Item 1. Business
Overview
Level 8 Systems, Inc. (the “Company” or “Level 8”) is a provider of business integration software, known as Cicero, which enables organizations to integrate new and existing information and processes at the desktop. Our Cicero business integration software addresses the emerging need for companies’ information systems to deliver enterprise-wide views of their business information processes. In addition to software products, Level 8 also provides technical support, training and consulting services as part of its commitment to providing its customers with industry-leading integration solutions. Level 8’s consulting team has in-depth experience in developing successful enterprise-class solutions as well as valuable insight into the business information needs of customers in the Global 5000.
The Company’s focus is on the growing desktop integration and business process automation market with our Cicero® product. Cicero is a business application integration platform that enhances end-user productivity, streamlines business operations and integrates systems and applications that would not otherwise work together. Cicero software offers a proven, innovative departure from traditional, costly and labor-intensive enterprise application integration, which occurs at the server level. Cicero provides non-invasive application integration at the desktop level. Desktop level integration provides the user with a single environment with a consistent look and feel for diverse applications across multiple operating environments, reduces enterprise integration implementation cost and time, and supports a Service-Oriented Architecture (SOA). Cicero’s desktop level integration also enables clients to transform applications, business processes and human expertise into a seamless, cost effective business solution that provides a cohesive, task-oriented and role-centric composite interface that works the way people think.
By using Cicero software, companies can decrease their customer management costs, increase their customer service level and more efficiently cross-sell the full range of their products and services resulting in an overall increase in return on their information technology investments. In addition, Cicero software enables organizations to reduce the business risks inherent in replacement of mission-critical applications and extend the productive life and functional reach of their application portfolio.
Cicero software is engineered to harness diverse business applications and shape them to more effectively serve the people who use them. Cicero provides an intuitive integration and development environment, which simplifies the integration of complex multi-platform applications. Cicero provides a unique approach that allows companies to organize components of their existing applications to better align them with tasks and operational processes. In addition, Cicero can streamline end-user tasks by providing a single, seamless user interface for simple access to multiple systems or be configured to display one or more composite applications to enhance productivity. Cicero software enables automatic information sharing among line-of-business applications and tools. It is ideal for deployment in contact centers where its highly productive, task-oriented user interface promotes user efficiency. Finally, Cicero software, by integrating diverse applications across multiple operating systems, is ideal for the financial services, for which Cicero was initially developed, insurance, telecommunications, intelligence, security, law enforcement, governmental and other industries requiring a cost-effective, proven application integration solution. Cicero is also an integration solution for merger and acquisition events where the sharing of data and combining of systems is imperative.
Some of the companies and other users that have implemented or are implementing our Cicero software product include Nationwide Financial Services, arvato services (a division of Bertelsmann A.G.), Science Applications International Corporation, IBM and N.E.W. Customer Service Companies. Since the beginning of 2005, we have experienced interest from intelligence, security, law enforcement and other government users. The U.S. Department of Agriculture installed Cicero software in January 2005, and the West Windsor Township, New Jersey Police Department deployed Cicero software in spring 2005.
In addition to our Cicero product, our Ensuredmail email encryption products address information and security compliance requirements from the individual to the enterprise. The Ensuredmail suite of products includes the Enterprise Email Encryption Server, Small Business Email Encryption Server, and Email Encryption Desktop for individual use. All of the Ensuredmail products use 3-DES encryption technology and are tested and federally certified FIPS 140-1. Ensuredmail products are easy to install, use and administer. They also use rules and other utilities that allow users to flag messages including attachments for encryption. Unlike other secure email encryption software applications, Ensuredmail products do not require the recipient to install software or use special secure keys to open and read messages and attachments. In conjunction with Cicero software, Ensuredmail email encryption technology has been used to secure information shared in Cicero integration projects.
Some of the companies using Ensuredmail server products include the United Postal Service, E-Loan, the U.S. Bureau of Alcohol, Tobacco, Firearms and Explosives, Science Application International Association, Physicians Plus Insurance Company, Wilmington Trust, Delta Dental, Truog-Ryding Company, and hundreds of individual users with the Ensuredmail Email Desktop product. Ensuredmail customers use email encryption primarily to secure outbound messages with confidential information for compliance (e.g., HIPAA) and security purposes.
Level Systems, Inc. was incorporated in New York in 1988, and re-incorporated in Delaware in 1999. Our principal executive offices are located to 1433 State Highway 34, Building C, Farmingdale, New Jersey 07727 and our telephone number is (732) 919-3150. Our web site is located at www.level8.com.
Strategic Realignment
Historically, Level 8 Systems, Inc. has been a global provider of software solutions to help companies integrate new and existing applications as well as extends those applications to the Internet. This market segment is commonly known as “Enterprise Application Integration” or “EAI.” Historically, EAI solutions work directly at the server or back-office level allowing disparate applications to communicate with each other.
Until early 2001, we focused primarily on the development, sale and support of EAI solutions through our Geneva product suite. After extensive strategic consultation with outside advisors and an internal analysis of our products and services, we recognized that a new market opportunity had emerged. This opportunity was represented by the increasing need to integrate applications that are physically resident on different hardware platforms, a typical situation in larger companies. In most cases, companies with large customer bases utilize numerous different, or "disparate," applications that were not designed to effectively communicate and pass information. In addition, traditional EAI is often times too costly and time-consuming to implement. It also requires a group of programmers with the necessary skills and ongoing invasive changes to application software code throughout the enterprise. With Cicero software, which non-invasively integrates the functionality of these disparate applications at the desktop, we believe that we have found a unique solution to this disparate application problem. We believe that our existing experience in and understanding of the EAI marketplace coupled with the unique Cicero software solution, which approaches traditional EAI needs in a more effective manner, position us to be a competitive provider of business integration solutions to the financial services and other industries with large deployed call centers, as well as our other target markets.
We originally licensed the Cicero technology and related patents on a worldwide basis from Merrill Lynch, Pierce, Fenner & Smith Incorporated in August of 2000 under a license agreement containing standard provisions and a two-year exclusivity period. On January 3, 2002, the license agreement was amended to extend our exclusive worldwide marketing, sales and development rights to Cicero in perpetuity (subject to Merrill Lynch's rights to terminate in the event of bankruptcy or a change in control of Level 8) and to grant ownership rights in the Cicero trademark. Merrill Lynch indemnifies us with regard to the rights granted to us by them. Consideration for the original Cicero license consisted of 1,000,000 shares of our common stock. In exchange for the amendment, we granted an additional 250,000 shares of common stock to MLBC, Inc., a Merrill Lynch affiliate and entered into a royalty sharing agreement. Under the royalty sharing agreement, we pay a royalty of 3% of the sales price for each sale of Cicero or related maintenance services. The royalties over the life of the agreement are not payable in excess of $20 million. We have completely re-implemented the Cicero software to provide increased functionality and much more powerful integration capabilities.
In April 2001, management reassessed the methodology by which Level 8 would make operating decisions and allocate resources. Operating decisions and performance assessments were based on the following reportable segments: (1) Desktop Integration (Cicero), (2) System Integration (Geneva Enterprise Integrator and Geneva Business Process Automator) and (3) Messaging and Application Engineering (Geneva Integration Broker, Geneva Message Queuing, Geneva XIPC and Geneva AppBuilder). In connection with executing our strategic realignment and focusing on Cicero, we have restructured our business, reduced our number of employees and, in the fourth quarter of 2002, sold the remaining assets associated with Geneva Enterprise Integrator and Geneva Business Process Automator. We have sold most of the assets comprising the Messaging and Application Engineering Products segment and all of the assets in the Systems Integration Segment. Level 8 has recognized the Systems Integration segment as a discontinued business and accordingly, has reclassified those assets and liabilities on the accompanying balance sheets for 2002 and 2003 and segregated the results of operations under gain or loss from a discontinued business on the accompanying statement of operations. As such, the Systems Integration segment has been eliminated. Geneva Integration Broker is the only current software product represented in the Messaging and Application Engineering segment.
The Company’s future revenues are entirely dependent on acceptance of Cicero which has limited success in commercial markets to date. The Company has experienced negative cash flows from operations for the past three years and operating losses for those three years. At December 31, 2005, the Company had a working capital deficiency of approximately $13,894,000. Accordingly, there is substantial doubt that the Company can continue as a going concern, and the independent auditor’s report accompanying our financial statements raises doubt about our ability to continue as a going concern. In order to address these issues and to obtain adequate financing for the Company’s operations for the next twelve months, the Company is actively promoting and expanding its product line and continues to negotiate with significant customers who have demonstrated interest in the Cicero technology. The Company is experiencing difficulty increasing sales revenue largely because of the inimitable nature of the product as well as customer concerns about the Company’s financial viability. Cicero software is a new “category defining” product in that most Enterprise Application Integration (EAI) projects are performed at the server level and Cicero’s integration occurs at the desktop level without the need to open and modify the underlying code for those applications being integrated. Many companies are not aware of this new technology or tend to look toward more traditional and accepted approaches. The Company is attempting to solve the former problem by improving the market’s knowledge and understanding of Cicero through increased marketing and leveraging its limited number of reference accounts while enhancing its list of resellers and system integrators to assist in the sales and marketing process. Additionally, the Company is seeking additional equity capital or other strategic transactions in the near term to provide additional liquidity.
In December 31, 2004, the Company completed a Note and Warrant Offering wherein it has raised a total of approximately $1,615,000, of which $67,000 was received in 2005. Under the terms of the Offer, warrant holders of Level 8’s common stock were offered a one-time conversion of their existing warrants at a conversion price of $0.10 per share as part of a recapitalization merger plan. Those warrant holders who elected to convert, tendered their conversion price in cash and received a Note Payable in exchange. In early 2005, the Company announced an extension to the Note and Warrant offering of which the Company raised an additional $944,000, for a total of approximately $2,559,000. Upon approval of the recapitalization merger at a Shareholders meeting, these Notes would convert into common shares of Cicero, Inc., the surviving corporation in the merger. The Company also entered into several Convertible Bridge Notes with a consortium of investors. As of December 31, 2005, the Company had raised $1,760,000 of Convertible Bridge Notes of which $566,000 was from various members of the Company’s Board of Directors. Under the terms of these Notes, holders will convert their Notes into 62,490,887 shares of Cicero, Inc. common stock upon effectiveness of the proposed recapitalization merger.
The Company expects that increased revenues will reduce its operating losses in future periods; however, there can be no assurance that management will be successful in executing as anticipated or in a timely manner. If these strategies are unsuccessful, the Company may have to pursue other means of financing that may not be on terms favorable to the Company or its stockholders. If the Company is unable to increase cash flow or obtain financing, it may not be able to generate enough capital to fund operations for the next twelve months. At our current rates of expense and assuming revenues for the next twelve months at an annualized rate of our revenue for the year ended 2005, we will be able to fund planned operations with existing capital resources for a minimum of four months and experience negative cash flow of approximately $1,900,000 during the next twelve months to maintain planned operations. The accompanying financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The financial statements presented herein do not include any adjustments relating to the recoverability of assets and classification of liabilities that might be necessary should Level 8 be unable to continue as a going concern.
Products
Desktop Integration Segment
Cicero. Cicero software integrates disparate applications regardless of the platform, enables rapid development of effective, simple-to-maintain composite applications, accelerates time to value and deploys cost-effective, "best-of-breed" business solutions by leveraging existing IT investments. Cicero software helps the architect maintain consistent integration project design and implementation by providing extensible, standardized methods for interacting with Windows applications, COM objects, web pages, commercial software packages, legacy applications, and Java applications among others. Cicero software can integrate applications running on the server or desktop, giving the architect complete flexibility in determining where, when, and how application integration occurs. Cicero software can also be used to capture and aggregate data from many different applications, apply business rules as needed, such as data transformation rules, and share that data bi-directionally via a composite view. An event in one application can cause processing in another unrelated application, even if these were implemented using differing technologies, such as Windows and Java.
The patented Cicero software technology, as exclusively licensed from Merrill Lynch, consists of several components, including the following: The Resource Manager, which manages the starting, stopping, and status of applications; the Event Manager, a Component Object Model (COM)-based messaging service; the Context Manager which administers the “publish and subscribe” protocols; and a Graphical User Interface (GUI) manager which allows applications to be presented to the user in one or more flexible formats selected by the user organization. In 2004, we released a version of the Cicero product which included our newly developed Cicero Studio integration tool, to allow applications to be integrated using point-and-click methods. Cicero software incorporates an Application Bus with code modules to handle the inter-application connections. There are additional tools that provide ancillary functions for the integrator including tools to debug, view history and trace logs.
Cicero Studio provides a nontraditional approach to application integration. By providing a high level of object-oriented integration, Cicero Studio eliminates the need for source code modification. It includes high-level integration objects called genes (which translate disparate application interface protocols to one common interface used by Cicero software), an event processor, a context manager and a publish-subscribe information bus that enables applications to share data. It also includes a set of integration wizards that greatly simplify the task of application integration.
Cicero Studio is a powerful integration tool that eliminates most of the technical complexity associated with application integration. Integrators avoid the high cost and complexity of invasive code modifications and extend the scope of their integration capabilities into new and legacy environments. Cicero Studio provides an open architecture that can be extended to incorporate new behaviors by adding genes and communicating with COM objects. This enables Cicero software to be extended to accommodate new platforms and interface requirements as needed and provides a rich paradigm for evolving integration behaviors over time. It also means that Cicero software can be implemented in both the desktop and n-tier server of a service-oriented architecture.
Cicero software runs on Windows NT, Windows XP, and Windows 2000 to organize applications in a flexible graphical configuration that keeps all the application functionality that the user needs within easy reach. For instance, selecting the “memo” tab might cause a Microsoft Word memo-template to be created within the Cicero desktop. The end-user need not even know that they are using Microsoft Word. Moreover, a customer-tracking database can be linked with a customer relationship management software package.
Cicero software technology provides non-intrusive integration of desktop and web applications, portals, third-party business tools, and even legacy mainframe and client server applications, so all co-exist and share their information seamlessly. Cicero software’s non-invasive technology means that clients don’t risk modifying either fragile source code or sensitive application program interfaces - and they can easily integrate off-the-shelf products and emerging technologies.
Cicero software allows end-users to access applications in the most efficient way possible, by only allowing them to use the relevant portions of that application. For instance, a contact center customer service representative may not use 90% of the functionality of Microsoft Word, but might need access to a memorandum and other custom designed forms as well as basic editing functionality. Cicero can be set to control access to only those templates and, in a sense, turn-off the unused functionality by not allowing the end-user direct access to the underlying application. Under the same Cicero implementation, however, a different Cicero configuration could allow the employees in the Marketing department full access to Word because they have need of the full functionality. The functionality of the
applications that Cicero integrates can be modulated by the business goals of the ultimate client, the parent company. This ability to limit user access to certain functions within applications enables companies to reduce their training burden by limiting the portions of the applications on which they are required to train their customer service representatives.
Messaging and Application Engineering Segment
Ensuredmail. Our Ensuredmail products provide encrypted email capabilities such as security, proof-of-delivery and non-repudiation of origination. The recipient of an Ensuredmail message does not need to be an Ensuredmail licensee or install software. When an Ensuredmail user sends a message to another user, the recipient receives an email message with an attached encrypted message. The recipient opens the attached, which starts their web browser, enters a password, and can read the message and attachments. If the recipient replies to the message, the message is fully encrypted and sent back securely to the original sender. Organizations typically use our server-based Ensuredmail products, whereas individuals can use a person-to-person desktop variation.
Ensuredmail is FIPS140-1 certified, and in use by agencies of the Federal Government, in addition to private sector organizations.
Geneva Integration Broker. Geneva Integration Broker does not represent a significant portion of Level 8’s current business or prospects. Geneva Integration Broker is a transport independent message broker that enables an organization to rapidly integrate diverse business systems regardless of platform, transport, format or protocol. The key feature of Geneva Integration Broker is its support for XML and other standards for open data exchange on the Internet. The product provides a robust platform for building eBusiness applications that integrate with existing back-office systems. Geneva Integration Broker’s support for open data exchange and secure Internet transports is used for building Internet-based business-to-business solutions.
Services
We provide a full spectrum of technical support, training and consulting services across all of our operating segments as part of our commitment to providing our customers industry-leading business integration solutions. Experts in the field of systems integration with backgrounds in development, consulting, and business process reengineering staff our services organization. In addition, our services professionals have substantial industry specific backgrounds with extraordinary depth in our focus marketplace of financial services.
Maintenance and Support
We offer customers varying levels of technical support tailored to their needs, including periodic software upgrades, telephone support and twenty-four hour, seven days a week access to support-related information via the Internet. Cicero and Ensuredmail software are frequently used in mission-critical business situations, and our maintenance and support services are accustomed to the critical demands that must be met to deliver world-class service to our clients. Many of the members of our staff have expertise in lights-out mission critical environments and are ready to deliver service commensurate with those unique client needs.
Training Services
Our training organization offers a full curriculum of courses and labs designed to help customers become proficient in the use of our products and related technology as well as enabling customers to take full advantage of our field-tested best practices and methodologies. Our training organization seeks to enable client organizations to gain the proficiency needed in our products for full client self-sufficiency but retains the flexibility to tailor their curriculum to meet specific needs of our clients.
Consulting Services
We offer consulting services around our product offerings in project management, applications and platform integration, application design and development and application renewal, along with expertise in a wide variety of development environments and programming languages. We also have an active partner program in which we recruit leading IT consulting and system integration firms to provide services for the design, implementation and deployment of our solutions. Our consulting organization supports third party consultants by providing architectural and enabling services.
Customers
Our customers include both end-users to whom we sell our products and services directly and distributors and other intermediaries who either resell our products to end-users or incorporate our products into their own product offerings. Typical end-users of our products and services are large businesses with sophisticated technology requirements for contact centers, in the financial services, insurance and telecommunications industries, and intelligence, security, law enforcement and other governmental organizations.
Our customers are using our solutions to rapidly deploy applications. Some examples of customers' uses of our products include:
· Business Process Outsourcers - use our Cicero solution to provide in contact centers real time integration among existing back-office systems, eliminate redundant data entry, shorten call times, provide real-time data access and enhance customer service and service levels.
· A financial institution - uses our Cicero solution to provide real-time integration among market data, customer account information, existing back-office systems and other legacy applications, eliminate redundant data entry, provide real-time data access and processing, and enhance customer service and service levels.
· An insurance company - uses our Cicero solution to integrate their customer information systems with over thirty software applications including a CRM application.
· A law enforcement organization - uses our Cicero solution to streamline and automate support for arrests and investigations while merging federal, state and local systems within a unified process.
Other customers are systems integrators, which use our Cicero product to develop integration solutions for their customers.
More than 4,000 Merrill Lynch personnel are currently using Cicero software. We licensed the Cicero technology from Merrill Lynch during 2000 and have enhanced it to license to contact centers and the financial services, insurance and telecommunications industries, as well as the intelligence, security, law enforcement and other governmental organizations. Our significant customers include Nationwide Financial Services, arvato services, a division of Bertelsmann A.G., Bank of America, IBM, Science Applications International Corporation, N.E.W. Customer Service Companies and the West Windsor Township, New Jersey Police Department.
Bank of America, Nationwide Financial Services, and Gateway Electronic Medical Management Systems (GEMMS) each accounted for more than ten percent (10%) of our operating revenues in 2003. In 2004, Bank of America, Convergys, IBM, Nationwide Financial Services and SAIC each accounted for more than ten percent (10%) of our operating revenue. In 2005, NEW Customer Service Companies and Innovative System Solutions Corporation accounted for more than ten percent (10%) of our operating revenue.
Sales and Marketing
Sales
An important element of our sales strategy is to supplement our direct sales force by expanding our relationships with third parties to increase market awareness and acceptance of our business integration software solutions. As part of these relationships, we continue to jointly sell and implement Cicero software solutions with strategic partners such as systems integrators and embed Cicero along with other products through OEM relationships. We provide training and other support necessary to systems integrators and OEMs to aid in the promotion of our products. To date we have entered into strategic partnerships with the following OEMs, for integrated business solutions: Science Applications International Corporation, ThinkCentric, Hewlett Packard, House of Code and Titan Systems Corporation. In addition, we have entered into strategic partnerships with Silent Systems, Inc., ADPI LLC, arvato services, a division of Bertelsmann A.G, GEMMS, Genesis Technology Group Inc., Plan B Technologies Inc., Pilar Services, Inc., and Gini Corporation. These organizations have relationships with existing customers and have access to organizations requiring top secret or classified access. In addition, several of these partners can bundle Cicero with other software to provide a comprehensive solution to customers. We are not materially dependent on any of these organizations. Generally, our agreements with such partners provide for price discounts based on their sales volume, with no minimum required volume.
Marketing
The target market for our products and services are large companies operating contact centers and in the financial services, insurance and telecommunications industries, as well users in the intelligence, security and law enforcement communities and other governmental organizations. Increasing competitiveness and consolidation is driving companies in such businesses to increase the efficiency and quality of their customer contact centers. As a result, customer contact centers are compelled by both economic necessity and internal mandates to find ways to increase internal efficiency, increase customer satisfaction, increase effective cross-selling, decrease staff turnover cost and leverage their investment in current information technology.
Our marketing staff has an in-depth understanding of the customer contact center software marketplace and the needs of these customers, as well as experience in all of the key marketing disciplines. They also have knowledge of the financial services industry and government organizations that have focused on application integration solutions to address needs in mergers and acquisitions and homeland security.
Core marketing functions include product marketing, marketing communications and strategic alliances. We utilize focused marketing programs that are intended to attract potential customers in our target vertical industries and to promote our company and our brands. Our marketing programs are specifically directed at our target markets, and include speaking engagements, public relations campaigns, focused trade shows and web site marketing, while devoting substantial resources to supporting the field sales team with high quality sales tools and ancillary material. As product acceptance grows and our target markets increase, we will shift to broader marketing programs.
The marketing department also produces ancillary material for presentation or distribution to prospects, including demonstrations, presentation materials, white papers, case studies, articles, brochures, and data sheets.
Research and Product Development
In connection with the narrowing of our strategic focus, and in light of the sale of our Systems Integration products, we have experienced an overall reduction in research and development costs. Since Cicero is a new product in a relatively untapped market, it is imperative to constantly enhance the feature sets and functionality of the product.
We incurred research and development expense of approximately $891,000, $1,111,000 and $1,017,000 in 2005, 2004, and 2003, respectively. The decrease in costs in 2005 reflects the reduction in headcount by two employees, plus associated overheads. The increase in research and development costs in 2004 as compared with 2003 is attributable to an allocation of certain costs primarily from General and Administrative costs.
The markets for our products are characterized by rapidly changing technologies, evolving industry standards, frequent new product introductions and short product life cycles. Our future success will depend to a substantial degree upon our ability to enhance our existing products and to develop and introduce, on a timely and cost-effective basis, new products and features that meet changing customer requirements and emerging and evolving industry standards.
Our budgets for research and development are based on planned product introductions and enhancements. Actual expenditures, however, may significantly differ from budgeted expenditures. Inherent in the product development process are a number of risks. The development of new, technologically advanced software products is a complex and uncertain process requiring high levels of innovation, as well as the accurate anticipation of technological and market trends.
The introduction of new or enhanced products also requires us to manage the transition from older products in order to minimize disruption in customer ordering patterns, as well as ensure that adequate supplies of new products can be delivered to meet customer demand. There can be no assurance that we will successfully develop, introduce or manage the transition to new products.
We have in the past, and may in the future, experience delays in the introduction of our products, due to factors internal and external to our business. Any future delays in the introduction or shipment of new or enhanced products, the inability of such products to gain market acceptance or problems associated with new product transitions could adversely affect our results of operations, particularly on a quarterly basis.
Competition
The markets in which we compete are highly competitive and subject to rapid change. These markets are highly fragmented and served by numerous firms. We believe that the competitive factors affecting the markets for our products and services include:
· Product functionality and features;
· Availability and quality of support services;
· Ease of product implementation;
· Price;
· Product reputation; and
· Our financial stability.
The relative importance of each of these factors depends upon the specific customer environment. Although we believe that our products and services can compete favorably, we may not be able to increase our competitive position against current and potential competitors. In addition, many companies choose to deploy their own information technology personnel or utilize system integrators to write new code or rewrite existing applications in an effort to develop integration solutions. As a result, prospective customers may decide against purchasing and implementing externally developed and produced solutions such as ours.
We compete with companies that utilize varying approaches to modernize, web-enable and integrate existing software applications:
·
Portal software offers the ability to aggregate information at a single point, but not the ability to integrate transactions from a myriad of information systems on the desktop. Plumtree is a representative company in the Portal market.
·
Middleware software provides integration of applications through messages and data exchange implemented typically in the middle tier of the application architecture. This approach requires modification of the application source code and substantial infrastructure investments and operational expense. Reuters, TIBCO and IBM MQSeries are competitors in the middleware market.
·
CRM software offers application tools that allow developers to build product specific interfaces and custom applications. This approach is not designed to be product neutral and is often dependent on deep integration with Level 8’s technology. Siebel is a representative product in the CRM software category.
Other competitors include Above All Software, Attachmate Corporation, Seagull Software Ltd. and Oracle. Our Cicero product competes directly with other contact center solutions offered by Microsoft, Corizon and Jacada. We expect additional competition from other established and emerging companies. Furthermore, our competitors may combine with each other, or other companies may enter our markets by acquiring or entering into strategic relationships with our competitors. Many of our current and possible future competitors have greater name recognition, a larger installed customer base and greater financial, technical, marketing and other resources than we have.
