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ISC8 INC. /DE - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
(Edgar Glimpses Via Acquire Media NewsEdge) Overview
We are engaged in the design, development, manufacture and sale of a family of
security products, consisting of cyber security solutions for commercial and
U.S. government applications, secure memory products, some of which utilize
technologies that we have pioneered for 3-D stacking of semiconductors, Systems
in a Package or SIP, and anti-tamper systems. In our government systems
portfolio, we utilize technologies such as high-speed processor assemblies and
miniaturized vision systems and sensors. In addition, we offer custom stacked
solutions for other customer specific systems in package applications. We also
perform customer-funded contract research and development related to these
products, mostly for U.S. government customers or prime contractors. We
generally use contract manufacturers to produce our products or their
subassemblies. Our current operations are located in California, Texas, and
Italy with other employees and consultants in various other locations globally.
Our operation in Italy was acquired in connection with our acquisition of
certain software assets of Bivio Networks, Inc. in October 2012.
As of September 30, 2012, we had approximately $27.1 million of debt, exclusive
of debt discounts, and approximately $3.3 million of accounts payable and
accrued expenses.
Critical Accounting Estimates
Our consolidated financial statements have been prepared in conformity with
accounting principles generally accepted in the United States of America
("GAAP"). As such, management is required to make judgments, estimates and
assumptions that affect the reported amounts of assets and liabilities at the
date of the consolidated financial statements and the reported amounts of
revenues and expenses during the reporting period. The significant accounting
policies that are most critical to aid in fully understanding and evaluating
reported financial results include the following:
Revenue Recognition. Our consolidated total revenues during Fiscal 2012 were
primarily derived from two sources, (i) contracts to develop prototypes and
provide research, development, design, testing and evaluation of complex
detection and control defense systems, and (ii) product sales.
Research and Development Contracts. This segment relates primarily to our
Government contracting business, our cyber products and some of our Secure
Memory products which are funded internally and are part of our operating
expense. The terms of our government research and development contracts are
usually cost reimbursement plus a fixed fee, fixed price with billing
entitlements based on the level of effort we expend, or occasionally firm fixed
price. Our cost reimbursement plus fixed fee research and development contracts
require our good faith performance of a statement of work within overall
budgetary constraints, but with latitude as to resources utilized. Our fixed
price level of effort research and development contracts require us to deliver a
specified number of labor hours in the performance of a statement of work. Our
firm fixed price research and development contracts require us to deliver
specified items of work independent of resources utilized to achieve the
required deliverables. For all types of research and development contracts, we
recognize revenues as we incur costs and include applicable fees or profits
primarily in the proportion that costs incurred bear to estimated final costs.
Costs and estimated earnings in excess of billings under U.S. government
research and development contracts are accounted for as unbilled revenues on
uncompleted contracts, stated at estimated realizable value and are expected to
be realized in cash within one year.
Upon the initiation of each research and development contract, a detailed cost
budget is established for direct labor, material, subcontract support and
allowable indirect costs based on our proposal and the required scope of the
contract as may have been modified by negotiation with the customer, usually a
U.S. government agency or prime contractor. A program manager is assigned to
secure the needed labor, material and subcontract in the program budget to
achieve the stated goals of the contract and to manage the deployment of those
resources against the program plan. Our accounting department collects the
direct labor, material and subcontract charges for each contract and provides
such information to the respective program managers and senior management.
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The program managers review and report the performance of their contracts
against the respective program plans with our senior management on a monthly
basis. These reviews are summarized in the form of estimates of costs to
complete the contracts ("ETCs"). If an ETC indicates a potential overrun against
budgeted program resources, it is the responsibility of the program manager to
revise the program plan in a manner consistent with the customer's objectives to
eliminate such overrun and achieve planned contract profitability, and to seek
necessary customer agreement to such revision. To mitigate the financial risk of
such re-planning, we attempt to negotiate the deliverable requirements of our
research and development contracts to allow as much flexibility as possible in
technical outcomes. Given the inherent technical uncertainty involved in
research and development contracts, in which new technology is being invented,
explored or enhanced, such flexibility in terms is frequently achievable. When
re-planning does not appear possible within program budgets, senior management
makes a judgment as to whether the program statement of work will require
additional resources to be expended to meet contractual obligations or whether
it is in our interest to supplement the customer's budget with our own funds. If
either determination is made, we record an accrual for the anticipated contract
overrun based on the most recent ETC of the particular contract.
