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UNITED STATES
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 June 30, 2006
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from ___________ to ___________
Commission file number 0-21151
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PROFILE TECHNOLOGIES, INC.
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(Name of Small Business Issuer in Its Charter)
Delaware 91-1418002
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(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
2 Park Avenue, Suite 201
Manhasset, New York 11030
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(Address of principal executive offices) (Zip Code)
(516) 365-1909
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(Issuer's Telephone Number, Including Area Code)
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $0.001 par value
Check whether the issuer is not required to file reports pursuant to
Section 13 or 15(d) of the Exchange Act. |_|
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 pursuant to Item 405
of Regulation S-B contained in this form, and no disclosure will be contained,
to the best of the 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. |_|
Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Exchange Act). Yes|_| No |X|
The issuer's revenues for the fiscal year ended June 30, 2006 were $0.
The aggregate market value, based on the average bid and asked prices on
NASD's OTC Bulletin Board on September 7, 2006, of the voting common stock,
$0.001 par value per share, held by non-affiliates of the issuer as of September
7, 2006 was approximately $12,141,427.
There were 12,456,445 shares of common stock, $0.001 par value per share,
outstanding as of September 7, 2006.
DOCUMENTS INCORPORATED BY REFERENCE
Part III of this Annual Report on Form 10-KSB incorporates certain information
by reference to the issuer's Definitive Proxy Statement on Form 14A for its
annual meeting of stockholders to be held on November 13, 2006.
Transitional Small Business Disclosure Format. Yes __ No |X|.
ii
Table of Contents
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Page
Description Number
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PART I
ITEM 1 DESCRIPTION OF BUSINESS.........................................1
ITEM 2 DESCRIPTION OF PROPERTIES.......................................6
ITEM 3 LEGAL PROCEEDINGS...............................................6
ITEM 4 SUBMISSION OF MATTERS TO VOTE
OF SECURITY HOLDERS.............................................6
PART II
ITEM 5 MARKET FOR COMMON EQUITY, RELATED STOCKHOLDER MATTERS
AND SMALL BUSINESS ISSUER PURCHASES OF EQUITY SECURITIES....... 7
ITEM 6 MANAGEMENT'S DISCUSSION AND ANALYSIS AND
PLAN OF OPERATION .............................................11
ITEM 7 FINANCIAL STATEMENTS...........................................20
ITEM 8 CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS
ON ACCOUNTING AND FINANCIAL DISCLOSURE.........................41
ITEM 8A CONTROLS AND PROCEDURES........................................41
ITEM 8B OTHER INFORMATION .............................................41
PART III
ITEM 9 DIRECTORS AND EXECUTIVE OFFICERS...............................42
ITEM 10 EXECUTIVE COMPENSATION.........................................43
ITEM 11 SECURITY OWNERSHIP OF CERTAIN BENEFICIAL
OWNERS AND MANAGEMENT..........................................43
ITEM 12 CERTAIN RELATIONSHIPS AND RELATED
TRANSACTIONS...................................................43
ITEM 13 EXHIBITS.......................................................43
ITEM 14 PRINCIPAL ACCOUNTANT FEES AND SERVICES.........................45
SIGNATURES ..................................................................46
EXHIBIT INDEX ...............................................................47
iii
Preliminary Note Regarding Certain Risks
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and Forward-Looking Statements
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This Annual Report on Form 10-KSB contains "forward-looking" information
within the meaning of the federal securities laws. These forward-looking
statements can generally be identified as such because the context of the
statement will include words such as the Company "believes," "anticipates,"
"expects" or words of similar import. Similarly, statements that describe the
Company's projected future results, future plans, objectives or goals or future
conditions or events are also forward-looking statements. Actual results are
inherently difficult to predict. Any such forward-looking statements are subject
to the risks and uncertainties that could cause actual results of operations,
financial condition, acquisitions, financing transactions, operations,
expenditures, expansion and other events to differ materially from those
expressed or implied in such forward-looking statements. Any such
forward-looking statements would be subject to a number of assumptions
regarding, among other things, future economic, competitive and market
conditions generally. Such assumptions would be based on facts and conditions as
they exist at the time such statements are made as well as predictions as to
future facts and conditions, the accurate prediction of which may be difficult
and involve the assessment of events beyond the Company's control.
The forward-looking statements contained in this report are based on
current expectations that involve a number of risks and uncertainties. Such
forward-looking statements are based on assumptions that the Company will obtain
or have access to adequate financing for each successive phase of its growth,
that the Company will market and provide products and services on a timely
basis, that there will be no material adverse competitive or technological
change with respect to the Company's business, demand for the Company's products
and services will significantly increase, that the Company's executive officers
will remain employed as such by the Company, that the Company's forecast
accurately anticipates market demand, and that there will be no material adverse
change in the Company's operations, business or governmental regulation
affecting the Company or its customers. The foregoing assumptions are based on
judgments with respect to, among other things, future economic, competitive and
market conditions and future business decisions, all of which are difficult or
impossible to predict accurately and many of which are beyond the Company's
control. Although the Company believes the expectations reflected in the
forward-looking statements are reasonable, the Company cannot guarantee future
results, levels of activity, performance or achievements.
iv
PART I
Item 1. Description of Business.
Business Overview
Profile Technologies, Inc. (the "Company"), a Delaware corporation, was
incorporated in 1986 and commenced operations in fiscal year 1988. The Company
is in the business of inspecting pipelines for corrosion and is in the final
stages of researching and developing a patented, non-destructive and
non-invasive, high speed scanning process using electro magnetic waves to
remotely inspect buried, encased and insulated pipelines for corrosion (the "EMW
Inspection Process").
During the summer of 1998, the Company completed work on its first
commercial contract with ASCG Inspection, Inc. testing British Petroleum
pipelines at approximately 100 road and caribou crossings located on the North
Slope of Alaska. During the summer of 1999, the Company continued work testing
pipelines under a contract with another large multi-national oil company related
to the inspection of approximately 250 below-grade pipelines. During the summer
of 2000, the Company expanded its Alaska efforts by testing a total of 372
below-grade pipelines. In 2001, the Company completed the testing of
approximately 441 pipelines in Alaska. In 2002 and 2003, the Company inspected
364 and 250 below-grade pipelines, respectively.
As a result of the Company's experience in Alaska and in response to
regulatory changes that occurred in 2003, the Company decided to improve its
buried pipe inspection capabilities to meet the needs of a more significant
portion of the buried-pipe market. The Company refocused its efforts on
improving its current technology to take advantage of this opportunity. These
efforts, which to some degree are still ongoing, refined our technology to
specifically address the buried pipeline market by developing a new pulse (wave
form) that is distorted by electrolysis i.e., active corrosion, in a specific
way. The Company also refined the hardware underlying its inspection process by
making its test system more powerful, portable and useful. Among other things,
it eliminated the need for a cumbersome, external power source.
Industry Overview
Refineries, chemical plants, utilities, natural gas transmission companies
and the petroleum industry have millions of miles of pipeline much of which may
be exposed to harsh and severe environments subjecting such pipeline to higher
incidence of corrosion. As a result of such environments these industries are
continually challenged to ensure that the quality of its pipeline meets
applicable standards established by relevant regulatory bodies to protect
operating personnel and the environment.
When pipeline is not insulated and above ground, external corrosion can be
identified visually. The petroleum and other related industries, however,
insulate much of their piping to conserve energy and to prevent injury to
personnel from high temperature levels on the pipelines. When pipeline is
insulated, corrosion can occur underneath the insulation due to moisture or
corrosive products that find their way through broken or poorly sealed
insulation. Corrosion underneath the insulation of insulated pipelines is very
1
difficult and costly to locate. In the past, corrosion testing on insulated
pipelines has been conducted on a limited sample basis and relied upon
inspection processes that were both cumbersome and costly.
The two prevalent testing methods used to detect corrosion on insulated
pipelines, X-ray and eddy current, detect defects by analyzing visual image and
decay. These methods require the physical stripping away of the pipeline
insulation to conduct visual inspection, depth gauges, ultrasonics and X-ray are
then used to determine the severity of the visually located corrosion. The
physical removal of insulation required by these methods is costly for various
reasons including the assembly of scaffolding for testing otherwise inaccessible
above ground pipe (particularly in refineries and petrochemical plants) or the
actual dig-up on below ground pipe. The Company's technology enables it to test
pipe segments in a refinery setting for a distance up to three hundred feet and
to use "cherry pickers" instead of costly scaffolding.
Corrosion under the insulation of insulated pipelines presents a very
complicated testing problem because corrosion cannot be easily identified by
statistical sampling. If, for example, a small section of the insulation on a
segment of insulated pipe is removed every ten feet for visual inspection using
eddy current or x-ray techniques, there is no statistical basis to assume that
the external condition of the piping between the removed sections of insulation
is corrosion free.
The Company's EMW Inspection Process
The EMW Inspection Process provides a corrosion inspection method which
does not require the inspector to physically remove the pipeline's insulation or
otherwise dig up the pipeline to visually inspect for corrosion. In certain
instances, limited access points to buried pipelines exist for reasons unrelated
to corrosion inspection. As a result, corrosion inspection may be conducted at
these access points. Where such access points are not already available, the EMW
Inspection Process permits the inspection of pipelines with a minimal amount of
disturbance to the coating or insulation on the pipeline. In addition, the EMW
Inspection Process permits corrosion inspection over the entire pipeline, as
opposed to other inspection methods, which only provide for spot point
inspections. Such "spot inspections" are not necessarily accurate in indicating
the overall condition of a pipeline.
The Company has developed two basic EMW Inspection Process techniques,
namely, Dual Pulse or Pulse Propagation Analyzer and Single-Pulse or Calibration
Mark Z. For above-grade piping, the Company has used both the Dual-Pulse and
Single-Pulse techniques to determine the condition of a pipeline segment in the
open field as well as in refineries, chemical plants and power plants. For
below-grade piping under streets and road crossings, the Company has
historically used only the Dual Pulse technique. However, for more than a year,
the Company has been developing new hardware and software to permit the testing
of direct buried pipe from a single location while, at the same time, capturing
data from the pipe traveling in both directions. This new equipment has been
tested at the Company's pipe test facility in Ferndale, Washington, and is now
being field tested on natural gas pipelines in Pennsylvania with the cooperation
and assistance of a host company engaged in the natural gas distribution
business.
Correlating pipeline corrosion information using the Company's technology
requires a combination of state-of-the-art instrumentation plus an understanding
of the physical phenomena that are being measured. Management believes that the
EMW measurement and analysis are on the leading edge of inspection technology.
The Company believes that its technology has at least two significant
competitive advantages. First, it can inspect certain pipelines that are
inaccessible to other testing methods. Second, with respect to facilities that
2
are accessible to other inspection methods, the Company's technology does not
require the removal of much, if any, insulation, coatings or encasements or
pipeline excavation as a prerequisite to testing. Accordingly the Company's
technology will typically have a lower cost of site preparation that results in
a significant cost advantage. The Company's ongoing research and development
efforts are designed to produce new applications for the Company's technology in
the oil, natural gas and other industries.
The New Test Set
To position the Company to address the buried pipeline market, the Company
redesigned and improved the hardware underlying the EMW Inspection Process. The
new hardware (the "New Test Set") provides a different pulse waveform
specifically tailored to the buried pipe environment. This waveform has
increased low frequency energy content, which enables efficient wave propagation
through sand, soil, and moist earth.
The New Test Set is smaller than the previous more cumbersome generation
hardware used in Alaska. The New Test Set weighs less than 12 pounds, including
the data acquisition digitizer and battery power supply. The New Test Set can be
hand-carried and operated by a single person and no longer requires an
oscilloscope or a gasoline powered AC generator which were necessary with the
previous generation hardware. This portable system is designed to allow testing
of both underground and above-grade pipelines with one test set.
As noted above, initial testing of the new buried-pipe inspection hardware
has been completed at the Company's Ferndale, Washington pipe test facility.
This hardware has also been field tested on a natural gas pipeline in Washington
and is now being tested on natural gas pipelines in Pennsylvania.
The results of all these tests should provide the Company with critical
information as to the detection capabilities of its new hardware in different
"real world" conditions and accelerate the commercial deployment of the
Company's new hardware and software.
Although several important milestones have been achieved in the testing of
the Company's new hardware and software, there can be no assurance that the
field testing portion of this testing program can be funded or that the new
hardware and software can be successfully tested and deployed on a commercial
basis. Failure to do so could have a serious and material effect on the business
and financial condition of the Company.
Regulatory Environment
A combination of federal, state, and industry rules combine to regulate
corrosion protection. The U.S. Department of Labor, operating through the
Occupational Safety and Health Administration has jurisdiction over numerous
plants and facilities containing corrosion protected pipeline that, if breached,
could cause serious bodily injury or death to on-site workers. The U.S.
Department of Transportation has jurisdiction over interstate natural gas and
hazardous liquids pipelines. Counterpart state agencies have jurisdiction over
intrastate natural gas and hazardous liquids pipelines. In addition, the
American Petroleum Institute has promulgated a comprehensive Piping Inspection
Code which requires that extensive corrosion testing be done by all members
(which includes the vast majority of the petroleum and petrochemical
industries). As a result of extensive regulation and testing requirements, the
industry is faced with the requirement to engage in extensive testing for
corrosion. In 1993, the American Petroleum Institute imposed stricter test
standards for corrosion under the insulation on pipelines.
3
The American Petroleum Institute testing standard adopted in 1993, in
essence, mandates either the stripping of larger amounts of coating or using an
alternate system that will identify corrosion under the insulation without
stripping the coating on suspected and unsuspected pipe. Because of the enormous
cost involved in using the stripping and visual testing process, the Company
believes that the industry will be receptive to an alternate testing system that
is reliable and less costly. The Company believes that its EMW Inspection
Process provides an alternate testing system that could be widely accepted by
the industry. However, while the Company has obtained some commercial contracts
and prospects for expanded commercial contracts in the future appear strong,
there can be no assurance that such acceptance will continue to grow or that
competitors will not develop newer and better technologies.
