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Wave Systems 10-Q 2006

Documents found in this filing:

  1. 10-Q
  2. Ex-31.1
  3. Ex-31.2
  4. Ex-32.1
  5. Ex-32.1

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

FORM 10-Q

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

For the quarterly period ended September 30, 2006

OR

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

For the transition period from                      to                     

Commission File Number 0-24752

Wave Systems Corp.

(Exact name of registrant as specified in its charter)

Delaware

 

13-3477246

(State or other jurisdiction of
incorporation or organization)

 

(I.R.S. Employer
Identification No.)

 

480 Pleasant Street

Lee, Massachusetts 01238

(Address of principal executive offices)

(Zip code)

(413) 243-1600

(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 or a non-accelerated filer. See definition of “accelerated filer” and “large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large accelerated filer o         Accelerated filer x         Non-accelerated filer o

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

The number of shares outstanding of each of the issuer’s classes of common stock as of November 2, 2006: 42,138,828 shares of Class A Common Stock and 41,908 shares of Class B Common Stock.

 




 

PART I - FINANCIAL INFORMATION

Item 1. Financial Statements

WAVE SYSTEMS CORP. AND SUBSIDIARIES
Consolidated Balance Sheets
(Unaudited)

 

 

September 30,

 

December 31,

 

 

 

2006

 

2005

 

Assets

 

 

 

 

 

 

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

3,128,673

 

$

2,006,022

 

Accounts receivable, net of allowance for doubtful accounts of $67,559 and $14,087 at September 30, 2006 and December 31, 2005, respectively

 

672,837

 

334,659

 

Prepaid expenses

 

179,542

 

139,686

 

Total current assets

 

3,981,052

 

2,480,367

 

Property and equipment, net

 

494,726

 

754,153

 

Other assets

 

133,307

 

195,245

 

Total assets

 

4,609,085

 

3,429,765

 

Liabilities and Stockholders’ Equity (Deficiency)

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Accounts payable and accrued expenses

 

3,005,564

 

3,089,150

 

Deferred revenue

 

557,196

 

503,630

 

Total current liabilities

 

3,562,760

 

3,592,780

 

 

 

 

 

 

 

Liability for warrants containing cash settlement provisions

 

 

2,794

 

Total liabilities

 

3,562,760

 

3,595,574

 

 

 

 

 

 

 

Common stock, $.01 par value. Authorized 150,000,000 shares as Class A; 38,621,598 shares issued and outstanding in 2006 and 31,113,918 in 2005

 

386,216

 

311,139

 

Common stock, $.01 par value. Authorized 13,000,000 shares as Class B; 41,908 shares issued and outstanding in 2006 and 58,575 in 2005

 

419

 

586

 

Capital in excess of par value

 

299,424,800

 

284,269,292

 

Accumulated deficit

 

(298,765,110

)

(284,746,826

)

Total stockholders’ equity (deficiency)

 

1,046,325

 

(165,809

)

Total liabilities and stockholders’ equity

 

$

4,609,085

 

$

3,429,765

 

 

See accompanying notes to unaudited consolidated financial statements.

2




 

WAVE SYSTEMS CORP. AND SUBSIDIARIES
Consolidated Statements of Operations
(Unaudited)

 

 

Three months ended

 

Nine months ended

 

 

 

September 30,
2006

 

September 30,
2005

 

September 30,
2006

 

September 30,
2005

 

Net Revenues:

 

 

 

 

 

 

 

 

 

Licensing

 

$

826,946

 

$

324,169

 

$

1,817,993

 

$

639,318

 

Services

 

19,334

 

11,166

 

431,846

 

31,548

 

Total Net Revenues

 

846,280

 

335,335

 

2,249,839

 

670,866

 

Cost of sales:

 

 

 

 

 

 

 

 

 

Licensing

 

104,447

 

21,059

 

203,695

 

32,628

 

Services

 

5,579

 

8,503

 

280,883

 

32,226

 

Amortization expense

 

92,959

 

155,354

 

289,326

 

466,064

 

Total Cost of sales

 

202,985

 

184,916

 

773,904

 

530,918

 

Gross profit

 

643,295

 

150,419

 

1,475,935

 

139,948

 

Operating expenses:

 

 

 

 

 

 

 

 

 

Selling, general, and administrative

 

2,998,236

 

2,787,761

 

9,400,495

 

8,721,623

 

Research and development

 

2,163,201

 

1,827,118

 

6,175,701

 

5,091,220

 

 

 

5,161,437

 

4,614,879

 

15,576,196

 

13,812,843

 

Other income (expense):

 

 

 

 

 

 

 

 

 

Interest income

 

30,872

 

17,855

 

79,183

 

57,925

 

Gain on sale of marketable securities

 

 

92,340

 

 

92,340

 

Unrealized (loss) gain in value of warrant liability

 

 

(7,543

)

2,794

 

455,317

 

 

 

30,872

 

102,652

 

81,977

 

605,582

 

Net loss

 

(4,487,270

)

(4,361,808

)

(14,018,284

)

(13,067,313

)

Basic and diluted loss per common share

 

$

(0.12

)

$

(0.15

)

$

(0.40

)

$

(0.48

)

Weighted average number of common shares outstanding during the period

 

37,800,037

 

28,366,752

 

35,279,324

 

27,058,285

 

 

See accompanying notes to unaudited consolidated financial statements.

3




 

WAVE SYSTEMS CORP. AND SUBSIDIARIES
Consolidated Statements of Cash Flows
(Unaudited)

 

 

Nine Months ended

 

 

 

September 30,

 

September 30,

 

 

 

2006

 

2005

 

Cash flows from operating activities:

 

 

 

 

 

Net loss

 

$

(14,018,284

)

$

(13,067,313

)

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

 

 

 

 

 

Depreciation and amortization

 

501,530

 

623,123

 

Gain on decrease in value of warrant liability

 

(2,794

)

(455,317

)

Compensation associated with issuance of stock options

 

1,141,775

 

5,470

 

Realized gain on marketable securities

 

 

(92,340

)

 

 

 

 

 

 

Changes in assets and liabilities:

 

 

 

 

 

Increase in accounts receivable

 

(338,178

)

(308,938

)

Increase in prepaid expenses

 

(39,856

)

(25,880

)

Decrease in other assets

 

61,938

 

10,451

 

Decrease in accounts payable and accrued expenses

 

(83,586

)

(56,223

)

Increase in deferred revenue

 

53,566

 

161,389

 

Net cash used in operating activities

 

(12,723,889

)

(13,205,578

)

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

Acquisition of property and equipment

 

(242,103

)

(116,004

)

Proceeds from sale of marketable securities

 

 

289,003

 

Net cash (used in) provided by investing activities

 

(242,103

)

172,999

 

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

Net proceeds from issuance of common stock and warrants

 

14,088,643

 

9,642,518

 

Net cash provided by financing activities

 

14,088,643

 

9,642,518

 

 

 

 

 

 

 

Net increase (decrease) in cash and cash equivalents

 

1,122,651

 

(3,390,061

)

 

 

 

 

 

 

Cash and cash equivalents at beginning of period

 

2,006,022

 

5,805,912

 

 

 

 

 

 

 

Cash and cash equivalents at end of period

 

$

3,128,673

 

$

2,415,851

 

 

See accompanying notes to unaudited consolidated financial statements.

4




 

WAVE SYSTEMS CORP. AND SUBSIDIARIES
Consolidated Statements of Stockholders’ Equity (Deficiency) and Comprehensive Income (Loss)
(Unaudited)

 

 

Class A Common Stock

 

Class B Common Stock

 

Capital in
excess

 

Accumulated

 

 

 

 

 

Shares

 

Amount

 

Shares

 

Amount

 

of Par Value

 

Deficit

 

Total

 

Balance at December 31, 2005

 

31,113,918

 

$

311,139

 

58,575

 

$

586

 

$

284,269,292

 

$

(284,746,826

)

$

(165,809

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net Loss and comprehensive loss

 

 

 

 

 

 

(14,018,284

)

(14,018,284

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Issuance of Class A Common Stock at $1.605 per share, net of issuance costs of $216,289

 

2,782,866

 

27,828

 

 

 

4,222,383

 

 

4,250,211

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Issuance of Class A Common Stock at $2.40 per share, net of issuance costs of $281,561

 

2,012,500

 

20,125

 

 

 

4,528,314

 

 

4,548,439

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Warrants exercised at $2.16 per share net of issuance costs of $14,000

 

162,037

 

1,620

 

 

 

334,380

 

 

336,000

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Warrants exercised at $2.40 per share net of issuance costs of $11,000

 

114,583

 

1,146

 

 

 

262,853

 

 

263,999

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Issuance of Class A Common Stock pursuant to the Wave Employee Stock Purchase Plan at $1.9635

 

82,706

 

827

 

 

 

161,566

 

 

162,393

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Exchange of Class B Common Stock for Class A Common Stock

 

16,667

 

167

 

(16,667

)

(167

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Fractional shares paid out in cash in connection with reverse stock split

 

(431

)

(4

)

 

 

(770

)

 

(774

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Issuance of Class A Comman Stock at $2.05 per share, net of issuance costs of $261,966

 

2,336,752

 

23,368

 

 

 

4,505,007

 

 

4,528,375

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Stock-based compensation

 

 

 

 

 

1,141,775

 

 

1,141,775

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance at September 30, 2006

 

38,621,598

 

$

386,216

 

41,908

 

$

419

 

$

299,424,800

 

$

(298,765,110

)

$

1,046,325

 

 

See accompanying notes to unaudited consolidated financial statements.

5




 

WAVE SYSTEMS CORP. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements

September 30, 2006 and 2005

In the opinion of management, the accompanying unaudited consolidated financial statements contain all adjustments (consisting only of normal recurring adjustments) necessary to present fairly the financial position of Wave Systems Corp. as of September 30, 2006 and December 31, 2005, and the results of its operations and cash flows for the three-month and nine-month periods ended September 30, 2006 and 2005.  Such financial statements have been prepared in accordance with the applicable regulations of the Securities and Exchange Commission (the “Commission”).

Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been omitted.  It is suggested that these consolidated financial statements be read in conjunction with Wave’s audited financial statements and notes thereto for the year ended December 31, 2005, included in its Form 10-K filed on March 9, 2006.  The results of operations for the three-month and nine-month periods ended September 30, 2006 are not necessarily indicative of the operating results for the full year or any future periods.

The consolidated financial statements of Wave include the financial statements of Wave Systems Corp.; Wave Systems Holdings, Inc., a wholly owned subsidiary, and Wavexpress, Inc., a joint venture between Wave and Sarnoff Corporation.  All significant inter-company transactions have been eliminated.  Prior to January 1, 2006, the financial statements of Wave were presented in the development stage format as prescribed by Statement of Financial Accounting Standards No. 7 — “Accounting and Reporting by Development Stage Enterprises.”

On July 24, 2006, our Board of Directors approved a reverse stock split of our common stock at a ratio of one-for-three, causing each three outstanding shares of Class A common stock and Class B common stock to convert automatically into one share of Class A common stock or Class B common stock, respectively.  The par value of Class A common stock and Class B common stock remains $0.01 per share.  The reverse split became effective at the close of business on July 25, 2006.  In lieu of fractional shares, stockholders received a cash payment based on an average trading price of the Class A common stock prior to the effectiveness of the reverse split.  Stockholders’ equity has been restated to give retroactive recognition to the reverse split for all periods presented by reclassifying the excess par value resulting from the reduced number of shares from common stock to paid-in capital.  Except as otherwise noted, all references to common share and per common share amounts (including warrant shares, shares reserved for issuance and applicable exercise prices) for all periods presented have been retroactively restated to reflect this reverse split.

1.     Liquidity

The accompanying consolidated financial statements have been prepared assuming that Wave will continue as a going concern.  Wave has substantial operating losses since its inception, and as of September 30, 2006, has an accumulated deficit of $298,765,110.  We also expect Wave will incur an operating loss for the calendar year 2006.  As of September 30, 2006, we had working capital of $418,292.

Wave has begun market introduction of its security and broadband media distribution software products and has signed initial distribution contracts for these applications.  However, due to the early stage nature of this market, it is unlikely that Wave will generate sufficient revenue to cover all of its cash flow needs to fund its operating requirements for the twelve months ending September 30, 2007.

6




 

Because Wave does not have sufficient cash to fund operations for the twelve months ending September 30, 2007, and the uncertainty as to whether Wave will generate sufficient revenues to fund its operations over this time period, Wave has been, and will likely continue to be, actively engaged in financing activities in order to generate additional funding to cover its operating costs for the year ending September 30, 2007.  These activities have included the filing of a $25,000,000 S-3 shelf registration with the Commission on December 16, 2005, which was declared effective on January 13, 2006; and the sale of 2,782,866 shares of common stock at $1.605 per share for gross proceeds of $4,466,500 in an initial round of financing under this shelf registration on February 15, 2006, for which we received approximately $4,250,000 in net proceeds.  We also granted warrants as part of the February 15 financing that allowed the purchasers to acquire an additional 516,956 shares of Wave common stock for $2.16 per share.  On May 8, 2006 an investor exercised one of these warrants for 162,037 shares, at an exercise price of $2.16 per share.  Wave received $336,000 from this warrant exercise after subtracting the 4% placement agent fee. The remaining warrants granted in connection with the February 16, 2006 financing expired on August 15, 2006.

Pursuant to a financing entered into on May 3, 2006 under the same shelf registration statement,  we also sold 2,012,500 shares of Wave’s Class A common stock at $2.40 per share for gross proceeds of $4,830,000, for which we received approximately $4,548,400 in net proceeds.  In connection with that financing, we also agreed to issue a warrant to the placement agent (as part of the fees paid to the placement agent) that will allow the placement agent to acquire 100,625 shares of Wave Class A common stock for $2.40 per share.  The warrant expires on June 3, 2007.