We provide for anticipated losses on contracts by recording a charge to earnings
during the period in which a potential for loss is first identified. We adjust
the accrual for contract losses quarterly based on the review of outstanding
contracts. Upon completion of a contract, we reduce any associated accrual of
anticipated loss on such contract as the previously recorded obligations are
satisfied.
We consider many factors when applying GAAP related to revenue recognition.
These factors generally include, but are not limited to:
• The actual contractual terms, such as payment terms, delivery dates, and
pricing terms of the various product and service elements of a contract;
• Time period over which services are to be performed;
• Costs incurred to date;
• Total estimated costs of the project;
• Anticipated losses on contracts; and
• Collectability of the revenues.
We analyze each of the relevant factors to determine its impact, individually
and collectively with other factors, on the revenue to be recognized for any
particular contract with a customer. Our management is required to make
judgments regarding the significance of each factor in applying the revenue
recognition standards, as well as whether or not each factor complies with such
standards. Any misjudgment or error by our management in evaluation of the
factors and the application of the standards could have a material adverse
effect on our future operating results.
Product Sales. Our revenues derived from product sales in Fiscal 2012 and
Fiscal 2011 were primarily the result of shipments of sales of our stacked chip
products. Production orders for our products are generally priced in accordance
with established price lists. We primarily ship chip stack products to original
equipment manufacturers ("OEMs").
We recognize revenue from product sales upon shipment, provided that the
following conditions are met:
• There are no unfulfilled contingencies associated with the sale;
• We have a sales contract or purchase order with the customer; and
• We are reasonably assured that the sales price can be collected.
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The absence of any of these conditions, including the lack of shipment, would
cause revenue recognition to be deferred. Our terms are freight on board ("FOB")
shipping point.
We record product support expenses incurred and accrue such expenses expected to
be incurred in relation to shipped products. We do not offer contractual price
protection on any of our products. Accordingly, we do not maintain any reserves
for post-shipment price adjustments.
We do not utilize distributors for the sale of our products, but we are engaged
with channel partners that act as an extension of our internal sales team. We do
not enter into revenue transactions in which the customer has the right to
return product. Accordingly, we do not make any provisions for sales returns or
adjustments in the recognition of revenue.
Valuation Allowances. We maintain allowances for doubtful accounts for
estimated losses resulting from a deterioration of a customer's ability to make
required payments to the point where we believe it is likely that there has been
an impairment of its ability to make payments. Such allowances are established,
maintained or modified at each reporting date based on the most current
available information. We record a valuation allowance to reduce our deferred
tax assets to the amount that is more likely than not to be realized. We have
considered future taxable income and ongoing prudent and feasible tax planning
strategies in assessing the need for the valuation allowance.
Stock-Based Compensation. We calculate stock option-based compensation by
estimating the fair value of each option using the Black-Scholes option-pricing
model. Our determination of fair value of stock option-based payment awards is
made as of their respective dates of grant using the Black-Scholes
option-pricing model and is affected by our stock price, as well as assumptions
regarding a number of other variables, including the expected stock price
volatility over the term of the awards, the portion of stock options granted
that will ultimately vest, and the periods from the grant date until the options
vest and expire. The Black-Scholes option-pricing model was developed for use in
estimating the value of traded options that have no vesting or hedging
restrictions and are fully transferable. Because our employee stock options have
certain characteristics that are significantly different from traded options,
the existing valuation models may not provide an accurate measure of the fair
value of our outstanding employee stock options. We recognize compensation
expense on a straight-line basis over the requisite service period of the option
after consideration of the estimated forfeiture rate.
We calculate compensation expense for both vested and nonvested stock awards by
determining the fair value of each such grant as of their respective dates of
grant using the closing sales price of our common stock on the OTCBB at such
dates without any discount. We recognize compensation expense for nonvested
stock awards on a straight-line basis over the requisite service period.
Executive Salary Continuation Plan Liability. We have estimated liability
related to our Executive Salary Continuation Plan (the "ESCP") based upon the
expected lifetime of participants using Social Security mortality tables and
discount rates comparable to rates of return on high quality investments
providing yields in amount and timing equivalent to expected benefit payments.
