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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-QSB
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2004
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM ______ TO ______
COMMISSION FILE NUMBER 1-14896
NETWORK-1 SECURITY SOLUTIONS, INC.
(EXACT NAME OF SMALL BUSINESS ISSUER AS
SPECIFIED IN ITS CHARTER)
DELAWARE 11-3027591
(STATE OR OTHER JURISDICTION OF (IRS EMPLOYER IDENTIFICATION NO.)
INCORPORATION OR ORGANIZATION)
445 Park Avenue, Suite 1028, New York, New York 10022
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)
212-829-5770
(ISSUER'S TELEPHONE NUMBER)
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 [ ]
The number of shares of Common Stock, $.01 par value per share, outstanding as
of August 9, 2004 was 15,012,572.
Transitional Small Business Disclosure Format (check one):
Yes [ ] No [X]
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NETWORK-1 SECURITY SOLUTIONS, INC.
INDEX
Page No.
PART I. FINANCIAL INFORMATION
Item 1. FINANCIAL STATEMENTS
Condensed Balance Sheets as of June 30, 2004 (unaudited)
and December 31, 2003...........................................3
Condensed Statements of Operations for the three and
six months ended June 30, 2004 and 2003 (unaudited).............4
Condensed Statements of Cash Flows for the six months ended
June 30, 2004 and 2003 (unaudited)..............................5
Notes to Condensed Financial Statements...........................6
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION........10
Item 3. CONTROLS AND PROCEDURES..........................................16
PART II. OTHER INFORMATION
Item 1. Legal Proceedings................................................16
Item 2. Changes in Securities and Small Business Issuer Purchases
of Equity Securities...........................................16
Item 3. Defaults Upon Senior Securities..................................16
Item 4. Submission of Matters to a Vote of Security Holders..............16
Item 5. Other Information................................................16
Item 6. Exhibits and Reports on Form 8-K.................................17
SIGNATURES................................................................18
2
NETWORK-1 SECURITY SOLUTIONS, INC.
CONDENSED BALANCE SHEETS
JUNE 30, DECEMBER 31,
------------ -------------
2004 2003
(UNAUDITED)
ASSETS
Current assets:
Cash and cash equivalents $ 454,000 $ 984,000
Prepaid expenses and other current assets 37,000 86,000
------------ ------------
Total current assets 491,000 1,070,000
Patents 96,000 99,000
------------ ------------
$ 587,000 $ 1,169,000
============ ============
LIABILITIES
Current liabilities:
Accounts payable $ 49,000 $ 78,000
Accrued expenses and other current liabilities 470,000 520,000
------------ ------------
Total current liabilities 519,000 598,000
------------ ------------
Liability to be settled with equity instrument 81,000 54,000
------------ ------------
Commitments and contingencies
STOCKHOLDERS' EQUITY (DEFICIT)
Preferred stock - $0.01 par value, 10,000,000 shares authorized,
Series D - convertible, voting, authorized 1,250,000 shares;
231,054 shares issued and outstanding at December 31, 2003
liquidation preference of $705,000 at December 31, 2003 -- 2,000
Series E - convertible, authorized 3,500,000 shares; 2,483,508
shares issued and outstanding at December 31, 2003,
liquidation preference of $ 5,265,000 at December 31, 2003
-- 25,000
Common stock - $0.01 par value; authorized 40,000,000 shares;
15,012,572 shares and 8,314,458 shares issued and 150,000 83,000
outstanding at June 30, 2004 and December 31, 2003, respectively
Additional paid-in capital 41,454,000 41,443,000
Accumulated deficit (41,617,000) (41,036,000)
------------ ------------
Total stockholders' equity (deficit) (13,000) 517,000
------------ ------------
$ 587,000 $ 1,169,000
============ ============
SEE NOTES TO CONDENSED FINANCIAL STATEMENTS
3
NETWORK-1 SECURITY SOLUTIONS, INC.
