Item 1.
Business
General
Verso Technologies, Inc., a Minnesota corporation (the “Company”, “we” or “our”), is a global technology company providing next-generation communications network solutions to carriers, enterprises, governments and government related entities. We offer a core-to-edge product portfolio enabling our customers to reduce communications costs, generate additional revenue, and secure and optimize network bandwidth. We manufacture, deliver, and support these hardware, software, and service solutions primarily to large wireline, cellular, wireless and satellite carriers. Our product offerings include WiMAX, cellular backhaul, voice over broadband (“VoBB”), voice over internet protocol (“VoIP”), integrated access devices (“IAD”), and internet usage solutions which are enabled by the Company’s hardware and software. Our solutions are utilized in mission critical satellite and wireless communications of all kinds. The Company’s proprietary and other technologies utilize the latest industry protocols and are open and scalable providing the customer with the flexibility of rapid deployment, faster revenue generation, performance optimization and efficiency. Today, the Company has installations in more than 38 countries and sells its products primarily through original equipment manufacturers (“OEM”) and other agreements with several parties, including the following entities or certain of their affiliates: AT&T Inc., Verizon Communications, Inc., Alcatel-Lucent, Interlink Communication Systems, Inc., ND SatCom GmbH, Avaya Inc., Veraz Networks, Inc., ViaSat Inc., and Navini Networks, Inc.
The Company’s headquarters is located at 400 Galleria Parkway, Suite 200, Atlanta, Georgia 30339, and the Company’s telephone number at that location is (678) 589-3500. The Company maintains a worldwide web address at www.verso.com. The Company’s annual, quarterly and current reports, and amendments thereto, which the Company files with, or furnishes to, the SEC, are available free of charge in the investors section of the Company’s website at www.verso.com. Such reports and amendments are available on the Company’s website as soon as reasonably practical after the Company has filed such reports with, or furnished such reports to, the SEC.
The Company’s operations include two separate business segments: (i) the Technologies Group, which includes the Company’s softswitching, I-Master, and NetPerformer divisions and the Company’s Telemate.Net Software, Inc. (“Telemate.Net”) and Verso Verilink, LLC (“Verso Verilink”) subsidiaries; and (ii) the Advanced Applications Services Group, which includes the Company’s technical applications support group and customer care center. The Technologies Group includes domestic and international sales of hardware and software, integration, applications and technical training and support and offers software-based solutions (which include hardware) for customers seeking to build converged packet-based voice and data networks. In addition, the Technologies Group offers software-based solutions for Internet access and usage management that include call accounting and usage reporting for Internet protocol network devices. In 2006, the Technologies Group enhanced its technology offerings by adding the product suites from the Verilink Acquisition and the iMarc Acquisition (each as defined below). These products provide access, multiplexing and transport of voice and data services. The addition of Verilink and iMarc product suites provided substantial revenue to the Company and, in connection therewith, the Company obtained two large Tier 1 North American customers to the Company. The Advanced Applications Services Group includes outsourced technical application services and application installation and training services to both customers of the Technologies Group and outside customers.
Technologies Group
The Technologies Group develops softswitch, software and hardware-based converged packet solutions that use next generation protocols such as VoIP, VoIP based applications and server devices that provide multiplexing and transport of voice and data services, as well as other advanced protocols for specialized applications such as a Global System for Mobile Communication (“GSM”) and CDMA backhaul and voice/data over satellite transmissions. The Technologies Group focuses on the VoIP, GSM, pre-paid, post-paid, and integrated access device sectors of the communications industry. The group’s solutions enable service providers to rapidly deploy highly efficient converged communication networks which are more cost-effective to operate and which enhance revenues by supporting innovative, higher margin services. The Technologies Group differentiates its solutions portfolio from those of the Company’s competitors by providing complete, end-to-end, bundled solutions that range from the central core to the edge of the network, as well as offering applications that generate and enhance revenues.
In the first quarter of 2003, the Company acquired substantially all of the operating assets of Clarent Corporation (“Clarent”), a pioneer in packet-based technology. The acquisition included Clarent’s softswitch and NetPerformer product lines. Today, the former Clarent product line supports a variety of diverse business applications from VoBB enterprise managed services and retail calling cards to wholesale Internet protocol (“IP”) telephony, IP network clearing services, international long distance and residential dial tone services, as well as network optimization solutions for industry segments such as satellite operators. In August 2004, the Company began working with WSECI, Inc., formerly known as Jacksonville Technology Associates, Inc. (“WSECI”), to resell WSECI’s open and next generation based pre-paid and post-paid I-Master® solution. This solution is scalable to Tier I and Tier II carriers and is compatible with other equipment provider’s technologies, including the Company’s technologies, and as such, presents a larger market opportunity for the Company. In March 2005, the Company acquired substantially all the operating assets of WSECI.
On June 16, 2006, the Company acquired the outstanding equity interests of Winslow Asset Holdings, LLC (now known as Verso Verilink) from Winslow Asset Group, LLC (the “Verilink Acquisition”). Winslow Asset Holdings, LLC had earlier acquired substantially all of the business assets of Verilink Corporation and Larscom Incorporated (together, the “Verilink Sellers”), other than the accounts receivable and certain fixed assets of the Verilink Sellers which were transferred to Winslow Asset Group, LLC. As a result of the Company’s equity purchase, the Company acquired the Verilink Sellers’ business of developing, manufacturing, marketing and selling broadband access solutions for computer networks.
On December 29, 2006, the Company purchased certain assets of Paradyne Networks, Inc. related to the business of manufacturing, selling and supporting the iMarc product line (the “iMarc Acquisition”). The iMarc product line is a family of asynchronous transfer mode (“ATM”), IP service units, and branch monitors that provides intelligent demarcation between carrier and enterprise networks, allowing for easier management.