At the end of each fiscal year, we determine the assumed discount rate to be
used to discount ESCP liability. We considered various sources in making this
determination, including the Citigroup Pension Liability Index, which was 3.94%
at September 30, 2012. Based upon this review, we used a 3.94% discount rate for
determining ESCP liability at September 30, 2012.
Derivatives. A derivative is an instrument, the value of which is "derived"
from an underlying instrument or index such as a future, forward, swap, option
contract, or other financial instrument with similar characteristics, including
certain derivative instruments embedded in other contracts ("embedded
derivatives") and for hedging activities. As a matter of policy, we do not
invest in separable financial derivatives or engage in hedging transactions.
However, we have entered into complex financing transactions, including certain
convertible debt transactions in Fiscal 2011 and 2012 and certain warrant grants
in Fiscal 2012, that involve financial instruments containing certain features
that have resulted in the instruments being deemed derivatives or containing
embedded derivatives. We may engage in other similar complex debt transactions
in the future, but not with the intention to enter into derivative instruments.
Derivatives and embedded derivatives, if applicable, are measured at fair value
using the binomial lattice pricing model and marked to market through earnings.
However, such new and/or complex instruments may have immature or limited
markets. As a result, the pricing models used for valuation of derivatives often
incorporate significant estimates and assumptions, which may impact the level of
precision in the financial statements. Furthermore, depending on the terms of a
derivative or embedded derivative, the valuation of derivatives may be removed
from the financial statements upon conversion of the underlying instrument into
some other security.
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COMPARISON OF FISCAL YEARS ENDED SEPTEMBER 30, 2012 AND OCTOBER 2, 2011
Results of Operations
Total Revenues. Our total revenues are generally derived from sales of
specialized chips, modules, stacked chip products, secure memory products and
amounts realized or realizable from funded research and development contracts,
largely from U.S. government agencies and U.S. government contractors. Our total
revenues decreased by approximately $1.0 million in Fiscal 2012 as compared to
total revenues in Fiscal 2011, and changed in composition as shown in the
following table and discussed more fully below.
Total Revenues
Fiscal 2011 $ 5,178,300
Dollar decrease in Fiscal 2012 (981,900 )
Fiscal 2012 $ 4,196,400
Percentage decrease for Fiscal 2012 (19 %)
The decrease in our total revenues in Fiscal 2012 as compared to Fiscal 2011 was
primarily the result of an overall decline in funded research and development
contracts in the current fiscal year. We believe this decrease was substantially
related to the timing of funding or shipment releases under existing contracts
and the size and availability of award of new contracts. We are unable to
ascertain what future effects the U.S. defense budget timing may have on our
total revenues for Fiscal 2013. We are promoting sales of our recently
introduced products, which, while no assurances can be given, could become a
material contributor to our total revenues in Fiscal 2013.
Total Cost of Revenues. Cost of revenues includes wages and related benefits of
our personnel, as well as subcontractor, independent consultant and vendor
expenses directly incurred in the manufacture of products sold or in the
performance of funded research and development contracts, plus related overhead
expenses and, in the case of funded research and development contracts, such
other indirect expenses as are permitted to be charged pursuant to the relevant
contracts. Our cost of revenues for Fiscal 2012 decreased as compared to Fiscal
2011 in terms of both absolute dollars and as a percentage of total revenues, as
shown in the following table:
Percentage of
Cost of Revenues Total Revenues
Fiscal 2011 $ 4,771,700 92 %
Dollar decrease in Fiscal 2012 (1,622,700 )
Fiscal 2012 $ 3,149,000 75 %
Percentage decrease for Fiscal 2012 (34 %)
The decrease in absolute dollar cost of revenues in Fiscal 2012 as compared to
Fiscal 2011 was primarily the result of a decrease in funded research and
development contract cost of revenue in the comparable periods, which
corresponds with a decrease in total revenues related to funded research and
development contracts in the comparable periods. This decrease also related to a
non-recurring charge made in December 2010 due to one-time compensation to our
staff in consideration of the salary reductions and deferrals experienced in
Fiscal 2010 and the first quarter of Fiscal 2011. The portion allocated to
overhead was applied to cost of revenues in Fiscal 2011 with no comparable
expense incurred in Fiscal 2012. Because of the nature of these non-recurring
expenses, management does not believe that the changes in cost of revenues as a
percentage of total revenues in the comparable periods are indicative of a
continuing trend.
