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SatCon Technology 10-Q 2008

Table of Contents

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


 

FORM 10-Q

 

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

 

For the Quarterly Period Ended June 28, 2008

 

Commission File Number 1-11512

 


 

SATCON TECHNOLOGY CORPORATION

(Exact name of registrant as specified in its charter)

 

Delaware

 

04-2857552

(State or other jurisdiction of

 

(IRS Employer Identification No.)

incorporation or organization)

 

 

 

 

 

27 Drydock Avenue

 

 

Boston, Massachusetts

 

02210

(Address of principal executive offices)

 

(Zip Code)

 

(617) 897-2400

(Registrant’s telephone number, including area code)

 


 

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x  No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company.  See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer o

 

Accelerated filer o

 

Non-accelerated filer o

Smaller reporting company x

 

 

 

(Do not check if a smaller reporting company)

 

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

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

Common Stock, $0.01 Par Value,

50,995,962 shares outstanding as of August 1, 2008.

 

 

 



Table of Contents

 

TABLE OF CONTENTS

 

PART I. FINANCIAL INFORMATION

 

Item 1. Financial Statements (Unaudited)

 

Financial Statements of SatCon Technology Corporation

 

Consolidated Balance Sheets

 

Consolidated Statements of Operations

 

Consolidated Statements of Changes in Stockholders’ Equity (Deficit)

 

Consolidated Statements of Cash Flows

 

Notes to Interim Consolidated Financial Statements

 

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk

 

Item 4T. Controls and Procedures

 

PART II. OTHER INFORMATION

 

Item 1. Legal Proceedings

 

Item 1A. Risk Factors

 

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

 

Item 3. Defaults Upon Senior Securities

 

Item 4. Submission of Matters to a Vote of Security Holders

 

Item 5. Other Information

 

Item 6. Exhibits

 

Signature

 

Exhibit Index

 

 



Table of Contents

 

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

 

SATCON TECHNOLOGY CORPORATION

CONSOLIDATED BALANCE SHEETS

(Unaudited)

 

 

 

June 28,

 

December 31,

 

 

 

2008

 

2007

 

ASSETS

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

9,769,382

 

$

12,615,566

 

Restricted cash and cash equivalents

 

84,000

 

84,000

 

Accounts receivable, net of allowance of $139,350 and $211,263 at June 28, 2008 and December  31, 2007, respectively

 

10,253,131

 

10,462,323

 

Unbilled contract costs and fees

 

493,694

 

536,567

 

Inventory

 

20,865,346

 

17,190,424

 

Prepaid expenses and other current assets

 

963,411

 

1,073,194

 

Total current assets

 

42,428,964

 

41,962,074

 

Property and equipment, net

 

2,978,599

 

3,059,651

 

Goodwill, net

 

704,362

 

704,362

 

Intangibles, net

 

596,595

 

793,739

 

Other long-term assets

 

57,481

 

88,851

 

Total assets

 

$

46,766,001

 

$

46,608,677

 

 

 

 

 

 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Bank line of credit

 

$

3,000,000

 

$

 

Accounts payable

 

6,112,552

 

9,153,234

 

Accrued payroll and payroll related expenses

 

1,850,446

 

1,880,867

 

Other accrued expenses

 

3,783,994

 

3,453,883

 

Accrued contract losses

 

1,368,642

 

1,300,000

 

Accrued restructuring

 

451,152

 

 

Deferred revenue

 

14,108,156

 

8,103,093

 

Total current liabilities

 

$

30,674,942

 

$

23,891,077

 

 

 

 

 

 

 

Warrant liability

 

5,536,264

 

3,244,316

 

Redeemable convertible Series B preferred stock (340 shares issued and outstanding at June 28, 2008 and December 31, 2007; face value $5,000 per share; liquidation preference $1,700,000)

 

1,700,000

 

1,700,000

 

Other long-term liabilities

 

194,579

 

133,900

 

Total liabilities

 

$

38,105,785

 

$

28,969,293

 

 

 

 

 

 

 

Commitments and contingencies (Note H)

 

 

 

 

 

Redeemable convertible Series C preferred stock (25,000 shares issued and outstanding at June 28, 2008 and December 31, 2007, face value $1,000 per share, liquidation preference $30,000,000 at June 28, 2008 and December 31, 2007)

 

15,091,845

 

13,276,091

 

 

 

 

 

 

 

Stockholders’ equity (deficit):

 

 

 

 

 

Common stock; $0.01 par value, 200,000,000 shares authorized; 50,921,737 and 49,803,979 shares issued and outstanding at June 28, 2008 and December 31, 2007, respectively

 

509,217

 

498,040

 

Additional paid-in capital

 

181,985,571

 

180,933,100

 

Accumulated deficit

 

(188,174,472

)

(176,757,615

)

Accumulated other comprehensive loss

 

(751,945

)

(310,232

)

Total stockholders’ equity (deficit)

 

$

(6,431,629

)

$

4,363,293

 

Total liabilities and stockholders’ equity (deficit)

 

$

46,766,001

 

$

46,608,677

 

 

The accompanying notes are an integral part of these unaudited consolidated financial statements.

 

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Table of Contents

 

SATCON TECHNOLOGY CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

 

 

 

Three Months Ended

 

Six Months Ended

 

 

 

June 28,
2008

 

June 30,
2007

 

June 28,
2008

 

June 30,
2007

 

Revenue:

 

 

 

 

 

 

 

 

 

Product revenue

 

$

13,130,161

 

$

9,919,486

 

$

26,832,651

 

$

16,452,072

 

Funded research and development and other revenue

 

3,807,450

 

1,774,666

 

4,991,128

 

3,559,845

 

Total revenue

 

$

16,937,611

 

$

11,694,152

 

$

31,823,779

 

$

20,011,917

 

Operating costs and expenses:

 

 

 

 

 

 

 

 

 

Cost of product revenue

 

12,410,366

 

10,044,974

 

25,058,835

 

16,415,446

 

Research and development and other revenue expenses:

 

 

 

 

 

 

 

 

 

Funded research and development and other revenue expenses

 

2,666,547

 

1,312,047

 

3,682,420

 

2,668,846

 

Unfunded research and development expenses

 

1,250,582

 

645,603

 

2,248,660

 

1,323,012

 

Total research and development and other revenue expenses

 

$

3,917,129

 

$

1,957,650

 

$

5,931,080

 

$

3,991,858

 

Selling, general and administrative expenses

 

5,451,620

 

3,113,879

 

8,606,875

 

5,937,720

 

Amortization of intangibles

 

78,572

 

83,773

 

157,144

 

193,594

 

Restructuring costs

 

606,607

 

 

606,607

 

 

Total operating costs and expenses

 

$

22,464,294

 

$

15,200,276

 

$

40,360,541

 

$

26,538,618

 

Operating loss

 

$

(5,526,683

)

$

(3,506,124

)

$

(8,536,762

)

$

(6,526,701

)

Change in fair value of convertible notes and warrants

 

(2,396,717

)

385,035

 

(2,864,198

)

584,628

 

Other expense, net

 

(64,509

)

(24,925

)

(10,777

)

(65,479

)

Interest income

 

70,886

 

36,692

 

140,271

 

122,231

 

Interest expense

 

(98,634

)

(626,322

)

(145,391

)

(1,235,706

)

Net loss

 

$

(8,015,657

)

$

(3,735,644

)

$

(11,416,857

)

$

(7,121,027

)

 

 

 

 

 

 

 

 

 

 

Accretion on Series C Preferred Stock to redemption value

 

(679,008

)

 

(1,317,000

)

 

Dividend on Series C Preferred Stock

 

(310,792

)

 

(614,754

)

 

Deemed dividend on Series C Preferred Stock

 

(116,000

)

 

(116,000

)

 

 

 

 

 

 

 

 

 

 

 

Net loss attributable to common stockholders

 

$

(9,121,457

)

$

(3,735,644

)

$

(13,464,611

)

$

(7,121,027

)

 

 

 

 

 

 

 

 

 

 

Net loss attributable to common stockholders per weighted average share, basic and diluted

 

$

(0.18

)

$

(0.09

)

$

(0.27

)

$

(0.17

)

 

 

 

 

 

 

 

 

 

 

Weighted average number of common shares, basic and diluted

 

50,414,800

 

42,869,473

 

50,174,860

 

42,132,067

 

 

The accompanying notes are an integral part of these unaudited consolidated financial statements.

 

4



Table of Contents

 

SATCON TECHNOLOGY CORPORATION

CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY (DEFICIT)

For the six months ended June 28, 2008

(Unaudited)

 

 

 

Common
Shares

 

Common
Stock

 

Additional
Paid-in
Capital

 

Accumulated
Deficit

 

Accumulated
Other
Comprehensive
Loss

 

Total
Stockholders’
Equity
(Deficit)

 

Comprehensive
Loss

 

Balance, December 31, 2007

 

49,803,979

 

$

498,040

 

$

180,933,100

 

$

(176,757,615

)

$

(310,232

)

$

4,363,293

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net loss

 

 

 

 

 

 

 

(11,416,857

)

 

(11,416,857

)

$

(11,416,857

)

Beneficial conversion feature on Series C Preferred Stock

 

 

 

116,000

 

 

 

116,000

 

 

Series C Preferred Stock deemed dividend

 

 

 

(116,000

)

 

 

(116,000

)

 

Issuance of warrants to Series C Preferred Stockholders

 

 

 

116,000

 

 

 

116,000

 

 

Issuance of common stock to 401(k) Plan

 

156,863

 

1,568

 

270,416

 

 

 

271,984

 

 

Issuance of common stock in connection with the exercise of stock options to purchase common stock

 

679,919

 

6,799

 

1,155,127

 

 

 

1,161,926

 

 

Issuance of common stock in lieu of six-month cash dividend on redeemable convertible Series B preferred stock.