In 2006, the Company’s primary base of customers of the Technologies Group consisted of large, domestic and international Tier I telecommunications carriers, emerging international service providers, domestic rural carriers, and Internet service providers (“ISPs”). In 2006, the Company made a strategic decision to sell to larger customers and to close larger individual carrier sales by bundling its products into packaged solutions, a strategy that has resulted in agreements and sales with larger partners. The Company is in active negotiations with additional partners to form similar large relationships and it expects that these will continue to drive larger initial sales and greater long-term opportunities. The Company is leveraging its distribution network and worldwide installed base of customers towards sales of the Company’s newest solutions. In addition, the Company continues to build a select, efficient network of larger distributors that include OEM partners in a continued effort to grow the business.
For the year ended December 31, 2006, revenue from the Technologies Group was $35.2 million, or 83%, of the Company’s consolidated revenue. Summarized financial information for the Company’s Technologies Group is set forth in Note 17 to the Company’s consolidated financial statements for the year ended December 31, 2006, which statements are contained elsewhere in this Annual Report.
Technologies Group: Market
General
In today’s competitive telecommunications marketplace, service providers are increasingly challenged to lower operating costs, enhance service quality, and generate revenue from new service offerings. Burdened by the high costs of continuing to build, manage and maintain separate voice and data networks, service providers have begun to combine voice and data services onto converged IP-based network infrastructures that leverage the low cost delivery of IP networks while delivering the high reliability and voice quality standards of the circuit-switched, public switched telephone network (“PSTN”). At the same time, these infrastructures are enabling service providers to launch new innovative services which provide important market share opportunities and enhance their revenue potential. These new applications are driving widespread adoption of converged packet-based technology among Tier I service providers in developed markets like North America and Europe, as well as in emerging market carriers in Asia-Pacific and elsewhere around the developing world.
Further, deregulation and privatization of the global telecommunications industry continues to drive demand for converged packet-based technology for small, emerging, international service providers who are not encumbered by massive, legacy time division multiplexing networks. More flexible and more agile than larger carriers, these emerging service providers are opening up large, previously untapped markets such as Africa, the Middle East, and India, driving much of the worldwide VoIP spending as they launch traditional voice services through a variety of wholesale and retail business models.
As the global business environment becomes increasingly competitive, enterprises and government entities of all kinds are driven by a common desire to lower operational costs, improve productivity, increase customer retention and speed time to market. Many enterprises depend on a robust technology infrastructure to help them achieve these business goals. Many emerging markets could not deploy a financially feasible network without the efficiencies provided by advanced technology. To that end, enterprises and other customers are migrating their legacy voice and data systems into single, converged networks that enable more efficient use of resources and easier integration of distributed, disparate resources, including applications, equipment and people. Emerging market operators are utilizing the technology as a primary communications infrastructure. As adoption of VoIP technology continues, so does demand for new IP-centric tools that enable businesses to manage and enhance the performance, utilization and efficiency of evolving communication infrastructures.
The market for the Technologies Group consists of VoIP, GSM, pre-paid, and IAD segments. The VoIP segment is characterized by operators and enterprises of all sizes and is being driven by deregulation and service providers’ desire to lower operating costs as well as the deployment of value added applications over wireless
broadband and WiMAX networks. The market for wireless GSM technology is still the largest market for handsets, especially in foreign and developing countries. The Company’s NetPerformer GSM technology lowers the cost for operators by increasing the service provider’s bandwidth and ultimately increasing its efficiency. The pre-paid segment is ideal for emerging markets where credit is not readily available to consumers but demand for communication products is growing rapidly as cost efficiencies actually create demand by making communications affordable to the end user and profitable for the operator. Pre-paid solutions include applications such as traditional telephony, pre-paid data services over networks such as digital subscriber line (“DSL”), cable, and broadband wireless. Sales in the VoIP, GSM, and pre-paid segments are achieved through the Company’s network of distributors and OEM partners in conjunction with the Company’s internal sales teams. The market for IAD’s is characterized by small and medium sized enterprises that are looking to optimize their voice and data networks. Demand is driven by their desire to lower telecommunications operating costs. The Company’s IAD business falls into two segments: bandwidth aggregation and converged access. In the bandwidth aggregation segment, market demand is shifting towards integrated solutions which incorporate CSU/DSU functionality such as IADs, access routers and new generation multiplexers. With this evolution in the market, the IAD product mix is positioned to transition from legacy stand-alone CSU/DSUs toward integrated, next-generation access products. In the converged access segment, the Company designs, manufactures, and sells products that connect to the Wide Area Network (“WAN”) to provide high-speed connectivity to end user businesses for the delivery of converged voice, video, and data applications. These products are commonly deployed at enterprise locations including main office, branch offices, remote offices, as well as the small office/home office. Sales of the Technologies Group IAD products are achieved through resellers or carrier partners as part of an integrated solution to their end customers.
Technologies Group: Products and Solutions
Softswitch Solutions
A softswitch is typically used to control connections at the junction point between circuit and packet networks and takes care of functions such as billing, call routing, signaling, call services as well as connecting different types of digital media streams together to create an end-to-end path for voice and data. Customers deploy softswitches to replace legacy technology, to build out new networks, and to increase capacity in existing markets.