We believe that our ability to compete depends in part on a number of competitive factors outside our control, including the ability of our competitors to hire, retain and motivate senior project managers, the ownership by competitors of software used by potential clients, the development by others of software that is competitive with our products and services, the price at which others offer comparable services and the extent of our competitors’ responsiveness to customer needs.
Intellectual Property
Our success is dependent upon developing, protecting and maintaining our intellectual property assets. We rely upon combinations of copyright, trademark and trade secrecy protections, along with contractual provisions, to protect our intellectual property rights in software, documentation, data models, methodologies, data processing
systems and related written materials in the international marketplace. In addition, Merrill Lynch holds a patent with respect to the Cicero technology. Copyright protection is generally available under United States laws and international treaties for our software and printed materials. The effectiveness of these various types of protection can be limited, however, by variations in laws and enforcement procedures from country to country. We use the registered trademarks “Level 8 Systems”, “Cicero”, “Ensuredmail”, and the trademarks “Level 8”, “Level 8 Technologies”, and “Geneva Integration Broker”.
All other product and company names mentioned herein are for identification purposes only and are the property of, and may be trademarks of, their respective owners.
There can be no assurance that the steps we have taken will prevent misappropriation of our technology, and such protections do not preclude competitors from developing products with functionality or features similar to our products. Furthermore, there can be no assurance that third parties will not independently develop competing technologies that are substantially equivalent or superior to our technologies. Additionally, with respect to the Cicero line of software products, there can be no assurance that Merrill Lynch will protect its patents or that we will have the resources to successfully pursue infringers.
Although we do not believe that our products infringe the proprietary rights of any third parties, there can be no assurance that infringement claims will not be asserted against our customers or us in the future. In addition, we may be required to indemnify our distribution partners and end users for similar claims made against them. Furthermore, we may initiate claims or litigation against third parties for infringement of our proprietary rights or to establish the validity of our proprietary rights. Litigation, either as a plaintiff or defendant, would cause us to incur substantial costs and divert management resources from productive tasks whether or not said litigation is resolved in our favor, which could have a material adverse effect on our business operating results and financial condition.
As the number of software products in the industry increases and the functionality of these products further overlaps, we believe that software developers and licensors may become increasingly subject to infringement claims. Any such claims, with or without merit, could be time consuming and expensive to defend and could adversely affect our business, operating results and financial condition.
Employees
As of December 31, 2005, we employed 20 employees. Our employees are not represented by a union or a collective bargaining agreement.
We believe that to fully implement our business plan we will be required to enhance our ability to work with the Microsoft Windows NT, Windows XP, and Windows operating systems as well as the Linux operating system by adding additional development personnel as well as additional direct sales personnel to complement our sales plan. Although we believe that we will be successful in attracting and retaining qualified employees to fill these positions, no assurance can be given that we will be successful in attracting and retaining these employees now or in the future.
Available Information
Our web address is www.level8.com. We make available free of charge through our Web site our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities Exchange Commission.
Forward Looking and Cautionary Statements
Certain statements contained in this Annual Report may constitute "forward looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995 ("Reform Act"). We may also make forward looking statements in other reports filed with the Securities and Exchange Commission, in materials delivered to shareholders, in press releases and in other public statements. In addition, our representatives may from time to time make oral forward-looking statements. Forward looking statements provide current expectations of future events based on certain assumptions and include any statement that does not directly relate to any historical or current fact. Words such as "anticipates," "believes," "expects," "estimates," "intends," "plans," "projects," and similar expressions, may identify such forward looking statements. In accordance with the Reform Act, set forth below are cautionary statements that accompany those forward looking statements. Readers should carefully review these cautionary statements as they identify certain important factors that could cause actual results to differ materially from those in the forward-looking statements and from historical trends. The following cautionary statements are not
exclusive and are in addition to other factors discussed elsewhere in our filings with the Securities and Exchange Commission and in materials incorporated therein by reference: there may be a question as to our ability to operate as a going concern, our future success depends on the market acceptance of the Cicero product and successful execution of the new strategic direction; general economic or business conditions may be less favorable than expected, resulting in, among other things, lower than expected revenues; an unexpected revenue shortfall may adversely affect our business because our expenses are largely fixed; our quarterly operating results may vary significantly because we are not able to accurately predict the amount and timing of individual sales and this may adversely impact our stock price; trends in sales of our products and general economic conditions may affect investors' expectations regarding our financial performance and may adversely affect our stock price; our future results may depend upon the continued growth and business use of the Internet; we may lose market share and be required to reduce prices as a result of competition from our existing competitors, other vendors and information systems departments of customers; we may not have the ability to recruit, train and retain qualified personnel; rapid technological change could render the Company's products obsolete; loss of any one of our major customers could adversely affect our business; our business is subject to a number of risks associated with doing business abroad including the effect of foreign currency exchange fluctuations on our results of operations; our products may contain undetected software errors, which could adversely affect our business; because our technology is complex, we may be exposed to liability claims; we may be unable to enforce or defend its ownership and use of proprietary technology; because we are a technology company, our common stock may be subject to erratic price fluctuations; and we may not have sufficient liquidity and capital resources to meet changing business conditions.
Market Risk
The Company was delisted from the NASDAQ SmallCap market effective January 23, 2003. The Company’s common stock presently is quoted on the Over-the-Counter Bulletin Board.
Item 2.
Item 2. Properties
Our corporate headquarters are located in approximately 1,300 square feet of office space in Farmingdale, New Jersey, pursuant to a twelve-month sublease from one of our resellers that expired in August, 2005. We are continuing to occupy such premises on a month-to-month basis. The United States operations group and administrative functions are based in offices of approximately 2,956 square feet in our Cary, North Carolina office pursuant to a lease expiring in 2007. The research and development and customer support groups are located in the Farmingdale, New Jersey and Cary, North Carolina facilities.
Item 3.
Item 3. Legal Proceedings
Various lawsuits and claims have been brought against us in the normal course of our business. In January 2003, an action was brought against us in the Circuit Court of Loudon County, Virginia, for a breach of a real estate lease. The case was settled in August 2003. Under the terms of the settlement agreement, we agreed to assign a note receivable with recourse equal to the unpaid portion of the note should the note obligor default on future payments. The unpaid balance of the note was $545,000, of which the current unpaid principal portion is approximately $247,000 and it matures in December 2007. We assessed the probability of liability under the recourse provisions using a weighted probability cash flow analysis and have recognized a long-term liability in the amount of $131,000.
In October 2003, we were served with a summons and complaint in Superior Court of North Carolina regarding unpaid invoices for services rendered by one of our subcontractors. The amount in dispute was approximately $200,000 and is included in accounts payable. Subsequent to March 31, 2004, we settled this litigation. Under the terms of the settlement agreement, we agreed to pay a total of $189,000 plus interest over a 19-month period ending November 15, 2005. The Company is in the process of negotiating a series of payments for the remaining liability of approximately $80,000.
In March 2004, we were served with a summons and complaint in Superior Court of North Carolina regarding a security deposit for a sublease in Virginia. The amount in dispute is approximately $247,000. In October 2004, we reached a settlement agreement wherein we agreed to pay $160,000 over a 24-month period ending October 2006.
In August 2004, we were notified that we were in default under an existing lease agreement for office facilities in Princeton, New Jersey. The amount of the default is approximately $65,000. Under the terms of the lease agreement, we may be liable for future rents should the space remain vacant. We have reached a settlement agreement with the landlord which calls for a total payment of $200,000 over a 20-month period ending July 2006.
In April 2005, we were notified that Critical Mass Mail, Inc. had filed a claim against us for failure to pay certain liabilities under an Asset Purchase Agreement dated January 9, 2004. We in turn filed that Critical Mass Mail, Inc. failed to deliver certain assets and other documents under the same Asset purchase agreement. We had already reserved the potential liability under the Agreement as part of the asset purchase accounting. On March 1, 2006, Critical Mass Mail amended their complaint and is seeking damages of approximately $600,000 for our failure to timely register the underlying securities issued in the Asset Purchase. We believe that the probability of an unfavorable outcome is remote and accordingly, we have not reserved for this contingency.
Under the indemnification clause of the Company’s standard reseller agreements and software license agreements, the Company agrees to defend the reseller/licensee against third party claims asserting infringement by the Company’s products of certain intellectual property rights, which may include patents, copyrights, trademarks or trade secrets, and to pay any judgments entered on such claims against the reseller/licensee.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
None.
PART II
Item 5.
Item 5. Market For Registrant's Common Stock, Related Shareholder Matters and Issuer Purchases of Equity Securities.
Our common stock has been traded on the Nasdaq National Market under the symbol ''LVEL” from 1996 until December 23, 2002. From December 24, 2002, until January 23, 2003, our common stock traded on the Nasdaq SmallCap Market. As of January 23, 2003, our common stock was delisted from the Nasdaq SmallCap Market and is currently quoted on the over-the-counter bulletin board. We have never declared or paid any cash dividends on our common stock. We anticipate that all of our earnings will be retained for the operation and expansion of our business and do not anticipate paying any cash dividends for common stock in the foreseeable future. The chart below sets forth the high and low stock prices for the quarters of the fiscal years ended December 31, 2005 and 2004.
The closing price of the common stock on December 31, 2005 was $0.02 per share. As of March 13, 2006 we had 205 registered shareholders of record.
Recent Sales of Unregistered Securities
In 2004, the Company announced a Note and Warrant Offering in which warrant holders of Level 8’s common stock were offered a one-time conversion of their existing warrants at a conversion price of $0.10 per share as part of a recapitalization merger plan. The senior secured notes issued in the aggregate principal amount of $2,559,000 to holders of warrants of Level 8 who loaned to Level 8 the exercise price of their warrants and other investors who lent funds to Level 8 in exchange for Senior Reorganization Notes and additional warrants, pursuant to note and warrant offerings in December 2004 ($1,615,000, of which $67,000 was received in 2005) and March 2005 ($944,000) (the “Note and Warrant Offerings”), will be cancelled and the existing warrants in respect of which the exercise price was loaned to Level 8, as evidenced by the Senior Reorganization Notes, will be exercised. Such warrant holders were offered a special one-time exercise price of the lesser of $0.10 per share and the original exercise price as part of the merger agreement. The exercise price of the warrants at that time ranged from $0.07 to $0.60.
As part of the Note and Warrant Offering Level 8 will issue Additional Warrants to Senior Reorganization Noteholders in connection with their loans to Level 8, such warrants exercisable at $0.002 per share in the event of the consummation of the merger agreement, these warrants will automatically be deemed exercised, by applying the accrued interest on their Senior Reorganization Notes and by cashless exercise to the extent of the balance of the exercise price, upon the consummation of the recapitalization merger. The shares issuable upon exercise of the Additional Warrants will convert into an aggregate of 19,360,959 shares of Cicero common stock in the recapitalization merger (less the number of shares to be applied to the cashless exercise).
Senior Reorganization Noteholders who loaned Level 8 the first $1,000,000 in respect of the exercise price of their warrants pursuant to the Note and Warrant Offering will receive warrants of Level 8 (“Early Adopter Warrants”) at a ratio of 2:1 for shares issuable upon exercise of each existing warrant exercised at the special exercise price (before adjustment by the merger exchange ratio) of $0.10 per share, as part of the recapitalization merger. In the recapitalization merger, Early Adopter Warrants will convert into warrants of Cicero for an aggregate of 1,005,562 shares of Cicero, and the exercise price increased to $2.00 per share.
These securities were issued under the exemption offered by Rule 506 of Regulation D under Section 4(2) of the Securities Act of 1933.
In 2005, the Company entered into several Convertible Bridge Notes with a consortium of investors. These notes bear interest at 10% and mature at various dates beginning on September 15, 2005. The Notes are convertible into shares of Cicero, Inc. common stock upon effectiveness of the proposed recapitalization merger at a conversion rate of $0.025. As of December 31, 2005, the Company has raised $1,760,000 of Convertible Bridge Notes of
which $566,000 was from various members of the Company’s Board of Directors. If the merger proposal is not approved, the Notes will immediately become due and payable. These securities were issued under the exemption offered by Rule 506 of Regulation D of the Securities Act of 1933.
The Company has not repurchased any shares of its stock.
Item 6.
Item 6. Selected Financial Data.
The following selected financial data is derived from the consolidated financial statements of the Company. The data should be read in conjunction with the consolidated financial statements, related notes, and other financial information included herein.
See Item 7
Item 7 for a discussion of the entities included in operations (in thousands).
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations, (dollars in thousands, except share and per share amounts).
General Information
Level Systems is a global provider of business integration software that enables organizations to integrate new and existing information and processes at the desktop with our Cicero software product. Business integration software addresses the emerging need for a company's information systems to deliver enterprise-wide views of the company's business information processes. The Company also provides email encryption products that address information and security compliance from the individual to the enterprise.
In addition to software products, Level 8 also provides technical support, training and consulting services as part of its commitment to providing its customers industry-leading integration solutions. Level 8’s consulting team has in-depth experience in developing successful enterprise-class solutions as well as valuable insight into the business information needs of customers in the Global 5000. Level 8 offers services around our integration and encryption software products.
This discussion contains forward-looking statements relating to such matters as anticipated financial performance, business prospects, technological developments, new products, research and development activities, liquidity and capital resources and similar matters. The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements. In order to comply with the terms of the safe harbor, the Company notes that a variety of factors could cause its actual results to differ materially from the anticipated results or other expectations expressed in the Company's forward-looking statements. See ''Item 1. Business-Forward Looking and Cautionary Statements.''
Business Strategy
Management makes operating decisions and assesses performance of Level 8’s operations based on the following reportable segments: (1) Desktop Integration and (2) Messaging and Application Engineering.
The Desktop Integration segment is comprised of the Cicero product. Cicero is a business integration software product that maximizes end-user productivity, streamlines business operations and integrates disparate systems and applications, while renovating or rejuvenating older legacy systems by making them usable in the business processes.
The products that comprise the Messaging and Application Engineering segment are Geneva Integration Broker and Ensuredmail. Geneva Integration Broker is a transport independent message broker that enables an organization to rapidly integrate diverse business systems regardless of platform, transport, format or protocol. Ensuredmail is an encrypted email technology that can reside on either the server or the desktop.
Results of Operations
The following table sets forth, for the years indicated, the Company's results of continuing operations expressed as a percentage of revenue and presents information for our three categories of revenue.
The following table sets forth data for total revenue for continuing operations by geographic origin as a percentage of total revenue for the periods indicated:
The table below present’s information about reported segments for the twelve months ended December 31, 2005, 2004, and 2003 (in thousands):
A reconciliation of segment operating expenses to total operating expense follows (numbers are in thousands):
A reconciliation of total segment profitability to net loss for the fiscal years ended December 31(in thousands):
Years Ended December 31, 2005, 2004, and 2003
Revenue and Gross Margin. The Company has three categories of revenue: software products, maintenance, and services. Software products revenue is comprised primarily of fees from licensing the Company's proprietary
software products. Maintenance revenue is comprised of fees for maintaining, supporting, and providing periodic upgrades to the Company's software products. Services revenue is comprised of fees for consulting and training services related to the Company's software products.
The Company's revenues vary from quarter to quarter, due to market conditions, the budgeting and purchasing cycles of customers and the effectiveness of the Company’s sales force. The Company does not have any material backlog of unfilled software orders and product revenue in any period is substantially dependent upon orders received in that quarter. Because the Company's operating expenses are based on anticipated revenue levels and are relatively fixed over the short term, variations in the timing of the recognition of revenue can cause significant variations in operating results from period to period. Fluctuations in operating results may result in volatility of the price of the Company's common stock.
Total revenues increased slightly, or 1% from $775,000 in 2004 to $785,000 in 2005. Revenues increased 46% from $530,000 in 2003 to $775,000 in 2004. During 2003, 2004, and 2005 the Company was unable to secure significant large scale contracts but did secure several smaller installations from several different companies. Gross profit margin (loss) was (51)%, (658)%, and (925)% for 2005, 2004, and 2003, respectively.
The Desktop Integration segment had a gross margin (loss) of (56)% for the year ended December 31, 2005, (701)% for the year ended December 31, 2004 and a gross margin (loss) of (1,053)% for the year ended December 31, 2003. At each balance sheet date, the Company reassesses the recoverability of the Cicero technology in accordance with SFAS 86, “Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed”. This assessment was completed due to the Company’s continued operating losses and the limited software revenue generated by the Cicero technology over the prior periods. The Company had been in negotiations with numerous customers to purchase licenses, which would have a significant impact on the cash flows from the Cicero technology and the Company. Since the negotiations had been in process for several months and expected completion of the transactions had been delayed, the Company reduced its cash flow projections. Historical cash flows generated by the Cicero technology did not support the long-lived asset and accordingly the Company impaired the excess of the unamortized book value of the technology in excess of the expected net realizable value as of June 30, 2004, September 30, 2003 and at December 31, 2003. These charges, in the amount of $2,844,000, $745,000 and $248,000 respectively, have been recorded as cost of software revenue.
The Messaging and Application Engineering segment gross margin for the year ended December 31, 2005 was 100%, and the gross margin (loss) was (213%) for the year ended December 31, 2004. For the year ended December 31, 2003, the Messaging and Application Engineering segment had a gross margin 3%. In January 2004 the Company acquired substantially all of the assets and certain liabilities of Critical Mass Mail, Inc., d/b/a Ensuredmail, a federally certified encryption software company. The total purchase price of the assets being acquired plus certain liabilities assumed was $750,000. The purchase price was allocated to the assets acquired and liabilities assumed based on the Company’s estimates of fair value at the acquisition date. The Company assessed the net realizable value of the Ensuredmail software technology acquired and determined the purchase price exceeded the amounts allocated to the software technology acquired less liabilities assumed by approximately $587,000. This excess of the purchase price over the fair values of the assets acquired less liabilities assumed was allocated to goodwill, and, because it was deemed impaired, charged to the Statement of Operations for the period ended March 31, 2004. The Company completed an assessment of the recoverability of the Ensuredmail product technology, as of June 30, 2004 in accordance with SFAS 86, “Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed”. This assessment was completed due to the Company’s revised cash flow projections from software revenue. These revised cash flow projections did not support the long-lived asset and accordingly the Company impaired the excess of the unamortized book value of the technology in excess of the expected net realizable value as of June 30, 2004. This charge, in the amount of $154,000, was recorded as software amortization for the period ended June 30, 2004.
Software Products. Software product revenue increased approximately 70% in 2005 from those results achieved in 2004 and increased 134% in 2004 as compared to 2003. The increase in software revenues in 2005 and 2004 is attributed to the successful deployment of a few small integration engagements, which were non-existent in 2003.
The gross margin (loss) on software products was 96%, (1,773)%, and (3,971)% for the 2005, 2004 and 2003 years ended, respectively. Cost of software is composed primarily of amortization of software product technology, amortization of capitalized software costs for internally developed software, impairment of software product technology, and royalties to third parties, and to a lesser extent, production and distribution costs. All software costs have been fully amortized as of December 31, 2004. The Cicero software technology and related patents was licensed by Level 8 on a worldwide basis from Merrill Lynch in August of 2000 under a license agreement containing standard provisions and a two-year exclusivity period. On January 3, 2002, the license agreement was
amended to extend Level 8’s exclusive worldwide marketing, sales and development rights to Cicero in perpetuity (subject to Merrill Lynch’s rights to terminate in the event of bankruptcy or a change in control of Level 8) and to grant ownership rights in the Cicero trademark. Level 8 is indemnified by Merrill Lynch with regard to the rights granted to Level 8 by them. It is a condition to consummation of the recapitalization merger that the license agreement be amended so that the recapitalization merger would not give rise to a right of Merrill Lynch to terminate the license. Consideration for the original Cicero license consisted of 1,000,000 shares of Level 8 common stock. In exchange for the amendment, Level 8 granted an additional 250,000 shares of common stock to MLBC, Inc., a Merrill Lynch affiliate and entered into a royalty sharing agreement. Under the royalty sharing agreement, Level 8 pays a royalty of 3% of the sales price for each sale of Cicero software or related maintenance services. The royalties over the life of the agreement are not payable in excess of $20,000,000.
The software product gross margin (loss) for the Desktop Integration segment was 96% in 2005, (1,950)% in 2004, and (3,971)% in 2003. The software product gross margin (loss) on the Messaging and Application Engineering segment was 100% for 2005, (587)% for 2004, and 0 for 2003.
The Company expects to see significant increases in software sales related to the Desktop Integration segment coupled with improving margins on software products as Cicero gains acceptance in the marketplace. The Company’s expectations are based on its review of the sales cycle that has developed around the Cicero product since being released by the Company, its review of the pipeline of prospective customers and their anticipated capital expenditure commitments and budgeting cycles, as well as the status of in-process proof of concepts or beta sites with select corporations. The Messaging and Application Engineering segment revenue is expected to increase marginally with on-line sales of its products.
Maintenance. Maintenance revenues for the year ended December 31, 2005 decreased by approximately 52% or $159,000 from 2004. The decline in maintenance revenues in 2005 as compared to 2004 is primarily due to the non-renewal of one maintenance contract for the Cicero product within the Desktop Integration segment. Maintenance revenues for the year ended December 31, 2004 decreased by approximately 3% or $10,000 from 2003. The decline in maintenance revenues in 2004 as compared to 2003 is the result of one maintenance contract not being renewed.
The Desktop Integration segment accounted for approximately 88% of total maintenance revenue and the Messaging and Application Engineering segment accounted for approximately 12% of total maintenance revenues in 2005.
Cost of maintenance is comprised of personnel costs and related overhead and the cost of third-party contracts for the maintenance and support of the Company’s software products. The Company experienced a gross margin (loss) on maintenance products of (138)% for 2005. Gross margin (loss) on maintenance products for 2004 and 2003 were (25)% and (18)% respectively.
Maintenance revenues are expected to increase, primarily in the Desktop Integration segment, as a result of our expected increase in sales of the Cicero product. The Messaging and Application Engineering segment is now composed of the new Ensuredmail encryption technology and maintenance revenues should increase as the product achieves market acceptance. The cost of maintenance should increase slightly for the Desktop Integration segment.
Services. Services revenue for the year ended December 31, 2005 were approximately the same as in 2004. Services revenue for the year ended December 31, 2004 increased by approximately 105% or $118,000 over the same period in 2003. The increase in service revenues as compared to 2003 is attributable to the pilot engagements that were incurred during the past two years.
Cost of services primarily includes personnel and travel costs related to the delivery of services. Services gross margin (loss) was (256)%, (341)%, and (711)% for the years ended 2005, 2004 and 2003, respectively.
Services revenues are expected to increase for the Desktop Integration segment as the Cicero product gains acceptance. The Messaging and Application Engineering segment service revenues will continue to be deminimus as the new products that comprise that segment do not require substantial service oriented work.
Sales and Marketing. Sales and marketing expenses primarily include personnel costs for salespeople, marketing personnel, travel and related overhead, as well as trade show participation and promotional expenses. Sales and marketing expenses decreased by 42% or approximately $461,000 in 2005 and decreased by 35% or approximately $592,000 in 2004 due to a continued reduction in the Company’s sales and marketing workforce, decreased promotional activities and a change in the sales compensation structure. Specifically, the Company changed the compensation structure to lower fixed costs and increase variable success-based costs.
Sales and marketing expenses are expected to increase slightly as the Company adds additional direct sales personnel and supports the sales function with collateral marketing materials. The Company's emphasis for the sales and marketing groups will be the Desktop Integration segment.
Research and Development. Research and development expenses primarily include personnel costs for product authors, product developers and product documentation and related overhead. Research and development expense decreased by 20% or $220,000 in 2005 as compared to 2004. The decrease in costs in 2005 reflects the reduction in headcount by two employees, plus associated overheads. Research and development expense increased by 9% or $94,000 in 2004 as compared to 2003. The increase in research and development spending is attributable to an allocation of certain costs primarily from general and administrative costs.
The Company intends to continue to make a significant investment in research and development while enhancing efficiencies in this area.
General and Administrative. General and administrative expenses consist of personnel costs for the executive, legal, financial, human resources, IT and administrative staff, related overhead, and all non-allocable corporate costs of operating the Company. General and administrative expenses for the year ended December 31, 2005 decreased by 25% or $385,000 over the prior year. In fiscal 2004, general and administrative expenses decreased by 41% or $1,036,000 as compared to 2003. The sharp decline in general and administrative costs in 2005 and 2004 reflects the general downsizing conducted by the Company in both years.
General and administrative expenses are expected to slightly increase going forward as the Company’s revenues increase.
Write-Off of Goodwill and Other Intangible Assets. Write-off of goodwill was $0 for the years ended December 31, 2005 and 2003, and $587,000 for the year ended December 31, 2004. During 2004, the Company acquired substantially all of the assets and certain liabilities of Critical Mass Mail, Inc., d/b/a Ensuredmail, a federally certified encryption software company. The total purchase price of the assets being acquired plus certain liabilities assumed was $750,000. The purchase price was allocated to the assets acquired and liabilities assumed based on the Company’s estimates of fair value at the acquisition date. The Company assessed the net realizable value of the Ensuredmail software technology acquired and determined the purchase price exceeded the amounts allocated to the software technology acquired less liabilities assumed by approximately $587,000. This excess of the purchase price over the fair values of the assets acquired less liabilities assumed was allocated to goodwill, and, because it was deemed impaired, charged to the Statement of Operations for the period ended March 31, 2004. At December 31, 2005, 2004 and 2003, there was no remaining goodwill on the Company’s balance sheet.