On December 15, 2003, the U.S Department of Transportation ("DOT") issued
regulations under the Pipeline Safety Improvement Act of 2002 requiring
regulated companies to gather baseline integrity data on pipelines in so-called
"high consequence areas" ("HCA's") (e.g., populated areas) initially over a
ten-year period and then every seven years thereafter. Based on consultations
with industry representatives, the Company believes that its new buried pipe
inspection hardware will provide such regulated companies with a superior tool
for gathering the baseline integrity data required under the DOT regulations.
Sales and Marketing
The Company's sales and marketing strategy has been to position the
Company's EMW inspection process as the method of choice to detect pipeline
corrosion where the pipelines are either inaccessible to other inspection tools
or much more costly to inspect with tools other than the Company's EMW
technology. Pipelines are commonly found in refinery and chemical plants (such
as insulated, overhead pipes), natural gas distribution systems (such as pipes
buried in city streets), and natural gas transmission systems (such as road,
bridge and stream crossings and concrete-encased pipes).
As described above, the Company has fabricated new buried pipe inspection
hardware and is actively seeking industry and other financing sources in order
to rigorously field test that hardware (initial testing having been completed in
Ferndale, WA). In order to obtain additional revenue generating contracts, the
Company intends to emphasize the reliability of its buried pipeline testing
method, the flexibility of the method's application, and its cost effectiveness
as compared to other methods. In fiscal year 2007, the Company intends to
continue its marketing efforts in the pipeline and utility buried pipe
inspection markets in the lower-48 states, particularly in "high consequence
areas" as defined in the federal Department of Transportation's regulations
("HCAs"). However, there can be no assurance that the Company will be successful
in concentrating its marketing efforts for the EMW technology on natural gas
utility and pipeline markets.
Revenues and Customers
The Company derives revenue solely from the sale of the EMW inspection
technology service. The Company relies solely upon several employees, including
the Chief Executive Officer and the Chief Operating Officer to conduct the
Company's sales activities.
The Company did not have revenues during the years ended June 30, 2006 and
2005, respectively, as it was engaged solely in the redevelopment of its testing
hardware and software. The testing of that hardware and software is nearing
completion.
4
Patents, Intellectual Property and Licensing
The Company pursues a policy of generally obtaining patent protection both
in the United States and abroad for patentable subject matter in its proprietary
technology. As of June 30, 2006, the Company had ten issued U.S. patents, two
issued foreign patents, one U.S. patent application pending, and five foreign
patents pending.
The Company's success depends in large part upon its ability to protect its
process and technology under United States and international patent laws and
other intellectual property laws. U.S. patents have a term of 17 years from date
of issuance or, for more recently filed patent applications, 20 years from the
filing of such applications, and patents in most foreign countries have a term
of 20 years from the proprietary filing date of the patent application. The
first U.S. patent was issued in 1990; two patents were issued in 1993; one
patent was issued in 1998; two patents were issued in 2000, two patents were
issued in 2001, and two patents were issued in 2002.
The Company believes that it owns and has the right to use or license all
proprietary technology necessary to license and market its EMW process under
development. The Company is not aware of the issuance of any patents or the
filing of any patent applications which relate to processes or products which
utilize the Company's proprietary technology in a manner which could be similar
to or competitive with the Company's products or processes. The Company has no
knowledge that it is infringing on any existing patent such that it would be
prevented from marketing or licensing products or services currently being
developed by the Company.
The Company may decide for business reasons to retain a patentable
invention as a trade secret. In such event or if patent protection is not
available, the Company must rely upon trade secrets, internal knowledge and
continuing technological innovation to develop and maintain its competitive
position. The Company's employees and consultants have access to the Company's
proprietary information and have signed confidentiality agreements. However,
even inadvertent disclosure of such a trade secret without a promise of
confidentiality could destroy trade secret protection. There can be no assurance
that inadvertent disclosures might not occur. If the Company's proprietary
information is disclosed to competitors, it may have a material adverse effect
on the Company's business.
Competition
Although a number of inspection technologies have been developed to aid in
ascertaining the condition of piping throughout the pipeline corrosion control
industry, information needed to determine the integrity of these critical
systems is often difficult and costly to acquire. The Company has numerous
indirect competitors, but the Company believes that its inspection services have
significant competitive advantages over other services provided by competitors.
The Company's EMW inspection service is designed to help pipeline operators
quickly and less expensively screen buried, insulated, or hard to-access piping
for external corrosion. Although its technology does not provide pipeline and
plant operators with all the data they will require to manage and remediate
corrosion, when used as a "front-end" screening tool in combination with one or
more spot inspection tools, it can dramatically lower the cost of acquiring all
5
of the data necessary to manage corrosion risks to their piping systems. There
can be no assurances, however, that the Company's competitors will not develop
newer, more efficient and less costly technologies.
Employees
As of June 30, 2006, the Company had four employees.
Research and Development Expenditures
During the last year, the Company has re-developed and improved the
hardware and software it uses to detect corrosion on direct-buried pipe. As a
result of such re-development and improvement, the Company believes that its
technology is now ready to obtain broad acceptance in the U.S pipeline and
utility industry segments. However, additional funding and certifications must
be acquired to gain significant market share in the Company's target markets.
Research and development expenses for the year ended June 30, 2006 and 2005
were $357,709 and $261,617, respectively.
Item 2. Description of Properties.
The Company's executive offices are located at 2 Park Avenue, Suite 201,
Manhasset, NY 11030. The Company leases on a month-to-month basis approximately
500 square feet of office space from a non-affiliate. The rental payment is
approximately $788 per month.
The Company's research and development facility is located in Ferndale,
Washington. The Company leases 1,800 square feet of space from a non-affiliate
at a monthly cost of approximately $2,107, pursuant to a lease that expires on
January 31, 2007.
The Company does not own any real estate.
Item 3. Legal Proceedings.
The Company is not aware of any legal proceedings contemplated by any
governmental authority or any other party involving the Company or its
properties. As of the date of this report, no director, officer or affiliate is
a party adverse to the Company in any legal proceeding or has an adverse
interest to the Company in any legal proceedings. The Company is not aware of
any other legal proceedings pending or that have been threatened against the
Company or its properties.
Item 4. Submission of Matters to Vote of Security Holders.
No matters were submitted to a vote of the Company's security holders
during the fourth quarter of the fiscal year ended June 30, 2006.
6
PART II
Item 5. Market for Common Equity, Related Stockholder Matters, and Small
Business Issuer Purchases of Equity Securities.
Market Information
The Company's common stock traded on the NASDAQ Small Cap market from the
date it began to be publicly traded in February 1997 until August 10, 2001 under
the symbol PRTK. On August 13, 2001, the Company's common stock was delisted
from the NASDAQ Small Cap market and began trading on the NASD's Over the
Counter Bulletin Board (the "OTCBB") under the same symbol. The Company's common
stock continues to be traded on the OTCBB.
The following table sets forth the high and low bid prices for the
Company's common stock for each quarter within the past two fiscal years as
reported by the OTCBB. The quotations reflect inter-dealer prices, with retail
mark-up, mark-down or commissions, and may not represent actual transactions.
Range of
Bid Prices
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High Low
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Fiscal Year 2006
First Quarter $1.40 $0.70
Second Quarter $1.40 $0.80
Third Quarter $1.89 $1.00
Fourth Quarter $1.45 $0.70
Fiscal Year 2005
First Quarter $0.90 $0.35
Second Quarter $1.55 $0.35
Third Quarter $1.15 $0.60
Fourth Quarter $0.90 $0.55
As of September 7, 2006, the Company had approximately 1,050 holders of
record of the Company's common stock.
Dividends
The payment of dividends by the Company is within the discretion of its
Board of Directors and depends in part upon the Company's earnings, capital
requirements, debt covenants and financial condition. Since its inception, the
Company has not paid any dividends on its common stock and does not anticipate
paying such dividends in the foreseeable future. The Company intends to retain
earnings, if any, to finance its operations.
7
Securities Authorized for Issuance Under Equity Compensation Plans
The following table sets forth certain information regarding the common
stock that may be issued upon the exercise of options, warrants and other rights
that have been or may be granted to employees, directors or consultants under
all of the Company's existing equity compensation plans, as of June 30, 2006.
Number of
securities
remaining
available for
Number of future issuance
securities to be Weighted-average under equity
issued upon exercise exercise price of compensation plans
of outstanding outstanding (excluding securities
options, warrants options, warrants reflected in
and rights and rights column (a))
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(a) (b) (c)
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Equity compensation plans 385,000 $0.77 115,000
approved by security holders (1)
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Equity compensation plans not 3,924,600(3) $1.53 N/A
approved by security holders(2)
---------------------------------- ------------------- ---------------- ----------------------
Total 4,309,600 $1.46 115,000
(1) Consists of grants under the Company's 1999 Stock Plan.
(2) Consists of grants under individual compensation arrangements approved
separately by the Board of Directors and are not part of any written or
formal plan under which the Company will be obligated to issue equity
compensation in the future.
8
(3) Includes non-qualified stock options granted to officers, directors, and
consultants to purchase 2,315,000 shares of common stock and warrants to
purchase 1,609,600 shares of common stock.
The stock options granted to officers, directors, and consultants were
granted with an exercise price at or greater than the fair value of the
Company's common stock on the date of grant as reported by the NASD's Over
the Counter Bulletin Board. Compensatory stock options granted outside of
the 1999 Stock Plan consists of the following: (A) 15,000 options at an
exercise price of $6.50 per share, expiring on October 31, 2007, (B) 15,000
options at an exercise price of $10.50 per share, expiring on October 31,
2007, (C) 1,850,000 options at an exercise price of $1.155, of which
1,600,000 expire on February 15, 2015 and 250,000 expire on February 15,
2010, (D) 200,000 options at an exercise price of $1.12 per share, expiring
on December 12, 2015, (E) 150,000 options at an exercise price of $1.21 per
share, expiring on December 12, 2015, and (F) 85,000 options at an exercise
price of $1.12, expiring on December 12, 2010.
Compensatory warrants consists of the following: (A) 15,000 warrants at an
exercise price of $0.55 per share, expiring on December 9, 2007, (B)
439,600 warrants at an exercise price of $0.60 per share, expiring on
August 14, 2011, (C) 40,000 warrants at an exercise price of $0.70 per
share, expiring on December 16, 2008, (D) 50,000 warrants at an exercise
price of $1.00 per share, expiring on January 2, 2007, (E) 150,000 warrants
at an exercise price of $1.05 per share, expiring on March 18, 2007, (F)
305,000 warrants at an exercise price of $1.125 per share, expiring on
October 31, 2007, (G) 40,000 warrants at an exercise price of $1.50 per
share, expiring on October 31, 2007, (H) 235,000 warrants at an exercise
price of $3.00 per share, expiring on October 31, 2007, (I) 285,000
warrants at an exercise price of $3.50 per share, expiring on October 31,
2007, (J) 30,000 warrants at an exercise price of $7.20 per share, expiring
on October 31, 2007, and (K) 20,000 warrants at an exercise price of $13.50
per share, expiring on October 31, 2007.
Recent Sales of Unregistered Securities
Convertible Debentures and Warrants
On June 19, 2003, the Board of Directors approved the offering (the "2003
Offering") of $1,000,000 in convertible debentures (the "Debentures"). The
Debentures are convertible into that number of shares of the Company's common
stock equal to the amount of the converted indebtedness divided by $0.50 per
share. The Debentures bear interest at a rate of 5% per annum, payable
quarterly. Delinquent interest payments bear interest at a rate of 12% per
annum. The Company is required to redeem each Debenture on the 5th anniversary
of the date of the Debenture. The Company may, in its discretion, redeem any
Debenture at any time prior to the mandatory redemption date of the Debenture by
providing no less than 60 days' prior written notice to the holder of the
Debenture. Certain events of default will result in the Debentures being
redeemable by the Company upon demand of the holder.
Upon the purchase of, and for each $0.50 of the Debenture's principal
amount, the Company issued to each investor a warrant (the "Warrant") to
purchase one (1) share of the Company's common stock at an exercise price of
$0.75 per share. The Warrants are exercisable at any time prior to the 5th
anniversary date of the redemption of the Debenture.
The 2003 Offering was exempt from the registration under Section 4(2) of
the Securities Act of 1933, as amended (the "Securities Act"), and Rule 506 of
Regulation D, promulgated by the SEC. In the 2003 Offering, no general
solicitation was made by the Company or any person acting on behalf of the
Company, the Debentures and Warrants were sold subject to transfer restrictions,
and the certificates for the Debentures and Warrants contained an appropriate
legend stating that such securities have not been registered under the
Securities Act and may not be offered or sold absent registration or an
exemption therefrom.
9
During the year ended June 30, 2006, six investors exercised their
conversion right under the Debentures, pursuant to the terms of the 2003
Offering, and converted $228,369 of principal and accrued interest pursuant to
the terms of the 2003 Offering. Accordingly, the Company issued 456,740 shares
of common stock in accordance with the conversion terms of the Debentures.
Common Stock and Warrants
On January 19, 2005, the Board of Directors approved the offering (the
"2005 Offering") of 2,000,000 units (the "Units") to accredited investors for a
total offering price of $1,000,000. Each Unit consists of one share of common
stock and a warrant to acquire common stock. On November 21, 2005, the Board of
Directors approved an increase in the number of Units offered in the 2005
Offering to 6,000,000 Units, for a total offering price of $3,000,000. The
purchase price of one Unit is $0.50. Each Unit consists of one share of common
stock and a warrant to purchase one share of common stock at an exercise price
of $0.75. The warrants are exercisable at any time prior to the fifth
anniversary from the date of their issuance.
The 2003 Offering was exempt from the registration under Section 4(2) of
the Securities Act of 1933, as amended (the "Securities Act"), and Rule 506 of
Regulation D, promulgated by the SEC. In the 2003 Offering, no general
solicitation was made by the Company or any person acting on behalf of the
Company, the Debentures and Warrants were sold subject to transfer restrictions,
and the certificates for the Debentures and Warrants contained an appropriate
legend stating that such securities have not been registered under the
Securities Act and may not be offered or sold absent registration or an
exemption therefrom.
During the year ended June 30, 2006, the Company raised $1,738,500 and
issued 3,477,000 shares of common stock and warrants to purchase up to 3,477,000
shares of common stock in accordance with the terms of the 2005 Offering.