On May 8, 2006, an investor also exercised a warrant issued by Wave to that investor in connection with Wave’s December 5, 2005 financing.  The warrant was exercised in full for 114,583 shares of Wave Class A Common Stock, at an exercise price of $2.40 per share.  Wave received $264,000 from the exercise of this warrant after subtracting the 4% placement agent fee.

Also, pursuant to a financing entered into on August 4, 2006 under the same shelf registration statement, we sold 2,336,752 shares of Wave’s Class A common stock at $2.05 per share for gross proceeds of $4,790,342, for which we received $4,528,375 in net proceeds.  In connection with that financing, we also agreed to issue a warrant to the placement agent (as part of the fees paid to the placement agent) that will allow the placement agent to acquire 116,837 shares of Wave Class A common stock for $2.05 per share.  The warrant expires on September 3, 2007.

In addition, under the same shelf registration statement, on October 30, 2006, we sold and issued 3,517,240 shares of Wave’s Class A common stock for $2.73 per share. We have received gross proceeds from the sale of these shares of $9,602,038.  We expect to realize net proceeds of approximately $9,092,000 after paying all transaction costs.  In connection with that financing, we also agreed to issue a warrant to the placement agent (as part of the fees paid to the placement agent) that will allow the placement agent to acquire 175,861 shares of Wave Class A common stock for $2.73 per share.  The warrant expires on November 30, 2007.

The October 30, 2006 financing referred to above used all of the remaining availability under the January 13, 2006 shelf registration statement.  It is likely that we will be required to sell additional shares of common stock, preferred stock, obtain debt financing or engage in a combination of these financing alternatives, to raise additional capital to continue to fund our operations for the twelve months ending September 30, 2007.

Previously, on April 15, 2004, Wave filed a $25,000,000 registration statement with the Commission, under which Wave has drawn down a total of $22,494,000 in gross proceeds, through various sales of common stock.  There remains approximately $2,506,000 in gross proceeds available under the April 15, 2004 shelf registration statement, which may be utilized for future financings.

Considering our current cash balance, including the additional capital raised on October 30, 2006, we project that we have enough liquid assets to continue operating into June 2007.  We estimate we will need a minimum of approximately $5,600,000 of additional cash, over and above the funds received from the October 30, 2006 financing, from a combination of additional revenue growth

7




 

and additional financings, to fund operating expenses and capital expenditures for the twelve months ending September 30, 2007.

If Wave is not successful in raising the needed capital referred to above, or is not successful in executing its business plan, we could be forced to cease operations or merge with another company.   No assurance can be provided that any of these initiatives will be successful.   Due to our current cash position, our capital needs over the next year and beyond, the fact that we have not at this time secured enough financing to fund our operations through September 30, 2007 and beyond, and the uncertainty as to whether we will achieve our sales forecast for our products and services, substantial doubt exists with respect to our ability to continue as a going concern.

2.          Loss per Share

Basic net loss per common share has been calculated based upon the weighted-average number of shares of common stock outstanding during the period.  Diluted net loss per share is also computed using the weighted average number of common shares and excludes dilutive potential common shares outstanding, as their effect is anti-dilutive.  Dilutive potential common shares consist primarily of employee stock options and stock warrants.  Diluted net loss per share is equal to basic net loss per share and is therefore not presented separately in the financial statements.  The weighted average number of potential common shares that would have been included in diluted loss per share, had their effect not been anti-dilutive for each of the three-month and nine-month periods ended September 30, 2006, were approximately 2,000 shares and 60,000 shares, respectively, versus 92,000 shares and 85,000 shares for the three-month and nine-month periods ended September 30, 2005, respectively.  Employee stock options and other stock warrants to purchase a weighted average of approximately 5,583,000 and  5,632,000 shares were outstanding for the three-month and nine-month period ended  September 30, 2006, respectively versus 5,154,000 and 5,627,000 shares of the three-month and nine-month periods ended September 30, 2005, respectively, but would not have been included in the computation of diluted loss per share because their exercise price was greater than the average share price of Wave’s common shares and, therefore, their effect would have been anti-dilutive.

3.     Wavexpress

In April 1999, Wave joined with Sarnoff Corporation to form Wavexpress.  Wavexpress develops secure broadband media distribution software products, infrastructure and content services.  On October 15, 1999, Wave and Sarnoff signed a Joint Venture Agreement, which formally established Wavexpress.  Under this agreement, Sarnoff and its affiliates received a 40% equity stake in Wavexpress.  Wave received a 53% equity interest, and its affiliates, who purchased founders stock in April 1999 for a nominal amount, owned the remaining 7% of the outstanding capital stock.  The affiliates of Wave include Peter Sprague, the former Chairman of Wave and Steven Sprague, the Chief Executive Officer of Wave, certain members of the Board of Directors of Wave and certain Wave employees.

Wave has funded Wavexpress through a series of convertible notes, some with attached warrants.  The notes bear interest at the rate of 2% to 3% above the Prime Rate of Chase Manhattan Bank.  Generally, the notes are convertible into shares of common stock of Wavexpress at varying prices per share.  Through September 30, 2006, Wave has funded Wavexpress with approximately $39,597,000 in cash, plus approximately $14,522,000 in accrued interest.  Such amounts include approximately $9,500,000 that automatically converted into 1,826,571 additional shares of Wavexpress at an average conversion price of $5.20 per share.  These amounts are eliminated in consolidation.

As of September 30, 2006, Wave owned 69% of Wavexpress, while Sarnoff owned 25.6%.  None of the minority shareholders have provided, or are obligated to provide, funding to Wavexpress.  Accordingly, the financial statements of Wavexpress have been included in the consolidated financial statements of Wave for all periods presented herein.  In addition, Wave has not recorded a minority interest in Wavexpress in the consolidated financial statements and therefore has reflected 100% of Wavexpress’ balance sheet and operating results in its consolidated financial statements.  Wavexpress’ net losses included in Wave’s consolidated financial statements were approximately $540,000 and $ 530,000 for the three-month periods

8




 

ended September 30, 2006 and September 30, 2005, respectively, and $1,735,000 versus $1,676,000 for the nine-month periods ended September 30, 2006 and 2005, respectively.

4.     Share-based Compensation

In January 1994, Wave adopted the 1994 Employee Stock Option Plan (the “1994 Plan”).  The total number of shares of Class A Common Stock reserved for issuance under the 1994 Plan, as amended is 6,833,333 shares. The 1994 Plan Expires on January 1, 2009.  In September 1996, Wave adopted the 1996 Performance Stock Option Plan (the “1996 Plan”). The number of shares of Class A Common Stock subject to the 1996 Plan was 266,666.   Under 1994 and 1996 Plans, both incentive stock options and non-qualified stock options may be granted to officers, key employees and other persons providing services to Wave. Options granted under the plans generally vest over three years and expire ten years from the date of grant.  In January 1994, Wave adopted the Non-Employee Directors Stock Option Plan (the “Directors’ Plan”).  The total number of shares of Class A Common Stock reserved for issuance under the Directors’ Plan, as amended is 333,333 shares.  Under the Directors’ Plan, each director who is not an employee of Wave receives an initial grant of options to purchase 4,000 shares of Class A Common Stock; and an additional annual grant to purchase 3,333 shares on the day immediately following each of the dates on which an incumbent director is reelected.  The options granted to non-employee directors vest on the day following the grant and expire ten years from the date of grant.  Under all of Wave’s stock option plans, options are granted with exercise prices that approximate fair market value at the date of grant.  All of Wave’s stock option plans and amendments thereto have been approved by shareholder vote.

In November 2004 Wave adopted the 2004 Employee Stock Purchase Plan (the “Purchase Plan”) pursuant to which a total of 1,000,000 shares of Wave’s Common Stock may be sold to eligible employees at a 15% discount from the market value of the shares.  The Purchase Plan was approved by a vote of Wave’s shareholders.  Under the terms of the Purchase Plan, employees may elect to have withheld up to 15% of their base earnings to purchase these shares during each offering period, up to a maximum of $25,000 in market value of Wave Common Stock.  Offering periods commence on May 1st and December 1st and are for a period of six months.  The purchase price under the Purchase Plan is 85% of the lesser of the market price on the beginning or the ending of the offering period.

On January 1, 2006, Wave adopted Statement of Financial Accounting Standards No. 123 (R), “Share-Based Payment,” (“SFAS No. 123(R)”), which requires the measurement and recognition of compensation expense for all stock-based payment awards made to employees and directors including employee stock options and employee stock purchases based on estimated fair values. In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107 (“SAB 107”) relating to SFAS No. 123(R). The Company has applied the provisions of SAB 107 in its adoption of SFAS No. 123(R).

SFAS No. 123(R) requires companies to estimate the fair value of stock-based payment awards on the date of grant using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in the Company’s consolidated statement of operations. SFAS No. 123(R) supersedes Wave’s previous accounting under the provisions of SFAS No. 123, “Accounting for Stock-Based Compensation.” As permitted by SFAS No. 123, Wave measured compensation cost for options granted prior to January 1, 2006, in accordance with Accounting Principles Board Opinion (APB) No. 25, “Accounting for Stock Issued to Employees” and related interpretations. Accordingly, no accounting recognition was given to stock options granted at fair market value until they were exercised. Upon exercise, net proceeds, including tax benefits realized, were credited to equity.

Wave adopted SFAS No. 123(R) using the modified prospective transition method, which requires the application of the accounting standard as of January 1, 2006.  In accordance with the modified prospective transition method, Wave’s consolidated financial statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS No. 123(R).   Stock-based compensation expense recognized under SFAS No. 123(R) for the three-month and nine-month periods ended September 30, 2006, was $381,171and $1,141,775, respectively.   There was no stock-based compensation expense recognized during the three-month and nine-month periods ended September 30, 2005.  SFAS 123(R)

9




 

requires that the classification of the cost of share based compensation, in the statement of operations, is consistent with the nature of the services being rendered in exchange for the share based payment.   The following table summarizes the effect of share based compensation in Wave’s statement of operations, for the three-month and nine-month periods ended September 30, 2006:

 

Three months ended
September 30, 2006

 

Nine months ended
September 30, 2006

 

Cost of Sales

 

$

3,578

 

$

22,656

 

Selling, General & Administrative

 

246,333

 

777,726

 

Research & Development

 

131,260

 

341,393

 

Total

 

$

381,171

 

$

1,141,775

 

 

Wave uses the Black-Scholes-Merton option pricing model to value stock options. The Black-Scholes-Merton model requires the use of employee exercise behavior data and the use of a number of assumptions including volatility of the company’s stock price, the weighted-average, risk-free interest rate and the weighted-average expected term of the options. As Wave does not pay dividends, the dividend rate variable in the Black-Scholes-Merton model is zero. The following values for the indicated variables were used to value options granted during the three-month and nine-month periods ended September 30, 2006; and we expect the assumptions used for grants in future quarters of fiscal 2006 to approximate these values.

 

Nine months ended
September 30, 2006

 

Expected Term (in years)

 

5 Years

 

Risk-free Rate

 

4.67% - 5.11

%

Expected Volatility

 

97.6% - 100.5

%

Dividend Yield

 

0

%

 

The volatility assumption is based on the historical weekly price data of Wave’s stock over a period equivalent to the weighted average expected term of the options.  Management did not identify any factors during that period which were unusual and which would distort the volatility figure if used to estimate future volatility.

The risk-free interest rate assumption is based upon the implied yield available on U.S. Treasury zero-coupon issues with a remaining term equal to the expected term of the option granted.

The expected term of employee stock options represents the weighted average period that the stock options are expected to remain outstanding. It is based upon an analysis of the historical behavior of option holders during the period from January 1, 2000 to December 31, 2005. Management believes historical data is representative of future exercise behavior.

As stock-based compensation expense recognized in the consolidated statement of operations pursuant to SFAS No. 123(R) is based on awards ultimately expected to vest, expense for grants beginning upon adoption of SFAS No. 123(R) on January 1, 2006 is reduced for estimated forfeitures.  The estimated forfeiture rate used in the calculation of share-based compensation expense was 20.95% for the three-month and nine-month periods ended September 30, 2006.  SFAS No. 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Forfeitures are estimated based on historical experience.

10




 

A summary of option activity for all Wave option plans through September 30, 2006 follows:

 

Number of
Shares

 

Weighted Average-
Exercise Price

 

Outstanding as of December 31, 2005

 

4,122,849

 

$

11.4719

 

Granted

 

975,217

 

1.8861

 

Canceled

 

(304,551

)

17.9468

 

Balance as of September 30, 2006

 

4,793,515

 

9.1103

 

Remaining contractual term — options outstanding

 

6.0 years

 

 

 

 

 

 

 

 

 

Exercisable as of September 30, 2006

 

3,142,548

 

$

12.5678

 

Remaining contractual term — options exercisable

 

4.6 years

 

 

 

 

The weighted average grant date fair value of options granted in the three-month and nine-month periods ended September 30, 2006, was $1.38 and $1.45 per share, respectively.

As of  September 30, 2006, unrecognized stock-based compensation related to stock options was approximately $1,244,000.  This cost is expected to be expensed over the three-year period ended September 30, 2009.  The total fair value of shares that vested during the three-month and nine-month periods ended September 30, 2006, was approximately $56,000 and $1,159,000 respectively.

As of September 30, 2006, the intrinsic value of outstanding, vested and currently exercisable share options was $0.

Pro forma Information under SFAS No.123

The following table shows the pro forma effect on net loss and net loss per share if Wave had applied the fair value recognition provisions of SFAS 123 to stock-based employee awards.

 

For the quarter ended
September 30, 2005

 

For the nine months
ended September 30, 2005

 

Net loss to common shareholders — as reported

 

$

(4,361,808

)

$

(13,067,313

)

Fair value compensation cost under SFAS 123

 

(482,118

)

(1,548,459

)

Net loss to common shareholders — pro forma

 

(4,843,926

)

(14,615,772

)

Loss per common share — as reported

 

(0.15

)

(0.48

)

Loss per common share — pro forma

 

$

(0.17

)

$

(0.54

)

 

The following values for the indicated variables were used to value options granted during the quarter ended September 30, 2005.