Edge C5 Softswitch Solution
The Company’s Edge Class 5 (“C5”) Softswitch Solution enables traditional and alternative telecommunications service providers to deliver residential and advanced enterprise managed services over the “last mile” of any IP communications network, opening the door to new business and revenue opportunities. The solution supports IP connectivity via H.323, media gateway control protocol, and session initiation protocol (“SIP”) for interoperability with a wide range of access gateways as well as customer premise gateways (“CPGs”) and IP handsets. Additionally, the Company’s products support VoIP over newer access technologies such as broadband cable, xDSL and broadband wireless such as WiMAX technologies. The components of this solution include: C5 Call Manager; C4 Call Manager; Command Center; Element Management System; BHG Media Gateways; Border Agent; Clarent CPG; and Connect.
In 2005, the Company introduced the Edge C5 Call Manager versions 3.3 and 3.4, which further expanded the Company’s opportunity at the network edge by providing key features such as hotline, limiting simultaneous calls, private networking configurations, distinctive music on hold, do not disturb, anonymous call rejection, simultaneous ring, video edge device support, SIP and GR303 access gateways, topology hiding, local number portability, E911, lawful intercept and a radius interface to authentication, authorization and accounting servers such as I-Master. These newly-introduced features expanded the Company’s opportunity to create new revenue enhancing opportunities for its customers as well as allowed them to comply with the emerging VoIP regulatory requirements. These features are further discussed in the section of this Annual Report titled “Business - Research and Development.” In 2005, the Company deployed softswitch in several emerging markets, including Slovenia, Africa, and India.
In 2006, the Company enhanced the Edge C5 solution with the following: a Back Office component, IP Centrex, a wholesale reporting module, enhanced software interactive voice response (“IVR”) capabilities, and
the introduction of IBM platform support. The Back Office component offers customers integrated provisioning, management, reporting and automated billing for VoBB as well as wholesale peering business markets. An integrated wholesale reporting module enables the Company’s wholesale peering customers to offer their wholesalers as well as virtual wholesalers the ability to monitor and manage their traffic being offloaded and terminated into their networks. A hosted IP Centrex optional component that is integrated with the Verso Class 5 Call Manager and Back Office components offers a feature set that meets the needs of small office/home office (“SOHO”) users and small business customers. The Company also enhanced its software based IVR and pre-paid application through support of dual tone multi-frequency (“DTMF”) handling using named events as defined by Internet Engineering Task Force (“IETF”) RFC 2833. This enables the Company to offer a scalable IVR system for the support of multiple services such as VoBB and pre-paid calling. The Company signed a teaming agreement with IBM in 2006. As part of this relationship, the Company has certified its C5 product for VoBB overlay solutions as well as wholesale peering on the IBM BladeCenter platforms running on Linux.
PSTN C4 Softswitch Solution
The Company’s PSTN Class 4 (“C4”) Softswitch Solution seamlessly facilitates the migration to VoIP, allowing carriers to preserve and leverage existing telecom investments to realize lower operating costs and lower overall total cost of ownership. A significantly more cost-effective and scalable alternative to traditional tandem circuit switches, this Unix-based, software-centric, modular tandem trunking solution enables wholesale transport and termination of voice traffic over global IP networks. The components of this solution include: C4 Call Manager; Command Center; Element Management System; SS7 Signaling; BHG Media Gateways; and Connect.
In 2005, the Company introduced C4 Call Manager version 2.1, which further expanded the Company’s opportunity in this market by providing key features such as local number portability, E911, private networking configurations, a radius interface to authentication, authorization and administration via the I-Master.
In 2006, the C4 Call Manager was enhanced with support of SIP and ISUP transport within SIP or SIP-T. These enhancements enable the C4 to interoperate as a standalone component with any Class 5 softswitch or VoIP based feature server enabling SS7, PRI, CAS/MFCR2 TDM connectivity. Like the edge solution, the PSTN C4 solution was validated on the IBM BladeCenter solution on Linux.
Access Compression Solutions
Compression technology allows a service provider to optimize available bandwidth and reduce the cost of existing bandwidth. Customers deploy this technology when they are expanding an existing network, building out a next-generation network, or simply endeavoring to lower operating costs
NetPerformer® Integrated Access VoIP Routers
The Company’s NetPerformer® line of access compression devices enables multi-site enterprises to lower communications costs, alleviate bandwidth constraints, reduce network complexity and extend telecom services to remote locations with poor or nonexistent telecom infrastructures. This versatile line of products enables information technology managers to integrate mission critical networks and applications across their enterprise, regardless of where they are in the VoIP migration process. In addition, NetPerformer enables enterprises to dramatically reduce telecom costs by eliminating monthly fees associated with tie lines that link remote offices to corporate headquarters and eliminating the toll charges on inter-office long distance calls.
In 2004, the Company announced support for GSM A.bis/A.ter, an industry protocol for wireless transmission. This additional functionality coupled with the existing support for the GSM A and E interfaces allows the NetPerformer to be integrated into the key portions of GSM networks. The NetPerformer offers GSM operators a cost effective solution for reducing the bandwidth required by their GSM network thus lowering the carrier’s operating expenses. In early 2007, the Company introduced a high density version NetPerformer, further adding to the functionality and application of the Company’s technology in this area.
In 2005, the Company released its GSM A.bis/A.ter bandwidth optimization solution for the NetPerformer platform offering cellular backhaul optimization. This solution provides GSM network operators with a new way to
reduce their operating costs by providing bandwidth optimization for their entire GSM backhaul network, including the data portion. The NetPerformer platform offers multiple connectivity options, including IP, easily integrating with any existing network infrastructure. NetPerformer’s GSM A.bis/A.ter option converts Time Division Multiplex (“TDM”) voice and data traffic channels to a more efficient packet-based format, which results in better bandwidth utilization without any GSM transcoding that would impact the voice quality. While optimizing the bandwidth required for GSM A.bis/A.ter up to 2:1 or greater, the NetPerformer also provides a convergence path for GSM 3G using a common network infrastructure. This reduces the cost of the introduction of both technologies and reduces the recurring costs of the facilities serving sites that are migrating to 3G.