During the year ended June 30, 2006, Murphy Evans, the Company's President,
exercised a conversion right pursuant to the terms of an amended loan agreement
with the Company, converting $1,276,000 of principal and accrued interest on his
loan into Units in the 2005 Offering. Accordingly, the Company issued 2,552,000
shares of common stock and warrants to purchase up to 2,552,000 shares of common
stock to Mr. Evans, in accordance with the terms of the 2005 Offering.
Warrants
During the year ended June 30, 2006, the Company issued a warrant to R.F.
Larrerty & Co., Inc. ("Laffety"), a brokerage firm which provided consulting
services to the Company, to purchase 427,100 shares of common stock at an
exercise price of $0.60 per share. The warrant may be exercised for up to five
years from the date of issuance. The warrant was issued to Lafferty pursuant to
the terms of a consulting agreement that the Company executed with Lafferty on
November 1, 2004. The issuance of the warrant was exempt from registration
pursuant to Section 4(2) of the Securities Act.
Stock Options
On December 12, 2005, the Board approved the issuance of options
exercisable for 435,000 shares of common stock to certain directors, officers,
an employee and three consultants of the Company. The options were granted by
10
the Company on December 12, 2005. Directors, officers, and an employee were
granted options exercisable for 350,000 shares of common stock that have a
ten-year term. Options exercisable for the remaining 85,000 shares of common
stock were granted to three of the Company's consultants and have a five-year
term. The exercise price of the options granted to insiders owning or
controlling more than ten percent of the Company's common stock was $1.21, which
is ten percent over the closing bid price of the Company's common stock as
quoted on the OTCB on the grant date, December 12, 2005. The exercise price of
the stock options granted to non-insiders and insiders not owning more than 10%
of the Company's common stock was $1.12.
Item 6. Management's Discussion and Analysis and Plan of Operation.
Plan of Operation
The Company is currently focused on the buried pipe market in the United
States. Accordingly, the Company redesigned and improved the hardware underlying
the EMW Inspection Process, which provides a different pulse waveform
specifically tailored to the buried pipe environment.
Initial testing of the new buried-pipe inspection hardware has been
completed at the Company's Ferndale, Washington pipe test facility. This
hardware has also been field tested on a natural gas pipeline in Washington and
is now being tested on natural gas pipelines in Pennsylvania.
The results of all these tests should provide the Company with critical
information as to the detection capabilities of its new hardware in different
"real world" conditions and accelerate the commercial deployment of the
Company's new hardware and software.
Although several important milestones have been achieved in the testing of
the Company's new hardware and software, there can be no assurance that
necessary additional field testing can be funded or that the new hardware and
software can be successfully deployed on a commercial basis. Failure to do so
could have a serious and material effect on the business and financial condition
of the Company.
Capital will be expended to support operations until the Company can
generate sufficient cash flows from operations. In order for the Company to
generate cash flows from operations, the Company must obtain revenue generating
contracts. Management is currently directing the Company's activities towards
obtaining service contracts, which, if obtained, will necessitate the Company
attracting, hiring, training and outfitting qualified technicians. If service
contracts are obtained, it will also necessitate additional field test equipment
purchases in order to provide the services. The Company expects that if revenue
contracts are secured, working capital requirements will increase. The Company
will incur additional expenses as it hires and trains field crews and support
personnel related to the successful receipt of commercial contracts.
Additionally, the Company anticipates that cash will be used to meet capital
expenditure requirements necessary to develop infrastructure to support future
growth.
The Company has expended a significant amount of cash in developing its
technology and patented processes. These conditions raise substantial doubt
about the Company's ability to continue as a going concern. Management
recognizes that in order to meet the Company's capital requirements, and
continue to operate, additional financing, including seeking industry-partner
investment through joint ventures or other possible arrangements, will be
necessary. The Company is evaluating alternative sources of financing to improve
11
its cash position and is undertaking efforts to raise capital. If the Company is
unable to raise additional capital or secure revenue contracts and generate
positive cash flow, it is unlikely that the Company will be able to continue as
a going concern.
Management's Discussion and Analysis
Revenue
The Company did not have revenues during the years ended June 30, 2006 and
2005, respectively, as it was engaged solely in the redevelopment of its testing
hardware and software. The testing of that hardware and software is nearing
completion.
Sales and Marketing
The Company's sales and marketing strategy has been to position the
Company's EMW inspection process as the method of choice to detect pipeline
corrosion where the pipelines are either inaccessible to other inspection tools
or much more costly to inspect with tools other than the Company's EMW
technology. Pipelines are commonly found in refinery and chemical plants (such
as insulated, overhead pipes), natural gas distribution systems (such as pipes
buried in city streets), and natural gas transmission systems (such as road,
bridge and stream crossings and concrete-encased pipes).
As described above, the Company has fabricated new buried pipe inspection
hardware and is actively seeking industry sources in order to rigorously field
test that hardware (initial testing having been completed in Ferndale, WA). In
order to obtain additional revenue generating contracts, the Company intends to
emphasize the reliability of its buried pipeline testing method, the flexibility
of the method's application, and its cost effectiveness as compared to other
methods. In fiscal year 2007, the Company intends to continue its marketing
efforts in the pipeline and utility buried pipe inspection markets in the
lower-48 states, particularly in "high consequence areas" as defined in the
federal Department of Transportation's regulations ("HCAs"). However, there can
be no assurance that the Company will be successful in concentrating its
marketing efforts for the EMW technology on natural gas utility and pipeline
markets.
Critical Accounting Estimates and Policies
The discussion and analysis of financial condition and results of
operations is based upon the Company's financial statements, which have been
prepared in accordance with accounting principles generally accepted in the
United States. The preparation of these financial statements requires the
Company to make estimates and judgments that affect the reported amounts of
assets, liabilities, revenue and expenses, and related disclosure of contingent
assets and liabilities. On an on-going basis, the Company evaluates its
estimates, including contract revenue recognition and impairment of long-lived
assets. The Company bases its estimates on historical experience and on various
other assumptions that the Company believes to be reasonable under the
circumstances, the results of which form its basis for making judgments about
the carrying values of assets and liabilities that are not readily apparent from
other sources. Actual results may differ materially from these estimates under
different assumptions and conditions, and such variations may be adverse.
12
The Company recognizes revenue from service contracts using the
percentage-of-completion method of contract accounting. Contract revenues earned
are measured using either the percentage-of-contract costs incurred to date to
total estimated contract costs or, when the contract is based on measurable
units of completion, revenue is based on the completion of such units.
Anticipated losses on contracts, if any, are charged to earnings as soon as such
losses can be estimated. Changes in estimated profits on contracts are
recognized during the period in which the change in estimate is known. The
Company records claims for additional compensation on contracts upon revision of
the contract to include the amount to be received for the additional work
performed. Contract costs include all direct material and labor costs and those
indirect costs related to contract performance, such as indirect labor,
supplies, tools and repairs, and depreciation costs. Selling, general, and
administrative costs are charged to expense as incurred. Service contracts
generally extend no more than six months.
The Company reviews long-lived assets and certain identifiable intangibles
for impairment whenever events or changes in circumstances indicate that the
carrying amount of an asset may not be recoverable. Recoverability of assets to
be held and used is measured by a comparison of the carrying amount of an asset
to estimated undiscounted future cash flows expected to be generated by the
asset. If the carrying amount of an asset exceeds its estimated future cash
flows, an impairment charge is recognized by the amount which the carrying
amount of the asset exceeds the fair value of the asset.
The Company estimates the value of warrants and option grants using a
Black-Scholes pricing model based on management assumptions regarding the
expected volatility and risk free interest rates.
Results of Operations
The Company's operating results depend exclusively on its ability to market
its EMW inspection technology services. If the Company is not able to automate
completely the EMW inspection process and fully implement its new technology,
the Company may not be able to obtain future contracts to sell or license its
EMW technology. Since the Company's revenues are derived solely from sales of
its EMW technology, any failure to obtain future contracts will have a material
adverse effect on the business and financial condition of the Company.
The Company did not generate any revenues during the years ended June 30,
2006 and June 30, 2005, as the Company was engaged solely in the redevelopment
and improvement of its testing hardware and software.
The Company did not have any cost of revenues for the years ended June 30,
2006 and June 30, 2005. The Company did not have any employees working in the
field because the Company did not have any revenue generating contracts during
these periods.
Research and development expenses for the year ended June 30, 2006 were
$357,709 as compared to $261,617 for the year ended June 30, 2005. The increase
of $96,092 for the year ended June 30, 2006 as compared to the year ended June
30, 2005 is substantially the result of the Company retaining the services of
two consultants and a scientist during the year ended June 30, 2006, to focus
increased efforts on the design, fabrication, and testing of the Company's new
hardware. Research and development related consulting fees were approximately
$190,000 more during the year ended June 30, 2006 than during the year ended
June 30, 2005. Offsetting the increase in the cash related consulting fees is a
13
decrease of $98,250 in the value of the stock options granted to a consultant
and the scientist. Included in research and development for the year ended June
30, 2006, is $75,750 for the fair value of 75,000 options granted to a
consultant and the scientist as partial compensation for their past services
rendered. Included in research and development for the year ended June 30, 2005
is $174,000 for the fair value of 200,000 stock options granted to the scientist
as partial compensation for past services rendered.
General and administrative expenses for the year ended June 30, 2006 were
$633,156 as compared to $705,542 for the year ended June 30, 2005. The decrease
of $72,386 for the year ended June 30, 2006 as compared to the year ended June
30, 2005 is the result of a general reduction of operating expenditures as the
Company focuses on reducing its overall burn rate. Contributing to the decrease
in general and administrative expenses was a decrease in professional fees of
approximately $3,100 and a decrease in insurance premiums of approximately
$11,700 for the year ended June 30, 2006 as compared to the year ended June 30,
2005.
Loss from operations for the year ended June 30, 2006 was $990,865 as
compared to $967,159 for the year ended June 30, 2005. The increase of $23,706,
or 2%, is primarily due to the increase in research and development expenses
resulting from an increase in equity compensation issued to the Company's
consultants and a scientist during the year ended June 30, 2006 as compared to
the year ended June 30, 2005. Offsetting the increase in research and
development expense is a decrease in general and administrative expenses due to
reductions in professional fees and insurance premiums as discussed above.
Interest expense for the year ended June 30, 2006 was $241,382 as compared
to $179,857 for the year ended June 30, 2005. The increase of $61,525 for the
year ended June 30, 2006 as compared to the year ended June 30, 2005 is
substantially the impact of investors exercising their conversion right in
accordance with the terms of the 2003 Offering. Six investors exercised their
conversion right during the year ended June 30, 2006 as compared to five
investors during the year ended June 30, 2005. However, the principal balance
and related discount for the six investors that exercised their conversion right
during the year ended June 30, 2006 was significantly higher than the principal
balance and related discount for the five investors that exercised their
conversion right during the year ended June 30, 2005. The unamortized discount
recognized as interest expense upon conversion was approximately $198,000 during
the year ended June 30, 2006 as compared to approximately $100,000 during the
year ended June 30, 2005. This increase is offset by a decrease in interest
expense on the Amended Evans Loan of approximately $31,100 for the year ended
June 30, 2006 as compared to the year ended June 30, 2005 as a result of Mr.
Evans converting the remaining outstanding principal balance and accrued
interest of the Amended Evans Loan in January 2006. Also contributing to the
overall decrease in interest expense is a reduction of interest expense related
to the 5% interest bearing Debentures. Interest expense related to the 5%
interest bearing Debentures decreased by approximately $8,500 for the year ended
June 30, 2006 as compared to the year ended June 30, 2005 as a result of
investors who previously exercised their conversion right, converting their
Debentures to equity, thereby reducing the outstanding principal balance on the
Debentures.
Recently Issued Accounting Standards
In February 2006, the FASB issued Statement No. 155, "Accounting for
Certain Hybrid Financial Instruments - an amendment of FASB Statements No. 133
and 140" (FASB No. 155). FASB No. 155 permits fair value remeasurement for any
14
hybrid financial instrument that contains an embedded derivative that otherwise
would require bifurcation, clarifies which interest-only strips and
principal-only strips are not subject to the requirements of FASB Statement No.
133, and establishes a requirement to evaluate interests in securitized
financial assets to identify interests that are freestanding derivatives or that
are hybrid financial instruments that contain an embedded derivative requiring
bifurcation. In addition, FASB No. 155 clarifies that concentrations of credit
risk in the form of subordination are not embedded derivatives and amends FASB
No. 140 to eliminate the prohibition on a qualifying special purpose entity from
holding a derivative financial instrument that pertains to a beneficial interest
other than another derivative financial instrument. FASB No. 155 is effective
for all financial instruments acquired or issued after the beginning of an
entity's first fiscal year that begins after September 15, 2006. The Company
does not expect that this Statement will have a material impact on their
financial position, results of operations or cash flows.
In March 2006, the FASB issued Statement No. 156, "Accounting for Servicing
of Financial Assets--an amendment of FASB Statement No. 140" (FASB No. 156).
FASB No. 156 requires that an entity separately recognize a servicing asset or a
servicing liability when it undertakes an obligation to service a financial
asset under a servicing contract in certain situations. Such servicing assets or
servicing liabilities are required to be initially measured at fair value, if
practicable. FASB No. 156 also allows an entity to choose either the
amortization method or the fair value measurement method to account for
servicing assets and servicing liabilities within the scope of this Statement.
FASB No. 156 is effective after the beginning of an entity's first fiscal year
that begins after September 15, 2006. The Company does not expect that this
Statement will have a material impact on their financial position, results of
operations or cash flows.
In April 2006, the FASB issued FASB Staff Position (FSP) FIN 46R-6,
"Determining the Variability to Be Considered in Applying FASB Interpretation
No. 46(R) (FIN 46R-6). FIN 46R-6 addresses certain implementation issues related
to FASB Interpretation No. 46 (revised December 2003), "Consolidation of
Variable Interest Entities" (FIN 46R). Specifically, FSP FIN 46R-6 addresses how
a reporting enterprise should determine the variability to be considered in
applying FIN 46R. The variability that is considered in applying FIN 46R affects
the determination of (a) whether an entity is a variable interest entity (VIE),
(b) which interests are "variable interests" in the entity, and (c) which party,
if any, is the primary beneficiary of the VIE. That variability affects any
calculation of expected losses and expected residual returns, if such a
calculation is necessary. The Company is required to apply the guidance in FIN
46R-6 prospectively to all entities (including newly created entities) and to
all entities previously required to be analyzed under FIN 46R when a
"reconsideration event" has occurred, beginning July 1, 2006. The Company will
evaluate the impact of this FSP at the time any such "reconsideration event"
occurs and for any new entities created.