Restructuring. As of December 31, 2002, the Company’s accrual for restructuring was $772,000, which was primarily comprised of excess facility costs. As more fully discussed in Note 21 Contingencies, in 2003 the Company settled litigation relating to these excess facilities. Accordingly, the Company has reversed the restructuring balance. Under the terms of the settlement agreement, the Company agreed to assign the note receivable from the sale of Geneva to EM Software Solutions, Inc., with recourse equal to the unpaid portion of the note receivable should the note obligor, EM Software Solutions, Inc., default on future payments. The current unpaid principal portion of the note receivable assigned is approximately $247,000 and matures in December 2007. The Company assessed the probability of liability under the recourse provisions using a probability weighted cash flow analysis and has recognized a long-term liability in the amount of $131,000.
Warrants Liability. The Company has issued warrants to Series A3 and Series B3 preferred stockholders which contain provisions that allow the warrant holders to force a cash redemption for events outside the control of the Company. The fair value of the warrants is accounted for as a liability and is re-measured at each balance sheet date. As of December 31, 2005, the warrant liability had a fair value of $0 and the Company had recorded the change in the fair value of the warrant liability of $198,000 for the year ended December 31, 2004 in the consolidated statements of operations.
Provision for Taxes. The Company’s effective income tax rate for continuing operations differs from the statutory rate primarily because an income tax benefit was not recorded for the net loss incurred in 2005, 2004 or 2003. Because of the Company’s inconsistent earnings history, the deferred tax assets have been fully offset by a valuation allowance.
Impact of Inflation. Inflation has not had a significant effect on the Company’s operating results during the periods presented.
Liquidity and Capital Resources
Operating and Investing Activities
The Company utilized cash of $78,000 for the year ended December 31, 2005.
Operating activities utilized approximately $2,564,000 in cash, which was primarily comprised of the loss from operations of $3,681,000, offset by non-cash charges for depreciation and amortization of approximately $11,000, and stock compensation expense of $149,000. In addition, the Company had a reduction in accounts receivable of $146,000, as well as a reduction of prepaid expenses and other assets of $55,000. The Company generated approximately $804,000 in cash through an increase in its amount owing its creditors. The Company had a decrease of $29,000 in assets and liabilities of discontinued operations, a decrease in $12,000 for credit of uncollectible accounts, and a decrease of $7,000 in deferred revenue.
The Company utilized approximately $6,000 in cash in the purchase of updating the Company’s network equipment.
The Company generated approximately $2,487,000 of cash during the year from financing activities of the extension to its Note and Warrant offering of $944,000 and $1,615,000 of financing from its Convertible bridge notes offset by repayments of the Company’s short-term debt in the amount of $55,000.
By comparison, the Company generated cash of $88,000 for the year ended December 31, 2004.
Operating activities utilized approximately $3,365,000 in cash, which was primarily comprised of the loss from operations of $9,761,000, offset by non-cash charges for depreciation and amortization of approximately $4,287,000, an impairment of intangible assets of $587,000, stock compensation expense of $635,000, offset by a non-cash decrease in the fair value of its warrant liability of $198,000. In addition, the Company utilized cash through an increase in accounts receivable of $143,000 as well as through a reduction of prepaid expenses and other assets of $216,000 and generated approximately $884,000 in cash through an increase in its amount owing its creditors, and an increase in assets and liabilities of discontinued operations of $86,000.
The Company generated approximately $3,455,000 of cash during the year from financing activities as a result of proceeds from a private placement of common stock and warrants in the amount of $1,250,000 and cash proceeds from warrant exercises of $112,000. In addition, the Company generated approximately $1,483,000 as a result of its Note and Warrant Offering which expired on December 31, 2004. In addition, the Company incurred gross borrowings of $1,057,000 and repaid $447,000 against those borrowings.
Financing Activities
The Company funded its cash needs during the year ended December 31, 2005 with cash on hand from December 31, 2004, through the use of proceeds from borrowings under convertible debt agreements as well as the proceeds from a Note and Warrant Offering.
The Company has a $1,971,000 term loan bearing interest at LIBOR plus 1.5% (approximately 5.26% at December 31, 2005), which is payable quarterly. There are no financial covenants and the term loan is guaranteed by Liraz Systems, Ltd., the Company’s former principal shareholder. During 2000, the loan and guaranty were amended to extend the due date from May 31, 2001 to November 30, 2003 and to provide the Company with additional borrowings. In exchange for the initial and amended guarantees, the Company issued Liraz a total of 170,000 shares of the Company’s common stock. Based upon fair market value at the time of issuance, the Company recorded total deferred costs of $4,013,000 related to the guaranty. These costs were amortized in the statement of operations as a component of interest expense over the term of the guaranty. In November 2003, the Company and Liraz Systems Ltd. agreed to extend its guaranty on the Company’s term loan and with Bank Hapoalim, the note holder, to extend the maturity date on the loan to November 8, 2004. Under the terms of the agreement with Liraz, the Company agreed to issue 300,000 shares of its common stock. In September 2004, The Company and Liraz Systems Ltd. agreed to extend its guaranty on the term loan with Bank Hapoalim, and to extend the maturity date on the loan to November 3, 2005. Under the terms of the agreement with Liraz, the Company agreed to issue 3,942,000 shares of its common stock. In November 2005, The Company and Liraz Systems Ltd. agreed to extend its guaranty on the term loan with Bank Hapoalim, and to extend the maturity date on the loan to November 15, 2006. Under the terms of the agreement with Liraz, the Company agreed to issue 2,400,000 shares of its common stock and granted a warrant to purchase an additional 3,600,000 shares of our common stock at an exercise price of $0.002 per share. Based upon fair market value at the time of issuance, the Company recognized
$48,000 as loan amortization costs in the Statement of Operations for the year ended December 31, 2005. Because the warrants are contingently issuable upon an event outside the control of the Company (the proposed recapitalization merger see Note 13), the Company has not recognized any value to these warrants until the contingency is removed.
In 2004, the Company announced a Note and Warrant Offering in which warrant holders of Level 8’s common stock were offered a one-time conversion of their existing warrants at a conversion price of $0.10 per share as part of a recapitalization merger plan. Under the terms of the Offer, which expired on December 31, 2004, warrant holders who elect to convert, would tender their conversion price in cash and receive a Note Payable in exchange. As of December 31, 2004 the company had raised $1,615,000. Upon approval of the recapitalization merger at a Shareholders meeting, these Notes would convert into common shares of Cicero, Inc., the surviving corporation in the merger. In addition, those warrant holders who elected to convert the first $1 million of warrants would receive additional replacement warrants at a ratio of 2:1 for each warrant converted, with a strike price of $0.10 per share. In addition, upon approval of the recapitalization merger, each warrant holder would be entitled to additional warrants to purchase common stock in Cicero, Inc. In early 2005, the Company announced an extension to the Note and Warrant offering and as of December 31, 2005, the Company has raised an additional $944,000 for a total of approximately $2,559,000.
From July through December 2005, the Company entered into several Convertible Bridge Notes with a consortium of investors. As of December 31, 2005, the Company had raised $1,760,000 of Convertible Bridge Notes of which $566,000 was from various members of the Company’s Board of Directors. Under the terms of these Notes, holders will convert their Notes into 62,490,887 shares of Cicero, Inc. common stock upon effectiveness of the proposed recapitalization merger. If the merger proposal is not approved, the Notes will immediately become due and payable.
The Company believes that the recapitalization merger will have a positive impact on the future operations of the Company and its ability to raise additional capital that it will need to continue operations, however, there can be no assurance that management will be successful in executing as anticipated or in a timely enough manner. If these strategies are unsuccessful, the Company may have to pursue other means of financing that may not be on terms favorable to the Company or its stockholders. If the Company is unable to increase cash flow or obtain financing, it may not be able to generate enough capital to fund operations for the next twelve months. We do not believe that we currently have sufficient cash on hand to finance operations for the next twelve months. At our current rates of expense and assuming revenues for the next twelve months at the annualized rate of revenue for the year ended 2005, we will be able to fund planned operations with existing capital resources for a minimum of four months and experience negative cash flow of approximately $1.9 million during the next twelve months to maintain planned operations. The accompanying financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The financial statements presented herein do not include any adjustments relating to the recoverability of assets and classification of liabilities that might be necessary should Level 8 be unable to continue as a going concern.
In April 2005, the Company borrowed $30,000 from a member of the Company’s Board of Directors pursuant to a convertible loan agreement. Under the term of this agreement, the loan bears interest at 1% per month and is convertible upon the option of the note holder into 428,571 shares of our common stock at a conversion price of $0.07 per share.
In January 2004, the Company completed a common stock financing round wherein it raised $1,247,000 of capital from several new investors as well as certain investors of Critical Mass Mail, Inc. The Company sold 3,369,192 shares of common stock at a price of $0.37 per share. As part of the financing, the Company has also issued warrants to purchase 3,369,192 shares of the Company’s common stock at an exercise price of $0.37. The warrants expire three years from the date of grant.
On March 19, 2003, the Company completed a $3.5 million private placement of Series D Convertible Redeemable Preferred Stock (“Series D Preferred Stock”), convertible at a conversion ratio of $0.32 per share of common stock into an aggregate of 11,031,250 shares of common stock. As part of the financing, the Company has also issued warrants to purchase an aggregate of 4,158,780 shares of common stock at an exercise price of $0.07 per share (“Series D-1 Warrants”). On October 10, 2003, the Company, consistent with its obligations, also issued warrants to purchase an aggregate of 1,665,720 shares of common stock at an exercise price the lesser of $0.20 per share or market price at the time of exercise (“Series D-2 Warrants”). The Series D-2 Warrants became exercisable on November 1, 2003, because the Company failed to report $6 million in gross revenues for the nine-month period ended September 30, 2003. Both existing and new investors participated in the financing. The Company also agreed to register the common stock issuable upon conversion of the Series D Preferred Stock and exercise of the warrants for resale under the Securities Act of 1933, as amended. Under the terms of the financing agreement, a redemption
event may occur if any one person, entity or group shall control more than 35% of the voting power of the Company’s capital stock. The Company allocated the proceeds received from the sale of the Series D Preferred Stock and warrants to the preferred stock and detachable warrants on a relative fair value basis, resulting in the allocation of $2,890,000 to the Series D Preferred Stock and $640,000 to the detachable warrants. Based upon the allocation of the proceeds, the Company determined that the effective conversion price of the Series D Preferred Stock was less than the fair value of the Company’s common stock on the date of issuance. The beneficial conversion feature was recorded as a discount on the value of the Series D Preferred Stock and an increase in additional paid-in capital. Because the Series D Preferred Stock was convertible immediately upon issuance, the Company fully amortized such beneficial conversion feature on the date of issuance.
As part of the financing, the Company and the lead investors agreed to form a joint venture to exploit the Cicero technology in the Asian market. The terms of the agreement required that the Company deposit $1 million of the gross proceeds from the financing into escrow to fund the joint venture. The escrow agreement allowed for the immediate release of funds to cover organizational costs of the joint venture. During the quarter ended March 31, 2003, $225,000 of escrowed funds was released. Since the joint venture was not formed and operational on or by July 17, 2003, the lead investors had the right, but not the obligation, to require the Company to purchase $1 million in liquidation value of the Series D Preferred Stock at a 5% per annum premium, less their pro-rata share of expenses. On October 21, 2004, the Company received notification from the lead investors of their intent to redeem the escrow balance and surrender the equivalent amount of Series D preferred shares. This redemption was completed in November 2004.
Another condition of the financing required the Company to place an additional $1 million of the gross proceeds into escrow, pending the execution of a definitive agreement with Merrill Lynch providing for the sale of all right, title and interest to the Cicero technology. Since a transaction with Merrill Lynch for the sale of Cicero was not consummated by May 18, 2003, the lead investors had the right, but not the obligation, to require the Company to purchase $1 million in liquidation value of the Series D Preferred Stock at a 5% per annum premium. In addition, the Company and the lead investor agreed to extend the escrow release provisions until the end of July 2003 when all remaining escrow monies were released to the Company.
In connection with the sale of Series D Preferred Stock, the holders of the Company’s Series A3 Preferred Stock and Series B3 Preferred Stock (collectively, the “Existing Preferred Stockholders”), entered into an agreement whereby the Existing Preferred Stockholders have agreed to waive certain applicable price protection anti-dilution provisions. Under the terms of the waiver agreement, the Company is also permitted to issue equity securities representing aggregate proceeds of up to an additional $4.9 million following the sale of the Series D Preferred Stock. Additionally, the Existing Preferred Stockholders have also agreed to a limited lock-up restricting their ability to sell common stock issuable upon conversion of their preferred stock and warrants and to waive the accrual of any dividends that may otherwise be payable as a result of the Company’s delisting from Nasdaq. As consideration for the waiver agreement, the Company has agreed to issue on a pro rata basis up to 1,000,000 warrants to all the Existing Preferred Stockholders on a pro rata basis at such time and from time to time as the Company closes financing transactions that represent proceeds in excess of $2.9 million, excluding the proceeds from the Series D Preferred Stock transaction and any investments made by a strategic investor in the software business. Such warrants will have an exercise price that is the greater of $0.40 or the same exercise price as the exercise price of the warrant, or equity security, that the Company issues in connection with the Company’s financing or loan transaction that exceeds the $2.9 million threshold.
In October 2003, the Company completed a common stock financing round wherein it raised $853,000 of capital. The offering closed on October 15, 2003. The Company sold 1,894,444 shares of common stock at a price of $0.45 per share for a total of $853,000 in proceeds and issued warrants to purchase 473,611 shares of the Company’s common stock at an exercise price of $0.45. The warrants expire three years from the date of grant. As part of an agreement with Liraz Systems Ltd, the guarantor of the Company’s term loan, the Company used $200,000 of the proceeds to reduce the principal outstanding on the term loan to $1,971,000.
The Company incurred loss of approximately $3,681,000 for the year ended December 31, 2005 in addition to losses from continuing operations of approximately $19,605,000 for the previous two fiscal years. The Company has experienced negative cash flows from operations for the past three years. At December 31, 2005, the Company had a working capital deficiency of approximately $13,894,000. The Company’s future revenues are entirely dependent on acceptance of Cicero, which has limited success in commercial markets to date. Accordingly, there is substantial doubt that the Company can continue as a going concern and the independent auditor’s report accompanying our financial statements raises doubts about our ability to continue as a going concern.. In order to address these issues and to obtain adequate financing for the Company’s operations for the next twelve months, the Company is actively promoting and expanding its product line and continues to negotiate with significant customers who have demonstrated interest in the Cicero software technology. The Company is experiencing difficulty increasing sales revenue largely because of the unique nature of the product as well as customer concerns about
the financial viability of the Company. Cicero software is a new “category defining” product in that most Enterprise Application Integration (EAI) projects are performed at the server level and Cicero’s integration occurs at the desktop level without the need to open and modify the underlying code for those applications being integrated. Many companies are not aware of this new technology or tend to look toward more traditional and accepted approaches. The Company is attempting to solve the former problem by improving the market’s knowledge and understanding of Cicero software through increased marketing and leveraging our limited number of reference accounts, while enhancing our list of resellers and systems integrators to assist in the sales and marketing process. Additionally, we must seek additional equity capital or other strategic transactions in the near term to provide additional liquidity.
Contractual Obligations
Future minimum payments for all contractual obligations for years subsequent to December 31, 2005 are as follows (in thousands):
Short and long-term debt, including interest payments includes approximately $992,000 of convertible notes and $2,559,000 of short term debt related to the Note and Warrant Offering and $1,760,000 of Convertible Bridge Notes. Upon approval of the recapitalization merger, these amounts will convert into equity in the surviving company.
Under the employment agreement between the Company and Mr. Pizi effective January 1, 2005, the Company is to pay Mr. Pizi an annual base salary of $200,000, and a performance bonus in cash of up to $400,000 per annum based upon certain revenue goals, as determined by the Compensation Committee of the Board of Directors of the Company, in its discretion. In August 2005, Mr. Pizi voluntarily reduced his annual salary to $150,000 for the year. Upon termination of Mr. Pizi's employment by the Company without cause, the Company has agreed to pay Mr. Pizi (a) a lump sum payment of one year of Mr. Pizi's then base salary within thirty (30) days of termination, (b) all then outstanding but unvested stock options shall vest one hundred percent (100%), and (c) two hundred thousand (200,000) shares of the Company's common stock.
Under the employment agreement between the Company and Mr. Broderick effective January 1, 2005, the Company pays Mr. Broderick a base salary of $200,000 and a performance bonus of cash up to 50% of Mr. Broderick’s base salary. In August 2005, Mr. Broderick voluntarily reduced his annual salary to $150,000 for the year. Upon termination of Mr. Broderick's employment by the Company without cause, the Company has agreed to provide Mr. Broderick with salary continuation of six months of Mr. Broderick's then base salary beginning on the first payday after the date of termination.
Off Balance Sheet Arrangements
The Company does not have any off balance sheet arrangements. We have no subsidiaries or other unconsolidated limited purpose entities, and we have not guaranteed or otherwise supported the obligations of any other entity.
Significant Accounting Policies and Estimates
The policies discussed below are considered by us to be critical to an understanding of our financial statements because they require us to apply the most judgment and make estimates regarding matters that are inherently uncertain. Specific risks for these critical accounting policies are described in the following paragraphs. With respect to the policies discussed below, we note that because of the uncertainties inherent in forecasting, the estimates frequently require adjustment.
Our financial statements and related disclosures, which are prepared to conform to accounting principles generally accepted in the United States of America, require us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and accounts receivable and expenses during the period reported.
We are also required to disclose amounts of contingent assets and liabilities at the date of the financial statements. Our actual results in future periods could differ from those estimates. Estimates and assumptions are reviewed periodically, and the effects of revisions are reflected in the Consolidated Financial Statements in the period they are determined to be necessary.
We consider the most significant accounting policies and estimates in our financial statements to be those surrounding: (1) revenue recognition; (2) allowance for doubtful trade accounts receivable; and (3) valuation of deferred tax assets. These accounting policies, the basis for any estimates and potential impact to our Consolidated Financial Statements, should any of the estimates change, are further described as follows:
Revenue Recognition. Our revenues are derived principally from three sources: (i) license fees for the use of our software products; (ii) fees for consulting services and training; and (iii) fees for maintenance and technical support. We generally recognize revenue from software license fees when a license agreement has been signed by both parties, the fee is fixed or determinable, collection of the fee is probable, delivery of our products has occurred and no other significant obligations remain. For multiple-element arrangements, we apply the “residual method”. According to the residual method, revenue allocated to the undelivered elements is allocated based on vendor specific objective evidence (“VSOE”) of fair value of those elements. VSOE is determined by reference to the price the customer would be required to pay when the element is sold separately. Revenue applicable to the delivered elements is deemed equal to the remainder of the contract price. The revenue recognition rules pertaining to software arrangements are complicated and certain assumptions are made in determining whether the fee is fixed and determinable and whether collect ability is probable. For instance, in our license arrangements with resellers, estimates are made regarding the reseller’s ability and intent to pay the license fee. Our estimates may prove incorrect if, for instance, subsequent sales by the reseller do not materialize. Should our actual experience with respect to collections differ from our initial assessment, there could be adjustments to future results.
Revenues from services include fees for consulting services and training. Revenues from services are recognized on either a time and materials or percentage of completion basis as the services are performed and amounts due from customers are deemed collectible and non-refundable. Revenues from fixed price service agreements are recognized on a percentage of completion basis in direct proportion to the services provided. To the extent the actual time to complete such services varies from the estimates made at any reporting date, our revenue and the related gross margins may be impacted in the following period.
Allowance for Doubtful Trade Accounts Receivable. In addition to assessing the probability of collection in conjunction with revenue arrangements, we continually assess the collectability of outstanding invoices. Assumptions are made regarding the customer’s ability and intent to pay and are based on historical trends, general economic conditions, and current customer data. Should our actual experience with respect to collections differ from our initial assessment, there could be adjustments to bad debt expense.
Capitalization and Valuation of Software Product Technology. Our policy on capitalized software costs determines the timing of our recognition of certain development costs. In addition, this policy determines whether the cost is classified as development expense or cost of software revenue. Management is required to use professional judgment in determining whether development costs meet the criteria for immediate expense or capitalization. Additionally, we review software product technology assets for net realizable value at each balance sheet date. Should we experience reductions in revenues because our business or market conditions vary from our current expectations, we may not be able to realize the carrying value of these assets and will record a write down at that time. For the year ended December 31, 2004, the Company recorded a write down of software product technology totaling $3,585,000 and as of December 31, 2005 the Company had $0 in capitalized software product technology.
Valuation of Deferred Tax Assets. 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 income 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 income 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 established to the extent that it is more likely than not, that we will be unable to utilize deferred income tax assets in the future. At December 31, 2005, we had a valuation allowance of $96,454,000 against $96,454,000 of gross deferred tax assets. We considered all of the available evidence to arrive at our position on the net deferred tax asset; however, should circumstances change and alter our judgment in this regard, it may have an impact on future operating results.
At December 31, 2005, the Company has net operating loss carryforwards of approximately $230,926,000, which may be applied against future taxable income. These carryforwards will expire at various times between 2006 and 2025. A substantial portion of these carryforwards is restricted to future taxable income of certain of the Company’s subsidiaries or limited by Internal Revenue Code Section 382. Thus, the utilization of these carryforwards cannot be assured.
Restructuring Reserves. At December 31, 2002, the Company’s restructuring liabilities totaled $772,000 which represented estimated excess facilities costs. In August 2003, the Company settled litigation relating to these excess facilities. Accordingly, the Company has reversed the restructuring balance. Under the terms of the settlement agreement, the Company agreed to assign the note receivable from the sale of Geneva to EM Software Solutions, Inc., with recourse equal to the unpaid portion of the note receivable should the note obligor, EM Software Solutions, Inc., default on future payments. The current unpaid principal portion of the note receivable at assignment is approximately $247,000 and matures December 2007. The Company assessed the probability of liability under the recourse provisions using a probability weighted cash flow analysis and has recognized a long-term liability in the amount of $131,000.
Recent Accounting Pronouncements:
In December 2004, the FASB issued SFAS 123 (revised 2004), Share-Based Payment, (SFAS 123R). SFAS 123R addresses the accounting for share-based payments to employees, including grants of employee stock options. Under the new standard, companies will no longer be able to account for share-based compensation transactions using the intrinsic method in accordance with APB Opinion No. 25, “Accounting For Stock Issued To Employees”. Instead, companies will be required to account for such transactions using a fair-value method and recognize the expense in the consolidated statement of income. SFAS 123R will be effective for periods beginning after June 15, 2005 and allows, but does not require, companies to restate the full fiscal year of to reflect the impact of expensing share-based payments under SFAS 123R. The Company has not yet determined which fair-value method and transitional provision it will follow. However, the Company expects that the adoption of SFAS 123R will have a significant impact on its results of operations. The Company does not expect the adoption of SFAS 123R will impact its overall financial position. See Stock-Based Compensation in Note 1 for the pro forma impact on net income and net income per share from calculating stock-based compensation costs under the fair value alternative of SFAS 123. However, the calculation of compensation cost for share-based payment transactions after the effective date of SFAS 123R may be different from the calculation of compensation cost under SFAS 123, but such differences have not yet been quantified.
In January 2003, the FASB issued Interpretation No. 46 or FIN 46 “Consolidation of Variable Interest Entities”, an interpretation of Accounting Research Bulletin No. 51, “Consolidated Financial Statements”. In October 2003, the FASB issued FASB Staff Position FIN 46-6, “Effective Date of FASB Interpretation No. 46, Consolidation of Variable Interest Entities” deferring the effective date for applying the provisions of FIN 46 for public entities’ interests in variable interest entities or potential variable interest entities created before February 1, 2003 for financial statements of interim or annual periods that end after December 15, 2003. FIN establishes accounting guidance for consolidation of variable interest entities that function to support the activities of the primary beneficiary. In December 2003, the FASB issued FIN 46 (revised December 2003), “Consolidation of Variable Interest Entities.” This revised interpretation is effective for all entities no later than the end of the first reporting period that ends after March 15, 2004. The Company has no investment in or contractual relationship or other business relationship with a variable interest entity and therefore the adoption of this interpretation did not have any impact on its consolidated financial position or results of operations. However, if the Company enters into any such arrangement with a variable interest entity in the future or an entity with which we have a relationship is reconsidered based on guidance in FIN 46 to be a variable interest entity, the Company’s consolidated financial position or results of operations might be materially impacted.
In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity”. SFAS No. 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). Many of those instruments were previously classified as equity. Some of the provisions of this Statement are consistent with the current definition of liabilities in FASB Concepts Statement No. 6, “Elements of Financial Statements”. The adoption of this statement did not have a material impact on the Company’s results of operations and financial condition.
Item 7a.
Item 7a. Quantitative and Qualitative Disclosures about Market Risk
As the Company has sold most of its European based business and has closed several European sales offices, the majority of revenues are generated from US sources. The Company expects that trend to continue for the next year. As such, there is minimal foreign currency risk at present. Should the Company continue to develop a reseller presence in Europe and Asia, that risk will be increased.