CONDENSED STATEMENTS OF OPERATIONS
(UNAUDITED)
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
----------------------------- -----------------------------
2004 2003 2004 2003
------------ ------------ ------------ ------------
Revenue:
Licenses $ -- $ 130,000 $ -- $ 130,000
Services -- 34,000 -- 76,000
------------ ------------ ------------ ------------
Total revenue -- 164,000 -- 206,000
Cost of revenue:
Amortization of software
Development costs
Cost of licenses
Cost of services -- 17,000 -- 34,000
------------ ------------ ------------ ------------
Total cost of revenue -- 17,000 -- 34,000
------------ ------------ ------------ ------------
Gross Profit -- 147,000 -- 172,000
------------ ------------ ------------ ------------
Operating expenses:
Product development costs
Selling and marketing
General and administrative 218,000 285,000 582,000 590,000
------------ ------------ ------------ ------------
Total operating expenses 218,000 285,000 582,000 590,000
------------ ------------ ------------ ------------
LOSS BEFORE OTHER INCOME (218,000) (138,000) (582,000) (418,000)
Interest income - net -- 3,000 1,000 7,000
Gain on sale of assets -- 415,000 -- 415,000
------------ ------------ ------------ ------------
Net (loss) income $ (218,000) $ 280,000 $ (581,000) $ 4,000
============ ============ ============ ============
(LOSS) EARNINGS PER COMMON SHARE:
BASIC $ (0.02) $ 0.03 $ (0.05) $ 0.00
============ ============ ============ ============
DILUTED $ (0.02) $ 0.03 $ (0.05) $ 0.00
============ ============ ============ ============
WEIGHTED AVERAGE SHARES:
BASIC 14,129,308 8,314,458 11,221,883 8,314,458
============ ============ ============ ============
DILUTED 14,129,308 8,314,458 11,221,883 8,314,458
============ ============ ============ ============
SEE NOTES TO CONDENSED FINANCIAL STATEMENTS
4
NETWORK-1 SECURITY SOLUTIONS, INC.
CONDENSED STATEMENTS OF CASH FLOWS
(UNAUDITED)
SIX MONTHS ENDED
JUNE 30,
-------------------------------
2004 2003
----------- -----------
Cash flows from operating activities:
Net (loss) income $ (581,000) $ 4,000
Adjustments to reconcile net (loss) income to net cash used in operating
activities:
Valuation adjustment for outstanding stock options 78,000 (41,000)
Gain on sale of assets -- (415,000)
Depreciation and amortization 3,000 22,000
Security deposits written off -- 8,000
Changes in:
Accounts receivable -- 6,000
Prepaid expenses and other current assets 49,000 57,000
Accounts payable, accrued expenses and other current liabilities (79,000) (329,000)
Deferred revenue -- (206,000)
----------- -----------
Net cash used in operating activities (530,000) (894,000)
----------- -----------
Cash flows provided by investing activities:
Proceeds from the sale of assets -- 415,000
----------- -----------
NET DECREASE IN CASH AND CASH EQUIVALENTS (530,000) (479,000)
Cash and cash equivalents, beginning of period 984,000 2,029,000
----------- -----------
CASH AND CASH EQUIVALENTS, END OF PERIOD $ 454,000 $ 1,550,000
=========== ===========
NON-CASH TRANSACTIONS:
Non-employee compensation paid with equity stock options $ 51,000 $ 5,000
=========== ===========
Par Value of Common Stock issued on conversion of Series D and E Preferred Stock
(See Note B)
$ 67,000 $
=========== ===========
SEE NOTES TO CONDENSED FINANCIAL STATEMENTS
5
NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
[1] BASIS OF PRESENTATION:
The accompanying condensed financial statements as of June 30, 2004 and
for the three and six month periods ended June 30, 2004 and June 30,
2003, are unaudited, but, in the opinion of the management of Network-1
Security Solutions, Inc. (the "Company") contain all adjustments which
the Company considers necessary for the fair presentation of the
Company's financial position as of June 30, 2004, the results of its
operations and its cash flows for the three and six month periods ended
June 30, 2004 and June 30, 2003. The condensed financial statements
included herein have been prepared in accordance with the accounting
principles generally accepted in the United States of America for
interim financial information and the instructions to Form 10-QSB.