In July 2006, the Financial Accounting Standards Board (FASB) issued FASB
Interpretation (FIN) No. 48, "Accounting for Uncertainty in Income Taxes-an
interpretation of FASB Statement No. 109." This Interpretation provides guidance
for recognizing and measuring uncertain tax positions, as defined in Statement
of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes."
FIN No. 48 prescribes a threshold condition that a tax position must meet for
any of the benefit of an uncertain tax position to be recognized in the
financial statements. Guidance is also provided regarding derecognition,
classification and disclosure of uncertain tax positions. FIN No. 48 is
effective for fiscal years beginning after December 15, 2006. The Company does
not expect that this Interpretation will have a material impact on their
financial position, results of operations or cash flows.
15
Liquidity and Capital Resources
The accompanying financial statements have been prepared assuming the
Company will continue as a going concern. The Company incurred cumulative losses
of $12,837,386 through June 30, 2006 and had negative working capital of
$390,440 as of June 30, 2006. Additionally, the Company has expended a
significant amount of cash in developing its technology and patented processes.
These conditions raise substantial doubt about the Company's ability to continue
as a going concern. Management recognizes that in order to meet the Company's
capital requirements, and continue to operate, additional financing, including
seeking industry-partner investment through joint ventures or other possible
arrangements, will be necessary. The Company is evaluating alternative sources
of financing to improve its cash position and is undertaking efforts to raise
capital. If the Company is unable to raise additional capital or secure
additional revenue contracts and generate positive cash flow, it is unlikely
that the Company will be able to continue as a going concern. The financial
statements do not include any adjustments that might result from the outcome of
this uncertainty.
Deferred Wages and Accrued Professional Fees
To reduce cash outflows, certain of the Company's employees, officers,
consultants, and directors have agreed to defer a portion of their salaries and
professional fees until the Company has sufficient resources to pay the amounts
owed or to exchange such amounts into options as described below. At June 30,
2006, the Company has accrued $903,751 related to the deferred payment of
salaries and professional fees of which $711,601 is included under deferred
wages and $192,150 in accrued professional fees. On March 18, 2002, the Board
approved a conversion right on all deferred wages and accrued professional fees
deferred as of March 18, 2002. Pursuant to this conversion right, employees,
officers, consultants, and directors may elect to convert $1.00 of fees owed to
them as of March 18, 2002 for an option to purchase two shares of the Company's
common stock, at an exercise price of $1.00 per share for a term of five years.
Deferred salaries and fees as of March 18, 2002 were $111,500, resulting in the
potential issuance of 223,000 options under the terms mentioned above. No
conversions have occurred to date. At March 18, 2002, there was no intrinsic
value associated with these exchange rights. As such, no additional compensation
cost was recorded.
Convertible Debentures and Warrants
On June 19, 2003, the Board of Directors approved the offering (the "2003
Offering") of $1,000,000 in convertible debentures (the "Debentures"). The
Debentures are convertible into that number of shares of the Company's common
stock equal to the amount of the converted indebtedness divided by $0.50 per
share. The Debentures bear interest at a rate of 5% per annum, payable
quarterly. Delinquent interest payments bear interest at a rate of 12% per
annum. The Company is required to redeem each Debenture on the 5th anniversary
of the date of the Debenture. The Company may, in its discretion, redeem any
Debenture at any time prior to the mandatory redemption date of the Debenture by
providing no less than 60 days' prior written notice to the holder of the
Debenture. Certain events of default will result in the Debentures being
redeemable by the Company upon demand of the holder.
Upon the purchase of, and for each $0.50 of the Debenture's principal
amount, the Company issued to each investor a warrant (the "Warrant") to
16
purchase one (1) share of the Company's common stock at an exercise price of
$0.75 per share. The Warrants are exercisable at any time prior to the 5th
anniversary date of the redemption of the Debenture.
Warrants issued in connection with the 2003 Offering were recorded based on
their relative fair value as compared to the fair value of the debt at issuance.
The relative fair value of the warrants was recorded as paid-in capital,
estimated at $0 and $101,977 for the years ended June 30, 2006 and June 30,
2005, respectively. The fair value of the warrants issued during the year ended
June 30, 2005, was determined based on an option pricing model with the
following assumptions: warrant lives of 10 years, risk free interest rates
ranging from 4.14% to 4.30%, volatility of 120%, and a zero dividend yield. The
intrinsic value of the Debentures results in a beneficial conversion feature
that reduces the book value of the convertible debt to not less than zero.
Accordingly, the Company recorded a discount of $0 and $158,000 during the years
ended June 30, 2006 and June 30, 2005, respectively, on the convertible debt
issued under the 2003 Offering. The Company amortizes the discount using the
effective interest method over the five-year life of the Debentures.
During the quarter ended March 31, 2005, the Board of Directors terminated
the 2003 Offering. As of the closing date of the 2003 Offering, the Company had
raised $503,000 from the 2003 Offering.
During the years ended June 30, 2006 and June 30, 2005, six and five
investors, respectively, exercised their conversion right under the terms of the
Debentures. Accordingly, the carrying value of the convertible debt was
reclassified as equity upon conversion. Since the convertible debt instruments
include a beneficial conversion feature, the remaining unamortized discount of
approximately $198,000 and $100,000 at the conversion date was recognized as
interest expense during the years ended June 30, 2006 and June 30, 2005,
respectively.
As of June 30, 2006, accrued interest on the Debentures was $2,182. The
Company recorded interest expense related to the accretion of the discount on
the Debentures and amortization of the convertible debt discount as a result of
the conversions discussed above of $198,128 and $100,061 for the years ended
June 30, 2006 and June 30, 2005, respectively.. As of June 30, 2006 the carrying
value of the long-term portion of the Debentures was $189, net of unamortized
debt discount of $67,311.
Common Stock and Warrants
On January 19, 2005, the Board of Directors approved the offering (the
"2005 Offering") of 2,000,000 units (the "Units") to accredited investors for a
total offering price of $1,000,000. Each Unit consists of one share of common
stock and a warrant to acquire common stock. On November 21, 2005, the Board of
Directors approved an increase in the number of Units offered in the 2005
Offering to 6,000,000 Units, for a total offering price of $3,000,000. The
purchase price of one Unit is $0.50. Each Unit consists of one share of common
stock and a warrant to purchase one share of common stock at an exercise price
of $0.75. The warrants are exercisable at any time prior to the fifth
anniversary from the date of their issuance.
During the year ended June 30, 2006, the Company raised $1,738,500 under
the terms of the 2005 Offering. Accordingly, the Company issued 3,477,000 shares
of common stock and warrants to purchase up to 3,477,000 shares of common stock
at an exercise price of $0.75 per share.
17
The 2005 Offering was terminated on June 9, 2006. As of the closing date of
the 2005 Offering, the Company had raised $1,801,000 from the 2005 Offering.
The Company engaged a brokerage firm to help in the fund raising efforts of
the 2005 Offering. Pursuant to the terms of the agreement with the brokerage
firm, the Company will pay the brokerage firm a ten percent cash commission on
all funds that the brokerage firm helps raise. Additionally, subsequent to the
closing of the 2005 Offering, the brokerage firm and the Company agreed that the
Company would issue warrants to purchase a total of 439,600 shares of common
stock at $0.60 per share. The warrants may be exercised up to five years from
the date of issuance, which is the date the proceeds are received under the 2005
Offering. During the years ended June 30, 2006 and June 30, 2005, the Company
incurred $141,050 and $6,250, respectively, of cash fees to be paid to the
brokerage firm and issued warrants to purchase 427,100 and 12,500, respectively,
shares of common stock. During the year ended June 30, 2006, the Company
recorded $355,531 as a reduction to paid-in capital for the fair value of the
427,100 warrant grants. The fair value of the warrants issued to the brokerage
firm during the year ended June 30, 2006 were estimated using the Black-Scholes
option pricing model with the following weighted average assumptions: expected
volatility ranging from 79.12% to 376.15%, risk-free interest rates ranging from
4.14% to 5.10%, expected lives of five years, and a 0% dividend yield.
Other Commitments
The Company's other contractual obligations consist of commitments under an
operating lease and repayment of loans payable to certain officers, directors
and stockholders.
As of June 30, 2006, the Company had outstanding loans payable to certain
stockholders with principal amounts, in the aggregate, equal to $57,500. The
terms of the various notes are described above under "Note 6: Notes Payable -
Stockholders."
As of June 30, 2006, the Company has future minimum lease payments of
approximately $14,750 under its operating lease.
Capital will be expended to support operations until the Company can
generate sufficient cash flows from operations. In order for the Company to
generate cash flows from operations, the Company must obtain additional revenue
generating contracts. Management is currently directing the Company's activities
towards obtaining additional service contracts, which, if obtained, will
necessitate the Company attracting, hiring, training and outfitting qualified
technicians. If additional service contracts are obtained, it will also
necessitate additional field test equipment purchases in order to provide the
services. The Company's intention is to purchase such equipment for its field
crews for the foreseeable future, until such time as the scope of operations may
require alternate sources of financing equipment. The Company expects that if
additional contracts are secured, and revenues increase, working capital
requirements will increase. There can be no assurance that the Company's process
will gain widespread commercial acceptance within any particular time frame, or
at all. The Company will incur additional expenses as it hires and trains field
crews and support personnel related to the successful receipt of commercial
contracts. Additionally, the Company anticipates that cash will be used to meet
capital expenditure requirements necessary to develop infrastructure to support
future growth. There can be no assurance that the Company will be able to secure
additional revenue generating contracts to provide sufficient cash.
18
Pending the deployment of the Company's new hardware and software and the
receipt of new contracts, and in an effort to reduce its out-of-pocket expenses
to the lowest practicable level, the Company has furloughed all of its field
crews. If and when revenue-generating contracts are obtained, the Company will
re-hire former crew personnel or may hire and train new crews. The Company was
not obligated to make any severance payments for salaries, health benefits or
accrued vacation and sick time related to the termination of any of its
employees.
Off-Balance Sheet Arrangements
The Company has no off-balance sheet arrangements.
19
Item 7. Financial Statements
Profile Technologies, Inc.
Table of Contents
Page
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Reports of Independent Registered Public Accounting Firms 21
Balance Sheet as of June 30, 2006 22
Statements of Operations for Years Ended June 30, 2006 and 2005 23
Statements of Stockholders' Deficit for Years Ended
June 30, 2006 and 2005 24
Statements of Cash Flows for Years Ended June 30, 2006 and 2005 25
Notes to Financial Statements 26
20
PS
Peterson Sullivan PLLC
Certified Public Accountants
601 Union Street, Suite 2300 Tel 206 382 7777 - Fax 206 382 7700
Seattle, Washington 98101 http://www.pascpa.com
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
-------------------------------------------------------
The Board of Directors
Profile Technologies, Inc.
We have audited the accompanying balance sheet of Profile Technologies, Inc. as
of June 30, 2006, and the related statements of operations, stockholders'
deficit, and cash flows for the years ended June 30, 2006 and 2005. 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 the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. The Company has determined that it
is not required to have, nor were we engaged to perform, an audit of its
internal control over financial reporting. Our audits included consideration of
internal control over financial reporting as a basis for designing audit
procedures that are appropriate in the circumstances, but not for the purpose of
expressing an opinion on the effectiveness of the Company's internal control
over financial reporting. Accordingly, we express no such opinion. 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 referred to above present fairly, in
all material respects, the financial position of Profile Technologies, Inc. as
of June 30, 2006, and the results of its operations and its cash flows for the
years ended June 30, 2006 and 2005, in conformity with accounting principles
generally accepted in the United States.
The accompanying financial statements have been prepared assuming that the
Company will continue as a going concern. As discussed in Note 8 to the
financial statements, the Company has incurred cumulative losses and had
negative working capital of $390,440 at June 30, 2006. These conditions raise
substantial doubt about the Company's ability to continue as a going concern.
Management's plan regarding those matters is also described in Note 8. The
financial statements do not include any adjustments that might result from the
outcome of this uncertainty.
/S/ PETERSON SULLIVAN PLLC
Seattle, Washington
September 6, 2006
21
PROFILE TECHNOLOGIES, INC.
Balance Sheet
June 30,
2006
-------------
Assets
Current assets:
Cash $ 852,468
Prepaid expenses and other current assets 12,722
------------
Total current assets 865,190
Equipment, net of accumulated depreciation of $544,040 15,630
Deferred financing fees 840
Other assets 1,550
------------
Total assets $ 883,210
============
Liabilities and Stockholders' Deficit
Current Liabilities:
Accounts payable $ 172,053
Notes payable to stockholders 57,500
Current portion of convertible debt 107,500
Deferred wages 711,601
Accrued professional fees 192,150
Accrued interest 2,182
Other accrued expenses 12,644
------------
Total current liabilities 1,255,630
Long-term convertible debt, net of unamortized discount of $67,311 189
Stockholders' deficit:
Common stock, $0.001 par value. Authorized 25,000,000
shares; issued and outstanding 12,111,445 shares 12,111
Common stock issuable; 345,000 shares 345
Additional paid-in capital 12,452,321
Accumulated deficit (12,837,386)
------------
Total stockholders' deficit (372,609)
Commitments, contingencies and subsequent events
------------
Total liabilities and stockholders' deficit $ 883,210
============
See accompanying notes to financial statements.
22
PROFILE TECHNOLOGIES, INC.
