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U. S. Securities and Exchange Commission
WASHINGTON, D.C. 20549
FORM 10-KSB
[X] ANNUAL REPORT UNDER SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2003.
[_] TRANSITION REPORT UNDER SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from ____________ to ___________.
Commission File Number: 1-14896
NETWORK-1 SECURITY SOLUTIONS, INC.
(Name of small business issuer in its Charter)
DELAWARE 11-3027591
(State or other jurisdiction (IRS Employer
of incorporation) Identification Number)
445 PARK AVENUE, SUITE 1028
NEW YORK, NEW YORK 10022
(Address of Principal Executive Offices)
Issuer's telephone number : (212) 829-5770
Securities registered under Section 12(b) of the Exchange Act:
Title of each class Name of each exchange on which registered
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Common Stock, $.01 par value None
Securities registered under Section 12(g) of the Exchange Act:
None
Check whether the issuer (1) filed all reports required to be filed by
Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such
shorter period that the registrant was required to file such reports), and (2)
has been subject to such filing requirements for the past 90 days.
Yes [X] No [_]
Check if there is no disclosure of delinquent filers in response to Item
405 of Regulation S-B contained in this form, and no disclosure will be
contained, to the best of registrant's knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this Form 10-KSB
or any amendment to this Form 10-KSB. [X]
The issuer's revenues for its most recent fiscal year: $218,000.
The aggregate market value of the voting common stock of the registrant
held by non-affiliates computed by reference to the price at which the stock was
sold on March 31, 2004 was approximately $1,554,094 (after giving effect to the
exchange of all convertible preferred stock for common stock completed on April
13, 2004).
The number of shares of Common Stock outstanding as of April 13, 2004 was
15,012,576.
Transitional Small Business Disclosure Format (Check One): Yes [_] No [X]
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PART I
THIS ANNUAL REPORT ON FORM 10-KSB CONTAINS CERTAIN STATEMENTS WHICH ARE
FORWARD-LOOKING STATEMENTS WITHIN THE MEANING OF THE SAFE HARBOR PROVISIONS OF
SECTION 27A OF THE SECURITIES ACT OF 1933, AS AMENDED, AND SECTION 21E OF THE
SECURITIES EXCHANGE ACT OF 1934, AS AMENDED. ACTUAL RESULTS, EVENTS AND
CIRCUMSTANCES (INCLUDING FUTURE PERFORMANCE, RESULTS AND TRENDS) COULD DIFFER
MATERIALLY FROM THOSE SET FORTH IN SUCH STATEMENTS DUE TO VARIOUS RISKS AND
UNCERTAINTIES, INCLUDING BUT NOT LIMITED TO, THOSE DISCUSSED IN THE SECTION
ENTITLED "RISK FACTORS THAT MAY AFFECT FUTURE RESULTS" IN ITEM 1 OF THIS REPORT
AS WELL AS THOSE RISKS DISCUSSED ELSEWHERE IN THIS REPORT.
ITEM 1. DESCRIPTION OF BUSINESS.
BACKGROUND
During the period June 1995 until December 2002, Network-1 Security Solutions,
Inc. (the "Company") developed, marketed, licensed and supported security
software products designed to prevent unauthorized access to information
residing on an enterprise's data network. In December 2002, the Company
discontinued offering its security software product line as it was unable to
achieve sufficient product revenue to support the expenses of such operations.
Thereafter, the Company sought a new business either through a merger or other
strategic transaction. In May 2003, the Company completed the sale of its
security software technology and related intellectual property to an
unaffiliated third party for $415,000. In November 2003, the Company acquired a
portfolio of telecommunications and data networking patents. As part of its new
business, the Company is pursuing licensing opportunities related to the
technologies covered by the patent portfolio. Provided below is a description of
the Company's current business and its business activities during the year ended
December 31, 2003.
OVERVIEW
The principal business of the Company is the acquisition, development,
licensing and protection of its intellectual property. The Company presently
owns six patents covering various telecommunications and data networking
technologies. The Company is pursuing licensing and strategic business alliances
with companies in the industries that manufacture and sell products that make
use of the technologies underlying its patents as well as with other users of
the technology who benefit directly from the technology including corporate,
educational and governmental entities.
On November 18, 2003, the Company acquired a portfolio of
telecommunications and data networking patents (the "Patent Portfolio") from
Merlot Communications, Inc., a broadband communications solutions provider. In
February 2004, following the acquisition of the Patent Portfolio and its review
of applicable markets, the Company commenced initial efforts to license its
Patent Portfolio. The Patent Portfolio consists of six patents issued by the
U.S. Patent Office that relate to various telecommunications
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and data networking technologies and includes, among other things, patents
covering the transmission of audio, video and data over computer and telephony
networks and the delivery of power over Ethernet networks for the purpose of
remotely powering network devices.
THE PATENTS
The Company's Patent Portfolio consist of the following patents:
U.S. Patent No. 6,577,631: Communication switching module for
the transmission and control of audio, video, and computer data over a single
network fabric;
U.S. Patent No. 6,574,242: Method for the transmission and
control of audio, video, and computer data over a single network fabric;
U.S. Patent No. 6,570,890: Method for the transmission and
control of audio, video, and computer data over a single network fabric using
Ethernet packets;
U.S. Patent. No. 6,539,011: Method for initializing and
allocating bandwidth in a permanent virtual connection for the transmission and
control of audio, video, and computer data over a single network fabric;
U.S. Patent No. 6,218,930: Apparatus and method for remotely
powering access equipment over a 10/100 switched Ethernet network; and
U.S. Patent No. 6,215,789: Local area network for the.
transmission and control of audio, video, and computer data
The Company's future success is largely dependent upon its proprietary
technologies and its ability to protect its intellectual property rights. The
complexity of patent and common law, combined with the Company's limited
resources, create risk that its efforts to protect its proprietary technologies
may not be successful. The Company cannot be assured that its patents will be
upheld, or that third parties will not invalidate its patents. In March 2004,
PowerDsine Inc. commenced litigation against the Company seeking, among other
things, a declaratory judgement that the Company's patent covering remote
delivery of power over Ethernet cables (U.S. Patent No. 6,218,930) is invalid
(See "Risk Factors - We Face Uncertainty As To The Outcome of Litigation with
PowerDsine" and Item 3. Legal Proceedings).
In February 2004, the Company initiated its licensing efforts relating
to its patent (U.S. Patent No. 6,218,930) covering the remote delivery of power
over Ethernet cables (the "Remote Power Patent"). As of March 31, 2004, the
Company transmitted letters to approximately 80 companies offering licenses to
the Remote Power Patent. To date the Company has not entered into any license
agreements with third parties with respect to its Remote Power Patent.
The Company was incorporated under the laws of the State of Delaware in
July 1990. The Company's offices are located at 445 Park Avenue, Suite 1028, New
York, New York 10022 and its telephone number is (212) 829-5770.
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HISTORICAL BUSINESS
From June 1995 until December 2002, the Company developed, marketed,
licensed and supported a suite of security software products designed to prevent
unauthorized access to critical information residing on networked servers,
desktops and laptops. In May 2003, the Company completed the sale of its
security software technology and related intellectual property to an
unaffiliated foreign corporation for an aggregate consideration of $415,000.
MARKET OVERVIEW
Management has determined that the Company's initial licensing efforts
will be focused on its Remote Power Patent. U.S. Patent No. 6,218,930 relates to
several technologies which describe a methodology for remotely powering devices
on an Ethernet network. The Remote Power Patent application was filed on March
11, 1999 and the patent was granted by the U.S. Office of Patent and Trademark
on April 21, 2001. The Remote Power Patent expires on March 11, 2019.
The Institute of Electrical and Electronic Engineers (IEEE) is a
non-profit, technical professional association of more than 360,000 individual
members in approximately 175 countries. The Standards Association of the IEEE is
responsible for the creation of global industry standards for a broad range of
technology industries. In 1999, at the urging of several industry vendors, the
IEEE formed a task force to facilitate the adoption of a standardized
methodology for the delivery of remote power over Ethernet networks which would
insure interoperability among vendors of switches and terminal devices. On June
13, the IEEE Standards Association approved the 802.3af Power Over Ethernet
standard (the "Standard"), which covers technologies deployed in delivering
power over Ethernet cables including whether deployed in switches or as
standalone midspan hubs both of which provide power to remote devices such as
wireless access point, IP phones and network based cameras. The technology is
commonly referred to as Power Over Ethernet ("PoE"). The Company believes its
Remote Power Patent covers several of the key technologies covered by the
Standard.
Ethernet is the leading local area networking technology in use today.
PoE technology allows for the delivery of power over Ethernet cables rather than
by separate power cords. As a result, a variety of network devices, including IP
telephones, wireless LAN Access Points, web-based network security cameras, data
collection terminals and other network devices, will be able to receive power
over existing data cables without the need to modify the existing infrastructure
to facilitate the provision of power for such devices through traditional AC
outlets. Advantages such as lower installation costs, remote management
capabilities, lower maintenance costs, centralized power backup, and flexibility
of device location as well as the advent of worldwide power compatibility create
the possibility of POE becoming widely adopted in networks throughout the world.
The benefits of PoE are compelling as evidenced by the introduction of
products by such leading vendors as 3Com, Seimens, Nortel Networks and Avaya, as
well as many others. In February 2004, Cisco Systems, Inc., the world's largest
network switch manufacturer, announced that all of its switches will be PoE
enabled in 2004.
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PowerDsine, Inc., the world's leader in PoE technology and a founding member of
the IEEE Task Force that developed the Standard, and Motorola, Inc., have
announced a partnership to develop chip-based POE solutions thereby reducing
cost and the number of components necessary to deliver manufacture Standard
compliant products.
The Company believes the cost savings as well as the other benefits that
can be realized by utilizing the technology contained in the Remote Power Patent
will be of significant importance to the growth of the Wireless Local Area
Networking (WLAN) industry and Voice Over IP Telephony (VOIP) industry.
According to In-Stat/MDRs, a market research firm, purchases of wireless
hardware, including Access Points for IEEE 802.11b/g (Wi-Fi) networks, reached
$2.2 billion in 2002 and are expected to exceed $3.9 billion by 2006. In
addition, In-State/MDR also estimated that units sold will rise from 18 million
to 75 million in 2006, which suggests that the cost of deploying wireless will
continue to fall as demand for wireless technologies continues to grow.
The VOIP market is currently one of the fastest growing segments in the
telecommunications industry. VOIP traffic has steadily increased over the last
several years and is being deployed by service providers and carriers worldwide.
IDC, a market research firm, estimates that worldwide IP telephone unit sales
are set to grow from 1.5 million units in 2003 to nearly 5 million units in
2007.
The Company also owns five (5) additional patents covering various
methodologies that provide for allocating bandwidth and establishing Quality of
Service for delay sensitive data, such as voice, on packet data networks.
Quality of Service issues become important when data networks carry packets that
contain audio and video which may require priority over data packets traveling
over the same network. Covered within these patents are also technologies that
establish bi-directional communications control channels between
network-connected devices in order to support advanced applications on
traditional data networks. The Company believes that potential licensees of the
technologies contained in these patents would be vendors deploying applications
that require the low latency transport of delay sensitive data such as video
over data networks.
NETWORK-1 STRATEGY
The Company's strategy is to capitalize on its Patent Portfolio through
entering into licensing arrangements with third parties including manufacturers
and users that utilize the Patent Portfolio's proprietary technologies as well
as any additional proprietary technologies covered by patents which may be
acquired by the Company in the future.
The Company does not anticipate manufacturing products utilizing the
Patent Portfolio or any of the proprietary technologies contained in the Patent
Portfolio. Accordingly, the Company does not anticipate establishing a
manufacturing, sales or marketing infrastructure. Consequently, the Company
believes that its capital requirements will be less than the capital
requirements for companies with such infrastructure requirements.
5
In connection with the Company's activities relating to the protection
of its Patent Portfolio, it may be necessary to assert patent infringement
claims against third parties that the Company believes are infringing its Patent
Portfolio. Such litigation may be costly and based on the Company's current
limited financial resources, it may not be able to pursue litigation as
aggressively as companies with substantially greater financial resources.
MARKETING AND DISTRIBUTION
In February 2004, the Company commenced licensing efforts for its Remote
Power Patent. The Company believes that potential licensees include, among
others, Wireless Local Area Networking (WLAN) equipment manufacturers, Wireless
Internet Service Providers (WISPs), Local Area Networking (LAN) equipment
manufacturers, Voice Over IP Telephony (VOIP) equipment manufacturers, and
Network Camera manufacturers. In addition, the Company believes that additional
potential licensees include users of the equipment embodying the PoE technology
covered by its Remote Power Patent, including corporate, educational and
federal, state and local government users, as they are significant beneficiaries
of the technologies covered by the Remote Power Patent. As of March 31, 2004,
the Company transmitted letters to approximately 80 companies offering licenses
to the Remote Power Patent.
COMPETITION
The telecommunications and data networking licensing market is
characterized by intense competition and rapidly changing business conditions,
customer requirements and technologies. The Company's current and potential
competitors have longer operating histories, greater name recognition and
possess substantially greater financial, technical, marketing and other
competitive resources than the Company. Although Management believes that the
Company has enforceable patents relating to telecommunications and data
networking, there can be no assurance that the Patent Portfolio will be upheld
or that third parties will not invalidate any or all of the patents in the
Patent Portfolio. In addition, the Company's current and potential competitors
may develop technologies that may be more effective than the Company's
proprietary technologies or that would render the Company's technologies less
marketable or obsolete. The Company may not be able to compete successfully.
In addition, other companies may develop competing technologies that
offer better or less expensive alternatives to PoE and the other technologies
covered by the Patent Portfolio. Several companies have notified the IEEE that
they may have patents and proprietary technologies that are covered by the
Standard. In the event any of those companies assert claims relating to its
patents, the licensing royalties available to the Company may be limited.
Moreover, technological advances or entirely different approaches developed by
one or more of its competitors or adopted by various standards groups could
render the Company's Remote Power Patent obsolete, less marketable or
unenforceable.
EMPLOYEES AND CONSULTANTS
As of March 31, 2004, the Company had one employee and one consultant.
6
RISK FACTORS THAT MAY AFFECT FUTURE RESULTS
The Company operates in a highly competitive environment that involves a
number of risks, some of which are beyond the Company's control. The following
discussion highlights the most material of the risks.
WE HAVE A HISTORY OF LOSSES, NO REVENUE FROM CURRENT OPERATIONS AND WE
MAY NOT BE ABLE TO CONTINUE OUR OPERATIONS IN THE FUTURE.
We have incurred substantial operating losses since our inception, which
has resulted in an accumulated deficit of $(41,036,000) as of December 31, 2003.
For the years ended December 31, 2003 and 2002, we incurred net losses of
$(614,000) and $(5,905,000), respectively. Since December 31, 2003, we have
continued to incur operating losses. We have financed our operations primarily
from the balance of funds from sales of equity and convertible debt securities
as well as the sale of our CyberWall PLUS security software technology in May
2003. Since December 2002, when we discontinued our offering of security
software products, we have not had material revenue from operations. We may not
have sufficient funds to continue our operations if we are unable to generate
sufficient revenue from our new business of licensing our telecommunications and
data networking patents.
WE COULD BE REQUIRED TO STOP OPERATIONS IF WE ARE UNABLE TO DEVELOP OUR
TECHNOLOGY LICENSING BUSINESS OR RAISE CAPITAL WHEN NEEDED.
