial Accounting
Standards No. 123 (revised 2004), "Share-Based Payment," ("SFAS 123(R)") which
requires the measurement and recognition of compensation expense for all
share-based payment awards made to employees and directors based on estimated
fair values. SFAS 123(R) supersedes the Company's previous accounting under
Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to
Employees" ("APB 25") for periods beginning in fiscal 2006. In March 2005, the
SEC issued Staff Accounting Bulletin No. 107 ("SAB 107") relating to SFAS
123(R). The Company has applied the provisions of SAB 107 in its adoption of
SFAS 123(R).
SFAS 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 condensed
consolidated statements of operations. Prior to the adoption of SFAS 123(R), the
Company accounted for stock-based awards to employees and directors using the
intrinsic value method in accordance with APB 25 as allowed under Statement of
Financial Accounting Standards No. 123, "Accounting for Stock-Based
Compensation" ("SFAS 123"). Under the intrinsic value method, stock-based
compensation expense was recognized in the Company's condensed consolidated
statement of operations based on the difference between the exercise price of
the Company's stock options granted to employees and directors, and the fair
market value of the underlying stock at the date of grant.
The Company adopted SFAS 123(R) using the modified prospective transition
method, which requires the application of the accounting standard as of January
1, 2006, the first day of the Company's fiscal year. The Company's condensed
consolidated financial statements as of and for the three and nine months ended
September 30, 2006 reflect the impact of adoption of SFAS 123(R). In accordance
with the modified prospective transition method, the Company's condensed
consolidated financial statements for prior periods have not been restated to
reflect, and do not include, the impact of adoption of SFAS 123(R).
Share-based compensation expense recognized under SFAS 123(R) for the three and
nine months ended September 30, 2006 was $157,008 and $338,689, respectively.
Share-based compensation expense recognized in the Company's condensed
consolidated statements of operations for the three and nine months ended
September 30, 2006 includes 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 provisions of SFAS 123.
SFAS 123(R) requires forfeitures to be estimated at the time of grant in order
to estimate the amount of share-based awards that will ultimately vest. As there
were only a nominal amount of option holders as of January 1, 2006, management
evaluated each of the grants outstanding upon adoption of SFAS 123(R) to
determine an appropriate forfeiture rate. Based on this evaluation and
considering options which were cancelled during management's evaluation in the
nine months ended September 30, 2006, the Company adjusted the value of the
options outstanding as of January 1, 2006 for actual cancellations during the
three and nine months ended September 30, 2006. After adjusting for the value
such cancellations, management determined that a forfeiture rate was not
required for the remaining outstanding option grants. This determination was
based principally on the nature of the option holders' involvement with the
Company and the quantity held by such individuals. In the Company's pro forma
information required under SFAS 123 for the periods prior to fiscal year 2006,
the Company accounted for forfeitures as they occurred. Effectively, for all
periods presented forfeitures have been accounted for as they occurred.
8
NETFABRIC HOLDINGS INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
On November 10, 2005, the Financial Accounting Standards Board ("FASB") issued
FASB Staff Position No. FAS 123(R)-3 "Transition Election Related to Accounting
for Tax Effects of Share-Based Payment Awards." The Company has elected to adopt
the alternative transition method provided in the FASB Staff Position for
calculating the tax effects of stock-based compensation pursuant to SFAS 123(R).
The alternative transition method includes simplified methods to establish the
beginning balance of the additional paid-in capital pool ("APIC pool") related
to the tax effects of employee stock-based compensation, and to determine the
subsequent impact on the APIC pool and consolidated statements of cash flows of
the tax effects of employee stock-based compensation awards that are outstanding
upon adoption of SFAS 123(R).
The net loss for the three and nine months ended September 30, 2005 includes
compensation charges related to options granted to employees based on the
intrinsic value method. The following table illustrates the pro forma effect on
net loss and net loss per common share assuming the Company had applied the fair
value recognition provisions of SFAS 123, as amended by SFAS No. 148,
"Accounting for Stock-Based Compensation--Transition and Disclosure" ("SFAS
148"), instead of the intrinsic value method under APB No. 25, to stock based
employee compensation for the three and nine months ended September 30, 2005:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, 2005 SEPTEMBER 30, 2005
------------------ -----------------
Net loss as reported $(1,314,117) $(3,468,148)
Add: Stock-based employee compensation expense included
in reported loss 4,253 26,768
Deduct: Total stock-based compensation expense determined
under the fair value based method (103,680) (570,081)
----------- -----------
Net loss pro forma $(1,413,544) $(4,011,461)
=========== ===========
Loss per Common Share--Basic and Diluted:
As reported $ (0.02) $ (0.07)
Pro forma $ (0.02) $ (0.08)
As of September 30, 2006, the unvested portion of share-based compensation
expense attributable to employees and directors stock options and the period in
which such expense is expected to vest and be recognized is as follows:
Remainder of year ending December 31, 2006 $ 157,008
Year ending December 31, 2007 370,982
Year ending December 31, 2008 349,680
Year ending December 31, 2009 180,607
Year ending December 31, 2010 4,883
----------
$1,063,160
==========
INCOME TAXES
Deferred income tax assets and liabilities are recognized for the future tax
consequences attributable to temporary differences between the financial
statement carrying amounts of existing assets and liabilities and their
respective tax bases and operating loss and tax credit carryforwards. Deferred
tax assets and liabilities are measured using enacted tax rates expected to
apply to taxable income in the years in which those temporary differences are
expected to be recovered or settled. Deferred tax assets are reduced by a
valuation allowance if it is more likely than not that the tax benefits will not
be realized. The ultimate realization of deferred tax assets depends upon the
generation of future taxable income during the periods in which those temporary
differences become deductible.
EARNINGS (LOSS) PER SHARE
The Company calculates earnings (loss) per share in accordance with SFAS No.
128, "Earnings per Share." SFAS No. 128 computes basic earnings (loss) per share
by dividing the net income (loss) by the weighted average number of shares of
common stock outstanding during the period. Diluted earnings (loss) per share is
computed by dividing the net income (loss) by the weighted average number of
shares of common stock outstanding during the period plus the effects of any
potentially dilutive securities. Diluted earnings (loss) per share considers the
impact of potentially dilutive securities except in periods in which there is a
loss because the inclusion of the potential common shares would have an
anti-dilutive effect. The Company's potentially dilutive securities include
common shares which may be issued upon exercise of its stock options, and
warrants and the conversion of convertible debt.
9
NETFABRIC HOLDINGS INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Diluted loss per share for the three and nine months ended September 30, 2006
and 2005 exclude potentially issuable common shares of 20,431,124 and
12,947,526, respectively, primarily related to the Company's outstanding stock
options, warrants and convertible debt, because the assumed issuance of such
potential common shares is antidilutive.
SEGMENT REPORTING
The Company determines and discloses its segments in accordance with SFAS No.
131, "Disclosures About Segments of an Enterprise and Related Information,"
which uses a "management" approach for determining segments. The management
approach designates the internal organization that is used by management for
making operating decisions and assessing performance as the source of a
company's reportable segments. SFAS No. 131 also requires disclosures about
products or services, geographic areas and major customers.
NOTE 3. DISCONTINUED OPERATIONS
On May 5, 2006, the Company announced its decision to exit from the
hardware-based VoIP communications product line (including resale of transport
services) that is targeted at SMB's. In accordance with Statement of Financial
Accounting Standards No. 144 "Accounting for the Impairment or Disposal of
Long-Lived Assets", ("SFAS No. 144"), the Company recorded losses from
discontinued operations of $0 and $474,411 for the three and nine months ended
September 30, 2006, respectively. The Company has reclassified prior period
results to conform with the current period presentation. Accordingly, $485,090
and $1,609,911 for the three and nine months ended September 2005, respectively,
have been classified as loss from discontinued operations. Revenues from VoIP
operations have been nominal in all periods presented and operating expenses are
the losses reported.
NOTE 4. INTANGIBLE ASSETS
The Company's intangible assets, consisting of customer contacts and restricted
covenants related to employment agreements, were acquired and initially
accounted for at fair values at the acquisition date using the purchase method
of accounting. The following table summarizes the net asset value for each
intangible asset category as of September 30, 2006:
Gross Asset Accumulated Net Asset
Value Amortization Value
----------- ----------- ---------
Customer relationships $1,153,424 $(264,326) $889,098
Covenants not to compete 83,333 (37,725) 45,608
---------- --------- --------
$1,236,757 $(302,051) $934,706
========== ========= ========
The Company did not have any intangibles prior to the acquisition of UCA
Services in May 2005.
NOTE 5. ACQUISITION
The Company acquired UCA Services on May 20, 2005. Pursuant to the terms of the
Exchange Agreement, Holdings acquired all of the issued and outstanding shares
of UCA Services from the UCA Services' shareholders in exchange for the issuance
of 24,096,154 shares of common stock of the Company. The acquisition was
accounted for as a business combination with the Company as the acquirer. Under
the purchase method of accounting, the assets and liabilities of UCA Services
acquired by the are recorded as of the acquisition date at their respective fair
values, and added to those of the Company, and the results of UCA Services have
been included with those of the Company since the date of acquisition.
The Company recognized goodwill of $13,982,451 as a result of the cost in excess
of the net assets acquired of UCA Services. Such goodwill is assigned to the
Company's IT services segment. Any charge to expense related such goodwill will
not be deductible for tax purposes.
Summarized below are the pro forma unaudited results of operations for the nine
months ended September 30, 2005 as if the results of UCA Services were included
for the entire periods presented. The pro forma results may not be indicative of
the results that would have occurred if the acquisition had been completed at
the beginning of the period presented or which may be obtained in the future:
For the nine
months ended
September 30,
2005
-------------
Revenues $14,365,378
-----------
Net loss (4,353,301)
-----------
Basic and diluted net loss common share $ (0.07)
-----------
Weighted average common shares outstanding 61,688,902
-----------
10
NETFABRIC HOLDINGS INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
NOTE 6. TECHNOLOGY LICENSE ACQUISITION
On August 11, 2006, the Company entered into an agreement with Utek Corporation
("Utek"), an unaffiliated specialty finance company focused on technology
transfers, to acquire a technology license for intrusion detection software
developed by a university. To facilitate the transfer of technology; Utek formed
a subsidiary, Intrusion Detection Technologies, Inc. ("ITDI"). IDTI did not have
any business operations and its assets consisted of cash and a license agreement
with a university for intrusion detection software by the university. The
Company acquired all of the outstanding shares of IDTI from Utek for
consideration of 7,500,000 shares of the Company's common stock, including
375,000 shares assigned by Utek to its consultant. In addition, the Company had
a consultant for the transaction to whom it paid $50,000 of cash and issued
750,000 shares of its common stock. The term of the license agreement is until
the later of 15 years from the date of filing of the licensed patents or the
expiration of the last patent. The university requires a royalty in the amount
of five percent of net sales of the licensed products.