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General and Administrative Expense. General and administrative expense largely
consists of wages and related benefits for our executive, financial,
administrative and marketing staff, as well as professional fees and costs,
primarily legal and accounting, plus various fixed costs such as rent, utilities
and telephone. The comparison of general and administrative expense for Fiscal
2012 and Fiscal 2011 is shown in the following table:
General and
Administrative Percentage of
Expense Total Revenue
Fiscal 2011 $ 7,874,600 152 %
Dollar increase in Fiscal 2012 834,200
Fiscal 2012 $ 8,708,800 208 %
Percentage increase for Fiscal 2012 11 %
The largest contributor to the increase in general and administrative expense in
Fiscal 2012 as opposed to Fiscal 2011 was an increase in stock-based
compensation, including the acceleration of vesting of stock options upon the
retirement of our former Chief Financial Officer in December 2011. This
non-recurring expense, as well as increased expense related to marketing
personnel, was partially offset by decreases in bid and proposal fees, and SEC
and stockholder-related expenses in Fiscal 2012 as compared to Fiscal 2011.
Research and Development Expense. Research and development expense consists of
wages and related benefits for our research and development staff, independent
contractor consulting fees and subcontractor and vendor expense directly
incurred in support of internally funded research and development projects, plus
associated overhead expense. Research and development expense for Fiscal 2012 as
compared to Fiscal 2011 increased as shown in the following table:
Research and Percentage of
Development Expense Total Revenue
Fiscal 2011 $ 3,171,600 61 %
Dollar increase in Fiscal 2012 4,704,000
Fiscal 2012 $ 7,875,600 188 %
Percentage increase for Fiscal 2012 148 %
The increase in our research and development expense in Fiscal 2012 as compared
to Fiscal 2011 was largely related to the acceleration of our development
expense of our cyber security products incurred subsequent to the opening and
staffing of an office in Texas for development of those products in April 2011.
Many of the expenses of this office have been allocated to research and
development expense, including software licensing expense incurred to support
our cyber security product development. Concurrent with implementation of this
focused cyber security product development activity, we de-emphasized other
internal research and development activities. The net effect of these changes
was an increase in absolute dollars of research and development expense in
Fiscal 2012 as compared to Fiscal 2011. We expect to continue to allocate
significant resources to the development of our cyber security products in
future periods, which may result in further increases in research and
development expense as compared to prior fiscal year periods.
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Interest Expense. Our interest expense for Fiscal 2012, compared to that of
Fiscal 2011, decreased as shown in the following table:
Interest Expense
Fiscal 2011 $ 7,544,700
Dollar decrease in Fiscal 2012 (963,600 )
Fiscal 2012 $ 6,581,100
Percentage decrease in Fiscal 2012 (13 %)
The decrease in interest expense in Fiscal 2012 as compared to Fiscal 2011 was
attributable primarily to interest and amortization of debt discounts and
financing related costs on our Bridge Notes that was incurred in Fiscal 2011. No
similar expenses were incurred during Fiscal 2012. This decrease was mainly
offset by interest and amortization of debt discounts and financing related
costs incurred during Fiscal 2012, which resulted from our Revolving Facility
and 2012 Notes.
Change in Fair Value of Derivative Liability. We recorded a substantial
decrease in fair value of derivative liability for Fiscal 2012, compared to
Fiscal 2011, as shown in the following table:
Change in Fair Value of
Derivative Liability
Fiscal 2011 $ 1,512,700
Dollar decrease in Fiscal 2012 (6,334,800 )
Fiscal 2012 $ (4,822,100 )
Percentage decrease in Fiscal 2012 (419 %)
As of September 30, 2012, instruments deemed to be derivatives consisted of
embedded derivatives related to our Subordinated Notes, 2012 Notes, and certain
warrants issued in connection with our Revolving Line of Credit. The Company
revalued these derivatives as of September 30, 2012 and recorded an increase in
their fair value to approximately $18.1 million, $0.1 million, and $1.7 million
respectively for Fiscal 2012. Given the price volatility of our common stock, we
anticipate that there could be additional substantial change in fair value of
derivative liability expense that we will be required to record in future
reporting periods, unless and until the Subordinated Notes and 2012 Notes are
converted into, and/or the warrants are exercised for the purchase of shares of
common stock pursuant to their respective terms. In the event of such conversion
or exercise, the derivative liability associated with these instruments would be
eliminated.