 

43,873

 

439

 

67,561

 

 

 

68,000

 

 

Issuance of common stock in connection with the exercise of warrants to purchase common stock

 

154,757

 

1,548

 

199,544

 

 

 

201,092

 

 

Issuance of restricted stock to employees

 

82,346

 

823

 

144,930

 

 

 

145,753

 

 

Accretion of Series C Preferred Stock to its redemption value

 

 

 

(1,317,000

)

 

 

(1,317,000

)

 

Issuance of warrants to purchase common stock to contractor

 

 

 

121,000

 

 

 

121,000

 

 

Dividend on Series C Preferred Stock

 

 

 

(614,754

)

 

 

(614,754

)

 

Employee stock-based compensation

 

 

 

909,647

 

 

 

909,647

 

 

Foreign currency translation adjustment

 

 

 

 

 

(441,713

)

(441,713

)

(441,713

)

Comprehensive loss

 

 

 

 

 

 

 

$

(11,858,570

)

Balance, June 28, 2008

 

50,921,737

 

$

509,217

 

$

181,985,571

 

$

(188,174,472

)

$

(751,945

)

$

(6,431,629

)

 

 

 

The accompanying notes are an integral part of these unaudited consolidated financial statements

 

5



Table of Contents

 

SATCON TECHNOLOGY CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

 

 

 

Six Months Ended

 

 

 

June 28, 2008

 

June 30, 2007

 

Cash flows from operating activities:

 

 

 

 

 

Net loss

 

$

(11,416,857

)

$

(7,121,027

)

Adjustments to reconcile net loss to net cash used in operating activities:

 

 

 

 

 

Depreciation and amortization

 

776,427

 

829,039

 

Provision for uncollectible accounts

 

(28,641

)

(11,973

)

Provision for excess and obsolete inventory

 

251,135

 

209,954

 

Non-cash compensation expense, including stock based compensation costs of $909,647 and $336,895 for the six months ended June 28, 2008 and June 30, 2007, respectively

 

1,195,943

 

622,795

 

Non-cash expense associated with the issuance of warrants

 

121,000

 

 

 

Change in fair value of senior secured convertible notes and investor and placement agent warrant liability

 

2,864,198

 

(584,628

)

Non-cash interest expense

 

68,000

 

1,143,133

 

Changes in operating assets and liabilities:

 

 

 

 

 

Accounts receivable

 

63,674

 

(678,666

)

Unbilled contract costs and fees

 

42,873

 

(44,496

)

Prepaid expenses and other current assets

 

106,987

 

(2,637,179

)

Inventory

 

(4,204,916

)

(6,660,795

)

Other long-term assets

 

13,901

 

(1,600

)

Accounts payable

 

(2,900,297

)

2,281,413

 

Accrued payroll and payroll related expenses and other expenses

 

474,427

 

306,286

 

Accrued contract losses

 

99,851

 

(78,326

)

Accrued restructuring

 

451,152

 

679,895

 

Deferred revenue

 

6,126,013

 

7,268,868

 

Other liabilities

 

(27,025

)

(2,406

)

Total adjustments

 

5,494,702

 

2,641,314

 

Net cash used in operating activities

 

(5,922,155

)

(4,479,713

)

Cash flows from investing activities:

 

 

 

 

 

Purchases of property and equipment

 

(441,619

)

(702,568

)

Net cash used in investing activities

 

(441,619

)

(702,568

)

Cash flows from financing activities:

 

 

 

 

 

Net borrowings under line of credit

 

3,000,000

 

 

Payments related to warrant holder redemption rights

 

(572,250

)

 

Repayment of long-term debt

 

 

(81,530

)

Repayment of Senior Secured Convertible Notes

 

 

(500,000

)

Net proceeds from exercise of options to purchase common stock

 

1,196,926

 

754

 

Net proceeds from exercise of warrants to purchase common stock

 

201,092

 

 

Net cash provided (used in) by financing activities

 

3,825,768

 

(580,776

)

Effect of foreign currency exchange rates on cash and cash equivalents

 

(308,178

)

406,027

 

Net decrease in cash and cash equivalents

 

(2,846,184

)

(5,357,030

)

Cash and cash equivalents at beginning of period, including restricted cash and cash equivalents

 

12,615,566

 

7,274,827

 

Cash and cash equivalents at end of period, including restricted cash and cash equivalents

 

$

9,769,382

 

$

1,917,797

 

 

 

 

 

 

 

SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION

 

 

 

 

 

Non-Cash Investing and Financing Activities:

 

 

 

 

 

Valuation adjustment for Series B preferred stock and warrants

 

$

 

$

41,730

 

Employee stock-based compensation.

 

$

909,647

 

$

336,896

 

Common stock issued related to 401(k) contributions.

 

$

271,984

 

$

285,103

 

Common stock issued in lieu of interest on Senior Secured Notes.

 

$

 

$

556,741

 

Common stock issued for principal payment on Senior Secured Notes

 

$

 

$

2,818,722

 

Amortization of debt discount associated with the valuation of the Senior Secured Notes

 

$

 

$

544,252

 

Common stock issued in lieu of dividends on redeemable convertible Series B Preferred Stock

 

$

68,000

 

$

69,000

 

Accretion of redeemable convertible preferred stock discount

 

$

1,317,000

 

$

 

Financing of long term capital leases

 

$

87,704

 

$

 

Issuance of warrants and beneficial conversion feature

 

$

232,000

 

$

 

Interest and Income Taxes Paid:

 

 

 

 

 

Interest

 

$

77,391

 

$

270,000

 

Income Taxes

 

$

 

$

 

 

The accompanying notes are an integral part of these unaudited consolidated financial statements.

 

6



Table of Contents

 

SATCON TECHNOLOGY CORPORATION

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

June 28, 2008 (“2008”) AND June 30, 2007 (“2007”)

(Unaudited)

 

Note A. Basis of Presentation

 

The accompanying unaudited consolidated financial statements include the accounts of SatCon Technology Corporation and its wholly-owned subsidiaries (collectively, the “Company”) as of June 28, 2008 and for the three and six months then ended and have been prepared by the Company in accordance with accounting principles generally accepted in the United States of America for interim financial reporting and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X.  Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. All intercompany accounts and transactions have been eliminated. These unaudited consolidated financial statements, which, in the opinion of management, reflect all adjustments (including normal recurring adjustments) necessary for a fair presentation, should be read in conjunction with the financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2007. Operating results for the three and six months ended June 28, 2008 are not necessarily indicative of the results that may be expected for any future interim period or for the entire fiscal year.

 

Note B. Realization of Assets and Liquidity

 

The Company anticipates that its current cash, along with the availability under its credit facility with Silicon Valley Bank, will be sufficient to fund its operations through at least June 30, 2009.   The Company has developed a business plan that envisions a significant increase in revenue and significant reductions in the cost structure and the cash burn rate from the results experienced in the recent past.  Although the Company believes it has developed a realistic business plan, there is no assurance that it can achieve these objectives.  Accordingly, if the Company is unable to realize its business plan or does not remain in compliance with the covenants of the credit facility, the Company would need to raise additional funds in the near future in order to sustain operations by selling equity or taking other actions to conserve its cash position, which could include selling of certain assets and incurring additional indebtedness.  Such actions would likely require the consent of the holders of the Company’s Series C Preferred Stock (the “Investors”), and there can be no assurance that such consent would be given.  Furthermore, there can be no assurance that the Company will be able to raise such funds if they are required.

 

Note C. Significant Accounting Policies and Basis of Consolidation

 

There have been no material changes from the Significant Accounting Policies and Basis of Presentation previously disclosed in Part II, Item 8, contained within “Notes to Consolidated Financial Statements” of our Annual Report on Form 10-K for the fiscal year ending December 31, 2007.

 

Basis of Consolidation

 

The consolidated financial statements include the accounts of SatCon and its wholly-owned subsidiaries (SatCon Applied Technology, Inc., SatCon Electronics, Inc., SatCon Power Systems, Inc. and SatCon Power Systems Canada, Ltd.). All intercompany accounts and transactions have been eliminated in consolidation.

 

Revenue Recognition

 

The Company recognizes revenue from product sales in accordance with Staff Accounting Bulletin (SAB) No. 104, Revenue Recognition. Product revenue is recognized when there is persuasive evidence of an arrangement, the fee is fixed or determinable, delivery of the product to the customer has occurred and the Company has determined that collection of the fee is probable. Title to the product passes upon shipment of the product, as the products are typically shipped FOB shipping point, except for certain foreign shipments. If the product requires installation to be performed by the Company, all revenue related to the product is deferred and recognized upon the completion of the installation. If the product requires specific customer acceptance, revenue is deferred until customer acceptance occurs or the acceptance provisions lapse, unless the Company can objectively and reliably demonstrate that the criteria specified in the acceptance provisions are satisfied. When appropriate the Company provides for a warranty reserve at the time the product revenue is recognized.  If a contract involves the provisions of multiple elements and the elements qualify for separation under EITF 00-21, Revenue Arrangements with Multiple Deliverables, total estimated contact revenue is allocated to each element based on the relative fair value of each element provided.  The amount of revenue allocated to each element is limited to the amount that is not

 

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Table of Contents

 

contingent upon the delivery of another element in the future.  Revenue is recognized on each element as described above.

 

The Company performs funded research and development and product development for commercial companies and government agencies under both cost reimbursement and fixed-price contracts. Product development revenue is included in product revenue. Cost reimbursement contracts provide for the reimbursement of allowable costs and, in some situations, the payment of a fee. These contracts may contain incentive clauses providing for increases or decreases in the fees depending on how costs compare with a budget. On fixed-price contracts, revenue is generally recognized on the percentage of completion method based upon the proportion of costs incurred to the total estimated costs for the contract. Revenue from reimbursement contracts is recognized as the services are performed. In each type of contract, the Company receives periodic progress payments or payments upon reaching interim milestones. All payments to the Company for work performed on contracts with agencies of the U.S. government are subject to audit and adjustment by the Defense Contract Audit Agency. Adjustments are recognized in the period made. When the current estimates of total contract revenue for commercial product development contracts indicate a loss, a provision for the entire loss on the contract is recorded. As of June 28, 2008 and December 31, 2007, the Company has accrued $1.4 million and $1.3 million, respectively, for anticipated contract losses on commercial contracts. The Company recorded a charge to operations of approximately $0.1 million during the six month period ended June 28, 2008.