The purchase price of $1,200,000, which consists of the estimated fair value of
common stock issued of $1,650,000 net of cash acquired, was allocated to the
license agreement. The Company anticipates further development and testing of
the technology. Because of the uncertainties surrounding the ultimate commercial
deployment of the technology and due to the technology not having alternative
use, the Company charged the cost of the license agreement as in process
research and development costs during the three months ended September 30, 2006.
The determination of the purchase price allocated to the estimated fair values
of the assets acquired and liabilities assumed as reflected in the unaudited
condensed consolidated financial statements are preliminary and subject to
change based on finalization of the Company's valuation. The actual purchase
price and its allocation, to reflect the fair values of assets acquired and
liabilities assumed will be based upon management's ongoing evaluation and final
assessment which is expected to be completed during the Company's fiscal quarter
ending December 31, 2006. Accordingly, the final purchase price and its
allocation may differ significantly from the preliminary amount.
NOTE 7. DEBT FINANCINGS
Debt financings consist of the following as of September 30, 2006 and December
31, 2005:
September 30, 2006
Unamortized Debt
Principal Discount Net
---------- ------------------ ----------
April 2006 Debentures, due December 15, 2006 $ 400,000 $ (29,721) $ 370,729
Convertible debenture payable to stockholder
due December 15, 2006 150,000 -- 150,000
Laurus Revolving Note due February 10, 2009 1,405,906 (508,239) 897,667
Laurus Convertible Note due February 10, 2009 1,500,000 (1,182,482) 317,518
Loans and advances from officer and directors 52,639 -- 52,639
---------- ----------- ----------
$3,508,545 $(1,720,442) $1,788,553
========== =========== ==========
During the three and nine months ended September 30, 2006, $364,144 and
$2,582,274, respectively, of the debt discounts were charged to amortization of
debt discounts and debt issuance costs included in the accompanying condensed
statements of operations. During the three and nine months ended September 30,
2005, $428,067 and $792,436, respectively, of the debt discounts were charged to
amortization of debt discounts and debt issuance costs included in the
accompanying condensed statements of operations.
December 31, 2005
Unamortized Debt
Principal Discount Net
----------- ----------------- ----------
Macrocom Bridge Loan II, due October 10, 2006 $ 500,000 $ (58,875) $ 441,125
Macrocom Convertible Debenture due April 15, 2006 500,000 (194,444) 305,556
Convertible debentures payable to stockholder
and officer due April, 15, 2006 100,000 (38,890) 61,110
Cornell convertible debenture 1,658,160 (1,046,101) 612,059
Note payable issued to officer 200,000 (99,059) 100,941
Loans and advances from officer and directors 202,639 -- 202,639
---------- ----------- ----------
$3,160,799 $(1,437,369) $1,723,430
========== =========== ==========
APRIL 2006 PRIVATE PLACEMENT
On April 19, 2006, the Company sold Convertible Debentures (the "April 2006
Debentures") in the face amount of $500,000 to five individuals (the "Debenture
Holders" or a "Debenture Holder") including $150,000 face value to an officer
and director, and $50,000 face value to a stockholder of the Company. The April
2006 Debentures bear interest at 8% and were due originally on June 17, 2006. At
the option of the Debenture Holders, the April 2006 Debentures can be converted
into shares of the Company's common stock at a conversion price of $.50 per
share. In connection with the sale, the Company issued warrants to two Debenture
Holders to acquire an aggregate of 200,000 shares of its common stock with a
nominal exercise price. The warrants expire in three years from the date of
issuance. The remaining three Debenture Holders received an aggregate of 225,000
shares of the Company's common stock as additional consideration. In connection
with the issuance of the debt to the three Debenture Holders the Company has
agreed to place 3,000,000 shares of its common stock as collateral with an
escrow agent. No collateral has been issued for the April 2006 Debentures issued
to the officer and director and to the stockholder.
11
NETFABRIC HOLDINGS INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
The Company used the proceeds from the sale of the April 2006 Debentures to
repay $500,000 due to the Macrocom Investors, LLC ("Macrocom") pursuant to a
Macrocom Debenture (herein defined) issued in July of 2005.
The Company allocated the $500,000 of proceeds received from the April 2006
Debentures to debt, warrants and stock instruments issued based on the then
computed relative fair values. The fair value of the shares issued was $168,750
which resulted in a relative fair value of $103,271. The warrants issued were
valued using a Black-Scholes option-pricing model with the following
assumptions: (1) common stock fair value of $0.75 per share (2) expected
volatility of 71.26%, (3) risk-free interest rate of 4.86%, (4) life of 3 years
and (5) no dividend, which resulted in a fair value of $148,271 and a relative
fair value of $90,739. Additionally, the resulting relative fair value allocated
to the debt component was used to measure the intrinsic value of the embedded
conversion option of the April 2006 Debentures which resulted in a beneficial
conversion feature with a fair value of $444,010. The relative fair value of
$305,990 was recorded to additional paid-in capital. The value of the beneficial
conversion feature was limited to the amount of the proceeds allocated to the
debt component of the April 2006 Debentures. The aggregate amounts allocated to
the warrants, stock instruments and beneficial conversion feature, of $500,000
were recorded as a debt discount at the date of issuance of the April 2006
Debentures and were amortized to interest expense using the interest method over
the originally stated term of the April 2006 Debentures. During the nine months
ended September 30, 2006, $500,000 of discount was accreted and recorded as
amortization of debt discounts and debt issuance costs included in the
accompanying condensed consolidated statements of operations.
In June 2006, the Company and the Debenture Holders entered into an agreement to
extend the term of the April 2006 Debentures to September 15, 2006. In exchange
for the extension, the Company issued to the holders an aggregate of 150,000
shares of its common stock and warrants to acquire an aggregate of 400,000
shares of its common stock with a nominal exercise price. The warrants expire in
three years from the date of issuance. The fair value of the shares of common
stock and warrants approximated $137,201 and was recorded as additional discount
and is being amortized over the new term of the April 2006 Debentures. For the
three and nine months ended September 30, 2006, $114,831 and 137,201,
respectively, of debt discount was accreted and recorded as amortization of debt
discounts.
In September 2006, the Company repaid April 2006 Debentures in the face amount
of $100,000 and entered into an agreement with other Debenture Holders to extend
the term of the remaining April 2006 Debentures to December 15, 2006. In
exchange for the extension, the Company issued to the holders an aggregate of
200,000 shares of its common stock and warrants to acquire an aggregate of
200,000 shares of its common stock with a nominal exercise price. The warrants
expire in three years from the date of issuance. The fair value of the shares of
common stock and warrants approximated $35,049 and was recorded as additional
discount and is being amortized over the new term of the April 2006 Debentures.
For the three and nine months ended September 30, 2006 $5,777, of debt discount
was accreted and recorded as amortization of debt discounts resulting in
carrying value of $370,279 on the April 2006 Debentures at September 30, 2006.
STOCKHOLDER CONVERTIBLE DEBENTURE
On June 8, 2006, the Company sold a Convertible Debenture in the face amount of
$150,000 to a stockholder (the "Stockholder Convertible Debenture"). The
Stockholder Convertible Debenture bears interest at 8% and was due on August 4,
2006. At the option of the holder, the Stockholder Convertible Debenture can be
converted into shares of the Company's common stock at a conversion price of
$.50 per share. In connection with the sale, the Company issued 300,000 shares
of its common stock as additional consideration.
The Company allocated the $150,000 of proceeds received from the Stockholder
Convertible Debenture based on the computed relative fair values of the debt and
stock instruments issued. The fair value of the common stock issued was $105,000
which resulted in a relative fair value of $61,764. Additionally, the resulting
relative fair value allocated to the debt component was used to measure the
intrinsic value of the embedded conversion option of the Stockholder Convertible
Debenture which resulted in a beneficial conversion feature of $16,765 recorded
to additional paid-in capital. The aggregate amounts allocated to the stock
instruments and beneficial conversion feature, of $78,529 were recorded as a
debt discount at the date of issuance of the Stockholder Convertible Debenture
and are being amortized to interest expense using the interest method over the
stated term of the Stockholder Convertible Debenture. During the three and nine
months ended September 30, 2006, $48,220 and $78,529, respectively, of debt
discount was accreted and recorded as amortization of debt discounts resulting
in carrying value of $150,000 on the Stockholder Convertible Debenture at
September 30, 2006. In August 2006, the Company and the stockholder agreed to
extend the maturity of the Stockholder Convertible Debenture to December 15,
2006 without any additional consideration.
12
NETFABRIC HOLDINGS INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
MACROCOM BRIDGE LOANS
On July 22, 2004, NetFabric entered into a financing agreement which was amended
on December 2, 2004 (the "Financing Agreement") with Macrocom whereby Macrocom
provided a loan to NetFabric in the amount of $500,000 ("Loan I") for a period
of 180 days from the original date of the Financing Agreement ("Due Date") at an
annual simple interest rate of 5%. On the Due Date, the Company had the option
to repay the principal in cash or in kind by issuing 1,000,000 shares of its
common stock. The interest on Loan I was payable in cash on the Due Date.
Additionally, in connection with the Financing Agreement the Company issued to
Macrocom 250,000 shares of its common stock at a fair value of $144,000 as
additional consideration for Loan I in December 2004. In January 2005, in
accordance with the terms of the Financing Agreement, the Company elected to
repay the principal of Loan I in kind by issuing 1,000,000 shares of its common
stock. On October 14, 2004, NetFabric and Macrocom entered into a loan agreement
which was amended on December 2, 2004 (the "Loan Agreement"), whereby Macrocom
agreed to loan an additional $500,000 to NetFabric ("Loan II" or the "Second
Loan"), due 180 days from the original date of the Loan Agreement ("Second Due
Date") at an annual simple interest rate of 5%. On the Second Due Date, at the
option of Macrocom, Macrocom could convert the principal of the Second Loan into
1,000,000 shares of common stock or demand repayment of the principal in cash.
In either event, the interest on the Second Loan was payable in cash on the
Second Due Date. In addition, in December 2004 the Company issued to Macrocom
250,000 shares of its common stock with a fair value of $144,000 as additional
consideration for the Second Loan. As noted below, on the Second Due Date in
April 2005 Macrocom did not request repayment or conversion of such debt into
shares of the Company's common stock.
As a result of the Loan I and Loan II financing transactions, total debt
discounts of $411,403 were recorded on Loan I and Loan II (the "Bridge Loans")
during 2004, including the value of the beneficial conversion feature of
$187,801 on Loan II. During the three and nine months ended September 30, 2005,
$0 and $354,226, respectively of the discounts were amortized on the
accompanying consolidated statements of operations.
On May 24, 2005, NetFabric and Macrocom entered into an agreement to amend the
Second Loan between the parties. Under the terms of the amendment, the due date
for Loan II was extended from April 10, 2005 until October 10, 2005. At the same
time and in connection with the extension of the due date for Loan II, Macrocom
and Holdings also amended the terms of the Financing Agreement with respect to a
warrant Macrocom originally received on December 9, 2004. The warrant was set to
expire on June 7, 2005; however, the parties agreed to extend the term of the
warrant until December 9, 2006. As a result of these changes in terms, a debt
discount of $392,196 was recorded on April 11, 2005 on Loan II.