Expected Term (in years)

 

5 Years

 

Risk-free Rate

 

4.06%

 

Expected Volatility

 

107.7%

 

Dividend Yield

 

0%

 

5.       Warrants Containing Cash Settlement Provisions

Wave follows the FASB’s Emerging Issues Task Force pronouncement No. 00-19 (“EITF 00-19”) to account for derivative financial instruments indexed to, and settled in our own stock.  These include financial instruments such as options or warrants to purchase Wave stock, but does not include employee stock options.  EITF 00-19 requires that freestanding financial instruments of this nature be classified as an

11




 

asset or liability at fair value, in the event that the contract underlying any such financial instruments includes a net cash settlement provision.  In addition, EITF 00-19 requires any such asset or liability to be marked to market at the end of each period, with any resulting difference in fair value to be recorded as income or loss, through the company’s statement of operations, depending upon whether the difference results in a gain or loss.

On November 18, 2003, Wave granted warrants to purchase 310,436 shares of Wave common stock at an exercise price of $7.86 per share in connection with a private placement of common stock with a group of accredited investors.  The warrants have a three-year term.  The contract underlying the warrants includes a provision that would require Wave to pay liquidated damages in cash to the warrant holders if at any time the warrants are “in the money” and the registration statement underlying such shares ceases to remain continuously effective. Because of this provision, the contract is considered to contain a net cash settlement provision as defined in EITF 00-19.  Although the registration statement was declared effective by the Commission on February 12, 2004, the net cash settlement provision still applies because of the stipulation that it must remain continuously effective and because there are circumstances that could potentially cause the registration statement to cease to remain effective.  Accordingly, Wave recorded a liability in its balance sheet that was valued at $-0- as of September 30, 2006, and $2,794 as of December 31, 2005.  These values were determined utilizing the Black-Scholes-Merton option pricing model with the following assumptions:

 

As of
September 30,
2006

 

As of
December 31,
2005

 

Expected life (years)

 

0.15

 

0.90

 

Interest rate

 

4.68

%

4.36

%

Volatility

 

82.8

%

62

%

Dividend yield

 

0

%

0

%

 

The decrease in fair value of the liability associated with the warrants of $2,794 was recorded as an unrealized gain in Wave’s statement of operations in the nine-month period ended September 30, 2006, versus a gain of $455,317 that was recorded for the nine-month period ended September 30, 2005, in accordance with EITF 00-19.

6.    Contingencies

Securities and Exchange Commission Investigation

On December 17, 2003, Wave received an Order by the Securities and Exchange Commission (the “Commission”) regarding a formal investigation.  The focus of this investigation is on certain public statements made by Wave during and around August 2003, as well as certain trading in Wave’s securities during such time.  Wave is cooperating fully with the Commission in this investigation.  Wave is unable to predict the outcome of this investigation at this time.

Purported Class Actions

A consolidated amended class action complaint is pending in the United States District Court for the District of Massachusetts, naming Wave, its Chief Executive Officer and its Chief Financial Officer as defendants.  Brumbaugh et al. v. Wave Systems Corp. et al., Civ. No. 04-30022 (D. Mass.) (MAP).

The purported class action has been filed by alleged purchasers of Wave’s Class A Common Stock during the purported class period July 31, 2003 through February 2, 2004.  The complaint claims that Wave and the named individuals violated Section 10(b) of the Securities Exchange Act of 1934 (the “1934 Act”), Rule 10(b)-5 promulgated thereunder and Section 20(a) of the 1934 Act by publicly disseminating materially false and misleading statements, relating to Wave’s agreements with Intel and IBM.  The complaint did not specify the amount of alleged damages plaintiffs seek to recover.

12




 

In January 2006, the Court granted in part and denied in part defendants’ motion to dismiss.  The Court dismissed two but let stand seven alleged misrepresentations or omissions.  This is not a finding of fault or liability, it is a decision not entirely to dismiss plaintiffs’ pleading.

Without admitting liability, the defendants recently reached a mediated settlement in principle of all claims asserted by the plaintiffs.  The settlement must be approved by the Court before it is final.  Wave’s insurer has agreed to pay the plaintiffs a total of $1,750,000 in exchange for the dismissal with prejudice and release of the claims against all defendants.

Derivative Demand Letter

Previously, a purported shareholder derivative action was filed in the United States District Court for the District of Massachusetts.  The case was dismissed by the District Court, and on April 25, 2006, an appeal filed by the plaintiff was voluntarily dismissed, with prejudice.

On May 17, 2006, one of the named plaintiffs in the dismissed derivative action sent a shareholder demand letter to our board of directors.  The shareholder demands that we initiate litigation against the same defendants named in, and asserting the same claims as made in, the dismissed derivative litigation.  The board has taken the matter under advisement.  An adverse resolution of the shareholder derivative demand letter may have a negative effect on our financial condition and operating results.

13




 

7.     Segment Reporting

Wave’s products include the Wave EMBASSY® digital security products and services and Wavexpress broadband media distribution products and services.  These products and services constitute Wave’s reportable segments under “Statement of Financial Accounting Standard No. 131 ― Disclosures about Segments of an Enterprise and Related Information.   Net losses for reportable segments exclude interest, and gain on decrease in value of warrant liability.  These items are not reported by segment since they are excluded from the measurement of segment performance reviewed by Wave’s management.

The following sets forth reportable segment data:

 

 

Three months ended
September 30,

 

Nine months ended
September 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

Operating Revenues:

 

 

 

 

 

 

 

 

 

EMBASSY® digital security products and services

 

$

841,404

 

$

325,983

 

$

2,224,969

 

$

644,255

 

Wavexpress broadband media distribution products and services

 

4,876

 

9,352

 

24,870

 

26,611

 

Total Operating Revenues

 

846,280

 

335,335

 

2,249,839

 

670,866

 

Net Loss:

 

 

 

 

 

 

 

 

 

EMBASSY® digital security products and services

 

(3,977,721

)

(3,934,381

)

(12,365,523

)

(11,996,794

)

Wavexpress broadband media distribution

 

(540,422

)

(530,079

)

(1,734,738

)

(1,676,101

)

Total Segments Net Loss

 

(4,518,143

)

(4,464,460

)

(14,100,261

)

(13,672,895

)

Interest income

 

30,873

 

17,855

 

79,183

 

57,925

 

Gain on sale of marketable securities

 

 

92,340

 

 

92,340

 

Unrealized gain (loss) on change in value of warrant liability

 

 

(7,543

)

2,794

 

455,317

 

Net Loss

 

$

(4,487,270

)

$

(4,361,808

)

$

(14,018,284

)

$

(13,067,313

)

Depreciation and Amortization Expense:

 

 

 

 

 

 

 

 

 

EMBASSY® digital security products and services

 

144,458

 

186,942

 

401,522

 

550,245

 

Wavexpress broadband media distribution

 

33,568

 

22,545

 

100,008

 

72,878

 

Total Depreciation and Amortization Expense

 

$

178,026

 

$

209,487

 

$

501,530

 

$

623,123

 

Capital Expenditures:

 

 

 

 

 

 

 

 

 

EMBASSY® digital security products and services

 

59,911

 

63,099

 

202,978

 

111,271

 

Wavexpress broadband media distribution

 

3,763

 

2,095

 

39,125

 

4,733

 

Total Capital Expenditures

 

$

63,674

 

$

65,194

 

$

242,103

 

$

116,004

 

 

 

September 30,

 

December 31,

 

 

 

2006

 

2005

 

Assets:

 

 

 

 

 

EMBASSY® Trusted Client Platform and services

 

$

4,566,539

 

$

3,235,946

 

Wavexpress Data Broadcasting

 

42,546

 

193,819

 

Total Assets

 

$

4,609,085

 

$

3,429,765

 

 

8.  Issuance of Common Stock

On August 4, 2006, Wave entered into subscription agreements, pursuant to which Wave agreed to sell and issue 2,336,752 shares of Class A Common Stock, par value $.01 per share, to certain purchasers for an aggregate purchase price of $4,790,342.  These shares were priced at $2.05 per share.  Securities Research

14




 

Associates, Inc. (“SRA”) entered into a placement agency agreement with Wave in which they agreed to act as placement agent in connection with the offering.  Wave agreed to pay SRA a fee equal to 5.0% of the gross proceeds of this offering.  Wave also agreed to issue a warrant to SRA to purchase up to 116,837 shares of Class A common stock at an exercise price of $2.05.  The Warrant expires on September 3, 2007.  Wave realized net proceeds of approximately $4,528,376 after deducting the placement agent fees of $239,517 and additional legal and other fees associated with the issuance of these securities which totaled $22,429.  The shares sold on August 4, 2006 were offered and issued pursuant to a shelf registration statement which was filed by Wave on December 16, 2005 and declared effective by the Commission on January 13, 2006.

On May 8, 2006, Wave received gross proceeds of $625,000 less placement agent fees of $25,000 for net proceeds of $600,000, in connection with the issuance of 276,620 shares of Class A Common Stock upon the exercise of two warrants that were granted to an investor as part of Wave’s December 5, 2005 financing and February 15, 2006 financing.  The warrant issued to this investor in connection with the December 5, 2005 financing was exercised in full for 114,583 shares of Class A Common Stock at an exercise price of $2.40 per share.  The warrant issued to the investor in connection with the February 15, 2006 financing was exercised in full for 162,037 shares of Class A Common Stock at an exercise price of $2.16 per share.

On May 3, 2006, Wave entered into subscription agreements, pursuant to which Wave agreed to sell and issue 2,012,500 shares of Class A Common Stock to certain purchasers for an aggregate purchase price of $4,830,000.  The shares were priced at $2.40 per share.  SRA entered into a placement agency agreement with Wave in which they agreed to act as placement agent in connection with the offering.  Wave agreed to pay SRA a fee equal to 5.0% of the gross proceeds of this offering.  Wave also agreed to issue a warrant to SRA to purchase up to 100,625 shares of Class A common stock at an exercise price of $2.40.  The Warrant will be exercisable for a period of thirteen months following the date of the transaction.  Wave realized net proceeds of approximately $4,548,400 after deducting the placement agent fees of $241,500 and additional legal and other fees associated with the issuance of these securities, which Wave estimates will be approximately $40,000.  The shares were offered and issued pursuant to the shelf registration statement referred to above.

On February 15, 2006, Wave entered into a securities purchase agreement, pursuant to which Wave agreed to sell and issue 2,782,866 shares of Class A Common Stock for $1.605 per share, to certain purchasers for an aggregate purchase price of $4,466,500.  The purchasers were also granted warrants (the “Warrants”) to purchase up to 516,956 shares of Class A common stock at an exercise price of $2.16.  The Warrants were exercisable for a period of six months following the date of issuance.  All unexercised warrants granted in connection with the February 15, 2006 securities purchase agreement were expensed on August 16, 2006.  Each Warrant was subject to cancellation if the closing bid price of Wave’s common stock exceeded $2.58 for 10 out of 20 consecutive trading days and the Warrant had not been exercised by the close of business on the trading day after the 10th trading day on which the closing bid price exceeded $2.58.  The placement agent, JPC Capital Partners, Inc. (formerly Corpfin, Inc.) (the “Placement Agent”) had entered into a placement agency agreement with Wave in which they agreed to act as placement agent in connection with the offering.  Wave agreed to pay the Placement Agent a fee equal to 4.0% of the gross proceeds of this offering.  Wave realized net proceeds of $4,250,211 after deducting the placement agent fees of $216,289 and additional legal and other fees associated with the issuance of these securities.  The shares were issued pursuant to the shelf registration statement referred to above.

9.  Subsequent Event

On October 30, 2006, Wave entered into subscription agreements, pursuant to which Wave agreed to sell and issue 3,517,230 shares of Class A Common Stock, par value $.01 per share, to certain purchasers for which we received the aggregate purchase price of $9,602,038.  Wave expects to realize net proceeds of approximately $9,092,000 after deducting the placement agent fees of $480,102 and additional legal and other fees associated with the issuance of these securities which are estimated to equal $30,000.  These shares were priced at $2.73 per share.  SRA entered into a placement agency agreement with Wave in which they agreed to act as placement agent in connection with the offering.  Wave agreed to pay SRA a fee equal to 5.0% of the gross proceeds of this offering.  Wave also agreed to issue a warrant to SRA to purchase up to 175,861 shares of Class A common stock at an exercise price of $2.73.  The Warrant expires

15




 

on November 30, 2007.    The shares sold on October 30, 2006 were offered and issued pursuant to a shelf registration statement which was filed by Wave on December 16, 2005 and declared effective by the Commission on January 13, 2006.

CERTAIN FORWARD-LOOKING INFORMATION:

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934.  These statements include, but are not limited to, statements regarding contingencies, future prospects, liquidity and capital expenditures herein under “Part I Financial Information—Item 2 Management’s Discussion and Analysis of Financial Condition and Results of Operations.”  Actual results could differ materially from those projected in the forward-looking statements as a result of the risk factors set forth below and detailed in our other filings with the Commission during the past 12 months.

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

On July 24, 2006, our Board of Directors approved a reverse stock split of our common stock at a ratio of one-for-three, causing each three outstanding shares of Class A common stock and Class B common stock to convert automatically into one share of Class A common stock or Class B common stock, respectively.  The par value of Class A common stock and Class B common stock remains $0.01 per share.  The reverse split became effective at the close of business on July 25, 2006.  In lieu of fractional shares, stockholders  received a cash payment based on an average trading price of the Class A common stock prior to the effectiveness of the reverse split.   Except as otherwise noted, all references to common share and per common share amounts (including warrant shares, option shares, shares reserved for issuance and applicable exercise prices) for all periods presented herein have been retroactively restated to reflect this reverse split.

Overview

Our Business

Wave Systems Corp. develops, produces and markets products for hardware-based digital security, including security applications and services that are complementary to and work with the specifications of the Trusted Computing Group, www.trustedcomputinggroup.org  (“TCG”).  Specifications developed by the TCG are designed to address a broad range of current and evolving digital security issues.  These issues include: identity protection, data security, digital signatures, electronic transaction integrity, platform trustworthiness, network security and regulatory compliance.