In 2006, the Company continued to enhance the GSM backhaul solution. A new 1U high equipment, SDM-9210 was developed for interconnection into the base transceiver station (“BTS”). It provides high reliability features like E1 bypass in case of failure as well as 1:1 redundancy. Additional improvements include a high precision clock compliant with the G.823 PDH standard which enables quality handover in high density urban areas. The high density chassis SDM-9600 has been introduced with the SDM-9606 hot-swappable blades. The fully loaded chassis supports up to 30 T1/E1s. A new set of digital signal processor (“DSPs”) has been deployed that, in conjunction with several software enhancements, has improved the performance in GPRS/EDGE support and enabled a reduction of the overall latency of the solution. Other software enhancements include SS7 call setup detection and message transfer part - layer 2 (“MTP2”) spoofing for improved compression efficiency in digital current multiplication equipment (“DCME”) applications. The Company developed a number of features related to better operation over satellite networks, including features developed in connection with partnerships with particular satellite equipment vendors.
Enhanced Services Solutions
Pre-paid and value-added applications represent the greatest potential for immediate revenue to the global operator. These services are leading the way as competitive realities drive wireless vendors and software developers to create more cohesiveness among services, service management and operations.
I-Master Pre-paid, Rating and Billing Platform
The Company’s I-Master® Pre-paid, Rating and Billing Solution enables service providers and carriers to launch multiple voice and next generation revenue generating services while maintaining the revenue assurance associated with a pre-paid model. This solution also enables a significant level of personalization to the end user. Personal preferences are stored and used to enhance the end user’s experience which increases customer retention for the service provider. This pre-paid solution is based on open standards, meaning that it can integrate with the Company’s softswitch products and also with many other next generation equipment providers’ technologies, including the technologies of Cisco Systems, Inc., Veraz Networks, Inc., Gallery IP Telephony, Inc., Sonus Networks, Inc., Siemens AG, and Telica (now owned by Alcatel-Lucent).
In addition to being compatible with the technologies of other equipment providers, I-Master is scalable to Tier I and Tier II carriers, and as such, presents a larger market opportunity for the Company. In combination with direct marketing campaigns, the Company plans to exploit multi-vendor interoperability by marketing this product in opportunities led by other vendors providing the customer with a complete vertical solution to increase the Company’s market penetration. The solution also offers real-time authentication for revenue enhancing voice and data services, including calling, additional real-time authentication for Internet and virtual private network access via Asymmetric DSL (“ADSL”) and dial-up, and pre-paid broadband access.
In 2006, the Company added a number of rating features to I-Master to support the competitive North American pre-paid market. These include disconnect rate plans and global rate management tools. The Company executed a reseller agreement with one of the world’s leading providers of telecommunication systems which enables the provider to offer a product that provides real-time rating for cellular, data, VoBB, WiFi, WiMAX and calling cards.
Integrated Access Devices
An IAD is a customer premise device that provides access to wide area networks and the internet. Specifically, it aggregates multiple channels of information including voice and data across a single shared access link to a carrier or service provider PoP (“Point of Presence”). The access link may be a T-1 line, a DSL connection, a cable network, a broadband wireless link, or a metro-Ethernet connection.
Verso Verilink® Integrated Access Devices
In the second quarter of 2006, the Company indirectly acquired the outstanding equity interests of Verso Verilink which had previously acquired substantially all of the business assets of Verilink Corporation and Larscom Incorporated through the acquisition of the Verso Verilink subsidiary. Verso Verilink provides next-generation broadband access products and services which support the delivery of voice, video and data services over converged access networks and enable the smooth migration from present TDM-based networks to IP-based networking. The Verilink business develops, manufactures, and markets IADs, Optical Ethernet access products, wireless access devices and bandwidth aggregation solutions which are sold to service providers, enterprise customers, and OEM partners. The products are deployed worldwide as targeted solutions for applications involving VoIP, voice over ATM (“VoATM”), voice over DSL (“VoDSL”), wireless backhaul aggregation, Frame Relay service transport, point-to-point broadband services, service inter-working, and the migration of networks from traditional TDM based access to IP/Ethernet. Our customers for this business include Inter-exchange carriers (“IXCs”), incumbent local exchange carriers (“ILECs”), independent operating companies (“IOCs”), competitive local exchange carriers (“CLECs”), international post, telephone, and telegraph companies, wireless service providers, equipment vendors, Fortune 500 companies, small to mid-sized business customers, and various local, state, and federal government agencies.
Verso Verilink Products
The Company’s Verso Verilink products and product families address issues and applications faced by both wireline and wireless communications carriers and enterprises. The products utilized by wireline carriers are typically deployed (i) in either the “last mile” of their networks to enable the delivery of telecommunications services to end users, both business and residential customers, or (ii) in their internal corporate networks providing the communications connectivity within the corporation. The products utilized by the enterprise customers typically are deployed as access devices connecting the corporation’s offices to the telecommunications network.
Series IAD Product Family
The 8000 Series IAD product family enables carriers to deliver high quality voice and data services to small and medium-sized businesses over any access technology (T1/E1 or xDSL). We offer an industry leading software configurable device for TDM, ATM, and IP transports which equips service providers with a “future proof” solution and a solid migration path to VoIP. The devices can move from one protocol application to another by changing the configuration of the unit.