On October 10, 2005 Macrocom did not require repayment or conversion of Loan II
into shares of the Company's common stock. The Company and Macrocom agreed to
extend the due date for Loan II until October 10, 2006. As a result of the
modification of the term, a debt discount of $100,758 was recorded on October
10, 2005 on Loan II which was be amortized from October 11, 2005 through October
10, 2006. During the three and nine months ended September 30, 2006, $0 and
$58,875, respectively, of the discount was amortized on the accompanying
condensed consolidated statements of operations.
On May 24, 2006 the Company entered into a Waiver and Agreement to Convert (the
"Waiver Agreement") with Macrocom. Pursuant to the Waiver Agreement, Macrocom
agreed to convert Loan II issued by the Company in the principal amount of
$500,000, including all interest accrued thereon, into 1,000,000 shares of
restricted common stock of the Company. In addition, Macrocom and the Company
agreed to waive and release each other from any claims in connection with Loan
II and all other agreements executed to date between Macrocom and the Company.
In exchange for the Waiver Agreement and the Loan II conversion, the Company
agreed to issue to an additional 1,500,000 shares additional shares of its
restricted common stock. The fair value of the additional consideration was
$1,125,000 and the amount was charged to operations during the nine months ended
September 30, 2006 as debt extinguishment costs.
EMPLOYEE NOTE
An officer of the Company and an employee of UCA Services, advanced $200,000 to
the Company during 2005. In December 2005, the Company and the employee entered
into a Promissory Note (the" Employee Note") related to the advance. The
Employee Note bears interest at a rate of 5% per annum and a fee of $10,000 is
due to the employee at maturity. The principal balance of the Employee Note
together with accrued and unpaid interest and the fee were due and payable in
one installment on January 31, 2006. The Company repaid the principal and
interest in February 2006. In connection with the Employee Note, on December 8,
2005 the Company's Board of Directors authorized for issuance warrants to the
employee to acquire 300,000 shares of our common stock at an exercise price of
$1.00 per share. The warrants were issued on January 24, 2006 and expire on
January 24, 2009.
13
NETFABRIC HOLDINGS INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
MACROCOM CONVERTIBLE DEBENTURES
On July 19, 2005, the Company issued a convertible debenture in the amount of
$500,000 to Macrocom (the "Macrocom Debenture"). The Macrocom Debenture bore
interest at 5% per annum and was due on April 15, 2006. At the option of
Macrocom, the Macrocom Debenture could have been converted into shares of the
Company's common stock at a conversion price of $.50 per share. The Company also
issued Macrocom warrants to acquire 1,000,000 shares of the Company's common
stock at an exercise price of $1.50 per share. The warrants expire in three
years from the date of issuance. Additionally, the Company issued 375,000 shares
of the Company's common stock to Macrocom as additional consideration. As
collateral for the Macrocom Debenture, the Company placed 5,000,000 shares of
its common stock with an escrow agent.
The Company allocated the $500,000 of proceeds received from the Macrocom
Debenture to the debt, warrants and stock instruments issued based on the then
computed relative fair values. Additionally, the resulting relative fair value
allocated to the debt component was used to measure the intrinsic value of the
embedded conversion option of the Macrocom Debenture which resulted in a
beneficial conversion feature recorded to additional paid-in capital. The value
of the beneficial conversion feature was limited to the amount of the proceeds
allocated to the debt component of the Macrocom Debenture. The aggregate amounts
allocated to the warrants, stock instruments and beneficial conversion feature,
of $500,000 were recorded as a debt discount at the date of issuance of the
Macrocom Debenture and were charged to interest expense using the interest
method over the stated term of the Macrocom Debenture. During the three and nine
months ended September 30, 2006, $0 and $194,444, respectively of discount
charged to interest expense. In April 2006, the Macrocom Debenture was repaid in
full from the proceeds of the April 2006 Debenture debt financing.
STOCKHOLDER AND OFFICER CONVERTIBLE DEBENTURES
On July 19, 2005, the Company agreed with a stockholder, and an entity
affiliated with a former officer of the Company, that aggregate advances of
$100,000 made in June 2005 from the stockholder and an entity affiliated with
the former officer to the Company be structured as convertible debentures in the
face amount of $50,000 each ("Related Party Convertible Debentures"). The
Related Party Convertible Debentures were sold on substantially similar terms as
the Macrocom Debenture and, accordingly, bear interest at 5% per annum, and were
originally due on April 15, 2006. At the option of the holder, the Related Party
Convertible Debentures may be converted into shares of the Company's common
stock at a conversion price of $.50 per share. Additionally, in connection with
the sale of the Related Party Convertible Debentures, the Company issued
warrants to each holder to acquire 200,000 shares (or 100,000 each debenture) of
the Company's common stock at an exercise price of $1.50 per share which expire
in three years from the date of issuance. The Company also issued 75,000 shares
(or 37,500 for each debenture) of the Company's common stock to the stockholder
and the entity affiliated with an officer as additional consideration. The
Company did not provide any collateral.
The Company allocated the $100,000 of proceeds received from the Related Party
Convertible Debentures based on the computed relative fair values of the debt,
warrant and stock instruments issued. Accordingly, the resulting relative fair
value allocated to the debt component was used to measure the intrinsic value of
the embedded conversion option of the Related Party Convertible Debentures which
resulted in a beneficial conversion feature recorded to additional paid-in
capital. The aggregate amounts allocated to the warrants, stock instruments and
beneficial conversion feature of $100,000 were recorded as a debt discount at
the date of issuance of the Related Party Convertible Debentures and were
amortized to interest expense using the interest method over the original stated
term of the Related Party Convertible Debentures. During the three and nine
months ended September 30, 2006, $0 and $38,890, respectively, of discount has
been accreted and recorded as interest expense on the accompanying condensed
consolidated statements of operations.
In April 2006, one holder of Related Party Convertible Debentures in the face
amount of $50,000 converted the Related Party Debentures into 100,000 shares of
the Company's common stock and the other holders in the face amount of $50,000
entered into an extension agreement with the Company to extend the due date of
the debenture to September 15, 2006. In connection with the extension, the
Company issued 100,000 share of its common stock as additional consideration.
The fair value of the shares of common stock was $75,000 which resulted in a
relative fair value of $30,000 which was recorded as additional discount and are
being amortized over the new term of the Related Party Convertible Debentures.
For the three and nine months ended September 30, 2006, $15,098 and $30,000,
respectively, of debt discount was accreted and recorded as interest expense.
In September 2006, the holder which the Company entered into a previous
extension of Related Party Convertible Debentures in the face amount of $50,000
converted the Related Party Convertible Debentures into 100,000 shares of the
Company common stock. In exchange for the conversion, the Company issued to the
holder of Related Party Convertible Debentures an additional 300,000 shares of
restricted common stock of the Company to the holder. The fair value of the
additional consideration was $27,104 and the amount was charged to operations
during the three and nine months ended September 30, 2006 as debt extinguishment
costs.
14
NETFABRIC HOLDINGS INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
CORNELL CONVERTIBLE DEBENTURES
On July 5, 2005, the Company entered into an agreement pursuant to which the
Company was to sell Cornell Capital Partners, LP ("Cornell") secured convertible
debentures in the aggregate principal amount of $1,000,000, which are
convertible, at Cornell's discretion, into common stock of the Company. A
$400,000 debenture was funded in July 2005, and a $50,000 debenture was funded
in September 2005 (collectively the "Original Cornell Debentures"). In
connection with the Original Cornell Debentures, the Company issued Cornell
warrants to acquire 560,000 shares of its common stock at an exercise price of
$0.50 per share as additional consideration. The Original Cornell Debentures
could have been redeemed at the Company's option at any time, in whole or in
part prior to maturity at a redemption premium of 15% of the principal amount
redeemed in addition to principal and accrued interest.
On October 27, 2005, the Company entered into a Securities Purchase Agreement
(the "Securities Purchase Agreement") with Cornell whereby the Company and
Cornell agreed to amend and consolidate all of the Original Convertible
Debentures, and related accrued interest of $8,160, issued to Cornell through
October 26, 2005 into one new secured convertible debenture in the principal
amount of $1,658,160 (the "October Cornell Debenture"). The October Cornell
Debentures had the same terms and provisions of the Original Cornell Debentures
except that the October Cornell Debentures no longer had a fixed conversion by
the holder but is convertible at the option of the holder at the lesser of (i)
$1.00 or (ii) an amount equal to 95% of the lowest closing bid price of the
Company's common stock for the 30 trading days immediately proceeding the
conversion date. Pursuant to the Securities Purchase Agreement, Cornell funded
the remaining $1,200,000 balance of October Cornell Debenture on October 27,
2005. The October Cornell Debenture was repaid in full in February 2006 (the
"Cornell Repayment"), with the proceeds received from a new debt financing
described below.
As a result of the change in the conversion terms of the October Convertible
Debenture on October 27, 2005, the Company determined that the embedded
conversion feature of the October Cornell Debenture became subject to the
provisions of SFAS No. 133 and therefore the Company accounted for the embedded
conversion feature as a liability in accordance with the guidance of EITF 00-19,
"Accounting for Derivative Financial Instruments Indexed to, and Potentially
Settled in, a Company's Own Stock"("EITF 00-19"). Accordingly, the Company
recorded the fair value of the embedded conversion feature of $784,784 as a
non-current liability on its balance sheet as of October 27, 2005 and a portion
of the amounts previously recorded to additional paid-in capital as part of the
Original Cornell Debentures were reclassified from equity to liabilities. For
the nine months ended September 30, 2006, the Company recorded a gain in value
for derivative financial instruments through the date of repayment of $201,754
related to the change in fair value of the embedded conversion feature which is
recorded in the accompanying condensed consolidated statement of operations. As
a result of the Cornell Repayment, the value of the embedded conversion feature
was reclassified to additional paid-in capital in February 2006.
After the allocation of value to the embedded conversion feature of the October
Cornell Debenture the Company allocated the remaining $873,376 principal amount
of the total $1,658,160 October Cornell Debenture based on the computed relative
fair values of the debt and warrant components, which resulted in additional
debt discounts of $210,665. As a result of the Cornell Repayment, the remaining
unamortized debt discounts were amortized as of the date of the Cornell
Repayment. Accordingly, $1,045,678 of amortization expense related to discount
on the October Cornell Debentures was recorded in the accompanying condensed
consolidated statement of operations during the nine months ended September 30,
2006.