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Net Loss. Our net loss for Fiscal 2012 increased as compared to Fiscal 2011 as
shown in the following table:
Net Loss
Fiscal 2011 $ (15,762,800 )
Dollar increase in Fiscal 2012 (3,905,600 )
Fiscal 2012 $ (19,668,400 )
Percentage increase in Fiscal 2012 (25 %)
The increase in net loss in Fiscal 2012 as compared to Fiscal 2011 was
substantially attributable to lower revenue and higher total operating expense
primarily driven by higher research and development costs associated with our
cyber security products.
Liquidity and Capital Resources
Our liquidity in terms of cash and cash equivalents was affected positively by
the proceeds realized from the sale of our Thermal Imaging Business as well as
the proceeds of additional debt issuance, which was offset by significant cash
used in operations. Our working capital deficit was affected negatively in
Fiscal 2012, largely as a result of net losses generated from continuing
operations, partially offset by the proceeds realized from the sale of our
Thermal Imaging Business, as shown in the following table:
Cash and Working Capital
Cash Equivalents (Deficit)
October 2, 2011 $ 2,734,600 $ (4,119,800 )
Dollar change in Fiscal 2012 (996,200 ) (5,971,000 )
September 30, 2012 $ 1,738,400 $ (10,090,800 )
Percentage change in Fiscal 2012 (36 %) (145 %)
The aggregate of our non-cash depreciation and amortization expense, non-cash
interest expense, non-cash change in fair value of derivative liability, and
non-cash stock-based compensation was $13,041,400 in Fiscal 2012. These non-cash
operational expenses partially offset the use of cash derived from our net loss
from operations and various timing and cash deployment effects, the largest of
which was a $100,500 decrease in advance billings on uncompleted contracts. The
aggregate of these and other less significant factors contributed to our
operational use of cash in the amount of $12,715,700 in Fiscal 2012. During
Fiscal 2012, we also received $5.0 million in cash as proceeds from our
Revolving Credit Facility and used approximately $2,729,400 to pay in full a
secured promissory note previously issued by us to Mr. Timothy Looney (the
"Secured Promissory Note"). We received an additional $1.2 million in cash as
proceeds from the issuance of a Senior Subordinated Convertible Promissory Note
to Griffin in September 2012. The totality of these financing activities and
other less significant activities yielded net cash of $3,523,300. We also used
$438,200 of cash for equipment expenditures in Fiscal 2012. These and other uses
of cash were offset by $8,634,400 of net cash provided by discontinued
operations, derived from the sale of our Thermal Imaging Business, resulting in
a net decrease of cash in the amount of $996,200 in the Fiscal 2012. These
proceeds from financing and discontinued operations were the primary source of
improvement in our working capital in the current period. The repayment
obligations of our debt over the next twelve months will be substantial, and if
we are unable to meet these obligations in a timely manner, or at all, our
business, results of operations and financial condition could be materially and
adversely affected.
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Our Senior Subordinated Notes have a feature that permits the holders to demand
repayment any time on or after July 16, 2012. Although the holders did not
exercise this right on that date and have given no present indication that they
intend to exercise this right, its possibility requires us to classify the
approximate $4.8 million balance of the Senior Subordinated Notes as a current
obligation at September 30, 2012.
At September 30, 2012, our funded backlog was approximately $1.7 million.
Although no assurances can be given, we expect that a substantial portion of our
funded backlog at September 30, 2012 will result in revenue recognized in the
next twelve months, provided that we are able to enhance our liquidity to meet
our working capital requirements. In addition, our U.S. government research and
development contracts and product purchase orders typically include unfunded
backlog, which is funded when the previously funded amounts have been expended
or product delivery schedules are released. As of September 30, 2012, our total
backlog, including unfunded portions, was approximately $2.1 million.
Contracts with U.S. government agencies may be suspended or terminated by the
U.S. government at any time, subject to certain conditions. Similar termination
provisions are typically included in agreements with prime contractors. While we
have only experienced a limited number of contract terminations, none of which
were recent, we cannot assure you that we will not experience suspensions or
terminations in the future. Any such termination, if material, could cause a
disruption of our revenue stream, materially adversely affect our liquidity and
results of operations and could result in employee layoffs.