WANsuite Product Family
The WANsuite® product family is a suite of software programmable, intelligent integrated access devices that target customer premises applications for last mile or network edge communications. The WANsuite platform supports copper-based transmission services for 56/64kbps, T1, E1 and SHDSL, and includes software support for TDM, ATM, Frame Relay and IP services and applications. The WANsuite product line combines integrated CSU/DSU, bridging and routing, probe and network monitoring capabilities. WANsuite products also utilize an embedded web server to provide an innovative user interface that aligns with the Internet for ease-of-use by service providers and end users. Among the key WANsuite features are a powerful web interface for simplified configuration, automatic protection switching (“APS”), performance monitoring and diagnostics for all service layers, and access routing, bridging, and switching for Frame Relay, ATM, Ethernet and IP applications.
Shark Product Family
The XSP 100 Shark® product is the industry’s first OSMINE-compliant IAD, terminating up to two T1 of bandwidth to deliver voice, high-speed data, Internet access and networking connections to end customers over a single network connection. The Shark is equipped with ports for up to 24 FXS lines, includes DSX/CSU functionality, 10/100 Base-T and serial Ethernet interfaces, Frame Relay Assembler/Disassembler and a digital cross connect system. The Shark works with a variety of management systems, including HTTP, CLI, SNMP or TL1, and can be configured remotely or through a local craft port on the chassis.
iMarc® IP Service Units
The iMarc® IP service units and branch monitors provide intelligent demarcation between carrier and enterprise networks, allowing service level management and end-to-end network monitoring. This provides carriers the critical ability to monitor and manage compliance of service level agreements to enterprise customers, which ensures that quality of service is delivered. As a result, iMarc solutions enable new services to be deployed faster, existing services to remain reliable, and inactive services to be restored more quickly.
Access System 2000
The Access System 2000tm product (“AS2000”) is a flexible network access and management solution that provides cost-effective integrated access to a broad range of network services. AS2000 products are installed at the origination and termination points at which service providers offer communications services to their corporate customers. AS2000 systems provide transmission link management, multiplexing and inverse multiplexing functions for T1, E1, multi-T1, multi-E1 and T3 access links. A key feature of the AS2000 is its flexibility and adaptability made possible by a modular architecture that allows customers to access new services or expanded network capacity simply by configuring or changing circuit cards. In a single platform, the AS2000 combines the functions of a T1 CSU/DSU, E1 NTU, inverse multiplexer, cross-connect, T3 CSU/DSU, automatic protection switch and an SNMP management agent. Modular line cards from the WANsuite product family are also available for the AS2000 system for applications involving SCADA, IP routing and CSU/DSU terminations.
PRISM Product Family
The PRISM® product family supports legacy TDM applications at transmission rates ranging from 56/64kbps through T1/E1. Products included in this family are the NEBs compliant 1024 shelf system, 1051 shelf, 3030/3060 intelligent channel bank, 2000 & 2100 CSUs and 3111/3112 CSU/DSUs. These devices provide physical layer performance monitoring and diagnostic functions. Management of the PRISM product family ranges from SNMP through simple DIP switches. The PRISM products are produced to carrier-grade standards of quality and are typically found deployed in the mission-critical applications used by wireline and wireless carriers, banks, utilities, government and other corporate enterprises.
Orion 4000 Product Family
The Orion 4000® product family provides a high-density, modular suite of solutions for T1/E1 and T3/E3 multiplexing and inverse multiplexing applications. The product line is designed for carriers and large enterprises challenged with rapidly changing broadband networking environments. The Orion 4000 is a rack-mountable family of 12-slot and 5-slot shelves, supporting a variety of modules to deliver T3 or E3 access multiplexing (or inverse multiplexing T1s and E1s), transition between circuit- and cell-based services, or to transport data, voice and video over a single DS3 circuit.
The Access-T Family
The Access-T® product family is primarily used by carriers for delivering Internet backbone and scalable, fractional T1 Internet access services. Network management is simplified with centralized configuration, performance monitoring, and diagnostics. The Access-T Family allows enterprises and service providers to cut maintenance costs, optimize uptime, and maximize existing bandwidth without increasing the network infrastructure.
The Terra Family
The Terra product family (TerraMux®, TerraBoss®, and TerraUno®) are Verso Verilink’s main solutions for full and fractional T1/E1 CSUs/DSUs because they are the industry’s only plug ’n play solutions. The products are designed to automatically configure the network port, drop-and-insert ports, and the speed of the primary data port to the network IP address. The product family is designed for T1 and E1 markets with extensive maintenance capabilities and managed via Telnet access, SNMP, and a web browser interface.
Mega-T Family
The Mega-T® product is a family of T1-based inverse multiplexers. The product suite is an ideal solution for carriers and enterprises looking to deploy the simplest, bit-based approach at the Layer 1 level of the serial bitstream. It combines up to four T1 or E1 lines to create a single, logical, high-speed data channel. The advantage is that this method is entirely independent of the protocols of the data being transmitted and of the network equipment and can be used in virtually any application.
Professional Services
The Company’s Professional Services are tailored to help our customers roll out their networks more efficiently and rapidly within the areas of GSM optimization, VoIP, Pre-paid and IAD’s, These services are characterized as being unique to the access equipment industry and serve as a differentiator compared to other access companies. Customers consider it as a key enabler in the deployment of managed bundled services. The Professional Services program features a comprehensive set of support services geared to assist carriers in the design, planning, deployment, and on-going support of their communications service offerings. The Professional Services group partners with the carrier from the initial design and planning stage through the equipment delivery, installation, configuration, and service turn-up stages. From an on-going support standpoint, the program’s key network operations activities include maintenance services, returned material authorizations, and equipment inventory management.