As part of the Cornell Repayment, the Company paid an early redemption premium
charge of $248,724, calculated based on 15% of the principal amount redeemed,
which is included in Debt extinguishment costs on the accompanying condensed
consolidated statement of operations for the nine months ended September 30,
2006. In connection with the Cornell Repayment, the Company also agreed to
reduce the exercise price of the 560,000 warrants previously issued to Cornell
from $0.50 to $0.40. The change in exercise price of the warrants was treated as
a new issuance of warrants and was valued using the Black Scholes option-pricing
model with the following assumptions: (1) common stock fair value of $0.95 per
share, (2) expected volatility of 71.26%, (3) risk-free interest rate of 4.62%,
(4) life of 2.71 years and (5) no dividend. The change in exercise price
resulted in a fair value of $372,353 for the warrants which was charged to debt
extinguishment costs on the accompanying condensed consolidated statement of
operations for the nine months ended September 30, 2006.
The Company and Cornell entered into a Registration Rights Agreement (the
"Cornell Registration Rights") related to the October Cornell Debenture. As a
result of the Cornell Repayment, the Company's obligations under the Cornell
Registration Rights were terminated.
15
NETFABRIC HOLDINGS INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
LAURUS CONVERTIBLE AND NON CONVERTIBLE FINANCINGS
On February 14, 2006, the Company entered into a Security Agreement, dated
February 10, 2006 with Laurus Master Fund, Ltd ("Laurus"). Under the Security
Agreement, Laurus purchased from the Company a Secured Convertible Note from the
Company with a maturity date of February 10, 2009 (the "Laurus Convertible
Note") in the aggregate principal amount of $1,500,000 and a Secured
Non-Convertible Revolving Note ( "Laurus Revolving Note"), in the aggregate
principal amount of $1,500,000. The Laurus Convertible Note and the Laurus
Revolving Note are collectively the "Laurus Notes". The Company's ability to
receive financing under the Laurus Notes is based on an advance rate equal to
90% of eligible accounts receivable, as defined. However, Laurus has agreed to
provide the Company an over advance until July 30, 2007. Through September 30,
2006 $1,500,000 was advanced for the Laurus Convertible Note and $1,405,906 was
advanced for the Laurus Revolving Note.
The Laurus Convertible Note has a three-year term, and bears interest at 1%
above the prime rate, with a minimum interest rate of 8%. Laurus has the option,
at any time until February 9, 2009 to convert all or any portion of the Laurus
Convertible Note and accrued interest into shares of the Company's common stock
at a conversion price of $0.91 per share. The Company has the option, to repay
the Laurus Convertible Note by paying Laurus the principal amount, accrued
interest and a certain redemption premium, as defined.
The Laurus Revolving Note has a three-year term and bears interest at 1% above
the prime rate, with a minimum interest rate of 8%.
In connection with the Laurus Notes, the Company issued to Laurus an option (the
"Laurus Option") to purchase up to 4,256,550 shares of the Company's common
stock at an exercise price of $0.001 per share. Additionally, the Company and
Laurus entered into a registration rights agreement (the " Laurus Registration
Rights Agreement") covering the registration of common stock underlying the
Laurus Convertible Note and the Laurus Option.
The Company's obligations under the Laurus Notes are secured by first liens on
all assets of the Company, and Laurus may accelerate all obligations under the
Laurus Notes upon an event of default.
The Company allocated the $1,500,000 of proceeds from the Laurus Convertible
Note based on the computed relative fair values of the debt and stock
instruments issued. The Laurus Options were valued using a Black-Scholes
option-pricing model with the following assumptions: (1) common stock fair value
of $0.95 per share (2) expected volatility of 71.26%, (3) risk-free interest
rate of 4.59%, (4) life of 10 years and (5) no dividend, which resulted in a
fair value of $2,569,546 for the Laurus Options. The resulting relative fair
value of the Laurus Options was $918,923. Accordingly, the resulting relative
fair value allocated to the debt component of $511,577 was used to measure the
intrinsic value of the embedded conversion option of $1,054,357 which resulted
in a beneficial conversion feature of $511,577 recorded to additional paid-in
capital. The aggregate amounts allocated to the Laurus Options and beneficial
conversion feature, of $1,430,500 were recorded as a debt discount at the date
of issuance of the Laurus Convertible Notes and are being amortized to interest
expense using the interest method over the three-year term. For the three and
nine months ended September 30, 2006, $125,912 and $317,518 respectively of
amortization expense was recorded in the accompanying condensed consolidated
statement of operations.
The Company allocated the $1,028,000 of proceeds from the Laurus Revolving Note
based on the computed relative fair values of the debt and Laurus Options. The
Laurus Options were valued using a Black-Scholes option-pricing model with the
following assumptions: (1) common stock fair value of $0.95 per share (2)
expected volatility of 71.26%, (3) risk-free interest rate of 4.59%, (4) life of
10 years and (5) no dividend, which resulted in a fair value of $1,471,494 for
the options. The resulting relative fair value of the Laurus Options was
$513,820. Accordingly, the resulting relative fair value allocated to the debt
component was $275,680. The aggregate amount allocated to the options of
$513,820 was recorded as a debt discount at the date of issuance of the Laurus
Notes and are being amortized to interest expense using the interest method
three-year term.
Transaction fees of $139,000 paid to Laurus and its affiliates in connection
with the Laurus Notes were netted against the proceeds and considered in the
calculation of the beneficial conversion feature. Financing costs of $20,696
paid to third parties associated with the Laurus Notes are included as debt
issuance costs in other assets and amortized over the term of the debt.
The Company utilized approximately $1.9 million of the initial borrowing from
Laurus to repay all amounts owed under the October Cornell Debenture.
16
NETFABRIC HOLDINGS INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
NOTE 8. STOCKHOLDERS' EQUITY
COMMON STOCK
The Company issued 50,000 shares of common stock to Macrocom in January 2006 in
settlement of accrued interest of $25,000 for the Macrocom Bridge Loan II due on
October 10, 2006.
In January 2006, the Company issued 10,526 shares of its Common Stock to a
vendor to offset outstanding trade payables of $10,000.
In May 2006, the Company entered into a consulting agreement with an
unaffiliated entity that agreed to provide new technology acquisition services
to the Company and amended the consulting agreement in August 2006. Pursuant to
the consulting agreement, the Company issued the consultant 40,000 shares of its
common stock. The Company had initially issued the consultant 160,000 shares of
common stock but the consultant surrendered 120,000 of the previously issued
shares pursuant to an amendment of the agreement. The fair value of the shares
is charged to operations as consulting expense. For the three and nine months
ended September 30, 2006, $6,367 and $11,034 were charged to operations.
CONTRACT TERMINATION
In January 2006, the Company and a consultant to the Company terminated a
services arrangement whereby the consultant was to provide services to the
Company over a certain future period. In connection with the termination of this
arrangement, an individual who is an officer, director and stockholder of the
Company transferred one million shares of the Company's common stock owned by
the officer, director and stockholder into escrow. The shares will be held in
escrow for a period of up to five years during which the consultant will have
the option to purchase the shares for an aggregate of $10,000 or $0.01 per
share. As a result, the consultant released the Company from all liabilities.
The Company has accounted for the settlement as an expense in the Company's
financial statements as a non-cash charge for dispute settlements based on the
value of the option of $0.94 per share on the date of settlement, with a
corresponding credit to contributed (paid-in) capital from the officer, director
and stockholder during the three months ended March 31, 2006. The option was
valued using a Black-Scholes option-pricing model with the following
assumptions: (1) common stock fair value of $0.95 per share, (2) expected
volatility of 71.26%, (3) risk-free interest rate of 4.59%, (4) life of 5 years
and (5) no dividend, which resulted in a fair value of $942,070.
EXCHANGE AGREEMENT AMENDMENT
During January and February 2006, the former shareholders of UCA Services with
whom the Company previously entered into an Exchange Agreement related to the
acquisition of UCA Services (See Note 5) and the Company entered into
negotiations related to a dispute over compliance with the provisions of the
Exchange Agreement.
In connection with the discussions, the Company and the former UCA shareholders
entered into an Amendment to the Exchange Agreement ("Exchange Amendment") which
was executed in February 2006. The Exchange Amendment provides that an
individual who is an officer, director and stockholder of the Company transfer
9,000,000 shares (fair value of approximately $8,500,000) of the Company's
common stock owned by such individual to the former shareholders of UCA. This
arrangement was structured whereby the individual surrendered his shares to the
Company, and the Company reissued such shares to the former UCA shareholders.
Since the settlement was not a contingency associated with the acquisition of
UCA Services, the Company accounted for the shares transferred by the
individuals as an expense, based on the value of the shares, in the Company's
condensed consolidated financial statements with a corresponding credit to
contributed (paid-in) capital by the individual during the three months ended
March 31, 2006. Management determined the fair value of the shares issued based
on the quoted market price of the Company's common stock on the date of
settlement.
17
NETFABRIC HOLDINGS INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
OTHER SECURITIES
Outstanding warrant and option securities issued in connection with financings
consist of the following at September 30, 2006 and December 31, 2005:
September 30, 2006
----------------------------------------------------
Warrants Exercise Price Expiration
---------- -------------- ----------------------
Laurus 4,256,550 $ 0.001 n/a
Macrocom warrants 2,000,000 $ 0.75 12/9/2006
Macrocom warrants 1,000,000 $ 1.50 7/19/2008
Cornell warrants 560,000 $ 0.50 10/27/2008
Officer and directors warrants, including
former officers and directors 500,000 $0.50 to $1.50 7/15/2008 to 12/8/2008
other 2,266,137 $0.01 to $0.82 12/3/2008 to 6/14/2011
----------
10,582,687
==========
December 31, 2006
---------------------------------------------------
Warrants Exercise Price Expiration
---------- -------------- ----------------------
Macrocom warrants 2,000,000 $ 0.75 12/9/2006
Macrocom warrants 1,000,000 $ 1.50 7/19/2008
Cornell warrants 560,000 $ 0.50 10/27/2008
Officer and director warrants, including
former officers and directors 664,805 $0.50 to $1.50 12/3/2008 to 12/8/2008
other 988,832 $ 0.50 1/1/2009 to 1/29/2009
---------
5,213,637
=========
Since the conversion of the October Cornell Debenture could result in a
conversion into an indeterminable number of shares common stock, in October 2005
the Company determined that under the guidance of EITF 00-19, the Company could
not conclude that it had sufficient authorized and unissued shares to settle any
warrants or options issued to non-employees. Therefore in October 2005, the
Company reclassified the fair value of all warrants and options issued to
non-employees that were outstanding as of October 27, 2005 from equity to
liabilities. The fair value of the Company's warrants and options issued to
non-employees was estimated at approximately $3,065,000 on October 27, 2005
using a Black-Scholes option pricing model for each of the individual
securities. As a result, the Company incurred a charge of approximately
$2,035,000 on October 27, 2005, which was computed based on the difference
between the fair value of the securities and the value of the securities as of
October 27, 2005 which had previously been recorded to additional paid-in
capital. On December 31, 2005, the fair value of the warrants and options issued
to non-employees was re-measured and estimated at $2,940,000 using a
Black-Scholes option pricing model for each of the individual securities. For
the nine months ended September 30, 2006, the Company recorded a gain of
$336,352 on derivative financial instruments related to the change in the fair
value of the warrants through the repayment date. The liability for warrants and
options issued to non-employees was reclassified to additional paid-in capital
upon the Cornell Repayment in February 2006, which terminated Cornell's
conversion rights.