Item 8.
Item 8. Financial Statements and Supplementary Data
The information required by this item appears beginning on page of this report.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
During the two most recent fiscal years there were no changes in or disagreements with the Company’s independent public accountants.
Item 9A.
Item 9A. Controls and Procedures
The Company, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer, President and Chief Operating Officer and Chief Financial Officer, carried out an evaluation of the effectiveness of the design and operation of the Company’s disclosure controls and procedures (the “Evaluation”) as of the end of the period covered by this Report. Based upon the Evaluation, the Company’s Chief Executive Officer, President and Chief Operating Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective to ensure that information required to be disclosed in our periodic reports filed with the Securities and Exchange Commission is recorded, processed, summarized and reported as and when required. In addition, they concluded that there were no significant deficiencies or material weaknesses in the design or operation of internal controls which could significantly affect the Company’s ability to record, process, summarize and report financial information. It should be noted that any system of controls, however well designed and operated, can provide only reasonable, and not absolute, assurance that the objectives of the system will be met. In addition, the design of any control system is based in part upon certain assumptions about the likelihood of future events. Because of these and other inherent limitations of control systems, there is only reasonable assurance that the Company’s controls will succeed in achieving their stated goals under all potential future conditions.
In addition, the management of the Company, with the participation of the Company's Chief Executive Officer and the Chief Financial Officer, has evaluated whether any change in the Company's internal control over financial reporting (as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934) occurred during the Company's fourth fiscal quarter. Based on that evaluation, the Company's Chief Executive Officer and Acting Chief Financial
Officer have concluded that there has been no change in the Company's internal control over financial reporting during the fourth fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting.
Item 9B.
Item 9B. Other Information
The following disclosure has been filed on Form 8-K under the heading “Item 5.02. Departure of Directors or Principal Officers, Election of Directors, Appointment of Principal Officers.
On March 10, 2005, Level 8 Systems reported the election of Mr. Ralph Martino as Chairman of the Board of Directors replacing Mr. Anthony Pizi who remains as a director.
On June 3, 2005, the Company reported the resignation of Mr. Ralph Martino as Chairman of the Board of Directors.
On June 6, 2005 the Company reported the election of Mr. Charles B. Porciello to the Board of Directors.
On July 27, 2005, the Company reported the resignations of Nicholas Hatalski and Kenneth Nielsen as members of the Board of Directors and the appointments of Mark Landis, Bruce Miller, Fredric Mack and John Broderick as members to the Company’s Board of Directors.
On January 10, 2006, Mr. Bruce Percelay was elected by the Board of Directors to serve as a member of the Board of Directors of Level 8 Systems, Inc.
On March 9, 2006, the Company reported the resignation of Mr. Fredric Mack from the Board of Directors.
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant
As of December 31, 2005, the Board of Directors of the Company consisted Mark Landis, Fredric Mack, Bruce Miller, John Broderick, Charles B. Porciello, Anthony Pizi, Bruce Hasenyager and Jay Kingley. On January 10, 2006 Bruce Percelay was elected to the Board of Directors by vote of existing Directors. Messrs. Pizi, Kingley, and Hasenyager were elected at the 2003 Special Meeting of Stockholders and Messrs. Landis, Mack, Miller, Broderick, and Porciello were elected by unanimous vote of the board of directors, to serve until the election and qualification of their successors or until their earlier death, resignation or removal. On March 7, 2005 the board of directors elected by unanimous vote Mr. Ralph Martino to serve on the board until the next special meeting of stockholders. On May 31, 2005, Mr. Martino resigned from the board. Mr. Nicholas Hatalski and Mr. Kenneth Nielsen resigned from the board in July 2005. On March 7, 2006 Mr. Fredric Mack resigned from the Board of Directors. Messrs. Martino’s, Hatalski’s, Nielsen’s, and Mack’s resignations were not the result of a disagreement with Level 8 or its management.
Set forth below with respect to each director is his name, age, principal occupation and business experience for the past five years and length of service as a director of the Company.
Mark Landis
Director since July 2005. Age: 64
Mr. Mark Landis is the Senior Managing Member of the Security Growth Fund, a newly established private equity firm focused on the electronic security industry. Prior to joining the Security Growth Fund and since 2003, Mr. Landis was the Executive in Residence of The Jordan Company, a private equity firm based in New York. Mr. Landis retired from being President of the North American Security Division of Siemens Building Technologies, Inc. in July of 2003, having spent years with the company.
Anthony C. Pizi
Director since August 2000. Age: 46
Mr. Pizi has served as Chairman of the Board of Directors from December 1, 2000 until March 7, 2005 and from June 1, 2005 until July 22, 2005. Mr. Pizi currently is Chief Information Officer. He served as Chief Executive Officer and Chief Technology Officer from February 1, 2001 to July 22, 2005. Mr. Pizi has been a director since August 2000. Until December 2000, he was First Vice President and Chief Technology Officer of Merrill Lynch’s Private Client Technology Architecture and Service Quality Group. Mr. Pizi’s 16 years with Merrill Lynch included assignments in Corporate MIS, Investment Banking and Private Client. Mr. Pizi earned his B.S. in Engineering from West Virginia University.
Bruce W. Hasenyager
Director since October 2002. Age: 63
Mr. Hasenyager has been a director of Level 8 since October 2002. Since November 2004, Mr. Hasenyager has served as Principal of Bergen & Webster Executive Communications. Prior to that, he served as Director of Business and Technology Development at the Hart eCenter at Southern Methodist University (SMU) and Chief Operating Officer of the Guildhall at SMU. From April 1996 to April 2002, Mr. Hasenyager was a founder and served as Senior Vice President of Technology and Operations and Chief Technology Officer at MobilStar Network Corporation. Prior to April 1996, Mr. Hasenyager held executive and senior management positions in information technology at Chemical Bank, Merrill Lynch, Kidder Peabody, and Citibank.
Jay R. Kingley
Director since November 2002. Age: 44
Mr. Kingley has been a director of Level 8 since November 2002. Mr. Kingley is currently the Chief Executive Officer of Kingley Institute LLC, a medical wellness company. Prior to that, Mr. Kingley has served as CEO of Warren Partners, LLC, a software development and consultancy company. Mr. Kingley was Managing Director of a business development function of Zurich Financial Services Group from 1999-2001. Prior to joining Zurich Financial Services Group, Mr. Kingley was Vice President of Diamond Technology Partners, Inc., a management-consulting firm.
Charles B. Porciello
Director since June 2005. Age: 70
Mr. Porciello has been a director since June 6, 2005. Mr. Porciello graduated from the U.S. Military Academy with a B.S. in Engineering and received his Masters Degree in Management from the University of Nebraska. Mr. Porciello is the Chief Executive Officer of Pilar Services, Inc. Prior to that, Mr. Porciello served as Chief Operating Officer for Enterprise Integration Corporation until 2003. Mr. Porciello was Vice President of Capstone Corporation from 1998 to 2000. Mr. Porciello retired from the U.S. Air Force in 1982 after serving his country for twenty five years.
Bruce Miller
Director since July 2005. Age: 55
Mr. Bruce Miller is a General Partner of Delphi Partners, Ltd. a privately-owned investment partnership since 1989. He is a director of American Season Corporation. Mr. Miller has served as a consultant for various entities including a long-standing association with Cape Air/Nantucket Airlines, Inc. Mr. Miller sits on the board of the Nantucket Historical Association and is involved in other non-profit activities. Mr. Miller received his B.S. in Finance from Lehigh University and subsequently earned an M.B.A. from Lehigh.
Bruce A. Percelay
Director since January 2006. Age: 50
Mr. Percelay has been a director since January 10, 2006. Mr. Percelay is the Founder and Chairman of the Mount Vernon Company, a real estate investment company specializing in the acquisition and renovation of multi-family and commercial properties in Greater Boston Communities. Since Mr. Percelay has been President of the Board of Habitat for Humanity in Greater Boston. Mr. Percelay is currently Chairman of the Board of Make-A-Wish Foundation of Greater Boston and Eastern Massachusetts. Since 2002 Mr. Percelay has been a Board Member of the Nantucket Historic Association. Mr. Percelay received his B.S. from Boston University School of Management, and a BA in Business and Economics from City of London Polytechnic, Special Studies in Economics.
John P. Broderick
Director since July 2005. Age: 56
Mr. Broderick is currently the Chief Executive Officer and Chief Financial Officer of Level 8. Mr. Broderick has served as the Chief Operating Officer of Level since June 2002, as the Chief Financial Officer of Level 8 since April 2001, and as Corporate Secretary since August 2001. Prior to joining our Company, Mr. Broderick was Executive Vice President of Swell Inc., a sports media e-commerce company where he oversaw the development of all commerce operations and served as the organization's interim Chief Financial Officer. Previously, Mr. Broderick served as chief financial officer for Programmer's Paradise, a publicly held (NASDAQ: PROG) international software marketer. Mr. Broderick received his B.S. in accounting from Villanova University.
Compensation Committee Interlocks and Insider Participation
The Compensation Committee for 2005 was comprised of Messrs. Kingley and Porciello. Messrs. Neilsen and Hatalski served on the Committee until their resignation from the Board in July 2005. None of the current members of the Compensation Committee has served as an executive officer of the Company, and no executive officer of the Company has served as a member of the Compensation Committee of any other entity of which Messrs. Kingley and Porciello have served as executive officers. Mr. Porciello is the Chief Executive Office of Pilar Services Inc., a reseller partner of the Company. The Company has not recognized any revenues with Pilar to date. There were no interlocking relationships between the Company and other entities that might affect the determination of the compensation of the directors and executive officers of the Company.
Director Compensation
In May 1999, stockholders of the Company approved the Outside Director Stock Incentive Plan of the Company. Under this plan, the outside directors may be granted an option to purchase 12,000 shares of common stock at a price equal to the fair market value of the common stock as of the grant date. In January 2002, the board of directors approved an amendment to the Outside Director Stock Incentive Plan to provide an increase in the number of options to be granted to outside directors to 24,000. These options vest over a three-year period in equal increments upon the eligible director’s election to the Board, with the initial increment vesting on the date of grant. The Outside Director Stock Incentive Plan also permits eligible directors to receive partial payment of director fees
in common stock in lieu of cash, subject to approval by the board of directors. In addition, the plan permits the board of directors to grant discretionary awards to eligible directors under the plan. None of the Company’s directors received additional monetary compensation for serving on the board of directors of the Company in 2001, other than reimbursement of reasonable expenses incurred in attending meetings.
In October 2002, the board of directors approved an amendment to the stock incentive plan for all non-management directors. Under the amendment, each non-management director will receive 100,000 options to purchase common stock of the Company at the fair market value of the common stock on the date of grant. These shares will vest in three equal increments with the initial increment vesting on the date of grant. The option grant contains an acceleration of vesting provision should the Company incur a change in control. A change in control is defined as a merger or consolidation of the Company with or into another unaffiliated entity, or the merger of an unaffiliated entity into the Company or another subsidiary thereof with the effect that immediately after such transaction the stockholders of the Company immediately prior to the transaction hold less than fifty percent (50%) of the total voting power of all securities generally entitled to vote in the election of directors, managers or trustees of the entity surviving such merger or consolidation. Under the amendment, there will be no additional compensation awarded for committee participation. The shares allocated to the board of directors are being issued out of the Level 8 Systems, Inc. 1997 Employee Stock Plan.
Executive Officers
The Company’s current executive officers are listed below, together with their age, position with the Company and business experience for the past five years.
Anthony C. Pizi. Age:
Mr. Pizi currently serves as the Chief Information Officer of Level 8. He served as the Chief Executive Officer and Chief Technology Officer of Level 8 from February 1, 2001 until July 22, 2005. Prior to joining our Company, Mr. Pizi was First Vice President and Chief Technology Officer of Merrill Lynch’s Private Client Technology Architecture and Service Quality Group. Mr. Pizi’s 16 years with Merrill Lynch included assignments in Corporate MIS, Investment Banking and Private Client. Mr. Pizi earned his B.S. in Engineering from West Virginia University.
John P. Broderick. Age:
Mr. Broderick serves as the Chief Executive Officer since July 22, 2005 and as the Chief Financial Officer of Level 8 since April 2001. He has served as the Chief Operating Officer of Level 8 since June 2002 and as Corporate Secretary since August 2001. Prior to joining our Company, Mr. Broderick was Executive Vice President of Swell Inc., a sports media e-commerce company where he oversaw the development of all commerce operations and served as the organization's interim Chief Financial Officer. Previously, Mr. Broderick served as chief financial officer for Programmer's Paradise, a publicly held (NASDAQ: PROG) international software marketer. Mr. Broderick received his B.S. in accounting from Villanova University.
Audit Committee
The Board of Directors has determined that the members of the Audit Committee are independent as defined in Rule 4200(a)(15) of the National Association of Securities Dealers’ listing standards. Mr. Frank Artale was designated the “audit committee financial expert” as defined in Item 401(h) of Regulation S-K. Following the resignation of Mr. Artale in January 2004, the Company has not appointed a replacement “audit committee financial expert” and continues to look for a candidate to fill this role on the board or directors and the Audit Committee.
Code of Ethics and Conduct
Our Board of Directors has adopted a code of ethics and a code of conduct that applies to all of our directors, Chief Executive Officer, Chief Financial Officer, and employees. We will provide copies of our code of conduct and code of ethics without charge upon request. To obtain a copy of the code of ethics or code of conduct, please send your written request to Level 8 Systems, Suite 542, 8000 Regency Pkwy, Cary, North Carolina 27511, Attn: Corporate Secretary. The code of ethics is also available on the Company’s website at www.level8.com.
Compliance with Section 16(a) of the Exchange Act
Section 16(a) of the Securities Exchange Act of 1934, as amended, requires the Company’s officers, directors and persons who own more than ten percent of the Company’s Common Stock (collectively, “Reporting Persons”)
to file reports of ownership and changes in ownership with the SEC and Nasdaq. Reporting Persons are required by SEC regulations to furnish the Company with copies of all Section 16(a) reports they file. Based solely on its review of the copies of such reports received by it and written representations all Section 16(a) reports were filed in a timely manner.
Item 11.
Item 11. Executive Compensation.
The following summary compensation table sets forth the compensation earned by all persons serving as the Company’s executive officers during fiscal year 2005, serving or having served at the end of fiscal 2004 whose salary and bonus exceeded $100,000 for services rendered to the Company during the fiscal year 2005. The table reflects compensation earned for each of the last three years or for such shorter period of service as an executive officer as is reflected below. For the principal terms of the options granted during fiscal 2005, see “Option Grants in Fiscal 2005.”
Summary Compensation Table
(1)
Mr. Pizi’s base salary for fiscal 2005 was $200,000. Mr. Pizi had voluntarily elected to defer $31,250 of salary from 2005. In August 2005 Mr. Pizi voluntarily reduced his annual salary to $150,000 for the year. Mr. Pizi was the Company’s Chief Executive Officer and Chairman until July 22, 2005. As of December 31, 2005, Mr. Pizi is owed approximately $94,935 of deferred salary and all of his earned bonus from
(2)
Mr. Pizi’s base salary for fiscal 2004 was $200,000. Mr. Pizi had voluntarily elected to defer $50,000 of salary from 2004. In December 2004, Mr. Pizi received approximately $55,000 of deferred salary from 2004 and 2003 and used those proceeds to participate in the Note and Warrant Offering.
(3)
Mr. Pizi’s base salary for fiscal 2003 was $200,000. Mr. Pizi had voluntarily elected to defer $31,250 of salary from 2003 and all of his 2003 earned bonus.
(4)
Mr. Broderick’s base salary for 2005 was $200,000. Mr. Broderick had voluntarily elected to defer $31,250 of salary from 2005. In August 2005, Mr. Broderick voluntarily reduced his annual salary to $150,000 for the year. Mr. Broderick was appointed the Company’s Chief Executive Officer in addition to being the Chief Financial Officer in July 2005. During 2005, Mr. Broderick was paid $13,000 of his accrued bonus from 2003. As of December 31, 2005, Mr. Broderick is owed approximately $112,500 of deferred salary and $47,000 of earned bonus from 2003.
(5)
Mr. Broderick’s base salary for 2004 was $200,000. Mr. Broderick voluntarily elected to defer $50,000 of salary from 2004 and all of his earned bonus ($60,000) from 2003.
(6)
Mr. Broderick’s base salary for 2003 was $200,000. Mr. Broderick voluntarily elected to defer $31,250 of salary from 2003 and all of his earned bonus.
The Company did not award any grants of stock options to the Named Executives during fiscal 2005. The Company did not award any stock appreciation rights (“SARs”) during fiscal 2005.
The following table sets forth information concerning the options exercised during fiscal 2005 and held at December 31, 2005 by the Named Executives.
Fiscal 2005 Year-End Option Holdings and Values
(1)
Based on $0.02 per share, the December 31, 2005, closing price as quoted on the OTC Bulletin Board.
Employment Agreements, Termination of Employment and Change-In-Control Arrangements
Under the employment agreement between the Company and Mr. Pizi effective January 1, 2005, the Company is to pay Mr. Pizi an annual base salary of $200,000 and a performance bonus in cash of up to $400,000 per annum based upon certain revenue goals, as determined by the Compensation Committee of the Board of Directors of the Company, in its discretion. Upon termination of Mr. Pizi’s employment by the Company without cause, the Company has agreed to pay Mr. Pizi (a) a lump sum payment of one year of Mr. Pizi’s then base salary within thirty (30) days of termination and (b) two hundred thousand (200,000) shares of the Company’s common stock. In the event there occurs a substantial change in Mr. Pizi’s job duties, there is a decrease in or failure to provide the compensation or vested benefits under the employment agreement or there is a change in control of the Company, the Company has agreed to grant Mr. Pizi five hundred thousand (500,000) shares of the Company’s common stock. If Mr. Pizi’s employment is terminated for any reason, Mr. Pizi has agreed that, for one (1) year after such termination, he will not directly or indirectly solicit or divert business from the Company or assist any business in attempting to do so or solicit or hire any person who was an employee of the Company during the term of his employment agreement or assist any business in attempting to do so.
Under the employment agreement between the Company and Mr. Broderick effective January 1, 2005, the Company pays Mr. Broderick a base salary of $200,000 and a performance bonus of cash up to $100,000 per annum based upon certain revenue goals, as determined by the Compensation Committee of the Board of Directors of the Company, in its discretion. Upon termination of Mr. Broderick’s employment by the Company without cause, the Company has agreed to provide Mr. Broderick with salary continuation of six months of Mr. Broderick’s then base salary beginning on the first payday after the date of termination. In the event there occurs a substantial change in Mr. Broderick’s job duties, there is a decrease in or failure to provide the compensation or vested benefits under the employment agreement or there is a change in control of the Company, the Company has agreed to pay Mr. Broderick (a) a lump sum payment of one year of Mr. Broderick’s then base salary within thirty (30) days of termination and (b) two hundred fifty thousand (250,000) shares of the Company’s common stock and immediately vest all unvested stock options held by Mr. Broderick. Mr. Broderick will have thirty (30) days from the date written notice is given about either a change in his duties or the announcement and closing of a transaction resulting in a change in control of the Company to resign and execute his rights under this agreement. If Mr. Broderick’s employment is terminated for any reason, Mr. Broderick has agreed that, for one (1) year after such termination, he will not directly or indirectly solicit or divert business from the Company or assist any business in attempting to do so or solicit or hire any person who was an employee of the Company during the term of his employment agreement or assist any business in attempting to do so.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management.
The following table sets forth information as of December 31, 2005 with respect to beneficial ownership of shares by (i) each person known to the Company to be the beneficial owner of more than 5% of the outstanding common stock, (ii) each of the Company’s directors, (iii) the executive officers of the Company named in the Summary Compensation Table (the “Named Executives”) and (iv) all current directors and executive officers of the Company as a group. Unless otherwise indicated, the address for each person listed is c/o Level 8 Systems, Inc., 1433 State Highway 34, Farmingdale, New Jersey 07727.
The named person has furnished stock ownership information to the Company. Beneficial ownership as reported in this section was determined in accordance with Securities and Exchange Commission regulations and includes shares as to which a person possesses sole or shared voting and/or investment power and shares that may be acquired on or before December 31, 2005 upon the exercise of stock options as well as exercise of warrants. The chart is based on 48,039,947 common shares outstanding as of December 31, 2005. Except as otherwise stated in the footnotes below, the named persons have sole voting and investment power with regard to the shares shown as beneficially owned by such persons.
·
Represents less than one percent of the outstanding shares.
1.
The address of Brown Simpson Partners I, Ltd. is c/o Xmark Asset Mgmt. LLC, 152 West 57th St., 1st Floor, New York, New York 10019.
2.
Includes 1,197,032 shares of common stock issuable upon conversion of Series B-3 preferred stock, 460,526 shares of common stock issuable upon conversion of Series C preferred stock and 4,009,093 shares issuable upon the exercise of warrants and 270,270 shares of common stock. The exercise prices of the warrants are as follows: 115,132 at $0.38 per share, 270,270 at $0.37 per share and 3,623,691 at $0.40 per share. Brown Simpson Partners I, Ltd. disclaims beneficial ownership of 4,009,093 warrant shares because they are anti-dilutive.
3.
The address of Liraz Systems, Ltd. is 5 Hazoref St., Holon 58856, Israel.
4.
Includes 2,632 shares of common stock issuable upon the conversion of Series C preferred stock, 82,237 shares of common issuable upon the exercise of warrants at an exercise price of $0.38 per share of common stock, 3,600,000 shares of common issuable upon the exercise of warrants at an exercise price of $0.002, and 6,342,000 shares of common stock.
5.
The address of Mark and Carolyn P. Landis is 251 Crandon Blvd., Key Biscayne, Fl. 33149
6.
Includes 5,220,273 shares of common stock issuable upon the exercise of warrants issuable in connection with convertible promissory notes as follows: (i) 1,875,000 shares with an exercise price of is $0.08 per share; (ii), 2,000,000 shares with an exercise price of $0.10 per share; (iii) 781,250 shares with an exercise price of $0.16 per share; (iv) 446,429 shares with an exercise price of $0.28 per share; and (v) 117,594 shares with an exercise price of $0.37 per share. Also includes: (ii) 446,429 shares of common stock issuable upon conversion of $125,000 principal amount of convertible promissory notes issued on February 1, 2004 at a conversion price of $0.28; (ii) 781,250 shares of common stock issuable upon conversion of $125,000 principal amount of convertible promissory notes issued on June 30, 2004 at a conversion price of $0.16 (iii) 1,000,000 shares of common stock issuable upon conversion of $100,000 principal amount of convertible promissory notes issued October 12, 2004; and (iv) 1,875,000 shares of common stock issuable upon conversion of $150,000 principal amount of convertible promissory notes issued November 11, 2004. Also includes 581,623 shares of common stock. Disclaims beneficial ownership of 5,220,273 shares because they are anti-dilutive.
7.
The address of Fredric H. Mack is 2115 Linwood Avenue, Fort Lee, New Jersey 07024. Fredric H. Mack, trustee of 4-30-92 Trust, Fred Mack Trust - Hailey Mack, and Fred Mack Trust - Jason Mack, exercises sole or shared voting or dispositive power with respect to the securities held by 4-30-92 Trust, Fred Mack Trust - Hailey Mack, and Fred Mack Trust - Jason Mack.
8.
Includes 394,737 shares of common stock issuable upon conversion of Series C preferred stock and 632,883 shares of common stock issuable upon the exercise of warrants. The exercise price of warrants is as follows: 390,625 shares at $0.32 per share of common stock; 202,703 shares at $0.37 per share of common stock; 22,222 shares at $0.45 per share of common stock; and 17,333 shares $0.60 per share. Also includes 390,625 shares of common stock issuable upon conversion of $125,000 principal amount of convertible promissory notes issued on May 10, 2004 at a conversion price of $0.32. Also includes, in the Fredric Mack 4-30-92 Trust, 203,125 shares of common stock issuable upon conversion of Series D preferred stock, 30,672 shares of common stock issuable upon exercise of Series D-2 Warrants at an exercise price the lower of $0.20 or the trading price of Level 8’s common stock at the time of exercise and 9,334 shares of common stock issuable upon exercise of warrants at an exercise price of $0.60 per share. Also includes, in the trust for Hailey Mack and the trust for Jason Mack, 4,167 each shares of common stock issuable upon exercise of warrants at an exercise price of $0.45 per share.
9.
Includes 1,833,300 shares subject to stock options exercisable within sixty (60) days, 394,737 shares of common stock issuable upon conversion of Series C preferred stock and 835,742 shares of common stock issuable upon the exercise of warrants. The exercise price of warrants is as follows: 90,118 shares at $0.17 per share of common stock; 560,000 shares at $0.20 per share of common stock; and 185,624 shares at $0.32 per share of common stock. Also includes 270,270 shares of common stock issuable upon conversion of $100,000 principal amount of convertible promissory notes issued on April 12, 2004 at a conversion price of $0.37, 560,000 shares of common stock issuable upon conversion of $112,000 principal amount of convertible promissory note issued on June 11, 2004 at a conversion price of $0.20 and 90,118 shares of common stock issuable upon conversion of $15,320 principal amount of convertible promissory note issued on June 14, 2004 at a conversion price of $0.17. Disclaims beneficial ownership of 223,330 shares of common stock because they are anti-dilutive.