We anticipate, based on our currently proposed plans and assumptions
relating to our operations (including the timetable of, costs and expenses
associated with our continued operations), that our current cash position will
more likely than not be sufficient to satisfy our operations and capital
requirements until at least September 2004. There can be no assurance, however,
that such funds will not be expended prior thereto. In the event our plans
change, or our assumptions change or prove to be inaccurate (due to
unanticipated expenses, difficulties, delays or otherwise), we could have
insufficient funds to support our operations prior to September 2004. We are
currently pursuing licensing opportunities for our patented technologies.
However, to date we have not entered into any such licensing arrangements. In
addition, even if we consummate licensing arrangements, such agreements may not
result in sufficient cash to support our operations or achieve material revenues
or profitability. Since we do not anticipate material revenues from our
licensing business in the near term, we intend to make efforts to raise capital
during the second or third quarter of 2004 to continue to fund our operations.
We have no current arrangements with respect to any additional financing.
Consequently, there can be no assurance that any additional financing will be
available to the Company when needed, on commercially reasonable terms or at
all. Our inability to consummate licensing arrangements and derive revenues
therefrom on a timely basis or obtain additional financing when needed would
have a material adverse effect on the Company, requiring us to curtail or
possibly cease our operations. In addition, any additional equity financing may
involve substantial dilution to the interests of our then existing stockholders.
7
WE RECENTLY ENTERED A NEW LICENSING BUSINESS AND MAY NOT BE SUCCESSFUL.
In November 2003, we entered the technology licensing business as a
result of our acquisition of six patents relating to various telecommunications
and data networking technologies including, among others, patents covering the
transmission of audio, video and data over computer and telephony networks and
the delivery of remote power over Ethernet. Accordingly we have a very limited
history in the technology licensing business upon which an evaluation of our
prospects and future performance can be made. Our prospects must be considered
in light of the risks, expenses and difficulties frequently encountered in the
development, operation and expansion of a new business based on rapidly changing
technologies in a highly specialized and competitive market. We may not be able
to achieve revenues or profitable operations from our new licensing business.
OUR FUTURE SOURCE OF LICENSING REVENUE IS UNCERTAIN.
In February 2004, we initiated our first licensing efforts relating to
the technologies in our Remote Power Patent (U.S. Patent No. 6,212,930). To
date, we have not entered into any licensing agreements with third parties with
respect to our patented technologies. Our inability to consummate licensing
agreements and achieve revenue from our patented technologies would have a
material adverse effect on our operations and our ability to continue our
business. In addition, in the event we consummate license arrangements with
third parties, such arrangements are unlikely to produce a stable or predictable
stream of revenue in the foreseeable future. Furthermore, the success of our
licensing efforts may depend upon the strength of our intellectual property
rights.
WE FACE UNCERTAINTY AS TO THE OUTCOME OF LITIGATION WITH POWERDSINE.
On March 31, 2004, PowerDsine Inc. ("PowerDsine") commenced an action
against us in the United District Court, Southern District of New York (Civil
Action No. 04 CV 2502) seeking a declaratory judgment that our Remote Power
Patent (U.S. Patent No. 6,218,930) is invalid and is not infringed by PowerDsine
and/or its customers. PowerDsine further seeks an order permanently enjoining us
(i) from making any claims to any person or entity that PowerDsine's products
infringe the Remote Power Patent or contributes to infringement of the patent,
(ii) from interfering with or threatening to interfere with the importation,
sale, license or use of PowerDsine's PoE components or products, and (iii) from
instituting or prosecuting any lawsuit or proceeding placing at issue the right
of PowerDsine, its customers, licensees, successors, or assigns to import, use
or sell PowerDsine's PoE components or products. We believe our Remote Power
Patent is valid and that we have meritorious defenses to the action. We intend
to vigorously defend the action and take whatever actions are necessary to
protect our intellectual property. In the event, however, that the Court granted
the declaratory judgment and our patent was determined to be invalid, such a
determination would have a material adverse effect on us. Regardless of the
outcome, this litigation may subject us to significant costs and diversion of
management time.
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WE FACE INTENSE COMPETITION AND WE MAY NOT BE ABLE TO SUCCESSFULLY
COMPETE.
The telecommunications and data networking licensing market is
characterized by intense competition and rapidly changing business conditions,
customer requirements and technologies. Our current and potential competitors
have longer operating histories, greater name recognition and possess
substantially greater financial, technical, marketing and other competitive
resources than us. Although we believe that we have rights to enforceable
patents relating to telecommunications and data networking, there can be no
assurance that third parties will not invalidate any or all of our patents. In
addition, our current and potential competitors may develop technologies that
may be more effective than our proprietary technologies or that render our
technologies less marketable or obsolete. We may not be able to compete
successfully.
OUR MARKETS ARE SUBJECT TO RAPID TECHNOLOGICAL CHANGE AND OUR
TECHNOLOGIES FACE POTENTIAL TECHNOLOGY OBSOLESCENCE.
The telecommunications and data networking technology market including,
transmission of audio, video and data over computer and telephony networks and
the delivery of remote power over Ethernet markets, are characterized by rapid
technological changes, changing customer requirements, frequent new product
introductions and enhancements, and evolving industry standards. The
introduction of products embodying new technologies and the emergence of new
industry standards may render our technologies obsolete or less marketable. To
the extent we are able to achieve revenue in the future, such revenue will be
derived from licensing our technologies based on existing and evolving industry
standards.
OUR SUCCESS IS DEPENDENT UPON OUR ABILITY TO PROTECT OUR PROPRIETARY
TECHNOLOGIES.
Our success is substantially dependent upon our proprietary technologies
and our ability to protect our intellectual property rights. We currently hold 6
patents issued by the U.S. Patent Office that relate to various
telecommunications and data networking technologies and include among other
things, patents covering the transmission of audio, voice and data over computer
and telephony networks and the delivery of remote PoE networks. We rely upon our
patents and trade secret laws, non-disclosure agreements with our employees,
consultants and third parties to protect our intellectual property rights. The
complexity of patent and trade secret law, and common law, combined with our
limited resources, create risk that our efforts to protect our proprietary
technologies may not be successful. We cannot assure you that our patents will
be upheld or that third parties will not invalidate our patent rights. In the
event our intellectual property rights are not upheld, such an event would have
a material adverse effect on our company. In addition, there is a risk that
third parties may independently develop substantially equivalent or superior
technologies.
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ANY LITIGATION TO PROTECT OUR INTELLECTUAL PROPERTY OR ANY THIRD PARTY
CLAIMS OF INFRINGEMENT COULD INVOLVE SUBSTANTIAL TIME AND MONEY AND COULD HAVE A
MATERIAL ADVERSE EFFECT ON OUR BUSINESS.
Our success depends on our ability to protect our intellectual property
rights. Accordingly, we may be subject to third-party claims seeking to
invalidate our patents. These types of claims, with or without merit, may
subject us to costly litigation and diversion of management's focus. In
addition, based on our limited financial resources, we may not be able to pursue
litigation as aggressively as competitors with substantially greater financial
resources. If third parties making claims against us seeking to invalidate our
patent are successful, they may be able to obtain injunctive or other equitable
relief, which effectively could block our ability to license or otherwise
capitalize on our proprietary technologies. Successful litigation against us
resulting in a determination that our patents are invalid, would have a material
adverse effect on our company.
DEPENDENCE UPON CEO AND CHAIRMAN.
Our success will largely be dependent upon the personal efforts of Corey
M. Horowitz, Chairman and Chief Executive Officer and Chairman of the Board of
Directors. Mr. Horowitz does not currently have an employment agreement with the
Company and serves as an employee-at-will. The loss of the services of Mr.
Horowitz could have a material adverse effect on our business and prospects.
DELISTING OF OUR SECURITIES FROM NASDAQ; RISKS RELATING TO LOW-PRICED
STOCKS.
On March 26, 2003 our common stock was delisted from The Nasdaq Stock
Market's SmallCap Market. As a result of the delisting, an investor could find
it more difficult to dispose of or to obtain accurate quotations as to the
market value of our common stock. Our common stock currently trades on the
over-the-counter market in the "pink sheets."
In addition, since our common stock has been delisted from trading on
Nasdaq and the trading price of our common stock is below $5.00 per share, our
common stock is considered a penny stock. SEC regulations generally define a
penny stock to be an equity security that is not listed on Nasdaq or a national
securities exchange and that has a market value of less than $5.00 per share,
subject to certain exceptions. The SEC regulations would require broker-dealers
to deliver to a purchaser of our common stock a disclosure schedule explaining
the penny stock market and the risks associated with it. Various sales practice
requirements are also imposed on broker-dealers who sell penny stocks to persons
other than established customers and accredited investors (generally
institutions). Broker-dealers must also provide the customer with current bid
and offer quotations for the penny stock, the compensation of the broker-dealer
and monthly account statements disclosing recent price information for the penny
stock held in the customer's account. As a result of the delisting of our Common
Stock from Nasdaq, investors may find it more difficult to obtain timely and
accurate quotes and execute trades in our common stock.
10
THE SIGNIFICANT NUMBER OF OPTIONS AND WARRANTS OUTSTANDING MAY ADVERSELY
EFFECT THE MARKET PRICE FOR OUR COMMON STOCK.
As of March 31, 2004, there are outstanding (i) options and warrants to
purchase an aggregate of 5,841,860 shares of our common stock at exercise prices
ranging from $.12 to $10.13, and (ii) 727,630 additional shares of our common
stock which may be issued in the future under our stock option plan. To the
extent that outstanding options and warrants are exercised, your percentage
ownership will be diluted and any sales in the public market of the common stock
underlying such options may adversely affect prevailing market prices for our
common stock.
WE HAVE A SIGNIFICANT AMOUNT OF AUTHORIZED BUT UNISSUED PREFERRED STOCK,
WHICH MAY AFFECT THE LIKELIHOOD OF A CHANGE OF CONTROL IN OUR COMPANY.
Our Board of Directors has the authority, without further action by the
stockholders, to issue 10,000,000 shares of preferred stock on such terms and
with such rights, preferences and designations as our Board of Directors may
determine. Such terms may include restricting dividends on our common stock,
dilution of the voting power of our common stock or impairing the liquidation
rights of the holders of our common stock. Issuance of such preferred stock,
depending on the rights, preferences and designations thereof, may have the
effect of delaying, deterring or preventing a change in control. In addition,
certain "anti-takeover" provisions in Delaware law may restrict the ability of
our stockholders to authorize a merger, business combination or change of
control.
ITEM 2. DESCRIPTION OF PROPERTY
The Company currently leases office space in New York City at a cost of
$2,700 per month. The lease is for six months with automatic renewals unless
terminated upon 60 days notice.
ITEM 3. LEGAL PROCEEDINGS
PowerDsine Litigation
On March 31, 2004, PowerDsine Inc. commenced an action against the
Company in the United District Court, Southern District of New York (Civil
Action No. 04 CV 2502) seeking a declaratory judgment that the Company's Remote
Power Patent (U.S. Patent No. 6,218,930) is not infringed by PowerDsine and/or
its customers. PowerDsine further seeks an order permanently enjoining the
Company (i) from making any claims to any person or entity that PowerDsine's
products infringe the Remote Power Patent or contributes to infringement of the
patent, (ii) from interfering with or threatening to interfere with the
importation, sale, license or use of PowerDsine's PoE components or products,
and (iii) from instituting or prosecuting any lawsuit or proceeding placing at
issue the right of PowerDsine, its customers, licensees, successors, or assigns
to import, use or sell PowerDsine's PoE components or products. The Company
believes its Remote Power Patent is valid and has meritorious defenses to the
action. The Company intends to vigorously defend the action and take whatever
actions are necessary to protect it's intellectual property. In the event,
however, that
11
the Court granted the declaratory judgment and the patent was determined to be
invalid, such a determination would have a material adverse effect on the
Company.
Additional Litigation
In January 2003, Richard J. Kosinski, former Chief Executive Officer,
President and a director of the Company, and Murray P. Fish, former Chief
Financial Officer and a director of the Company, commenced lawsuits against the
Company in the Commonwealth of Massachusetts, County of Essex, Superior Court,
seeking severance and bonus compensation and other benefits allegedly due them
in the aggregate amount of $400,000. In June 2003, the Company entered into a
settlement agreement with Mr. Kosinski pursuant to which the Company paid Mr.
Kosinski the sum of $127,000 in full settlement of all claims asserted by him in
the litigation. In addition, as part of the settlement, Mr. Kosinski agreed to
forfeit options to purchase 1,200,000 shares of the Company's Common Stock. In
February 2004, the Company reached an agreement in principal with Mr. Fish
pursuant to which the Company has agreed to pay Mr. Fish the sum of $55,000 in
full settlement of all claims asserted by him in the litigation.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None
12
PART II
ITEM 5. MARKET FOR COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND SMALL BUSINESS
PURCHASES OF EQUITY SECURITIES
MARKET INFORMATION. The Company's Common Stock had traded from November
12, 1998 until March 26, 2003 on the NASDAQ SmallCap Market under the symbol
"NSSI." The Company's Common Stock currently trades on the over-the-counter
market in the "Pink Sheets" under the symbol NSSI.PK. The following table sets
forth, for the periods indicated, the range of the high and low closing bid
prices for the Common Stock as reported on NASDAQ and thereafter on the "Pink
Sheets". Such prices reflect inter-dealer quotations, without retail mark-up,
mark-down or commission and may not necessarily represent actual transactions.
YEAR ENDED DECEMBER 31, 2003 HIGH LOW
---- ---
Fourth Quarter $0.22 $0.01
Third Quarter $0.04 $0.01
Second Quarter $0.06 $0.01
First Quarter $0.16 $0.05
YEAR ENDED DECEMBER 31, 2002 HIGH LOW
---- ---
Fourth Quarter $0.56 $0.13
Third Quarter $0.93 $0.50
Second Quarter $1.38 $0.62
First Quarter $2.23 $1.26
On March 31, 2004, the last sale price for the Common Stock as reported
on the Pink Sheets was $.25 per share. The number of record holders of the
Company's Common Stock was approximately 60 as of March 31, 2004.
DIVIDEND POLICY. The Company has never declared or paid any cash
dividends on its Common Stock and does not intend to declare or pay cash or
other dividends in the foreseeable future. The Board of Directors currently
expects to retain any future earnings, if any, for use in the operation and
expansion of its business. The declaration and payment of any future dividends
will be at the discretion of the Board of Directors and will depend upon a
variety of factors, including future earnings, if any, operations, capital
requirements, the general financial condition of the Company, the preferences of
any series of Preferred Stock, the general business conditions and future
contractual restrictions on payment of dividends, if any.
RECENT ISSUANCES OF UNREGISTERED SECURITIES. None.
ISSUER PURCHASES OF EQUITY SECURITIES. None.
13
EQUITY COMPENSATION PLAN INFORMATION
The following table summarizes share and exercise price information
about the Company's equity compensation plans as of December 31, 2003.