In June 2006, the Company entered into a consulting agreement with an
unaffiliated entity that agreed to provide investment banking services to the
Company. Pursuant to the agreement, the Company issued the consultant warrants
to acquire 312,500 share of its common stock at $0.82 per share that vest over
the term specified in the consulting agreement. The warrants expire five years
from the date of issuance. The fair value of the vested warrants is being
charged to operations as a consulting expense. For the three and nine months
ended September 30, 2006, $38,900 and $51,516, respectively, were charged to
operations for such services.
18
NETFABRIC HOLDINGS INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
NOTE 9. STOCK-BASED COMPENSATION
On March 3, 2005, the Board of Directors adopted the 2005 Stock Option and Grant
Plan (the "Plan"). The purpose of the Plan is to encourage and enable the
employees, directors and consultants of the Company upon whose judgment,
initiative and efforts the Company largely depends for the success of its
business to acquire a proprietary interest in the Company. The Plan became
effective on April 19, 2005 and was authorized with 9,000,000 shares of the
Company's common stock.
From time to time, the Company issues stock-based compensation to its officers,
directors, employees and consultants. The maximum term of options granted is
generally 10 years and generally options vest over a period of one to four
years. However, the Board of Directors of the Company may and has approved other
vesting schedules. The Company has issued options to employees and non-employees
under stock option agreements. Options may be exercised in whole or in part.
The exercise price of stock options granted is generally the fair market value
of the Company's common stock as determined by the Board of Directors on the
date of grant.
The following is a summary of the Company's stock option activity for the nine
months ended September 30, 2006:
Weighted Average Aggregate
Options Exercise Price Intrinsic Value
--------- ---------------- ---------------
Outstanding, December 31, 2005 3,869,010 0.63
Options granted 3,850,000 0.36
Options exercised --
Options cancelled (618,925) 1.57
--------- ----- ----------
Outstanding, June 30, 2006 7,100,085 0.41 $2,009,525
========= ===== ==========
Exercisable, June 30, 2006 2,731,351 $0.39 $ 808,969
========= ===== ==========
The options outstanding at September 30, 2006 have a weighted average remaining
contractual life of approximately 8.8 years. The options exercisable at
September 30, 2006 have a weighted average remaining contractual life of
approximately 7.5 years. No options have been exercised to date.
The fair value of the options granted during the three and nine months ended
September 30, 2006 was estimated as of the date of the grant using the Black
Scholes option pricing model, based on the following assumptions: (1) common
stock fair value ranging from $0.35 to $0.75 per share (2) expected volatility
of 71.26%, (3) risk-free interest rate ranging from 4.59% to 4.92%, (4) life of
5 years and (5) no dividend. For the three and nine months ended September 30,
2005 assumptions were (1) common stock fair value ranging from $1.40 to $2.10
(2) expected volatility of 100% (3) risk free interest rate ranging from 2.72%
to 3.97% (4) life of 5 years and (5) no dividend.
The Weighted average fair value of options granted during the nine months ended
September 30, 2006 and 2005, was $0.23 and $1.41 per share, respectively.
NOTE 10. RELATED PARTY TRANSACTIONS
Loans and advances payable to stockholders and directors on the accompanying
condensed consolidated balance sheet at September 30, 2006 represent amounts
owed to stockholders and directors of the Company for advances of cash provided
to the Company. Convertible debentures payable to stockholders and directors
represent amounts received by the Company pursuant to financings arrangements.
The Company subleases certain office space and incurs occupancy related costs
under an agreement with UCA Global, Inc. ("Global"), an entity affiliated with a
shareholder of the Company, whereby the Company pays rent and other occupancy
costs based on the proportion of square footage occupied by the Company in
Global's office facility. Rent and occupancy expenses incurred by the Company
under this agreement, which commenced on May 20, 2005, were $31,875 and $95,625
during the three and nine months ended September 30, 2006, respectively, and
$33,063 and $36,078 during the three and nine months ended September 30, 2005,
and are included in selling, general and administrative expenses.
In the normal course of business, the Company performs services for an entity
affiliated with certain significant stockholders. The Company charged
approximately $8,000 and $71,000 for such services during the three and nine
months ended September 30, 2006, respectively.
19
NETFABRIC HOLDINGS INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
NOTE 11. SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND FINANCING ACTIVITIES
For the nine Months
ended September 30,
------------------------
2006 2005
---------- -----------
Settlement of bridge loan with common stock $ 500,000 $ 500,000
Non-cash offering costs, netted against proceeds from sales
of common stock $ -- $ 368,683
Common stock issued in the acquisition of UCA services $ -- $32,770,769
Discount on bridge loans relating to warrants $ 392,196
Discount on convertible debentures relating to warrants $ 375,804
Discount on convertible debentures relating to shares $ 156,058
Discount on convertible debentures relating to beneficial
Conversion feature $ 416,509
Discount on revolving note relating to warrants $ 513,820 $ --
Discount on convertible note relating to warrants $ 918,923 $ --
Discount on convertible debt relating to beneficial
conversion feature $ 511,577 $ 67,500
Issuance of common shares in connection with settlement of
payables $ 35,000 $ --
Discount on convertible debenture due to officer relating to
common stock $ 30,000 $ --
Discount on convertible debenture due to a stockholder
relating to common stock $ 61,765 $ --
Discount on convertible debenture due to a stockholder
relating to beneficial conversion feature $ 16,765 $ --
Discount on April 2006 Debentures relating to common stock $ 103,272 $ --
Discount on April 2006 Debentures relating to warrants $ 90,739 $ --
Discount on April 2006 Debentures relating to beneficial
conversion feature $ 305,990 $ --
Discount on April 2006 Debentures extension relating to
warrants $ 115,908 $ --
Discount on April 2006 Debentures extension relating to
common stock $ 56,342 $ --
Conversion of convertible debenture issued to stockholder
and officer with common stock $ 130,000 $ --
Common stock issued for technology licensing acquisition $1,650,000
Rescission of shares previously issued for services $ 15,452
NOTE 12. SUBSEQUENT EVENTS
In October 2006, the Company sold Convertible Debentures (the "Debentures") in
the face amount of $200,000 to two individuals. The Debentures bear interest at
8% and are due in three months from the date of issuance. At the option of the
Debenture holder, the Debentures can be converted into shares of the Company's
common stock at a conversion price of $.50 per share. In connection with the
sale, the Company issued warrants to individuals to acquire an aggregate of
400,000 shares of the Company's common stock with a nominal exercise price. The
warrants expire three years from the date of issuance.
In October 2006, the Company's board of directors approved an amendment to the
Certificate of Incorporation to increase the number authorized common stock to
200 million shares. The change will become effective on or about November 20,
2006 following a written consent of the shareholders.
20
ITEM 2.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
The following discussion and analysis of our financial condition and plan of
operation should be read in conjunction with the consolidated financial
statements and accompanying notes and the other financial information appearing
elsewhere in this report and reports included herein by reference. The following
discussion contains forward-looking statements that reflect our plans, estimates
and beliefs. Our actual results could differ materially from those discussed in
the forward-looking statements.
Our independent registered public accounting firm has indicated in their report
dated April 17, 2006 on our December 31, 2005 financial statements that we had
net losses from inception and have a working capital deficiency. The report
indicates that these matters raise substantial doubt about our ability to
continue as a going concern. Our plan with regard to this matter is discussed
elsewhere in this document. The condensed consolidated financial statements do
not include any adjustments that might result from the outcome of this
uncertainty.
CORPORATE HISTORY
NetFabric Holdings, Inc. ("Holdings" "our", "we" or the "Company") were formerly
known as Houston Operating Company and were incorporated in Delaware in August
of 1989. On December 9, 2004, we entered into an Acquisition Agreement with all
of the stockholders of NetFabric Corp (the "Acquisition agreement"). At the
closing, which occurred at the same time as the execution of the Acquisition
Agreement, we acquired all of the issued and outstanding capital stock of
NetFabric Corp. from the stockholders in exchange for an aggregate of 32,137,032
newly-issued shares of our common stock. The acquisition was accounted for as a
reverse merger whereby NetFabric Corp. was treated as the acquirer. NetFabric
Corp. was incorporated in the State of Delaware on December 17, 2002, as a new
corporation. On April 19, 2005, our name was changed from Houston Operating
Company to NetFabric Holdings, Inc. and our stock symbol was changed from "HOOC"
to "NFBH."
UCA SERVICES, INC. ACQUISITION
On May 20, 2005, we entered into and closed on a share exchange agreement,
whereby we purchased all of the issued and outstanding shares of UCA Services,
Inc. ("UCA") from its shareholders in exchange for the issuance of 24,096,154
shares of our common stock. UCA is an IT services and solutions company that
serves the information needs of a wide range of Fortune 500 clients in the
financial markets industry as well as the pharmaceutical, health care and
hospitality sectors. UCA delivers a broad range of IT services in managed
services, professional services, infrastructure builds and maintenance and
application development and maintenance areas.
The acquisition was accounted using the purchase method of accounting with the
results of operations of UCA included in the consolidated financial statements
from the date of acquisition.
DISCONTINUED OPERATIONS
Prior to acquiring NetFabric Corp., Houston Operating Company did not have any
operations, and we were a shell company whose primary business objective was to
merge and become public. NetFabric Corp., a Delaware corporation incorporated on
December 17, 2002, began operations in July 2003. NetFabric Corp. was a provider
of hardware and services to small to mid-sized businesses ("SMBs") that utilized
the Internet for telephone communications or Voice over Internet Protocol
("VoIP"). It developed and marketed appliances or Customer Premises Equipment
("CPE") that simplified the integration of standard telephone systems with an IP
infrastructure. In addition, it resold transport services of a third party VoIP
transport provider. Our operations, prior to the UCA acquisition, consisted of
developing VoIP appliances, including research and product development
activities. We also hired additional personnel for sales and marketing and
developed our sales and marketing programs.
Our revenues from VoIP operations were minimal. We have concluded that we cannot
implement our original business for VoIP operations within resources we have or
with the additional capital we can raise in the near term. On May 3, 2006, our
Board of Directors decided to exit from the hardware-based VoIP communications
product line (including resale of transport services) that is targeted to SMBs.
In accordance with Statement of Financial Accounting Standards No. 144
"Accounting for the Impairment or Disposal of Long-Lived Assets", ("SFAS No.
144"), the results of operations from its VoIP business segment has been
reclassified as discontinued operations for all periods presented. After the
discontinuation of VoIP operations, our only operations are that of UCA's.
21
OVERVIEW
UCA derives revenues primarily from managed IT services, professional services,
application development services and from business process management services.