10.
Consists of 1,099,200 shares subject to stock options exercisable within sixty (60) days.
11.
Consists of 100,000 shares subject to stock options exercisable within sixty (60) days.
12.
Consists of 101,372 shares of Level 8 common stock issuable upon the exercise warrants. The exercise price of the warrants range from $0.37 to the lower of $0.20 or the trading price of Level 8’s common stock at the time of exercise. Includes 300,000 shares of common stock upon the conversion of $21,000 principal amount of convertible promissory note issued on April 25, 2005 at a conversion price of $0.07 per share. Mr. Miller has sole or shared voting or dispositive power with respect to the securities held by Delphi Partners, Ltd., which holds a senior promissory note in the amount of $10,203.49 which bears interest at 10% per annum. Delphi Partners, Ltd. also owns 128,571 shares of common stock issuable upon conversion of $9,000 principal amount of convertible promissory note issued on April 25, 2005 at a conversion price of $0.07. Delphi Partners owns 175,686 shares of common stock issuable upon the exercise of warrants. The exercise price of the warrants range from $0.45 to the lower of $0.20 or the trading price of Level 8’s common stock at the time of exercise.
13.
Includes shares issuable upon exercise of options and warrants exercisable within sixty (60) days as described in Notes 5-12 to our financial statements.
EQUITY COMPENSATION PLAN INFORMATION
The following table sets forth certain information as of December 31, 2005, about shares of Common Stock outstanding and available for issuance under the Company’s existing equity compensation plans: the Level 8 Systems, Inc. 1997 Stock Option Incentive Plan, the 1995 Non-Qualified Option Plan and the Outside Director Stock Option Plan. All of the Company’s Equity Compensation Plans were approved by the Company’s stockholders.
(1) The Company does not have any Equity Compensation Plans that were not approved by stockholders.
Item 13.
Item 13. Certain Relationships and Related Transactions.
Loan from Related Parties
During 2005, the Company entered into short term notes payable with Anthony Pizi, the Company’s former Chief Executive Officer, and current Chief Information Officer, for various working capital needs. The Notes bear interest at 1% per month and are unsecured. At December 31, 2005, the Company was indebted to Mr. Pizi in the amount of $9,000.
Convertible Promissory Notes. Directors and executive officers made the following loans to us for convertible promissory notes: In June 2004, the Company entered into a convertible promissory note with Mr. Pizi. The note, in the face amount of $112,000, bears interest at 1% per month and is convertible into 560,000 shares of the Company’s common stock and warrants to purchase 560,000 shares of our common stock at $0.20 per share. Also in June 2004, Mr. Pizi entered into a second convertible promissory note in the face amount of $15,000 which is convertible into 90,118 shares of the Company’s common stock and warrants to purchase 90,118 shares of the Company’s common stock at $0.17 per share.
On April 12, 2004, the Company entered into a convertible promissory note with Mr. Pizi. The note, in the face amount of $100,000, bears interest at 1% per month and is convertible into common stock of the Company at a conversion rate of $0.37 per share. In addition, Mr. Pizi was granted 270,270 warrants to purchase the Company’s common stock at $0.37 per share.
In October 2004, the Company entered into a convertible promissory note with Mr. and Mrs. Landis in the amount of $100,000. Under the terms of the agreement, the loan bears interest at 1% per month and is convertible into 1,000,000 shares of our common stock and warrants to purchase 2,000,000 shares of the Company’s common stock exercisable at $0.10 per share.
In June 2004, the Company entered into a convertible promissory note with Mr. and Mrs. Landis in the amount of $125,000. Under the terms of the note, the loan bears interest at 1% per month and is convertible into 781,250 shares of Level 8 common stock and warrants to purchase 781,250 shares of Level 8 common stock exercisable at $0.16 per share.
In March 2004, the Company entered into a convertible promissory note with Mr. and Mrs. Landis in the amount of $125,000. Under the terms of the note, the loan bears interest at 1% per month, and is convertible into
446,429 shares of Level 8 common stock and warrants to purchase 446,429 shares of Level 8 common stock exercisable at $0.28 per share.
In June 2004, the Company entered into a convertible promissory note with Fredric Mack, a former director of Level 8, in the amount of $125,000. Under the terms of the note, the loan bears interest at 1% per month, and is convertible into 390,625 shares of Level 8 common stock and warrants to purchase 390,625 shares of Level 8 common stock exercisable at $0.32 per share.
In April 2005, the Company entered into a convertible promissory note with Bruce Miller, a director of Level 8, in the amount of $30,000. Under the terms of the note, the loan bears interest at 1% per month and is convertible into 428,571 shares of Level 8 common stock.
In July 2004, the Company entered into a convertible promissory note with Nicholas Hatalski, who until July 22, 2005 (during the period when the terms of the recapitalization merger were being negotiated and at the time of approval of the recapitalization merger by our board of directors), was a director of Level 8, in the amount of $25,000. Under the terms of the note, the loan bears interest at 1.5% per month and is convertible into 78,125 shares of Level 8 common stock and warrants to purchase 78,125 shares of Level 8 common stock exercisable at $0.32 per share.
All of such warrants expire three years from date of grant.
Senior Reorganization Notes. From March 2004 to April 2005, directors and executive officers made the following loans to us for Senior Reorganization Notes: Mr. Pizi holds $423,333 of Senior Reorganization Notes, which may be converted into warrants to purchase an additional 57,165,993 shares of Level 8 common stock at a purchase price of $0.002 per share.
Mr. Landis holds $327,860 of Senior Reorganization Notes, which may be converted into warrants to purchase an additional 44,234,523 shares of Level 8 common stock at an exercise price of $0.002 per share.
Mr. Mack holds, together with his affiliates, $88,122 of Senior Reorganization Notes, which may be converted into warrants to purchase an additional 44,234,523 shares of Level 8 common stock at a purchase price of $0.002 per share.
Mr. Miller holds, together with his affiliates, $77,706 of Senior Reorganization Notes, which may be converted into warrants to purchase an additional 11,459,727 shares of Level 8 common stock at a purchase price of $0.002.
John Broderick, Chief Executive Officer and Chief Financial Officer of Level 8, holds $2,300 of Senior Reorganization Notes, which may be converted into warrants to purchase 333,333 shares of Level 8 common stock at a purchase price of $0.002 per share, and options to purchase 1,099,200 shares of common stock under the Level 8 stock option plan that will convert into options to purchase Cicero common stock.
Such warrants are only issuable upon approval of the recapitalization merger, and are to be automatically exercised in connection with the consummation of the recapitalization merger.
Convertible Bridge Notes. From July to December 2005, directors and executive officers made the following loans to us for Convertible Bridge Notes:
Mr. Pizi holds $85,000 of Convertible Bridge Notes which bear interest at 10% and mature on September 15, 2005. Upon consummation of the recapitalization merger, these notes will automatically convert into 3,400,000 shares of Cicero common stock.
Mr. Landis holds $213,000 of Convertible Bridge Notes which bear interest at 10% and mature on September 15, 2005. Upon consummation of the recapitalization merger, these notes will automatically convert into 8,520,000 shares of Cicero common stock.
Mr. Mack holds, together with his affiliates, $74,000 of Convertible Bridge Notes which bear interest at 10% and mature on September 15, 2005. Upon consummation of the recapitalization merger, these notes will automatically convert into 2,960,000 shares of Cicero common stock.
Mr. Miller holds, together with his affiliates, $90,000 of Convertible Bridge Notes which bear interest at 10% and mature on September 15, 2005. Upon consummation of the recapitalization merger, these notes will automatically convert into 3,600,000 shares of Cicero common stock.
Bruce Hasenyager, a member of our Board of Directors, holds $4,061 of Convertible Bridge Notes which bear interest at 10% and mature on September 15, 2005. Upon consummation of the recapitalization merger, these notes will automatically convert into 162,425 shares of Cicero common stock.
Bruce Percelay, a member of our Board of Directors, holds $100,000 of Convertible Bridge Notes which bear interest at 10% and mature on December 15, 2005. Upon consummation of the recapitalization merger, these notes will automatically convert into 4,000,000 shares of Cicero common stock.
Transactions with Merrill Lynch
On January 3, 2002, the Company entered into a Purchase Agreement with MLBC, Inc., an affiliate of Merrill Lynch. Pursuant to the Purchase Agreement, the Company issued 250,000 shares of its common stock to MLBC and entered into a royalty sharing agreement for sales of Cicero. Under the royalty sharing agreement, the Company is obligated to pay a royalty of 3% of the sales price for each sale of Cicero or related maintenance services. The royalties are not payable in excess of $20 million. As consideration for the issuance of the shares and the royalty payments, Merrill Lynch has entered into an amendment to the Cicero license agreement, which extends our exclusive worldwide marketing, sales, and development rights to Cicero and granted us certain ownership rights in the Cicero trademark. Pursuant to the Purchase Agreement, the Company also entered into a Registration Rights Agreement granting MLBC certain rights to have the shares of common stock it received under the Purchase Agreement registered under the Securities Act.
Preferred Stock and Warrant Exchange
On March 19, 2003, Level 8 Systems, Inc. completed a $3.5 million private placement of Series D Convertible Preferred Stock (“Series D Preferred Stock”), convertible at a conversion ratio of $0.32 per share of common stock into an aggregate of 11,031,250 shares of common stock. As part of the financing, the Company has also issued warrants to purchase an aggregate of 4,158,780 shares of common stock at an exercise price of $0.07 per share (“Series D-1 Warrants”). On October 10, 2003, the Company, consistent with its obligations, also issued warrants to purchase an aggregate of 1,665,720 shares of common stock at an exercise price the lesser of $0.20 per share or market price at the time of exercise (“Series D-2 Warrants”). The Series D-2 Warrants became exercisable on November 1, 2003, because the Company failed to report $6 million in gross revenues for the nine-month period ended September 30, 2003. Both existing and new investors participated in the financing. The Company also agreed to register the common stock issuable upon conversion of the Series D Preferred Stock and exercise of the warrants for resale under the Securities Act of 1933, as amended. Under the terms of the financing agreement, a redemption event may occur if any one person, entity or group shall control more than 35% of the voting power of the Company’s capital stock. The Company allocated the proceeds received from the sale of the Series D Preferred Stock and warrants to the preferred stock and detachable warrants on a relative fair value basis, resulting in an allocation of $2,890,000 to the Series D Preferred Stock and $640,000 to the detachable warrants. Based upon the allocation of the proceeds, the Company determined that the effective conversion price of the Series D Preferred Stock was less than the fair value of the Company’s common stock on the date of issuance. The beneficial conversion feature was recorded as a discount on the value of the Series D Preferred Stock and an increase in additional paid-in capital. Because Series D Preferred Stock was convertible immediately upon issuance, the Company fully amortized such beneficial conversion feature on the date of issuance.
On October 25, 2002, we effected an exchange of all of our outstanding shares of Series A2 Convertible Redeemable Preferred Stock (“Series A2 Preferred Stock”) and Series B2 Convertible Redeemable Preferred Stock (“Series B2 Preferred Stock”) and related warrants for an equal number of shares of newly created Series A3 Convertible Redeemable Preferred Stock (“Series A3 Preferred Stock”) and Series B3 Convertible Redeemable Preferred Stock (“Series B3 Preferred Stock”) and related warrants. This exchange was made to correct a deficiency in potential conversion price adjustments from the prior exchange of Series A1 and B1 Preferred Stock and related warrants for Series A2 and B2 Preferred Stock and related warrants on August 29, 2002. The conversion price for the Series A3 Preferred Stock and the conversion price for the Series B3 Preferred Stock remain the same as the previously issued Series A1 and A2 Preferred Stock and Series B1 and B2 Preferred Stock, at $8.333 and $12.531, respectively. The exercise price for the aggregate 753,640 warrants relating to the Series A3 Preferred Stock was increased from $0.38 to $0.40 per share which is a reduction from the $1.77 exercise price of the warrants relating to the Series A1 Preferred Stock. The exercise price for the aggregate 1,047,382 warrants relating to the Series B3 Preferred Stock was increased from $0.38 to $0.40 per share which is a reduction from the $1.77 exercise price of the warrants relating to the Series B1 Preferred Stock. The adjusted exercise price was based on the closing price of the Company’s Series C Convertible Redeemable Preferred Stock and warrants on August 14, 2002, plus $0.02, to reflect accurate current market value according to relevant Nasdaq rules. This adjustment was made as part of the agreement under which the holders of the Company’s Preferred Stock agreed to waive their price-protection anti-
dilution protections to allow the Company to issue the Series C Preferred Stock and warrants without triggering the price-protection anti-dilution provisions and excessively diluting its Common Stock.
Under the terms of the agreement, we are authorized to issue equity securities in a single or series of financing transactions representing aggregate gross proceeds to the Company of approximately $5 million, or up to an aggregate 17,500 shares of common stock, whichever occurs first, without triggering the price-protection anti-dilution provisions in the Series A3 Preferred Stock and B3 Preferred Stock and related warrants. In exchange for the waiver of these price-protection anti-dilution provisions, we repriced the warrants as described above and have agreed to issue on a pro rata basis up to 4,600 warrants to the holders of Series A3 Preferred Stock and Series B3 Preferred Stock at such time and from time to time as the Company closes subsequent financing transactions up to the $5 million issuance cap or the 17,500 share issuance cap. As a result of the Series C Preferred Stock financing which represented approximately $1.6 million of the Company’s $5 million in allowable equity issuances, the Company is obligated to issue an aggregate of 1,462,801 warrants at an exercise price of $0.40 per share to the existing Preferred Stockholders. Additionally, the Company has agreed to issue a warrant to purchase common stock to the existing Preferred Stockholders on a pro rata basis for each warrant to purchase common stock that the Company issues to a third-party lender in connection with the closing of a qualified loan transaction. The above referenced warrants will have the same exercise price as the exercise price of the warrant, or equity security, that the Company issues in connection with the Company’s subsequent financing or loan transaction or $0.40 per share (adjusted for recapitalizations, stock splits and the like), whichever is greater.
As a result of the Series D preferred Stock financing which represented approximately $3.5 million against the allowable equity issuances, the Company was obligated to issue an aggregate of 3,048,782 warrants at an exercise price of $0.40 per share to the existing Series A3 and Series B3 Preferred shareholders. The warrants were issued on October 8, 2003 and had a fair value of $1,062,000 which was recorded as a deemed dividend to preferred stockholders. Additionally, the Company has agreed to issue a warrant to purchase common stock to the existing Preferred Stockholders on a pro rata basis for each warrant to purchase common stock that the Company issues to a third-party lender in connection with the closing of a qualified loan transaction. The above referenced warrants will have the same exercise price as the exercise price of the warrant, or equity security, that the Company issues in connection with the Company’s subsequent financing or loan transaction or $0.40, whichever is greater. These warrants are not classified as a liability under EITF 00-19.
Borrowings and Commitments from Liraz
Liraz Systems Ltd. guarantees certain debt obligations of the Company. In September 2004, the Company and Liraz agreed to extend the guarantee and with the approval of the lender, agreed to extend the maturity of the debt obligation until November 3, 2005. The Company issued 3,942,000 shares of common stock to Liraz in exchange for this debt extension. In 2003, the Company and Liraz also agreed to extend the guarantee and maturity of the debt obligation until November 2004. The Company agreed to issue Liraz 300,000 shares of stock for that extension. In November 2005, The Company and Liraz Systems Ltd. agreed to extend its guaranty on the term loan and with Bank Hapoalim, to extend the maturity date on the loan to October 30,, 2006. Under the terms of the agreement with Liraz, the Company agreed to issue 2,400,000 shares of its common stock and granted a warrant to purchase an additional 3,600,000 shares of our common stock at an exercise price of $0.002 per share. Based upon fair market value at the time of issuance, the Company recognized $48,000 as loan amortization costs in the Statement of Operations for the year ended December 31, 2005.
Item 14.
Item 14. Principal Accountant Fees and Services
INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Margolis & Company P.C. audited our financial statements for each of the years ended December 31, 2005 and 2004.
AUDIT FEES
Audit fees include fees for the audit of the Company’s annual financial statements, fees for the review of the Company’s interim financial statements, and fees for services that are normally provided by the Independent Registered Public Accounting Firm in connection with statutory and regulatory filings or engagements. The aggregate fees billed by Margolis & Company P.C. for professional services rendered to our company for the audit of the Company's annual financial statements for fiscal years 2005 (and reviews of quarterly financial statements on form 10-Q), 2005 and 2004 was $36,000 for each year.
AUDIT-RELATED FEES
Audit-related fees include fees for assurance and related services that are reasonably related to the performance of the audit or review of the Company’s financial statements. There were no audit-related fees paid to Margolis & Company P.C. for fiscal years 2005 and 2004.
TAX FEES
Tax fees include fees for tax compliance, tax advice and tax planning. There were no fees billed by Margolis & Company P.C. for these services in 2005 and 2004.
OTHER FEES
All other fees include fees for all services except those described above. The aggregate other fees billed by Margolis & Company P.C. was $18,000 related to the review of the Company’s S-4 filing in 2005, and $6,100 for the Company’s S-1 filing in 2004. In addition, other fees billed by Deloitte & Touche in 2005 amounted to $27,500. These fees relate to the review of the Company’s S-4 filing during 2005.
DETERMINATION OF AUDITOR INDEPENDENCE
The Audit Committee considered the provision of non-audit services by Margolis & Company P.C. and determined that the provision of such services was consistent with maintaining the independence of Margolis & Company P.C.
AUDIT COMMITTEE'S PRE-APPROVAL POLICIES
The Audit Committee has adopted a policy that all audit, audit-related, tax and any other non-audit service to be performed by the Company’s Independent Registered Public Accounting Firm must be preapproved by the Audit Committee. It is the Company’s policy that all such services be preapproved prior to commencement of the engagement. The Audit Committee is also required to preapprove the estimated fees for such services, as well as any subsequent changes to the terms of the engagement.
PART IV
Item 15.
Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K.
(A) 1. FINANCIAL STATEMENTS
The following financial statements of the Company and the related reports of Independent Registered Public Accounting Firms thereon are set forth immediately following the Index of Financial Statements which appears on page of this report:
Independent Registered Public Accounting Firm Report
Consolidated Balance Sheets as of December 31, 2005 and 2004
Consolidated Statements of Operations for the years ended December 31, 2005, 2004 and
Consolidated Statements of Stockholders' Equity for the years ended December 31, 2005, 2004 and 2003
Consolidated Statements of Comprehensive Loss for the years ended December 31, 2005, 2004 and
Consolidated Statements of Cash Flows for the years ended December 31, 2005, 2004 and
Notes to Consolidated Financial Statements
2. FINANCIAL STATEMENT SCHEDULES
All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable and therefore have been omitted.
3. EXHIBITS
The exhibits listed under Item 15(c) hereof are filed as part of this Annual Report on Form 10-K.
(B)
REPORTS ON FORM 8-K
On December 12, 2005 the Company filed a Form 8-K reporting the filing of participation in a recapitalization reorganization merger filed on Form S-4/A on December 9, 2005, an amendment to Form S-4 filed May 13, 2005, subject to approval by the stockholders, of a recapitalization reorganization merger of the Company to Cicero, Inc.
On December 5, 2005, Level 8 Systems filed a Form 8-K reporting the Company reached an agreement with Liraz Systems, Ltd. (“Liraz”), the guarantor of the Bank Hapoalim term loan, to extend the guaranty and maturity of the Bank Hapoalim debt until November 2006.
On March 10, 2005, Level 8 Systems filed a Form 8-K reporting the election of Mr. Ralph Martino as Chairman of the Board of Directors replacing Mr. Anthony Pizi who remains as a director.
On June 3, 2005, the Company filed a Form 8-K reporting the resignation of Mr. Ralph Martino as Chairman of the Board of Directors.
On June 6, 2005 the Company filed a Form 8-K reporting the election of Mr. Charles B. Porciello to the Board of Directors.
On June 17, 2005 the Company filed a Form 8-K reporting the approval by the Board of Directors, subject to approval by the stockholders, of a recapitalization reorganization merger of the Company to Cicero, Inc.
On July 27, 2005, the Company filed a Form 8-K reporting the resignations and appointments of members to the Company’s Board of Directors.
On February 6, 2004, Level 8 Systems filed a Form 8-K reporting the appointment of Margolis & Company P.C. as the Company’s new Independent Registered Public Accounting Firm.
On November 26, 2003, Level 8 Systems filed a Form 8 K reporting the resignation of Deloitte & Touche LLP as the Company’s Independent Registered Public Accounting Firm.
(C) EXHIBITS
Exhibit
Number
Description
2.1
Asset Purchase Agreement, dated as of January 9, 2004, by and among Level Systems, Inc. and Critical Mass Mail, Inc. (incorporated by reference to exhibit 2.1 to Level 8’s Form 8-K filed January 23, 2004).
3.1
Certificate of Incorporation of Level 8 Systems, Inc., a Delaware corporation, as amended August 4, 2003 (incorporated by reference to exhibit 3.1 to Level 8’s Form 10-K filed March 31, 2004).
3.2
Bylaws of Level 8 Systems, Inc., a Delaware corporation (incorporated by reference to exhibit 3.2 to Level 8’s Form 10-K filed April 2, 2002).
3.3
Certificate of Designations, Preferences and Rights dated March 19, 2003 relating to Series D Convertible Redeemable Preferred Stock (incorporated by reference to exhibit 3.1 to Level 8's Form 8-K, filed March 31, 2003).
3.4
Certificate of Designation relating to Series A3 Convertible Redeemable Preferred Stock (incorporated by reference to exhibit 3.1 to Level 8’s Form 10-Q filed November 15, 2002).
3.5
Certificate of Designation relating to Series B3 Convertible Redeemable Preferred Stock (incorporated by reference to exhibit 3.1 to Level 8’s Form 10-Q filed November 15, 2002).
3.6
Certificate of designation relating to Series C Convertible Redeemable Preferred Stock (incorporated by reference to exhibit 3.1 to Level 8’d Form 8-K filed August 27, 2002).
4.1
Form of term sheet dated December 15, 2005, with extension of term sheet dated February 27, 2006 (filed herewith).
4.2
Form of term sheet dated October 6, 2004 (incorporated by reference to exhibit 4.1 to Cicero, Inc. Report on Form S-4, filed May 13, 2005).
4.3
Form of term sheet dated March 2, 2005 (incorporated by reference to exhibit 4.2 to Cicero, Inc. Report on Form S-4, filed May 13, 2005).
4.4
Form of Promissory Note (incorporated by reference to exhibit 4.3 to Cicero, Inc. Report on Form S-4, filed May 13, 2005).
4.5
Form of Extended Promissory Note (incorporated by reference to exhibit 4.4 to Cicero, Inc. Report on Form S-4, filed May 13, 2005).
4.6
Form of Note Purchase Agreement (incorporated by reference to exhibit 4.5 to Cicero, Inc. Report on Form S-4, filed May 13, 2005).
4.7
Form of Extended Note Purchase Agreement (incorporated by reference to exhibit 4.5 to Cicero, Inc. Report on Form S-4, filed May 13, 2005).
4.8
Registration Rights Agreement, dated January 2004, by and among Level 8 Systems, Inc. and the Purchasers in the January 2004 Private Placement listed on Schedule I thereto relating to the Security Purchasers Agreement (incorporated by reference to exhibit 4.1 to Level 8’s Form 10-K/A filed April 21, 2004).
4.9
Registration Rights Agreement dated as of March 19, 2003 by and among Level 8 Systems, Inc. and the Purchasers listed on Schedule I thereto relating to the Series D Convertible Redeemable Preferred Stock (incorporated by reference to exhibit 4.1 to Level 8’s Form 8-K, filed March 31, 2003).
4.10
Registration Rights Agreement dated as of October 15, 2003 by and among Level Systems, Inc. and the Purchasers in the October Private Placement listed on schedule I thereto (incorporated by reference to exhibit 4.2 to Level 8’s Form 10-K, filed March 31, 2004).
4.11
Registration Rights Agreement, dated as of January 16, 2002, by and among Level Systems, Inc. and the Purchasers in the January Private Placement listed on Schedule I thereto (incorporated by reference to exhibit 4.1 to Level 8's Report on Form 8-K, filed January 25, 2002).
4.12
Registration Rights Agreement, dated as of January 3, 2002, between Level 8 Systems, Inc. and MLBC, Inc. (incorporated by reference to exhibit 4.1 to Level 8's Report on Form 8-K, filed January 11, 2002).
4.13
Registration Rights Agreement, dated as of August 29, 2002, entered into by and between Level 8 Systems, Inc. and the holders of Series A2/A3 Preferred Stock and Series B2/B3 Preferred Stock (incorporated by reference to exhibit 10.4 to Level 8’s Form 8-K filed August 30, 2002).
4.13A
First Amendment to Registration Rights Agreement, dated as of October 25, 2002, entered into by and between Level 8 Systems, Inc. and the holders of Series A2/A3 Preferred Stock and Series B2/B3 Preferred Stock (incorporated by reference to exhibit 10.4 to Level 8’s Form 10-Q filed November 15, 2002).
4.14
Registration Rights Agreement, dated as of June 13, 1995, between Level 8 Systems, Inc. and Liraz Systems Ltd. (incorporated by reference to exhibit 10.24 to Across Data Systems, Inc.'s (Level 8's predecessor) Registration Statement on Form S-1, filed May 12, 1995, File No. 33-92230).