Statements of Operations
For the years ended June 30, 2006 and 2005
2006 2005
----------- -----------
Revenue $ -- $ --
Cost of revenues -- --
----------- -----------
Gross profit -- --
----------- -----------
Operating expenses:
Research and development 357,709 261,617
General and administrative 633,156 705,542
----------- -----------
Total operating expenses 990,865 967,159
----------- -----------
Loss from operations (990,865) (967,159)
Interest expense 241,382 179,857
----------- -----------
Net loss $(1,232,247) $(1,147,016)
=========== ===========
Basic and diluted net loss per share $ (0.13) $ (0.20)
Weighted average shares outstanding used to
calculate basic and diluted net loss per share 9,667,742 5,744,371
See accompanying notes to financial statements.
23
PROFILE TECHNOLOGIES, INC.
Statements of Stockholders' Deficit
For the years ended June 30, 2006 and 2005
Common Stock Common Stock Issuable
------------------------- ------------------------
Shares Amount Shares Amount
----------- ------------ ----------- ----------
Balance at June 30, 2004 5,494,661 $ 5,495 -- $ --
Issuance of common stock for services 150,000 150 -- --
Issuance of common stock warrants and options
for services -- -- -- --
Issuance of common stock warrants related to
the convertible debt -- -- -- --
Recording beneficial conversion feature on
convertible debt -- -- -- --
Issuance of common stock upon conversion
of convertible debt to equity 201,044 201 -- --
Issuance of common stock warrants related to
the 2005 Offering -- -- -- --
Issuance of common stock related to the
2005 Offering 80,000 80 -- --
Common stock issuance costs -- -- -- --
Common stock issuable related to the 2005
Offering -- -- 45,000 45
Net loss -- -- -- --
------------ ------------ ----------- -------------
Balance at June 30, 2005 5,925,705 $ 5,926 45,000 $ 45
Issuance of common stock previously reported as "issuable" 45,000 45 (45,000) (45)
Issuance of common stock warrants and options
for services -- -- -- --
Issuance of common stock upon conversion
of stockholder loan and accrued interest to equity 2,552,000 2,552 -- -- 1,273,448
Issuance of common stock upon conversion
of convertible debt to equity 456,740 456 -- --
Issuance of common stock warrants related to
the 2005 Offering -- -- -- --
Issuance of common stock related to the
2005 Offering 3,132,000 3,132 345,000 345,000
Common stock issuance costs -- -- -- --
Net loss -- -- -- --
------------ ------------ ----------- ------------
Balance at June 30, 2006 12,111,445 $ 12,111 345,000 $ 345
============ ============ =========== =============
(Continued on following page)
PROFILE TECHNOLOGIES, INC.
Statements of Stockholders' Deficit (Continued)
For the years ended June 30, 2006 and 2005
Additional Total
Paid-in Accumulated Stockholders'
Capital Deficit Deficit
------------ ------------ -------------
Balance at June 30, 2004 $ 8,669,341 $(10,458,123) $ (1,783,287)
Issuance of common stock for services 69,850 -- 70,000
Issuance of common stock warrants and options
for services 224,525 -- 224,525
Issuance of common stock warrants related to
the convertible debt 101,977 -- 101,977
Recording beneficial conversion feature on
convertible debt 56,023 -- 56,023
Issuance of common stock upon conversion
of convertible debt to equity 100,321 -- 100,522
Issuance of common stock warrants related to
the 2005 Offering 33,059 -- 33,059
Issuance of common stock related to the
2005 Offering 18,439 -- 18,519
Common stock issuance costs (13,275) -- (13,275)
Common stock issuable related to the 2005
Offering 10,877 -- 10,922
Net loss -- (1,147,016) (1,147,016)
------------ ------------ ------------
Balance at June 30, 2005 $ 9,271,137 $(11,605,139) $ (2,328,031)
Issuance of common stock previously reported as "issuable" -- -- --
Issuance of common stock warrants and options
for services 441,381 -- 441,381
Issuance of common stock upon conversion
of stockholder loan and accrued interest to equity 2,552,000 -- 1,276,000
Issuance of common stock upon conversion
of convertible debt to equity 227,913 -- 228,369
Issuance of common stock warrants related to
the 2005 Offering 1,192,381 -- 1,192,381
Issuance of common stock related to the
2005 Offering 542,642 -- 546,119
Common stock issuance costs (496,581) -- (496,581)
Net loss -- (1,232,247) (1,232,247)
------------ ------------ ------------
Balance at June 30, 2006 $ 12,452,321 $(12,837,386) $ (372,609)
============ ============ ============
See accompanying notes to financial statements.
24
PROFILE TECHNOLOGIES, INC.
Statements of Cash Flows
For the years ended June 30, 2006 and 2005
2006 2005
----------- -----------
Cash flows from operating activities:
Net loss $(1,232,247) $(1,147,016)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization 5,109 8,323
Accreted discount on convertible debt 183 61
Amortization of convertible debt discount included in interest expense 197,945 100,000
Accrued interest on convertible debt converted to equity 370 522
Accrued interest on notes payable to stockholders converted to equity 114,777 --
Amortization of debt issuance costs 10,520 5,240
Equity issued for services 85,850 294,525
Changes in operating assets and liabilities:
Prepaid expenses and other current assets 4,929 1,621
Other assets 865 --
Accounts payable (24,312) (61,827)
Deferred wages 72,475 255,800
Accrued professional fees 24,000 24,000
Accrued interest (101,170) 45,105
Other accrued expenses (7,950) 3,423
----------- -----------
Net cash used in operating activities (848,656) (470,223)
Cash flows from investing activies:
Purchase of fixed assets (13,104) --
----------- -----------
Net cash used in investing activities (13,104) --
----------- -----------
Cash flows from financing activies:
Allocated proceeds from issuance of convertible debt -- 56,023
Allocated proceeds from issuance of warrants attached to convertible debt -- 101,977
Common stock issuance costs (141,050) (13,275)
Allocated proceeds from issuance of common stock 546,119 29,441
Allocated proceeds from issuance of warrants attached to issuance of common stock 1,192,381 33,059
Proceeds from issuance of notes payable to stockholders 89,733 278,500
Repayments of note payable to stockholders -- (48,270)
----------- -----------
Net cash provided by financing activities 1,687,183 437,455
----------- -----------
Increase (decrease) in cash 825,423 (32,768)
Cash at beginning of period 27,045 59,813
----------- -----------
Cash at end of period $ 852,468 $ 27,045
=========== ===========
Supplemental disclosure of cash flow information:
Debt discount recorded for beneficial conversion feature $ -- $ 56,023
Cash paid for interest $ 12,884 $ 21,720
Convertible debt and related accrued interest converted into 456,740 and
201,044 shares of common stock during the twelve months ended
June 30, 2006 and 2005, respectively $ 228,369 $ 100,522
Notes payable to stockholder converted into 2,322,446 shares of common stock
during the twelve months ended June 30, 2006 $ 1,161,223 $ --
Accrued interest on notes payable to stockholder converted into
229,554 shares of common stock
during the twelve months ended June 30, 2006 $ 114,777 $ --
See accompanying notes to financial statements.
25
Note 1: Description of Business
Profile Technologies, Inc. (the "Company"), was incorporated in 1986 and
commenced operations in fiscal year 1988. The Company is in the business of
inspecting pipelines for corrosion and is in the final stages of researching and
developing a patented, non-destructive and non-invasive, high speed scanning
process, using electro magnetic waves to remotely inspect buried, encased and
insulated pipelines for corrosion.
Note 2: Summary of Significant Accounting Policies
Cash
Cash includes highly liquid investments with original maturities of three
months or less. On occasion, the Company has amounts deposited with financial
institutions in excess of federally insured limits.
Fair Value of Financial Instruments
The Company has the following financial instruments: cash, accounts
payable, notes payable to stockholders, and convertible debt. The carrying value
of these instruments, other than the convertible debt, approximates fair value
based on their liquidity. The fair value of the convertible debt was determined
as the excess of the proceeds over the fair value of the warrants.
Deferred Financing Fees
The Company records costs incurred related to debt financings as deferred
financing fees and amortizes, on a straight-line basis, the costs incurred over
the life of the related debt. The amortization is recognized as interest in the
financial statements. Upon conversion into equity or extinguishment of the
related debt, the Company recognizes any unamortized portion of the deferred
financing fees as interest expense.
Contract Revenue Recognition
The Company recognizes revenue from service contracts using the percentage
of completion method of accounting. Contract revenues earned are measured using
either the percentage of contract costs incurred to date to total estimated
contract costs or, when the contract is based on measurable units of completion,
revenue is based on the completion of such units. This method is used because
management considers total cost or measurable units of completion to be the best
available measure of progress on contracts. Because of the inherent
uncertainties in estimating costs, it is at least reasonably possible that the
estimates used may change in the near term.
Anticipated losses on contracts, if any, are charged to earnings as soon as
such losses can be estimated. Changes in estimated profits on contracts are
recognized during the period in which the change in estimate is known.
Cost of revenues include contract costs incurred to date as well as any
idle time incurred by personnel scheduled to work on customer contracts.
The Company records claims for additional compensation on contracts upon
revision of the contract to include the amount to be received for the additional
work performed. Contract costs include all direct material and labor costs and
those indirect costs related to contract performance, such as indirect labor,
26
supplies, tools and repairs, and depreciation costs. Selling, general, and
administrative costs are charged to expense as incurred. Service contracts
generally extend no more than six months.
Research and Development
Research and development costs are expensed when incurred. During the years
ended June 30, 2006 and June 30, 2005, the Company incurred $357,709 and
$261,617, respectively, on research and development activities.
Equipment
Equipment is stated at cost and is depreciated using the straight-line
method over estimated useful lives of three to seven years.
Impairment of Long-Lived Assets and Long-Lived Assets to Be Disposed Of
The Company reviews long-lived assets, such as equipment and intangibles,
for impairment at least annually or whenever events or changes in circumstances
indicate that the carrying amount of an asset may not be recoverable.
Recoverability of assets to be held and used is measured by a comparison of the
carrying amount of an asset to estimated undiscounted future cash flows expected
to be generated by the asset. If the carrying amount of an asset exceeds its
estimated future cash flows, an impairment charge is recognized by the amount by
which the carrying amount of the asset exceeds the fair value of the asset.
Valuation of Warrants and Options
The Company estimates the value of warrants and option grants using a
Black-Scholes pricing model based on management assumptions regarding the
warrant and option lives, expected volatility, and risk free interest rates.
Income Taxes
Income taxes are accounted for under the asset and liability 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 and operating loss and tax credit carry forwards. Deferred tax assets and
liabilities are measured using enacted tax rates expected to apply to taxable
income in the years in which those temporary differences are expected to be
recovered or settled. The effect on deferred tax assets and liabilities of a
change in tax rates is recognized in income in the period that includes the
enactment date. A valuation allowance is recorded for deferred tax assets when
it is more likely than not that such deferred tax assets will not be realized.
Net Loss Per Share
Basic net loss per share is computed by dividing the net loss by the
weighted average number of common shares outstanding during the period. Diluted
net loss per share is computed by dividing the net loss by the weighted average
number of common and dilutive common equivalent shares outstanding during the
period. As the Company had a net loss attributable to common shareholders in
each of the periods presented, basic and diluted net loss per share are the
same.
27
Excluded from the computation of diluted net loss per share for the year
ended June 30, 2006, because their effect would be antidilutive, are options and
warrants to acquire 12,643,418 shares of common stock with a weighted-average
exercise price of $1.06 per share. Also excluded from the computation of diluted
net loss per share for the year ended June 30, 2006 are 350,000 shares of common
stock that may be issued if investors exercise their conversion right under the
Debentures related to the 2003 Offering as discussed in Note 8 because their
effect would be antidilutive.
Excluded from the computation of diluted net loss per share for the year
ended June 30, 2005, because their effect would be antidilutive, are options and
warrants to acquire 5,762,318 shares of common stock with a weighted-average
exercise price of $1.40 per share. Also excluded from the computation of diluted
net loss per share for the year ended June 30, 2005 are 806,000 shares of common
stock that may be issued if investors exercise their conversion right under the
Debentures related to the 2003 Offering as discussed in Note 8 because their
effect would be antidilutive.
For the years ended June 30, 2006 and June 30, 2005, additional potential
dilutive securities that were excluded from the diluted net loss per share
computation are the exchange rights discussed in Note 8 that could result in
options to acquire up to 223,000 shares of common stock with an exercise price
of $1.00 per share at June 30, 2006 and June 30, 2005.
For purposes of earnings per share computations, shares of common stock
that are issuable at the end of a reporting period are included as outstanding.
Use of Estimates
The preparation of financial statements in conformity with U.S. generally
accepted accounting principles 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.
Patents, Proprietary Technology, and Other Intellectual Property
The Company pursues a policy of generally obtaining patent protection both
in the United States of America and abroad for patentable subject matter in its
proprietary technology. The Company's success depends in a large part upon its
ability to protect its products and technology under United States of America
and international patent laws and other intellectual property laws. U.S. patents
have a term of 17 years from date of issuance or, for more recently filed patent
applications, 20 years from the filing of such applications, and patents in most
foreign countries have a term of 20 years from the proprietary filing date of
the patent application.
The Company believes that it owns and has the right to use or license all
proprietary technology necessary to license and market its products under
development. The Company is not aware of the issuance of any patents or the
filing of any patent applications, which relate to processes or products which
utilize the Company's proprietary technology in a manner which could be similar
to or competitive with the Company's products or processes. The Company has no
28
knowledge that it is infringing on any existing patent such that it would be
prevented from marketing or licensing products or services currently being
developed by the Company.
Financial Instruments and Concentrations of Credit Risk
At June 30, 2006, the Company has the following financial instruments:
notes payable to stockholders, convertible short-term and long-term debt,
accounts payable and accrued expenses. The carrying value of these instruments,
other than the convertible debt, approximate fair value based on their
liquidity. The fair value of the convertible debt was determined as the excess
of the proceeds over the fair value of the warrants. Credit is extended to
customers based on an evaluation of their financial condition. The Company does
not require any collateral.
Vendor Concentration
The Company relies on the expertise of a scientist to facilitate the
development and testing of the Company's hardware and software. The scientist is
also instrumental in interpreting the data captured during the testing of the
hardware and software. The loss of the specialized knowledge provided by this
scientist could have an adverse effect on the ability of the Company to reach
marketability of its hardware and software. During the years ended June 30, 2006
and June 30, 2005, the Company incurred cash fees payable to the scientist of
approximately $154,000 and $13,500, respectively, which are included in research
and development expenses in the Company's statements of operations. As of June
30, 2006, the Company owed the scientist approximately $77,000, which is
included in accounts payable at June 30, 2006.