 

Cost of product revenue includes materials, labor and overhead. Costs incurred in connection with funded research and development and other revenue arrangements are included in research and development and other revenue expenses.

 

Deferred revenue consists of payments received from customers in advance of services performed, product shipped or installation completed.

 

Unbilled Contract Costs and Fees and Funded Research and Development Costs in Excess of Billings

 

Unbilled contract costs and fees represent revenue recognized in excess of amounts billed due to contractual provisions or deferred costs that have not been recognized as revenue or billed to the customer.

 

Cash and Cash Equivalents

 

Cash and cash equivalents include demand deposits, overnight repurchase agreements with Silicon Valley Bank (the “Bank”) and highly liquid investments with maturities of three months or less when acquired. Cash equivalents are stated at cost, which approximates market value. At June 28, 2008, the Company had approximately $9.2 million invested in a money market account with a national bank. At June 28, 2008 and December 31, 2007, the Company had restricted cash of approximately $84,000, of which $34,000 related to the security deposit requirement, which is backed by a stand-by letter of credit, and $50,000 related to a certificate of deposit backing up the Company’s credit cards. In addition, at June 28, 2008 and December 31, 2007, the Company had overnight repurchase agreements with the Bank of $112,605 and $1,763,502, respectively.

 

Accounts Receivable

 

Accounts receivable are reduced by an allowance for amounts that may become uncollectible in the future. The estimated allowance for uncollectible amounts is based primarily on a specific analysis of accounts in the receivable portfolio and historical write-off experience. While management believes the allowance to be adequate, if the financial condition of our customers were to deteriorate, resulting in impairment of their ability to make payments, additional allowances may be required.

 

Inventory

 

Inventory is stated at the lower of cost or market and costs are determined based on the first-in, first-out method of accounting and include material, labor and manufacturing overhead costs.  The Company periodically reviews quantities of inventory on hand and compares these amounts to expected usage of each particular product or product line. The Company records, as a charge to cost of sales, any amounts required to reduce the carrying value to net realizable value.

 

8



Table of Contents

 

Foreign Currency Translation

 

The functional currency of the Company’s foreign subsidiary is the local currency. Assets and liabilities of foreign subsidiaries are translated at the rates in effect at the balance sheet date, while stockholders’ equity including the long-term portion of intercompany advances is translated at historical rates. Statements of operations and cash flow amounts are translated at the average rate for the period. Translation adjustments are included as a component of accumulated other comprehensive income (loss). Foreign currency gains and losses arising from transactions that are included as a component of other income (expense) were approximately income of $35,000 of income for the six months ended June 28, 2008 and were $77,000 for the six months ended June 30, 2007.   Foreign currency gains (losses) included as a component of cost of goods sold were income of approximately $0.2 million and approximately $0.0 for the six months ended June 28, 2008 and June 30, 2007, respectively.

 

Use of Estimates

 

The preparation of 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 financial statements and the reported amounts of revenue and expenses during the period reported. Management believes the most significant estimates include the net realizable value of accounts receivable and inventory, the recoverability of long-lived assets and intangible assets, the accrued contract losses on fixed-price contracts, the recoverability of deferred tax assets and the fair value of equity and financial instruments.  Actual results could differ from these estimates.

 

Income Taxes

 

The Company accounts for income taxes in accordance with SFAS No. 109, Accounting for Income Taxes, which is the asset and liability method for accounting and reporting for income taxes. Under SFAS No. 109, deferred tax assets and deferred tax liabilities are recognized based on temporary differences between the financial reporting and income tax basis of assets and liabilities using statutory rates. In addition, SFAS No. 109 requires a valuation allowance against net deferred tax assets if, based upon the available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized.

 

In June 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109” (“FIN 48”).  FIN 48 requires companies to recognize the tax benefits of uncertain tax positions only where the position is “more likely than not” to be sustained assuming examination by tax authorities.  The amount recognized is the amount that represents the largest amount of tax benefit that is greater than 50% likely of being ultimately realized.  A liability is recognized for any benefit claimed, or expected to be claimed, in a tax return in excess of the benefit recorded in the financial statements, along with any interest and penalties (if applicable) on that excess.  FIN 48 requires a tabular reconciliation of the change in the aggregate unrecognized tax benefits claimed, or expected to be claimed, in tax returns and disclosure relating to the accrued interest and penalties for unrecognized tax benefits.  Discussion is also required for those uncertain tax positions where it is reasonably possible that the estimate of the tax benefit will change significantly in the next twelve months.

 

The Company adopted the provisions of FIN 48 on January 1, 2007.  The Company did not recognize any change in the liability for unrecognized tax benefits as a result of the adoption.

 

The tax years 2002 through 2007 remain open to examination by major taxing jurisdictions to which the Company is subject, which are primarily in the United States, as carryforward attributes generated in years past may still be adjusted upon examination by the Internal Revenue Service or state tax authorities if they are or will be used in a future period.  The Company is currently not under examination by the Internal Revenue Service or any other jurisdiction for any tax years.  The Company did not recognize any interest and penalties associated with unrecognized tax benefits in the accompanying financial statements.  The Company would record any such interest and penalties as a component of interest expense.  The Company does not expect any material changes to the unrecognized benefits within 12 months of the reporting date.

 

Accounting for Stock-based Compensation

 

The Company has several stock-based employee compensation plans, as well as stock options issued outside of such plans as an inducement to engage new executives.  The Company adopted Statement of Financial Accounting Standards No. 123R (“SFAS 123R”) Accounting for Stock-based Compensation, using the modified prospective method, which results in the provisions of SFAS 123R only being applied to the consolidated financial statements on a going-forward basis (that is, the prior period results have not been restated).  Under the fair value recognition provisions of SFAS 123R, stock-based compensation cost is measured at the grant date based on the value of the award and is recognized as expense over the service period.  Previously, the Company had followed Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations, which resulted in the accounting

 

9



Table of Contents

 

for employee share options at their intrinsic value in the consolidated financial statements.

 

On March 29, 2005, the SEC issued SAB 107 which expresses the view of the SEC regarding the interaction between SFAS No. 123R and certain SEC rules and regulations concerning the valuation of share-based payment arrangements for public companies. In particular, SAB 107 provides guidance related to share-based payment transactions with non-employees, the transition from nonpublic to public entity status, valuation methods (including assumptions such as expected volatility and expected term), the accounting for certain redeemable financial instrument issues under shares-based payment arrangements, the classification of compensation expense, non-GAAP financial measures, first-time adoption of SFAS No. 123R in an interim period, capitalization of compensation costs related to share-based payment arrangements, the accounting for income tax effects of share-based payment arrangements, the accounting for income tax effects of share-based payment arrangements upon adoption of SFAS No. 123R, the modification of employee share options prior to adoption of SFAS No. 123R, and disclosures in Management’s Discussion and Analysis of Financial Condition and Results of Operations subsequent to adoption of SFAS No. 123R. The Company has accounted for its stock option grants in compliance with SAB 107 and Staff Accounting Bulletin No. 110, Year-End Help for Expensing Employee Stock Options (SAB No. 110).

 

On November 10, 2005, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position SFAS 123R-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 the FASB Staff Position for calculating the tax effects (if any) of stock-based compensation expense pursuant to SFAS 123R.  The alternative transition method includes simplified methods to establish the beginning balance of the additional paid-in capital pool related to the tax effects of employee stock-based compensation, and to determine the subsequent impact to the additional paid-in capital pool and the consolidated statements of operations and cash flows of the tax effects of employee stock-based compensation awards that are outstanding upon adoption of SFAS 123R.

 

The Company uses historical volatility as it believes it is more reflective of market conditions and a better indicator of volatility. The Company uses the simplified calculation of expected life described in the SAB No. 107 and SAB No. 110. If the Company determines that another method used to estimate expected volatility was more reasonable than our current methods, or if another method for calculating these input assumptions was prescribed by authoritative guidance, the fair value calculated for share-based awards could change significantly. Higher volatility and longer expected lives result in an increase to share-based compensation determined at the date of grant.

 

The Company recognized the full impact of its share-based compensation arrangements in the consolidated financial statements for the three and six months ended June 28, 2008 and  June 30, 2007 under SFAS 123R and did not capitalize any such costs on the consolidated balance sheets, as such costs that qualified for capitalization were not material.  The following table presents share-based compensation expense included in the Company’s consolidated statement of operations:

 

 

 

Three Months Ended

 

Six Months Ended

 

 

 

June 28, 
2008

 

June 30, 
2007

 

June 28,  
2008

 

June 30, 
 2007

 

Cost of product revenue

 

$

24,438

 

$

12,465

 

$

50,614

 

$

24,932

 

Funded research and development and other revenue expense

 

26,795

 

20,793

 

53,590

 

41,922

 

Unfunded research and development and other revenue expenses

 

13,693

 

 

26,445

 

 

Selling, general and administrative expenses

 

698,706

 

183,940

 

778,998

 

270,042

 

Share based compensation expense before tax

 

$

763,632

 

$

217,198

 

$

909,647

 

$

336,896

 

Income tax benefit

 

 

 

 

 

Net compensation expense

 

$

763,632

 

$

217,198

 

$

909,647

 

$

336,896

 

 

Compensation expense associated with the granting of stock options to employees is being recognized on a straight-line basis over the service period of the option.  In instances where the actual compensation expense would be greater than that calculated using the straight-line method, the actual compensation expense is recorded in that period.

 

During the period ended June 28, 2008, the Company accelerated unvested options for one of its senior executives.  In addition, the Company extended the time to exercise these options, normally ninety days, to two years from the date of his last day of employment.  As a result, the Company recorded a  non-cash restructuring charge of approximately $146,000, of which approximately $39,000 related to the acceleration of unvested options and $107,000 related to the extension of time to exercise these options.  The company valued this extension using a Black-Scholes option pricing model.