The TCG is an industry standards body, comprised of computer and device manufacturers, software vendors and others, whose purpose is to develop, define and promote open industry standard specifications for embedded hardware-enabled computing products, including security technologies across multiple platforms, peripherals and devices. The current TCG specification recommends a hardware-based trusted computing platform, which is a platform that uses a semiconductor device, known as a Trusted Platform Module (“TPM”) that performs protected activities, including protected storage, platform authentication, protected cryptographic  processes  and attestable state capabilities to provide the first level of trust for the computing platform (a “Trusted Platform”).  The TPM is a hardware chip that is separate from the platform’s main CPU(s) that enables secure protection of files and other digital secrets, and performs critical security functions such as generating, storing and protecting “cryptographic keys,” which are secret codes used to decipher  encrypted or coded data.  While TPMs provide the anchor for hardware security, known as the “root of trust”, trust is achieved by integrating the TPM within a carefully architected trust infrastructure and supporting the TPM with essential operational and lifecycle services; such as, key management and credential authentication.

In 2003, Wave began the market introduction of its first commercial products designed to support the first emerging products that include TPMs in this marketplace.  Through 2005, Wave continued to develop

16




 

enhancements to its existing products and has developed additional products in support of the emerging TCG-specifications. Wave continued to develop these products during the first nine months of 2006.

As the market for TPM-enabled products developed, with computing devices being shipped in volume by leaders in the PC industry, Wave has developed its products to support security hardware, based on the TCG specifications.  Wave’s products are unique because they support cross platform interoperability for the currently available TPM chips from Winbond Electronics Corp. (“WEC”), Broadcom, Atmel, Infineon and ST Microsystems, and have been certified and/or approved for usage on TPM-based platforms shipped by Dell, Intel, Gateway, IBM and HP.

Wave is devoting its resources to capitalize on the opportunities presented by this developing market, and to overcome the specific challenges in achieving this goal.

The market trends and opportunities on which management focused its activities on during the quarter ended September 30, 2006 included the following:

·                  A new study by Infonetics forecasts sharp rises in end-point security. The study predicts that in the coming years, endpoint security will require a range of new types of software and hardware to be effective, including endpoint-security appliances and improved network-infrastructure equipment. Accordingly, the study forecasts the overall network access control (NAC) enforcement market will grow to $3.9 billion by 2008, up from just $323 million last year, a 1107% increase. More information is available from the IT Compliance Institute.

·                  Adoption of TPMs and Trusted Computing technology is also growing — according to industry analyst, IDC, shipments of TPMs are expected to grow from under 25 million units in 2005 to over 250 million units in 2010.

·                  The persistence of security threats indicates that hardware is needed to provide more robust security than traditional software solutions.

·                  There is an emergence of TPM-enabled PCs being sold into the marketplace.  This emergence is complementary to Wave’s business model, which largely relies upon providing software and services for Trusted Platforms rather than selling the hardware itself.

·                  Business and security strategies are becoming more closely aligned due to the increasing rate of significant high profile and costly security breaches and the associated risks presented by these breaches.

·                  In-house security expertise remains in short supply.  Wave seeks to capitalize on its expertise as awareness of TPM-enabled solutions increases.

·                  In its Windows Vista Logo Program for Systems, Version 3.0, Draft Revision 0.7, Microsoft has required TPM version 1.2 in its draft operating system hardware requirements specification for logo compliance for “Gold” level business PCs.  Wave believes that a significant percentage of the approximately 150-million-unit PC market will include TPMs by December 2006, which is Microsoft’s stated launch date for Vista for business PCs.

·                  The emergence of additional trusted PC components, such as Seagate’s Momentus 5400 Full Disc Encryption drive, which was announced in Q3 of 2005, represent additional opportunities for Wave’s products to support and integrate these devices with the TPM elements in the PC.

·                  On February 3, 2006, the U.S. Army, in the new Consolidated Buy-2 (CB2) Desktop and Notebook minimum specifications for Army customers as published by the Army Small Computer Program, specifies the requirement for desktop and laptop personal computers to be equipped with TPMs.

In pursuing these opportunities, we recognize many significant challenges that must be overcome, including:

·                  Tight enterprise IT budgets — industry data appears to show that, while enterprise security will be a priority, it will be challenged by tight budgets.

·                  Long sales cycle due to continued lack of support for enterprise spending on security solutions — information security continues to be viewed as an IT issue versus a business issue.

·                  Market awareness — there is a need to educate the marketplace of the advantages of utilizing hardware-trusted platforms as a security solution.

17




 

·                  Limited availability of capital resources — Wave continues to rely on financing the development of its business by issuing new equity.

As more PC and chip original equipment manufacturers (“OEMs”) have begun introducing their Trusted Platform offerings, Wave’s management has focused on entering into licensing contracts pursuant to which the OEM licenses our applications and bundles them with their offering, paying Wave a royalty for each unit shipped. Wave currently has signed such bundling agreements with seven separate OEM partners.  In addition, we have sought to develop our products so that they operate on all of the Trusted Platforms of the major chip OEMs currently shipping product in the marketplace.  Our applications have been approved to work with the Trusted Platforms of Dell, Intel, Gateway, IBM, HP, WEC, Atmel, Broadcom, Infineon, ST Microsystems and others.

Management is also focused on developing the client and server-side applications and tools that will enable enterprises to manage an IT infrastructure that relies on TCG hardware-enabled security.  Wave is devoting a significant portion of its research and development budget to address this opportunity, as this will be a key ingredient for enterprises to successfully implement a Trusted Platform solution.  Wave released these tools and applications in 2004, and has signed license agreements in 2005 and 2006 for Wave’s TCG-Enabled Toolkit, EMBASSY Key Management Server and EMBASSY Authentication Server.

With respect to sales and marketing, management is focused on broadening our distribution strategies to include the direct engagement of our channel partners using their resellers and systems integrators and has hired regional representation in Japan. We have also expanded our targeted presence selling directly to OEMs.  We have specifically focused many of our resources towards solution selling in these channels.  As an example of our channel partner relationship strategy, in July 2006 Wave signed a reseller agreement with NTT Data Corporation (“NTT”), a Japanese information technology systems integrator, pursuant to which NTT is authorized to resell Wave’s products and solutions and to provide support services to NTTs customers in an effort to introduce those products and solutions to the Japanese enterprise market.

Management is also focused on opportunities for its eTMS product suite to provide digital signing and document management solutions to the financial services and other vertical markets in which there is a clear and identifiable value proposition in implementing these solutions.  Although we have met significant implementation challenges and long sales cycles with this effort, we have also entered into contracts with a la mode, inc., in the real estate industry in 2004 and with Efficient Forms, LLC, in the financial services sector in 2005 and 2006.  We continue to pursue additional opportunities for the eTMS product line.

Wavexpress is focused on building a sustainable revenue stream by establishing partnerships with branded content providers to provide paid and advertising supported video entertainment services. Wavexpress’ TVTonic service has recently added new content partners and has been designed to support any video channel distributed via RSS.  RSS is the standard format for blogs and podcasts and is being increasingly used for open video distribution on the Internet.  It is intended that TVTonic will be an advertising supported service.  TVTonic is currently being promoted with all Microsoft Media Center Edition PCs through their Online Spotlight partner program.  In addition, Wavexpress is extending its technology so that its subscriber management system can leverage the added security of a TPM and is preparing back-office systems for standalone deployment into enterprise installations.

Management plans to devote ongoing development resources toward enhancing the TVTonic client software and services.

Our Products

Client-side Applications

The EMBASSY Trust Suite

The current version of the EMBASSY Trust Suite is a set of applications and services that are designed to bring functionality and user value to TPM-equipped products.  Designed to make the TPM easy for users to set up and use, the EMBASSY Trust Suite includes the EMBASSY Security Center (the “ESC”),

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Document Manager Vault (“Vault”), Private Information Manager (“PIM”), SmartSignature and Key Transfer Manager (“KTM”).

The ESC enables the user to set up and configure the TPM platform.  In addition to the basic function of making the TPM operational, ESC is designed to enable the user to manage extended TPM-based security settings and policies, including strong authentication, Windows logon preferences to add biometrics and streamlined password policy management.  Wave also announced that it would develop the Trusted Drive Manager functions for ESC to support the newly announced Seagate Full Disc Encryption drives.

Data Protection is addressed by the Vault, which provides document encryption, decryption and client side storage of documents. The Vault, which works with Microsoft Windows and Microsoft Office, secures documents against unauthorized users and hackers.

Password management is a security challenge due to the increasing number of passwords required and the tendency of users to select easily guessed passwords.  To help improve these password issues, PIM uses the TPM to securely store and manage user information; such as, user names, passwords, credit card numbers and other personal information.  It retrieves login information to efficiently fill in applications, web forms and web login information.

Backup and recovery of keys used for logon, signing and protection of data is an essential requirement for deployment of TPM- based systems.  KTM is an archive application for the cryptographic keys that is designed to provide a simple, yet fully featured method to securely archive, restore and transfer keys having migratable properties that are secured by the TPM.

SmartSignature is a digital signing application that utilizes the signing keys generated by the TPM.

Additionally, Wave has developed TPM Wizards as part of the EMBASSY Trust Suite, which allow users to set up and use the TPM for securing 802.11x wireless networks, the Windows Encrypting File System and encrypting email.  The TPM Wizard enhancement was released during the first quarter of 2005.

In August 2005, Wave signed an agreement with Seagate Technology LLC (“Seagate”) to develop a trusted drive manager software module for the EMBASSY Trust Suite, which will support the Seagate Momentus 5400 Full Disc Encryption products  announced by Seagate (the “Seagate Trusted Drives”).  Wave’s support for the Seagate Trusted Drives will also utilize its EMBASSY Trust Suite software for TPM and key management.

Wave plans to continue to develop and enhance the current products being developed within this product group and will develop new applications and services as the trusted computing market continues to evolve.  Current planned development costs for this product group are expected to be approximately $2.9 million for the twelve-month period ending September 30, 2007.

Middleware and Tools

TCG-Enabled Toolkit

The Wave TCG-Enabled Toolkit is a compilation of software designed to assist application developers writing new applications or modifying existing ones to function on TCG-compliant platforms. Wave provides two versions of the Toolkit, Discovery and Commercial, which enable developers to leverage basic and enhanced TCG services such as integrated key lifecycle management, including key escrow and key recovery. The Discovery Toolkit offers application developers a license for internal evaluation only, whereas the Commercial Toolkit is a license for external redistribution.

Wave TCG-Enabled Cryptographic Service Provider (“CSP”)

Wave offers a TCG-enabled CSP, which allows software developers to utilize the enhanced security of a TCG standards-based platform, facilitating a common user experience independent of the platform.  It also enables applications to utilize functionality available on TCG-compliant platforms directly through the Microsoft cryptographic application programming interface, without requiring user knowledge of any specific TCG software stack layer.

Current planned development costs for this product group are expected to be approximately $4.1 million for the twelve-month period ending September 30, 2007.

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EMBASSY Trust Server Applications

EMBASSY Key Management Server (EKMS)

EKMS is a server application that is designed to provide corporate-level backup and transition of the TPM keys, a process known as key migration.  Key migration using EKMS is designed to help prevent the risk of serious data loss in the event that a TPM, hard drive or motherboard becomes corrupted, or a user leaves the organization.  For instance, an organization may require access to a former employee’s encrypted data or TPM-secured keys for business continuity or disaster recovery purposes.  EKMS enables enterprise- level key protection services, while ensuring proper archive procedures and recovery capabilities.

EMBASSY Authentication Server (EAS)

EAS provides centralized management, provisioning and enforcement of multifactor domain access policies.  With EAS, authentication policies can be based on TPM credentials, SmartCard credentials, user passwords and fingerprint templates.  With EAS, authentication policies can be provisioned and managed from the domain controller.  EAS has an integrated biometric template capability with support for a variety of third-party vendors.

Current planned development costs for this product are expected to be approximately $1.5 million for the twelve-month period ending September 30, 2007.

Digital Signature and Electronic Document Management

On October 4, 2001, Wave acquired the digital signature and electronic document management technology, SmartSignature and SmartSAFE, from SignOnLine, Inc. (“SignOnLine”), a California-based company.  This group of products initially made up our eSign Transaction Management Suite, also known as eTMS (“eTMS”), which consisted of four core products: SmartIdentity, SmartSignature, SmartSAFE and SmartConnect.  SmartSignature Version 3.0 is a digital signature application that connects signers and institutions — banks, insurance companies, enterprises, etc. — through a legally binding digital signature.  In Q4 of 2005, Wave launched SmartSignature Server, a server-side electronic signature application, which enables individuals to electronically sign and store virtually any format of document, while connected to a server, as opposed to the signing taking place on the client PC.

To increase the security associated with identity protection and digital signing credentials, Wave’s SmartSignature is currently enabled for the support of TPMs.  SmartSAFE Version 3.0 is a web-based document management application where signed documents are archived and tracked.  SmartSAFE provides an easy-to-use environment where a client institution can view, manage, store and transfer sensitive signed and unsigned documents.  SmartSAFE also supports archival and management of unsigned documents in virtually any format.  These products allow a document to be executed, verified, accepted and filed in minutes at a lower cost compared to traditional paper-based documentation methods. SmartSignature Version 3.0 and SmartSAFE Version 3.0 have been completed and Wave commercially released these products in the first quarter of 2003.  SmartIdentity, an optional service to verify a signer’s identity through strong authentication methods, including issuing encrypted digital certificates. based on public key infrastructure technology, was completed and released in January of 2003.  Wave will continue to allocate resources toward marketing and sales to promote these products.