Accordingly, certain information and footnote disclosures normally
included in the financial statements prepared in accordance with
accounting principles generally accepted in the United States of
America have been omitted pursuant to such rules and regulations,
although management believes that the disclosures are adequate to make
the information presented not misleading. These financial statements
should be read in conjunction with the audited financial statements for
the year ended December 31, 2003 included in the Company's Annual
Report on Form 10-KSB filed with the Securities and Exchange
Commission. The results of operations for the six months ended June 30,
2004 and 2003 are not necessarily indicative of the results of
operations to be expected for the full year.
[2] BUSINESS:
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 "Patent Portfolio"). 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 the Patent Portfolio 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 Patent Portfolio was acquired from Merlot
Communications, Inc., a broadband communications solutions provider and
a related party through common ownership. In February 2004, following
the acquisition of the Patent Portfolio and its review of applicable
markets, the Company commenced initial efforts to license one of its
patents (U.S. Patent No. 6,218,930) covering the remote delivery of
power over Ethernet cables (the "Remote Power Patent").
As of the date of this Report, the Company has not entered into any
license arrangements with respect to its Remote Power Patent, 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.
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 December 2002, the Company
discontinued its security software product line and associated
operations, ceased its product development and eliminated its sales and
marketing efforts. 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.
6
[3] GOING CONCERN:
The Company has incurred substantial net losses from operations during
2003 and for the six months ended June 30, 2004, has a stockholders'
deficit and has a negative working capital position at June 30,2004.
The Company as of June 30, 2004 has cash and cash equivalents of
$454,000 and currently is not generating revenues to support its
operations. The Company has been dependent upon capital raised through
both public and private placements 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 the Patent Portfolio and is
pursuing licensing opportunities for these patents. However, the
Company has not entered into any license arrangements as of June 30,
2004. Until the Company generates sufficient positive cash flow 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 condensed 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.
[4] 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 Statement of Financial
Accounting Standards ("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.
SIX MONTHS ENDED
JUNE 30,
----------------------
2004 2003
--------- ---------
Reported net (loss) income attributable to
common stockholders $(581,000) $ 4,000
Stock-based employee compensation expense
included in reported net (loss) income, net
of related tax effects -- --
Stock-based employee compensation determined
under the fair value-based method, net of
related tax effects (3,000) (4,000)
--------- ---------
Pro forma net (loss) income $(584,000) $ --
--------- ---------
(Loss) income per common share
(basic and diluted):
As reported $ (0.05) $ 0.00
Pro forma $ (0.05) $ 0.00
7
The fair value of each warrant grant on the date of grant is estimated
using the Black-Scholes option-pricing utilizing the following weighted
average assumptions :
SIX MONTHS ENDED
JUNE 30,
--------------------------
2004 2003
-------- --------
Risk-free interest rates 3.93% 2.36%
Expected option life in years 3.00 5.00
Expected stock price volatility 229.49% 112.00%
Expected dividend yield 0.00% 0.00%
[5] 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.
[6] (LOSS) EARNINGS PER SHARE:
Basic (loss) earnings per share is calculated by dividing the net
(loss) income by the weighted average number of outstanding common
shares during the period. Diluted (loss) income per share data includes
the dilutive effects of options, warrants and convertible securities.
Potential shares of 6,053,104 for the three and six month periods
ending June 30, 2004 are antidilutive and are not included in the
calculation of diluted (loss) earnings per share. Such potential common
shares reflect options and warrants. Potential shares of 17,823,724 and
17,985,282 were outstanding for the three and six months ended June 30,
2003, respectively. However, these shares were not included in the
calculation of diluted earnings per share because the exercise prices
of the options and warrants and the conversion prices of the preferred
shares were greater than the average market price of the Company's
common stock during the three and six month periods ending June 30,
2003.
[7] CASH EQUIVALENTS:
The Company places cash investments in high quality financial
institutions insured by the Federal Deposit Insurance Corporation
("FDIC"). At June 30, 2004, the Company maintained cash balance of $
382,000 in excess of FDIC limits.
NOTE B - CONVERSION OF COMPANY'S "SERIES D" AND "SERIES E" PREFERRED STOCK TO
COMMON STOCK
In April 2004, the Company entered into an exchange agreement with the
holders of the Company's Series E convertible preferred stock ("Series
E") and Series D convertible preferred stock ("Series D") to exchange
2,483,508 shares of Series E into 6,208,769 shares of common stock and
231,054 shares of Series D into 489,347 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 Capital Management Corp. ("CMH"),
the sole stockholder, officer and director of which is Corey M.