Call Accounting, Content Management, and Web Filtering
As companies endeavor to drive productivity, it has become more and more important to minimize communications costs and monitor and control employee productivity and computer usage through sophisticated software products which provide monitoring, reporting, and filtering functions.
TeleMate® Call Accounting Software
The Company’s TeleMate® calling accounting solution is a comprehensive, easy-to-use reporting tool used to facilitate the migration to next generation VoIP networks. TeleMate helps enterprises minimize voice communications costs, simplify capacity planning, and monitor employee productivity. Additionally, TeleMate measures resource utilization, provides reports for internal departmental charge-back or client billing, and handles dozens of other control reporting tasks.
NetSpective® Content Management and Web Filtering Solution
The NetSpective® content management and web filtering solution enables enterprises to monitor, filter and/or report on usage of critical IP network resources. With a comprehensive set of feature functionality that tracks Internet activity and detects usage of a variety of web-based applications, including peer-to-peer, instant messaging, online chat and streaming media, NetSpective helps enterprises, governments, schools and libraries maintain control of critical network resources and facilitate compliance with filtering and communications tracking regulations.
In 2004, the Company launched its NetAuditor® product for reporting and analysis of the Company’s NetSpective product in addition to analysis of log files from Cisco Systems, Inc.’s PIX firewalls; Check Point Software Technologies Ltd.’s Firewall NG; Novell, Inc.’s Boarder Manager; Symantec Corp.’s Enterprise Firewall; Juniper Networks, Inc.’s NetScreen; and Microsoft Corp.’s ISA Proxy.
In 2005, the Company launched its NetSpective C-Class and M-Class products targeting wireline carriers as well as mobile carriers. These NEBS-3/ETSI compatible products enable carriers to screen out web traffic such as Skypetm, instant messaging and other peer-to-peer applications that consume substantial bandwidth on carrier networks.
Advanced Applications Services Group
The Company’s Advanced Applications Services Group consists of the Company’s technical assistance center which provides support for the Company’s technical applications and services to outside customers and customers of the Company’s Technologies Group.
The Company’s Advanced Applications Services Group delivers full-service, custom technical support to customers that want to ensure satisfaction with each end-user technology interaction, and supports all of the Company’s product lines, allowing the Company to better leverage resources while ensuring the highest level of customer support. The Company’s Advanced Applications Services Group delivers 24 x 7 help desk support, Tier I, II and III product support, insourcing, on-site deployment services, hardware and software training, and project management resources.
Customers
In 2006, the Company’s primary base of customers in the Technologies Group included incumbent carriers inside and outside the United States (Tier I) and emerging or rural domestic and international alternative carriers (Tiers II and III) in the United States and abroad, particularly those service providers seeking to roll out telecommunications networks based on converged packet-based technology.
The Company continues to seek to expand its largely indirect domestic and international distribution channel. In 2006, several OEM, marketing and sales agreements were signed. It is expected that several similar agreements will be entered into in 2007. Additionally, the acquisition of the Verilink business and the iMarc product line delivered an installed base with two large North American customers, and the Company established a Global Accounts Team to service these customers and expand the Company’s North American presence. As an incumbent supplier to these two customers the Company is pursuing additional revenue opportunities with these customers as they continue to upgrade and expand their networks.
The Company’s TeleMate call accounting software and NetSpective Internet content and web filtering solution are used by several thousand large to mid-size enterprises as well as government agencies to manage communication costs and network efficiency, to manage network policy, and to protect their networks.
The Verso Verilink products continued to generate demand from large domestic and international carriers as well as smaller carriers and enterprises in the second half of 2006. Most of the sales to smaller carriers and enterprises are processed through several well established distribution channels.
In the Advanced Applications Services Group, the business focus is onsite installation and training, remote upgrades, and 24/7 support for enterprises. Customers are primarily organizations that install and support advanced software applications and terminals that are connected via telecommunications networks, wherein 50% of this business is outsourced software installations and training, 35% is technical support services and 15% is project management.
During the years ended December 31, 2006 and 2004, the Company had one customer which individually accounted for greater than 10% of its total revenue. For the year ended December 31, 2005, the company had no customers that accounted for greater than 10% of its total revenue.
Sales and Marketing
The Company achieves broader market penetration of its solutions in primarily three ways: expanding international and domestic distribution; pursuing new markets and customers, including ISPs, IP telephony service providers and pre-paid service bureaus; and selling new, next generation communication solutions to its current base of customers.
In 2006, the Company began focusing its distribution strategy on select larger distributors with a global footprint who have a strong presence in the specific product markets corresponding to the respective products of the Company. Prior to the acquisition of Verilink and the iMarc product family in 2006, Verso’s sales were primarily international. With the acquisitions, the Company believes that sales in 2007 will be balanced between international and domestic customers. The Company’s goal in 2007 is to continue to build on its indirect distribution channel which includes developing and securing additional OEM partnerships and developing key distribution relationships centered on specific products and select geographic regions. In order to further this goal in North America and strengthen the Company’s position domestically, the Company formed the Global Accounts Team which is focused on relationships with large domestic customers.
The Company’s sales and marketing organization is responsible for building sales distribution channels, including OEM relationships, promoting brand awareness, identifying key markets, and developing innovative products and services to meet the evolving demands of the marketplace. Another objective of the marketing effort is to stimulate the demand for services through a broad range of marketing, communications and public relations activities. Primary communication vehicles include channel promotions, marketing communications, tradeshows, media outreach efforts, trade analyst relationships, corporate promotions, and websites.