Wave’s eTMS, in addition to being part of the EMBASSY Trust Suite applications and supporting TPMs, is also being independently marketed in the insurance, mortgage, finance, government and other markets which are seeking digital and electronic signature solutions that are compliant with the Electronic Signatures in Global and National Commerce Act (“ESIGN”).  In 2005, eTMS’ SmartSignature Server product was licensed to a la mode, inc., a leading provider of desktop, mobile and Web tools for the real estate and mortgage industries, to provide digital signature solutions for their XSites product line.  Wave also signed licensing agreements in 2005 and in the second quarter of 2006 with Efficient Forms, LLC, a leading provider of interview-based electronic forms creation, to offer a comprehensive managed-service solution for electronic forms and electronic signatures.  In Q4 of 2005, the Wave/Efficient Forms managed service was launched, and deployed at FISERV ISS to automate internal and consumer business processes.  Wave has focused on digital signature applications that can make effective use of the stronger security features provided by trusted computing platforms.

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Current planned development costs for this product are expected to be approximately $334,000 for the year ending September 30, 2007.

Broadband Media Distribution Services

Wave offers broadband content distribution products and services through Wavexpress, a joint venture between Wave and Sarnoff Corporation.  The joint venture was established on October 15, 1999.  Under the joint venture agreement, Sarnoff and its affiliates received a 40% equity stake in Wavexpress.  Wave received a 53% equity interest and its affiliates, who purchased founders stock in April 1999 for a nominal amount, owned the remaining 7% of the outstanding capital stock.  The affiliates of Wave include Peter Sprague, former Chairman of Wave, Steven Sprague, Chief Executive Officer of Wave, certain members of the Board of Directors of Wave and certain Wave employees.  As of September 30, 2006, Wave owned 69% of Wavexpress and Sarnoff owned 25.6%.

Wavexpress has developed a vertically integrated suite of products designed to enable the optimum broadband distribution of digital programming. The current product offering combines industry standard syndication protocols with proprietary back-end software to create an end-to-end content syndication and monetization platform. This system is offered to content providers looking to deliver high-quality broadband media services using either Wavexpress’ distribution facility or on their own, through Really Simple Syndication (“RSS”).  RSS is the standard format for blogs and podcasts and is being increasingly used for open video distribution on the Internet.  Content providers connect through the Wavexpress client and backend software to generate advertising revenue or subscription fees for premium services.  Wavexpress’ business model intends to derive revenue either from direct fees charged to content providers for the use of Wavexpress software and facilities, or from a share of advertising proceeds collected.  Wavexpress proprietary client software is integrated and promoted through Microsoft’s Media Center Edition operating system, as well as with Microsoft’s Internet Explorer web browser.

We believe Wavexpress’ products deliver value to content providers by bringing a traditional advertising sales model to the emerging market for cached, syndicated, high-quality video content.  By leveraging an open standard, RSS, Wavexpress believes it is in a position to work with any content provider — large or small.  Wavexpress’ investment in proprietary backend and distribution technology creates opportunities to differentiate and capitalize on this rapidly growing segment of the content industry.

Planned future development expenditures are expected to approximate $1.6 million for the year ending September 30, 2007.

Our Market

Software has traditionally secured critical information on networks and PCs and allowed for user access to various applications.  However, virus attacks and breaches of security have proven that software, on its own, is not capable of completely securing a network or platform.  Because of these persistent security concerns, there is now a recognized need in the computer industry for the development and deployment of a more robust and reliable security infrastructure, including new security hardware in devices to guard against these persistent security risks.  The TCG was formed to develop, define and promote open industry standard specifications for embedded hardware-enabled trusted computing and security technologies, including secure hardware and software interfaces across multiple platforms, peripherals and devices.  The underlying premise of the creation of a Trusted Platform that meets the TCG specification is that only when a platform is secured by hardware, in effect creating root of trust and an authenticatable security environment within the computer itself, will the information stored on the platform be adequately secure.  Wave is seeking to become a software, application and services leader in hardware-based digital security and e-commerce products markets.  Because Wave has been a pioneer in developing hardware-based computer security systems, it is distinctively positioned to take advantage of its unique knowledge, significant technology assets and trusted computing intellectual properties.

Because hardware-based trusted computing involves a new approach to conducting business and exchanging information using computer systems, it will require traditional software-based security be augmented with next generation hardware-based security and an enhanced support infrastructure. Intensive marketing and sales efforts have been and will continue to be necessary, in order to generate demand for products using Wave’s technology, and to ensure that Wave’s solution is accepted in this emerging market.  The current primary focus is on closing business with chip OEM, PC OEMs, enterprise customers and

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systems integrators.  Wave has also undertaken steps to develop and establish a reseller channel for our products.

R&D

Wave has realized minimal operating revenues since its inception.  At September 30, 2006, Wave has an accumulated deficit of approximately $298,765,110.  Wave has made a substantial investment in research and development, including approximately $6,175,701 for the nine-month period ended September 30, 2006, and expects to continue to make substantial investments in its products and technology.  For the years ended December 31, 2005, 2004 and 2003, Wave spent approximately $6.9 million, $6.9 million and $7.4 million, respectively, on research and development activities.

Wave was incorporated in Delaware on August 12, 1988 and was known previously as Indata Corp. Wave changed its name to Cryptologics International, Inc., on December 4, 1989 and to Wave Systems Corp. in January 1993.  Wave’s principal executive offices are located at 480 Pleasant Street, Lee, Massachusetts 01238, and its telephone number is (413) 243-1600.

Critical Accounting Policies

Wave’s discussion and analysis of its financial condition and results of operations are based on its consolidated financial statements.  The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported revenues and expenses during the reporting periods. On an ongoing basis, management evaluates its estimates and judgments, including those related to revenue recognition, accounts receivable reserves, valuation of long-lived and intangible assets, accounting for joint ventures and software development.  Management bases its estimates on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

The following accounting policies are deemed critical to the understanding of the consolidated financial statements included under Item 1 - Financial Information:

Method of Accounting for Joint Ventures - Wave accounts for its investments in joint ventures using the equity method of accounting when its ownership interest in the joint venture is less than fifty percent and it is determined that Wave has the ability to exercise significant influence over the joint venture’s operating and financial policies.  The financial statements of joint ventures in which Wave owns greater than a fifty percent interest are consolidated with Wave’s financial statements pursuant to APB Opinion No. 18.

Research and Development and Software Development Costs - Research and development costs are expensed as incurred.  Software development costs are accounted for pursuant to SFAS No. 86 “Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed” (“SFAS No. 86”). SFAS No. 86 specifies that costs incurred internally in creating a computer software product should be charged to expense when incurred as research and development costs until technological feasibility is established for the product.  Once technological feasibility is established and the product has achieved commercial marketability, all development costs should be capitalized until the product is available for general release to customers.  We consider technological feasibility to be established upon completion of a detail program design or in the absence of a detail program design, upon completion of a working model of the software, as defined in SFAS No. 86.  Judgment is required in determining when the technological feasibility of a product is established, if the product has achieved commercial marketability and in estimating the life of the product for which the capitalized costs will be amortized.

Impairment of Long-Lived Assets and Long-Lived Assets to Be Disposed - Wave reviews the valuation of long-lived assets, including property and equipment and capitalized software, under the

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provisions of SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS No. 144”) and SFAS No. 86. Wave is required to assess the recoverability of long-lived assets and capitalized software costs whenever events and circumstances indicate that the carrying value may not be recoverable. Factors we consider important that could trigger an impairment review include the following:

·                  significant underperformance relative to expected historical or projected future operating results;

·                  significant changes in the manner of our use of the acquired assets or the strategy of our overall business;

·                  significant negative industry or economic trends; and

·                  significant decline in our stock price for a sustained period.

In accordance with SFAS No. 144, when we determine that the carrying value of applicable long-lived assets may not be recoverable based upon the existence of one or more of the above indicators of impairment, we evaluate whether the carrying amount of the asset exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of that asset. If such a circumstance exists, we would measure an impairment loss to the extent the carrying amount of the particular long-lived asset or group exceeds its fair value. We would determine the fair value based on a projected discounted cash flow method using a discount rate determined by our management to be commensurate with the risk inherent in our current business model.  In accordance with SFAS No. 86, when we determine that the carrying value of certain other types of long-lived assets may not be recoverable, we evaluate whether the unamortized cost exceeds the expected future net realizable value of the products. If the unamortized costs exceed the expected future net realizable value of the products, the excess amount is written off. Changes in judgments on any of these factors could impact the value of the asset being evaluated.

Revenue Recognition — Wave’s business model targets revenues from various sources including: licensing of EMBASSY Trust Suite, EMBASSY Trust Server, Wavexpress’ broadband media distribution and eTMS software products and professional service contracts.  Many of our sales arrangements include multiple elements, and in some cases require significant modification or customization of our software.

Wave follows the provisions of statement of position “SOP” 97-2, Software Revenue Recognition as amended by SOP 98-9, Modification of SOP 97-2, Software Revenue Recognition, with Respect to Certain Transactions.  Generally, Wave recognizes revenue when it is realized or realizable and earned. Wave considers revenue realized or realizable and earned when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable and collectibility is reasonably assured. Wave reduces revenue for estimated customer returns, rotations and sales rebates when such amounts can be estimated. When these amounts cannot be estimated Wave defers revenue until the product is sold to the end-user. Revenue from software license agreements that have significant customizations and modification of the software product is deferred and recognized in a manner that approximates the percentage of completion method.  In addition to the aforementioned general policy, the following are the specific revenue recognition policies for each major category of revenue.

SOFTWARE

Revenue from delivered elements of one-time charge licensed software is recognized at the inception of the license term, provided Wave has vendor-specific objective evidence of the fair value of each undelivered element for arrangements that contain multiple elements. Revenue is deferred for undelivered elements for these arrangements.  Revenue is also deferred for the entire arrangement, if vendor-specific objective evidence does not exist for each undelivered contract element.  Examples of undelivered elements in which the timing of delivery is uncertain include contractual elements that give customers rights to any future upgrades at no additional charge or future maintenance that is provided within the overall price. The revenue that is deferred for any contract element is recognized when all of the revenue recognition criteria have been met for that element.

Prepaid royalty fees received pursuant to distribution software licenses with OEMs in which Wave earns a royalty, based upon units shipped by the OEM to end customers, are deferred when received and recognized as revenue, as units are shipped by the OEM.

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SERVICES

Revenue from time and material service contracts is recognized as the services are provided. Revenue from fixed price, long-term service or development contracts is recognized over the contract term based on the percentage of services that are provided during the period compared with the total estimated services to be provided over the entire contract. Losses on fixed price contracts are recognized during the period in which the loss first becomes apparent.  Payment terms vary by contract.

Share-based Payment - On January 1, 2006, Wave adopted Statement of Financial Accounting Standard No. 123 (R), “Share-Based Payment,” (“SFAS No. 123(R)”) which requires the measurement and recognition of compensation expense for all stock-based payment awards made to employees and directors including employee stock options and employee stock purchases based on estimated fair values. In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107 (“SAB 107”) relating to SFAS No. 123(R). The Company has applied the provisions of SAB 107 in its adoption of SFAS No. 123(R).

SFAS No. 123(R) requires companies to estimate the fair value of stock-based payment awards on the date of grant using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in the Company’s consolidated statement of operations. SFAS No. 123(R) supersedes Wave’s previous accounting under the provisions of SFAS No. 123, “Accounting for Stock-Based Compensation.” As permitted by SFAS No. 123 Wave measured compensation cost for options granted prior to January 1, 2006, in accordance with Accounting Principles Board Opinion (APB) No. 25, “Accounting for Stock Issued to Employees” and related interpretations. Accordingly, no accounting recognition was given to stock options granted at fair market value until they were exercised. Upon exercise, net proceeds, including tax benefits realized, were credited to equity.

Wave adopted SFAS No. 123(R) using the modified prospective transition method, which requires the application of the accounting standard as of January 1, 2006.  In accordance with the modified prospective transition method, Wave’s consolidated financial statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS No. 123(R).

Wave uses the Black-Scholes-Merton option pricing model to value stock options. The Black-Scholes-Merton model requires the use of employee exercise behavior data and the use of a number of assumptions including volatility of the company’s stock price, the weighted average risk-free interest rate and the weighted average expected term of the options. Since Wave does not pay dividends, the dividend rate variable in the Black-Scholes-Merton model is zero.

Results of Operations

Three Months Ended September 30, 2006 and 2005

Wave had revenues of $846,280 and $ 335,335 for the three months ended September 30, 2006, and 2005, respectively.   The increase was due primarily to licensing revenues, which increased by $502,777, due to higher volume of shipments of Wave’s OEM customer products for which Wave receives royalty income.

The table below sets forth the components that make up the revenue for the quarters ended September 30:

 

2006

 

2005

 

Increase/
(Decrease)

 

% Change

 

Licensing

 

$

826,946

 

$

324,169

 

$

502,777

 

155.1

%

Services

 

19,334

 

11,166

 

8,168

 

73.2

%

Total Net Revenues

 

$

846,280

 

$

335,335

 

$

510,945

 

152.3

%

 

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Cost of sales for the three months ended September 30, 2006, was $202,985 compared with $184,916 for the same period in 2005.  The increase in costs of sales was due to higher customer support costs in connection with the increased license revenue in the quarter ended September, 2006 versus 2005.

Selling, general and administrative (“SG&A) expenses for the three months ended September 30, 2006, were $2,998,236 as compared to $2,787,761 for the comparable period of 2005, an increase of approximately 8%.  The increase was due mainly to non-cash, share-based compensation expense totaling approximately $214,854 for Wave and approximately $31,479 for Wavexpress that was incurred in the quarter ended September 30, 2006, in accordance with SFAS 123(R). This expense was not incurred in the quarter ended September 30, 2005, because Wave did not adopt SFAS 123(R) until its effective date of January 1, 2006.  Included in the SG&A expenses listed above are Wavexpress’ selling, general and administrative expenses, which were $224,334 and $276,449 for the quarters ended September 30, 2006, and 2005, respectively.  This 19% decrease was due primarily to a decrease in rent and other facilities-related costs.