Arrangements with customers for services are generally on a time and material
basis or fixed-price, fixed-timeframe revenue. UCA's principal operating
expenses are direct employee costs and consultant expenses and selling, general
and administrative expenses. Direct employee cost and consultant expenses are
comprised primarily of the costs of consultant labor, including employees,
subcontractors and independent contractors, and related employee benefits.
Approximately 50% of our consultants are employees and the remainder are
subcontractors and independent contractors.
We compensate most of our consultants only for the hours that we bill to our
clients for projects undertaken, which allows us to better match our labor costs
with our revenue generation. With respect to our consultant employees, we are
responsible for employment-related taxes, medical and health care costs and
workers' compensation. Labor costs are sensitive to shifts in the supply and
demand of IT professionals, as well as increases in the costs of benefits and
taxes. The principal components of selling, general and administrative expenses
are salaries of sales and support personnel, and office rent.
As previously noted, the December 9, 2004 acquisition was accounted for as a
reverse merger whereby NetFabric Corp. was treated as the acquirer. Accordingly,
the historical financial statements of NetFabric Corp. have been presented for
all periods required. NetFabric Corp. began operations in January 2003 and was a
development stage company until the UCA acquisition. The UCA acquisition was
accounted for using the purchase method of accounting with the results of the
operations included in the Company's condensed consolidated financial statements
from the date of acquisition.
COMPARISON OF THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2006 AND 2005:
Revenues. Revenues for the nine months ended September 30, 2006, increased by
$5,467,781 or 73.1% compared to the same period of the prior year. This increase
was due to the UCA acquisition. We anticipate that our revenues will increase
for fiscal year 2006 due to the full year impact of the UCA acquisition. For the
three months ended September 30, 2006, revenues decreased by $657,294 or 12.6%
compared to the same period of the prior year. The decrease was due to certain
one-time projects undertaken in 2005. For the nine months ended September 30,
2005, on a pro forma basis, UCA had revenues of $14,365,378. The decrease on a
pro forma basis was due to certain one-time projects undertaken in 2005.
Direct employee compensation and consultant expenses. For the three months ended
September 30, 2006, our direct employee compensation and consultant expenses
decreased by $297,471 or 7.9% to $3,489,443.The decrease was due to decreased
revenues in comparable period of 2006. For the nine months ended September 30,
2006, our direct employee compensation and consultant expenses increased by
$4,119,612 or 74.0% to $9,684,601. The increases were due to increased revenues
resulting from the UCA acquisition. We anticipate direct employee compensation
and consultant expenses to increase for fiscal year 2006 in line with the
anticipated increase in our revenues.
Selling, general and administrative expenses. Our selling, general and
administrative expenses decreased for the three months ended September 30, 2006
by $517,878 or 29.3% to $1,247,345. The principal component of the decrease was
$350,000 of prospective financing costs incurred during the three months ended
September 30, 2005.For the nine months ended September 30, 2006, our selling,
general and administrative expenses increased by $1,185,251 or 40.9% to
$4,081,025. The increases were due to the UCA acquisition.
Amortization of debt discount. Amortization of debt discount for the three
months ended September 30, 2006 decreased by $79,844 or 18.0% to $364,144. For
the nine months ended September 30, 2006 amortization of debt discount increased
by $1,792,215 or 221.7% to $2,600,572. The increase was due to the amortization
of debt discount resulting from the allocation of value to certain equity
instruments issued in connection with debt issued in 2006 and 2005. At September
30, 2006 the aggregate unamortized debt discount was $1,720,442, which will be
amortized and charged to operations over the term of the respective debt.
Depreciation and amortization. For the three months ended September 30, 2006
depreciation and amortization increased by $67,077 or 469.4% to $81,367. For the
nine months ended September 30, 2006, depreciation and amortization increased by
$203,434 or 999.2% to $223,794. The increases were due to additional assets
arising from the UCA acquisition.
Interest expense. For the three and nine months ended September 30, 2006
interest expense increased by $31,592 and $176,026, respectively, due to
increased borrowing levels in 2006.
22
Derivative Financial Instruments. As a result of the change in the conversion
terms of the October Convertible Debentures on October 27, 2005, we determined
that the embedded conversion feature of the October Cornell Debenture became
subject to the provisions of SFAS No. 133 and therefore we accounted for the
embedded conversion feature as a liability in accordance with the guidance of
EITF 00-19, "Accounting for Derivative Financial Instruments Indexed to, and
Potentially Settled in, a Company's Own Stock" ("EITF 00-19"). Accordingly, we
recorded the fair value of the embedded conversion feature of $784,784 as a
non-current liability on its balance sheet as of October 27, 2005 and a portion
of the amounts previously recorded to additional paid-in capital as part of the
Original Cornell Debentures were reclassified from equity to liabilities. For
the nine months ended September 30, 2006 we recorded a gain in value for
derivative financial instruments of $336,352 related to the change in fair value
of the embedded conversion feature which is recorded in the accompanying
condensed consolidated statement of operations. As a result of the Cornell
Repayment, the value of the embedded conversion future was reclassified to
additional paid-in capital.
Debt extinguishment costs. As part of the Cornell Repayment we paid an early
redemption charge of 15% of the principal amount redeemed or $248,724 which
charge is included on the accompanying condensed statement for operations for
the nine months ended September 30, 2006. In connection with the Cornell
Repayment we also agreed to reduce the exercise price of the 560,000 warrants
from $0.50 to $0.40. The change in exercise price of the warrants was treated as
a new issuance of warrants and was valued using the Black Scholes option-pricing
model. The reduction in exercise price resulted in a fair value of $372,353 for
the warrants, which was charged to operations for the nine months ended
September 30, 2006.
On May 24, 2006 the Company entered into a Waiver and Agreement to Convert (the
"Agreement") with Macrocom Investors LLC ("Macrocom"). Pursuant to the
Agreement, Macrocom agreed immediately to convert a note issued by the Company
in the principal amount of $500,000 and due on October 10, 2006, including all
interest accrued thereon, into 1,000,000 shares of restricted common stock of
the Company. In addition, Macrocom and the Company agreed to waive and release
each other from any claims in connection with the Note and all other agreements
executed to date between Macrocom and the Company. In exchange for the waiver
and the early conversion, the Company agreed to issue to an additional 1,500,000
shares of restricted common stock to Macrocom. The fair value of the additional
consideration was $1,125,000 and the amount was charged to operations during the
nine months ended September 30, 2006 as debt extinguishment costs.
Non cash charge for dispute settlement. In January 2006, we entered into a
termination agreement with a consultant. In connection with the termination, an
individual who is our officer, director and stockholder transferred 1,000,000
shares of our common stock to the benefit of the consultant. We accounted for
the settlement expense, based on the value of the shares of our shares on the
settlement date ($0.95) during the nine months ended September 30, 2006. In
February 2006, we entered into an amendment agreement with the former UCA
shareholders. Pursuant to the amendment agreement, an individual who was our
officer, director and stockholder transferred 9,000,000 shares of our common
stock owned by him to the former UCA shareholders. Since the settlement was not
a contingency associated with the acquisition of UCA Services, we accounted for
the shares transferred by the individual as an expense, based on the value of
the shares, during the nine months ended September 30, 2006.
In process research and development. On August 11, the Company entered into an
agreement with Utek Corporation ("Utek"), an unaffiliated specialty finance
company focused on technology transfers, to acquire a technology license for
intrusion detection software developed by a university. We anticipate further
development and testing of the technology. Because of the uncertainties
surrounding the ultimate commercial deployment of the technology and due to the
technology not having alternative use, we charged the cost of the license
agreement of $1,200,000 as in process research and development costs during the
three months ended September 30, 2006.
Discontinued Operations On May 3, 2006, our Board of Directors decided to exit
from the hardware-based VoIP communications product line (including resale of
transport services) that is targeted to SMBs. In accordance with Statement of
Financial Accounting Standards No. 144 "Accounting for the Impairment or
Disposal of Long-Lived Assets", ("SFAS No. 144"), the results of operations from
its VoIP business segment has been reclassified as discontinued operations for
all periods presented. For the nine months ended September 30, 2006, loss from
discontinued operations decreased by $1,135,500 or 70.5%. The decreases were due
to our scaling back of VoIP operations in 2006 and eventual exit from the
business during 2006. Revenues from VoIP operations have been nominal in all
periods presented and operating expenses are the losses reported.
Net loss. As a result of the foregoing, for the three months ended September 30,
2006, net loss increased by $804,958 or 61.3% to a loss of $2,119,075, compared
to a net loss of $1,314,117 in the three months ended September 30, 2006. For
the nine months ended September 30, 2006, net loss increased by $13,446,348 to
net a loss of $16,914,496 compared to a net loss of $3,468,148 in the nine
months ended September 30, 2005.
LIQUIDITY AND CAPITAL RESOURCES
At September 30, 2006, our working capital deficiency was $3,125,743 compared to
a working capital deficiency of $2,176,606 at December 31, 2005. The increase in
the working capital deficiency was principally due to operating losses. During
the nine months ended September 30, 2006, our operating activities from
continuing operations used cash of approximately $632,000 compared to
approximately $451,000 used during the nine months ended September 30, 2005.
23
During the nine months ended September 30, 2006, our operating losses, after
adjusting non cash items utilized approximately $1,269,000 of cash, and working
capital items provided approximately $637,000 of cash. The principal components
of working capital changes were an increase in our accounts payables and
increase of deferred revenue or customer advance offset by an increase in our
accounts receivable. During the nine months ended September 30, 2005, our
operating losses after adjusting for non cash items utilized approximately
$600,000 of cash and working capital items provided approximately $149,000 of
cash.
Pursuant to a financing commitment, in two separate closings in January and
March 2005, we sold 1,000,000 shares of common stock to Macrocom and 1,000,000
shares of our common stock to Michael Millon, resulting in aggregate proceeds of
$1,000,000 for $0.50 per share. Additionally, under this arrangement, Macrocom
received warrants to purchase 2,000,000 shares of common stock at a purchase
price of $1,500,000. The warrants expire in December 2006. We also issued
250,000 shares to Michael Millon as consideration for arranging the Macrocom
financing.
In February 2006, we repaid $ 70,000 owed to Fred Nazem, a stockholder of the
Company and $200,000 owed to Fahad Syed, an officer and director of the Company.
In addition, we repaid $100,000 due to Faisal Syed, a stockholder of the
Company. Prior to our acquisition of UCA, UCA issued a promissory note to Faisal
Syed for $100,000. The note bore interest at the rate of 6%. The promissory note
together with accrued but unpaid interest was due in June 2005.
In February 2006, we along with our subsidiaries, entered into a Security
Agreement, dated February 10, 2006 ( the "Security Agreement")with Laurus Master
Fund, Ltd., a Cayman Islands company ("Laurus"). Under the Security Agreement,
Laurus purchased us a Secured Convertible Note (the "Laurus Convertible Note"),
with a maturity date of February 10, 2009, in the aggregate principal amount of
$1,500,000 and a Secured Non-Convertible Revolving Note (the "Laurus Revolving
Note"") in the aggregate principal amount of $1,500,000. The Laurus Convertible
Note and Laurus Revolving Notre are collectively referred to as "Laurus Notes".