Horowitz, Chairman and CEO of the Company (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).
8
NOTE C - LIABILITY TO BE SETTLED WITH EQUITY INSTRUMENTS
On April 18, 2002, in consideration of additional consulting and
financial advisory services, the Company issued to 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 and CEO of
the Company, is the sole stockholder, officer and director 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 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 valued utilizing the Black-Scholes option pricing model at
each balance sheet date. These options were originally priced in the
quarter ended June 30, 2002 at $416,000 and have been subsequently
revalued at end of each quarter or when a portion of these options
vested. 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. On April 18, 2004, 250,000 options of the remaining
500,000 options, having a fair value of $51,000 as of that date,
vested. Accordingly, $51,000 was reallocated to additional paid-in
capital by correspondingly reducing the liability. The options to
purchase the remaining 250,000 shares continue to be treated as
contingent options and valued utilizing the Black-Scholes option
pricing model at each balance sheet date. These unvested options were
valued at $81,000 at June 30, 2004. Any increase/decrease in the
valuation has been reflected as addition/reduction of general and
administrative expenses at each balance sheet date.
NOTE D - LITIGATION
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 and
PowerDsine have commenced settlement discussions in an effort to
resolve the litigation. In the event the settlement discussions are not
successful, the Company intends to vigorously defend the lawsuit and
take whatever actions are necessary to protect its intellectual
property.
9
Item 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
THIS QUARTERLY REPORT ON FORM 10-QSB CONTAINS FORWARD-LOOKING STATEMENTS WITHIN
THE MEANING OF SECTION 27A OF THE SECURITIES ACT OF 1933, AS AMENDED (THE
"SECURITIES ACT"), AND SECTION 21E OF THE SECURITIES EXCHANGE ACT OF 1934, AS
AMENDED (THE "EXCHANGE ACT"). 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 BEGINNING ON PAGES 12-15 OF THIS
QUARTERLY REPORT ON 10-QSB FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2004.
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 "Patent Portfolio"). 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 the Patent
Portfolio 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 Patent Portfolio was acquired from Merlot
Communications, Inc., a broadband communications solutions provider and a
related party through common ownership. The Patent Portfolio consists of six
patents issued by the U.S. Patent Office that relate to various
telecommunications 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.
In February 2004, the Company initiated licensing efforts relating to
one of its patents (U.S. Patent No. 6,218,930) covering the remote delivery of
power over Ethernet cables (the "Remote Power Patent"). As of the date of this
Report, the Company has not entered into any license arrangements with respect
to its Remote Power Patent, 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 as of June 30,
2004, had an accumulated deficit of $(41,617,000). In addition, the Company had
a Stockholders' deficit and a negative working capital as of that date. At June
30, 2004, the Company had $454,000 of cash and cash equivalents. Management
believes that based on its current cash position, the Company has sufficient
capital to fund its operations through December 2004, although there is no
assurance that such funds will not be expended prior thereto. (See "Liquidity
and Capital Resources" at page 12 hereof.
Results of Operations:
THREE MONTHS ENDED JUNE 30, 2004 COMPARED TO THREE MONTHS ENDED JUNE 30, 2003
The Company had no revenues for the quarter ended June 30, 2004 compared to
revenues of $164,000 for the quarter ended June 30, 2003, of which $130,000 was
related to the recognition of deferred revenue arising out of an agreement with
Falconstor Software, Inc., a former strategic partner of the Company
("Falconstor"), and $30,000 of which was related to the amortization of deferred
maintenance revenues from customers who, in earlier periods, had elected to
purchase maintenance and support contracts for the Company's software product
line which was discontinued in December 2002.
10
The Company did not incur any cost of revenues for the three months ended June
30, 2004. as compared to $17,000 for the three months ended June 30, 2003, which
was related to the cost of one employee who provided the support services for
former customers of the Company's software business. There was no gross profit
for the three months ended June 30, 2004 compared to a gross profit of $147,000
for the three months ended June 30, 2003.