As partial compensation for services rendered, the Company also granted
stock options to the scientist. During the year ended June 30, 2006 the Company
granted the scientist a stock option to purchase 50,000 shares of common stock
at an exercise price of $1.12, expiring December 12, 2010. The 50,000 options
had a fair value at the date of grant of $50,500, which is included in research
and development expenses in the Company's statements of Operations for the year
ended June 30, 2006.
During the year ended June 30, 2005 the Company granted the scientist a
stock option to purchase 200,000 shares of common stock at an exercise price of
$1.16, expiring February 15, 2010. The 200,000 options had a fair value at the
date of grant of $174,000, which is included in research and development
expenses in the Company's statements of operations for the year ended June 30,
2005.
Total cash and stock compensation expense incurred for settlement of
services rendered by the scientist totaled $204,500 or approximately 57% of
research and development expense for the year ended June 30, 2006. Total cash
and stock compensation expense incurred for settlement of services rendered by
the scientist totaled $187,500 or approximately 72% of research and development
expense for the year ended June 30, 2005.
Stock-Based Compensation
Prior to January 1, 2006, the Company accounted for stock-based awards
under the intrinsic value method, which followed the recognition and measurement
principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and
related Interpretations. The intrinsic value method of accounting resulted in
compensation expense for stock options to the extent that the exercise prices
were set below the fair market price of the Company's stock at the date of
grant.
29
As of January 1, 2006, the Company adopted SFAS No. 123(R) using the
modified prospective method, which requires measurement of compensation cost for
all stock-based awards at fair value on date of grant and recognition of
compensation over the service period for awards expected to vest. The fair value
of stock options is determined using the Black-Scholes valuation model, which is
consistent with the Company's valuation techniques previously utilized for
options in footnote disclosures required under SFAS No. 123, Accounting for
Stock Based Compensation, as amended by SFAS No. 148, Accounting for Stock-Based
Compensation--Transition and Disclosure. Such value is recognized as expense
over the service period. To date, all stock option grants have been fully vested
upon grant.
The application of SFAS 123(R) had the following effect on net loss as
reported:
For the years ended
June 30,
--------------------------------
2006 2005
----------- ----------
Net loss:
As reported $(1,232,247) $(1,147,016)
Plus: stock-based employee compensation expense
included in reported net loss -- --
Less: stock based compensation expense determined under
fair value based method for all employee rewards (352,000) (1,255,965)
----------- -----------
----------- -----------
Pro forma net loss $(1,584,247) $(2,402,981)
----------- -----------
----------- -----------
Net loss per share
Basic and diluted - as reported $ (0.13) $ (0.20)
Basic and diluted - pro forma $ (0.16) $ (0.42)
The fair value of option and warrant grants is estimated using the
Black-Scholes option pricing model with the following weighted average
assumptions used for grants made during the year ended June 30, 2006: expected
volatility of 150%, risk-free interest rate of 4.46%, expected lives of five
years, and a 0% dividend yield. The weighted average assumptions used for grants
made during the year ended June 30, 2005 were: expected volatility of 163%, risk
free interest rate of 3.41%, expected lives of two years, and a 0% dividend
yield.
Segment Reporting
The Company has one operating segment. Expenses incurred to date are
reported according to their expense category.
Comprehensive Income(Loss)
Comprehensive income (loss) is equal to net income (loss) for the years
ended June 30, 2006 and June 30, 2005.
30
Recently Issued Accounting Pronouncements
In February 2006, the FASB issued Statement No. 155, "Accounting for
Certain Hybrid Financial Instruments - an amendment of FASB Statements No. 133
and 140" (FASB No. 155). FASB No. 155 permits fair value remeasurement for any
hybrid financial instrument that contains an embedded derivative that otherwise
would require bifurcation, clarifies which interest-only strips and
principal-only strips are not subject to the requirements of FASB Statement No.
133, and establishes a requirement to evaluate interests in securitized
financial assets to identify interests that are freestanding derivatives or that
are hybrid financial instruments that contain an embedded derivative requiring
bifurcation. In addition, FASB No. 155 clarifies that concentrations of credit
risk in the form of subordination are not embedded derivatives and amends FASB
No. 140 to eliminate the prohibition on a qualifying special purpose entity from
holding a derivative financial instrument that pertains to a beneficial interest
other than another derivative financial instrument. FASB No. 155 is effective
for all financial instruments acquired or issued after the beginning of an
entity's first fiscal year that begins after September 15, 2006. The Company
does not expect that this Statement will have a material impact on their
financial position, results of operations or cash flows.
In March 2006, the FASB issued Statement No. 156, "Accounting for Servicing
of Financial Assets--an amendment of FASB Statement No. 140" (FASB No. 156).
FASB No. 156 requires that an entity separately recognize a servicing asset or a
servicing liability when it undertakes an obligation to service a financial
asset under a servicing contract in certain situations. Such servicing assets or
servicing liabilities are required to be initially measured at fair value, if
practicable. FASB No. 156 also allows an entity to choose either the
amortization method or the fair value measurement method to account for
servicing assets and servicing liabilities within the scope of this Statement.
FASB No. 156 is effective after the beginning of an entity's first fiscal year
that begins after September 15, 2006. The Company does not expect that this
Statement will have a material impact on their financial position, results of
operations or cash flows.
In April 2006, the FASB issued FASB Staff Position (FSP) FIN 46R-6,
"Determining the Variability to Be Considered in Applying FASB Interpretation
No. 46(R) (FIN 46R-6). FIN 46R-6 addresses certain implementation issues related
to FASB Interpretation No. 46 (revised December 2003), "Consolidation of
Variable Interest Entities" (FIN 46R). Specifically, FSP FIN 46R-6 addresses how
a reporting enterprise should determine the variability to be considered in
applying FIN 46R. The variability that is considered in applying FIN 46R affects
the determination of (a) whether an entity is a variable interest entity (VIE),
(b) which interests are "variable interests" in the entity, and (c) which party,
if any, is the primary beneficiary of the VIE. That variability affects any
calculation of expected losses and expected residual returns, if such a
calculation is necessary. The Company is required to apply the guidance in FIN
46R-6 prospectively to all entities (including newly created entities) and to
all entities previously required to be analyzed under FIN 46R when a
"reconsideration event" has occurred, beginning July 1, 2006. The Company will
evaluate the impact of this FSP at the time any such "reconsideration event"
occurs and for any new entities created.
In July 2006, the Financial Accounting Standards Board (FASB) issued FASB
Interpretation (FIN) No. 48, "Accounting for Uncertainty in Income Taxes-an
interpretation of FASB Statement No. 109." This Interpretation provides guidance
31
for recognizing and measuring uncertain tax positions, as defined in Statement
of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes."
FIN No. 48 prescribes a threshold condition that a tax position must meet for
any of the benefit of an uncertain tax position to be recognized in the
financial statements. Guidance is also provided regarding derecognition,
classification and disclosure of uncertain tax positions. FIN No. 48 is
effective for fiscal years beginning after December 15, 2006. The Company does
not expect that this Interpretation will have a material impact on their
financial position, results of operations or cash flows.
Note 3: Related Parties
Notes Payable - Stockholders
In April 2002, the Company issued a non-interest bearing bridge note
payable to an officer of the Company in the amount of $7,500. The note is
payable in full when the Company determines it has sufficient working capital to
do so. On September 29, 2002, the officer who was owed the $7,500 died.
The Company has entered into various loan agreements with Murphy Evans,
President, a director and stockholder of the Company. On March 6, 2003, the
Company's Board of Directors approved the Loan Amendment and Promissory Note
(the "Amended Evans Loan") between the Company and Murphy Evans. The Amended
Evans Loan aggregates all previous debt and supersedes and replaces all of the
terms of the previous loans with Mr. Evans, including any conversion features.
The Amended Evans Loan bears interest on the aggregate principal balance at a
rate of 5% per annum, payable on June 30 and December 31 of each year, with the
principal balance due and payable in full on December 31, 2003. The Amended
Evans Loan is exempt from registration under Section 4(2) of the Securities Act.
During the year ended June 30, 2006, Mr. Evans loaned the Company an
additional $89,733 pursuant to the terms of the Amended Evans Loan. During the
year ended June 30, 2006, Mr. Evans converted the entire then outstanding
$1,161,223 of principal and $114,777 of accrued interest of the Amended Evans
Loan pursuant to the terms of the 2005 Offering as defined below. Accordingly,
Mr. Evans received 2,552,000 shares of common stock and warrants to purchase
2,552,000 shares of common stock at an exercise price of $0.75 per share. The
warrants are exercisable any time prior to the fifth anniversary from the date
of grant.
Interest expense related to the Amended Evans Loan was $16,449 and $47,533
for the years ended June 30, 2006 and June 30, 2005, respectively.
In September 2002, the Company entered into two non-interest bearing bridge
loans in the respective principal amounts of $40,000 and $10,000 (the
"Stockholder Loans") payable to two stockholders of the Company. The terms of
the Stockholder Loans provide for payment at such time as the Company determines
it has sufficient working capital to repay the principal balances of the
Stockholder Loans. The Stockholder Loans are convertible into 57,142 and 14,286
equity units, respectively, at any time prior to re-payment. Each equity unit is
comprised of one share of the Company's common stock, with a detachable 5-year
32
warrant to purchase one additional share at an exercise price of $1.05 per
share. Neither stockholder has converted either Stockholder Loan into equity
units.
On June 19, 2003, the Board of Directors approved a promissory note (the
"2003 Gemino Note") in the principal amount of $34,047 payable to Henry E.
Gemino, the Chief Executive Officer, Chief Financial Officer and a director and
stockholder of the Company. From time to time, Mr. Gemino loaned the Company
additional money and the Company repaid various amounts under the terms of the
2003 Gemino Note. The 2003 Gemino Note bears interest at the rate of 5% per
annum, payable on June 30 and December 31 of each year. During the year ended
June 30, 2005, the Company repaid the then outstanding principal balance of
$48,270 and accrued interest to Mr. Gemino. Interest expense related to the 2003
Gemino Note was $0 and $892 for the years ended June 30, 2006 and June 30, 2005,
respectively.
The following is a summary of notes payable to stockholders as of June 30,
2006:
Deceased Officer Note 7,500
Stockholder Loans 50,000
------
Total $57,500
-------
Royalty Arrangement
In September, 1988, at the time Gale D. Burnett, a beneficial shareholder
of more than 10% of the Company's common stock, first transferred certain
technology, know-how and patent rights to the Company, a royalty interest of 4%
of all pre-tax profits derived from the technology and know-how transferred was
granted to Northwood Enterprises, Inc., a family-owned company controlled by Mr.
Burnett. Northwoods Enterprises subsequently assigned such royalty interest back
to Mr. Burnett. On April 8, 1996, Mr. Burnett assigned 2% of this royalty
interest to certain shareholders of the Company, 1 1/4% of which was assigned to
Henry Gemino, currently the Chief Executive Officer and Chief Financial Officer,
and a director of the Company. This royalty arrangement also applies to all
future patent rights and technology developed by Mr. Burnett and assigned to the
Company. To date, no royalty payments have been made or earned under the above
described arrangement.
Note 4: Income Taxes
Federal income taxes reported by the Company differ from the amount
computed by applying the statutory rate due primarily to an increase in the
valuation allowance for deferred tax assets.
The tax effect of temporary differences that give rise to federal deferred
tax assets are comprised of the following at June 30, 2006:
33
Deferred tax assets:
Net operating loss carryforwards $ 3,613,330
Depreciation and amortization 2,586
Wages and professional fees 269,365
Stock compensation 442,000
Research and development credit carryforwards 86,033
------------
Gross deferred tax assets 4,413,314
Less: valuation allowance (4,413,314)
------------
Net deferred tax assets $ --
============
The net increase in the valuation allowance for deferred tax assets was
$394,586 and $389,123 for the years ended June 30, 2006 and June 30, 2005,
respectively. The increases were primarily due to net operating loss carry
forwards, the realization of which was uncertain.
For federal income tax purposes, the Company has net operating loss carry
forwards at June 30, 2006 available to offset future federal taxable income, if
any, of approximately $10,627,440 which expire during the fiscal year ended June
30, 2005 through the fiscal year ended June 30, 2026. In addition, the Company
has research and development tax credit carry forwards of approximately $86,033
at June 30, 2006, which are available to offset federal income taxes and began
to expire during the year ended June 30, 2006.
The utilization of the tax net operating loss carry forwards may be limited
due to ownership changes that have occurred as a result of sales of common
stock.
The effects of state income taxes were insignificant for the years ended
June 30, 2006 and June 30, 2005.
Note 5: Common Stock
During the year ended June 30, 2006, six investors exercised their
conversion right in accordance with the terms of the 2003 Offering. As a result,
456,740 restricted shares of common stock were issued. Additionally, pursuant to
the terms of the 2005 Offering, the Company issued 3,477,000 restricted shares
of common stock during the year ended June 30, 2006.
During the year ended June 30, 2006, Mr. Evans converted the entire then
outstanding $1,161,223 of principal and $114,777 of accrued interest of the
Amended Evans Loan pursuant to the terms of the 2005 Offering. Accordingly, Mr.
Evans received 2,552,000 shares of common stock and warrants to purchase
2,552,000 shares of common stock at an exercise price of $0.75 per share. The
warrants are exercisable any time prior to the fifth anniversary from the date
of grant.
During the year ended June 30, 2005, the Company recorded stock
compensation expense totaling $70,000 for the fair market value of 150,000
shares of restricted common stock issued to third parties in exchange for
services. The restricted common stock was valued based on the market price of
34
the Company's common stock, as traded on the NASD's Over the Counter Bulletin
Board, on the day of grant.
During the year ended June 30, 2005, five investors exercised their
conversion right in accordance with the terms of the 2003 Offering. As a result,
201,044 restricted shares of common stock were issued. Additionally, pursuant to
the terms of the 2005 Offering, the Company issued 125,000 restricted shares of
common stock during the year ended June 30, 2005.