In the Technologies Group, sales are accomplished primarily through an indirect channel, and to a lesser degree, a direct sales force. There are approximately 35 sales and sales support personnel located throughout the United States, Canada, Mexico, the United Kingdom, India, Belgium, Italy, South Africa, China, Singapore, and the United Arab Emirates. The sales force is primarily responsible for cultivating strong relationships with systems integrators and distributors throughout the world and supporting them in the sales process. The Company has approximately 50 contracted resellers. In the Advanced Applications Services Group, sales are accomplished through direct sales methods.
Competition
The markets for the Company’s products are highly competitive, however, the Company believes that one of its competitive strengths is its ability to offer an end-to-end solution that leverages synergy across its product lines. Through both internal development efforts and strategic acquisitions, the Company continues to add intellectual property and innovative, patented technologies that deliver greater value to its worldwide base of customers.
Technologies Group
The market for application-based telephony services is intensely competitive, subject to rapid technological change and significantly affected by new product introductions and market entrants. In the market for the Company’s gateway solutions, the Company’s primary sources of competition include Class 4 and Class 5 solution providers, vendors of networking and telecommunications equipment, and telephony applications companies that bundle their offering with third-party equipment. Some competitors, especially networking and telecommunications equipment vendors, such as Alcatel-Lucent, Cisco Systems, Inc., Siemens AG, Huawei Technologies, and Nortel Networks Ltd., have significantly greater financial resources and broader customer relationships than does the Company. Other companies are focusing on market opportunities similar to those of the Company, including Veraz Networks, MERA Systems, Inc., Voiceware Systems Corporation, and iSoftel Ltd.
The Company’s I-Master pre-paid product line competes with Pactolus Communications Software Corporation, NACT Telecommunications, Inc., MIND CTI Ltd., and Portal Software, Inc.
The Company’s NetPerformer product lines compete with the products of telecommunications equipment manufacturers such as Cisco Systems, Inc., RAD Data Communications, Celtro, Inc., Memotec Inc., Avaya, Inc., Nortel Networks, Inc., Toshiba Corporation, ECI Telecom Ltd., and Fujitsu Limited.
The Company’s TeleMate call accounting software product competes with a number of products from companies such as MTS IntegraTRAK, MicroTel International, Inc., ISI Telemanagement Solutions, Inc., and Veramark Technologies, Inc.
The Company’s NetSpective products compete with filtering products from providers such as WebTrends Corporation, 8e6 Technologies, SurfControl PLC, St. Bernard Software, Inc., and Websense, Inc.
The Company’s Verso Verilink products, including iMarc, compete with access products from ADTRAN, Inc., Carrier Access Corporation, Huawei Technologies, Fluke Systems, Alcatel-Lucent, and Cisco Systems, Inc.
Advanced Application Services Group
The Company’s Advanced Applications Services Group competes with companies that provide integrated, multi-channel customer contact centers, including APAC Customer Services, Inc., ClientLogic Corporation, Convergys Corporation, and SITEL Corporation, as well as competing with in-house solutions.
Intellectual Property Rights
The Company regards its copyrights, trade secrets and other intellectual property as critical to its success. Unauthorized use of the Company’s intellectual property by third parties may damage its brand and its reputation. The Company relies on trademark and copyright law, trade secret protection, and confidentiality, license and other agreements with its employees, customers, partners and others to protect its intellectual property rights. Despite precautions, it may be possible for third parties to obtain and use the Company’s intellectual property without the Company’s authorization. Furthermore, the validity, enforceability and scope of protection of intellectual property in Internet-related industries are still evolving. The laws of some foreign countries do not protect intellectual property to the same extent as do the laws of the United States.
The Company cannot be certain that its services and the finished products that it delivers do not or will not infringe valid patents, copyrights, trademarks or other intellectual property rights held by third parties. The Company may be subject to legal proceedings and claims from time to time relating to the Company’s intellectual property other than in the ordinary course of business. Successful infringement claims against the Company may result in substantial monetary liability or may materially disrupt the conduct of the Company’s business.
On September 18, 2001, U.S. Patent No. 6,292,801 was issued to Telemate.Net, which the Company acquired in November 2001 by means of a merger. The patent covers technology developed by Telemate.Net for tracking PBX, VoIP and IP traffic from a variety of network sources and correlating communications activity with a database of user accounts. The patented techniques are employed in several of Telemate.Net’s products, including Telemate.Net’s call accounting and NetSpective Internet access management solutions. This technology allows users to combine statistics from diverse networks sources to create cohesive network information and reporting. This unique technology for aggregating and correlating network data from different vendors and device types has application to the VoIP softswitch, Operation Support System (“OSS”) and billing markets. The patented processes allow the Company’s OSS software to gather billing, reporting and maintenance from a variety of data sources and vendors’ products, in addition to its own.
On February 12, 2003, pursuant to the Company’s acquisition of substantially all of the operating assets of Clarent on such date, the Company acquired the following U.S. Patents: Dynamic Forward Error Correction Algorithm for Internet Telephone, No. 6,167,060, issued on December 26, 2000; System and Method for Real-Time Data and Voice Transmission over an Internet Network, No. 6,477,164, issued on November 5, 2002; Internet Telephone System with Dynamically Varying Codec, No. 6,356,545, issued on March 12, 2002; and System and Method for Roaming Billing, No. 6,453,030, issued on September 17, 2002. In addition, Patent No. 6,982,985 was issued on January 3, 2006 for Interaction of VoIP Calls and Cellular Networks. This patent was based on an application filed by Clarent and obtained by the Company in connection with the acquisition of substantially all of Clarent’s operating assets. The Company also has several patent applications pending relating to its VoIP products and other product lines.