----------------------------------------- -------------------------- ------------------------- -------------------------
NUMBER OF SECURITIES
REMAINING AVAILABLE
NUMBER OF SECURITIES TO BE FOR FUTURE ISSUANCE UNDER
ISSUED UPON EXERCISE OF WEIGHTED-AVERAGE EXERCISE EQUITY COMPENSATION PLANS
OUTSTANDING OPTIONS, PRICE OF OUTSTANDING (EXCLUDING SECURITIES
WARRANTS AND RIGHTS OPTIONS, WARRANTS AND REFLECTED IN COLUMN
(a) RIGHTS (a))
----------------------------------------- -------------------------- ------------------------- -------------------------
Equity compensation plans approved by
security holders 3,272,370 $0.99 727,630
----------------------------------------- -------------------------- ------------------------- -------------------------
Equity compensation plans not
approved by security holders 0 -- 0
----------------------------------------- -------------------------- ------------------------- -------------------------
Total 3,272,370 $0.99 727,630
----------------------------------------- -------------------------- ------------------------- -------------------------
ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION
THE FOLLOWING DISCUSSION AND ANALYSIS SHOULD BE READ IN CONJUNCTION WITH
THE COMPANY'S FINANCIAL STATEMENTS, INCLUDING THE NOTES THERETO, INCLUDED
ELSEWHERE IN THIS FORM 10-KSB. EXCEPT FOR THE HISTORICAL INFORMATION CONTAINED
HEREIN, THIS DISCUSSION CONTAINS FORWARD-LOOKING STATEMENTS THAT INVOLVE RISKS
AND UNCERTAINTIES, INCLUDING, BUT NOT LIMITED TO, THOSE DISCUSSED IN THE SECTION
ABOVE ENTITLED "RISK FACTORS WHICH MAY AFFECT FUTURE RESULTS" IN ITEM 1 OF THIS
REPORT AS WELL AS THOSE RISKS DISCUSSED IN THIS SECTION AND ELSEWHERE IN THIS
REPORT. BECAUSE SUCH STATEMENTS INVOLVE RISKS AND UNCERTAINTIES, ACTUAL RESULTS
MAY DIFFER MATERIALLY FROM THOSE EXPRESSED OR IMPLIED BY SUCH FORWARD-LOOKING
STATEMENTS.
OVERVIEW
From June 1995 until December 2002, the Company licensed and supported a
suite of security software products designed to prevent unauthorized access to
critical information residing on networked servers, desktops and laptops. In
December 2002, in order to preserve cash as the Company sought a merger or other
strategic transaction, the Company discontinued its products offerings, as
operating expenses continued to exceed product revenues. In May 2003, the
Company completed the sale of its security software technology and related
intellectual property to an unaffilitated foreign corporation for an aggregate
consideration of $415,000. As a part of this sale, the Company also assigned its
rights under its Distribution and License Agreement with
14
FalconStor Software, Inc. ("FalconStor") pursuant to which FalconStor had the
right to distribute the Company's software product offerings in its indirect and
OEM channels.
On November 18, 2003, the Company acquired the Patent Portfolio from
Merlot Communications, Inc., a broadband communications solutions provider. As
part of its new business, the Company is pursuing licensing opportunities
related to the technologies covered by the Patent Portfolio. After reviewing
numerous opportunities, the Company's Board of Directors decided that the
acquisition of the Patent Portfolio and the pursuit of licensing opportunities
related thereto was the most attractive available alternative for its
shareholders.
The Patent Portfolio consists of six patents issued by the U.S. Patent
Office that relate to various telecommunications and data networking
technologies and include, among other things, patents covering the transmission
of audio, voice and data over computer and telephony networks and the delivery
of remote power over Ethernet networks. The consideration paid by the Company to
Merlot Communications, Inc. ("Merlot") for the acquisition of the Patent
Portfolio consisted of a cash payment of $100,000 and contingent future payments
equal to 20% of the net income (as defined in the acquisition agreement) of the
Company from the sale or licensing of the Patent Portfolio after the Company
achieves $4.0 million of net income from each patent comprising the Patent
Portfolio ("Net Profit Payments"). The Company has an option to terminate the
Net Profit Payments, at any time between January 1, 2007 through March 31, 2007,
and from January 1 through March 31 of each year thereafter, by making payments
to Merlot in an amount equal to the greater of (i) two times the payment due for
the twelve month period following the notice of termination or (ii) $3.0 million
plus 10% for each additional year starting January 1, 2008. Wheatley Partners
II, L.P. and its affiliates and related parties (the "Wheatley Parties"), who
are principal stockholders of the Company, owned a majority of the outstanding
voting stock of Merlot at the time of the Company's acquisition of the Patent
Portfolio. The Wheatley Parties did not participate in the negotiation or the
approval of the patent acquisition transaction by Merlot or the Company.
As of the date hereof, the Company has not entered into any license
arrangements with respect to the Patent Portfolio, although it is pursuing such
arrangements with third parties. The Company does not currently have any revenue
from operations. The success of the Company and its ability to achieve revenue
is largely dependent on its ability to consummate such licensing arrangements
with third parties.
To date the Company has incurred significant losses and at December 31,
2003, had an accumulated deficit of $(41,036,000). At March 31, 2004, the
Company had approximately $600,000 of cash and cash equivalents. Management
believes that based on its current cash position, the Company has sufficient
capital to fund its operations until September 2004, although there is no
assurance that the Company will not have sufficient capital prior to such date.
(See "Liquidity and Capital Resources" at page 18 hereof).
15
CRITICAL ACCOUNTING POLICIES:
Revenue recognition:
License revenue is recognized upon delivery of software or delivery of a
required software key. License revenue from distributors or resellers is
recognized as the distributor or reseller delivers software or the required
software key to end users or original equipment manufacturers. Service revenues
consist of maintenance and training services. Annual renewable maintenance fees
are a separate component of each contract, and are recognized ratably over the
contract term. Training revenues are recognized as such services are performed.
Revenue from advance license fees are deferred until they are earned pursuant to
the agreements.
Software development costs:
Costs to maintain developed programs and development costs incurred to
establish the technological feasibility of computer software are expensed as
incurred. The Company capitalized costs incurred in producing computer software
after technological feasibility of the software has been established through the
date that the software is ready for general release to customers. Such costs are
amortized based on current and estimated future revenue of each product with an
annual minimum equal to the straight-line amortization over the remaining
estimated economic life of the product. The Company estimates the economic life
of its software to be three years. At each balance sheet date, the unamortized
capitalized software costs of each product are compared with the estimated net
realizable value of that product and any excess capitalized costs are written-
off.
Patents:
The Company owns a Patent Portfolio that relates to various
telecommunications and data networking technologies. The Company capitalizes the
costs associated with acquisition, registration and maintenance of the patents
and amortizes these assets over their remaining useful lives on a straight-line
basis. Any further payments made to maintain or develop the patents would be
capitalized and amortized over the balance of the useful life for the patents.
Impairment of long-lived assets:
In accordance with Statement of Financial Accounting Standards ("SFAS")
No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets", the
Company records impairment losses on long-lived assets used in operations or
expected to be disposed of when indicators of impairment exist and the cash
flows expected to be derived from those assets are less than carrying amounts of
those assets. During the year ended December 31, 2002, the Company recorded an
impairment charge related to its network security software of approximately
$401,000, which has been included in amortization of software development costs.
Subsequently, in May 2003, the Company sold its network security software (see
Note A). The Company also reduced the carrying value of its fixed assets to
their net realizable amount (see Note B[6]).
16
Use of estimates:
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and disclosure of contingent assets and liabilities at
the date of the financial statements and the reported amounts of revenues and
expenses during the reporting period. Actual results could differ from those
estimates.
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS:
See Note B[13] on page F-10 to the Financial Statements.
RESULTS OF OPERATIONS
YEAR ENDED DECEMBER 31, 2003 COMPARED TO YEAR ENDED DECEMBER 31, 2002.
Revenues decreased by $374,000 or 63%, from $592,000 for the year ended
December 31, 2002 ("2002") to $ 218,000 for the year ended December 31, 2003
("2003"). Revenues during 2003 consisted of $130,000 related to the recognition
of deferred revenue with respect to the FalconStor license agreement and $88,000
of revenues were related to the amortization of deferred maintenance revenues
from customers who had elected to purchase maintenance and support contracts in
earlier periods.
The cost of revenues during 2003 was $51,000. This cost relates to one
employee who provided services under the Company's maintenance and support
contracts. Amortization of software development costs decreased by $741,000 or
100%, from 2002 to 2003. Cost of licenses consists of software media (disks),
documentation, product packaging, production costs and product royalties. Cost
of licenses decreased by $15,000 or 100% from 2002 to 2003. Cost of services
consisted of salaries, benefits and overhead associated with the technical
support of maintenance contracts. Cost of services decreased by $196,000 or 65%,
from 2002 to 2003. The decrease in the cost of revenue is directly a result of
the Company's decision to discontinue its software product line in December
2002.
Gross profit was $167,000 for 2003 compared to a gross loss of $ 311,000
for 2002.
Product development costs consists of salaries, benefits, bonuses,
travel and related costs of the Company's product development personnel,
including consulting fees and the costs of computer equipment used in product
and technology development. Product development expenses were $1,599,000 for
2002. The Company made no expenditures on product development in 2003.
Sales and marketing expenses consist primarily of salaries, including
commissions, benefits, bonuses, travel, advertising, public relations,
consultants and trade shows. Sales and marketing expenses were $1,831,000 in
2002. The Company had no sales and marketing expenses in 2003 as a result of its
decision to discontinue its software product line in December 2002.
17
General and administrative expenses include employee costs, including
salary, benefits, travel and other related expenses associated with management,
finance and accounting operations, and legal and other professional services
provided to the Company. General and administrative expenses decreased by
$1,021,000 or 46%, from $2,229,000 in 2002 to $1,208,000 in 2003. The decrease
in general and administrative expenses was primarily due to substantial
reduction in employees following the discontinuance of the Company's software
business in December 2002.
Interest income decreased by $53,000 or 82% from $65,000 in 2002 to
$12,000 in 2003 primarily due to a decrease in funds invested in short term
instruments and reduced interest rates.
On May 30, 2003, the Company completed the sale of its CyberwallPlus
technology and related intellectual property (the "Assets") and assignment of
rights under the FalconStor license agreement for $415,000. The carrying value
of the Assets were written down to zero in the third quarter of 2002. The
$415,000 is included as "Gain on Sale of Assets" in the statements of
operations.
No provision for or benefit from federal, state or foreign income taxes
was recorded for 2002 or 2003 since the Company incurred net operating losses
for each year and fully reserved its deferred tax assets as their future
realization could not be determined.
As a result of the foregoing, the net loss decreased by $5,578,00 or
92%, from $5,905,000 for 2002 to $614,000 for 2003.
LIQUIDITY AND CAPITAL RESOURCES
At December 31, 2003, the Company had $984,000 of cash and cash
equivalents and working capital of $472,000. The Company has financed its
operations primarily through sales of equity and debt securities, and the sale
of its security software technology in May 2003. Net cash used in operating
activities was $4,927,000 in 2002 and $1,360,000 in 2003. Net cash used in
operating activities for 2003 was primarily attributable to the net loss of
$614,000, a decrease in accounts payable, accrued expenses and other current
liabilities of $205,000 and the recognition of deferred revenue of $218,000.
Net cash used in investing activities during 2003 was financed with the
remaining funds raised in the October 2001 financing of $6,765,000 and $415,000
received from the sale of its CyberwallPlus software and related intellectual
property in May 2003. The Company does not currently have a line of credit from
a commercial bank or other institution.
The Company anticipates, based on currently proposed plans and
assumptions, relating to its operations that its cash balance of approximately
$600,000 as of March 31, 2004 will more likely than not be sufficient to satisfy
the Company's operations and capital requirements until September 2004. There
can be no assurance, however, that such funds will not be expended prior
thereto. In the event the Company's plans change, or its assumptions change, or
prove to be inaccurate (due to unanticipated
18
expenses, difficulties, delays or otherwise), the Company may have insufficient
funds to support its operations prior to September 2004. The Company is
currently pursuing licensing opportunities for its Remote Power Patent, however,
to date the Company has not entered into any such licensing arrangements. Since
the Company does not anticipate material revenues from its licensing business in
the near term, the Company currently intends to make efforts to raise capital
during the second or third quarter of 2004. The Company has no current
arrangements with respect to any additional financing. Consequently, there can
be no assurance that any additional financing will be available to the Company
when needed, on commercially reasonable terms or at all. The Company's inability
to consummate licensing arrangements and derive revenues therefrom on a timely
basis or obtain additional financing when needed would have a material adverse
effect on the Company, requiring it to curtail or cease operations. In addition,
any equity financing may involve substantial dilution to the stockholders of the
Company.
ITEM 7. FINANCIAL STATEMENTS
The financial statements required hereby are located on pages F-1
through F-20 which follow Part III.
ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.
None.
ITEM 8A. CONTROLS AND PROCEDURES.
(a) Evaluation of Disclosure Controls and Procedures.
The Company's Chief Executive Officer and Chief Financial Officer have
reviewed the disclosure controls and procedures of the Company as of the end of
the period covered by this Annual Report on Form 10-KSB. Based upon this review,
these officers concluded that, as of the end of the period covered by this
Annual Report on Form 10-KSB, the Company's disclosure controls and procedures
are adequately designed to ensure that information required to be disclosed by
the Company in the reports it files or submits under Securities and Exchange Act
of 1934 is recorded, processed, summarized and reported, within the time periods
specified in applicable rules and forms.
(b) Changes in Internal Controls.
There were no significant changes in the Company's internal controls or
in other factors that could significantly affect these controls during the last
fiscal quarter included in this report or from the end of the reporting period
to the date of this Annual Report on Form 10-KSB.
19
PART III
ITEM 9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS, AND CONTROL PERSONS;
COMPLIANCE WITH SECTION 16(A) OF THE EXCHANGE ACT.
NAME AGE POSITION
---- --- --------
Corey M. Horowitz 49 Chairman and Chief Executive Officer,
Chairman of the Board of Directors
David C. Kahn 52 Chief Financial Officer
Harry B. Schessel 39 Director
Robert Graifman 47 Director
Robert M. Pons 47 Director
COREY M. HOROWITZ, AGE 49, became Chairman and Chief Executive Officer
of the Company in December 2003. Mr. Horowitz has also served as Chairman of the
Board of Directors of the Company since January 1996 and has been a member of
the Board of Directors since April 1994. In January 2003, Mr. Horowitz also
became Secretary of the Company. During the period June 2001 through December
2003, CMH Capital Management Corp. ("CMH"), an entity solely owned by Mr.
Horowitz, rendered financial advisory services to the Company. Mr. Horowitz is a
private investor and President and sole shareholder of CMH, a New York
investment advisory and merchant banking firm, which he founded in September
1991. From January 1986 to February 1991, Mr. Horowitz was a general partner in
charge of mergers and acquisitions at Plaza Securities Co., a New York
investment partnership.
DAVID C. KAHN, CPA, age 52, became Chief Financial Officer of the
Company in January 2004. Since December 1989, Mr. Kahn has provided accounting
and tax services on a consulting basis to private and public companies. He also
serves as a faculty member of Yeshiva University in New York, a position he has
held since August 2000.
HARRY B. SCHESSEL, age 39, has been a director of the Company since July
2001. Since July 2002, Mr. Schessel has been a real estate developer. From July
2001 until July 2002, Mr. Schessel was employed at Kroll, Inc. ("Kroll") as the
Global Practice Leader for the Information Security Group. From June 2000 to
July 2001, Mr. Schessel advised security companies, including Kroll, in the
areas of strategy, operations, marketing and business development and also as a
consultant to investment banking firms and venture capital firms for purposes of
evaluating investments in the information security industry. From March 2000
until June 2000, Mr. Schessel was Vice President of Cybersafe, Inc., a security
software company. In June 1997, Mr. Schessel co-founded Centrax, Inc., a company
engaged in the development and marketing of intrusion detection software, and
was employed from June 1997 until its sale in March
20
1999 in various capacities, including Chief Operating Officer and Executive Vice
President.