General and administrative expenses include management expenses, finance and
accounting and legal and other professional services provided to the Company.
General and administrative expenses decreased by $67,000, from $285,000 for the
three months ended June 30, 2003 to $218,000 for the three months ended June 30,
2004. Expenses during the quarter ended June 30, 2004 include expenses
associated with the Company's business of developing, licensing and protection
of its intellectual property.
The Company had a net operating loss of $218,000 for the three months ended June
30, 2004 compared with a net operating loss of $138,000 for the three months
ended June 30, 2003. No provision for or benefit from federal, state or foreign
income taxes was recorded for three months ended June 30, 2004 and 2003 because
the Company has net operating loss carry forwards and fully reserved its
deferred tax assets as their future realization could not be determined.
On May 30, 2003, the Company completed the sale of its CyberWallPlus technology
and related intellectual property (the "Software Assets") and assignment of its
rights under certain agreements with a former strategic partner for aggregate
proceeds of $415,000. The carrying value of the Software Assets was written down
to zero in the third quarter of 2002. The $415,000 was included as "Gain on Sale
of Assets" in the condensed statements of operations for the three months ended
June 30, 2003.
As a result of the foregoing, the Company incurred a net loss of $218,000 for
the three months ended June 30, 2004 compared with net income of $280,000 for
the three months ended June 30, 2003.
SIX MONTHS ENDED JUNE 30, 2004 COMPARED TO SIX MONTHS ENDED JUNE 30, 2003
The Company had no revenue for the six months ended June 30, 2004 compared to
revenues of $206,000 for the six months ended June 30, 2003. Revenues during the
six months ended June 30, 2003 of $130,000 were related to the recognition of
deferred revenue relating to a strategic agreement with Falconstor. Revenues
during the six months ended June 30, 2003 of $76,000 were related to the
amortization of deferred maintenance revenues from customers who had elected to
purchase maintenance and support contracts in earlier periods.
The Company incurred no cost of revenue for the six months ended June 30, 2004.
Cost of revenue was $34,000 for the six months ended June 30, 2003 which was
related to the cost of one employee who provided the support services for former
customers of the Company's software business. There was no gross profit for the
six months ended June 30, 2004 compared to a gross profit of $172,000 for the
six months ended June 30, 2003.
General and administrative expenses include employee costs, including salary,
benefits, travel and other related expenses associated with management, finance
and professional services provided to the Company. General and administrative
expenses decreased by $8,000, from $590,000 for the six months ended June 30,
2003 to $582,000 for the six months ended June 30, 2004. Expenses during the six
months ended June 30, 2003 included expenses associated with the discontinuation
of the Company's product line and associated headcount reduction and general
downsizing associated with the termination of the Company's software product
business.
The Company had an operating loss of $582,000 for the six months ended June 30,
2004 compared with an operating loss of $418,000 for the six months ended June
30, 2003. No provision for or benefit from federal, state or foreign income
taxes was recorded for six months ended June 30, 2004 and 2003 because the
Company has net operating loss carry forwards and fully reserved its deferred
tax assets as their future realization could not be determined.
11
On May 30, 2003, the Company completed the sale of its CyberwallPlus technology
and related intellectual property (the "Software Assets") and assignment of its
rights under the Falconstar Agreement for aggregate proceeds of $415,000. The
carrying value of these Software Assets was written down to zero in the third
quarter of 2002. The $415,000 is included as "Gain on Sale of Assets" in the
condensed statements of operations for the six months ended June 30, 2003.
As a result of the foregoing, the Company incurred a net loss of $581,000 for
the six months ended June 30, 2004, compared to net income of $4,000 for the six
months ended June 30, 2003.
Liquidity and Capital Resources
At June 30, 2004, the Company had $454,000 of cash and cash equivalents and a
working capital deficit of $28,000. Net cash used in operating activities was
$530,000 and $894,000 during the six months ended June 30, 2004 and 2003,
respectively. Net cash used in operating activities for the six months ended
June 30, 2004 was primarily attributable to the net loss of $581,000 and a
decrease in accounts payable, accrued expenses and other current liabilities of
$79,000, partially offset by a non-cash expense of $78,000 related to the
valuation of warrants and a decrease in prepaid expenses and other current
assets of $49,000.