 

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The weighted average grant date fair value of options granted during the three and six months ended June 28, 2008 and June 30, 2007 were $1.96 and $1.95 and $1.18 and $1.17, respectively, per option.  The fair value of each stock option is estimated on the date of the grant using the Black-Scholes option-pricing model with the following range of assumptions:

 

 

 

Three Months Ended

 

Six Months Ended

 

Assumptions:

 

June 28, 2008

 

June 30, 2007

 

June 28, 2008

 

June 30, 2007

 

Expected life (1)

 

5.0 years - 6.25 years

 

5.0 years - 6.25 years

 

5.0 years - 6.25 years

 

5.0 years - 6.25 years

 

Expected volatility range (2)

 

80.1% - 84.5%

 

84.7% - 86.21%

 

80.1% - 89.5%

 

84.7% - 89.9%

 

Dividends

 

none

 

none

 

none

 

none

 

Risk-free interest rate (3)

 

2.8% - 3.0%

 

4.8

%

2.70% – 3.16%

 

4.5% - 4.8%

 

Forfeiture Rate (4)

 

6.25%

 

6.25%

 

6.25%

 

6.25%

 

 


(1)

 

The option life was determined using the simplified method for estimating expected option life, which qualify as “plain-vanilla” options.

(2)

 

The stock volatility for each grant is measured using the weighted average of historical daily price changes of the Company’s common stock over the most recent period equal to the expected option life of the grant, the historical short term trend of the option and other factors, such as expected changes in volatility arising from planned changes in the Company’s business operations.

(3)

 

The risk-free interest rate for each grant is equal to the U.S. Treasury yield curve in effect at the time of grant for instruments with a similar expected life.

(4)

 

The estimated forfeiture rate for each option grant is 6.25%.  At the time SFAS 123R was adopted, all outstanding stock options were vested.  The Company periodically reviews the estimated forfeiture rate, in light of actual experience.

 

Concentration of Credit Risk

 

Financial instruments that subject the Company to concentrations of credit risk principally consist of cash equivalents, trade accounts receivable, unbilled contract costs and deposits in bank accounts.   The Company deposits its cash and invests in short-term investments primarily through a national commercial bank. Deposits in excess of amounts insured by the Federal Deposit Insurance Corporation (FDIC) are exposed to loss in the event of nonperformance by the institution. The Company has had cash deposits in excess of the FDIC insurance coverage.

 

The Company’s trade accounts receivable and unbilled contract costs and fees are primarily from sales to U.S. government agencies and commercial customers. The Company does not require collateral and has not historically experienced significant credit losses related to receivables or unbilled contract costs and fees from individual customers or groups of customers in any particular industry or geographic area.

 

Research and Development Costs

 

The Company expenses research and development costs as incurred. Research and development and other revenue expenses include costs incurred in connection with both funded research and development and other revenue arrangements and unfunded research and development activities.

 

Comprehensive Income (Loss)

 

Comprehensive income (loss) includes net loss and foreign currency translation adjustments.

 

Fair Value of Financial Instruments

 

The Company’s financial instruments consist of cash equivalents, accounts receivable, unbilled contract costs and fees, warrants to purchase shares of common stock, accounts payable, debt instruments, convertible notes, Series B Preferred Stock and Series C Preferred Stock. The estimated fair values of these financial instruments approximate their carrying values at June 28, 2008 and December 31, 2007. The estimated fair values have been determined through information obtained from market sources and management estimates.   The Company’s warrant liability is recorded at fair value.  See “Fair Value Measurement” section below.

 

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Table of Contents

 

Fair Value Measurements

 

Effective January 1, 2008, the Company adopted SFAS No. 157, “Fair Value Measurements” (“SFAS 157”). In February 2008, the FASB issued FASB Staff Position No. FAS 157-2, “Effective Date of FASB Statement No. 157,” which provides a one year deferral of the effective date of SFAS 157 for non-financial assets and non-financial liabilities, except those that are recognized or disclosed in the financial statements at fair value at least annually. Therefore, the Company has adopted the provisions of SFAS 157 with respect to its financial assets and liabilities only. SFAS 157 defines fair value, establishes a framework for measuring fair value under generally accepted accounting principles and enhances disclosures about fair value measurements. Fair value is defined under SFAS 157 as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Valuation techniques used to measure fair value under SFAS 157 must maximize the use of observable inputs and minimize the use of unobservable inputs. The standard describes a fair value hierarchy based on three levels of inputs, of which the first two are considered observable and the last unobservable, that may be used to measure fair value which are the following:

 

·

 

Level 1 - Quoted prices in active markets for identical assets or liabilities.

 

 

 

·

 

Level 2 - Inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.

 

 

 

·

 

Level 3 - Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.

 

The adoption of this statement did not have a material impact on the Company’s consolidated results of operations and financial condition. Level 1 financial assets measured at fair value on a recurring basis consist of money market funds (cash equivalents) of approximately $9.2 million as of June 28, 2008.  Level 2 financial assets measured at fair value on a recurring basis consist of long-term investor warrant liabilities of approximately $5.5 million as of June 28, 2008 (see Note J. Convertible Debt Instruments and Warrant Liabilities Valuation – Methodology and Significant Assumptions).  The Company has no Level 3 financial assets measured at fair value on a recurring basis as of June 28, 2008. Within the Company’s Level 2 financial assets, which consists of the Warrant As, Warrant Cs and the placement agent warrants, the Warrant As and Warrant Cs are being fair valued utilizing a binomial lattice model and the placement agent warrants are being fair valued using a Black-Scholes option pricing model.

 

Convertible Debt Instruments and Warrant Liabilities

 

The Company accounted for its senior secured convertible notes (the “Convertible Notes”), which were paid off on November 7, 2007, and continues to account for the associated warrants in accordance with SFAS 155, Accounting for Certain Hybrid Financial Instruments - an amendment of FASB Statements No. 133 and 140, and SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, (SFAS 155).  The Convertible Notes included features that qualify as embedded derivatives, such as (i) the holders’ conversion option, (ii) the Company’s option to settle the Convertible Notes at the scheduled dates in cash or shares of its common stock, and (iii) premiums and penalties the Company would be liable to pay in the event of default.  As permitted under SFAS 155, the Company has irrevocably elected, as of January 1, 2007, to measure the Convertible Notes and embedded derivatives in their entirety at fair value with changes in fair value recognized as either gain or loss.

 

The Company recorded interest expense under the Convertible Notes based on the greater of (i) 7% or (ii) the six-month LIBOR in effect at the time plus 350 basis points, as well as the amortization of the debt discount, which the Company computed using the effective interest method.  The debt discount represented the difference between the Company’s gross proceeds from the sale of the Convertible Notes in July 2006 of $12.0 million and the fair value of the convertible debt upon issuance, after separately valuing the investor warrants, the placement agent warrants and the Convertible Notes on a relative fair value basis.  By amortizing the debt discount to interest expense, rather than recognizing it as a change in fair value of the convertible debt instrument and warrants, which is a separate line item in the Company’s statement of operations, the Company believes its interest expense line item more appropriately reflects the cost of the debt associated with the Convertible Notes.

 

The Company determined the fair values of the Convertible Notes, investor warrants and placement agent warrants using valuation models it considers to be appropriate. The Company’s stock price has the most significant influence on the fair value of its Convertible Notes and related warrants. An increase in the Company’s common stock price would cause the fair values of both the Convertible Notes and warrants to increase, because the conversion and exercise prices, respectively, of such instruments are fixed at $1.65 and $1.815 per share, respectively, and result in a charge to our statement of operations. A decrease in the Company’s stock

 

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Table of Contents

 

price would likewise cause the fair value of the Convertible Notes and the warrants to decrease and result in a credit to our statement of operations. If the price of the Company’s common stock were to decline significantly, however, the decrease in the fair value of the Convertible Notes would be limited by the instrument’s debt characteristics. Under such circumstances, the Company’s estimated cost of capital would become another significant variable affecting the fair value of the Convertible Notes.

 

Redeemable Convertible Series B Preferred Stock

 

The Company accounts for its Series B Preferred Stock and associated warrants in accordance with in accordance with EITF 00-27, Application of Issue No. 98-5 to Certain Convertible Instruments, allocating the proceeds received net of transaction costs based on the relative fair value of the redeemable convertible Series B Preferred Stock and the warrants issued to the investors, and then to any beneficial conversion rights contained in the convertible redeemable preferred securities.  The Company determined the initial value of the Series B Preferred Stock and investor warrants using valuation models it considers to be appropriate.  The Series B Preferred Stock is classified within the liability section of the Company’s balance sheet.  To the extent that the Series B Preferred Stock is subject to a remeasurement event under EITF Topic D-98 or is otherwise modified, the Series B Preferred Stock will be reclassified to temporary equity.

 

Redeemable Convertible Series C Preferred Stock

 

The Company accounts for its Convertible Series C Preferred Stock (the “Series C Preferred Stock”), and associated warrants in accordance with in accordance with EITF 00-27, Application of Issue No. 98-5 to Certain Convertible Instruments, allocating the proceeds received net of transaction costs based on the relative fair value of the redeemable convertible Series C Preferred Stock and the warrants issued to the Investors, and then to any beneficial conversion rights contained in the convertible redeemable preferred securities and in accordance with EITF Topic D-98, classifying the Series C Preferred Stock as temporary equity on the balance sheet between the captions for liabilities and shareholder’s equity.  The Company determined the initial value of the Series C Preferred Stock and investor warrants using valuation models it considers to be appropriate.  The Company is using the effective interest method to accrete the carrying value of the Series C Preferred stock through the earliest possible redemption date (November 8, 2011), at which time the value of the Series C Preferred Stock would be $30.0 million or 120% of its face value.