ROBERT GRAIFMAN, age 47, became a director of the Company in December
2003. Mr. Graifman currently serves as Managing Member of Skyfarm Management,
LLC, a New Jersey based investment management company, and also as a Managing
Member of Federal Autocat Recycling, LLC, a resource reclamation and recycling
Company. From June 2000 to August 2003, Mr. Graifman also served as Chief
Financial Officer of Gilo Ventures, LLP, a California based venture capital firm
focused on emerging technology companies.
ROBERT M. PONS, age 47, became a director of the Company in December
2003. Mr. Pons currently serves as President and Chief Executive Officer of
SmartServ Online, Inc., a wireless applications service provider, (OTCBB:SSRV),
a position he has held since January 2004. From August 2003 until January 2004,
Mr. Pons served as Interim Chief Executive Officer of SmartServ Online, Inc. on
a consulting basis. From March 1999 to August 2003, he was President of
FreedomPay, Inc., a wireless device payment processing company. During the
period January 1994 to March 1999, Mr. Pons was President of Lifesafety
Solutions, Inc., an enterprise software company. Mr. Pons has over 20 years of
management experience with telecommunications companies including MCI, Inc.,
Sprint, Inc. and Geotek, Inc.
COREY M. HOROWITZ and ROBERT GRAIFMAN are brothers-in-law.
COMMITTEES OF THE BOARD OF DIRECTORS
During 2003 Harry Schessel was the sole member of the Audit Committee.
In March 2004, Robert Graifman was added to the Audit Committee. Mr. Graifman is
the audit committee financial expert. The Audit Committee meets with the
Company's independent auditors at least annually to review the scope and results
of the annual audit; reviews with the Company's independent auditors the
Company's quarterly reports on Form 10-QSB prior to filing, recommends to the
Board the independent auditors to be retained; and receives and considers the
auditors' comments as to internal controls, accounting staff and management
performance and procedures in connection with audit and financial controls. The
Audit Committee has adopted a written Audit Committee Charter. Harry Schessel
served as the sole member of the Compensation Committee during 2003. In March
2004 Robert Pons was added to the Compensation Committee. The Compensation
Committee is responsible for determining compensation for the executive officers
of the Company, including bonuses and benefits, and administration of the
Company's compensation programs, including the Company's Stock Option Plan.
LIMITATION ON LIABILITY AND INDEMNIFICATION MATTERS
The Company's Certificate of Incorporation limits the liability of
directors to the maximum extent permitted by Delaware law. Delaware law provides
that directors of a corporation will not be personally liable for monetary
damages for breach of their fiduciary duties as directors, except for liability
(i) for any breach of their duty of loyalty to the corporation or its
stockholders, (ii) for acts or omissions not in good faith or that involve
intentional misconduct or a knowing violation of law, (iii) for unlawful
payments
21
of dividends or unlawful stock repurchases or redemptions as provided in Section
174 of the Delaware General Corporation Law or (iv) for any transaction from
which the director derived an improper personal benefit. The Company's Bylaws
provide that the Company shall indemnify its directors, officers, employees and
agents to the fullest extent permitted by law. The Company's Bylaws also permit
the Company to secure insurance on behalf of any officer, director, employee or
other agent for any liability arising out of his or her actions in such
capacity. The Company currently maintains liability insurance for its officers
and directors. At present, there is no pending material litigation or proceeding
involving any director, officer, employee or agent of the Company where
indemnification will be required or permitted. The Company is not aware of any
threatened litigation or proceeding that might result in a material claim for
such indemnification.
DIRECTOR COMPENSATION
The Company has compensated each director, who is not an employee of the
Company, by granting to each outside director (upon joining the Board) stock
options to purchase between 25,000 - 50,000 shares of Common Stock, at an
exercise price equal to the closing price of the Common Stock on the date of
grant, with the options vesting over a one year period in equal quarterly
amounts. In addition, each non-employee director receives an option grant to
purchase 5,000 - 25,000 shares of Common Stock for each year of service (after
the first year) as a member of the Board of Directors. Such options vest over a
one year period in equal quarterly amounts. In addition to the aforementioned
option grants, directors may be granted additional options at the discretion of
the Board of Directors and the Compensation Committee.
SECTION 16(A) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE
Section 16(a) of the Exchange Act requires the Company's executive
officers, directors, and persons who own more than 10% of the Company's
outstanding Common Stock to file initial reports of ownership and changes in
ownership with the Securities and Exchange Commission. Officers, directors and
greater than 10% stockholders are required by Commission regulations to furnish
the Company with copies of all Section 16(a) forms they file. The Company
believes that its executive officers, directors, and greater than 10%
stockholders complied during the year ended December 31, 2003.
CODE OF ETHICS
The Board of Directors has adopted a Code of Ethics that applies to the
principal executive officers, principal financial officer, principal accounting
officer or controller, or persons performing similar functions. The Code of
Ethics is filed as Exhibit 14 of this Annual Report on Form 10-KSB.
22
ITEM 10. EXECUTIVE COMPENSATION
The following table summarizes compensation, for the fiscal years
indicated, awarded to, earned by or paid to the Company's Chief Executive
Officer ("CEO") and to each of its executive officers, (collectively, the "Named
Executive Officers") who received annual salary and bonus in excess of $100,000
for the year ended December 31, 2003 for services rendered in all capacities to
the Company.
SUMMARY COMPENSATION TABLE
ANNUAL COMPENSATION LONG TERM COMPENSATION AWARDS
-------------------------------------------- ------------------------------
SHARES
YEAR ENDED OTHER ANNUAL UNDERLYING ALL OTHER ANNUAL
NAME AND PRINCIPAL POSITION DECEMBER 31 SALARY ($) BONUS ($) COMPENSATION(1) OPTIONS(#) COMPENSATION(1)
--------------------------- ----------- ---------- --------- ------------ ---------- ---------------
Corey M. Horowitz 2003 $210,000(2) -- -- 1,600,000 --
Chairman and Chief 2002 -- -- -- -- --
Executive Officer 2001 -- -- -- -- --
Edward James 2003 $148,750(3) -- -- 55,000 --
Interim Chief Executive 2002 $ -- $ -- -- -- --
Officer and Chief Financial 2001 $ -- $ -- -- -- --
Officer
(1) The Company has concluded that the aggregate amount of perquisites and
other personal benefits paid to each of the Named Executive Officers did
not exceed the lesser of ten percent (10%) of such individual's annual
salary and bonus for each fiscal year indicated or $50,000.
(2) On December 22, 2003, Mr. Horowitz became Chairman and Chief Executive
Officer of the Company. CMH Capital Management Corp.("CMH"), the sole
stockholder and officer of which is Mr. Horowitz, rendered financial
consulting services from June 2001 until December 2003 and was paid
consulting fees of $205,398 for 2003 which is included in Mr. Horowitz's
salary. Mr. Horowitz's salary for 2003 includes (i) his salary for
December 2003 as Chairman and Chief Executive Officer and (ii) consulting
fees received by CMH for the period January 2003 until December 2003.
(3) Mr. James was elected interim Chief Executive Officer and Chief Financial
Officer in January 2003. Mr. James was no longer employed by the Company
as of January 31, 2004.
23
EMPLOYMENT CONTRACTS, TERMINATION OF EMPLOYMENT AND CHANGE-IN-CONTROL
ARRANGEMENTS
On December 22, 2003, the Company entered into an offer letter with
Corey M. Horowitz, pursuant to which Mr. Horowitz agreed to serve as the
Company's Chairman and Chief Executive Officer, on an at-will basis, at an
annual base salary of $210,000 per annum. In addition, Mr. Horowitz was granted
options to purchase an aggregate of 1,600,000 shares of the Company's common
stock consisting of (i) incentive stock options to purchase 1,084,782 shares of
common stock at an exercise price of $.23 per share, of which 434,782 shares
vested on the date of grant, 250,000 shares vest on December 22, 2004 and
200,000 shares vest on each of December 22, 2005 and December 22, 2006 and (ii)
a non-qualified stock option to purchase an aggregate of 515,218 shares of
common stock at an exercise price of $.13 per share which vested in full on the
date of grant. In the event of a Change of Control (as defined in the Option
Agreement), 100% of the unvested option shall accelerate and immediately vest.
Mr. Horowitz also received certain anti-dilution protection in the event the
Company completes a securities offering (common stock or any other securities
convertible or exercisable into common stock) so that Mr. Horowitz shall be
issued additional options, up to a maximum of options to purchase 600,000
shares, so that he maintains the same percentage ownership of options and
warrants (15.6%) that he maintained on December 22, 2003.
On January 22, 2004, the Company entered into an agreement with David C.
Kahn pursuant to which he agreed to serve as Chief Financial Officer of the
Company for the year ending December 31, 2004 on a consulting basis, in
consideration for annual compensation of $54,000. In addition, Mr. Kahn was also
granted a ten-year option to purchase 50,000 shares of Common Stock, at an
exercise price of $.35 per share, of which 20,000 shares vested on the date of
grant and the balance vest on an equal monthly basis through December 31, 2004.
In the event that Mr. Kahn's services are terminated "without good cause" (as
defined in the agreement), he is entitled to receive the balance of cash
compensation due him through December 31, 2004 and 100% accelerated vesting of
all unvested options.
OPTION GRANTS IN 2003
The following stock options were granted to each of the Named Executive
Officers during the year ended December 31, 2003:
NUMBER OF % OF TOTAL
SHARES OPTIONS GRANTED EXERCISE
UNDERLYING TO EMPLOYEES PRICE PER EXPIRATION
OPTIONS GRANTED IN 2003(1) SHARE(2) DATE
--------------- ---------- -------- ----
Corey M. Horowitz 1,084,782(3) 97% $.23 12/22/08
515,218(3) $.13
Edward James 30,000 3% $.19 01/07/13
25,000 $.12 11/24/13
---------------------------
(1) The number of options granted to employees during the year ended
December 31, 2003 used to compute this percentage is based on 1,139,782
incentive stock options and 515,218 non-qualified stock options.
24
(2) All options were granted at an exercise price equal to the fair market
value of the Company's Common Stock at the date of grant, as determined
by the Board of Directors except for the grant to Corey M. Horowitz of
options to purchase 515,218 shares of Common Stock at an exercise price
of $13 per share (at a time when the fair market value was $.23 per
share).
FISCAL YEAR-END OPTION VALUES
No options were exercised by any of the Named Executive Officers during
the year ended December 31, 2003. The following table sets forth information
relating to the fiscal year-end value of unexercised options held by Named
Executive Officers on an aggregated basis:
Number of Securities Underlying Value of Unexercised
Unexercised Options In-the-Money Options
at 12/31/2003 at Fiscal Year-End ($)(1)
------------------------------- -----------------------------
Name Exercisable Unexercisable Exercisable Unexercisable
---- ----------- ------------- ----------- -------------
Corey M. Horowitz(2) 1,971,616 1,160,625 $30,913 $-0-
Edward James 42,500 32,500 $1,125 $-0-
------------------------
(1) Options are "in-the-money" if the market price of the Common Stock on
December 31, 2003 ($.19) exceeds the exercise price of such options. The
value of such options is calculated by determining the difference
between the aggregate market price of the Common Stock underlying the
options on December 31, 2003 and the aggregate exercise price of such
options.
(2) Includes (i) options to purchase 750,000 shares held by CMH Capital
Management Corp. ("CMH"), an entity in which Mr. Horowitz is the sole
owner and officer, (ii) warrants to purchase 85,220 shares held by Mr.
Horowitz and (iii) warrants to purchase 643,896 shares of Common Stock
held by CMH.
25
ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The following table sets forth information regarding the beneficial
ownership of the Company's shares of Common Stock as of April 13, 2004 (i) each
person known by the Company to be the beneficial owner of more than 5% of the
outstanding shares of Common Stock, (ii) each director and nominee, (iii) each
of the executive officers of the Company, and (iv) all executive officers and
directors of the Company as a group.
NAME AND ADDRESS(1) OF NUMBER OF SHARES PERCENTAGE OF SHARES
BENEFICIAL OWNER BENEFICIALLY OWNED BENEFICIALLY OWNED(2)
---------------- ------------------ ---------------------
Corey M. Horowitz(3) 5,574,085 32.5%
Barry Rubenstein(4) 4,343,204 28.0%
CMH Capital Management Corp. (5) 3,917,800 24.4%
Irwin Lieber (6) 2,696,607 17.4%
Barry Fingerhut (7) 2,607,203 16.9%
Wheatley Partners II, L.P. (8) 1,430,507 9.5%
Woodland Venture Fund(9) 1,016,064 6.7%
First New York Securities L.L.C.(10) 848,900 5.7%
Harry B. Schessel (11) 93,750 *
Robert Graifman(12) 67,277 *
David C. Kahn (13) 32,500 *
Robert Pons(14) 12,500 *
All officers and directors as a group 5,780,112 33.4%
(5 Persons)
-------------------------------------
* Less than 1%.
(1) Except as otherwise indicated, the address for each beneficial owner is
c/o Network-1 Security Solutions, Inc., 445 Park Avenue, Suite 1028, New
York, New York 10022
(2) Unless otherwise indicated, the Company believes that all persons named
in the above table have sole voting and investment power with respect to
all shares of Common Stock beneficially owned by them. A person is
deemed to be the beneficial owner of securities that can be acquired by
such person within 60 days from the date hereof upon the exercise of
options, warrants or convertible securities. Each beneficial owner's
percentage ownership is determined by assuming that options, warrants
and convertible securities held by such person (but not those held by
any other person) and which are exercisable or convertible within 60
days have been exercised and converted. Assumes a base of 15,012,576
shares of Common Stock outstanding.
(3) Includes (i) 486,303 shares of Common Stock held by Mr. Horowitz, (ii)
992,500 shares of Common Stock subject to currently exercisable stock
options held by Mr. Horowitz, (iii) 2,867,800 shares of Common Stock
held by CMH Capital Management Corp. ("CMH"), (iv) 550,000 shares of
Common Stock subject to currently exercisable warrants
26
held by CMH, (v) 500,000 shares of Common Stock subject to currently
exercisable options held by CMH, (vi) 85,220 shares of Common Stock
subject to currently exercisable warrants held by Mr. Horowitz, (vii)
89,971 shares of Common Stock owned by Donna Slavitt, the wife of Mr.
Horowitz and (viii) 2,291 shares of Common Stock held by Horowitz
Partners, a general partnership of which Mr. Horowitz is a partner. Does
not include options to purchase 910,625 shares of Common Stock which are
not currently exercisable. The address of CMH Capital Management Corp.
is 445 Park Avenue, New York, New York 10022.
(4) Includes (i) 1,430,507 shares of Common Stock held by Wheatley Partners
II,L.P., (ii) 216,980 shares of Common Stock held by Wheatley Partners,
L.P., (iii) 18,868 shares of Common Stock held by Wheatley Foreign
Partners, L.P., (iv) 150,012 shares of Common Stock held by Mr.