Availability under the Laurus Notes is based on an advance rate equal to 90% of
eligible accounts receivable, and Laurus has agreed to provide us an over
advance for a specified period. The Laurus Convertible Note has a three-year
term, and bears interest at 1% above the prime rate, with a minimum interest
rate of 8%. Laurus shall have the option, but not the obligation, at any time
until the maturity date, to convert all or any portion of the Laurus Convertible
Note and accrued interest into shares of our common stock at an exercise price
of $0.91 per share. If converted in full we would be obligated to issue an
aggregate of 1,648,352 shares of our common stock. We have the option, to prepay
the Laurus Convertible Note by paying Laurus the applicable redemption premium.
The Laurus Revolving Note has a three-year term, and bears interest at 1% above
the prime rate, with a minimum interest rate of 8%.
In connection with the borrowing, we issued to Laurus a common stock purchase
option ("Option") to purchase up to 4,256,550 shares of our common stock for
nominal consideration. Additionally, we entered into a registration rights
agreement with Laurus ("Registration Rights Agreement"), covering the
registration of common stock underlying the Secured Convertible Note and the
Option. Our obligations under the Laurus Notes are secured by first liens on all
of our assets, and Laurus may accelerate all obligations under the Laurus Notes
upon an event of default.
Our initial borrowing was approximately $2,300,000 and we utilized approximately
$1,900,000 of the initial borrowing to repay all amounts owed to Cornell
pursuant to a Secured Convertible Debenture, including an applicable redemption
premium. At September 30, 2006, our availability with Laurus was $2,985,000 and
our aggregate borrowings with Laurus were approximately $2,905,000 (face
amount).
On April 19, 2006, we sold Convertible Debentures (the "April 2006 Debentures")
in the face amount of $500,000 to five individuals including $150,000 face value
to Fahad Syed, an officer and director, and $50,000 face value to Fred Nazem, a
stockholder. The April 2006 Debentures bear interest at 8% and were due on June
17, 2006. At the option of the Debenture holder, the Debentures can be converted
into shares of our common stock at a conversion price of $.50 per share. In
connection with the sale, we issued two individuals warrants to acquire an
aggregate of 200,000 shares of its common stock with a nominal exercise price.
The warrants expire in three years from the date of issuance. For the other
three individuals, we issued an aggregate of 225,000 shares of our common stock
as additional consideration. For the three individuals, the Company has agreed
to place 3,000,000 shares of its common stock as collateral with an escrow
agent. There will not be any collateral for the April 2006 Debentures issued to
Fahad Syed and Fred Nazem. We used the proceeds from the sale of the Debentures
to repay $500,000 due to Macrocom pursuant to the Macrocom Convertible Debenture
issued in July of 2005.
On May 24, 2006 Macrocom converted a note issued by the Company in the principal
amount of $500,000 and due on October 10, 2006, including all interest accrued
thereon, into 2.5 million shares ( 1 million shares pursuant to the initial
agreement and 1.5 million shares pursuant to a waiver and agreement to convert)
of restricted common stock of the Company.
In June 2006, we and the holders of the April 2006 Debentures entered into an
agreement to extend the term of the debentures to September 15, 2006. In
exchange for the extension, we issued to the holders an aggregate of 150,000
shares of its common stock and warrants to acquire an aggregate of 400,000
shares of our common stock with a nominal exercise price. The warrants expire in
three years from the date of issuance. In September 2006, we repaid $100,000 of
face amount and entered into an agreement to extend the term of the debentures
to December 15, 2006. In exchange for the extension, we issued to the holders an
aggregate of 200,000 shares of common stock and warrants to acquire 200,000
shares of our common stock with a nominal strike price. The warrants expire in
three years from the date of issuance.
24
In April 2006, Fred Nazem, a stockholder, converted a convertible debenture
issued to him in July 2005 to 100,000 shares of our common stock. We also
extended the maturity date of another convertible debenture held by an entity
affiliated with our former officer in the face amount of $50,000 to September
15, 2006 and we issued 100,000 shares of our common stock to the debenture
holder as additional consideration. In September 2006, the holder converted the
convertible debenture into 100,000 shares of our common stock. As an inducement
for conversion, we issued the debenture holder 300,000 shares of our common
stock.
On June 8, 2006, we sold a Convertible Debenture (the "Stockholder Convertible
Debentures") in the face amount of $150,000 to Fred Nazem, a stockholder. The
Debentures bear interest at 8% and are due on August 4, 2006. At the option of
the Debenture holder, the Stockholder Convertible Debentures can be converted
into shares of our common stock at a conversion price of $.50 per share. In
connection with the sale, we issued 300,000 shares of its common stock as
additional consideration. In August we extended the due date of the debenture to
December 15, 2006.
On August 11, 2006, we entered into an agreement with Utek Corporation ("Utek"),
an unaffiliated specialty finance company focused on technology transfer, to
acquire a technology license for intrusion detection software developed by a
university. To facilitate the transfer of technology; Utek formed a subsidiary,
Intrusion Detection Technologies, Inc. ("ITDI"). IDTI did not have any business
operations and its assets consisted of cash balance of $500,000 and a license
agreement with a university for intrusion detection software by the university.
We acquired all of the outstanding shares of IDTI from Utek for a consideration
of 7,500,000 shares of the Company's common stock, including 375,000 shares
assigned by Utek to its consultant. The term of the license agreement is the
later of 15 years from the date of filing of the licensed patents or the
expiration of the last patent. The university requires a royalty in the amount
of five percent of net sales of the licensed products.
For continued growth, we need capital for both technology investments and
operations. Technology investments will improve our consultants with new skills
thereby enabling us to obtain additional projects from our existing customers
and from new customers. We can accomplish this either through investment and
strategic partnership with new software companies or through hiring consultants
and paying for their bench time until we obtain projects where they can be
placed on a billable basis. Working capital requirements are principally for
additional receivables that need to be supported by an increased revenue base
resulting from anticipated growth. We believe that the Revolver with Laurus will
provide us the necessary working capital required for the accounts receivable
growth.
In order to execute our business plan and achieve our objectives for the near
future, management believes it will require approximately $2,000,000 over the
next 12 months for working capital. A significant component of this is for
satisfying our obligations as they become due, both borrowing and vendor
payables. Our ability to continue as a going concern and our future success are
dependent upon our ability to raise capital in the near term to satisfy our
current obligations. Management's plans in this regard include, but are not
limited to current discussions and negotiations with a number of additional
financing alternatives, one or more of which it believes will be able to
successfully close to provide necessary working capital. There is no assurance
that we will be successful in completing the financing. The accompanying
consolidated financial statements do not include any adjustments that might
result from the outcome of this uncertainty.
To fund our operations for the remainder of fiscal year 2006, we need to raise
additional financing and generate cash flows from our operations. Should
additional cash flows not be available, we believe that we would have the
ability to restructure our operations, and if necessary, initiate significant
reductions in expenses. In addition, we will have to negotiate with our lenders
to extend the repayment dates of our indebtedness. There can be no assurance,
however, that we will be able to successfully restructure our operations or debt
obligations in the event we fail to obtain additional financing.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The discussion and analysis of our financial conditions and results of
operations is based upon our financial statements, which have been prepared in
accordance with accounting principles generally accepted in the United States of
America ("GAAP"). The preparation of these financial statements requires us to
make estimates and judgments that affect the reported amounts of assets,
liabilities, revenues and expenses, related disclosure of contingent assets and
liabilities. On an ongoing basis, we evaluate our estimates, including those
related to revenue recognition, accounts receivable and long-lived assets. We
base our estimates on historical experience and on various other assumptions
that we believe to be reasonable under the current circumstances, the results of
which form the basis for making judgments about the carrying values of assets
and liabilities that are not readily apparent from other sources. Actual results
may differ from these estimates under different assumptions or conditions.
We believe the following critical accounting policies affect the judgment and
estimates used in preparation of our consolidated financial statements.
25
REVENUE RECOGNITION
We derive revenue as a provider of IT services.
In accordance with Securities and Exchange Commission ("SEC") Staff Accounting
Bulletin No. 104, "Revenue Recognition," revenue is recognized when persuasive
evidence of an arrangement exists, delivery of the product or services has
occurred, the fee is fixed and determinable, collectibility is reasonably
assured, contractual obligations have been satisfied, and title and risk of loss
have been transferred to the customer.
Arrangements with customers for services are generally on a time and material
basis or fixed-price, fixed-timeframe. Revenue on time-and-material contracts is
recognized as the related services are performed. Revenue for fixed-price,
fixed-timeframe services is recognized as the service is performed. Revenue from
fixed-price, fixed-timeframe service contracts is recognized ratably over the
term of the contract, as per the proportional performance method. When we
receive cash advances from customers in advance of the service period, amounts
are reported as advances from customers until the commencement of the service
period. Billings and collections in excess of revenue recognized are classified
as deferred revenue.
ALLOWANCE FOR DOUBTFUL ACCOUNTS
We maintain allowances for doubtful accounts for estimated losses resulting from
the inability of our customers to make required payments. These estimated losses
are based upon historical bad debts, specific customer creditworthiness and
current economic trends. If the financial condition of a customer deteriorates,
resulting in the customer's inability to make payments within approved credit
terms, additional allowances may be required. We perform credit evaluations of
our customers' financial condition on a regular basis.
FAIR VALUE OF FINANCIAL INSTRUMENTS
The fair value of the Company's assets and liabilities that qualify as financial
instruments under Statement of Financial Accounting Standards ("SFAS") No. 107
"Disclosure about Fair Value of Financial Instruments", presented in the
consolidated balance sheets as of June30, 2006 and December 31, 2005 approximate
their carrying amounts.
GOODWILL AND OTHER INTANGIBLES
Goodwill and other intangibles represent the allocation, pursuant to an
independent appraisal of the cost to acquire UCA Services, in excess of the fair
value of assets acquired. Under SFAS No. 142, "Goodwill and Other Intangible
Assets", goodwill is not amortized but is reviewed for impairment annually, as
well as when a triggering event indicates impairment may have occurred. The
goodwill test for impairment consists of a two-step process that begins with an
estimation of the fair value of the reporting unit. The first step of the
process is a screen for potential impairment and the second step measures the
amount of impairment, if any. We will perform a goodwill impairment test
annually, as well as when a triggering event indicates impairment may have
occurred. Application of the goodwill impairment test requires significant
judgments including estimation of future cash flows, which is dependent on
internal forecasts, estimation of the long-term rate of growth, the useful life
over which cash flows will occur, and determination of cost of capital. Changes
in these estimates and assumptions could materially affect the determination of
fair value and/or conclusions on goodwill impairment. Intangible assets are
accounted for under the provisions of SFAS No. 142. Intangible assets arise from
business combinations and consist of customer relationships and restricted
covenants related to employment agreements that are amortized, on a
straight-line basis, over periods of up to six years. The Company follows the
impairment provisions and disclosure requirements of SFAS No. 142. Accordingly
intangible assets are reviewed for impairment whenever events or changes in
circumstances indicate that the carrying amount may not be recoverable.