Note 6: Stockholders' Equity
Stock Option Plan
The Company has granted stock options to compensate key employees,
consultants, and board members for past and future services. During 1999, the
Company adopted a stock option plan (the "Plan"). The Plan provides for both
incentive and nonqualified stock options to be granted to employees, officers,
directors, and consultants. In accordance with the Plan, the Company may grant
stock options to purchase up to 500,000 shares of common stock. The Plan allows
incentive and nonqualified stock options to be granted with an expiration date
of a maximum of five years from the date of grant. Since the inception of the
Plan, the Company has made various stock option grants that have expiration
dates exceeding five years from the date of grant. These stock option grants are
deemed to be granted outside of the Plan.
Subsequent to June 30, 2006, the Board adopted amendments to the Plan
increasing the period of time for which stock options are exercisable from a
period of five years to ten years from the date of grant and to increase the
aggregate number of shares of common stock which may be issued pursuant to the
Plan from 500,000 to 3,500,000. The Board is seeking approval by the
Stockholders as part of the 2006 proxy statement, which will be mailed to
Stockholders on or before October 17, 2006.
A summary of stock option-related activity follows:
Options outstanding
------------------------------------
Weighted
Shares average
available for Number of exercise
grant (1) shares price
--------- ------ -----
Balance at June 30, 2004 25,000 505,000 $ 1.96
Grants -- 1,850,000 1.16
Cancellations 15,000 (15,000) 5.00
Expiraions 35,000 (35,000) 6.07
---------- ---------
Balance at June 30, 2005 75,000 2,305,000 1.24
Grants -- 435,000 1.15
Expirations 40,000 (40,000) 3.75
---------- ---------
Balance at June 30, 2006 115,000 2,700,000 1.18
========== =========
(1) Consists of stock options available for grant under the Company's 1999
Stock Option Plan.
35
(2) Consists of stock options outstanding under the Company's 1999 Stock Option
Plan and stock options outstanding that were granted outside of the 1999
Stock Option Plan.
The following is a summary of all stock options outstanding, all of which
are exercisable at June 30, 2006:
Options outstanding
-----------------------------------------------
Weighted
average Weighted
remaining average
Number contractual exercise
Exercise price outstanding life (years) price
-------------- ----------- ------------ ------------
$ 0.50 30,000 2.56 $ 0.50
0.55 90,000 1.75 0.55
0.70 130,000 2.46 0.70
1.00 5,000 0.51 1.00
1.05 140,000 0.37 1.05
1.12 285,000 7.97 1.12
1.16 1,850,000 7.96 1.16
1.21 150,000 9.46 1.21
6.50 15,000 1.34 6.50
10.50 15,000 1.34 10.50
---------
$ 0.50-10.50 2,700,000 7.06 1.18
=========
The aggregate intrinsic value of stock options outstanding at June 30, 2006
is $82,000.
Prior to January 1, 2006, the Company accounted for stock-based awards
under the intrinsic value method, which followed the recognition and measurement
principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and
related Interpretations.
As of January 1, 2006, the Company adopted SFAS No. 123(R) using the
modified prospective method. Subsequent to January 1, 2006 and as of the date of
this report, the Company has not made any stock option grants to employees.
During the year ended June 30, 2006, the Company recorded stock
compensation expense totaling $85,850 for the fair market value of 85,000
options granted to third-parties in exchange for services. The options were
valued using the Black-Scholes option pricing model with the following
assumptions: Expected volatility of 150%, risk free interest rate of 4.46%,
expected lives of five years, and a 0% dividend yield.
During the year ended June 30, 2005, the Company recorded stock
compensation expense totaling $217,500 for the fair market value of 250,000
options granted to third-parties in exchange for services. The options were
valued using the Black-Scholes option pricing model with the following
assumptions: Expected volatility of 120.%, risk free interest rate of 3.78%,
expected lives of five years, and a 0% dividend yield.
The weighted average fair value per share of the option grants made during
the years ended June 30, 2006 and June 30, 2005 were $1.01 and $0.80,
respectively.
36
Warrants
The Company has granted warrants to compensate key employees, consultants,
and board members for past and future services and as incentives during
placements of stock and convertible debt.
A summary of warrant-related activity follows:
Number of Weighted
warrants average
outstanding exercise price
----------- --------------
Outstanding at June 30, 2005 3,088,818 $ 1.57
Grants 453,500 0.75
Expirations (55,000) 5.31
---------
Outstanding at June 30, 2005 3,487,318 1.57
Grants 6,456,100 0.74
---------
Outstanding at June 30, 2006 9,943,418 1.03
=========
The following is a summary of warrants outstanding, all of which are
exercisable at June 30, 2006:
Weighted
average Weighted
remaining average
Number contractual exercise
Exercise price outstanding life (years) price
-------------- ----------- ------------ ------------
$0.55 - 0.70 494,600 4.80 $ 0.61
0.75 7,160,000 4.93 0.75
1.00 - 1.50 1,718,818 0.75 1.05
3.00 - 3.50 520,000 1.34 3.27
7.20 30,000 1.34 7.20
13.50 20,000 1.34 13.50
---------
$0.55 - 13.50 9,943,418 4.00 1.03
=========
During the year ended June 30, 2006, the Company recorded $355,531 as a
reduction to paid-in capital for the fair value of the 427,100 warrants granted
to a brokerage firm. The fair value of the warrants issued to the brokerage firm
during the year ended June 30, 2006 were estimated using the Black-Scholes
option pricing model with the following weighted average assumptions: expected
volatility ranging from 79.12% to 376.15%, risk-free interest rates ranging from
4.14% to 5.10%, expected lives of five years, and a 0% dividend yield.
During the year ended June 30, 2005, the Company recorded $7,025 as a
reduction to paid-in capital for the fair market value of 12,500 warrants
granted to a brokerage firm. The fair value of the warrants issued to the
37
brokerage firm during the year ended June 30, 2005 were estimated using the
Black-Scholes option pricing model with the following weighted average
assumptions: expected volatility ranging from 133% to 183%, risk free interest
rates ranging from 3.63% to 3.88%, expected lives of five years, and a 0%
dividend yield.
The weighted average fair value per share of the warrant grants made during
the years ended June 30, 2006 and June 30, 2005 were $1.08 and $0.31,
respectively.
Note 7: Operating Leases
The Company's research and development facility is located in Ferndale,
Washington under a lease that renewed on January 31, 2003 for a one-year term.
The lease automatically renews thereafter for one year-terms. The lease may be
terminated upon ninety days written notice. The future minimum payments under
the lease extension are at the same monthly rate of approximately $2,107 per
month as under the terms of the original lease.
The Company's executive office is located in Manhasset, New York under a
lease agreement that is month to month.
The Company expects to continue to incur costs on leased properties, as the
Company has extended such leases in the past or will use alternate facilities.
Total rent expense under operating leases with third parties was $35,718
and $33,521 during the years ended June 30, 2006 and 2005, respectively.
Note 8: Liquidity
The accompanying financial statements have been prepared assuming the
Company will continue as a going concern. The Company incurred cumulative losses
of $12,837,386 through June 30, 2006 and had negative working capital of
$390,440 as of June 30, 2006. Additionally, the Company has expended a
significant amount of cash in developing its technology and patented processes.
These conditions raise substantial doubt about the Company's ability to continue
as a going concern. Management recognizes that in order to meet the Company's
capital requirements, and continue to operate, additional financing, including
seeking industry-partner investment through joint ventures or other possible
arrangements, will be necessary. The Company is evaluating alternative sources
of financing to improve its cash position and is undertaking efforts to raise
capital. If the Company is unable to raise additional capital or secure
additional revenue contracts and generate positive cash flow, it is unlikely
that the Company will be able to continue as a going concern. The financial
statements do not include any adjustments that might result from the outcome of
this uncertainty.
Deferred Wages and Accrued Professional Fees
To reduce cash outflows, certain of the Company's employees, officers,
consultants, and directors have agreed to defer a portion of their salaries and
professional fees until the Company has sufficient resources to pay the amounts
owed or to exchange such amounts into options as described below. At June 30,
2006, the Company has accrued $903,751 related to the deferred payment of
salaries and professional fees of which $711,601 is included under deferred
wages and $192,150 in accrued professional fees. On March 18, 2002, the Board
38
approved a conversion right on all deferred wages and accrued professional fees
deferred as of March 18, 2002. Pursuant to this conversion right, employees,
officers, consultants, and directors may elect to convert $1.00 of fees owed to
them as of March 18, 2002 for an option to purchase two shares of the Company's
common stock, at an exercise price of $1.00 per share for a term of five years.
Deferred salaries and fees as of March 18, 2002 were $111,500, resulting in the
potential issuance of 223,000 options under the terms mentioned above. No
conversions have occurred to date. At March 18, 2002, there was no intrinsic
value associated with these exchange rights. As such, no additional compensation
cost was recorded.
Convertible Debentures and Warrants
On June 19, 2003, the Board of Directors approved the offering (the "2003
Offering") of $1,000,000 in convertible debentures (the "Debentures"). The
Debentures are convertible into that number of shares of the Company's common
stock equal to the amount of the converted indebtedness divided by $0.50 per
share. The Debentures bear interest at a rate of 5% per annum, payable
quarterly. Delinquent interest payments bear interest at a rate of 12% per
annum. The Company is required to redeem each Debenture on the 5th anniversary
of the date of the Debenture. The Company may, in its discretion, redeem any
Debenture at any time prior to the mandatory redemption date of the Debenture by
providing no less than 60 days' prior written notice to the holder of the
Debenture. Certain events of default will result in the Debentures being
redeemable by the Company upon demand of the holder.
Upon the purchase of, and for each $0.50 of the Debenture's principal
amount, the Company issued to each investor a warrant (the "Warrant") to
purchase one (1) share of the Company's common stock at an exercise price of
$0.75 per share. The Warrants are exercisable at any time prior to the 5th
anniversary date of the redemption of the Debenture.
Warrants issued in connection with the 2003 Offering were recorded based on
their relative fair value as compared to the fair value of the debt at issuance.
The relative fair value of the warrants was recorded as paid-in capital,
estimated at $0 and $101,977 for the years ended June 30, 2006 and June 30,
2005, respectively. The fair value of the warrants issued during the year ended
June 30, 2005, was determined based on an option pricing model with the
following assumptions: warrant lives of 10 years, risk free interest rates
ranging from 4.14% to 4.30%, volatility of 120%, and a zero dividend yield. The
intrinsic value of the Debentures results in a beneficial conversion feature
that reduces the book value of the convertible debt to not less than zero.
Accordingly, the Company recorded a discount of $0 and $158,000 during the years
ended June 30, 2006 and June 30, 2005, respectively, on the convertible debt
issued under the 2003 Offering. The Company amortizes the discount using the
effective interest method over the five-year life of the Debentures.
During the quarter ended March 31, 2005, the Board of Directors terminated
the 2003 Offering. As of the closing date of the 2003 Offering, the Company had
raised $503,000 from the 2003 Offering.
39
During the years ended June 30, 2006 and June 30, 2005, six and five
investors, respectively, exercised their conversion right under the terms of the
Debentures. Accordingly, the carrying value of the convertible debt was
reclassified as equity upon conversion. Since the convertible debt instruments
include a beneficial conversion feature, the remaining unamortized discount of
approximately $198,000 and $100,000 at the conversion date was recognized as
interest expense during the years ended June 30, 2006 and June 30, 2005,
respectively.
As of June 30, 2006, accrued interest on the Debentures was $2,182. The
Company recorded interest expense related to the accretion of the discount on
the Debentures and amortization of the convertible debt discount as a result of
the conversions discussed above of $198,128 and $100,061 for the years ended
June 30, 2006 and June 30, 2005, respectively.. As of June 30, 2006 the carrying
value of the long-term portion of the Debentures was $189, net of unamortized
debt discount of $67,311.
Common Stock and Warrants
On January 19, 2005, the Board of Directors approved the offering (the
"2005 Offering") of 2,000,000 units (the "Units") to accredited investors for a
total offering price of $1,000,000. Each Unit consists of one share of common
stock and a warrant to acquire common stock. On November 21, 2005, the Board of
Directors approved an increase in the number of Units offered in the 2005
Offering to 6,000,000 Units, for a total offering price of $3,000,000. The
purchase price of one Unit is $0.50. Each Unit consists of one share of common
stock and a warrant to purchase one share of common stock at an exercise price
of $0.75. The warrants are exercisable at any time prior to the fifth
anniversary from the date of their issuance.
During the year ended June 30, 2006, the Company raised $1,738,500 under
the terms of the 2005 Offering. Accordingly, the Company issued 3,477,000 shares
of common stock and warrants to purchase up to 3,477,000 shares of common stock
at an exercise price of $0.75 per share.
The 2005 Offering was terminated on June 9, 2006. As of the closing date of
the 2005 Offering, the Company had raised $1,801,000 from the 2005 Offering.
The Company engaged a brokerage firm to help in the fund raising efforts of
the 2005 Offering. Pursuant to the terms of the agreement with the brokerage
firm, the Company will pay the brokerage firm a ten percent cash commission on
all funds that the brokerage firm helps raise. Additionally, subsequent to the
closing of the 2005 Offering, the brokerage firm and the Company agreed that the
Company would issue warrants to purchase a total of 439,600 shares of common
stock at $0.60 per share. The warrants may be exercised up to five years from
the date of issuance, which is the date the proceeds are received under the 2005
Offering. During the years ended June 30, 2006 and June 30, 2005, the Company
incurred $141,050 and $6,250, respectively, of cash fees to be paid to the
brokerage firm and issued warrants to purchase 427,100 and 12,500, respectively,
shares of common stock. During the year ended June 30, 2006, the Company
recorded $355,531 as a reduction to paid-in capital for the fair value of the
427,100 warrant grants. The fair value of the warrants issued to the brokerage
40
firm during the year ended June 30, 2006 were estimated using the Black-Scholes
option pricing model with the following weighted average assumptions: expected
volatility ranging from 79.12% to 376.15%, risk-free interest rates ranging from
4.14% to 5.10%, expected lives of five years, and a 0% dividend yield.