4.14A
First Amendment to Registration Rights Agreement, dated as of August 8, 2001, to the Registration Rights Agreement dated as of June 13, 1995, by and between Across Data Systems, Inc. (Level 8's predecessor) and Liraz Systems Ltd. (incorporated by reference to exhibit 4.1 to Level 8's Report on Form 8-K, filed August 14, 2001).
4.15
Registration Rights Agreement, dated as of August 14, 2002, entered into by and between Level 8 Systems, Inc. and the investors in Series C Preferred Stock (incorporated by reference to exhibit 4.1 to Level 8’s Form 8-K filed August 27, 2002).
4.16
Form of Registration Rights Agreement, dated January 2004, by and among Level 8 Systems, Inc. and the Purchasers of Convertible Promissory Note (incorporated by reference to exhibit 4.2 to Level 8's Report on Form 10-Q, filed May 12, 2004).
4.17
Form of Stock Purchase Warrant issued to Liraz Systems, LTD. for the November 3, 2005 extension of the Bank Hapoalim loan guaranty (filed herewith).
4.18
Form of Stock Purchase Warrant issued to Purchasers in the January 2004 Private Placement (incorporated by reference to exhibit 4.3 to Level 8's Report on Form 10-Q, filed May 12, 2004).
4.19
Form of Stock Purchase Warrant issued to Purchasers of Convertible Promissory Note (incorporated by reference to exhibit 4.3 to Level 8's Report on Form 10-Q, filed May 12, 2004).
4.20
Form of Warrant issued to the Purchasers in the Series D Preferred Stock transaction dated as of March 19, 2003 (incorporated by reference to exhibit 4.2 to Level 8's Form 8-K, filed March 31, 2003).
4.20A
Form of Warrant issued to the Purchasers in the Series D Preferred Stock transaction dated as of March 19, 2003 (incorporated by reference to exhibit 4.2 to Level 8's Form 8-K, filed March 31, 2003).
4.21
Form of Stock Purchase Warrant issued to Purchasers in the October 2003 Private Placement (incorporated by reference to exhibit 4.9 to Level 8’s Form 10-K, filed March 31, 2004).
4.22
Form of Stock Purchase Warrant issued to the Purchasers in the January Private Placement (incorporated by reference to exhibit 10.2 to Level 8's Report on Form 8-K, filed January 25, 2002).
4.23
Form of Series A3 Stock Purchase Warrant (incorporated by reference to exhibit 10.2 of Level 8’s Form 10-Q filed November 15, 2002).
4.24
Form of Series B3 Stock Purchase Warrant (incorporated by reference to exhibit 10.3 of Level 8’s Form 10-Q filed November 15, 2002).
4.25
Form of Series C Stock Purchase Warrant (incorporated by reference to exhibit 10.2 to Level 8’s Form 8-K filed August 27, 2002).
10.1
Securities Purchase Agreement dated January 2004 by and among Level 8 Systems, Inc. and the Purchasers in the January 2004 Private Placement (incorporated by reference to exhibit 10.1 to Level 8’s Form 10-K/A filed April 21, 2004).
10.2
Securities Purchase Agreement dated March 2004 by and among Level 8 Systems, Inc. and the Purchasers of Convertible Promissory Note (incorporated by reference to exhibit 10.2 to Level 8's Form 10-Q, filed May 12, 2004).
10.3
Form of Convertible Promissory Note dated March 2004 by and among Level Systems, Inc. and the Purchasers of Convertible Promissory Note (incorporated by reference to exhibit 10.3 to Level 8's Form 10-Q, filed May 12, 2004).
10.4
Securities Purchase Agreement dated as of March 19, 2003 by and among Level Systems, Inc. and the Purchasers (incorporated by reference to exhibit 10.1 to Level 8's Form 8-K, filed March 31, 2003).
10.5
Securities Purchase Agreement dated as of October 15, 2003 by and among Level Systems, Inc. and the Purchasers in the October Private Placement (incorporated by reference to exhibit 10.2 to Level 8’s Form 10-K, filed March 31, 2004).
10.6
Securities Purchase Agreement, dated as of January 16, 2002, by and among Level Systems, Inc. and the Purchasers in the January Private Placement (incorporated by reference to exhibit 10.1 to Level 8's Report on Form 8-K, filed January 25, 2002).
10.7
Purchase Agreement, dated as of January 3, 2002, between Level 8 Systems, Inc. and MLBC, Inc. (incorporated by reference to exhibit 10.1 to Level 8's Report on Form 8-K, filed January 11, 2002).
10.7A
Purchase Agreement, dated as of July 31, 2000, between Level 8 Systems, Inc. and Merrill Lynch, Pierce, Fenner & Smith Incorporated (incorporated by reference to Exhibit 10.1 to Level 8's Report on Form 8-K, filed August 11, 2000).
10.8
Securities Purchase Agreement, dated as of August 14, 2002, by and among Level Systems, Inc. and the purchasers of the Series C Preferred Stock (incorporated by reference to exhibit 10.1 to Level 8’s Form 8-K filed August 27, 2002).
10.9
Agreement by and among Level 8 Systems, Inc. and the holders of Series A1/A2/A3 and B1/B2/B3 Preferred Stock, dated as of August 14, 2002 (incorporated by reference to exhibit 10.3 to Level 8’s Form 8-K filed August 27, 2002).
10.10
Exchange Agreement among Level 8 Systems, Inc., and the various stockholders identified and listed on Schedule I, dated as of August 29, 2002 (incorporated by reference to exhibit 10.1 to Level 8’s Form 8-K filed August 30, 2002).
10.11A
First Amendment to Exchange Agreement, dated as of October 25, 2002, among Level 8 Systems, Inc., and the various stockholders identified and listed on Schedule I to that certain Exchange Agreement, dated as of August 29, 2002 (incorporated by reference to exhibit 10.1 to Level 8’s Form 10-Q filed November 15, 2002).
10.11B
Securities Purchase Agreement, dated as of June 29, 1999, among Level 8 Systems, Inc. and the investors named on the signature pages thereof for the purchase of Series A Preferred Stock (incorporated by reference to exhibit 10.1 to Level 8's Form 8-K filed July 23, 1999).
10.11C
Securities Purchase Agreement, dated as of July 20, 2000, among Level 8 Systems, Inc. and the investors named on the signature pages thereof for the purchase of Series B Preferred Stock (incorporated by reference to Exhibit 10.1 to Level 8's Report on Form 8-K filed July 31, 2000).
10.12
Amended PCA Shell License Agreement, dated as of January 3, 2002, between Level 8 Systems, Inc. and Merrill Lynch, Pierce, Fenner & Smith Incorporated (incorporated by reference to exhibit 10.2 to Level 8's Form 8-K, filed January 11, 2002).
10.12A
PCA Shell License Agreement between Level 8 Systems, Inc. and Merrill Lynch, Pierce, Fenner & Smith Incorporated (incorporated by reference to exhibit 10.2 to Level 8’s Report on Form 8-K, filed September 11, 2000).
10.14
Promissory Note of Level 8 Systems, Inc., dated as of September 28, 2001, among Level 8 Systems, Inc. and Bank Hapoalim (incorporated by reference to exhibit 10.2 to Level 8’s Form 10-K filed April 2, 2002).
10.14 A
Amendment No. 2 to Promissory Note of Level 8 Systems, Inc., dated as of November 30, 2005 and letter dated November 3, 2005 among Level 8 Systems, Inc. and Bank Hapoalim (filed herewith).
10.14 B
Amendment No. 1 to Promissory Note of Level 8 Systems, Inc., dated as of November 8, 2004 and letter dated November 8, 2004 among Level 8 Systems, Inc. and Bank Hapoalim (incorporated by reference to exhibit 10.14A to Level 8’s Form 10-K/A filed April 21, 2004).
10.14 C
Amendment to Promissory Note of Level 8 Systems, Inc., dated as of November 15, 2003 among Level 8 Systems, Inc. and Bank Hapoalim (incorporated by reference to exhibit 10.10 A to Level 8’s Form 10-K, filed March 31, 2004).
10.15
Employment Agreement between Anthony Pizi and the Company effective January 1, 2005 (filed herewith).*
10.16
Employment Agreement between John P. Broderick and the Company effective January 1, 2005 (filed herewith).*
10.18
Level 8 Systems Inc. 1997 Stock Option Plan, as Amended and Restated (incorporated by reference to exhibit 10.2 to Level 8’s Registration Statement of Form S-1/A, filed September 22, 2000, File No. 333-44588).*
10.18A
Fifth Amendment to Level 8 Systems Inc. 1997 Stock Option Plan (incorporated by reference to exhibit 10.9A to Level 8’s Form 10-K filed April 2, 2002).*
10.18B
Seventh Amendment to Level 8 Systems Inc. 1997 Stock Option Plan (incorporated by reference to exhibit 10.14 B to Level 8’s Form 10-K, filed March 31, 2004).*
10.20
Lease Agreement for Cary, N.C. offices, dated March 31, 1997, between Seer Technologies, Inc. and Regency Park Corporation (incorporated by reference to exhibit 10.47 to Seer Technologies, Inc.'s Quarterly Report on Form 10-Q for the period ended March 31, 1997, File No. 000-26194).
10.16A
Addendum #1 to the Lease Agreement for Cary, N.C. offices, dated July 6, 1998 (incorporated by reference to exhibit 10.58 to Seer Technology Inc.'s Quarterly Report on Form 10-Q for the period ended June 30, 1998, File No. 000-26194).
10.16B
Amendment to Lease Agreement for Cary, N.C. offices, dated January 21, 1999 (incorporated by reference to exhibit 10.21A to Level 8's Annual Report on Form 10-K for the fiscal year ended December 31, 1998).
10.17
Lease Agreement for Cary, N.C. offices, dated November 7, 2003, between Level 8 Systems, Inc. and Regency Park Corporation (incorporated by reference to exhibit 10.17 to Level 8’s Form 10-K, filed March 31, 2004).
10.18
Office Lease Agreement, dated April 25, 1996, between Template Software, Inc. and Vintage Park Two Limited Partnership (incorporated by reference to an exhibit to Template Software, Inc.'s Registration Statement on Form S-1, File No. 333-17063).
10.18A
Amendment to Office Lease Agreement, dated August 18, 1997, between Template Software, Inc. and Vintage Park Two Limited Partnership (incorporated by reference to an exhibit to Template Software, Inc.'s Annual Report on Form 10-K for the fiscal year ended December 31, 1997, File No. 000-21921).
10.19
Lease Agreement, dated February 23, 2001, between Level 8 Systems, Inc. and Carnegie 214 Associates Limited Partnership (incorporated by reference to exhibit 10.15 to Level 8's Annual Report on Form 10-K, filed March 29, 2001).
14.1
Code of Ethics (incorporated by reference to exhibit 14.1 to Level 8’s Form 10-K/A, filed March 31, 2004).
16.1
Letter from Margolis & Company PC regarding change of accountant (incorporated by reference to Exhibit 16.1 to Level 8’s Current Report on Form 8-K, filed February 6, 2004).
21.1
List of subsidiaries of the Company (filed herewith).
22.1
Consent of Margolis & Company LLP (filed herewith).
31.1
Certification of Chief Executive Officer pursuant to Rule 13a-14(a) (filed herewith).
31.2
Certification of Chief Financial Officer pursuant to Rule 13a-14(a) (filed herewith).
32.1
Certification of John P. Broderick, Chief Executive Officer and Chief Financial Officer pursuant to 18 USC § 1350, as adopted pursuant to §906 of the Sarbanes-Oxley Act of 2002 (filed herewith).
* Management contract or compensatory agreement.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.
LEVEL SYSTEMS, INC.
By: /s/ John P. Broderick
John P. Broderick
Chief Executive Officer
Date: March 31, 2006
Pursuant to the requirements of the Securities Exchange Act of 1934, the following persons on behalf of the Registrant and in the capacities and on the dates indicated have signed this Report below.
Signature
Title
Date
/s/ Mark Landis
Mark Landis
Chairman of the Board
March 31, 2006
/s/ John P. Broderick
John P. Broderick
Chief Executive Officer/Chief Financial Officer
(Principal Executive Officer)
March 31, 2006
/s/ Anthony C. Pizi
Anthony C. Pizi
Chief Information Officer
March 31, 2006
/s/ Bruce Hasenyager
Bruce Hasenyager
Director
March 31, 2006
/s/ Jay Kingley
Jay Kingley
Director
March 31, 2006
/s/ Bruce Miller
Bruce Miller
Director
March 31, 2006
/s/ Charles Porciello
Charles Porciello
Director
March 31, 2006
/s/ Bruce Percelay
Bruce Percelay
Director
March 31, 2006
Report of Independent Registered Public Accounting Firm
Financial Statements:
Consolidated Balance Sheets
Consolidated Statements of Operations
Consolidated Statements of Stockholders' Equity (Deficit)
Consolidated Statements of Comprehensive Loss
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
F
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of
Level Systems, Inc.
Farmingdale, New Jersey
We have audited the accompanying consolidated balance sheet of Level 8 Systems, Inc. and subsidiaries (the "Company") as of December 31, 2005 and 2004, and the related consolidated statements of operations, stockholders' equity (deficit), cash flows, and comprehensive loss for each of the three years in the period ended December 31, 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. 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 consolidated financial statements referred to above present fairly, in all material respects, the financial position of Level 8 Systems, Inc. and subsidiaries as of December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2005, in conformity with accounting principles generally accepted in the United States of America.
The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the consolidated financial statements, the Company's recurring losses from operations and working capital deficiency raise substantial doubt about its ability to continue as a going concern. Management's plans concerning these matters are also described in Note 1. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.
/s/ Margolis & Company P.C.
Certified Public Accountants
Bala Cynwyd, PA
March 23,
F
LEVEL 8 SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands, except share and per share amounts)
The accompanying notes are an integral part of the consolidated financial statements.
F
LEVEL 8 SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
The accompanying notes are an integral part of the consolidated financial statements.
F
LEVEL 8 SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
(in thousands)
The accompanying notes are an integral part of the consolidated financial statements.
F
LEVEL 8 SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS
(in thousands)
The accompanying notes are an integral part of the consolidated financial statements.
F
LEVEL 8 SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
The accompanying notes are an integral part of the consolidated financial statements.
F
LEVEL 8 SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS - CONTINUED
Non-Cash Investing and Financing Activities
During 2005, the Company issued 961,329 shares of common stock to vendors for outstanding liabilities valued at $103,000.
In November 2005, the Company issued 2,400,000 shares of common stock to a designated subsidiary of Liraz Systems Ltd. as compensation for extension of a bank debt guarantee valued at $48,000.
During 2005, the Company issued 956,250 shares of Level 8 Systems common stock upon conversion of 306 shares of Series D Convertible Redeemable Preferred Stock.
During 2005, 150 shares of Series C Convertible Redeemable Preferred Stock were converted into 394,737 shares of Level 8 Systems common stock.
During 2004, the Company issued 600,948 shares of common stock to vendors for outstanding liabilities valued at $92,000. The Company also issued 466,668 shares of common stock to contractors for compensation valued at $47,000.
In January 2004, the Company acquired substantially all assets and certain liabilities of a federally certified encryption software company. The Company issued 2,027,027 shares of common stock valued at $750,000.
During 2004, the Company issued 4,092,000 shares of common stock to a designated subsidiary of Liraz Systems Ltd. as compensation for extension of a bank debt guarantee valued at $447,000.
In October 2004, 750 shares of Series D Convertible Redeemable Preferred Stock were redeemed in return for $775,000 as a condition of escrow in the event that a joint venture for the Asian market was not formed or operational by July 17, 2003. Such redemption was concluded in November 2004 and the escrowed proceeds, including $4,000 of interest, were distributed back to the holders of Series D Preferred Stock. During 2004, the Company issued 3,791,999 shares of Level 8 Systems common stock upon conversion of 1,213 shares of Series D Convertible Redeemable Preferred Stock.
During 2004, 179 shares of Series C Convertible Redeemable Preferred Stock were converted into 523,684 shares of Level 8 Systems common stock.
In May 2004, the Company issued 135,135 shares of common stock on conversion of a $50,000 convertible note.
During 2003, the Company issued 161,438 shares of common stock to vendors for outstanding liabilities valued at $73,000. Of this total, 66,667 shares or $25,000, were issued as part of the 1,894,444 shares issued in the October private placement.
In November 2003, the Company issued 150,000 shares of common stock to a designated subsidiary of Liraz Systems Ltd. as compensation for extension of a bank debt guarantee valued at $51,000.
During 2003, the Company issued 546,875 shares of Level 8 Systems common stock upon conversion of 175 shares of Series D Convertible Redeemable Preferred Stock.
In October 2003, the Company issued 3,048,782 warrants to holders of the Series A3 Convertible Redeemable Preferred Stock and Series B3 Convertible Redeemable Preferred Stock under an existing agreement and in consideration for the waiver of certain price protection anti-dilution provisions of the Series A3 Preferred Stock and Series B3 Preferred Stock agreements. The warrants have a strike price of $0.40 valued at $1,062,000. (See Note 12.)
F
In April 2003, the Company agreed to exchange the warrants issued in the January 2002 private placement priced at $2.50 each for new warrants priced at $0.60 each and has extended the expiration date to until March 2007. This exchange was made as a result of a waiver by such warrant holders of certain terms and conditions that would trigger payments by the Company if the Company did not keep such shares registered under the Securities Act of 1933, as amended.
F
LEVEL 8 SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1.
SUMMARY OF OPERATIONS, SIGNIFICANT ACCOUNTING POLICIES AND RECENT ACCOUNTING PRONOUNCEMENTS
Level Systems, Inc. (''Level 8'' or the ''Company'') is a global provider of business integration software that enables organizations to integrate new and existing information and processes at the desktop. Business integration software addresses the emerging need for a company's information systems to deliver enterprise-wide views of the company's business information processes.
Going Concern:
The accompanying financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The Company has incurred a loss of $3,681,000 for the year ended December 31, 2005 and has experienced negative cash flows from operations for each of the years ended December 31, 2005, 2004 and 2003. At December 31, 2005, the Company had a working capital deficiency of approximately $13,894,000. The Company’s future revenues are entirely dependent on acceptance of a newly developed and marketed product, Cicero, which has had limited success in commercial markets to date. These factors among others raise substantial doubt about the Company’s ability to continue as a going concern for a reasonable period of time.
The financial statements presented herein do not include any adjustments relating to the recoverability of assets and classification of liabilities that might be necessary should Level 8 be unable to continue as a going concern. In order to address these issues and to obtain adequate financing for the Company’s operations for the next twelve months, the Company is actively promoting and expanding its Cicero-related product line and continues to negotiate with significant customers who have expressed interest in the Cicero software technology. The Company is experiencing difficulty increasing sales revenue largely because of the inimitable nature of the product as well as customer concerns about the financial viability of the Company. Cicero software is a new “category defining” product in that most Enterprise Application Integration (EAI) projects are performed at the server level and Cicero’s integration occurs at the desktop without the need to open and modify the underlying code for those applications being integrated. Many companies are not aware of this new technology or tend to look toward more traditional and accepted approaches. Level 8 is attempting to solve the former problem by improving the market’s knowledge and understanding of Cicero software through increased marketing and leveraging its limited number of reference accounts while enhancing its list of resellers and system integrators to assist in the sales and marketing process. Additionally, the Company is seeking additional equity capital or other strategic transactions in the near term to provide additional liquidity. In 2004, the Company announced a Note and Warrant Offering in which warrant holders of Level 8’s common stock were offered a one-time conversion of their existing warrants at a conversion price of $0.10 per share as part of a recapitalization merger plan. Under the terms of the Offer, warrant holders who elect to convert, would tender their conversion price in cash and receive a Note Payable in exchange. Upon approval of the recapitalization merger at a Shareholders meeting, these Notes would convert into common shares of Cicero, Inc., the surviving corporation in the merger. As of December 31, 2005, the Company raised a total of $2,559,000 from the Note and Warrant Offering. During 2005, the Company also entered into several Convertible Bridge Notes with a consortium of investors. As of December 31, 2005, the Company had raised $1,760,000 of Convertible Bridge Notes. The Convertible Bridge Notes convert into common stock of Cicero, Inc. upon approval of the recapitalization merger. Management expects that it will be able to raise additional capital, post merger, and to continue to fund operations and also expects that increased revenues will reduce its operating losses in future periods, however, there can be no assurance that management’s plan will be executed as anticipated.
Principles of Consolidation:
The accompanying consolidated financial statements include the accounts of the Company and its subsidiaries. All of the Company's subsidiaries are wholly-owned for the periods presented.
All significant inter-company accounts and transactions are eliminated in consolidation.
F
Use of Estimates:
The preparation of financial statements in conformity with accounting principals generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual amounts could differ from these estimates.
Financial Instruments:
The carrying amount of the Company’s financial instruments, representing accounts receivable, notes receivable, accounts payable and debt approximate their fair value.
Foreign Currency Translation:
The assets and liabilities of foreign subsidiaries are translated to U.S. dollars at the current exchange rate as of the balance sheet date. The resulting translation adjustment is recorded in other comprehensive income as a component of stockholders' equity. Statements of operations items are translated at average rates of exchange during each reporting period.
Transaction gains and losses that arise from exchange rate fluctuations on transactions denominated in a currency other than the functional currency are included in the results of operations as incurred.
Cash and Cash Equivalents:
Cash and cash equivalents include all cash balances and highly liquid investments with maturity of three months or less from the date of purchase. For these instruments, the carrying amount is considered to be a reasonable estimate of fair value. The Company places substantially all cash and cash equivalents with various financial institutions in both the United States and several foreign countries. At times, such cash and cash equivalents in the United States may be in excess of FDIC insurance limits.
Trade Accounts Receivable:
Trade accounts receivable are stated in the amount management expects to collect from outstanding balances. Management provides for probable uncollectible amounts through a charge to earnings and a credit to a valuation allowance based on its assessment of the current status of individual accounts. Balances that are still outstanding after management has used reasonable collection efforts are written off through a charge to the valuation allowance and a credit to trade accounts receivable. Changes in the valuation allowance have not been material to the financial statements.
Property and Equipment:
Property and equipment purchased in the normal course of business is stated at cost, and property and equipment acquired in business combinations is stated at its fair market value at the acquisition date. All property and equipment is depreciated using the straight-line method over estimated useful lives.
Expenditures for repairs and maintenance are charged to expense as incurred. The cost and related accumulated depreciation of property and equipment are removed from the accounts upon retirement or other disposition and any resulting gain or loss is reflected in the Consolidated Statements of Operations.
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Software Development Costs:
The Company capitalizes certain software costs after technological feasibility of the product has been established. Generally, an original estimated economic life of three years is assigned to capitalized software costs, once the product is available for general release to customers. Costs incurred prior to the establishment of technological feasibility are charged to research and development expense.
Additionally, the Company has recorded software development costs for its purchases of developed technology through acquisitions. (See Note 2.)
Capitalized software costs are amortized over related sales on a product-by-product basis using the straight-line method over the remaining estimated economic life of the product. (See Note 7.)
The establishment of technological feasibility and the ongoing assessment of recoverability of capitalized software development costs require considerable judgment by management with respect to certain external factors, including, but not limited to, technological feasibility, anticipated future gross revenue, estimated economic life and changes in software and hardware technologies.
Long-Lived Assets:
The Company reviews the recoverability of long-lived intangible assets when circumstances indicate that the carrying amount of assets may not be recoverable. This evaluation is based on various analyses including undiscounted cash flow projections. In the event undiscounted cash flow projections indicate impairment, the Company would record an impairment based on the fair value of the assets at the date of the impairment. Effective January 1, 2002, the Company accounts for impairments under the Financial Accounting Standards Board ("FASB") Statement of Financial Accounting Standards ("SFAS") No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”. During 2004 and 2003, the Company recorded impairments associated with its Cicero technology and for its Ensuredmail technology acquired in 2004.
Revenue Recognition:
The Company recognizes license revenue from end-users and third party resellers in accordance with the American Institute of Certified Public Accountants ("AICPA") Statement of Position ("SOP") 97-2, “Software Revenue Recognition”, as amended by SOP 98-9, ''Modification of SOP 97-2, 'Software Revenue Recognition,' with Respect to Certain Transactions''. The Company reviews each contract to identify elements included in the software arrangement. SOP 97-2 and SOP 98-9 require that an entity recognize revenue for multiple element arrangements by means of the ''residual method'' when (1) there is vendor-specific objective evidence (''VSOE'') of the fair values of all of the undelivered elements that are not accounted for by means of long-term contract accounting, (2) VSOE of fair value does not exist for one or more of the delivered elements, and (3) all revenue recognition criteria of SOP 97-2 (other than the requirement for VSOE of the fair value of each delivered element) are satisfied. VSOE of the fair value of undelivered elements is established on the price charged for that element when sold separately. Software customers are given no rights of return and a short-term warranty that the products will comply with the written documentation. The Company has not experienced any product warranty returns.
Revenue from recurring maintenance contracts is recognized ratably over the maintenance contract period, which is typically twelve months. Maintenance revenue that is not yet earned is included in deferred revenue. Any unearned receipts from service contracts result in deferred revenue.
Revenue from consulting and training services is recognized as services are performed. Any unearned receipts from service contracts result in deferred revenue.