The activities supported by SG&A expenses include business development, sales, marketing (including product development and product management), corporate communications and public relations, information technology and management information systems, human resources, accounting, executive management, corporate governance and general administrative functions.  Given the early stage nature of the markets for products that use our technology, we have expended and will continue to expend considerable resources in the sales, marketing, business development and support activities referred to above that will be necessary for us to be successful in developing salable products and markets for our technology.

Research and development expenses for the three months ended September 30, 2006, were $2,163,201 as compared to $1,827,118 for the comparable period of 2005, an increase of 18%.  This increase was primarily attributable to increased salaries, fringe and benefit expenditures of approximately $166,661 at Wave and $46,988 at Wavexpress, associated with salary rate increases and headcount additions to accommodate additional research and development efforts, which exceed those in the three months ended September 30, 2005.  The increase was due also to non-cash, share-based compensation expense totaling approximately $109,495 for Wave and approximately $21,765 for Wavexpress that was incurred in the quarter ended September 30, 2006, in accordance with SFAS 123(R).   Wavexpress’ research and development expenditures included in the above were approximately $324,916 and $253,442 for the quarters ended September 30, 2006, and 2005, respectively, for an increase of approximately 28%, due to the reasons set forth above.

Interest income for the three months ended September 30, 2006, was $30,872 as compared to $17,855 for the comparable period of 2005.  The increase in interest income is primarily attributable to a higher rate of interest earned on Wave’s money market accounts for the quarter ended September 30, 2006, compared with the same period in 2005.

Wave sold 200,000 shares of Saflink common stock for total proceeds of $289,003, during the quarter ended September 30, 2005, at an average selling price of $1.45 per share, realizing an aggregate gain from the sales of $92,340.  Wave did not hold any marketable securities during the quarter ended September 30, 2006.

For the quarter ended September 30, 2006, Wave recorded no gain or loss, in connection with the value of the outstanding warrants containing net cash settlement features, versus a loss of $7,543 for the quarter ended September 30, 2005.  These warrants were granted in connection with a private placement of Class A Common Stock completed on November 18, 2003.  The liability, calculated using the Black-Scholes option pricing model, was valued at $-0- as of September 30, 2006.  The loss for the quarter ended September 30, 2005, was primarily the result of the decrease in the quoted closing price on The Nasdaq Global Market of Wave’s Class A Common Stock from June 30, 2005 to September 30, 2005.  Because the price of Wave’s Class A Common Stock decreased, the fair value of the warrants decreased as well, resulting in the gain.

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Due to the reasons set forth above, our net loss to common stockholders for the three months ended September 30, 2006, was $4,487,270 as compared to $4,361,808 for the comparable period of 2005.

Nine Months Ended September 30, 2006 and 2005

Wave had revenues of $2,249,839 and $670,866 for the nine-month period ended September 30, 2006, and 2005, respectively.   Licensing revenues increased by $1,178,675, due to higher volume of shipments of Wave’s OEM customer products for which Wave receives royalty income.  Services revenue increased by $400,298 due to revenue from government time-and-materials contracts that were signed during the first quarter of 2006.

The table below sets forth the components that make up the revenue for the nine-month period ended September 30, 2006, and 2005:

 

2006

 

2005

 

Increase/
(Decrease)

 

% Change

 

Licensing

 

$

1,817,993

 

$

639,318

 

$

1,178,675

 

184.4

%

Services

 

431,846

 

31,548

 

400,298

 

1268.9

%

Total Net Revenues

 

$

2,249,839

 

$

670,866

 

$

1,578,973

 

235.4

%

 

Cost of sales for the nine-month period ended September 30, 2006, was $773,904, compared with $530,918 for the same period in 2005.  The increase in costs of sales was due to costs associated with time-and-materials contract revenue during the September 30, 2006 quarter versus the prior year quarter.

SG&A expenses for the nine months ended September 30, 2006, were $9,400,495, as compared to $8,721,623 for the comparable period of 2005, an increase of approximately 8%.  The increase was due mainly to non-cash, share-based compensation expense totaling approximately $700,279 for Wave and $77,447 for Wavexpress that was incurred in the nine-month period ended September 30, 2006, in accordance with SFAS 123(R). This expense was not incurred in the nine-month period ended September 30, 2005, because Wave did not adopt SFAS 123(R) until its effective date of January 1, 2006.  This increase was offset by a decrease in rent and other facilities-related expense of approximately $74,853 resulting from Wavexpress entering into a new, lower cost lease for its headquarters.  Included in the SG&A expenses listed above are Wavexpress’ selling, general and administrative expenses, which were $822,217 and $827,038 for the nine-month periods ended September 30, 2006, and 2005, respectively.  This less than 1% decrease was due to the reasons set forth above.

The activities supported by SG&A expenses include business development, sales, marketing (including product development and product management), corporate communications and public relations, information technology and management information systems, human resources, accounting, executive management, corporate governance and general administrative functions.  Given the early stage nature of the markets for products that use our technology, we have expended and will continue to expend considerable resources, in the sales, marketing, business development and support activities referred to above that will be necessary for us to be successful in developing products and markets for our technology.

Research and development expenses for the nine months ended September 30, 2006, were $6,175,701, as compared to $5,091,220 for the comparable period of 2005, an increase of 21%.  This increase was primarily attributable to increased salaries, fringe and benefit expenditures of approximately $728,520 associated with salary rate increases and headcount additions to accommodate additional research and development efforts that were undertaken since September 30, 2005.  In addition, non-cash, share-based compensation expense was approximately $293,833 at Wave and $47,560 at Wavexpress in connection with the adoption of SFAS 123(R) on January 1, 2006.  Wavexpress’ research and development expenditures included in the above were approximately $920,865 and $847,571 for the nine-month periods ended September 30, 2006, and 2005, respectively, for an increase of 9%. The increase in Wavexpress R&D expense was due to the share-based compensation referred to above and additional consultant

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expenses of approximately $35,000 associated with higher consultant headcount in 2006 versus the prior year nine-month period.

Interest income for the nine months ended September 30, 2006, was $79,183 as compared to $57,925 for the comparable period of 2005.  The increase in interest income is primarily attributable to an increase in interest rates earned on Wave’s money market accounts for the nine-month period ended September 30, 2006, compared with the same period in 2005.

Wave sold 200,000 shares of Saflink common stock for total proceeds of $289,003, during the nine months ended September 30, 2005, at an average selling price of $1.45 per share, realizing an aggregate gain from the sales of $92,340.  Wave did not hold any marketable securities during the nine months ended September 30, 2006.

For the nine months ended September 30, 2006, Wave recorded a gain, in connection with the value of the outstanding warrants containing net cash settlement features of $2,794, versus a gain of $455,317 for the nine-month period ended September 30, 2005.  These warrants were granted in connection with a private placement of Class A Common Stock completed on November 18, 2003.  The liability, calculated using the Black-Scholes option pricing model, was valued at $2,794 as of December 31, 2005, and $-0- as of  September 30, 2006.  The gain was primarily the result of the decrease in the quoted closing price on the Nasdaq National Exchange of Wave’s Class A Common Stock from December 31, 2005 to September 30, 2006.  Because the price of Wave’s Class A Common Stock declined, the fair value of the warrant liability decreased, as well resulting in the gain.

Due to the reasons set forth above, our net loss to common stockholders for the nine months ended September 30, 2006, was $14,018,254 as compared to $13,067,313 for the comparable period of 2005.

Liquidity and Capital Resources

Wave has experienced net losses and negative cash flow from its operations since its inception, and, as of September 30, 2006, had an accumulated deficit of $298,765,110.   Total stockholders’ equity as of September 30, 2006, was $1,046,325.  Wave has financed its operations through September 30, 2006, principally through the issuance of Class A and B Common Stock and various series of preferred stock.

Sources and uses of cash

As of September 30, 2006, Wave had $3,128,673 in cash and cash equivalents.  As of December 31, 2005, Wave had $2,006,022 in cash and cash equivalents.  The increase in cash and cash equivalents of $1,122,651, resulted from $12,723,889 used in operating activities, $242,102 used in investing activities for the acquisition of capital assets; offset by $14,088,643 generated through financing activities, from the sale of 7,491,013 shares of Class A Common Stock, including 82,706 shares sold pursuant to Wave’s Employee Stock Purchase Plan.  At September 30, 2006, Wave had working capital of $418,292.

Liquidity requirements and future sources of capital

Wave estimates that its total expenditures to fund operations for the twelve months ending September 30, 2007, will be approximately $20,900,000, including research and development, acquisition of capital assets, sales and marketing, general corporate expenses and overhead.

Expected sources of capital include the following:

·                  cash on hand of  $3,128,673 as of September 30, 2006

·                  cash from sales and licensing of products

·                  additional financings including the sale on October 30, 2006 of 3,517,230 shares of common stock for which we received gross proceeds of $9,602,038. We expect to realize approximately $9,092,000 after paying all transaction costs

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Given Wave’s capital requirements for the twelve-month period ending September 30, 2007, as indicated above, and Wave’s cash on hand as of September 30, 2006, it is likely that Wave will be required to raise additional capital to fund its operations.  The October 30, 2006 financing referred to above used all of the remaining availability under a $25,000,000 shelf registration that we filed on December 16, 2005, that the Commission declared effective on January 13, 2006.

We may obtain additional funding as needed, from further sales of newly issued shares of Class A Common Stock, including the sale of Class A Common Stock under the remaining availability of our $25,000,000 shelf registration statement that we filed on April 15, 2004 that the SEC declared effective on May 10, 2004.

There remains approximately $2,506,000 in gross proceeds available under the April 15, 2004 shelf registration statement, which may be utilized for future financings.  We can provide no assurances as to whether we will be successful in raising the needed capital to continue as a going concern.

Revenue outlook

Since 2003, Wave has begun licensing its EMBASSY Trust Suite software through bundling arrangements with OEMs with whom it signed contracts.  In addition, Wave receives revenues from software development and other services.  For the nine months ended September 30, 2006, we have received approximately $1,912,000 in cash from customers.  Total cash received from all revenue sources in 2005 was approximately $961,000.

In November of 2005, Wave signed a new OEM distribution agreement with Dell that permits Dell to distribute Wave software on certain Dell TPM-equipped business PCs.  Wave is being paid a per unit royalty fee for each Dell product shipment which includes Wave’s software.    In addition, pursuant to this same agreement, Dell is offering an upgrade package of Wave’s software that purchasers of certain models of TPM-equipped computers may buy. Wave will be paid a license fee, for each copy of the upgrade package that is purchased.  We are working with Dell to market our products in an effort to drive volume of purchases of the upgrade package.  However, we have no reliable basis to predict how many upgrade packages will be purchased, and what the resultant revenue to Wave might be from this program.  There are no minimum royalty or shipped quantity requirements.

In January of 2006, Wave signed a distribution agreement with Gateway that permits Gateway to distribute Wave software on Gateway TPM-equipped models.  Wave is being paid a per unit royalty fee for each Gateway shipment which includes Wave’s software.  In addition, pursuant to this same agreement, Gateway is offering an upgrade package of Wave’s software that purchasers of certain models of TPM-equipped computers may buy. Wave will be paid a license fee, for each copy of the upgrade package that is purchased.  We are working with Gateway to market our products in an effort to drive volume of purchases of the upgrade package.  However, we have no reliable basis to predict how many upgrade packages will be purchased, and what the resultant revenue to Wave might be from this program.  There are no minimum royalty or shipped quantity requirements.

In March of 2006, Wave signed a distribution agreement with Broadcom Corporation (“Broadcom”) that permits Broadcom to distribute Wave software on Broadcom TPM-equipped hardware devices.  Wave is being paid a per unit royalty fee for each Broadcom shipment, which includes Wave’s software.   We are working with Broadcom to market our products in an effort to drive volume of shipments of their TPM-equipped products.  However, we have no reliable basis to predict how many of Broadcom’s TPM-equipped products will be purchased, and what the resultant revenue to Wave might be from this program.  Although we have received a prepaid royalty, there are no minimum royalty or shipped quantity requirements.

In April of 2006, Wave signed a software license agreement with Winbond Electronics Corporation (“WEC”) that permits WEC to distribute Wave software on WEC TPM-equipped hardware devices.  Wave will be paid a per unit royalty fee for each WEC shipment which includes Wave’s software.   We are working with WEC to market our products in an effort to drive volume of shipments of their TPM-equipped products.  However, we have no reliable basis to predict how many of WEC’s TPM-equipped

28




 

products will be purchased, and what the resultant revenue to Wave might be from this program.  Although we received a prepaid royalty, there are no minimum royalty or shipped quantity requirements.  This software license agreement is in addition to the technology license agreement that Wave and WEC are a party to and royalties under this new software license agreement are in addition to the previously existing technology license agreement.

Wave also continues to work with all of its partners and customers to introduce and promote its existing software products and new software products which are under development, in an effort to expand the market for TPM-based secure computing and thereby increase its market share and revenues.  However, it should be noted that because of the early stage of Wave’s market and other factors, a high level of uncertainty exists with respect to the ability to forecast future revenues.    Although there has been a substantial increase in the volume of shipments of TPM chips, TPM hardware security that meets the TCG industry standard, which our business model depends upon, is still a new, developing category within the computer security market, the ultimate size of this market and the timeframe for its development are unknown and difficult to predict.

The license and distribution agreements referred to above began to generate royalty revenue in the second quarter of  2006.  The aggregate amount of royalty revenue from these arrangements for the remainder of 2006 and future years may be material.  We continued to receive payments of these additional royalties in the third quarter of 2006 and expect to continue to generate cash flow from these agreements as long as the agreements remain in effect and our software continues to ship with these products.  Enterprise customers are also expressing interest in the upgrade packages offered in connection with these distribution agreements.  We recorded modest initial revenues from the sale of license upgrade packages in the third quarter of 2006.

Wavexpress currently has one contract with a customer for its broadband media distribution services.  Given that this is a new type of service, it is difficult to predict the subscription levels and, therefore, the revenue that will be generated from this contract, or whether Wavexpress will generate revenues from future contracts or arrangements.