 

Note D. Loss per Share

 

The following is the reconciliation of the numerators and denominators of the basic and diluted per share computations of net loss:

 

 

 

Three Months Ended

 

Six Months Ended

 

 

 

June 28, 
2008

 

June 30, 
2007

 

June 28, 
2008

 

June 30, 
2007

 

Net loss attributable to common shareholders

 

$

(9,121,457

)

$

(3,735,644

)

$

(13,464,611

)

$

(7,121,027

)

Basic and diluted:

 

 

 

 

 

 

 

 

 

Common shares outstanding, beginning of period

 

49,961,607

 

42,113,810

 

49,803,979

 

40,105,073

 

Weighted average common shares issued during the period

 

453,193

 

755,663

 

370,881

 

2,026,994

 

 

 

 

 

 

 

 

 

 

 

Weighted average shares outstanding—basic and diluted

 

50,414,800

 

42,869,473

 

50,174,860

 

42,132,067

 

 

 

 

 

 

 

 

 

 

 

Net loss per weighted average share, basic and diluted

 

$

(0.18

)

$

(0.09

)

$

(0.27

)

$

(0.17

)

 

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Table of Contents

 

As of June 28, 2008 and June 30, 2007, shares of common stock issuable upon the exercise of options and warrants were excluded from the diluted average common shares outstanding, as their effect would have been antidilutive.  In addition, shares of common stock issuable upon the conversion of Series B and Series C Preferred Stock were excluded from the diluted weighted average common shares outstanding as their effect would also have been anti-dilutive.   The table below summarizes the option and warrants and convertible preferred stock that were excluded from the calculation above due to their effect being antidilutive:

 

 

 

June 28, 
2008

 

June 30, 
2007

 

Common Stock issuable upon the exercise of:

 

 

 

 

 

Options

 

9,548,307

 

4,000,370

 

Warrants

 

26,498,383

 

11,097,308

 

Total Options and Warrants excluded

 

36,046,690

 

15,097,678

 

Common stock issuable upon the conversion of senior secured convertible notes, at conversion price of $1.65 per share

 

 

5,454,545

 

Common Stock issuable upon the conversion of redeemable convertible Series B Preferred Stock

 

1,096,774

 

858,024

 

Common Stock issuable upon the conversion of redeemable convertible Series C Preferred Stock

 

24,038,461

 

 

 

 

61,181,925

 

21,410,247

 

 

The Company reports net loss per basic and diluted common share in accordance with SFAS No. 128, Earnings Per Share, which establishes standards for computing and presenting earnings per share. Basic earnings per share excludes dilution and is computed by dividing income attributable to common stockholders by the weighted average number of common shares outstanding for the period. Diluted earnings per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the Company, except when the effect would be anti-dilutive.  The table below details out shares of common stock underlying securities for which the securities would have been considered dilutive at June 28, 2008 and June 30, 2007 had the Company not been in a loss position:

 

 

 

# of Underlying
 Common Shares

 

 

 

June 28, 
2008

 

June 30, 
2007

 

Employee stock options

 

2,714,000

 

395,700

 

Warrants to purchase common stock

 

26,498,383

 

39,842

 

Series B Convertible Preferred Stock

 

1,096,774

 

858,024

 

Series C Convertible Preferred Stock

 

24,038,461

 

 

Common stock issuable upon the conversion of senior secured Convertible Notes, at conversion price of $1.65 per share

 

 

5,454,545

 

Total

 

54,347,618

 

6,748,111

 

 

Note E. Inventory

 

Inventory components at the end of each period were as follows:

 

 

 

June 28, 
2008

 

December 31, 
2007

 

Raw material

 

6,532,543

 

$

5,088,428

 

Work-in-process

 

12,241,761

 

10,125,641

 

Finished goods

 

2,091,042

 

1,976,355

 

 

 

$

20,865,346

 

$

17,190,424

 

 

14



Table of Contents

 

Note F. Segment Disclosures

 

The Company’s organizational structure is based on strategic business units that perform services and offer various products to the principal markets in which the Company’s products are sold. These business units equate to four reportable segments: Applied Technology, Power Systems, US, Power Systems, Canada and Electronics.

 

SatCon Applied Technology, Inc. performs research and development services in collaboration with third parties. SatCon Power Systems, Canada, Ltd. specializes in the engineering and manufacturing of power systems. Satcon Power Systems, US specializes in the engineering and manufacturing of electric motors and hybrid electric automobile systems.  SatCon Electronics, Inc. designs and manufactures electronic products. The Company’s principal operations and markets are located in the United States.

 

The accounting policies of each of the segments are the same as those described in the summary of significant accounting policies. The Company evaluates performance based on revenue and profit and loss from operations, including amortization of intangibles. Common costs not directly attributable to a particular segment are included in the corporate segment. These costs include corporate costs such as executive officer compensation, facility costs, legal, audit and tax and other professional fees.

 

The following is a summary of the Company’s operations by operating segment:

 

 

 

Three Months Ended

 

Six Months Ended

 

 

 

June 28,

 

June 30,

 

June 28,

 

June 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

Applied Technology:

 

 

 

 

 

 

 

 

 

Funded research and development and other revenue

 

$

3,807,450

 

$

1,774,666

 

$

4,991,128

 

$

3,559,845

 

Income (loss) from operations

 

$

41,001

 

$

(193,267

)

$

(486,264

)

$

(376,367

)

Power Systems, US

 

 

 

 

 

 

 

 

 

Product revenue

 

939,283

 

$

2,037,616

 

$

1,867,853

 

$

2,772,851

 

Income (loss) from operations

 

$

(309,005

)

$

345,942

 

$

(552,382

)

$

(411,411

)

Power Systems, Canada:

 

 

 

 

 

 

 

 

 

Product revenue

 

$

9,555,891

 

$

5,244,536

 

$

19,731,809

 

$

8,848,208

 

Loss from operations

 

$

(2,734,087

)

$

(2,751,268

)

$

(4,207,457

)

$

(4,157,819

)

Electronics:

 

 

 

 

 

 

 

 

 

Product revenue

 

$

2,634,987

 

$

2,637,334

 

$

5,232,989

 

$

4,831,013

 

Loss from operations

 

$

(236,051

)

$

(206,579

)

$

(472,803

)

$

(329,415

)

Corporate:

 

 

 

 

 

 

 

 

 

Loss from operations

 

$

(2,288,541

)

$

(700,952

)

$

(2,817,856

)

$

(1,251,689

)

Consolidated:

 

 

 

 

 

 

 

 

 

Product revenue

 

$

13,130,161

 

$

9,919,486

 

$

26,832,651

 

$

16,452,072

 

Funded research and development and other revenue

 

$

3,807,450

 

$

1,774,666

 

4,991,128

 

$

3,559,845

 

Total revenue

 

16,937,611

 

$

11,694,152

 

$

31,823,779

 

$

20,011,917

 

 

 

 

 

 

 

 

 

 

 

Operating loss

 

$

(5,526,683

)

$

(3,506,124

)

$

(8,536,762

)

$

(6,526,701

)

Change in fair value of Notes and Warrants

 

(2,396,717

)

385,035

 

(2,864,198

)

584,628

 

Other expense, net

 

(64,509

)

(24,925

)

(10,777

)

(65,479

)

Interest income

 

70,886

 

36,692

 

140,271

 

122,231

 

Interest expense

 

(98,634

)

(626,322

)

(145,391

)

(1,235,706

)

Net loss

 

$

(8,015,657

)

$

(3,735,644

)

$

(11,416,857

)

$

(7,121,027

)

 

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Table of Contents

 

Common assets not directly attributable to a particular segment are included in the Corporate segment. These assets include cash and cash equivalents, prepaid and other corporate assets.  The following is a summary of the Company’s assets by operating segment:

 

 

 

June 28, 
2008

 

December 31, 
2007

 

Applied Technology:

 

 

 

 

 

Segment assets

 

$

2,382,204

 

$

4,498,602

 

Power Systems, US:

 

 

 

 

 

Segment assets

 

$

2,664,822

 

2,697,828

 

Power Systems, Canada

 

 

 

 

 

Segment assets

 

24,719,532

 

20,897,103

 

Electronics:

 

 

 

 

 

Segment assets

 

6,896,269

 

6,070,848

 

Corporate:

 

 

 

 

 

Segment assets

 

10,103,174

 

12,444,296

 

Total assets

 

$

46,766,001

 

$

46,608,677

 

 

The Company operates and markets its services and products on a worldwide basis with its principal markets as follows:

 

 

 

Three Months Ended

 

Six Months Ended

 

 

 

June 28, 
2008

 

June 30, 
2007

 

June 28, 
2008

 

June 30, 
2007

 

Revenue by geographic region based on location of customer:

 

 

 

 

 

 

 

 

 

United States

 

$

15,025,611

 

$

10,184,541

 

$

28,931,712

 

$

17,985,058

 

Rest of world

 

1,912,000

 

1,509,611

 

2,892,067

 

2,026,859

 

Total revenue

 

$

16,937,611

 

$

11,694,152

 

$

31,823,779

 

$

20,011,917

 

 

 

 

June 28,

 

December 31,

 

 

 

2008

 

2007

 

Long-lived assets (including goodwill and intangible assets) by geographic region based on location of operations:

 

 

 

 

 

United States

 

$

2,933,086

 

$

3,258,009

 

Rest of world

 

1,346,470

 

1,299,743

 

Total long-lived assets (including goodwill and intangible assets)

 

$

4,279,556

 

$

4,557,752

 

 

Note G. Legal Matters

 

From time to time, the Company is a party to routine litigation and proceedings in the ordinary course of business.

 

On May 9, 2008, Advanced Energy Industries, Inc. (“AE”) filed a civil action in Colorado state court against the Company and its Chief Executive Officer, Charles S. Rhoades, seeking to enjoin Mr. Rhoades from employment by the Company based upon its claim that Mr. Rhoades was subject to a non-competition agreement with AE. On May 12, 2008, after a preliminary hearing, the Colorado court denied AE’s request for a temporary restraining order, ruling that AE had failed to meet its burden of demonstrating a reasonable likelihood of success on the merits of its claim. On July 1, 2008 and after an evidentiary hearing, the court denied AE’s request for a preliminary injunction, again finding that AE had not demonstrated a reasonable likelihood of success on the merits. Currently pending before the court is the Company’s motion to dismiss this action in its entirety.  The Company denies that there is any merit to the claims made by AE and intends to defend this matter vigorously through what it strongly believes will be a favorable conclusion.