STOCK-BASED COMPENSATION
Beginning January 1, 2006, we account for stock-based compensation in accordance
with the fair value recognition provisions of SFAS 123R. Under the fair value
recognition provisions of SFAS 123R, share-based compensation cost is measured
at the grant date based on the value of the award and is recognized as expense
over the vesting period. Stock-based compensation expense is calculated using
the Black Scholes option pricing model on the date of grant. This option
valuation model requires input of highly subjective assumptions. These
assumptions include estimating the length of time employees will retain their
vested stock options before exercising them ("expected term"), the estimated
volatility of our common stock price over the expected term, and the number of
options that will ultimately not complete their vesting requirements
("forfeitures"). Changes in these assumptions can materially affect the estimate
of the fair value of employee stock options and consequently, the related amount
of stock-based compensation expense recognized in the condensed consolidated
statements of operations.
26
ITEM 3. CONTROLS AND PROCEDURES
A. EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES:
Our disclosure controls and procedures are designed to ensure that information
required to be disclosed in the reports filed or submitted under the Securities
Exchange Act of 1934 (the "Exchange Act") is recorded, processed, summarized and
reported, within the time period specified in the SEC's rules and forms.
Disclosure controls and procedures include, without limitation, controls and
procedures designed to ensure that information required to be disclosed in the
reports filed under the Exchange Act are accumulated and communicated to
management, including the Chief Executive Officer ("CEO"") and Chief Financial
Officer ("CFO") , as appropriate, to allow timely decisions regarding required
disclosure. As of the end of the period covered by this report, we carried out
an evaluation, under the supervision and with participation of our management,
including our CEO and CFO, of the effectiveness of the design and operation of
our disclosure controls and procedures. Based upon and as of the date of that
evaluation, the CEO and CFO concluded that our disclosure controls and
procedures are effective to ensure that information required to be disclosed in
the reports we file and submit under the Exchange Act are recorded, processed,
summarized and reported as and when required.
B. CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING:
There were no changes in our internal controls over financial reporting during
the most recent fiscal quarter that have materially affected or are reasonably
likely to materially affect our internal control over financial reporting.
PART II. OTHER INFORMATION
ITEM 1 LEGAL PROCEEDINGS
The Company from time to time is involved in routine legal matters incidental to
business. In the opinion of management, the ultimate resolution of such matters
will not have a material adverse effect on the Company's financial position,
results of operations or liquidity.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.
During the three months ended September 30, 2006:
The Company issued 400,000 shares of common stock to CCS Group LLC upon their
conversion of a convertible debenture.
The Company issued 200,000 shares of common stock to the holder of a convertible
debenture as consideration for extending the due date of the convertible
debenture.
The Company issued 7,125,000 shares of common stock to Utek Corporation for a
technology license agreement and also issued 375,000 shares of common stock to
Aware Capital Consultants pursuant to an assignment by Utek Corporation.
The Company issued 750,000 shares of common stock to Scarborough Limited as
consulting fees.
The Company amended its May 25, 2006 agreement with Utek Corporation whereby
Utek Corporation surrendered 120,000 of 160,000 shares of the Company's common
stock issued to them on May 25, 2006.
The foregoing shares were issued pursuant to exemptions from registration under
Sections 3(a)(9) and 4(2) of the Securities Act of 1933.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None
ITEM 5. OTHER INFORMATION
None
ITEM 6. EXHIBITS
(a) Exhibits:
31.1 Rule 13a-14(a)/15d-14(a) Certification (CEO)
31.2 Rule 13a-14(a)/15d-14(a) Certification (CFO)
32.1 Section 1350 Certification (CEO)
32.2 Section 1350 Certification (CFO)
27
SIGNATURES
In accordance with the requirements of Section 13 or 15(d) of the Securities
Exchange Act , the registrant has caused this report to be signed on its behalf
by the undersigned, thereunto duly authorized.
Date: November, 2006 By: /s/ Fahad Syed
-------------------------------
Fahad Syed
Chairman and Chief
Executive Officer
By: /s/ Vasan Thatham
-------------------------------
Vasan Thatham
Principal Financial Officer and
Vice President
28
EXHIBIT 31.1
CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION
302 OF THE SARBANES OXLEY ACT OF 2002
I, Fahad Syed, Chairman and Chief Executive Officer, certify that:
1. I have reviewed this quarterly report on Form 10-QSB of NetFabric Holdings,
Inc. (the" Company").
2. Based on my knowledge, this report does not contain any untrue statement of a
material fact or omit to state a material fact necessary to make the statements
made, in light of the circumstances under which such statements were made, not
misleading with respect to the period covered by this report;
3. Based on my knowledge, the financial statements, and other financial
information included in this report, fairly present in all material respects the
financial condition, results of operations and cash flows of the Company as of,
and for, the periods presented in this report;
4. The Company's other certifying officer and I are responsible for establishing
and maintaining disclosure controls and procedures (as defined in Exchange Act
Rules 13a-15(e) and 15d 15 for the Company and have:
a) Designed such disclosure controls and procedures, or caused such disclosure
controls and procedures to be designed under our supervision, to ensure that
material information relating to the Company, including its consolidated
subsidiaries, is made known to us by others within those entities, particularly
during the period in which this report is being prepared;
b) [Reserved]
c) Evaluated the effectiveness of the Company's disclosure controls and
procedures and presented in this report our conclusions about the effectiveness
of the disclosure controls and procedures, as of the end of the period covered
by this report based on such evaluation; and
d) Disclosed in this report any change in the Company's internal control over
financial reporting that occurred during the Company's most recent fiscal
quarter ( the Company's fourth fiscal quarter in case of an annual report) that
has materially affected, or is reasonably likely to materially affect, the
Company's internal control over financial reporting; and
5. The Company's other certifying officer and I have disclosed, based on our
most recent evaluation of internal control over financial reporting, to the
Company's auditors and the audit committee of the Company's board of directors
(or persons performing the equivalent functions):
a) All significant deficiencies and material weaknesses in the design or
operation of internal control over financial reporting which are reasonably
likely to adversely affect the Company's ability to record, process, summarize
and report financial information; and
b) Any fraud, whether or not material, that involves management or other
employees who have a significant role in the Company's internal control over
financial reporting.
November __, 2006
/s/ Fahad Syed
-------------------------------------------
Name: Fahad Syed
Title: Chairman and Chief Executive Officer
EXHIBIT 31.2
CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION
302 OF THE SARBANES OXLEY ACT OF 2002
I, Vasan Thatham, Chief Financial Officer, certify that:
1. I have reviewed this quarterly report on Form 10-QSB of NetFabric Holdings,
Inc. (the" Company").
2. Based on my knowledge, this report does not contain any untrue statement of a
material fact or omit to state a material fact necessary to make the statements
made, in light of the circumstances under which such statements were made, not
misleading with respect to the period covered by this report;
3. Based on my knowledge, the financial statements, and other financial
information included in this report, fairly present in all material respects the
financial condition, results of operations and cash flows of the Company as of,
and for, the periods presented in this report;
4. The Company's other certifying officer and I are responsible for establishing
and maintaining disclosure controls and procedures (as defined in Exchange Act
Rules 13a-15(e) and 15d 15(e) for the Company and have:
a) Designed such disclosure controls and procedures, or caused such disclosure
controls and procedures to be designed under our supervision, to ensure that
material information relating to the Company, including its consolidated
subsidiaries, is made known to us by others within those entities, particularly
during the period in which this report is being prepared;
b) [Reserved]
c) Evaluated the effectiveness of the Company's disclosure controls and
procedures and presented in this report our conclusions about the effectiveness
of the disclosure controls and procedures, as of the end of the period covered
by this report based on such evaluation; and
d) Disclosed in this report any change in the Company's internal control over
financial reporting that occurred during the Company's most recent fiscal
quarter (the Company's fourth fiscal quarter in the case of an annual report)
that has materially affected, or is reasonably likely to materially affect, the
Company's internal control over financial reporting; and
5. The Company's other certifying officer and I have disclosed, based on our
most recent evaluation of internal control over financial reporting, to the
Company's auditors and the audit committee of the Company's board of directors
(or persons performing the equivalent functions):
a) All significant deficiencies and material weaknesses in the design or
operation of internal control over financial reporting which are reasonably
likely to adversely affect the Company's ability to record, process, summarize
and report financial information; and
b) Any fraud, whether or not material, that involves management or other
employees who have a significant role in the Company's internal control over
financial reporting.
November __, 2006
/s/ Vasan Thatham
----------------------------------------
Name: Vasan Thatham
Title: Chief Financial Officer
EXHIBIT 32.1
CERTIFICATION PURSUANT TO
18 U.S.C. SECTION 1350,
AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002
In connection with the Quarterly Report of NetFabric Holdings, Inc. (the"
Company") on Form 10-QSB for the period ended September 30, 2006 as filed with
the Securities and Exchange Commission on the date hereof (the "Report"), I,
Fahad Syed Chairman and Chief Executive Officer, certify, pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
2002, that:
(1) The Report fully complies with the requirements of Section 13(a) or 15(d) of
the Securities Exchange Act of 1934; and
(2) The information contained in the Report fairly presents, in all material
respects, the financial condition and result of operations of the Company.
November __, 2006
/s/ Fahad Syed
-------------------------------------------
Name: Fahad Syed
Title: Chairman and Chief Executive Officer
A signed original of this written statement required by Section 906 has been
provided to NetFabric Holdings, Inc. and will be retained by NetFabric Holdings,
Inc. and furnished to the Securities and Exchange Commission or its staff upon
request.
EXHIBIT 32.2
CERTIFICATION PURSUANT TO
18 U.S.C. SECTION 1350,
AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002
In connection with the Quarterly Report of NetFabric Holdings, Inc. (the
"Company") on Form 10-QSB for the period ended September 30, 2006 as filed with
the Securities and Exchange Commission on the date hereof (the "Report"), I,
Vasan Thatham, Chief Financial Officer, certify, pursuant to 18 U.S.C. Section
1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002,
that:
(1) The Report fully complies with the requirements of Section 13(a) or 15(d) of
the Securities Exchange Act of 1934; and
(2) The information contained in the Report fairly presents, in all material
respects, the financial condition and result of operations of the Company.
November __, 2006
/s/ Vasan Thatham
----------------------------------------
Name: Vasan Thatham
Title: Chief Financial Officer
A signed original of this written statement required by Section 906 has been
provided to NetFabric Holdings, Inc. and will be retained by NetFabric Holdings,
Inc. and furnished to the Securities and Exchange Commission or its staff upon
request.