Management is currently seeking to raise additional funds to meet our continuing
obligations and short-term working capital requirements. We may not be able to
complete any such transactions on acceptable terms, on a timely basis or at all,
and even if completed, such transactions could materially and adversely affect
our future revenues. Furthermore, we have lenders with security interests in
substantially all of our assets, and any asset-based transactions would require
such lenders' consent and be unlikely to generate any direct benefits to
stockholders.
Contractual Obligations and Commitments
Debt. At September 30, 2012, we had approximately $27.1 million of debt,
exclusive of discounts, which consisted of (i) an "Initial Revolving Loan", in
the original principal amount of $5.0 million; (ii) "Subordinated Notes" with an
aggregate principal balance of approximately $16.1 million; (iii) "Senior
Subordinated Notes" with an aggregate principal balance of approximately $4.8
million, and (iv) "Senior Subordinated Convertible Notes" with an aggregate
principal balance of approximately $1.2 million. Each of these instruments is
described more fully below.
In December 2011, we entered into a Loan and Security Agreement (the "Loan
Agreement") with Partners for Growth, L.P. ("PFG") pursuant to which we obtained
the two-year, $5.0 million line of credit (the "Revolving Credit Facility").
Upon execution of the Loan Agreement, we borrowed the entire $5.0 million
available thereunder (the "Initial Revolving Loan") and used approximately $1.9
million of that Initial Revolving Loan to repay the Secured Promissory Note. We
used the remaining proceeds of the Initial Revolving Loan, less expenses
thereof, for general working capital purposes.
The maturity date for the Initial Revolving Loan and any other loans issued
pursuant to the Revolving Credit Facility (collectively, the "Loans") is
December 14, 2013 (the "Maturity Date"). Interest on the Loans accrues at the
rate of 12% per annum. Interest only on the Loans is payable monthly on the
third business day of each month for interest accrued during the prior month,
and the remaining balance is payable on the Maturity Date. Each of Costa Brava
and Griffin, individually and collectively, jointly and severally, have
unconditionally guaranteed repayment to PFG of $2.0 million of our monetary
obligations under the Loan Agreement.
To secure the payment of all of our obligations under the Loans when due, we
granted to PFG a first position, continuing security interest in substantially
all of our assets, including substantially all of our intellectual property,
subject to the commitment by PFG to release any security interests in the assets
of the Thermal Imaging Business that we sold. That sale was consummated on
January 31, 2012, and PFG subsequently released the related security interests.
In addition, Costa Brava, Griffin and certain other of our existing creditors
have agreed that, while any obligations remain outstanding by us to PFG, their
respective security interests in and liens on our assets shall be subordinated
and junior to those of PFG.
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As of September 28, 2012, we issued and sold to Griffin a 12% Senior
Subordinated Convertible Note due November 30, 2012 (the "Senior Subordinated
Convertible Note") in the principal amount of $1.2 million. Subsequently, in
November 2012, the Senior Subordinated Convertible Note was amended to be due
March 31, 2013. Therefore, the Senior Subordinated Convertible Note has been
classified as a current obligation in our consolidated balance sheet as of
September 30, 2012.
Capital Lease Obligations. The outstanding principal balance on our capital
lease obligations of $79,800 at September 30, 2012 relate primarily to computer
equipment and software and are included as part of current and non-current
liabilities within our consolidated balance sheet.
Operating Lease Obligations. We have various operating leases covering
equipment and facilities located at our facilities in Costa Mesa, California and
Richardson, Texas.
Deferred Compensation. We have a deferred compensation plan, the Executive
Salary Continuation Plan or ESCP, for select key employees. Benefits payable
under the ESCP are established on the basis of years of service with the
Company, age at retirement and base salary, subject to a maximum benefits
limitation of $137,000 per year for any individual. The ESCP is an unfunded
plan. The recorded liability for future expense under the ESCP is determined
based on expected lifetime of participants using Social Security mortality
tables and discount rates comparable to that of rates of return on high quality
investments providing yields in amount and timing equivalent to expected benefit
payments. At the end of each fiscal year, we determine the assumed discount rate
to be used to discount the ESCP liability. We considered various sources in
making this determination for Fiscal 2012, including the Citigroup Pension
Liability Index, which was 3.94% at September 30, 2012. Based upon this review,
we used a 3.94% discount rate for determining ESCP liability at September 30,
2012. Presently, two of our retired executives are receiving benefits
aggregating $184,700 per annum under the ESCP. As of September 30, 2012,
$1,159,700 has been accrued in the accompanying consolidated balance sheet for
the ESCP, of which amount $184,700 is a current liability we expect to pay
during Fiscal 2013.