Rubenstein, (v) 47,500 shares of common stock subject to currently
exercisable stock options held by Mr. Rubenstein, (vi) 829,226, 619,983,
309,316 and 294,810 shares of Common Stock held by Woodland Venture
Fund, Seneca Ventures, Woodland Partners and Brookwood Partners, L.P.,
respectively, and (vi) 186,838, 93,417, 46,247, 47,170, 50,997 and 1,333
shares of common stock subject to currently exercisable warrants held by
Woodland Venture Fund, Seneca Ventures, Woodland Partners, Brookwood
Partners, L.P., Barry Rubenstein and Marilyn Rubenstein, respectively.
Does not include options to purchase 11,875 shares of Common Stock held
by Mr. Rubenstein which are not currently exercisable. Barry Rubenstein
is a general partner of Wheatley Partners II, L.P. and a member of the
general partner of each of Wheatley Partners, L.P. and Wheatley Foreign
Partners, L.P. Barry Rubenstein and Woodland Services Corp. are the
general partners of Woodland Venture Fund and Seneca Ventures. Barry
Rubenstein is the President and sole director of Woodland Services Corp.
Marilyn Rubenstein is the wife of Barry Rubenstein. Mr. Rubenstein
disclaims beneficial ownership of the shares of Common Stock held by
Wheatley Partners II, L.P., Wheatley Partners, L.P. and Wheatley Foreign
Partners, L.P., except to the extent of his equity interest therein. The
address of Barry Rubenstein is 68 Wheatley Road, Brookville, New York
11545. The address of Wheatley Partners II, L.P. and Wheatley Partners,
L.P. is 60 Cuttermill Road, Great Neck, New York 11021. The address of
Wheatley Foreign Partners, L.P. is c/o Fiduciary Trust, One Capital
Place, Snedden Road, P.O. Box 162, Grand Cayman, British West Indies.
The address for Woodland Venture Fund, Seneca Ventures, Brookwood
Partners, L.P. and Woodland Partners is c/o Barry Rubenstein, 68
Wheatley Road, Brookville, New York 11545.
(5) Includes (i) 2,867,800 shares of Common Stock; (ii) 550,000 shares of
Common Stock subject to currently exercisable warrants and (iii) 500,000
shares of Common Stock subject to currently exercisable stock options.
Does not include options to purchase 250,000 shares of Common Stock
which are not currently exercisable.
(6) Includes (i) 1,430,507 shares of Common Stock held by Wheatley Partners
II, L.P., (ii) 216,980 shares of Common Stock held by Wheatley Partners,
L.P., (iii) 18,868 shares of Common Stock held by Wheatley Foreign
Partners, L.P., (iv) 509,483 shares of Common Stock owned by Mr. Lieber,
(v) 47,500 shares of Common Stock subject to currently exercisable stock
options owned by Mr. Lieber, and (vi) 473,269 shares of Common Stock
subject to currently exercisable warrants owned by Mr. Lieber. Does not
include options to purchase 11,875 shares of Common Stock owned by Mr.
Lieber which are not currently exercisable. Mr. Lieber disclaims
beneficial ownership of the shares of Common Stock held by Wheatley
Partners II, L.P., Wheatley Partners, L.P. and Wheatley Foreign
Partners, L.P., except to the extent of his equity interest therein. The
address of Irwin Lieber is c/o Wheatley Partners, II, L.P., 80
Cuttermill Road, Great Neck, New York 11021.
27
(7) Includes (i) 1,430,507 shares of Common Stock held by Wheatley Partners,
II, L.P., (ii) 216,980 shares of Common Stock held by Wheatley Partners,
L.P., (iii) 18,868 shares of Common Stock held by Wheatley Foreign
Partners, L.P., (iv) 517,243 shares of Common Stock owned by Mr.
Fingerhut, and (vi) 423,605 shares of Common Stock subject to currently
exercisable warrants owned by Mr. Fingerhut. Mr. Fingerhut disclaims
beneficial ownership of the shares of Common Stock held by Wheatley
Partners II, L.P., Wheatley Partners, L.P. and Wheatley Foreign
Partners, L.P., except to the extent of his equity interest therein. The
address of Barry Fingerhut is c/o Wheatley Partner, II, L.P., 80
Cuttermill Road, Great Neck, New York 11021.
(8) Includes 1,430,507 shares of Common Stock. Does not include (i)
2,439,195, 745,331, 760,851, 140,945 and 32,584 shares of Common Stock
beneficially owned by Barry Rubenstein (including related entities),
Irwin Lieber, Barry Fingerhut, Jonathan Lieber and Seth Lieber,
respectively, each of whom is a general partner of Wheatley Partners II,
L.P. and (ii) an aggregate of 1,559,152 shares of Common Stock subject
to currently exercisable warrants and options owned by Barry Rubenstein
(473,502 shares), Irwin Lieber (520,769 shares), Barry Fingerhut
(423,605 shares), Jonathan Lieber (117,692 shares) and Seth Lieber
(23,584 shares). Each of Messrs. Rubenstein, I. Lieber, Fingerhut, J.
Lieber and S. Lieber disclaims beneficial ownership of the securities
held by Wheatley Partners II, L.P., except to the extent of their equity
interest therein. Jonathan Lieber and Seth Lieber each beneficially owns
less than 1% of the outstanding Common Stock of the Company exclusive of
shares beneficially owned by Wheatley Partners II, L.P., Wheatley
Partners, L.P. and Wheatley Foreign Partners, L.P. and as such have not
been included in the beneficial ownership table. Wheatley Partners II,
L.P.'s business address is 80 Cuttermill Road, Great Neck, New York
11021.
(9) Includes (i) 829,226 shares of Common Stock and (ii) 186,838 shares of
Common Stock subject to currently exercisable warrants. Woodland Venture
Fund's business address is 68 Wheatley Road, Brookville, New York 11546.
(10) Includes (i) 566,700 shares of Common Stock owned together by First New
York Securities, LLC ("FNY") and (ii) 282,200 shares of Common Stock
owned by Jay Goldstein (150,000 shares), Douglas Lipton and his wife
(82,200 shares), and Michael Marvin (50,000 shares), all employees of
FNY. The aforementioned is based upon an Amended Schedule 13G filed
jointly by the parties with the SEC on March 22, 2004 and a Form 3 filed
by FNY on the same date.
(11) Includes 93,750 shares of Common Stock subject to currently exercisable
stock options issued to Mr. Schessel pursuant to the Stock Option Plan.
Does not include 31,250 shares of Common Stock subject to stock options
which are not currently exercisable.
(12) Includes (i) 54,777 shares of Common Stock and (ii) 12,500 shares
subject to currently exercisable stock options issued to Mr. Graifman
pursuant to the Stock Option Plan. Does not include 37,500 shares of
Common Stock subject to options which are not currently exercisable.
(13) Includes 32,500 shares of Common Stock subject to currently exercisable
stock options issued to Mr. Kahn pursuant to the Stock Option Plan. Does
not include 17,500 shares of Common Stock subject to stock options which
are not currently exercisable.
(14) Includes 12,500 shares subject to currently exercisable stock options
issued to Mr. Pons pursuant to the Stock Option Plan. Does not include
37,500 shares of Common Stock subject to options which are not
exercisable.
28
The Equity Compensation Plan information presented in Item 5 of this
Annual Report is incorporated herein in its entirety.
ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
From June 2001 until December 2003 the Company paid CMH Capital
Management Corp ("CMH") a monthly fee of $17,500 and issued to CMH warrants to
purchase an aggregate of 1,300,000 shares of Common Stock (at exercise prices
ranging from $.70 per share to $1.48 per share) in consideration for financial
advisory and consulting services rendered. Corey M. Horowitz, Chairman, Chief
Executive Officer, Chairman of the Board of Directors and a principal
stockholder of the Company, is the sole officer, director and stockholder of
CMH. In addition, in connection with such financial advisory and consulting
services, CMH was reimbursed for expenses during 2002 and 2003 in the amount of
$50,000 and $41,000, respectively, including the allocable portion of rent for
office space in New York City. In December 2003, the Company employed Mr.
Horowitz as Chairman and Chief Executive Officer at which time CMH no longer
provided financial and advisory services to the Company.
In February 2003, the Company closed its principal offices in Waltham,
Massachusetts and moved its principal offices to space in New York City occupied
by CMH. Network-1 pays rent on a month to month basis of $2,700 per month for
its principal offices in New York City.
During 2002, Edward James was paid consulting fees of $68,164 by the
Company. In December 2002 Mr. James became a director of the Company and was
elected interim Chief Executive Officer and Chief Financial Officer in January
2003. From January 2003 until January 1, 2004, Mr. James was paid $12,500 per
month for his services as interim Chief Executive Officer and Chief Financial
Officer.
On November 18, 2003, the Company acquired six patents relating to
various telecommunications and data networking technologies from Merlot
Communications, Inc. ("Merlot"), a broadband communications solutions provider,
for a purchase price of $100,000 and contingent future payments equal to 20% of
the net income (as defined in the acquisition agreement) of the Company from the
sale or licensing of the Patent Portfolio after the Company achieves $4.0
million of net income for each patent comprising the Patent Portfolio ("Net
Profit Payments"). The Company has an option to terminate the Net Profit
Payments, at any time between January 1, 2007 through March 31, 2007, and from
January 1 through March 31 of each year thereafter, by making payments to Merlot
in an amount equal to the greater of (i) two times the payment due for the
twelve month period following the notice of termination or (ii) $3.0 million
plus 10% for each additional year starting January 1, 2008. Wheatley Partners,
II, L.P. and its affiliates and related parties (the "Wheatley Parties"), who
are principal stockholders of the Company, also owned a majority of the
outstanding voting stock of Merlot at the time of the transaction. The Wheatley
Parties
29
did not participate in the negotiation or the approval of the patent acquisition
transaction by Merlot or the Company.
On April 13, 2004, the Company as part of a recapitalization entered
into an exchange agreement with each of its outstanding holders of preferred
stock pursuant to which such holders exchanged an aggregate of 2,714,562 shares
of Preferred Stock (231,054 shares of Series D Preferred Stock and 2,483,508
shares of Series E Preferred Stock) for an aggregate of 6,698,118 shares of
Common Stock. Holders of preferred stock received 1.25 shares of Common Stock
for each share of Common Stock such holders would have received based upon the
conversion rate of their Preferred Stock. The holders of preferred stock
participating in the exchange included among the 27 holders, CMH (1,084,935
shares of Series E Preferred Stock), Donna Slavitt, the wife of Corey M.
Horowitz (35,377 shares of Series E Preferred Stock), Barry Rubenstein, his wife
and affiliated entities (471,686 shares of Series E Preferred Stock and 139,747
shares of Series D Preferred Stock), Wheatley Partners II, L.P. (94,339 shares
of Series E Preferred Stock), Wheatley Partners, L.P. (86,792 shares of Series E
Preferred Stock) and Wheatley Foreign Partners, L.P. (7,547 shares of Series E
Preferred Stock), Irwin Lieber (165,094 shares of Series E Preferred Stock and
34,689 shares of Series D Preferred Stock) and Barry Fingerhut (165,094 shares
of Series D Preferred Stock and 34,689 shares of Series D Preferred Stock).
ITEM 13. EXHIBITS LIST AND REPORTS ON FORM 8-K
(a) Exhibits
NO. DESCRIPTION
3.1 Certificate of Incorporation, as amended. Previously filed as
Exhibit 3.1 to the Company's Registration Statement on Form
SB-2 (Registration No. 333-59617), declared effective by the
SEC on November 12,1998 (the "1998 Registration Statement"),
and incorporated herein by reference.
3.1.1 Certificate of Amendment to the Certificate of Incorporation
dated November 27, 2001. Previously filed as Exhibit 3.1.1 to
the Company's Registration Statement on Form S-3 (Registration
No. 333-81344) declared effective by the SEC on February 12,
2002, and incorporated herein by reference (the "February 2002
Form S-3").
3.2 Certificate of Designations of Series D Preferred Stock.
Previously filed as Exhibit 3.1 to the Company's current
report on Form 8-K filed January 5, 2000 and incorporated
herein by reference.
3.3 Certificate of Designations of Series E Preferred Stock.
Previously filed as Exhibit 3.1 to the Company's current
report on Form 8-K filed October 12, 2001 (the "October 2001
Form 8-K") and incorporated herein by reference.
3.4 By-laws, as amended. Previously filed as Exhibit 3.2 to the
1998 Registration Statement and incorporated herein by
reference.
4.1 Form of Common Stock certificate. Previously filed as Exhibit
4.1 to the 1998 Registration Statement and incorporated herein
by reference.
30
10.1 Assignment Agreement, dated May 20, 2003, between the Company
and Trend Micro Incorporated (including exhibits). Previously
filed as Exhibit 10.8 to the Company's Current Report on Form
8-K filed June 2, 2003 and incorporated herein by reference.
10.2 Patents Purchase, Assignment and License Agreement, dated
November 18, 2003, between the Company and Merlot
Communications, Inc. Previously filed as Exhibit 10.10 to the
Company's current report on Form 8-K filed December 3, 2003
and incorporated herein by reference.
10.3* Letter Agreement, dated December 21, 2003, between the Company
and Corey M. Horowitz, including exhibits.
10.4* Letter Agreement dated January 22, 2004, between the Company
and David Kahn.
10.5* Exchange Agreement, dated April 13, 2004, between the Company
and its Preferred Stockholders.
14* Code of Ethics.
23.1* Consent of Eisner LLP, Independent Auditors'.
31.1* Controls and Procedure Certification of Chief Executive
Officer and Chief Financial Officer dated as of April 13,
2004.
32.1* Certification of Chief Executive Officer and Chief Financial
Officer dated April 13, 2004.
-------------------------------------
* Filed herewith.
(b) Reports on Form 8-K
On December 3, 2003, the Company filed a current report on Form 8-K with
respect to the acquisition of a patent portfolio from Merlot Communications,
Inc.
31
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
AUDIT FEES
Eisner LLP billed the Company aggregate fees of $88,000 and $119,000 for
the year ended December 31, 2003 and December 31, 2002, respectively, for the
audit of the Company's annual financial statements and review of financial
statements included in the Company's Form 10-QSB's and for other services in
connection with statutory or regulatory filings. Before Eisner LLP was engaged
to render audit services for the Company, the engagement was pre-approved by the
Company's Audit Committee.
AUDIT RELATED FEES, TAX FEES AND ALL OTHER FEES
Eisner LLP did not render any other professional service other than
those discussed above for the year ended December 31, 2003 or December 31, 2002.
32
SIGNATURES
In accordance with the requirements of Section 13 or 15(d) of the
Securities Exchange Act of 1934, the registrant caused this report to be signed
on its behalf by the undersigned, thereunto duly authorized, in the City of New
York, State of New York, on the 13 day of April 2004.
NETWORK-1 SECURITY SOLUTIONS, INC.
By /s/Corey M. Horowitz
-------------------------------------
Corey M. Horowitz
Chairman and Chief Executive Officer
In accordance with the requirements of Section 13 or 15(d) of the
Securities Exchange Act of 1934, the registrant caused this report to be signed
on its behalf by the following persons in the capacities and on the dates
indicated:
NAME TITLE DATE
---- ----- ----
/s/ Corey M. Horowitz Chairman and Chief Executive April 13, 2004
------------------------------ Officer, Chairman of the Board
Corey M. Horowitz of Directors (principal
executive officer.)
/s/ David Kahn Chief Financial Officer April 13, 2004
------------------------------
David Kahn
/s/ Harry Schessel Director April 13, 2004
------------------------------
Harry Schessel
/s/ Robert Graifman Director April 13, 2004
------------------------------
Robert Graifman
33
NETWORK-1 SECURITY SOLUTIONS, INC.