Known trends and uncertainties affecting future cash flows

Because Wave does not have sufficient cash to fund operations for the year ending September 30, 2007, and there is uncertainty as to whether Wave will generate sufficient revenues to fund its operations over this time period, Wave has been, and will likely continue to be, actively engaged in financing activities in order to generate additional funding to cover its operating costs for the year ending September 30, 2007.  These activities have included the filing of a $25,000,000 S-3 shelf registration with the SEC on December 16, 2005, which was declared effective on January 13, 2006; and the sale of 2,782,866 shares of common stock at $1.605 per share for gross proceeds of $4,466,500 in an initial round of financing under this shelf registration on February 15, 2006, for which we received approximately $4,250,000 in net proceeds.  We also granted warrants as part of the February 15 financing that allowed the purchasers to acquire an additional 516,956 shares of Wave common stock for $2.16 per share.  On May 8, 2006 an investor exercised one of these warrants for 162,037 shares, at an exercise price of $2.16 per share.  Wave received $336,000 from this warrant exercise after subtracting the 4% placement agent fee. The remaining warrants granted in connection with the February 16, 2006 financing, expired on August 15, 2006.

Pursuant to a financing entered into on May 3, 2006 under the same shelf registration statement,  we also sold 2,012,500 shares of Wave’s Class A common stock at $2.40 per share for gross proceeds of $4,830,000, for which we received approximately $4,548,400 in net proceeds.  In connection with that financing, we also agreed to issue a warrant to the placement agent (as part of the fees paid to the placement agent) that will allow the placement agent to acquire 100,625 shares of Wave Class A common stock for $2.40 per share.  The warrant expires on June 3, 2007.

On May 8, 2006, an investor also exercised a warrant issued by Wave to that investor in connection with Wave’s December 5, 2005 financing.  The warrant was exercised in full for 114,583 shares of Wave Class A Common Stock, at an exercise price of $2.40 per share.  Wave received $264,000 from the exercise of this warrant after subtracting the 4% placement agent fee.

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Also, pursuant to a financing entered into on August 4, 2006, under the same shelf registration statement, we sold 2,336,752 shares of Wave’s Class A common stock at $2.05 per share for gross proceeds of $4,790,342, for which we have received  $4,528,375 in net proceeds.  In connection with that financing, we also agreed to issue a warrant to the placement agent (as part of the fees paid to the placement agent) that will allow the placement agent to acquire 116,837 shares of Wave Class A common stock for $2.05 per share.  The warrant expires on September 3, 2007.

In addition, under the same shelf registration statement, on October 30, 2006, we sold and issued 3,517,240 shares of Wave’s Class A common stock for $2.73 per share.   We received gross proceeds from the sales of these shares of $9,602,038. We expect to realize net proceeds of approximately $9,092,000 after paying all transaction costs.  In connection with that financing, we also agreed to issue a warrant to the placement agent (as part of the fees paid to the placement agent) that will allow the placement agent to acquire 175,861 shares of Wave Class A common stock for $2.73 per share.  The warrant expires on November 30, 2007.

It is likely that we will be required to sell additional shares of common stock, preferred stock, obtain debt financing or engage in a combination of these financing alternatives, to raise additional capital to continue to fund our operations for the year ending September 30, 2007.   The availability and amount of any such financings are unknown at this time. Wave may also be required to reduce expenses which may significantly impede its ability to meet its sales, marketing and development objectives.  Given the available cash currently on hand and our expenditure forecast for the next twelve months ending September 30, 2007, we estimate that we will need to generate at least $5,600,000, over and above the proceeds from the October 30, 2006 financing, from a combination of revenue growth and additional financing activities, in order to continue as a going concern for the next twelve months ending September 30, 2007.

Other uncertainties that may impact the future business outlook

Uncertainty exists with respect to the formal Commission investigation.  There is uncertainty as to the amount of legal costs that Wave may incur in addressing this matter.  In addition, the extent of any impact due to negative publicity or perceived negative publicity is unknown.

Because the information security services market and the TCG hardware security category, in particular, are in early stages of development, customer requirements may change and new competitive pressures can emerge, which could require a shift in product development and/or market strategy.  Should such shifts occur, it may require development, marketing and sales strategies to re-start or expand, which would likely increase operating costs, requiring additional capital.  Such shifts have occurred several times throughout Wave’s history and have required significant changes in strategy and business plan.

Furthermore, the achievement of sufficient revenue is dependent upon continued significant expenditures, which will likely be required for research and development and sales and marketing beyond September 30, 2007 to increase market awareness.  Therefore, if Wave is not able to begin to generate significant revenues by September 30, 2007 to cover its operating costs, it will need to generate capital from other sources, including raising funds through either issuing additional common stock, preferred stock and/or debt to fund its operations beyond September 30, 2007.

Commitments

Wave has no significant long-term contractual obligations other than with respect to operating leases for its facilities, which are listed below:

 

 

Within
one year

 

Years two
and three

 

Years four
and five

 

Total

 

 Operating lease commitments

 

$

662,579

 

$

460,519

 

$

42,906

 

$

1,166,004

 

 

Net operating and capital loss carryforwards

As of December 31, 2005, Wave had available net operating and capital loss carryforwards for Federal income tax purposes of approximately $252 million, which expire beginning in 2006 through 2025.  Because of the “change in ownership” provisions of the Tax Reform Act of 1986, the utilization of our net operating and capital loss carryforwards against taxable income in future periods may be subject to an

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annual limitation if a cumulative change in ownership of more than 50 percent of Wave occurs within any three-year period.  We have made no determination concerning whether there have been such cumulative changes in ownership or the impact on the utilization of the loss carryforwards if such changes have occurred.  However, in considering Section 382 of the Internal Revenue Code, we believe that it is likely that such a change in ownership occurred prior to or following the completion of our initial public offering in September 1994 and, potentially, in periods following.  As a result, all of the utilization of our net operating losses is likely to be subject to annual limitations.

Going concern opinion

The accompanying consolidated financial statements have been prepared assuming that Wave will continue as a going concern. Wave’s independent auditors, KPMG LLP, have issued a report on Wave’s financial statements as of December 31, 2005, dated March 9, 2006, that includes an explanatory paragraph referring to our significant operating losses and substantial doubt of our ability to continue as a going concern.  (See also Note 1 to Wave’s consolidated financial statements.)

Item 3. Quantitative and Qualitative Disclosures about Market Risk

The exposure to market risk associated with interest rate-sensitive instruments is not material.  Wave’s cash and cash equivalents consist primarily of money market funds that meet high credit quality standards and the amount of credit exposure to any one issue is limited.

Item 4.  Controls and Procedures

Evaluation of Disclosure Controls and Procedures.

As of the end of the period covered by this report, an evaluation was carried out under the supervision and with the participation of Wave’s management, including the Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), of the effectiveness of Wave’s disclosure and control procedures pursuant to Rule 13a-15 of the Securities Exchange Act of 1934 (the “Exchange Act”).  Based on that evaluation, the CEO and CFO have concluded that Wave’s disclosure controls and procedures were effective as of September 30, 2006 to ensure that information required to be disclosed by Wave in the reports that it files or submits under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the SEC rules and forms.

There has been no change in our internal controls over financial reporting that occurred during the period ended September 30, 2006, that has materially affected, or is reasonably likely to materially affect, Wave’s internal controls over financial reporting.

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PART II - OTHER INFORMATION

ITEM 1. Legal Proceedings

Securities and Exchange Commission Investigation

On December 17, 2003, Wave received an Order by the Securities and Exchange Commission regarding a formal investigation.  The focus of this investigation is on certain public statements made by Wave during and around August 2003, as well as certain trading in Wave’s securities during such time.  Wave is cooperating fully with the SEC in this investigation.  Wave is unable to predict the outcome of this investigation at this time.

Purported Class Actions

A consolidated amended class action complaint is pending in the United States District Court for the District of Massachusetts, naming Wave, its Chief Executive Officer and its Chief Financial Officer as defendants.  Brumbaugh et al. v. Wave Systems Corp. et al., Civ. No. 04-30022 (D. Mass.) (MAP).

The purported class action has been filed by alleged purchasers of Wave’s Class A Common Stock during the purported class period July 31, 2003 through February 2, 2004.  The complaint claims that Wave and the named individuals violated Section 10(b) of the Securities Exchange Act of 1934 (the “1934 Act”), Rule 10(b)-5 promulgated thereunder and Section 20(a) of the 1934 Act by publicly disseminating materially false and misleading statements, relating to Wave’s agreements with Intel and IBM.  The complaint did not specify the amount of alleged damages plaintiffs seek to recover.

In January 2006, the Court granted in part and denied in part defendants’ motion to dismiss.  The Court dismissed two but let stand seven alleged misrepresentations or omissions.  This is not a finding of fault or liability, it is a decision not entirely to dismiss plaintiffs’ pleading.

Without admitting liability, the defendants recently reached a mediated settlement in principle of all claims asserted by the plaintiffs.  The settlement must be approved by the Court before it is final.  Wave’s insurer has agreed to pay the plaintiffs a total of $1,750,000 in exchange for the dismissal with prejudice and release of the claims against all defendants.

Item 1a.   Risk Factors

This report contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from the results contemplated by these forward-looking statements due to certain factors, including those discussed below, and elsewhere in this quarterly report.

We have a history of net losses and expect net losses will continue. If we continue to operate at a loss, our business will not be financially viable.

We have experienced significant losses and negative cash flow from operations since our inception. We have not realized a net operating profit in any quarter since we began our operations,. This is due primarily to the early stage nature of the digital security industry in which we operate. As of September 30, 2006, we have an accumulated deficit of $298,765,110 and working capital of $418,292.  Given the lack of significant sales of our products and services, there is little basis for evaluating the financial viability of our business and our long-term prospects. You should consider our prospects in light of the risks, expenses and difficulties that companies in new and rapidly evolving markets encounter.

To achieve profitability we must, among other things:

·                  Convince chip, personal computer motherboard, personal computer and computer peripheral manufacturers to license and distribute our products and services and/or make them available to their customers through their sales channels;

·                  Convince computer end users and enterprise computer users to purchase our upgrade software and server products for trusted computing;

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·                  Convince consumers to choose to order, purchase and accept products using our products and services;

·                  Continue to maintain the necessary resources, especially talented software programmers;

·                  Develop relationships with personal computer manufacturers and computer systems integrators to facilitate and to maximize acceptance of our products and services, and

·                  Generate substantial revenue, complete one or more commercial or strategic transactions or raise additional capital to support our operations until we can generate sufficient revenues and cash flows.

If we do not succeed in these objectives, we will not generate revenues; hence, our business will not be sustainable.

We may not be able to fund our operations and continue as a going concern.

Since we began our operations, we have incurred net losses and experienced significant negative cash flow from operations. This is due to the early stage nature of market development for our products and services and the digital security industry as a whole. Wave expects to continue to incur substantial additional expenses associated with continued research and development and business development activities that will be necessary to commercialize our technology. This will likely result in significant losses for the foreseeable future. Considering our current cash balance including net proceeds of approximately $9,092,000 that we received from the sale of 3,517,230 shares of common stock on October 30, 2006, and Wave’s projected operating cash requirements, we anticipate that our existing capital resources will be adequate to satisfy our cash flow requirements into June of 2007. In order to fund our business through June of 2007 and beyond, it will be necessary for us to generate substantial additional revenue, complete one or more commercial or strategic transactions or raise additional capital. Wave is uncertain as to the availability of financing from other sources to fund any cash deficiencies. Even if we are successful in raising additional capital, uncertainty with respect to Wave’s viability will continue until we are successful in achieving our objectives. Furthermore, although we may be successful at achieving our business objectives, a positive cash flow from operations may not ultimately be realized unless we are able to sell our products and services at a profit. Given the early stage nature of the markets for our products and services, considerable uncertainty exists as to whether or not Wave’s business model is viable.

We may be unable to raise the $5.6 million of additional cash flow, which is necessary to continue as a going concern for the next twelve months.

Based upon our current expense forecast, we estimate that our current available capital, including net proceeds of approximately $9,092,000 that we received from the sale of 3,517,230 shares of common stock on October 30, 2006, is sufficient to fund Wave into June of 2007.  In addition to our efforts to begin to generate revenue sufficient to fund our operations, or complete one or more commercial or strategic transactions, Wave is evaluating additional financing options to generate additional capital in order to continue as a going concern, to capitalize on business opportunities and market conditions and to insure the continued development of our technology, products and services. We estimate, based upon our current forecasts that we will need to generate approximately $5.6 million, in addition to the $9,092,000 in proceeds referred to above, from a combination of revenue growth, commercial or strategic transactions and/or additional financings, to continue as a going concern for the twelve months ending September 30, 2007. We expect we will be required to generate a significant portion of this cash through additional financings in the form of sales of securities.  We do not know if additional financing will be available or that, if available, it will be available on favorable terms. If we issue additional shares of our stock, our stockholders’ ownership will be diluted, or the shares issued may have rights, preferences or privileges senior to those of our common stock.   In addition, if we pursue debt financing we may be required to pay interest costs.     The failure to generate sufficient cash flow to fund our forecasted expenditures would require us to reduce our cash burn rate which would in turn impede our ability to achieve our business objectives.  Furthermore, if we are not successful in generating sufficient cash flow or obtaining additional

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funding, we will be unable to continue our operations, develop or enhance our products, take advantage of future opportunities, respond to competitive pressures and continue as a going concern.

Our market is in the early stage of development so we are unable to accurately ascertain the size and growth potential for revenue in such a market.

The market for our products and services is still developing and is continually evolving. As a result, substantial uncertainty exists with respect to the size of the market for these products and the level of capital that will be required to meet the evolving technical requirements of the marketplace.

Wave’s business model relies on an assumed market of tens of millions of units shipping with built-in security hardware. Because this market remains in the early stage of development, there is significant uncertainty with respect to the validity of the future size of the market. If the market for computer systems that utilize our products and services does not grow to the extent necessary for us to realize our business plan, we may not be successful.