Stock-Based Compensation
Aggregate stock-based compensation for Fiscal 2012 and Fiscal 2011 was
$1,618,600 and $1,202,400, respectively, and was included in:
Fiscal 2012 Fiscal 2011
Cost of revenue $ 279,700 $ 49,900
General and administrative expense 1,338,900 1,152,500
$ 1,618,600 $ 1,202,400
All transactions in which goods or services are the consideration received for
equity instruments issued to non-employees are accounted for based on the fair
value of the consideration received or the fair value of the equity instrument
issued, whichever is more reliably measurable. The measurement date used to
determine the fair value of any such equity instrument is the earliest to occur
of (i) the date on which the third-party performance is complete, (ii) the date
on which it is probable that performance will occur, or (iii) if different, the
date on which the compensation has been earned by the non-employee. In Fiscal
2012, we issued to PFG warrants to purchase 15.0 million shares of our common
stock, valued at $250,000 in connection with the Revolving Credit Facility. If
the Company attains certain specified revenue and EBITDA thresholds for calendar
year 2012, the aggregate number of shares issuable upon exercise of the PFG
Warrants will be reduced to 10,000,000 shares. We have recorded this expense as
a debt discount, which is being amortized over the two-year term of the
Revolving Credit Facility. In Fiscal 2011, we issued warrants to purchase
2,382,400 shares of our common stock, valued at $190,600, to an investment
banking firm for services rendered in a private placement. We recorded this
expense as a debt discount, which was fully amortized during Fiscal 2011.
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We have historically issued stock options to employees and outside directors for
which the only condition for vesting was continued employment or service during
the related vesting period. Typically, awards are granted with up to a four-year
vesting period for employee awards, immediate vesting or a one-year vesting
period for directors, although some director awards have been granted with a
two-year vesting period. In some fiscal years, we have also issued nonvested
stock grants to new employees and outside directors. The typical restriction
period for such grants is three years. We may impose other performance criteria
for the vesting of options or nonvested stock granted in the future.
We calculate stock option-based compensation by estimating the fair value of
each option granted using the Black-Scholes option valuation model and various
assumptions that are described in Note 1 to our Consolidated Financial
Statements. Once the compensation cost of an option is determined, we recognize
that cost on a straight-line basis over the requisite service period of the
option, which is typically the vesting period for options granted by us. We
calculate compensation expense of both vested and nonvested stock grants by
determining the fair value of each such grant as of their respective dates of
grant using our stock price at such dates with no discount. We recognize
compensation expense on a straight-line basis over the requisite service period
of a nonvested stock award.
For Fiscal 2012, stock-based compensation included compensation costs
attributable to such period for those options that were not fully vested upon
adoption of ASC 718, Compensation - Stock Compensation, compensation costs for
options and non-vested stock grants that were awarded during the period,
prorated from the date of award to September 30, 2012, adjusted for estimated
forfeitures and compensation costs for vested stock grants made during Fiscal
2012. During Fiscal 2012, options to purchase 7,765,500 shares of our common
stock were granted and previous awards of 7,900 shares of nonvested stock were
vested.
At September 30, 2012, the total compensation costs related to nonvested option
awards not yet recognized was $1,407,400. The weighted-average remaining vesting
period of nonvested options at September 30, 2012 was 1.0 years.
Off-Balance Sheet Arrangements
Our conventional operating leases are either immaterial to our financial
statements or do not contain the types of guarantees, retained interests or
contingent obligations that would require their disclosures as an "off-balance
sheet arrangement" pursuant to Regulation S-K Item 303(a)(4). As of September
30, 2012 and October 2, 2011, we did not have any other relationships with
unconsolidated entities or financial partners, such as entities often referred
to as structured finance or special purpose entities, which would have been
established for the purpose of facilitating off-balance sheet arrangements or
other contractually narrow or limited purposes.
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