 

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Table of Contents

 

Note H. Commitments and Contingencies

 

Operating Leases

 

The Company leases its facilities under various operating leases that expire through October 2011.

 

Future minimum annual rentals under lease agreements at June 28, 2008 are as follows:

 

Fiscal Year

 

 

 

2008

 

$

639,215

 

2009

 

$

1,078,196

 

2010

 

$

523,797

 

2011

 

$

159,408

 

2012

 

$

 

Thereafter

 

$

 

Total

 

$

2,400,616

 

 

Letters of Credit:

 

The Company utilizes a standby letter of credit to satisfy a security deposit requirement. Outstanding standby letters of credit as of June 28, 2008 and December 31, 2007 were $34,000, respectively.  The Company is required to pledge cash as collateral on these outstanding letters of credit. As of June 28, 2008 and December 31, 2007, the cash pledged as collateral for these letters of credit was $34,000, respectively, and is included in restricted cash and cash equivalents on the balance sheet.

 

Employment Agreements:

 

The Company has employment agreements with certain employees that provide severance payments and accelerated vesting of options upon termination of employment under certain circumstances or a change of control, as defined in the employment agreements. As of June 28, 2008 and December 31, 2007, the Company’s potential obligation to these employees was approximately $1.0 million and $500,000, respectively.

 

Line of Credit

 

On February 26, 2008, the Company entered into a Loan and Security Agreement (the “New Loan Agreement”) with a Bank.  Under the terms of the New Loan Agreement, the Bank agreed to provide the Company with a credit line up to $10.0 million.  The Company’s obligations under the New Loan Agreement are secured by substantially all of the assets of the Company and advances under the New Loan Agreement are limited to 80% of eligible receivables and the lesser of 25% of the value of the Company’s eligible inventory, as defined, or $1.0 million.  Interest on outstanding borrowings accrues at a rate per annum equal to the Prime Rate plus one percent (1.0%) per annum, as defined, or the LIBOR Rate plus three and three quarter percent (3.75%) per annum.  The New Loan Agreement contains certain financial covenants relating to tangible net worth, as defined, which the Company must satisfy in order to borrow under agreement.  In addition the Company agreed to pay to the Bank a collateral monitoring fee of $750 per month and agreed to the following additional terms: (i) $50,000 commitment fee, $25,000 to be paid at signing of the New Loan Agreement and $25,000 to be paid on the one year anniversary of the New Loan Agreement; (ii) an unused line fee in the amount of 0.5% per annum of the average unused portion of the revolving line; and (iii) an early termination fee of 0.5% of the total credit line if the Company terminates the New Loan Agreement prior to 12 months from the New Loan Agreement’s effective date.  The New Loan Agreement, if not sooner terminated in accordance with its terms, expires on February 25, 2010.  As of June 28, 2008, the Company had $3.0 million outstanding under the New Loan Agreement and the Bank’s prime rate was 5%. The Company has certain financial covenants related to this agreement. The Company obtained a waiver as of June 28, 2008.

 

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Table of Contents

 

Note I. Product Warranties

 

In its Power Systems divisions the Company provides a warranty to its customers for most of its products sold.  In general the Company’s warranties are for one year after the sale of the product, and five or ten years for photovoltaic inverters.  The Company reviews its warranty liability quarterly.  Factors taken into consideration when evaluating the Company’s warranty reserve are (i) historical claims for each product, (ii) the development stage of the product, (iii) volume increases, (iv) life of warranty and (v) other factors.  To the extent actual experience differs from the Company’s estimates the provision for product warranties will be adjusted in future periods.  Such differences may be significant.

 

The following is a summary of the Company’s accrued warranty activity for the following periods:

 

 

 

Three Months Ended

 

Six Months Ended

 

 

 

June 28,
2008

 

June 30,
2007

 

June 28,
2008

 

June 30,
2007

 

Balance at beginning of period

 

$

2,345,794

 

$

680,165

 

$

2,031,278

 

$

679,747

 

Provision

 

465,603

 

397,635

 

973,037

 

503,588

 

Usage

 

(195,745

)

(155,689

)

(388,663

)

(261,224

)

Balance at end of period

 

$

2,615,652

 

$

922,111

 

$

2,615,652

 

$

922,111

 

 

Note J. Convertible Debt Instruments and Warrant Liabilities

 

Features of the Convertible Notes and Warrants

 

On July 19, 2006, the Company entered into a Securities Purchase Agreement (the “Purchase Agreement”) with the purchasers named therein (the “Purchasers”) in connection with the private placement (the “Private Placement”) of:

 

·                  $12,000,000 aggregate principal amount of senior secured convertible notes (the “Convertible Notes”), convertible into shares of the Company’s common stock at a conversion price of $1.65 per share;

 

·                 Warrant As to purchase up to an aggregate of 3,636,368 shares of the Company’s common stock at a price of $1.815 per share for a period beginning six months from the date of such warrants and ending on the seventh anniversary of the date of such warrants; and

 

·                 Warrant Bs to purchase up to an aggregate of 3,636,368 shares of the Company’s common stock at a price of $1.68 per share for a period of 90 trading days beginning the later of six months from the date of such warrants and the date the Securities and Exchange Commission (the “SEC”) declares effective a shelf registration statement covering the resale of the common stock underlying the securities issued in the Private Placement (the “Registration Statement”); to the extent the Warrant Bs are exercised, the Purchasers were entitled to receive additional warrants (the Warrant Cs), as described below.  Because the registration statement was declared effective on September 27, 2006, these warrants were originally exercisable for the 90 trading day period beginning six months from the date of such warrants (i.e. until May 30, 2007). On December 20, 2006 the Warrant Bs were amended to extend the expiration date of the Warrant Bs issued in the Private Placement from May 30, 2007 to August 31, 2007. In addition, this amendment amended the definition of “Excluded Stock” set forth in the Purchase Agreement to enable the Company to issue up to 1.1 million shares of the Company’s common stock in connection with the early termination of the lease for the Company’s facility located in Worcester, Massachusetts, without such shares being subject to the Purchasers’ right of participation set forth in the Purchase Agreement and certain prohibitions set forth in the Convertible Notes and related warrants (the Company ultimately settled the lease for 850,000 shares).  The Warrant Bs were exercised in full on July 17, 2007 for $1.31 per share.  See below for a discussion related to the exercise of the Warrant Bs and the issuance of Warrant Cs to the holders as a result of such exercise.

 

In connection with the Private Placement, the Company also entered into a Security Agreement, dated July 19, 2006, with the Purchasers, pursuant to which the Company granted the Purchasers a security interest in all of its rights, title and interest in, to and under all of the Company’s personal property and other assets, including its ownership interest in the capital stock of its subsidiaries, as security for the prompt payment in full of all amounts due and owing under the Convertible Notes. The following is a summary of the material provisions of the Purchase Agreement, the Notes, the Warrant As, the Warrant Bs and the Warrant Cs.

 

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Table of Contents

 

Securities Purchase Agreement

 

As noted above, the Purchase Agreement provided for the issuance and sale to the Purchasers of the Convertible Notes, the Warrant As and the Warrant Bs for an aggregate purchase price of $12,000,000. Other significant provisions of the Purchase Agreement include:

 

·                  the requirement that the Company pay off all amounts outstanding under its previous credit facility with Silicon Valley Bank;

 

·                  for so long as the Convertible Notes were outstanding, the obligation that the Company offer to the Purchasers the opportunity to participate in subsequent securities offerings (up to 50% of such offerings), subject to certain exceptions for, among other things, certain underwritten public offerings and strategic alliances;

 

·                  for so long as the Convertible Notes were outstanding, the obligation that the Company not incur any indebtedness that is senior to, or on parity with, the Convertible Notes in right of payment, subject to limited exceptions for purchase money indebtedness and capital lease obligations.

 

On November 7, 2007, the Convertible Notes were retired by cash redemption.

 

Additionally, with respect to the common stock underlying the Warrant Cs issued in July 2007 upon exercise of the Warrant Bs, the Company was also obligated to (i) file a registration statement covering the resale of such common stock with the SEC within 30 days following the issuance of the Warrant Cs (which it has satisfied), (ii) use its best efforts to cause such registration statement to be declared effective within 60 days following the issuance of the Warrant Cs (or 90 days in the event of a review of such registration statement by the SEC) (which it has satisfied as such registration statement was declared effective on September 11, 2007) and (iii) use its best efforts to keep such registration statement effective until the earlier of (x) the fifth anniversary of the effective date of the registration statement, (y) the date all of the securities covered by the registration statement have been publicly sold and (z) the date all of the securities covered by the registration statement may be sold without restriction under SEC Rule 144.

 

Senior Secured Convertible Notes

 

The Convertible Notes originally had an aggregate principal amount of $12.0 million and were convertible into shares of the Company’s common stock at a conversion price of $1.65, subject to adjustment for stock splits, stock dividends, combinations, distributions of assets or evidence of indebtedness, mergers, consolidations, sales of all or substantially all assets, tender offers, exchange offers, reclassifications or compulsory share exchanges.

 

The Convertible Notes bore interest at the higher of (i) 7.0% per annum or (ii) the six-month LIBOR plus 3.5% (the “Stated Rate 6-Month LIBOR Condition”). Interest was payable quarterly, beginning on October 31, 2006, and could be paid in cash or, at the Company’s option if certain equity conditions (“Equity Conditions”) were satisfied, in shares of the Company’s common stock. If interest was paid in shares of common stock, the price per share was at a 10% discount to the volume weighted average price for the 20 trading days preceding the payment date.  The Equity Conditions included (1) the Company had sufficient authorized shares for issuance, (2) such shares were registered for resale or may be sold without volume restrictions pursuant to Rule 144 under the Securities Act, (3) the common stock was listed or quoted (and was not suspended from trading) on an eligible exchange and such shares were approved for listing upon issuance, (4) the issuance did not violate Section 6(c) of the Convertible Note or the rules and regulations of any trading market, (5) there had been no event of bankruptcy by the Company, (6) the Company was not in default with respect to any material obligation under any documents associated with issuance of the Convertible Notes and Warrants and (7) there had been no public announcement of a pending or proposed change of control that has not been consummated.