FINANCIAL STATEMENTS
DECEMBER 31, 2003 AND 2002
NETWORK-1 SECURITY SOLUTIONS, INC.
CONTENTS
PAGE
----
INDEX TO FINANCIAL STATEMENTS
Independent auditors' report F-2
Balance sheets as of December 31, 2003 and 2002 F-3
Statements of operations for the years ended December 31, 2003 and
2002 F-4
Statements of stockholders' equity for the years ended December 31,
2003 and 2002 F-5
Statements of cash flows for the years ended December 31, 2003 and
2002 F-6
Notes to financial statements F-7
F-1
INDEPENDENT AUDITORS' REPORT
Board of Directors and Stockholders
Network-1 Security Solutions, Inc.
New York, New York
We have audited the accompanying balance sheets of Network-1 Security Solutions,
Inc. (the "Company") as of December 31, 2003 and 2002 and the related statements
of operations, stockholders' equity and cash flows for each of the years then
ended. These financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted
in the United States of America. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the financial statements enumerated above present fairly, in all
material respects, the financial position of Network-1 Security Solutions, Inc.
as of December 31, 2003 and 2002 and the results of its operations and its cash
flows for each of the years then ended in conformity with accounting principles
generally accepted in the United States of America.
The accompanying financial statements have been prepared assuming that the
Company will continue as a going concern. As more fully described in Note A[2],
the Company has incurred a net loss during 2003 and has a substantial
accumulated deficit, and needs to obtain additional capital. These conditions
raise substantial doubt about the Company's ability to continue as a going
concern. Management's plans in regard to these matters are also described in
Note A[2]. The financial statements do not include any adjustments that may
result from the outcome of this uncertainty.
New York, New York
March 24, 2004
Except as to Note M[3] and M[4]
as to which the dates are
March 31, 2004 and April 13, 2004, respectively
F-2
NETWORK-1 SECURITY SOLUTIONS, INC.
BALANCE SHEETS
DECEMBER 31,
---------------------------------
2003 2002
------------ ------------
ASSETS
Current assets:
Cash and cash equivalents $ 984,000 $ 2,029,000
Accounts receivable 6,000
Prepaid expenses and other current assets 86,000 96,000
------------ ------------
Total current assets 1,070,000 2,131,000
Equipment and fixtures - net 22,000
Patents 99,000
Security deposits 8,000
------------ ------------
$ 1,169,000 $ 2,161,000
============ ============
LIABILITIES
Current liabilities:
Accounts payable $ 78,000 $ 193,000
Accrued expenses and other current liabilities 520,000 610,000
Deferred revenue 218,000
------------ ------------
Total current liabilities 598,000 1,021,000
------------ ------------
Liability to be settled with equity instrument 54,000 55,000
------------ ------------
Commitments and contingencies (Note G)
STOCKHOLDERS' EQUITY
Preferred stock - $.01 par value; 10,000,000 shares authorized; Series D -
convertible, voting, authorized 1,250,000 shares; 231,054 shares
issued and outstanding; liquidation preference of $705,000 2,000 2,000
Series E - convertible, authorized 3,500,000 shares; 2,483,508 shares
issued and outstanding; liquidation preference of $5,265,000 25,000 25,000
Common stock - $.01 par value; authorized 40,000,000 shares; 8,314,458
shares issued and outstanding 83,000 83,000
Additional paid-in capital 41,443,000 41,397,000
Accumulated deficit (41,036,000) (40,422,000)
------------ ------------
517,000 1,085,000
------------ ------------
$ 1,169,000 $ 2,161,000
============ ============
SEE NOTES TO FINANCIAL STATEMENTS F-3
NETWORK-1 SECURITY SOLUTIONS, INC.
STATEMENTS OF OPERATIONS
YEAR ENDED
DECEMBER 31,
---------------------------------
2003 2002
------------ ------------
Revenues:
Licenses $ 130,000 $ 374,000
Services 88,000 218,000
------------ ------------
Total revenues 218,000 592,000
------------ ------------
Cost of revenues:
Amortization and impairment of software development costs 741,000
Cost of licenses 15,000
Cost of services 51,000 147,000
------------ ------------
Total cost of revenues 51,000 903,000
------------ ------------
Gross profit (loss) 167,000 (311,000)
------------ ------------
Operating expenses:
Product development costs 1,599,000
Selling and marketing 1,831,000
General and administrative 1,208,000 2,229,000
------------ ------------
Total operating expenses 1,208,000 5,659,000
------------ ------------
Loss before interest income (1,041,000) (5,970,000)
Interest income - net 12,000 65,000
Gain on sale of assets 415,000
------------ ------------
NET LOSS $ (614,000) $ (5,905,000)
============ ============
LOSS PER COMMON SHARE - BASIC AND DILUTED $ (0.07) $ (0.78)
============ ============
WEIGHTED AVERAGE NUMBER OF COMMON SHARES OUTSTANDING 8,314,458 7,584,911
============ ============
SEE NOTES TO FINANCIAL STATEMENTS F-4
NETWORK-1 SECURITY SOLUTIONS, INC.
STATEMENTS OF STOCKHOLDERS' EQUITY
SERIES D CONVERTIBLE SERIES E CONVERTIBLE
PREFERRED STOCK PREFERRED STOCK COMMON STOCK
---------------------------- --------------------------- ----------------------------
SHARES AMOUNT SHARES AMOUNT SHARES AMOUNT
------------ ------------ ------------ ------------ ------------ ------------
BALANCE - DECEMBER 31, 2001 231,054 $ 2,000 3,191,037 $ 32,000 6,781,374 $ 68,000
Conversion of Series E preferred
stock (707,529) (7,000) 1,415,058 14,000
Exercise of Series E warrants 9,432
Exercise of Series D warrants 108,594 1,000
Net loss
------------ ------------ ------------ ------------ ------------ ------------
BALANCE - DECEMBER 31, 2002 231,054 2,000 2,483,508 25,000 8,314,458 83,000
Non-employee compensation paid
with stock options
Issuance of options for compensation
to an employee director
Net loss
------------ ------------ ------------ ------------ ------------ ------------
BALANCE - DECEMBER 31, 2003 231,054 $ 2,000 2,483,508 $ 25,000 8,314,458 $ 83,000
============ ============ ============ ============ ============ ============
ADDITIONAL
PAID-IN ACCUMULATED
CAPITAL DEFICIT TOTAL
------------ ------------ ------------
BALANCE - DECEMBER 31, 2001 $ 41,274,000 $(34,517,000) $ 6,859,000
Conversion of Series E preferred
stock (7,000) 0
Exercise of Series E warrants 12,000 12,000
Exercise of Series D warrants 118,000 119,000
Net loss (5,905,000) (5,905,000)
------------ ------------ ------------
BALANCE - DECEMBER 31, 2002 41,397,000 (40,422,000) 1,085,000
Non-employee compensation paid
with stock options 5,000 5,000
Issuance of options for compensation
to an employee director 41,000 41,000
Net loss (614,000) (614,000)
------------ ------------ ------------
BALANCE - DECEMBER 31, 2003 $ 41,443,000 $(41,036,000) $ 517,000
============ ============ ============
SEE NOTES TO FINANCIAL STATEMENTS F-5
NETWORK-1 SECURITY SOLUTIONS, INC.
STATEMENTS OF CASH FLOWS
YEAR ENDED
DECEMBER 31,
---------------------------------
2003 2002
------------ ------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss $ (614,000) $ (5,905,000)
Adjustments to reconcile net loss to net cash used in operating activities:
Issuance of options for compensation to an employee director 41,000
Valuation adjustment for outstanding stock options 4,000 55,000
Gain on sale of assets (415,000)
Depreciation, amortization and impairment charge 23,000 1,154,000
Changes in:
Accounts receivable 6,000 56,000
Prepaid expenses and other current assets 10,000 17,000
Security deposits 8,000
Accounts payable, accrued expenses and other current liabilities (205,000) (277,000)
Deferred revenue (218,000) (27,000)
------------ ------------
Net cash used in operating activities (1,360,000) (4,927,000)
------------ ------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Acquisitions of equipment and fixtures (116,000)
Capitalized software costs (180,000)
Acquisition of patents (100,000)
Proceeds from sale of assets 415,000
------------ ------------
Net cash provided by (used in) investing activities 315,000 (296,000)
------------ ------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from exercise of warrants 131,000
------------ ------------
NET DECREASE IN CASH AND CASH EQUIVALENTS (1,045,000) (5,092,000)
Cash and cash equivalents - beginning of year 2,029,000 7,121,000
------------ ------------
CASH AND CASH EQUIVALENTS - END OF YEAR $ 984,000 $ 2,029,000
============ ============
NON-CASH TRANSACTIONS:
Non-employee compensation paid with stock options $ 5,000
SEE NOTES TO FINANCIAL STATEMENTS F-6
NETWORK-1 SECURITY SOLUTIONS, INC.
NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 2003 AND 2002
NOTE A - THE COMPANY
[1] BUSINESS:
Network-1 Security Solutions, Inc. (the "Company") developed, marketed,
licensed and supported its proprietary network security software products
designed to provide comprehensive security to computer networks. The
Company also provided maintenance and training services.
In December 2002, the Company discontinued its software product line and
associated operations, ceased its product development and eliminated its
sales and marketing efforts and during May 2003, sold substantially all
of its intellectual property. Through a series of layoffs, the Company
has reduced its workforce to a current level of two employees. The
Company has closed its various offices upon termination of leases during
2002 and 2003. In February 2003, the Company closed its principal office
in Waltham, Massachusetts and moved its principal offices to space in New
York City in offices occupied by CMH Capital Management Corp. ("CMH") (a
company owned by the Chairman and CEO). The Company reimburses CMH for
rent in the amount of $2,700 per month on a month-to-month basis (see
Note G[1]).
As part of its new business strategy, in November 2003, the Company
acquired a portfolio of telecommunications and data networking patents
(the "Patent Portfolio") and is pursuing licensing opportunities related
to the technologies covered by the Patent Portfolio. As of December 31,
2003, the Company has not entered into any license arrangements with
respect to the Patent Portfolio. However, it is pursuing such
arrangements with third parties.
[2] GOING CONCERN:
The Company has incurred substantial net losses from operations during
2003. The Company as of December 31, 2003 has cash and cash equivalents
of $984,000 and currently is not generating revenues to support its
operations. The Company has been dependent upon capital raised through
both public and private placement of equity to finance its business
operations. This raises substantial doubt about the Company's ability to
continue as a going concern.
In November 2003, the Company acquired a Patent Portfolio (see Note E)
and is pursuing licensing opportunities for these patents. However, the
Company has not entered into any license arrangements as of December 31,
2003. Until the Company generates positive cash flows from operations, of
which there can be no assurance, the Company plans to seek additional
financing through the issuance of debt and/or equity securities.
The accompanying financial statements have been prepared assuming that
the Company will continue as a going concern and do not include any
adjustments that may result from the outcome of this uncertainty.
NOTE B - SIGNIFICANT ACCOUNTING POLICIES
[1] CASH EQUIVALENTS:
The Company considers all highly liquid short-term investments purchased
with a maturity of three months or less to be cash equivalents.
F-7
NETWORK-1 SECURITY SOLUTIONS, INC.
NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 2003 AND 2002
NOTE B - SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
[2] REVENUE RECOGNITION:
License revenue is recognized upon delivery of software or delivery of a
required software key. License revenue from distributors or resellers is
recognized as the distributor or reseller delivers software or the
required software key to end users or original equipment manufacturers.
Service revenues consist of maintenance and training services. Annual
renewable maintenance fees are a separate component of each contract, and
are recognized ratably over the contract term. Training revenues are
recognized as such services are performed. Revenue from advance license
fees are deferred until they are earned pursuant to the agreements.
[3] EQUIPMENT AND FIXTURES:
Equipment and fixtures are stated at cost and are depreciated using the
straight-line method over their estimated useful lives of five years.
[4] SOFTWARE DEVELOPMENT COSTS:
Costs to maintain developed programs and development costs incurred to
establish the technological feasibility of computer software are expensed
as incurred. The Company capitalizes costs incurred in producing computer
software after technological feasibility of the software has been
established through the date that the software is ready for general
release to customers. Such costs are amortized based on current and
estimated future revenue of each product with an annual minimum equal to
the straight-line amortization over the remaining estimated economic life
of the product. The Company estimates the economic life of its software
to be three years.
[5] PATENTS:
The Company owns a Patent Portfolio that relates to various
telecommunications and data networking technologies. The Company
capitalizes the costs associated with acquisition, registration and
maintenance of the patents and amortizes these assets over their
remaining useful lives on a straight-line basis. Any further payments
made to maintain or develop the patents would be capitalized and
amortized over the balance of the useful life for the patents.
[6] IMPAIRMENT OF LONG-LIVED ASSETS:
In accordance with Statement of Financial Accounting Standards ("SFAS")
No. 144, "Accounting for the Impairment or Disposal of Long-Lived
Assets," intangible assets with finite lives are tested for impairment
whenever events or circumstances indicate that the carrying amount may
not be recoverable. Accordingly, the Company records impairment losses on
long-lived assets used in operations or expected to be disposed of when
indicators of impairment exist and the cash flows expected to be derived
from those assets are less than carrying amounts of those assets. During
the year ended December 31, 2002, the Company recorded an impairment
charge related to its network security software of approximately
$401,000, which was included in amortization of software development
costs. On May 30, 2003, the Company completed the sale of its network
security software to an unrelated third party for $415,000. At December
31, 2002, the Company also reduced the carrying value of its fixed assets
to their net realizable amount and sold them in January 2003 for $22,000,
that being their carrying value at December 31, 2002 (see Note C).
F-8
NETWORK-1 SECURITY SOLUTIONS, INC.
NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 2003 AND 2002
NOTE B - SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
[7] INCOME TAXES:
The Company utilizes the liability method of accounting for income taxes.
Under such method, deferred tax assets and liabilities are recognized for
the future tax consequences attributable to differences between the
financial statement carrying amounts of existing assets and liabilities
and their respective tax bases. Deferred tax assets and liabilities are
measured using enacted tax rates in effect at the balance sheet date. The
resulting asset or liability is adjusted to reflect enacted changes in
tax law. Deferred tax assets are reduced, if necessary, by a valuation
allowance when the likelihood of realization is not assured.
[8] LOSS PER SHARE:
Basic loss per share is calculated by dividing the net loss by the
weighted average number of outstanding common shares during the year.
Diluted per share data includes the dilutive effects of options, warrants
and convertible securities. Potential common shares of 11,495,493 and
18,081,581 at December 31, 2003 and 2002, respectively, are
anti-dilutive, and are not included in the calculation of diluted loss
per share. Such potential common shares reflect options, warrants,
convertible preferred stock and convertible notes.
[9] USE OF ESTIMATES:
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America requires
management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and disclosure of contingent assets and
liabilities at the date of the financial statements and the reported
amounts of revenues and expenses during the reporting period. Actual
results could differ from those estimates.
[10] FINANCIAL INSTRUMENTS:
The carrying amounts of cash and cash equivalents, accounts receivable,
accounts payable and accrued expenses approximate their fair value due to
the short period to maturity of these instruments.