Cost of Revenue:
The primary components of the Company's cost of revenue for its software products are software amortization on internally developed and acquired technology, royalties on certain products, and packaging and distribution costs. The primary component of the Company's cost of revenue for maintenance and services is compensation expense.
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Advertising Expenses:
The Company expenses advertising costs as incurred. Advertising expenses were approximately $16,000, $7,000, and $9,000 for the years ended December 31, 2005, 2004 and 2003, respectively.
Research and Product Development:
Research and product development costs are expensed as incurred.
Income Taxes:
The Company uses SFAS No. 109, ''Accounting for Income Taxes'', to account for income taxes. This statement requires an asset and liability approach that recognizes deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in the Company's financial statements or tax returns. In estimating future tax consequences, all expected future events, other than enactments of changes in the tax law or rates, are generally considered. A valuation allowance is recorded when it is ''more likely than not'' that recorded deferred tax assets will not be realized. (See Note 11.)
Discontinued Operations:
During the third quarter of 2002, the Company made a decision to dispose of the Systems Integration segment and entered into negotiations with potential buyers. The Systems Integration segment qualified for treatment as a discontinued operation in accordance with SFAS 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”, and the Company reclassified the results of operations for the Systems Integration segment in 2002 to "loss from discontinued operations" in the Consolidated Statements of Operations. The sale of the Systems Integration segment was completed in December 2002.
Loss Per Share:
Basic loss per share is computed based upon the weighted average number of common shares outstanding. Diluted loss per share is computed based upon the weighted average number of common shares outstanding and any potentially dilutive securities. During 2005, 2004, and 2003, potentially dilutive securities included stock options, warrants to purchase common stock, and preferred stock.
The following table sets forth the potential shares that are not included in the diluted net loss per share calculation because to do so would be anti-dilutive for the periods presented:
In 2005, 2004 and 2003, no dividends were declared on preferred stock.
Stock-Based Compensation:
The Company has adopted the disclosure provisions of SFAS 123, “Accounting for Stock-Based Compensation”, and has applied Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees”, and related Interpretations in accounting for its stock-based compensation plans. Had compensation cost for the Company’s stock option plans been determined based on the fair value at the grant dates for awards under the plans, consistent with the method required by SFAS No. 123, the Company’s net loss and diluted net loss per common share would have been the pro forma amounts indicated below (in thousands).
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The fair value of the Company's stock-based awards to employees was estimated as of the date of the grant using the Black-Scholes option-pricing model, using the following weighted-average assumptions:
Warrants Liability:
The Company has issued warrants to Series A3 and Series B3 preferred stockholders which contain provisions that allow the warrant holders to force a cash redemption for events outside the control of the Company. The fair value of the warrants are accounted for as a liability and are re-measured through the Consolidated Statements of Operations at each balance sheet date.
Reclassifications:
Certain prior year amounts in the accompanying financial statements have been reclassified to conform to the 2005 presentation. Such reclassifications had no effect on previously reported net income or stockholders’ equity.
Recent Accounting Pronouncements:
In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections”, which changes the requirements for the accounting and reporting of a change in accounting principle. SFAS No. 154 applies to all voluntary changes in accounting principle as well as to changes required by an accounting pronouncement that does not include specific transition provisions. SFAS No. 154 requires that changes in accounting principle be retrospectively applied. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The Company does not believe adoption of this statement will have a material impact on the Company’s financial statements.
In December 2004, the FASB issued SFAS 123 (revised 2004), Share-Based Payment, (“SFAS 123R”). SFAS 123R addresses the accounting for share-based payments to employees, including grants of employee stock options. Under the new standard, companies will no longer be able to account for share-based compensation transactions using the intrinsic method in accordance with APB Opinion No. 25, “Accounting for Stock Issued to Employees”. Instead, companies will be required to account for such transactions using a fair-value method and recognize the expense in the consolidated statements of operations. SFAS 123R will be effective for periods beginning after June 15, 2005 and allows, but does not require, companies to restate the full fiscal year of 2005 to reflect the impact of expensing share-based payments under SFAS 123R. The Company has not yet determined which fair-value method and transitional provision it will follow. However, the Company expects that the adoption of SFAS 123R will have a significant impact on its results of operations. The Company does not expect the adoption of SFAS 123R will impact its overall financial position. See Stock-Based Compensation above for the pro forma impact on net loss and net loss per share from calculating stock-based compensation costs under the fair
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value alternative of SFAS 123. However, the calculation of compensation cost for share-based payment transactions after the effective date of SFAS 123R may be different from the calculation of compensation cost under SFAS 123, but such differences have not yet been quantified.
NOTE 2. ACQUISITIONS
In January 2004, the Company acquired substantially all of the assets and certain liabilities of Critical Mass Mail, Inc., d/b/a Ensuredmail, a federally certified encryption software company. Under the terms of the purchase agreement, the Company issued 2,027,027 shares of common stock at a price of $0.37. The total purchase price of the assets being acquired plus certain liabilities assumed was $750,000, and has been accounted for by the purchase method of accounting. The Company agreed to register the common stock for resale under the Securities Act of 1933, as amended.
The purchase price was allocated to the assets acquired and liabilities assumed based on the Company’s estimates of fair value at the acquisition date. The Company assessed the net realizable value of the Ensuredmail software technology acquired and determined the purchase price exceeded the amounts allocated to the software technology acquired less liabilities assumed by approximately $587,000. This excess of the purchase price over the fair values of the assets acquired less liabilities assumed was allocated to goodwill, and, because it was deemed impaired, charged to the Statements of Operations for the year ended December 31, 2004. (See Note 7.)
NOTE 3. DISPOSITIONS
In March 2003, the Company received notification of the finalization of the bankruptcy proceeding in the United Kingdom and recorded a gain on the closure of the subsidiary of $216,000 in gain (loss) on disposal of assets.
In December 2003, the Company received notification of the liquidation of the Denmark subsidiary and the Company recorded a gain on the closure of the subsidiary of $62,000 in gain (loss) on disposal of assets.
NOTE 4. ACCOUNTS RECEIVABLE
Trade accounts receivable was composed of the following at December 31 (in thousands):
The (credit) provision for uncollectible amounts was ($12,000), ($4,000), and ($52,000) for the years ended December 31, 2005, 2004, and 2003, respectively. Write-offs (net of recoveries) of accounts receivable were ($0) for the years ended December 31, 2005 and 2004, and ($488,000) for the year ended December 31, 2003.
NOTE 5. PROPERTY AND EQUIPMENT
Property and equipment was composed of the following at December 31 (in thousands):
Depreciation and amortization expense of property and equipment was $11,000, $11,000 and $167,000 for the years ended December 31, 2005, 2004, and 2003, respectively.
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NOTE 6. NOTES RECEIVABLE
In 2002, the Company disposed of the remaining assets of the Systems Integration segment through a sale to EM Software Solutions, Inc. As part of the proceeds, the Company received two notes receivable from the purchaser. The first note was due on February 13, 2003 in the amount of $744,000 and bore interest at prime plus 2.25%. This note was repaid in February 2003. The second note was in the principal amount of $617,000 and bears interest at prime plus 1%. Principal and interest is payable monthly and the note matures in 2007. Due to the uncertainty of the collection of the note at the time, the Company recorded the note net of an allowance of $494,000.
As more fully discussed in Note 21, the Company had been party to litigation for breach of a real estate lease. That case was settled in August 2003. Under the terms of the settlement agreement, the Company agreed to assign the note receivable due from EM Software Solutions, with recourse equal to the unpaid portion of the Note should the Note obligor default on future payments. The principal balance outstanding on the Note at the time of assignment was $545,000. The Company assessed the probability of liability under the recourse provisions using a weighted probability cash flow analysis and has recognized a long-term liability in the amount of $131,000. In addition, the Company wrote off the unreserved portion of the Note, or $51,000.
NOTE 7. SOFTWARE PRODUCT TECHNOLOGY
In accordance with SFAS 86, "Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed", the Company periodically completed an assessment of the recoverability of the Cicero product technology. This assessment was performed during 2004, due to the Company’s continued operating losses and the limited software revenue generated by the Cicero technology over the previous twelve to eighteen months. The Company was in negotiations with customers to purchase licenses, which would have a significant impact on the cash flows from the Cicero technology and the Company. Since the negotiations had been in process for several months and expected completion of the transactions had been delayed, the Company had reduced its cash flow projections. Historical cash flows generated by the Cicero technology do not support the long-lived asset and accordingly the Company impaired the excess of the unamortized book value of the technology in excess of the expected net realizable value for the year ended December 31, 2004. This charge, in the amount of $2,844,000 was recorded as software amortization for the year ended December 31, 2004. As of December 31, 2005, the Company has no capitalized costs for the Cicero technology.
Also in accordance with SFAS 86, the Company completed an assessment of the recoverability of the Ensuredmail product technology. This assessment was also completed during 2004, due to the Company’s revised cash flow projections from software revenue. These revised cash flow projections do not support the long-lived asset and accordingly the Company has impaired the excess of the unamortized book value of the technology in excess of the expected net realizable value. This charge, in the amount of $154,000, was recorded as software amortization for the year ended December 31, 2004. As of December 31, 2005, the Company has no capitalized costs for the Ensuredmail software technology.
Effective July 2002, the Company determined that the estimated asset life of the Cicero technology has been extended as a result of the January 2002 amended license agreement with Merrill Lynch, Pierce, Fenner & Smith Incorporated (“Merrill Lynch”) wherein the exclusive right to modify, commercialize, and distribute the technology was extended in perpetuity. Accordingly, the Company reassessed the estimated life of the technology and extended it from three years to five years. The effect of the change in the estimated life resulted in a reduction of $4,608,000 of amortization expense for the year ended December 31, 2003. The impact on the net loss applicable to common stockholders - basic and diluted was $(0.21) per share for December 31, 2003.
During the years ended December 31, 2004 and 2003, the Company recognized $4,276,000 of which $3,585,000 is an impairment charge, and $3,933,000 of which $993,000 is an impairment charge, respectively, of expense related to the amortization of these costs, which is recorded as cost of software revenue in the consolidated statements of operations. Accumulated amortization of capitalized software costs was $24,712,000 and $20,436,000 at December 31, 2004 and 2003, respectively.
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NOTE 8. SENIOR REORGANIZATION DEBT
In 2004, the Company announced a Note and Warrant Offering in which warrant holders of Level 8’s common stock were offered a one-time conversion of their existing warrants at a conversion price of $0.10 per share as part of a recapitalization merger plan. Under the terms of the Offer, which expired on December 31, 2004, warrant holders who elect to convert, would tender their conversion price in cash and receive a Note Payable in exchange. As of December 31, 2005 the company had raised $2,559,000. Upon approval of the recapitalization merger at a Shareholders meeting in mid 2006, these Notes would convert into common shares of Cicero, Inc., the surviving corporation in the merger. In addition, those warrant holders who elected to convert the first $1 million of warrants would receive additional replacement warrants at a ratio of 2:1 for each warrant converted, with a strike price of $0.10 per share. In addition, upon approval of the recapitalization merger, each warrant holder would be entitled to additional warrants to purchase common stock in Cicero, Inc. If the merger proposal is not approved, the Notes will immediately become due and payable.
NOTE 9. CONVERTIBLE BRIDGE DEBT
From July through December 2005, the Company entered into several Convertible Bridge Notes with a consortium of investors. These notes bear interest at 10% and mature at various dates beginning on September 15, 2005. The Notes are convertible into shares of Cicero, Inc. common stock upon effectiveness of the proposed recapitalization merger. Since the Company has not effected the recapitalization merger by December 31, 2005, the conversion rates on the Notes is $0.025. As of December 31, 2005, the Company has raised $1,760,000 of Convertible Bridge Notes of which $566,000 was from various members of the Company’s Board of Directors. If the merger proposal is not approved, the Notes will immediately become due and payable.
NOTE 10. SHORT TERM DEBT AND CONVERTIBLE NOTES
Notes payable, long-term debt, and notes payable to related party consist of the following at December 31(in thousands):
(a)
The Company has a $1,971 term loan bearing interest at LIBOR plus 1.5% (approximately 5.26% at December 31, 2005). Interest is payable quarterly. There are no financial covenants and the term loan is guaranteed by Liraz Systems Ltd., the Company’s former principal shareholder. The loan matures on October 30, 2006. (See Note 18.)
(b)
From time to time the Company borrowed money from the Company's Chief Information Officer. The notes bear interest at 12% per annum. As of December 31, 2005, the Company is indebted to Anthony Pizi, the Company’s former Chairman and CEO and current Chief Information Officer, in the amount of $9,000.
(c)
The Company does not have a revolving credit facility and from time to time has issued a series of short term promissory notes with private lenders, which provide for short term borrowings both secured and unsecured by accounts receivable. In addition, the Company has settled certain litigation and agreed to a series of promissory notes to support the obligations. The notes bear interest between 10% and 12% per annum.
(d) The Company entered into convertible notes with private lenders. The notes bear interest between 12% and 18% per annum and allow for the conversion of the principal amount due into common stock of the Company. In April 2005, the Company entered into a convertible loan in the amount of $30,000 with a member of the Company’s Board of Directors. Under the term of this agreement, the loan bears interest at 1% per month and is convertible upon the option of the note holder into 428,571 shares of our common stock at a conversion price of $0.07 per share. In May 2004, the Company entered into convertible loans aggregating $185,000 from several investors including a member of the Company’s
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Board of Directors. Under the terms of these agreements, the loans bear interest between 1% and 1.5% per month and are convertible upon the option of the note holder into an aggregate of 578,125 shares of our common stock and warrants to purchase an aggregate of 578,125 shares of our common stock exercisable at $0.32. The warrants expire three years from grant. Also in March 2004, the Company entered into a convertible loan in the amount of $50,000. Under the terms of this agreement, the loan bears interest at 1% per month and is convertible upon the option of the note holder into 135,135 shares of our common stock and warrants to purchase 135,135 shares of our common stock at an exercisable price of $0.37 per share. All such warrants expire three years from the date of grant.
(e) The Company entered into convertible promissory notes with Anthony Pizi, the Company’s Chief Information Officer and Mark and Carolyn Landis, who are related by marriage to Anthony Pizi, and Mr. Landis is the Company’s Chairman of the Board of Directors.
In April 2004, the Company entered into a convertible loan agreement with Mr. Pizi in the amount of $100,000. Under the terms of the agreement, the loan bears interest at 1% per month and is convertible upon the option of the note holder into 270,270 shares of our common stock and warrants to purchase 270,270 shares of our common stock exercisable at $0.37. The warrants expire in three years from the date of grant. In June 2004, the Company entered into a convertible promissory note with Mr. Pizi in the face amount of $112,000. Under the terms of the agreement, the loan bears interest at 1% per month and is convertible upon the option of the note holder into 560,000 shares of our common stock and warrants to purchase 560,000 shares of our common stock at $0.20 per share. Also in June 2004, Mr. Pizi entered into a second convertible promissory note in the face amount of $15,000 which bears interest at 1% per month and is convertible into 90,118 shares of our common stock and warrants to purchase 90,118 shares of our common stock at $0.17 per share. All such warrants expire three years from the date of grant.
In March 2004, the Company entered into a convertible loan agreement with Mark and Carolyn Landis, in the principal amount of $125,000. Under the terms of the agreement, the loan bears interest at 1% per month and is convertible upon the option of the note holder into 446,429 shares of our common stock and warrants to purchase 446,429 shares of our common stock exercisable at $0.28. The warrants expire in three years from the date of grant. In June 2004, we entered into a convertible loan agreement with Mark and Carolyn Landis, in the amount of $125,000. Under the terms of the agreement, the loan bears interest at 1% per month and also is convertible upon the option of the note holder into 781,250 shares of our common stock and warrants to purchase 781,250 shares of our common stock exercisable at $0.16. The warrants expire in three years from the date of grant. In October 2004, the Company entered into a convertible loan agreement with Mark and Carolyn Landis in the amount of $100,000. Under the terms of the agreement, the loan bears interest at 1% per month and is convertible upon the option of the note holder into 1,000,000 shares of our common stock and warrants to purchase 2,000,000 shares of the Company’s common stock exercisable at $0.10. The warrants expire in three years. In November 2004, the Company entered into a convertible loan agreement with Mark and Carolyn Landis in the amount of $150,000. Under the terms of the agreement, the loan bears interest at 1% per month and is convertible upon the option of the note holder into 1,875,000 shares of our common stock and warrants to purchase 1,875,000 shares of the Company’s common stock exercisable at $0.08. All such warrants expire three years from the date of grant.
NOTE 11. INCOME TAXES
A reconciliation of expected income tax at the statutory federal rate with the actual income tax provision is as follows for the years ended December 31 (in thousands) :
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Significant components of the net deferred tax asset (liability) at December 31 were as follows:
At December 31, 2005, the Company had net operating loss carryforwards of approximately $230,926,000, which may be applied against future taxable income. These carryforwards will expire at various times between 2006 and 2025. A substantial portion of these carryforwards are restricted to future taxable income of certain of the Company's subsidiaries or limited by Internal Revenue Code Section 382. Thus, the utilization of these carryforwards cannot be assured. Net operating loss carryforwards include tax deductions for the disqualifying dispositions of incentive stock options. When the Company utilizes the net operating loss related to these deductions, the tax benefit will be reflected in additional paid-in capital and not as a reduction of tax expense. The total amount of these deductions included in the net operating loss carryforwards is $21,177,000.
The undistributed earnings of certain foreign subsidiaries are not subject to additional foreign income taxes nor considered to be subject to U.S. income taxes unless remitted as dividends. The Company intends to reinvest such undistributed earnings indefinitely; accordingly, no provision has been made for U.S. taxes on those earnings. The determination of the amount of the unrecognized deferred tax liability related to the undistributed earnings is not practicable.
The Company provided a full valuation allowance on the total amount of its deferred tax assets at December 31, 2005 and 2004 since management does not believe that it is more likely than not that these assets will be realized.
NOTE 12. SENIOR CONVERTIBLE REDEEMABLE PREFERRED STOCK
On March 19, 2003, the Company completed a $3.5 million private placement of Series D Convertible Preferred Stock (“Series D Preferred Stock”), convertible at a conversion ratio of $0.32 per share of common stock into an aggregate of 11,031,250 shares of common stock. As part of the financing, the Company has also issued warrants to purchase an aggregate of 4,158,780 shares of common stock at an exercise price of $0.07 per share (“Series D-1 Warrants”). On October 10, 2003, the Company, consistent with its obligations, also issued warrants to purchase an aggregate of 1,665,720 shares of common stock at an exercise price the lesser of $0.20 per share or market price at the time of exercise (“Series D-2 Warrants”). The Series D-2 Warrants became exercisable on November 1, 2003, because the Company failed to report $6 million in gross revenues for the nine month period ended September 30, 2003. Both existing and new investors participated in the financing. The Company also agreed to register the common stock issuable upon conversion of the Series D Preferred Stock and exercise of the warrants for resale under the Securities Act of 1933, as amended. Under the terms of the financing agreement, a redemption event may occur if any one person, entity or group shall control more than 35% of the voting power of the Company’s capital stock. The Company allocated the proceeds received from the sale of the Series D Preferred Stock and warrants to the preferred stock and detachable warrants on a relative fair value basis, resulting in an allocation of $2,890,000 to the Series D Preferred Stock and $640,000 to the detachable warrants. Based upon the allocation of the proceeds, the Company determined that the effective conversion price of the Series D Preferred Stock was less than the fair value of the Company’s common stock on the date of issuance. The beneficial conversion feature was recorded as a discount on the value of the Series D Preferred Stock and an increase in additional paid-in capital. Because Series D Preferred Stock was convertible immediately upon issuance, the Company fully amortized such beneficial conversion feature on the date of issuance.
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As part of the financing, the Company and the lead investors have agreed to form a joint venture to exploit the Cicero technology in the Asian market. The terms of the agreement require that the Company place $1 million of the gross proceeds from the financing into escrow to fund the joint venture. The escrow agreement allows for the immediate release of funds to cover organizational costs of the joint venture. During the quarter ended March 31, 2003, $225,000 of escrowed funds was released. Since the joint venture was not formed and operational on or by July 17, 2003, the lead investors have the right, but not the obligation, to require the Company to purchase $1 million in liquidation value of the Series D Preferred Stock at a 5% per annum premium, less their pro-rata share of expenses. On October 21, 2004, the Company received notification from the lead investors of their intent to redeem the escrow balance and surrender the equivalent amount of Series D preferred shares. This redemption was completed in November 2004.
Another condition of the financing requires the Company to place an additional $1 million of the gross proceeds into escrow, pending the execution of a definitive agreement with Merrill Lynch, providing for the sale of all right, title and interest to the Cicero technology. Since a transaction with Merrill Lynch for the sale of Cicero was not consummated by May 18, 2003, the lead investors have the right, but not the obligation, to require the Company to purchase $1 million in liquidation value of the Series D Preferred Stock at a 5% per annum premium. In addition, the Company and the lead investor agreed to extend the escrow release provisions until the end of July 2003 when all remaining escrow monies were released to the Company.
NOTE 13. STOCKHOLDERS’ EQUITY
Common Stock:
In January 2004, the Company completed a common stock financing round wherein it raised $1,247,000 of capital from several new investors as well as certain investors of Critical Mass Mail, Inc. The Company sold 3,369,192 shares of common stock at a price of $0.37 per share. As part of the financing, the Company has also issued warrants to purchase 3,369,192 shares of the Company’s common stock at an exercise price of $0.37. The warrants expire three years from the date of grant. These shares were issued in reliance upon the exemption from registration under Rule 506 of Regulation D and on the exemption from registration provided by Section 4(2) of the Securities Act of 1933 for transactions by an issuer not involving a public offering.
In October 2003, the Company entered into a Securities Purchase Agreement with several investors wherein the Company agreed to sell 1,894,444 shares of its common stock and issue 473,611 warrants to purchase the Company’s common stock at a price of $0.45 per share for a total of $853,000 in proceeds. This offering closed on October 15, 2003. The warrants expire in three years from the date of grant. These shares were issued in reliance upon the exemption from registration under Rule 506 of Regulation D and on the exemption from registration provided by Section 4(2) of the Securities Act of 1933 for transactions by an issuer not involving a public offering.
In January 2002, the Company entered into a Securities Purchase Agreement with several investors wherein the Company agreed to sell up to 3,000,000 shares of its common stock and warrants. The common stock was valued at $1.50 per share and warrants to purchase additional shares were issued with an exercise price of $2.75 per share. This offering closed on January 16, 2002. Of the 3,000,000 shares, the Company sold 2,381,952 shares of common stock for a total of $3,574,000 and granted 476,396 warrants to purchase the Company’s common stock at an exercise price of $2.75 per share. The warrants expire in three years from the date of grant and have a call feature that forces exercise if the Company’s common stock exceeds $5.50 per share. These shares were issued in reliance upon the exemption from registration under Rule 506 of Regulation D and on the exemption from registration provided by Section 4(2) of the Securities Act of 1933 for transactions by an issuer not involving a public offering. Under this Private Placement, the Company had agreed to certain terms and conditions that would trigger payments by the Company if the Company did not keep such shares registered under the Securities Act of 1933, as amended. In April 2003, in exchange for a waiver of such provisions the Company agreed to exchange the warrants from the January 2002 Private Placement priced at $2.50 for new warrants priced at $0.60 and has extended the expiration date until March 2007. Each participant is required to execute a waiver prior to receiving the repriced warrants.
Stock Grants:
During 2005 and 2004, no stock awards were made to employees.
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Stock Options:
The Company maintains two stock option plans, the 1995 and 1997 Stock Incentive Plans, which permit the issuance of incentive and nonstatutory stock options, stock appreciation rights, performance shares, and restricted and unrestricted stock to employees, officers, directors, consultants, and advisors. In July 2003, stockholders approved a proposal to increase the number of shares reserved within these plans to a combined total of 10,900,000 shares of common stock for issuance upon the exercise of awards and provide that the term of each award be determined by the Board of Directors. In December 2005, 509,250 remaining options under the 1995 Stock Incentive Plan expired. The Company also has a stock incentive plan for outside directors and the Company has set aside 120,000 shares of common stock for issuance under this plan.
Under the terms of the Plans, the exercise price of the incentive stock options may not be less than the fair market value of the stock on the date of the award and the options are exercisable for a period not to exceed ten years from date of grant. Stock appreciation rights entitle the recipients to receive the excess of the fair market value of the Company's stock on the exercise date, as determined by the Board of Directors, over the fair market value on the date of grant. Performance shares entitle recipients to acquire Company stock upon the attainment of specific performance goals set by the Board of Directors. Restricted stock entitles recipients to acquire Company stock subject to the right of the Company to repurchase the shares in the event conditions specified by the Board are not satisfied prior to the end of the restriction period. The Board may also grant unrestricted stock to participants at a cost not less than 85% of fair market value on the date of sale. Options granted vest at varying periods up to five years and expire in ten years.
Activity for stock options issued under these plans for the fiscal years ending December 31, 2005, 2004 and 2003 was as follows:
The weighted average grant date fair value of options issued during the years ended December 31, 2005, 2004, and 2003 was equal to $0.09, $0.26, and $0.24 per share, respectively. There were no option grants issued below fair market value during 2005, 2004 or 2003.