As this early stage market develops and evolves, significant capital will likely be required to fund the resources needed to meet the changing technological demands of the marketplace. There is uncertainty with respect to the level of capital that may be required to meet these changing technological demands. If the amount of capital resources needed exceeds our ability to obtain such capital, we may not be a viable enterprise.

Wave is not established in the industry so we may not be accepted as a supplier or service provider to the market.

Wave’s offering represents a highly complex architecture designed to solve many of the security issues currently present with computer systems, such as identity theft, fraudulent transactions, virus attacks, unauthorized access to restricted networks and other security problems that users of computer systems generally encounter. We are uncertain as to whether the marketplace will accept our solution to these security problems. We will not be successful if the market does not accept the value proposition that we perceive to be present in our products and services.

Although Wave has expended considerable resources in developing technology and products that utilize our technology and in business development activities in an attempt to drive the development of the hardware security market, we do not have a track record as a substantial supplier or service provider to consumers of computer systems. Therefore, uncertainty remains as to whether we will be accepted as a supplier to the enterprise and consumer markets, which will likely be necessary for us to be a successful commercial enterprise.

Our products have not been accepted as industry standards, which may slow their sales growth.

We believe platforms adopting integrated hardware security into the PC will become a significant standard feature in the overall PC marketplace. However, our technologies have not been accepted as industry standards. Standards for trusted computing are still evolving. To be successful, we must obtain acceptance of our technologies as industry standards, modify our products and services to meet whatever industry standards ultimately develop, or adapt our products to be complementary to whatever these standards become. If we fail to do any of these, we will not be successful in commercializing our technology and, therefore, we will not generate sales to fund our operations and develop into a self-sustaining, profitable business.

If we do not keep up with technological changes, our product development and business growth will suffer.

Because the market in which we operate is characterized by rapidly changing technology, changes in customer requirements, frequent new products, service introductions and enhancements, and emerging industry standards, our success will depend upon, among other things, our ability to improve our products, develop and introduce new products and services that keep pace with technological developments, remain compatible with changing computer system platforms, respond to evolving customer requirements and

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achieve market acceptance on a timely and cost effective basis. If we do not identify, develop, manufacture, market and support new products and deploy new services effectively and timely, our business will not grow, our financial results will suffer and we may not have the ability to remain in business.

We encounter risks relating to security, system disruptions and computer infrastructure that could compromise our digital content.

Although we have implemented in our products various security mechanisms, our products and services may nevertheless be vulnerable to break-ins, piracy and similar disruptive problems caused by Internet users. Any of these disruptions would harm our business. Advances in computer capabilities, new discoveries in the field of security, or other developments may result in a compromise or breach of the technology we use to protect products and information in electronic form. Computer break-ins and other disruptions would jeopardize the security of information stored in, and transmitted through, the computer systems of users of our products, which may result in significant liability to us and may also deter potential customers.

A party who is able to circumvent our security measures could misappropriate proprietary electronic content or cause interruptions in our operations and those of our strategic partners. We may be required to expend significant capital and other resources to protect against security breaches or to alleviate problems caused by breaches. Our attempts to implement contracts that limit our liability to our customers, including liability arising from a failure of security features contained in our products and services, may not be enforceable. We currently do not have product liability insurance to protect against these risks.

Competition and competing technologies may render some or all of our products non-competitive or obsolete.

An increasing number of market entrants have introduced or are developing products and services that compete with Wave’s. Our competitors may be able to develop products and services that are more attractive to customers than our products and services. Many of our competitors and potential competitors have substantially greater financial, technical and marketing resources than we have. Also, many current and potential competitors have greater name recognition and larger customer bases that could be leveraged to enable them to gain market share or product acceptance to our detriment. Wave’s potential competitors include security solutions providers such as RSA Security, Inc., Symantec, Computer Associates, Verisign, Inc., Entrust, Inc., Utimaco, Safenet and major systems integrators such as IBM, HP and EDS.  In addition, Wave competes with other client security applications companies that have developed, or are developing, trusted computing applications, including Softex, Phoenix, Infineon and Microsoft.

Other companies have developed, or are developing, technologies that are, or may become, the basis for competitive products in the field of security and electronic content distribution. Some of those technologies may have an approach or means of processing that is entirely different from ours. Existing or new competitors may develop products that are superior to ours or that otherwise achieve greater market acceptance than ours. Due to Wave’s early stage, and lower relative name recognition compared to many of our competitors and potential competitors, our competitive position in the marketplace is vulnerable.

We have a high dependence on relationships with strategic partners that must continue or our ability to successfully produce and market our products will be impaired.

Due in large part to Wave’s early stage and lower-name recognition, we depend upon strategic partners such as large, well-established personal computer and semiconductor manufacturers and computer systems’ integrators to adopt our products and services within the Trusted Computing marketplace. These companies may choose not to use our products and could develop or market products or technologies that compete directly with us. We cannot predict whether these third parties will commit the resources necessary to achieve broad-based commercial acceptance of our technology. Any delay in the use of our technology by these partners could impede or prohibit the commercial acceptance of our products. Although we have established some binding commitments from some of our strategic partners, there can be no assurance that we will be able to enter into additional definitive agreements or that the terms of such agreements will be satisfactory. It will be necessary for Wave to expand upon current business relationships with our partners,

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or form new ones, in order to sell more products and services for Wave to become a viable, self-sufficient enterprise.

Product defects or development delays may limit our ability to sell our products.

We may experience delays in the development of our new products and services and the added features and functionality to our existing products and services that our customers and prospective customers are demanding. If we are unable to successfully develop products that contain the features and functionality being demanded by these customers and prospective customers in a timely manner, we may lose business to our competitors. In addition, despite testing by us and potential customers, it is possible that our products may nevertheless contain defects. Development delays or defects could have a material adverse effect on our business if such defects and delays result in our inability to meet the market’s demand.

If we lose our key personnel, or fail to attract and retain additional personnel, we will be unable to continue to develop our products and technology.

We believe that our future success depends upon the continued service of our key technical and management personnel and on our ability to attract and retain highly skilled technical, management, sales and marketing personnel. Our industry is characterized by a high level of employee mobility and aggressive recruiting of skilled personnel. There can be no assurance that our current employees will continue to work for us or that we will be able to hire any additional personnel necessary for our growth. Our future success also depends on our continuing ability to identify, hire, train and retain other highly qualified technical and managerial personnel. Competition for these employees can be intense. We may not be able to attract, assimilate or retain qualified technical and managerial personnel in the future. The failure to do so would have a material adverse effect on our business.

We have a limited ability to protect our intellectual property rights and others could infringe on or misappropriate our proprietary rights.

Our success depends, in part, on our ability to enjoy or obtain protection for our products and technologies under United States and foreign patent laws, copyright laws and other intellectual property laws and to preserve our trade secrets. We cannot assure you that any patent owned or licensed by us will provide us with adequate protection or will not be challenged, invalidated, infringed or circumvented.

We rely on trade secrets and proprietary know-how, which we protect, in part, by confidentiality agreements with our employees and contract partners. However, our confidentiality agreements may be breached, and we may not have adequate remedies for these breaches. Our trade secrets may also otherwise become known or be independently discovered by competitors. We also rely on intellectual property laws to prevent the unauthorized duplication of our software and hardware products. While we have and will continue to protect our software and our patented technology, intellectual property laws may not adequately protect our technology. We have registered trademark and service mark registrations with the United States Patent and Trademark Office for the marks WaveMeter and WaveNet, EMBASSY, Second Shift (the Wave juggler logo), WaveDirect and Charity Wave. Wave intends to apply for additional name and logo marks in the United States and foreign jurisdictions, as appropriate, but we cannot assure you that federal registration of any of these trademarks will be granted.

Regulation of international transactions may limit our ability to sell our products in foreign markets.

Most of our software products are controlled under various United States export control laws and regulations and may require export licenses for certain exports of the products and components outside of the United States and Canada. With respect to our EMBASSY Trust Suite software applications, we have applied for and received export classifications that allow us to export our products, without a license and with no restrictions, to any country throughout the world with the exception of Cuba, Iran, Iraq, Libya, North Korea, Sudan and Syria.

We believe the export classifications that we have received for our software products allow us to sell our products internationally in an effective, competitively advantageous manner. Enhancements to existing

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products may, and new products, including the EMBASSY Trust Server applications will, be subject to reviews by the BXA to determine what export classification they will receive. Some of our partners demand that our products be allowed to be exported without restrictions and/or reporting requirements. Current export regulations have, in part, allowed us to receive the desired classification without undue cost or effort. However, the export regulations may be modified at any time. Currently, we are allowed to export the products for which we’ve received classification, in an unrestricted manner without a license. However, modifications to the export regulations could prevent us from exporting our existing and future products in an unrestricted manner without a license. Such modifications could also make it more difficult to receive the desired classification. If export regulations were to be modified in such a way, we may be put at a competitive disadvantage with respect to selling our products internationally.

In addition, import and export regulations of encryption/decryption technology vary from country to country. We may be subject to different statutory or regulatory controls in different foreign jurisdictions, and as such, our technology may not be permitted in these foreign jurisdictions. Violations of foreign regulations or regulation of international transactions could prevent us from being able to sell our products in international markets. Our success depends in large part to having access to international markets.

Our stock price is volatile.

The price of our Class A common stock has been and likely will continue to be subject to wide fluctuations in response to a number of events and factors, such as:

·                  quarterly variations in operating results;

·                  announcements of technological innovations, new products, acquisitions, capital commitments or strategic alliances by us or our competitors;

·                  the operating and stock price performance of other companies that investors may deem comparable to us, and

·                  news reports relating to trends in our markets.

In addition, the stock market in general, and the market prices for technology-related companies in particular, have experienced significant price and volume fluctuations. These broad market fluctuations may adversely affect the market price of our Class A common stock or any of our other securities for which a market develops, regardless of our operating performance. Securities class action litigation has often been instituted against companies that have experienced periods of volatility in the market price for their securities. A settlement of a Class action lawsuit against us is currently pending (See “Item 1. Legal Proceeding” above.  It is possible that we could become the target of additional litigation of this kind that would require substantial management attention and expense.  The diversion of management’s attention and capital resources could have a material adverse affect on our business.  In addition, any negative publicity or perceived negative publicity of any such litigation could have an adverse impact on our business.

We may be subject to conflicts of interest that could adversely slow our corporate governance process.

Our Board of Directors does not include any representatives of our strategic partners. However, our Board of Directors has included in the past, and may include in the future, representatives of our strategic partners. It is possible that those corporations may be competing against us, or each other, directly or indirectly. A director who also represents another company may voluntarily abstain from voting on matters, where there could be conflicts of interest. Even if such a director does abstain, his presence on the Board could affect the process or the results of the Board’s deliberations. We have adopted no policies or procedures to reduce or avoid such conflicts. If such conflicts of interest arise, they may have a materially adverse effect on our business.

Governmental regulation may slow our growth and decrease our profitability.

There are currently few laws or regulations that apply directly to the Internet. Because our business is dependent in significant respect on the Internet, the adoption of new local, state, national or international

37




 

laws or regulations may decrease the growth of Internet usage or the acceptance of Internet commerce, which could, in turn, decrease the demand for our products and services and increase our costs or otherwise have a material adverse effect on our business.

Tax authorities in a number of states are currently reviewing the appropriate tax treatment of companies engaged in Internet commerce. New state tax regulations may subject us to additional state sales, use and income taxes.

If we make any acquisitions, we will incur a variety of costs and may never realize the anticipated benefits.

If appropriate opportunities become available, we may attempt to acquire businesses, technologies, services or products that we believe are a strategic fit with our business. We currently have no commitments or agreements with respect to any material acquisitions. If we do undertake any transaction of this sort, the process of integrating an acquired business, technology, service or product may result in operating difficulties and expenditures and may absorb significant management attention that would otherwise be available for ongoing development of our business. Moreover, we may never realize the anticipated benefits of any acquisition. Future acquisitions could result in potentially dilutive issuances of equity securities, the incurrence of debt, contingent liabilities and/or amortization expenses related to certain intangible assets and increased operating expenses, which could adversely affect our results of operations and financial condition.

A formal investigation by the Securities and Exchange Commission could affect our operations.

The SEC has commenced a formal investigation into certain matters relating to Wave. The SEC investigative order relates to certain public statements made by Wave during and around August 2003, as well as certain trading in Wave’s securities during such time. The SEC has not concluded that there has been any wrongdoing and Wave is cooperating fully with the SEC on this matter. An adverse resolution of the investigation may have a negative effect on our financial condition and operating results.

Shareholder derivative demand letters could affect our operations.

Previously, a purported shareholder derivative action was filed in the United States District Court for the District of Massachusetts.  The case was dismissed by the District Court, and on April 25, 2006, an appeal filed by the plaintiff was voluntarily dismissed, with prejudice.

On May 17, 2006, one of the named plaintiffs in the dismissed derivative action sent a shareholder demand letter to our board of directors.  The shareholder demands that we initiate litigation against the same defendants named in, and asserting the same claims as made in, the dismissed derivative litigation.  The board has taken the matter under advisement.

Item 6 Exhibits

(a)          Exhibits

 

Exhibit No.

 

 

 

Description of Exhibit

 

 

 

31.1

 

 

Certification of the Chief Executive Officer pursuant to Rule 13a-14a, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

 

 

 

31.2

 

 

Certification of the Chief Financial Officer pursuant to Rule 13a-14a, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

 

 

 

32.1

 

 

Certification of the Chief Executive Officer and Chief Financial Officer pursuant to 18.U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 

 

38




 

SIGNATURE

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

Dated: November 9, 2006

 

 

 

WAVE SYSTEMS CORP.

 

(Registrant)

 

 

 

 

By:

/s/ Steven K. Sprague

 

 

Name:Steven K. Sprague

 

 

Title:President and Chief Executive Officer

 

 

 

 

By:

/s/ Gerard T. Feeney

 

 

Name:Gerard T. Feeney

 

 

Title:Chief Financial Officer

 

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