 

Seventy-five percent (75%) of the original principal amount of the Convertible Notes was to be repaid in 18 equal monthly installments ($500,000 per month) beginning on February 28, 2007. Such principal payments could be made in cash or, at the Company’s option if certain equity conditions were satisfied, in shares of common stock. If principal was paid in shares of common stock, the price per share was the lesser of (i) the conversion price or (ii) a 10% discount to the volume weighted average price for the 20 trading days preceding the payment date. At any time following the 24-month anniversary of the issuance of the Convertible Notes, the holders had the right to elect to require the Company to redeem for cash all or any portion of the outstanding principal on the Convertible Notes; provided, however, that on the 60 month anniversary of the issuance of the Convertible Notes, the Company would have been required to redeem any remaining outstanding principal and unpaid interest. Notwithstanding the foregoing, at any time following the one year anniversary of the effective date of the Registration Statement, the Company had the right, under certain circumstances, including satisfaction of the Equity Conditions with respect to the underlying shares, redeem the Convertible Notes for cash equal to 120% of the aggregate outstanding principal amount plus any accrued and unpaid interest.

 

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Table of Contents

 

The Convertible Notes were convertible at the option of the holders into shares of the Company’s common stock at any time at the conversion price. If at any time following the one year anniversary of the effective date of the Registration Statement, the volume weighted average price per share of common stock for any 20 consecutive trading days exceeded 175% of the conversion price, then, if certain conditions were satisfied, including the Equity Conditions, the Company could require the holders of the Convertible Notes to convert all or any part of the outstanding principal into shares of common stock at the conversion price. The Convertible Notes contained certain limitations on optional and mandatory conversion, including that, absent stockholder approval of the transaction; the Company could not issue shares of common stock under the Convertible Notes or the Warrant Bs, in the aggregate, in excess of 19.99% of our outstanding shares on the closing date (or 7,901,276 shares of common stock).  On October 19, 2007, the Company received stockholder approval allowing for the issuance of additional shares of the Company’s common stock sufficient to allow for the full conversion of the Company’s outstanding Convertible Notes, as well as the full payment of interest and principal on such notes, all in accordance with the terms of such notes.

 

The Convertible Notes contained certain covenants and restrictions, including, among others, the following (for so long as any Convertible Notes remained outstanding):

 

·                  the Company was required to maintain aggregate cash and cash equivalents equal to the greater of (i) $1,000,000 or (ii) $3,000,000 minus 80% of eligible receivables (as defined in the Convertible Notes);

 

·                  if a change of control of the Company occurred, as defined in the Convertible Notes, the holders may elect to require the Company to purchase the Convertible Notes for 115% of the outstanding principal amount plus any accrued and unpaid interest; and

 

·                  the Company could not issue any common stock or common stock equivalents at a price per share less than the $1.65 conversion price.

 

Events of default under the Convertible Notes included, among others, payment defaults, cross-defaults, breaches of any representation, warranty or covenant that was not cured within the proper time periods, failure to perform certain required activities in a timely manner, the Company’s common stock was no longer listed on an eligible market, the effectiveness of the Registration Statement lapsed beyond a specified period and certain bankruptcy-type events involving us or any significant subsidiary. Upon an event of default, the holders could elect to require us to repurchase all or any portion of the outstanding principal amount of the Convertible Notes for a purchase price equal to the greater of (i) 115% of such outstanding principal amount, plus all accrued but unpaid interest or (ii) 115% of the then value of the underlying common stock.

 

In July 2007, $533,895 of the Convertible Notes and accrued interest were converted into shares of common stock.  The Convertible Notes and accrued interest converted at $1.65 per share.  The Company issued 318,182 shares of common stock related to the conversion of the principal on the Convertible Notes and 5,391 shares of common stock related to the accrued interest due through the date of conversion as a result of the Convertible Note holders’ conversions.

 

Warrant As

 

The Warrant As originally entitled the holders thereof to purchase up to an aggregate of 3,636,368 shares of the Company’s common stock at a price of $1.815 per share for a period beginning six months from the date of such warrants and ending on the seventh anniversary of the date of such warrants.  The period prior to six months from the date of the warrants is hereinafter referred to as the “non-exercise period.” The exercise price and the number of shares underlying these warrants are subject to adjustment for stock splits, stock dividends, combinations, distributions of assets or evidence of indebtedness, mergers, consolidations, sales of all or substantially all assets, tender offers, exchange offers, reclassifications or compulsory share exchanges.

 

If a change of control of the Company occurs, as defined, the holders may elect to require us to purchase the Warrant As for a purchase price equal to the Black-Scholes value of the remaining unexercised portion of each Warrant A.

 

For so long as any Warrant As remain outstanding, we may not issue any common stock or common stock equivalents at a price per share less than $1.65. In the event of a breach of this provision, the holders may elect to require us to purchase the Warrant As for a purchase price equal to the Black-Scholes value of the remaining unexercised portion of each Warrant A.  As a result of the November 8, 2007 and December 20, 2007 preferred stock financing, as described in Note K below, the holders were entitled for a limited period of time (45 days after each issuance) to exercise this right.  During the fourth quarter of fiscal 2007, the Company paid approximately $1.4 million to redeem Warrant As representing 1,242,426 shares of common stock.  During the first quarter of fiscal 2008, the Company paid approximately $0.4 million to redeem Warrant As representing 303,031 shares of common stock.  (See table below for assumptions used in valuing the warrants redeemed during the six months ended June 28, 2008).  As of June 28, 2008,

 

20



Table of Contents

 

2,090,911 Warrant As to purchase common stock were outstanding.

 

If following the later of (i) the effective date of the Registration Statement and (ii) the six month anniversary of the issuance date, the volume weighted average price per share of our common stock for any 20 consecutive trading days exceeds 200% of the exercise price, then, if certain conditions are satisfied, including the Equity Conditions, we may require the holders of the Warrant As to exercise up to 50% of the unexercised portions of such warrants. If following the 24 month anniversary of the issuance date, the volume weighted average price per share of our common stock for any 20 consecutive trading days exceeds 300% of the exercise price, then, if certain equity conditions are satisfied, we may require the holders of the Warrant As to exercise all or any part of the unexercised portions of such warrants.

 

Warrant Bs

 

The Warrant Bs entitled the holders thereof to purchase up to an aggregate of 3,636,368 shares of our common stock at a price of $1.68 per share for a period of 90 trading days beginning the later of six months from the date of such warrants and the date the SEC declares effective the Registration Statement.  As noted above, as a result of an amendment, the expiration date of the Warrant Bs was extended to August 31, 2007.

 

On July 17, 2007, the holders of the Warrant Bs exercised such warrants in full, acquiring 3,636,638 shares of common stock at $1.31 per share.  The Company received proceeds of approximately $4.8 million.  To entice the holders of the Warrant Bs to exercise such warrants the Company reduced the exercise price from $1.68 to $1.31 per share.  As a result of reducing the exercise price the Company recorded a charge to operations in its fiscal third quarter ending September 29, 2007 related to the warrant modification of approximately $0.9 million to change in fair value of the Convertible Notes and warrants on the accompanying statement of operations.  Pursuant to the original terms of the Warrant Bs, upon exercise of the Warrant Bs, the warrant holders were entitled to receive additional warrants (“Warrant Cs”) to purchase a number of shares of common stock equal to 50% of the number of shares of common stock purchased upon exercise of the Warrant Bs.  As a result of the full exercise of the Warrant Bs, the holders received Warrant Cs to purchase 1,818,187 shares of common stock at an exercise price of $1.815 per share for a period beginning six months from the date of such warrants and ending on the seventh anniversary of the date of such warrants.

 

Warrant Cs

 

As discussed above, upon the exercise of the Warrant Bs, the holders were entitled to receive additional warrants (the “Warrant Cs”).  The Warrant Cs originally entitled the holders thereof to purchase up to an aggregate of 1,818,187 shares of our common stock at a price of $1.815 per share for a period beginning six months from the date of such warrants and ending on the seventh anniversary of the date of such warrants.  The period prior to six months from the date of the warrants is hereinafter referred to as the “non-exercise period.” The exercise price and the number of shares underlying these warrants are subject to adjustment for stock splits, stock dividends, combinations, distributions of assets or evidence of indebtedness, mergers, consolidations, sales of all or substantially all assets, tender offers, exchange offers, reclassifications or compulsory share exchanges.

 

If a change of control of the Company occurs, as defined, the holders may elect to require us to purchase the Warrant Cs for a purchase price equal to the Black-Scholes value of the remaining unexercised portion of each Warrant C.

 

For so long as any Warrant Cs remain outstanding, the Company may not issue any common stock or common stock equivalents at a price per share less $1.65. In the event of a breach of this provision, the holders may elect to require the Company to purchase the Warrant Cs for a purchase price equal to the Black-Scholes value of the remaining unexercised portion of each Warrant C. As a result of the November 8, 2007 and December 20, 2007 preferred stock financing, as described in Note K below, the holders were entitled for a limited period of time (45 days after each issuance) exercise this right.  During the fourth quarter of fiscal 2007, the Company paid approximately $0.7 million to redeem Warrant Cs representing 621,215 shares of common stock.  During the first quarter ended March 29, 2008, the Company paid approximately $0.2 million to redeem Warrant Cs representing 151,516 shares of common stock. (See table below for assumptions used in valuing the warrants redeemed during the six months ended June 28, 2008).  As of June 28, 2008, 1,045,456 Warrant Cs to purchase common stock were outstanding.

 

The table below summarizes Black-Scholes option pricing model range of assumptions that were used in valuing the warrants redeemed for both the Warrant As and Warrant Cs during the six month period ended June 28, 2008.