At December 31, 2005, 2004, and 2003, options to purchase approximately 5,237,432, 4,775,040, and 2,770,126 shares of common stock were exercisable, respectively, pursuant to the plans at prices ranging from $0.12 to $39.32. The following table summarizes information about stock options outstanding at December 31, 2005:
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Preferred Stock:
In connection with the sale of Series D Preferred Stock, the holders of the Company’s Series A3 Preferred Stock and Series B3 Preferred Stock (collectively, the “Existing Preferred Stockholders”), entered into an agreement whereby the Existing Preferred Stockholders have agreed to waive certain applicable price protection anti-dilution provisions. Under the terms of the waiver agreement, the Company is also permitted to issue equity securities representing aggregate proceeds of up to an additional $4.9 million following the sale of the Series D Preferred Stock. Additionally, the Existing Preferred Stockholders have also agreed to a limited lock-up restricting their ability to sell common stock issuable upon conversion of their preferred stock and warrants and to waive the accrual of any dividends that may otherwise be payable as a result of the Company’s delisting from Nasdaq. As consideration for the waiver agreement, the Company has agreed to issue on a pro rata basis up to 1,000 warrants to all the Existing Preferred Stockholders on a pro rata basis at such time and from time to time as the Company closes financing transactions that represent proceeds in excess of $2.9 million, excluding the proceeds from the Series D Preferred Stock transaction. Such warrants will have an exercise price that is the greater of $0.40 or the same exercise price as the exercise price of the warrant, or equity security, that the Company issues in connection with the Company’s financing or loan transaction that exceeds the $2.9 million threshold.
On August 14, 2002, the Company completed a $1.6 million private placement of Series C Convertible Preferred Stock (“Series C Preferred Stock”), convertible at a conversion ratio of $0.38 per share of common stock into an aggregate of 4,184,211 shares of common stock. As part of the financing, the Company has also issued warrants to purchase an aggregate of 1,046,053 shares of common stock at an exercise price of $0.38 per share. As consideration for the $1.6 million private placement, the Company received approximately $1.4 million in cash and allowed certain debt holders to convert approximately $150,000 of debt and $50,000 accounts payable to equity. The Chief Information Officer of the Company, Anthony Pizi, converted $150,000 of debt owed to him into shares of Series C Preferred Stock and warrants. Both existing and new investors participated in the financing. The Company also agreed to register the common stock issuable upon conversion of the Series C Preferred Stock and exercise of the warrants for resale under the Securities Act of 1933, as amended. The Company allocated the proceeds received from the sale of the Series C Preferred Stock and warrants to the preferred stock and the detachable warrants on a relative fair value basis, resulting in the allocation $1,271,000 to the Series C Preferred Stock and $329,000 to the detachable warrants. Based on the allocation of the proceeds, the Company determined that the effective conversion price of the Series C Preferred Stock was less than the fair value of the Company’s common stock on the date of issuance. As a result, the Company recorded a beneficial conversion feature in the amount of $329,000 based on the difference between the fair market value of the Company’s common stock on the closing date of the transaction and the effective conversion price of the Series C Preferred Stock. The beneficial conversion feature was recorded as a discount on the value of the Series C Preferred Stock and an increase in additional paid-in capital. Because the Series C Preferred Stock was convertible immediately upon issuance, the Company fully amortized such beneficial conversion feature on the date of issuance.
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In connection with the sale of Series C Preferred Stock, the Company agreed with the existing holders of its Series A1 Convertible Preferred Stock (the “Series A1 Preferred Stock”) and the Series B1 Convertible Preferred Stock (the “Series B1 Preferred Stock”), in exchange for their waiver of certain anti-dilution provisions, to reprice an aggregate of 1,801,022 warrants to purchase common stock from an exercise price of $1.77 to $0.38. The Company entered into an Exchange Agreement with such holders providing for the issuance of 11,570 shares of Series A2 Convertible Preferred Stock (“Series A2 Preferred Stock”) and 30,000 Series B2 Convertible Preferred Stock (“Series B2 Preferred Stock”), respectively. Series A2 Preferred Stock and Series B2 Preferred Stock are convertible into an aggregate of 1,388,456 and 2,394,063 shares of the Company’s common stock at $8.33 and $12.53 per share, respectively. The exchange is being undertaken in consideration of the temporary release of the anti-dilution provisions of the Series A1 Preferred Stockholders and Series B1 Preferred Stockholders. Based on a valuation performed by an independent valuation firm, the Company recorded a deemed dividend of $293,000, to reflect the increase in the fair value of the preferred stock and warrants as a result of the exchange. (See “Stock Warrants” for fair value assumptions.) The dividend increased the fair value of the warrant liability. As of December 31, 2005, no warrants had been exercised.
On October 25, 2002, the Company effected an exchange of all of our outstanding shares of Series A2 Convertible Redeemable Preferred Stock (“Series A2 Preferred Stock”) and Series B2 Convertible Redeemable Preferred Stock (“Series B2 Preferred Stock”) and related warrants for an equal number of shares of newly created Series A3 Convertible Redeemable Preferred Stock (“Series A3 Preferred Stock”) and Series B3 Convertible Redeemable Preferred Stock (“Series B3 Preferred Stock”) and related warrants. This exchange was made to correct a deficiency in the conversion price from the prior exchange of Series A1 and B1 Preferred Stock and related warrants for Series A2 and B2 Preferred Stock and related warrants on August 29, 2002. The conversion price for the Series A3 Preferred Stock and the conversion price for the Series B3 Preferred Stock remain the same as the previously issued Series A1 and A2 Preferred Stock and Series B1 and B2 Preferred Stock, at $8.33 and $12.53, respectively. The exercise price for the aggregate 753,640 warrants relating to the Series A3 Preferred Stock (“Series A3 Warrants”) was increased from $0.38 to $0.40 per share which is a reduction from the $1.77 exercise price of the warrants relating to the Series A1 Preferred Stock. The exercise price for the aggregate 1,047,382 warrants relating to the Series B3 Preferred Stock (“Series B3 Warrants”) was increased from $0.38 to $0.40 per share which is a reduction from the $1.77 exercise price of the warrants relating to the Series B1 Preferred Stock. The adjusted exercise price was based on the closing price of the Company’s Series C Convertible Redeemable Preferred Stock and warrants on August 14, 2002, plus $0.02, to reflect accurate current market value according to relevant Nasdaq rules. This adjustment was made as part of the agreement under which the holders of the Company’s Preferred Stock agreed to waive their price-protection anti-dilution protections to allow the Company to issue the Series C Preferred Stock and warrants without triggering the price-protection anti-dilution provisions and excessively diluting its common stock. The Company may cause the redemption of the Series A3 Preferred Stock warrants and the Series B3 Preferred Stock warrants for $.0001 at any time if the closing price of the Company’s common stock over 20 consecutive trading days is greater than $5.00 and $7.50 per share, respectively. The holders of the Series A3 and Series B3 Warrants may cause the warrants to be redeemed for cash at the difference between the exercise price and the fair market value immediately preceding a redemption event as defined in the contract. As such, the fair value of the warrants at issuance has been classified as a warrant liability in accordance with EITF 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in a Company’s Own Stock”. As of December 31, 2005, no warrants have been exercised and the fair value of the liability is $0.
Under the terms of the agreement, the Company is authorized to issue equity securities in a single or series of financing transactions representing aggregate gross proceeds to the Company of approximately $5 million, or up to an aggregate 17,500 shares of common stock, without triggering the price-protection anti-dilution provisions in the Series A3 Preferred Stock and B3 Preferred Stock and related warrants. In exchange for the waiver of these price-protection anti-dilution provisions, the Company repriced the warrants as described above and have agreed to issue on a pro rata basis up to 4,600 warrants to the holders of Series A3 Preferred Stock and Series B3 Preferred Stock at such time and from time to time as the Company closes subsequent financing transactions up to the $5 million issuance cap or the 17,500 share issuance cap. As a result of the Series C Preferred Stock financing, which represented approximately $1.6 million of the Company’s $5 million in allowable equity issuances, the Company is obligated to issue an aggregate of 1,462,801 warrants at an exercise price of $0.40 per share to the existing preferred stockholders. The warrants were issued on December 31, 2002 and had a fair value of $373,000, which was recorded as a dividend to, Preferred stockholders. As a result of the Series D preferred Stock financing which represented approximately $3.5 million against the allowable equity issuances, the Company was obligated to issue an aggregate of 3,048,782 warrants at an exercise price of $0.40 per share to the existing Series A3 and Series B3 preferred shareholders. The warrants were issued on October 8, 2003 and had a fair value of $1,062,000, which was recorded as a deemed dividend to preferred stockholders. Additionally, the Company has agreed to issue a warrant to purchase common stock to the existing preferred stockholders on a pro rata basis for each warrant to purchase common stock that the Company issues to a third-party lender in connection with the closing of a qualified loan transaction. The above referenced warrants will have the same
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exercise price as the exercise price of the warrant, or equity security, that the Company issues in connection with the Company’s subsequent financing or loan transaction or $0.40, whichever is greater. These warrants are not classified as a liability under EITF 00-19.
During 2005 and 2004 there were 456 shares of preferred stock converted into 1,351,112 shares of the Company's common stock and 4,686 shares of preferred stock converted into 7,037,451 shares of the Company’s common stock, respectively. There were 1,571 shares of the Series A3 Preferred Stock and 30,000 shares of Series B3 Preferred Stock, 991 shares of Series C Preferred Stock, and 1,061 shares of Series D Preferred Stock outstanding at December 31, 2005.
Stock Warrants:
The Company values warrants based on the Black-Scholes pricing model. Warrants granted in 2004, 2003, and 2002 were valued using the following assumptions:
During December 2000, the Company issued a commercial lender rights to purchase up to 172,751 shares of the Company's common stock at an exercise price of $4.34 in connection with a new credit facility. The warrants were valued at $775,000 or $4.49 per share and were exercisable until December 28, 2004. As of the date of expiration, no warrants were exercised.
Increase in Capital Stock:
In July 2003, the stockholders approved a proposal to amend the Amended and Restated Certificate of Incorporation to increase the aggregate number of shares of Common Stock that the Company is authorized to issue from 60,000,000 to 85,000,000.
NOTE 14. EMPLOYEE BENEFIT PLANS
The Company sponsors one defined contribution plan for its U.S. employees - the Level 8 Systems 401(k). Under the terms of the Plan, the Company provides a 50% matching contribution up to 6% of an employee’s salary. Participants must be eligible Level 8 plan participants and employed at December 31 of each calendar year to be eligible for employer matching contributions. Matching contributions to the Plan included in the Consolidated Statement of Operations totaled $30,000, $54,000, and $14,000 for the years ended December 31, 2005, 2004, and 2003, respectively. On December 1, 2005 the company suspended further contributions to the defined contribution plan.
The Company also had employee benefit plans for each of its foreign subsidiaries, as mandated by each country's laws and regulations. The Company no longer maintains foreign subsidiaries.
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NOTE 15. SIGNIFICANT CUSTOMERS AND CONCENTRATION OF CREDIT RISK
In 2005, two customers accounted for 52.4% and 13.0% of operating revenues. In 2004, five customers accounted for 24.6%, 22.4%, 13.5%, 11.8% and 11.4% of operating revenues. In 2003, three customers accounted for 42.1%, 19.5% and 12.7% of operating revenues.
NOTE 16. FOREIGN CURRENCIES
As of December 31, 2005, the Company had $0 of U.S. dollar equivalent cash and trade receivable balances denominated in foreign currencies.
The Company’s net foreign currency transaction losses/ (gains) were $(23,000), $13,000, and $31,000 for the years ended 2005, 2004, and 2003, respectively.
NOTE 17. SEGMENT INFORMATION AND GEOGRAPHIC INFORMATION
The Company makes operating decisions and assesses performance of the Company’s operations based on the following reportable segments: (1) Desktop Integration segment, and (2) Messaging and Application Engineering segment. The Company previously had three reportable segments but the Company has reported the Systems Integration segment as discontinued operations.
The principal product in the Desktop Integration segment is Cicero. Cicero is a business integration software product that maximizes end-user productivity, streamlines business operations and integrates disparate systems and applications.
The products that comprise the Messaging and Application Engineering segment are Ensuredmail, Geneva Integration Broker, CTRC and Star/SQL.
Segment data includes a charge allocating all corporate headquarters costs to each of its operating segments based on each segment's proportionate share of expenses. The Company evaluates the performance of its segments and allocates resources to them based on earnings (loss) before interest and other income/(expense), taxes, in-process research and development, and restructuring.
The table below presents information about reported segments for the twelve months ended December 31, 2005, 2004 and 2003 (in thousands):
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A reconciliation of segment operating expenses to total operating expense follows (in thousands):
A reconciliation of total segment profitability to loss before income taxes for the fiscal years ended December 31(in thousands):
The following table presents a summary of long-lived assets by segment as of December 31 (in thousands):
The following table presents a summary of revenue by geographic region for the years ended December 31(in thousands):
Presentation of revenue by region is based on the country in which the customer is domiciled. As of December 31, 2005, 2004 and 2003, all of the long-lived assets of the Company are located in the United States. The Company reimburses the Company’s foreign subsidiaries for their costs plus an appropriate mark-up for profit. Intercompany profits and losses are eliminated in consolidation.
NOTE 18. RELATED PARTY INFORMATION
Liraz Systems Ltd. guarantees certain debt obligations of the Company. In November 2005, the Company and Liraz agreed to extend the guarantee and with the approval of the lender, agreed to extend the maturity of the debt obligation until October 30, 2006. The Company issued 2,400,000 shares of common stock and granted a warrant to purchase an additional 3,600,000 shares of our common stock at an exercise price of $0.002 per share to Liraz in exchange for this debt extension. In 2004, the
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Company and Liraz also agreed to extend the guarantee and maturity of the debt obligation until November 2005. The Company agreed to issue Liraz 3,942,000 shares of stock for that extension. (See Note 10.)
From time to time during 2005 and 2004, the Company entered into short term notes payable with Anthony Pizi, the Company’s former Chief Executive Officer and current Chief Information Officer. The Notes bear interest at 1% per month and are unsecured. At December 31, 2005, the Company was indebted to Mr. Pizi in the amount of $9,000.
Convertible Promissory Notes: Directors and executive officers made the following loans to the Company for convertible promissory notes: On April 12, 2004, the Company entered into a convertible promissory note with Mr. Pizi. The note, in the face amount of $100,000, bears interest at 1% per month and is convertible into common stock of the Company at a conversion rate of $0.37 per share. In addition, Mr. Pizi was granted 270,270 warrants to purchase the Company’s common stock at $0.37 per share.
In June 2004, the Company entered into a convertible promissory note with Mr. Pizi. The note, in the face amount of $112,000, bears interest at 1% per month and is convertible into 560,000 shares of the Company’s common stock and warrants to purchase 560,000 shares of our common stock at $0.20 per share. Also in June 2004, Mr. Pizi entered into a second convertible promissory note in the face amount of $15,000 which is convertible into 90,118 shares of the Company’s common stock and warrants to purchase 90,118 shares of the Company’s common stock at $0.17 per share.
In March 2004, the Company entered into a convertible promissory note with Mr. and Mrs. Mark Landis in the amount of $125,000. Mr. Landis is the Company’s Chairman of the Board and Mr. and Mrs. Landis are parents-in-law to Mr. Pizi, the Company’s Chief Information Officer. Under the terms of the note, the loan bears interest at 1% per month, and is convertible into 446,429 shares of Level 8 common stock and warrants to purchase 446,429 shares of Level 8 common stock exercisable at $0.28 per share.
In June 2004, the Company entered into a convertible promissory note with Mr. and Mrs. Landis in the amount of $125,000. Under the terms of the note, the loan bears interest at 1% per month and is convertible into 781,250 shares of Level 8 common stock and warrants to purchase 781,250 shares of Level 8 common stock exercisable at $0.16 per share.
In October 2004, the Company entered into a convertible promissory note with Mr. and Mrs. Landis in the amount of $100,000. Under the terms of the agreement, the loan bears interest at 1% per month and is convertible into 1,000,000 shares of our common stock and warrants to purchase 2,000,000 shares of the Company’s common stock exercisable at $0.10 per share.
In November 2004, the Company entered into a convertible promissory note with Mark and Carolyn Landis, in the amount of $150,000. Under the terms of the agreement, the loan bears interest at 1% per month and is convertible into 1,875,000 shares of our common stock and warrants to purchase 1,875,000 shares of the Company’s common stock exercisable at $0.08 per share.
In June 2004, the Company entered into a convertible promissory note with Fredric Mack, a former director of Level 8, in the amount of $125,000. Under the terms of the note, the loan bears interest at 1% per month, and is convertible into 390,625 shares of Level 8 common stock and warrants to purchase 390,625 shares of Level 8 common stock exercisable at $0.32 per share.
In April 2005, the Company entered into a convertible promissory note with Bruce Miller, a director of Level 8, in the amount of $30,000. Under the terms of the note, the loan bears interest at 1% per month and is convertible into 428,571 shares of Level 8 common stock.
In July 2004, the Company entered into a convertible promissory note with Nicholas Hatalski, who until July 22, 2005 (during the period when the terms of the recapitalization merger were being negotiated and at the time of approval of the recapitalization merger by our board of directors), was a director of Level 8, in the amount of $25,000. Under the terms of the note, the loan bears interest at 1.5% per month and is convertible into 78,125 shares of Level 8 common stock and warrants to purchase 78,125 shares of Level 8 common stock exercisable at $0.32 per share.
All of such warrants expire three years from date of grant.
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Senior Reorganization Notes. From March 2004 to April 2005, directors and executive officers made the following loans to us for Senior Reorganization Notes: Mr. Pizi holds $423,333 of Senior Reorganization Notes, which may be converted into warrants to purchase an additional 57,165,993 shares of Level 8 common stock at a purchase price of $0.002 per share.
Mr. Landis holds $327,860 of Senior Reorganization Notes, which may be converted into warrants to purchase an additional 44,234,523 shares of Level 8 common stock at an exercise price of $0.002 per share.
Mr. Mack holds, together with his affiliates, $88,122 of Senior Reorganization Notes, which may be converted into warrants to purchase an additional 44,234,523 shares of Level 8 common stock at a purchase price of $0.002 per share.
Mr. Miller holds, together with his affiliates, $77,706 of Senior Reorganization Notes, which may be converted into warrants to purchase an additional 11,459,727 shares of Level 8 common stock at a purchase price of $0.002.
John Broderick, Chief Executive Officer and Chief Financial Officer of Level 8, holds $2,300 of Senior Reorganization Notes, which may be converted into warrants to purchase 333,333 shares of Level 8 common stock at a purchase price of $0.002 per share, and options to purchase 1,099,200 shares of common stock under the Level 8 stock option plan that will convert into options to purchase Cicero common stock.
Such warrants are only issuable upon approval of the recapitalization merger, and are to be automatically exercised in connection with the consummation of the recapitalization merger.
Convertible Bridge Notes. From July to December 2005, directors and executive officers made the following loans to the Company for Convertible Bridge Notes:
Mr. Pizi holds $85,000 of Convertible Bridge Notes which bear interest at 10% and mature on September 15, 2005. Upon consummation of the recapitalization merger, these notes will automatically convert into 3,400,000 shares of Cicero common stock.
Mr. Landis holds $213,000 of Convertible Bridge Notes as of December 31, 2005, which bear interest at 10% and mature on September 15, 2005. Upon consummation of the recapitalization merger, these notes will automatically convert into 8,520,000 shares of Cicero common stock.
Mr. Mack holds, together with his affiliates, $74,000 of Convertible Bridge Notes which bear interest at 10% and mature on September 15, 2005. Upon consummation of the recapitalization merger, these notes will automatically convert into 2,960,000 shares of Cicero common stock.
Mr. Miller holds, together with his affiliates, $90,000 of Convertible Bridge Notes which bear interest at 10% and mature on September 15, 2005. Upon consummation of the recapitalization merger, these notes will automatically convert into 3,600,000 shares of Cicero common stock.
Bruce Hasenyager, a member of our Board of Directors, holds $4,061 of Convertible Bridge Notes which bear interest at 10% and mature on September 15, 2005. Upon consummation of the recapitalization merger, these notes will automatically convert into 162,425 shares of Cicero common stock.
Bruce Percelay, a member of our Board of Directors, holds $100,000 of Convertible Bridge Notes which bear interest at 10% and mature on December 15, 2005. Upon consummation of the recapitalization merger, these notes will automatically convert into 4,000,000 shares of Cicero common stock.
NOTE 19. RESTRUCTURING CHARGES
As part of the Company’s plan to focus on the emerging desktop integration marketplace with its new Cicero product, the Company completed substantial restructurings in 2002. At December 31, 2002, the Company’s accrual for restructuring was $772,000, which was primarily comprised of excess facility costs. As more fully discussed in Note 21 Contingencies, subsequent to September 30, 2003, the Company settled litigation relating to these excess facilities. Accordingly, the Company has reversed the restructuring balance, as of September 30, 2003. Under the terms of the settlement agreement, the Company agreed to assign the note receivable from the sale of Geneva to EM Software Solutions, Inc., with recourse equal to
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the unpaid portion of the note receivable should the note obligor, EM Software Solutions, Inc., default on future payments. The current unpaid principal portion of the note receivable assigned is approximately $247,000 and matures December 2007. The Company assessed the probability of liability under the recourse provisions using a probability weighted cash flow analysis and has recognized a long-term liability in the amount of $131,000.
NOTE 20. COMMITMENTS
Lease Commitments: The Company leases certain facilities and equipment under various operating leases. Future minimum lease commitments on operating leases that have initial or remaining non-cancelable lease terms in excess of one year as of December 31, 2005 were as follows (in thousands):
Rent expense for the years ended December 31, 2005, 2004 and 2003 was $122,000, $197,000, and $586,000, respectively. As of December 31, 2005 and 2004, the Company had no sublease arrangements. Sublease income for the year ended December 31, 2003 was $241,000.
Royalty Commitments: The Company is obligated under a royalty sharing agreement with Merrill Lynch to pay a royalty of 3% of the sales price for each sale of Cicero or related maintenance services. The royalties over the life of the agreement are not payable in excess of $20 million.
NOTE 21. CONTINGENCIES
Various lawsuits and claims have been brought against us in the normal course of our business. In January 2003, an action was brought against us in the Circuit Court of Loudon County, Virginia, for a breach of a real estate lease. The case was settled in August 2003. Under the terms of the settlement agreement, we agreed to assign a note receivable with recourse equal to the unpaid portion of the note should the note obligor default on future payments. The unpaid balance of the note was $545,000 and it matures in December 2007. We assessed the probability of liability under the recourse provisions using a weighted probability cash flow analysis and have recognized a long-term liability in the amount of $131,000.
In October 2003, we were served with a summons and complaint in Superior Court of North Carolina regarding unpaid invoices for services rendered by one of our subcontractors. The amount in dispute was approximately $200,000 and is included in accounts payable. Subsequent to March 31, 2004, we settled this litigation. Under the terms of the settlement agreement, we agreed to pay a total of $189,000 plus interest over a 19-month period ending November 15, 2005. The Company is in the process of negotiating a series of payments for the remaining liability of approximately $80,000.
In March 2004, we were served with a summons and complaint in Superior Court of North Carolina regarding a security deposit for a sublease in Virginia. The amount in dispute is approximately $247,000. In October 2004, we reached a settlement agreement wherein we agreed to pay $160,000 over a 24-month period ending October 2006.
In August 2004, we were notified that we were in default under an existing lease agreement for office facilities in Princeton, New Jersey. The amount of the default is approximately $65,000. Under the terms of the lease agreement, we may be liable for future rents should the space remain vacant. We have reached a settlement agreement with the landlord which calls for a total payment of $200,000, in accounts payable, over a 20-month period ending July 2006.
In April 2005, we were notified that Critical Mass Mail, Inc had filed a claim against us for failure to pay certain liabilities under an Asset Purchase Agreement dated January 9, 2004. We in turn filed that Critical Mass Mail, Inc, failed to deliver certain assets and other documents under the same Asset purchase agreement. We had already reserved the potential liability under the Agreement as part of the asset purchase accounting. On March 1, 2006, Critical Mass Mail amended their complaint and is seeking damages of approximately $600,000 for our failure to timely register the underlying securities issued in the Asset Purchase. We believe that the probability of an unfavorable outcome is remote and accordingly, we have not reserved for this contingency.
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Under the indemnification clause of the Company’s standard reseller agreements and software license agreements, the Company agrees to defend the reseller/licensee against third party claims asserting infringement by the Company’s products of certain intellectual property rights, which may include patents, copyrights, trademarks or trade secrets, and to pay any judgments entered on such claims against the reseller/licensee.
NOTE 22. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)
NOTE 23. SUBSEQUENT EVENTS
As of December 31, 2005, the Company has raised a total of $1,760,000 from the Convertible Bridge Notes. Since then, the Company has raised an additional $275,000. If the merger proposal is not approved, the Notes will immediately become due and payable. The Company filed its preliminary Form S-4 with the Securities and Exchange Commission on February 15, 2005 and its amendment to the Form on December 5, 2005. The Company will file an additional amendment to the Forms S-4 in March 2006.
On March 7, 2006, Mr. Fredric Mack resigned from the Company’s Board of Directors. Mr. Mack’s resignation did not involve a disagreement with Level 8 Systems, Inc. on any matter relating to the Company’s operations, policies, or practices.