Note 9. Subsequent Events
In July 2006, the Board approved an option grant to a consultant to
purchase 100,000 shares of the Company's common stock at an exercise price of
$1.05 per share. The option is in consideration for work the consultant is
performing for the Company. The option is fully vested upon grant and is
exercisable until July 13, 2011.
Item 8. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure.
None.
Item 8A. Controls and Procedures.
Disclosure controls and procedures are controls and other procedures that
are designed to ensure that information required to be disclosed in the
Company's reports filed or submitted under the Exchange Act is recorded,
processed, summarized and reported, within the time periods specified in the
Commission's rules and forms. The Company's executive officers, including the
Company's Chief Executive Officer, who also serves as Chief Financial Officer,
and the Chief Operating Officer, are responsible for establishing and
maintaining disclosure controls and procedures for the Company. These executives
have designed such controls to ensure that all material information related to
the Company is made known to them by others within the organization. As of June
30, 2006, the Company's Chief Executive Officer and Chief Operating Officer
completed an evaluation of the Company's disclosure controls and procedures and
have determined that such disclosure controls and procedures are functioning
properly and effectively. They did not discover any significant deficiencies or
material weaknesses within the controls and procedures that require
modification. There were no changes in the Company's internal control over
financial reporting identified in connection with the Company's evaluation that
occurred during the Company's fourth fiscal quarter that have materially
affected, or are reasonably likely to materially affect, the Company's internal
control over financial reporting.
Item 8B. Other Information.
None.
41
PART III
Item 9. Directors and Executive Officers.
Directors, Executive Officers, Promoters and Control Persons
The information regarding directors contained under the caption "Proposal
One: Election of Directors" in the Company's Proxy Statement for the 2006 Annual
Meeting of Shareholders, which will be filed with the Commission not later than
120 days after the end of the fiscal year covered by this report, is
incorporated herein by reference.
Executive Officers of the Company
In addition to Murphy Evans and Henry Gemino, who also serve as directors,
the following constitutes the executive officer of the Company:
Positions Held and Principal
Name Age Occupations During the Past 5 Years
---- --- -----------------------------------
Philip L. Jones 63 Mr. Jones has served as the Chief Operating
Officer and Executive Vice President for the
Company during the past five years. Previous to
his employment with the Company, he provided
energy consulting services to certain utility
companies for a period of one year. Prior to that
time, Mr. Jones held various executive positions
with Consolidated Natural Gas Company before
retiring in April 2000.
Compliance with Section 16(a) of the Exchange Act
The information regarding reports required under Section 16(a) of the
Securities Exchange Act of 1934, as amended, contained under the caption
"Section 16(a) Beneficial Ownership Reporting Compliance" in the Company's Proxy
Statement for the 2006 Annual Meeting of Shareholders, which will be filed with
the Commission not later than 120 days after the end of the fiscal year covered
by this report, is incorporated herein by reference.
Code of Ethics
The Company has adopted a Code of Ethics applicable to its chief executive
officer, chief operating officer, chief financial officer, president and other
finance leaders. A copy of the Code of Ethics may be obtained by any person
without charge, upon request, by contacting the principle office of the Company.
42
Audit Committee
The information contained under the caption "Board of Directors and
Committees" in the Company's Proxy Statement for the 2006 Annual Meeting of
Shareholders, which will be filed with the Commission not later than 120 days
after the end of the fiscal year covered by this report, is incorporated herein
by reference.
Item 10. Executive Compensation.
The information contained under the caption "Executive Compensation" in the
Company's Proxy Statement for the 2006 Annual Meeting of Shareholders, which
will be filed with the Commission not later than 120 days after the end of the
fiscal year covered by this report, is incorporated herein by reference.
Item 11. Security Ownership of Certain Beneficial Owners and Management.
The information contained under the caption "Security Ownership of Certain
Beneficial Owners and Management" in the Company's Proxy Statement for the 2006
Annual Meeting of Shareholders, which will be filed with the Commission not
later than 120 days after the end of the fiscal year covered by this report, is
incorporated herein by reference.
Information regarding securities authorized for issuance under equity
compensation plans is hereby incorporated by reference to Item 5 of Part II of
this Annual Report on Form 10-KSB, under the heading "Securities Authorized for
Issuance Under Equity Compensation Plans."
Item 12. Certain Relationships and Related Transactions.
The information contained under the caption "Certain Relationship and
Related Transactions" in the Company's Proxy Statement for the 2006 Annual
Meeting of Shareholders, which will be filed with the Commission not later than
120 days after the end of the fiscal year covered by this report, is
incorporated herein by reference.
Item 13. Exhibits.
The following exhibits were filed with or incorporated by reference into this
report.
Exhibit No. Description of Exhibit
----------- ----------------------
Exhibit 3.1 Articles of Incorporation (incorporated by reference to
Exhibit 3.1 to the Company's Registration Statement on Form
SB-2 filed with the Commission on May 10, 1996).
43
Exhibit No. Description of Exhibit
----------- ----------------------
Exhibit 3.2 Bylaws of the Company (incorporated by reference to Exhibit
3.3 to the Company's Registration Statement on Form SB-2
filed with the Commission on May 10, 1996).
Exhibit 3.3 Amendment to Certificate of Incorporation (incorporated by
reference to Exhibit A to the Company's Definitive Proxy
Statement filed with the Commission on October 28, 2002).
Exhibit 3.4 Amendment to Certificate of Incorporation (incorporated by
reference to Exhibit A to the Company's Preliminary Proxy
Statement filed with the Commission on September 13, 2006).
Exhibit 10.1 Service Agreement dated as of August 16, 2001 between
Profile Technologies, Inc. and BP Exploration (Alaska) Inc.
(incorporated by reference to Exhibit 10.1 to the Company's
Annual Report on Form 10-KSB filed with the Commission on
September 28, 2001).
Exhibit 10.2 Loan Agreement dated March 6, 2003, by and between the
Company and Murphy Evans (incorporated by reference to
Exhibit 4.1 to the Company's Quarterly Report on Form 10-QSB
filed with the Commission on May 15, 2003).
Exhibit 10.3 Loan Amendment and Promissory Note dated March 6, 2003, by
and between the Company and Murphy Evans (incorporated by
reference to Exhibit 10.1 to the Company's Quarterly Report
on Form 10-QSB filed with the Commission on May 20, 2003).
Exhibit 10.4 Lease Agreement dated January 26, 2001 by and between the
Company and Fatum LLC. (incorporated by reference to Exhibit
10.4 to the Company's Annual Report on Form 10-KSB filed
with the Commission on October 12, 2004).
Exhibit 10.5 Lease Extension dated February 26, 2003 by and between the
Company and Fatum LLC. (incorporated by reference to Exhibit
10.5 to the Company's Annual Report on Form 10-KSB filed
with the Commission on October 12, 2004).
Exhibit 10.6 Royalty Agreement (incorporated by reference to Exhibit 10.1
to the Company's Registration Statement on Form SB-2 filed
with the Commission on May 10, 1996).
44
Exhibit No. Description of Exhibit
----------- ----------------------
Exhibit 10.7 Assignment of Patent Rights (incorporated by reference to
Exhibit 10.2 to the Company's Registration Statement on Form
SB-2 filed with the Commission on May 10, 1996).
Exhibit 10.8 ConocoPhillips Alaska, Inc., Contract No. AK 990156,
Amendment No. 3 dated February 1, 2003, by and between the
Company and ConocoPhillips Alaska, Inc. (incorporated by
reference to Exhibit 10.2 to the Company's Quarterly Report
on Form 10-QSB filed with the Commission on May 20, 2003).
Exhibit 10.9 1999 Stock Option Plan (incorporated by reference to Exhibit
10.9 to the Company's Annual Report on Form 10-KSB filed
with the Commission on October 12, 2004).
Exhibit 10.10 First Amendment to the 1999 Stock Option Plan (incorporated
by reference to Appendix B to the Company's Preliminary
Proxy Statement filed with the Commission on September 13,
2006).
Exhibit 14.1 Code of Ethics (incorporated by reference to Exhibit 14 to
the Company's Annual Report on Form 10-KSB filed with the
Commission on October 12, 2004).
Exhibit 31.1 Rule 13a-14(a)/15d-14(a) Certification of Henry E. Gemino,
as Chief Executive Officer and Chief Financial Officer of
the Company.
Exhibit 31.2 Rule 13a-14(a)/15d-14(a) Certification of Philip L. Jones,
as Chief Operating Officer and Executive Vice President of
the Company.
Exhibit 32.1 Certification under Section 906 of the Sarbanes-Oxley Act of
2002 by Henry E. Gemino, as Chief Executive Officer and
Chief Financial Officer of the Company.
Exhibit 32.2 Certification under Section 906 of the Sarbanes-Oxley Act of
2002 by Philip L. Jones, as Chief Operating Officer and
Executive Vice President of the Company.
Item 14. Principal Accountant Fees and Services.
The information required by this item is incorporated by reference to the
sections entitled "Independent Public Accountants" and "Principal Accountant
Fees and Services" in the Company's Proxy Statement for the 2006 Annual Meeting
of Shareholders, which will be filed with the Commission not later than 120 days
after the end of the fiscal year covered by this report, is incorporated herein
by reference.
45
SIGNATURES
In accordance with Section 13 or 15(d) of the Exchange Act, the registrant
caused this report to be signed on its behalf by the undersigned, thereunto duly
authorized.
PROFILE TECHNOLOGIES, INC.
By /s/ Henry E. Gemino
---------------------------
Henry E. Gemino
Chief Executive Officer
and Chief Financial Officer
In accordance with the Exchange Act, this report has been signed below
by the following persons on behalf of the registrant in the capacities and as of
the dates indicated:
Signature Title Date
--------- ----- ----
/s/Charles Christenson Director September 28, 2006
----------------------
Charles Christenson
/s/Murphy Evans Director September 28, 2006
---------------
Murphy Evans
/s/Henry E. Gemino Director September 28, 2006
------------------
Henry E. Gemino
/s/William A. Krivsky Director September 28, 2006
---------------------
William A. Krivsky
46
Exhibit Index
Exhibit No. Description of Exhibit
----------- ----------------------
Exhibit 3.1 Articles of Incorporation (incorporated by reference to
Exhibit 3.1 to the Company's Registration Statement on Form
SB-2 filed with the Commission on May 10, 1996).
Exhibit 3.2 Bylaws of the Company (incorporated by reference to Exhibit
3.3 to the Company's Registration Statement on Form SB-2
filed with the Commission on May 10, 1996).
Exhibit 3.3 Amendment to Certificate of Incorporation (incorporated by
reference to Exhibit A to the Company's Definitive Proxy
Statement filed with the Commission on October 28, 2002).
Exhibit 3.4 Amendment to Certificate of Incorporation (incorporated by
reference to Exhibit A to the Company's Preliminary Proxy
Statement filed with the Commission on September 13, 2006).
Exhibit 10.1 Service Agreement dated as of August 16, 2001 between
Profile Technologies, Inc. and BP Exploration (Alaska) Inc.
(incorporated by reference to Exhibit 10.1 to the Company's
Annual Report on Form 10-KSB filed with the Commission on
September 28, 2001).
Exhibit 10.2 Loan Agreement dated March 6, 2003, by and between the
Company and Murphy Evans (incorporated by reference to
Exhibit 4.1 to the Company's Quarterly Report on Form 10-QSB
filed with the Commission on May 15, 2003).
Exhibit 10.3 Loan Amendment and Promissory Note dated March 6, 2003, by
and between the Company and Murphy Evans (incorporated by
reference to Exhibit 10.1 to the Company's Quarterly Report
on Form 10-QSB filed with the Commission on May 20, 2003).
Exhibit 10.4 Lease Agreement dated January 26, 2001 by and between the
Company and Fatum LLC. (incorporated by reference to Exhibit
10.4 to the Company's Annual Report on Form 10-KSB filed
with the Commission on October 12, 2004).
Exhibit 10.5 Lease Extension dated February 26, 2003 by and between the
Company and Fatum LLC. (incorporated by reference to Exhibit
10.5 to the Company's Annual Report on Form 10-KSB filed
with the Commission on October 12, 2004).
47
Exhibit No. Description of Exhibit
----------- ----------------------
Exhibit 10.6 Royalty Agreement (incorporated by reference to Exhibit 10.1
to the Company's Registration Statement on Form SB-2 filed
with the Commission on May 10, 1996).
Exhibit 10.7 Assignment of Patent Rights (incorporated by reference to
Exhibit 10.2 to the Company's Registration Statement on Form
SB-2 filed with the Commission on May 10, 1996).
Exhibit 10.8 ConocoPhillips Alaska, Inc., Contract No. AK 990156,
Amendment No. 3 dated February 1, 2003, by and between the
Company and ConocoPhillips Alaska, Inc. (incorporated by
reference to Exhibit 10.2 to the Company's Quarterly Report
on Form 10-QSB filed with the Commission on May 20, 2003).
Exhibit 10.9 1999 Stock Option Plan (incorporated by reference to Exhibit
10.9 to the Company's Annual Report on Form 10-KSB filed
with the Commission on October 12, 2004).
Exhibit 10.10 First Amendment to the 1999 Stock Option Plan (incorporated
by reference to Appendix B to the Company's Preliminary
Proxy Statement filed with the Commission on September 13,
2006).
Exhibit 14.1 Code of Ethics (incorporated by reference to Exhibit 14 to
the Company's Annual Report on Form 10-KSB filed with the
Commission on October 12, 2004).
Exhibit 31.1 Rule 13a-14(a)/15d-14(a) Certification of Henry E. Gemino,
as Chief Executive Officer and Chief Financial Officer of
the Company.
Exhibit 31.2 Rule 13a-14(a)/15d-14(a) Certification of Philip L. Jones,
as Chief Operating Officer and Executive Vice President of
the Company.
Exhibit 32.1 Certification under Section 906 of the Sarbanes-Oxley Act of
2002 by Henry E. Gemino, as Chief Executive Officer and
Chief Financial Officer of the Company.
Exhibit 32.2 Certification under Section 906 of the Sarbanes-Oxley Act of
2002 by Philip L. Jones, as Chief Operating Officer and
Executive Vice President of the Company.
48