 

Assumptions:

 

Warrant As

 

Warrant Cs

 

 

 

 

 

 

 

Expected life

 

5.5 years

 

6.5 years

 

Expected volatility ranging from

 

83.5%

 

85.6%

 

Dividends

 

none

 

none

 

Risk-free interest rate

 

3.0%

 

3.2%

 

 

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Table of Contents

 

If following the later of (i) the effective date of the Registration Statement and (ii) the six month anniversary of the issuance date, the volume weighted average price per share of our common stock for any 20 consecutive trading days exceeds 200% of the exercise price, then, if certain conditions are satisfied, including the Equity Conditions, the Company may require the holders of the Warrant Cs to exercise up to 50% of the unexercised portions of such warrants. If following the 24 month anniversary of the issuance date, the volume weighted average price per share of our common stock for any 20 consecutive trading days exceeds 300% of the exercise price, then, if certain equity conditions are satisfied, the Company may require the holders of the Warrant Cs to exercise all or any part of the unexercised portions of such warrants.

 

Placement Agent Warrants

 

First Albany Capital (“FAC”) acted as placement agent in connection with the Private Placement. In addition to a cash transaction fee, FAC or its designees were entitled to receive five-year warrants to purchase 218,182 shares of the Company’s common stock at an exercise price of $1.87 per share. These warrants will be callable after the second anniversary of the closing of the Private Placement if the 20-day volume weighted average price per share of the Company’s common stock exceeds 175% of the exercise price. At the direction of FAC, these warrants were issued to First Albany Companies Inc., the parent of FAC.

 

Accounting for the Convertible Debt Instrument and Warrants

 

The Company has determined that the Convertible Notes constitute a hybrid instrument that has the characteristics of a debt host contract containing several embedded derivative features that would require bifurcation and separate accounting as a derivative instrument pursuant to the provisions of SFAS 133, Accounting for Derivative Instruments and Hedging Activities (SFAS 133).   The Company has identified all of the derivatives associated with the July 19, 2006 financing, and concluded that two of the derivatives cannot be reliably measured nor reliably associated with another derivative that can be reliably measured.  As such, the Company has appropriately valued these derivatives as a single hybrid contract together with the Convertible Notes.  The contract will be remeasured at each period at the fair value with the changes in fair value recognized in the statement of operations until settlement of the Convertible Notes.  As permitted under SFAS 155, the Company has irrevocably elected, as of January 1, 2007, to continue to measure the Convertible Notes and embedded derivatives in their entirety at fair value with changes in fair value recognized as either gain or loss.  The Company has determined that this election had no impact on the accounting for the Convertible Notes.

 

Upon issuance, the Warrant As, Warrant Bs and Warrant Cs, along with the Placement Agent Warrants (together, the “Warrants”), did not meet the requirements for equity classification set forth in EITF Issue 00-19, Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in a Company’s Own Stock, because such warrants (a) must be settled in registered shares, (b) are subject to substantial liquidated damages if the Company is unable to maintain the effectiveness of the resale registration of the shares and (c) there is a cash-out election using a Black-Scholes valuation under various circumstances.  Therefore these Warrants are required to be accounted for as freestanding derivative instruments pursuant to the provisions of SFAS 133.  Changes in fair value are recognized as either a gain or loss in the statement of operations under the caption “change in fair value of Notes and warrants”.  In addition, prior to the exercise by the holders, the Warrant Bs had been classified as a current liability on the balance sheet as they were outstanding for less than one year.

 

Upon issuance of the Convertible Notes and Warrants, the Company allocated the proceeds received from the Convertible Notes and the Warrants on a relative fair value basis.  As a result of such allocation, the Company determined the initial carrying value of the Convertible Notes to be $9.4 million.  The Convertible Notes were immediately marked to fair value, resulting in a derivative liability in the amount of $16.3 million.  As of June 30, 2007, the Notes have been marked to fair value resulting in a derivative liability of $9.8 million.  The net charge Change in Fair Value of Convertible Notes and Warrants for the three months ended June 30, 2007 was $0.2 million.  The net credit to Change in Fair Value of Notes and Warrants for the six months ended June 30, 2007 was $0.2 million.  The Convertible Notes were paid off in full in the fourth quarter of 2007.

 

Upon issuance, the Company allocated $2.7 million of the initial proceeds to the Warrants and immediately marked them to fair value resulting in a derivative liability of $4.9 million and a charge to other expense of $2.2 million.  As of December 31, 2006, the Warrants have been marked to fair value resulting in a derivative liability of $2.9 million.  As of December 31, 2007, the remaining outstanding Warrants have been marked to fair value resulting in a derivative liability of $3.2 million.  The credit to Change in Fair Value of Convertible Notes and Warrants, related to the Warrants, for the three and six months ended June 30, 2007 was $0.4 million and $0.6 million, respectively. As of June 28, 2008 the remaining outstanding Warrants have been marked to fair value resulting in a

 

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derivative liability of $5.5 million.  The charge to Change in Fair Value of Convertible Notes and Warrants, related to the Warrants, for the three and six months ended June 28, 2008 was $2.4 million and $2.3 million, respectively.  At inception the transaction costs were immediately expensed as part of the fair value adjustment.

 

The debt discount in the amount of $2.6 million (resulting from the allocation of proceeds) was being amortized to interest expense using the effective interest method over the expected term of the Convertible Notes.  During 2007, as a result of the payment in full of the Convertible Notes, the Company amortized the remaining balance resulting in approximately $2.1 million, which is a component of interest expense.

 

A summary of the changes in the fair value of the Convertible Notes and the Warrants:

 

 

 

Fair Value
of Notes

 

Fair Value
of Warrant
Liabilities

 

Total

 

Balance December 31, 2006

 

$

12,740,482

 

$

2,920,553

 

$

15,661,035

 

Amortization of debt discount

 

544,252

 

 

544,252

 

Fair value adjustment (4)

 

(206,564

)

(378,064

)

(584,628

)

Redemptions:

 

 

 

 

 

 

 

- Cash

 

(500,000

)

 

(500,000

)

- Stock (1)

 

(2,818,724

)

 

(2,818,724

)

Balance at June 30, 2007

 

$

9,759,446

 

$

2,542,489

 

$

12,301,935

 

 

 

 

 

 

 

 

 

Balance at December 31, 2007 (2)

 

$

0

 

$

3,244,316

 

$

3,244,316

 

Fair value adjustment (4)

 

 

2,291,948

 

2,291,948

 

Change in fair value of redeemed Warrant As and Cs at redemption (3) (4)

 

 

572,250

 

572,250

 

Warrant Redemptions:

 

 

 

 

 

 

 

- Cash Paid for Warrant A redemption (3)

 

 

(387,591

)

(387,591

)

- Cash paid for Warrant C redemption (3)

 

 

(184,659

)

(184,659

)

Balance at June 28, 2008

 

$

0

 

$

5,536,264

 

$

5,536,264

 

 


(1)          Includes a fair value adjustment of $318,724.

(2)          The Company satisfied the Convertible Notes in full on November 7, 2007.  Pursuant to the terms of the Convertible Notes, the Company was required to pay a premium of 20% of the then outstanding balance of the Convertible Notes.

(3)          As a result of the Series C Preferred Stock financing, certain holders of both Warrant As (1,242,426) and Warrant Cs (621,215), through December 31, 2007, exercised their right of redemption, resulting in the Company paying to each redeeming warrant holder the Black-Scholes value of these warrants on the date of notification of redemption.  During the six months ended June 28, 2008 holders of  both Warrant As (303,031) and Warrant Cs (151,516) exercised their right of redemption, resulting in the Company paying to each redeeming warrant holder the Black-Scholes value of these warrants on the date of notification of redemption.

(4)          Amounts included in change in fair value of Convertible Notes and warrants on consolidated statement of operations.

 

The Company paid the January 31, 2007 interest payment due in cash.   The Company elected to pay the April 30, 2007 interest payment in shares of its common stock.  As a result, the Company recorded the following charges as it relates to the interest payment on the Convertible Notes (interest on the Convertible Notes was due quarterly on the last day of January, April, July and October, respectively):

 

Due Date

 

Shares

 

$ Value

 

Fair Value

 

Additional
Expense Recorded

 

April 30, 2007

 

226,746

 

$

252,824

 

$

303,941

 

$

51,116

 

 

Valuation - Methodology and Significant Assumptions

 

The valuation of derivative instruments utilizes certain estimates and judgments that affect the fair value of the instruments. Fair values for the Company’s derivatives are estimated by utilizing valuation models that consider current and expected stock prices, volatility, dividends, forward yield curves and discount rates.  Such amounts and the recognition of such amounts are subject to

 

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significant estimates which may change in the future.

 

In estimating the fair value of the Convertible Notes and Warrants the following methods and significant input assumptions were applied:

 

Methods

 

                  A binomial model was utilized to estimate the fair value of the Convertible Notes at December 31, 2006, March 31, 2007 and June 30, 2007.  A binomial model represents finite possible paths of the underlying instruments price over the life of the instrument and is most practical in valuations involving variable inputs or when the option/conversion feature is both exercisable and exercise prior to maturity is favorable (i.e., an American option).  The binomial model considers the key features of the Convertible Notes, and is subject to the significant assumptions discussed below.  First, a discrete simulation of the Company’s stock price was conducted at each monthly step (node) throughout the expected life of the instrument.  Second, an analysis of all future debt repayments was conducted using an appropriate discount rate, while considering the 10% discount in the event repayments are settled with shares rather than with cash, to estimate the fair value of the debt at each monthly date.  The Stated Rate 6-Month LIBOR Condition was estimated by utilizing a 6-month LIBOR forward yield curve based on LIBOR rates and interest rate swaps.  Third, an analysis of the higher of the fair value of debt or conversion/redemption value was conducted relative to each node.  Fourth, an analysis of the higher of a holding position (i.e., fair value of a future node value discounted using an applicable discount rate) or the fair value result of the second step above was conducted relative to each node until a final fair value of the instrument is concluded at initial node, representing the valuation date.  This model requires the following key inputs with respect to the Company and/or instrument:

 

Input

 

Dec. 31,
2006

 

March 31,
2007

 

June 30,
2007(1)

 

Quoted Stock Price

 

$

1.14

 

$

1.30

 

$

1.22

 

Exercise Price

 

$

1.65

 

$

1.65