[11] STOCK-BASED COMPENSATION:
The Company accounts for stock-based employee compensation under
Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock
Issued to Employees," and related interpretations. The Company has
adopted the disclosure-only provisions of SFAS No. 123, "Accounting for
Stock-Based Compensation" and SFAS No. 148, "Accounting for Stock-Based
Compensation - Transition and Disclosure," which was released in December
2002 as an amendment of SFAS No. 123. The following table illustrates the
effect on net loss and loss per share if the fair value-based method had
been applied to all awards:
YEAR ENDED
DECEMBER 31,
---------------------------------
2003 2002
------------ ------------
Reported net loss attributable to common stockholders $ (614,000) $ (5,905,000)
Stock-based employee compensation expense included
in reported net loss 41,000
Stock-based employee compensation determined under
the fair value-based method (203,000) (298,000)
------------ ------------
Pro forma net loss $ (776,000) $ (6,203,000)
============ ============
Loss per common share (basic and diluted):
As reported $ (0.07) $ (0.78)
============ ============
Pro forma $ (0.09) $ (0.82)
============ ============
F-9
NETWORK-1 SECURITY SOLUTIONS, INC.
NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 2003 AND 2002
NOTE B - SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
[11] STOCK-BASED COMPENSATION: (CONTINUED)
The fair value of options on the date of grant is estimated using the
Black-Scholes option-pricing model utilizing the following weighted
average assumptions:
YEAR ENDED
DECEMBER 31,
---------------------------------
2003 2002
------------ ------------
Risk-free interest rates 2.74 - 5.07% 2.63 - 6.44%
Expected option life in years 3.04 6.60
Expected stock price volatility 113.75 - 229.03% 112.00%
Expected dividend yield 0.00% 0.00%
[12] ADVERTISING COSTS:
Advertising costs are expensed as incurred. Advertising expense was $0
and $93,000 for the years ended December 31, 2003 and 2002, respectively.
[13] RECENTLY ISSUED ACCOUNTING STANDARDS:
SFAS No. 150, "Accounting for Certain Financial Instruments with
Characteristics of Both Liabilities and Equity," which was issued in May
2003, will require redeemable preferred stock to be classified, in
certain circumstances, as a liability, upon adoption by a public company
at the beginning of the first interim period beginning after June 15,
2003. SFAS No. 150 provides that mandatorily redeemable preferred stock
should be classified as a liability if it embodies an unconditional
obligation requiring the issuer to redeem the shares by transferring its
assets at a specified or determinable date or upon an event certain to
occur. The Company does not currently have any financial instruments with
these characteristics. SFAS No. 150 had no effect on the Company's
results of operations and financial position.
In November 2002, the FASB issued Interpretation No. 45, "Guarantor's
Accounting and Disclosures Requirements for Guarantees, Including
Indirect Guarantees of Indebtedness of Others" ("FIN 45"). FIN 45
requires that upon issuance of a guarantee, the guarantor must recognize
a liability for the fair value of the obligation it assumes under that
guarantee. FIN 45 is effective on a prospective basis to guarantees
issued or modified after December 15, 2002, but has certain disclosure
requirements effective for financial statements of interim or annual
periods ending after December 15, 2002. The Company does not currently
have any guarantees. The adoption of the disclosure requirements of FIN
45 had no effect on the Company's financial position or results of
operations.
In January 2003, the FASB issued FIN No. 46, "Consolidation of Variable
Interest Entities" ("FIN 46"). FIN 46 relates to certain entities in
which equity investors do not have the characteristics of a controlling
financial interest or do not have sufficient capital at risk for the
entity to finance its activities without additional subordinated
financial support from other parties. Under certain circumstances, an
enterprise may be required to consolidate such an entity if it will
absorb a majority of the entity's expected losses, receive a majority of
the entity's residual returns, or both. FIN 46 became effective for
variable interest entities created after January 31, 2003, and had no
effect on the Company's financial position as of December 31, 2003, and
its results of operations for the year then ended.
[14] RECLASSIFICATION:
Certain prior year amounts have been reclassified to conform to the 2003
presentation.
F-10
NETWORK-1 SECURITY SOLUTIONS, INC.
NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 2003 AND 2002
NOTE C - EQUIPMENT AND FIXTURES
Equipment and fixtures are summarized as follows at December 31, 2002:
Office and computer equipment $ 649,000
Furniture and fixtures 146,000
------------
795,000
Less accumulated depreciation (773,000)
------------
$ 22,000
============
Depreciation expense was $0 and $413,000 for the years ended December 31, 2003
and 2002, respectively. In January 2003, the Company sold all the remaining
equipment and fixtures at its carrying value as at December 31, 2002, resulting
in no profit or loss on sale of its assets.
NOTE D - CAPITALIZED SOFTWARE COSTS
YEAR ENDED
DECEMBER 31,
2002
------------
Balance, beginning of year (net of accumulated
amortization) $ 561,000
Additions 180,000
Amortization (741,000)
------------
Balance, end of year (net of accumulated
amortization) $ 0
============
During 2002, the Company wrote-off the remaining balance of $401,000
attributable to its capitalized software cost when it discontinued its
software product offering which is included in amortization expense.
NOTE E - PATENTS
In November 2003, the Company acquired a portfolio of telecommunications and
data networking patents (six patents) from Merlot Communications, Inc. (the
"Seller") in which controlling stockholders of the Company currently own a
majority of Merlot's voting stock. The purchase price for the Patent Portfolio
was $100,000, paid in cash. The cash price paid has been capitalized and is
being amortized over the remaining useful life of each patent. In addtion, the
Company shall pay the Seller 20% of the net income, as defined, after the first
$4,000,000 of net income realized by the Company on a per patent basis from the
sale or licensing of the patents. However, the Company has an option to
terminate these payments for each of the patents, commencing Janaury 1, 2007
through March 31, 2007, and for each Janaury 1 through March 31 period
therafter, by paying the greater of: (i) two times the payment due for the 12
months immediately following the notice for each patent; or (ii) $3 million plus
an extra 10% for each additional year starting the fourth year after the closing
of the patent agreement for each patent.
F-11
NETWORK-1 SECURITY SOLUTIONS, INC.
NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 2003 AND 2002
NOTE E - PATENTS (CONTINUED)
The Company has granted the Seller a nonexclusive, royalty free, license for the
term of each patent to use the patents for the development, manufacture or sale
of its own branded products to end users.
For the year ended December 31, 2003, the Company has not derived any income
from sale or licensing of these patents.
Balance - January 1, 2003
Additions $ 100,000
Amortization (1,000)
------------
Balance - December 31, 2003 $ 99,000
============
NOTE F - STOCKHOLDERS' EQUITY
[1] PREFERRED STOCK:
(a) Series D preferred stock:
Pursuant to a private placement in December 1999, the Company
received $1,500,000 from the sale of 491,803 shares of Series D
convertible preferred stock at $3.05 per share, including 172,129
shares to related parties. Such stock is convertible into common
shares at a conversion rate of 1.69431 (as adjusted), has identical
voting rights as the Company's common stock, and is entitled to
equivalent dividend rights as those paid on shares of common stock
obtainable on conversion. The holders of the Series D convertible
preferred stock are entitled to a liquidation preference of $3.05 per
share plus any declared but unpaid dividends before any payments are
made to holders of common stock, and rank equal with Series E
preferred stock in the event of liquidation, dissolution or winding
up of the Company. Through December 31, 2001, 384,780 shares of the
Series D preferred stock were converted to common stock and prior
outstanding notes were converted into 124,031 shares of the Series D
preferred stock. In connection therewith, the Company also issued
five-year warrants to purchase 491,803 shares of common stock at an
exercise price of $3.05 per share. The exercise price of the warrants
was reduced to $1.00 because the Company did not achieve a specified
revenue target. Holders of warrants for 444,857 shares waived such
exercise price reduction. Of these warrants, 147,149 were exercised
during 2000.
Pursuant to anti-dilution features of the Series D convertible
preferred stock and warrants, in connection with the October 2, 2001
private offering of Series E preferred stock and warrants (see (b)
below), the holders of outstanding Series D preferred stock and
related warrants received the right to purchase 1,145,207 additional
shares of common stock upon conversion or exercise of Series D
preferred stock and warrants as a result of the anti-dilution
provisions of such securities. The warrants expire in December 2004.
In addition, the exercise price of outstanding warrants was adjusted
from $3.05 to $1.114.
(b) Series E preferred stock:
On October 2, 2001, the Company completed a $6,765,000 private
offering of Series E preferred stock ("Series E") and warrants (the
"2001 Financing"). An aggregate of 3,191,037 shares of Series E
together with warrants to purchase 6,882,074 shares of common stock
were sold. The warrants were issued at the rate of two warrants, each
to purchase a share of common stock at $1.27 per share, with every
share of Series E, plus an additional warrant to purchase 500,000
shares to an investor,
F-12
NETWORK-1 SECURITY SOLUTIONS, INC.
NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 2003 AND 2002
NOTE F - STOCKHOLDERS' EQUITY (CONTINUED)
[1] PREFERRED STOCK: (CONTINUED)
(b) Series E preferred stock: (continued)
Falconstor Software, Inc. ("Falconstor"), for investing more than
$2,000,000 (the "Additional Warrant"). Out of the above warrants,
6,382,074 warrants expired on October 2, 2003. In connection with the
2001 Financing, the Company and Falconstor entered into a ten-year
License and Distribution Agreement (the "Falconstor Agreement")
pursuant to which Falconstor has the right to distribute the
Company's product offerings in its indirect and OEM channels. As part
of the Falconstor Agreement, Falconstor paid the Company a
non-refundable advance of $500,000 against future royalty payments
(the "Advance"). For accounting purposes, $350,000 of the Advance,
representing the estimated fair value of the Additional Warrant, was
accounted for as its purchase price, resulting in total proceeds
attributable to the 2001 Financing of $7,115,000. For accounting
purposes, an allocation of $4,952,000 and $2,163,000 was made to the
Series E and warrants, respectively, based on the relative fair
values of the common stock obtainable upon conversion of the Series E
and the warrants on the date of the 2001 Financing. The warrants were
valued using the Black-Scholes option pricing model using the
following assumptions: volatility of 113.45%, expected life of 1 year
and 3 years, dividend yield of 0, and risk-free interest rates of
2.47% and 3.14%, respectively. The difference between the proceeds
allocated to the Series E and the fair market value of the common
stock obtainable upon conversion of the Series E represents a
beneficial conversion feature, which has been imputed as a preferred
stock dividend in calculating the net loss available to common
stockholders. On May 30, 2003, as part of the Company's sale of its
CyberwallPLUS technology and related intellectual property (the
"Assets") to an unrelated third party (the "Purchaser"), the Company
assigned its rights under the Falconstor Agreement to the Purchaser.
Holders of the Series E may convert each such share into two shares
of common stock at any time, subject to adjustment. During the year
ended December 31, 2002, holders of 707,529 shares of Series E
converted their shares into 1,415,058 shares of common stock. The
Series E is entitled to vote on all matters with the holders of the
Company's common stock based on the number of shares of common stock
into which such shares may be converted, except that the holders of
the Series E have irrevocably waived any increased voting rights that
may be afforded to the holders of Series E resulting from
anti-dilution protection. Holders of Series E shall receive dividends
and other distributions, when, as and if declared by the Board of
Directors, out of funds legally available therefore equivalent to
those dividends paid on shares of common stock. The holders of Series
E will be entitled to a liquidation preference of $2.12 per share
plus any declared but unpaid dividends before any payments are made
to holders of common stock, and the Series E ranks equal with the
Series D preferred stock upon liquidation. The Company also agreed
with the holders of the Series E that, without the approval of the
Series E designee, a principal stockholder of the Company (see Note
J[3]), it will not take certain actions, including (i) issue
securities except for securities issued under its stock option plan,
(ii) incur debt in excess of $250,000, (iii) enter into a merger,
acquisition or sale of substantially all of its assets and (iv) take
any action to amend its Certificate of Incorporation or by-laws that
could in any way adversely affect the rights of the holders of the
Series E. In addition, the investors were granted registration rights
with respect to the shares of common stock to be received upon
conversion of the Series E preferred stock and exercise of the
warrants.
[2] STOCK OPTIONS:
During 1996, the Board of Directors and stockholders approved the
adoption of the 1996 Stock Option Plan (the "1996 Plan"). The 1996 Plan,
as amended, provides for the granting of both incentive and non-qualified
options to purchase common stock of the Company. A total of 4,000,000
shares are provided for under the 1996 Plan.
F-13
NETWORK-1 SECURITY SOLUTIONS, INC.
NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 2003 AND 2002
NOTE F - STOCKHOLDERS' EQUITY (CONTINUED)
[2] STOCK OPTIONS: (CONTINUED)
The term of options granted under the 1996 Plan may not exceed ten years
(five years in the case of an incentive stock option granted to an
optionee owning more than 10% of the voting stock of the Company) ("10%
stockholder"). The option price for incentive stock options can not be
less than 100% of the fair market value of the shares of common stock at
the time the option is granted (110% for a 10% stockholder). Option terms
and vesting periods are set by the Compensation Committee in its
discretion.
The following table summarizes stock option activity for the years ended
December 31:
2003 2002
------------------------------- ---------------------------------
WEIGHTED WEIGHTED
AVERAGE AVERAGE
OPTIONS EXERCISE OPTIONS EXERCISE
OUTSTANDING PRICE OUTSTANDING PRICE
------------ ------------ ------------ ------------
Options outstanding at beginning of year 3,154,498 $ 2.25 1,761,652 $ 3.36
Granted 1,860,000(d) 0.19 2,520,000(a)(c) 1.48
Cancelled/expired (1,742,128)(c) 2.42 (1,127,154) 2.26
------------ ------------
Options outstanding at end of year 3,272,370 0.99 3,154,498(b) 2.25
============ ============
Options exercisable at end of year 1,964,545 1.30 788,165 4.03
============ ============
(a) On April 18, 2002, in consideration of additional consulting and
financial advisory services, the Company issued to CMH Capital
Management Corp. ("CMH") an option to purchase 750,000 shares of the
common stock at an exercise price of $1.20 per share, which was the
market price of the Company's common stock on the date of issuance.
Corey M. Horowitz, Chairman of the Board of Directors of the
Company, is the sole owner and officer of CMH. The shares underlying
the option vest over a three-year period in equal amounts of 250,000
shares per year beginning April 18, 2003. In addition, the shares
underlying the option shall vest in full in the event of a "change
of control" or in the event that the closing price of the Company's
common stock reaches a minimum of $3.50 per share for 20 consecutive
trading days. These options are treated as contingent options and
were originally priced in the quarter ended June 30, 2002 at
$416,000. Subsequently, they were revalued to $55,000 at December
31, 2002 and $14,000 at March 31, 2003. The fair value of these
options remained unchanged at April 18, 2003. On April 18, 2003,
250,000 of these options, having a fair value of $5,000 as of that
date, vested. Accordingly, $5,000 was reallocated to additional
paid-in capital by correspondingly reducing the liability. The
options to purchase the remaining 500,000 shares continue to be
treated as contingent options and valued utilizing the Black-Scholes
option pricing model at each balance sheet date. At December 31,
2003 the 500,000 unvested options were valued at $54,000. Any
increase/decrease in the valuation has been reflected as
addition/reduction of general and administrative expenses at each
balance sheet date.
(b) Includes a five-year option to purchase 294,879 shares of common
stock at an exercise price of $2.42 per share issued outside the
1996 Plan which expired in May 2003. The option was issued in May
1998 in connection with an employment agreement with the Company's
former President and Chief Executive Officer.
F-14
NETWORK-1 SECURITY SOLUTIONS, INC.
NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 2003 AND 2002
NOTE F - STOCKHOLDERS' EQUITY (CONTINUED)
[2] STOCK OPTIONS: (CONTINUED)
(c) On March 11, 2002, the Company entered into a two-year employment
agreement with Richard J. Kosinski, as Chief Executive Officer and
President, and issued to Mr. Kosinski ten-year options to purchase
1,200,000 shares of the Company's common stock at an exercise price
of $1.65 per share. The vesting schedule for these options was as
follows: (i) 25% of the shares (300,000 shares) on March 11, 2003
and (ii) the balance of 75% of the shares over a three-year period
in equal amounts of 6.25% (75,000 shares) at the end of each
three-month period beginning March 11, 2003, subject to acceleration
upon a change of control of the Company. In July 2003, all of these
options issued were forfeited in connection with the settlement of a
lawsuit by Mr. Kosinski against the Company.
(d) Includes five-year options to purchase 1,600,000 shares of the
Company's common stock issued to Corey M. Horowitz, Chief Executive
Officer and Chairman of the Company in connection with an agreement
in December 2003 (see Note K) as follows: (i) incentive stock
options to purchase 1,084,782 shares of common stock, at an exercise
price of $0.23 per share, of which 434,782 shares vested
immediately, 250,000 shares vest on December 22, 2004 and 200,000
shares each vest on December 22, 2005 and December 22, 2006 and (ii)
non-qualified stock options to purchase 515,218 shares of common
stock, at an exercise price of $0.13 per share, which vested
immediately. The Company recognized $41,000 of expense in 2003
related to the 515,218 options representing the difference between
the exercise price of the options and the market price on the date
of grant.
(e) The following table presents information relating to stock options
outstanding and exercisable at December 31, 2003:
WEIGHTED
WEIGHTED AVERAGE WEIGHTED
RANGE OF AVERAGE REMAINING AVERAGE
EXERCISE OPTIONS EXERCISE LIFE IN OPTIONS EXERCISE
PRICES OUTSTANDING PRICE YEARS EXERCISABLE PRICE
---------------- ----------- ------ ---- ----------- ------
$ 0.12 - $ 2.91 2,955,093 $ 0.58 9.18 1,648,188 $ 0.63
$ 3.00 - $ 3.75 146,625 3.44 6.34 146,625 3.44
$ 4.13 - $ 5.69 69,600 5.17 6.14 68,680 5.16
$ 6.00 - $ 6.875 91,052 6.22 5.98 91,052 6.22
$10.00 - $10.125 10,000 10.00 6.08 10,000 10.00
----------- -----------
3,272,370 0.99 8.76 1,964,545 1.30
=========== ===========
The weighted average fair value on the option grant date during the
years ended December 31, 2003 and 2002 were $0.20 and $1.13 per
option, respectively.
F-15
NETWORK-1 SECURITY SOLUTIONS, INC.
NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 2003 AND 2002
NOTE F - STOCKHOLDERS' EQUITY (CONTINUED)
[3] WARRANTS:
As of December 31, 2003, the Company has the following outstanding
warrants to purchase shares of common stock:
NUMBER OF EXERCISE
WARRANTS PRICE EXPIRATION DATE
----------- ------ ----------------------------------
31,040 $ 1.61 January 15, 2004
62,856 2.42 April 4, 2004
100,104 6.44 March 14, 2006 - February 24, 2007
93,120 9.66 March 14, 2006
20,000 7.50 January 2, 2004 (a)
20,000 10.00 February 28, 2004 (a)
300,000 .70 July 11, 2011 (b)
250,000 1.48 October 8, 2006 (b)
1,352,048 1.11 December 22, 2004 (c)
500,000 1.27 October 2, 2006 (d)
66,621 2.03 April 13, 2006 (e)
64,352 2.00 July 2, 2006 (e)
4,489 2.10 October 1, 2006 (e)
-----------
2,864,630
===========
(a) Represents warrants issued pursuant to a consulting agreement with
an advisory firm. Under the agreement, entered into on October 31,
2000, the Company was required to pay a monthly fee and issue 60,000
warrants. The warrants have exercise prices ranging from $5.00 to
$10.00, expire three years after issuance, and were issued 1/3 at
the inception of the agreement, 1/3 at 60 days, and 120 days after
inception. The warrants were valued at $82,000 using the
Black-Scholes option pricing model using the following weighted
average assumptions on the issuance dates: risk-free interest rate
of 5.60, volatility of 113%, dividend yield of 0 and expected life
of 3 years.
(b) Issued to CMH in 2001, a company owned by the Chairman and Chief
Executive Officer (see Note J[1]).
(c) Issued in connection with the Series D preferred stock and notes.
(d) Issued with private offering of Series E preferred stock (see Note
F[1]).
(e) Issued to a software development company for services rendered. The
Company recognized an $80,000 expense in 2001 related to the
warrants based on their estimated fair value using the Black-Scholes
option pricing model utilizing the following weighted average
assumptions: risk free rate of 4.5%, expected life of 3 years,
volatility of 113%, and a dividend yield of 0. The software
development company has claimed they are entitled to additional
warrants for the services rendered (see Note G[4]).
F-16
NETWORK-1 SECURITY SOLUTIONS, INC.
NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 2003 AND 2002
NOTE G - COMMITMENTS AND CONTINGENCIES
[1] OPERATING LEASES:
At December 31, 2002, the Company leased an office facility in
Massachusetts, being its principal office, which expired during February
2003. During 2002, the Company closed its New Hampshire and Shanghai,
China, office facilities. The Company moved its principal offices to a
space in New York City and pays rent on a month-to-month basis (see Note
A).
Rental expense for the years December 31, 2003 and 2002 aggregated
$42,000 and $376,000, respectively.
[2] SOFTWARE DISTRIBUTION AGREEMENT:
Pursuant to an agreement under which certain technology was developed for
the Company, royalty payments of up to $100,000 may be payable. As of
December 31, 2003, royalties owed pursuant to such agreement were not
significant.
[3] SAVINGS AND INVESTMENT PLAN:
The Company has a Savings and Investment Plan which allows participants
to make contributions by salary reduction pursuant to Section 401(k) of
the Internal Revenue Code of 1986. The Company also may make
discretionary annual matching contributions in amounts determined by the
Board of Directors, subject to statutory limits. The Company did not make
any contributions to the 401(k) Plan during the years ended December 31,
2003 and 2002.
[4] SOFTWARE DEVELOPMENT CONTRACT DISPUTE:
The Company has a dispute with a software development company pertaining
to the number of warrants the Company is required to issue for services
rendered. The software development company has claimed they are entitled
to approximately 325,000 additional warrants than the Company has
included in the warrants outstanding in Note F[3]. The Company has
included in accrued expenses any additional liability it reasonably
expects to incur regarding this matter.
NOTE H - INCOME TAXES
At December 31, 2003, the Company has available net operating loss carryforwards
to reduce future federal taxable income of approximately $31,165,000 for tax
reporting purposes, which expire from 2009 through 2023. Pursuant to the
provisions of the Internal Revenue Code, future utilization of these past losses
is subject to certain limitations based on changes in the ownership of the
Company's stock that have occurred.
F-17
NETWORK-1 SECURITY SOLUTIONS, INC.
NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 2003 AND 2002
NOTE H - INCOME TAXES (CONTINUED)
The principal components of the net deferred tax asset are as follows:
YEAR ENDED
DECEMBER 31,
-----------------------------
2003 2002
------------ ------------
Deferred tax assets:
Net operating loss carryforwards $ 11,687,000 $ 11,238,000
Options and warrants not yet
deducted, for tax purposes 676,000 659,000
Other 146,000 382,000
------------ ------------
12,509,000 12,279,000
Valuation allowance (12,509,000) (12,279,000)
------------ ------------
Net deferred tax assets $ 0 $ 0
============ ============
The Company has recorded a valuation allowance for the full amount of its
deferred tax assets as the likelihood of its future realization cannot be
presently determined. The valuation allowance increased by $230,000 in 2003 and
$2,138,000 in 2002.
The reconciliation between the taxes as shown and the amount that would be
computed by applying the statutory federal income tax rate to the loss before
income taxes is as follows:
YEAR ENDED
DECEMBER 31,
-----------------------------
2003 2002
------------ ------------
Income tax benefit - statutory rate (34.0)% (34.0)%
State and local, net (3.5) (3.5)
Increase in valuation allowance on
deferred tax assets 37.5 37.5
------------ ------------
0.0% 0.0%
============ ============
NOTE I - CONCENTRATIONS
The Company places its cash investments in high quality financial institutions
insured by the Federal Deposit Insurance Corporation ("FDIC"). At December 31,
2003, the Company maintained cash balances of $878,000 in excess of FDIC limits.
F-18
NETWORK-1 SECURITY SOLUTIONS, INC.
NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 2003 AND 2002
NOTE J - RELATED PARTY TRANSACTIONS AND RELATIONSHIPS
[1] In June 2001, upon the resignation of the Company's Chief Executive
Officer, the Company entered into a six-month consulting agreement with
CMH, a company owned by the Chairman of the Board of the Company.
Pursuant to the agreement, the Company paid CMH $17,500 per month and
issued a warrant to purchase 300,000 shares of the Company's common stock
at an exercise price of $.70 per share, which was the market price of the
common stock on the date of issuance. The warrants were valued utilizing
the Black-Scholes option pricing model, resulting in an estimated fair
value of $180,000, which was expensed in 2001. In addition, in October
2001, as consideration for additional consulting and financial services,
the Company issued warrants to purchase 250,000 shares of common stock at
an exercise price of $1.48 per share which were expensed. In January
2002, the agreement was extended to the lesser of six months or three
months after the date of hire of a new Chief Executive Officer. In July
2002, the agreement was further extended until December 31, 2002. Until
December 2003, the Company continued its consulting arrangement with CMH
on a month-to-month basis. In addition, CMH was reimbursed for $41,000
and $50,000 of expenses incurred during the years ended December 31, 2003
and 2002, respectively, including the allocable portion of rent for
office space in New York City. In December 2003, Mr. Horowitz, the sole
officer and stockholder of CMH, became Chairman and Chief Executive
Officer of the Company (see Note K) and the CMH consulting agreement was
terminated.
[2] In December 2001, the Company entered into a one-year financial advisory
agreement with an investment banking firm, which required the Company to
pay $200,000 over the next ten months. At the time of entering into the
agreement, the firm's Chairman of the Board owned shares of Series E
preferred stock and an affiliate was the general partner of a partnership
that owned common stock and held convertible notes, subsequently
converted into common stock. During 2002, the Company agreed with the
investment banking firm that no further services would be needed and that
payments in the aggregate of $40,000 be considered as full satisfaction
under the agreement which was accrued at December 31, 2002 and paid in
January 2003. The Company charged $153,000 to operations during the year
ended December 31, 2002.
[3] As noted in F[1], the Company entered into a ten-year License and
Distribution Agreement with Falconstor, an investor in the 2001
Financing. This agreement required Falconstor to pay royalties after
utilizing the Advance as a credit. Deferred revenue at December 31, 2002
included $130,000 from this agreement, representing the unearned portion
of the $150,000 allocated from the Advance to the license fee, less
accumulated royalties earned of $20,000 through December 31, 2002. On May
30, 2003, as part of the Company's sale of its assets to the purchaser,
the Company assigned its rights under the Falconstor Agreement to the
Purchaser of its software (Note L) and recognized as income, the balance
of the deferred revenue during 2003. One of the Company's principal
stockholders is also a principal stockholder of Falconstor, and an
affiliated entity is the Series E designee noted in F[1].
NOTE K - EMPLOYMENT ARRANGEMENTS
On December 22, 2003, the Company entered into an arrangement with Corey M.
Horowitz to serve as the Chairman and Chief Executive Officer of the Company.
The Company will pay a salary of $210,000. In addition, Mr. Horowitz received
options to purchase 1,600,000 shares of common stock (see Note F[2](d). If, at
anytime up to December 31, 2005, the Company completes a financing transaction
and issues common stock or any other securities convertible or exercisable into
common stock, Mr. Horowitz will receive additional options to purchase common
stock, up to a maximum of 600,000 options, so that he will maintain his
ownership percentage of options and warrants as of December 22, 2003.
F-19
NETWORK-1 SECURITY SOLUTIONS, INC.
NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 2003 AND 2002
NOTE L - GAIN ON SALE OF ASSETS
On May 30, 2003, the Company completed the sale of its CyberwallPlus technology
and related intellectual property and assignment of its rights under the
Falconstar Agreement for aggregate proceeds of $415,000. The carrying value of
these assets was written down to zero in the third quarter of 2002. The $415,000
is reflected as "Gain on Sale of Assets" in the statements of operations.
NOTE M - SUBSEQUENT EVENTS
[1] In January 2003, the former Chief Financial Officer and a director (the
"Former CFO") of the Company commenced a lawsuit against the Company for
breach of his employment agreement for $190,000. In February 2004, the
Company agreed to pay $55,000 to the Former CFO in full settlement of all
claims asserted, which is accrued in the accompanying financial
statements.
[2] In January 2004, the Company entered into an agreement with an individual
to serve as the Company's Chief Financial Officer (the "New CFO"). The
agreement expires on December 31, 2004 and provides for a base salary of
$5,500 per month for the period January 22, 2004 through April 30, 2004,
$4,500 per month for the period May 1, 2004 through August 31, 2004 and
$3,500 per month from September 1, 2004 through December 31, 2004. In
connection with his agreement, the New CFO received options to purchase
50,000 shares of common stock of the Company at $0.35 per share under the
Company's stock option plan, at the fair market value of the shares on
the date of the grant, 20,000 of these options vest immediately and the
balance vests on a monthly basis through December 31, 2004.
[3] In March 2004, PowerDsine Inc. ("PowerDsine") commenced an action against
the Company in the United District Court, Southern District of New York,
seeking a declaratory judgment that the Company's patent (U.S. Patent No.
6,218,930) covering the remote delivery of power over Ethernet (the
"Remote Power Patent") is not infringed by PowerDsine and/or its
customers. PowerDsine further seeks an order permanently enjoining the
Company (i) from making any claims to any person or entity that
PowerDsine's products infringe the Remote Power Patent or contribute to
infringement of the patent, (ii) from interfering with or threatening to
interfere with the importation, sale, license or use of PowerDsine's
power over Ethernet components or products, and (iii) from instituting or
prosecuting any lawsuit or proceeding, placing at issue the right of
PowerDsine, its customers, licensees, successors, or assigns to import,
use or sell PowerDsine's power over Ethernet components or products. The
Company believes its Remote Power Patent is valid and has meritorious
defenses to the action. The Company intends to vigorously defend the
action and take whatever actions are necessary to protect its
intellectual property.
[4] In April 2004, the Company entered into an exchange agreement with the
holders of the Company's Series E ("Series E") and Series D ("Series D")
convertible preferred stock to exchange 2,483,508 shares of Series E into
6,208,770 shares of common stock and 231,054 shares of Series D into
489,348 shares of common stock. As an inducement for agreeing to such
conversion, the holders of the Series E and Series D received 1.25 times
the number of shares of common stock that each preferred stockholder
would have otherwise received upon conversion. The holders of preferred
stock participating in the exchange included, among others, CMH
(1,084,935 of Series E shares), the wife of Corey M. Horowitz (35,377 of
Series E shares) and other principal stockholders of the Company (990,552
of Series E shares and 209,125 of Series D shares).
F-20