The Company's operating activities during the six months ended June 30, 2004
were financed primarily with the remaining funds raised in the 2001 financing of
$6,765,000 and the $415,000 received from the sale of 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 $454,000 as of June 30, 2004
will more likely than not be sufficient to satisfy the Company's operations and
capital requirements through December 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 expenses, difficulties, delays or otherwise), the Company may have
insufficient funds to support its operations prior to January 2005. The Company
is currently pursuing licensing opportunities for its patent, however, to date
the Company has not entered into any such licensing arrangements. The Company
currently intends to make efforts to raise capital during the third or fourth
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 current stockholders of the
Company.
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 $(41,617,000) as of June 30,
2004. For the years ended December 31, 2003 and 2002, we incurred net losses of
$(614,000) and $(5,905,000), respectively. For the quarter ended June 30, 2004,
we incurred a net loss of ($218,000). We have financed our operations primarily
from the remaining balance of funds from sales of equity and convertible debt
securities in 2001 as well as the sale of our CyberWall PLUS security software
technology in May 2003. Since December 2002, when we
12
discontinued our offering of security software products, we have not had
material revenue from operations and for the six months ended June 30, 2004 we
had no revenues from operations. We may not have sufficient funds to continue
our operations if we are unable to secure additional financing or 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 through December 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 January 2005. 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. We intend
to attempt to raise capital during the third or fourth 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.
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 Remote Power Patent or other 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
13
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 have entered into settlement negotiations with PowerDsine in an
effort to resolve the litigation. In the event the settlement discussions are
not successful, we intend to vigorously defend the lawsuit 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.
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. Most of 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 power of Ethernet cables. 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.
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
14
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.
THE SIGNIFICANT NUMBER OF OPTIONS AND WARRANTS OUTSTANDING MAY
ADVERSELY EFFECT THE MARKET PRICE FOR OUR COMMON STOCK.
As of June 30, 2004, there are outstanding (i) options and warrants to
purchase an aggregate of 6,053,104 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.
15
Item 3. 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 Quarterly Report on Form 10-QSB. Based upon this
review, these officers concluded that, as of the end of the period covered by
this Quarterly Report on Form 10-QSB, 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 Quarterly Report on Form 10-QSB.
PART II. OTHER INFORMATION
Item 1. LEGAL PROCEEDINGS.
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 Power over Ethernet components or products.
The Company believes its Remote Power Patent is valid and has meritorious
defenses to the action. The Company and PowerDsine recently commenced settlement
discussions in an effort to resolve the litigation. In the event that the
settlement discussions are not successful, the Company intends to vigorously
defend the lawsuit and take whatever actions are necessary to protect it's
intellectual property. In the event, however, that 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.
Item 2. Changes in Securities and Small Business Issuer Purchases of Equity
Securities.
None
Item 3. Defaults Upon Senior Securities.
None.
Item 4. Submission of Matters to a Vote of Security Holders.
None.
Item 5. Other Information.
None.
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Item 6. Exhibits and Reports on Form 8-K.
(a) Exhibits
31.1 Controls and Procedure Certification of Chief Executive Officer
pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2 Controls and Procedure Certification of Chief Financial Officer
pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1 Certification of Chief Executive Officer pursuant to Section 906
of the Sarbanes-Oxley Act of 2002.
32.1 Certification of Chief Financial Officer pursuant to Section 906
of the Sarbanes-Oxley Act of 2002.
(b) Reports of Form 8-K
The Company filed a Form 8-KA on April 26, 2004 relating to the Patents
Purchase, Assignment and License Agreement, dated November 18, 2003. between the
Company and Merlot Communications, Inc. (the "Agreement") as a result of
withdrawal of its request to the SEC for confidentiality of certain provisions
of the Agreement.
17
SIGNATURES
In accordance with the requirements of the Exchange Act, the registrant
caused this report to be signed on its behalf by the undersigned, thereunto duly
authorized.
NETWORK-1 SECURITY SOLUTIONS, INC.
By: /s/ Corey M. Horowitz
--------------------------------
Corey M. Horowitz
Chairman and Chief Executive Officer
Date: August 11, 2004
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