In connection with the Verilink Acquisition, Verso Verilink owns the rights to twelve U.S. patents, six U.S. patent applications, and numerous registered U.S. and international trademarks. In connection with the iMarc acquisition, the Company purchased four U.S. patents and the registered U.S. trademark for iMarc.
The Company is exploring means of monetizing its patent resources, including entering into cooperative agreements and license agreements with third parties.
Research and Development
The Company believes that one of its competitive strengths is the synergy across its product lines, which enables the Company to accelerate the development of new technologies, the delivery of new products and expansion into new markets. Through both internal development efforts and strategic acquisitions, the Company continues to add intellectual property and innovative, patented technologies that deliver greater value to its worldwide base of customers. The Company’s research and development expenses totaled $7.8 million for the year ended December 31, 2006.
In the Technologies Group, the research and development initiatives centered around introducing product features targeted towards increasing its customer’s revenue creation opportunities as well as extending the market reach through the introduction of additional applications.
In 2004, the Company introduced key enhancements to the C5 Call Manager based on market trends and key customer requirements. The newly-introduced features expanded the Company’s opportunity to lower data communications costs and create new revenue enhancing opportunities for its customers. In addition to the enhancements to the C5 Call Manager, the Company introduced two new products and established key partnerships to provide further value to customers. These enhancements included further standards-based compliance by adding support for SIP based endpoints with top revenue generating CLASS features. This enhancement augments the C5 Call Manager’s support of MGCP and H.323 VoIP protocols. Enhanced features such as pre-paid for VoIP subscribers, Integrated Voice Mail, and 3-way Conference Calling gives service providers further revenue generating opportunities while enhanced high availability improves quality of service within the service providers VoIP network.
The Company also introduced the Subscriber Portal product which allows consumers to control their own phone account behavior from a web-based browser as well as view account and phone usage information. The introduction of this product allows service providers to offer enhanced services not currently available with PSTN phone service and reduces operational costs by putting more control into the consumers’ hands. In addition to the Company’s Subscriber Portal, the Company also introduced the Border Agent product. The Border Agent provides network address translation traversal for SIP and MGCP endpoints. This is a critical component for broadband service providers enabling them to offer residential VoIP services without incurring the expense of a traditional session border controller.
In 2005, the Company introduced key enhancements to the C5 Call Manager based on market trends and key customer requirements. The newly-introduced features expanded the Company’s opportunity at the network edge with features such as hotline, distinctive music on hold, limiting simultaneous calls from groups of edge devices, do not disturb, anonymous call rejection, simultaneous ring, video edge device support, SIP and GR303 access gateways integration, topology hiding, a radius interface to authentication, authorization and accounting servers such as I-Master, private networking configurations as well as producing features needed by its customer base for regulatory compliance such as local number portability, E911, and lawful intercept.
In 2006, the Company focused on enhancing its bundle solution through the addition of optional components as well as features targeted towards the VoIP overlay market. The Company enhanced the value proposition offered to its customers by the bundled solution with the introduction of a Back Office component and IP Centrex application. The wholesale peering solution was enhanced with the addition of a reporting module enabling the service providers as well as their customers (e.g. wholesalers and virtual wholesales) web-based access to real time traffic statistics, call detail records, as well as consumption reports. The Company also enhanced its software based IVR and pre-paid application through support of DTMF handling using named events as defined by the IETF RFC 2833. This enables the Company to offer a scalable IVR system through software as opposed to hardware for the support of multiple services such as VoBB and pre-paid calling. The Company signed a teaming agreement with IBM in 2006 which includes certification of its edge solution for VoBB overlay solutions as well as wholesale peering on the IBM BladeCenter platforms running on Linux.
In 2004, the Company also introduced key enhancements to its C4 Call Manager, providing tandem network capabilities within the core of the service provider’s network, including international and national long distance. The key feature enhancements included integration with a service provider’s existing Intelligent Network (“IN”)
infrastructure through support of the Transactional Capabilities Application Port (“TCAP”) protocol. This enables service providers to leverage their existing investment in IN services while reducing the cost associated with training existing personnel on new service platforms. In addition to IN support, a number of operational efficiency enhancements were made allowing service providers to better manage and troubleshoot problems within their VoIP network.
In 2004, the Company introduced C4 Call Manager version 2.0, which further expanded the Company’s opportunity in this market by providing key features such as compatibility with the legacy PSTN Advance Intelligent Network, the BHG2500 universal gateway which quadrupled the media gateway port density as well as added Signaling System 7 (“SS7”) signaling and media server capabilities in the same chassis, and ANSI SS7 for US deployments.
In 2005, the Company also introduced key enhancements to its C4 Call Manager providing regulatory compliance features such as local number portability and E911 as well as features to support private networking configurations, a radius interface to authentication, authorization and accounting servers such as I-Master and M2UA SS7 tunneling over IP.
In 2006, the C4 Call Manager was enhanced with support of SIP and ISUP transport within SIP or SIP-T. These enhancements enable the C4 to interoperate as a standalone component with any Class 5 softswitch or VoIP based feature server enabling SS7, PRI, CAS/MFCR2 TDM connectivity. Similar to the edge solution, the PSTN access solution was validated on the IBM BladeCenter solution on Linux.
These key enhancements to the distributed softswitch, comprised of the Class 5 Call Manager and Class 4 Call Manager, enable service providers to increase top line consumer revenues through enhanced service offerings while simultaneously increasing bottom line profitability by reducing operational expenses within the service provider network.
In 2004, the Company announced support for GSM A.bis/A.ter for the NetPerformer solution. This allows the NetPerformer to offer GSM operators a cost effective solution for reducing the bandwidth required by their GSM network.
In 2006, the Company launched two new products to be used mainly in GSM backhauling and DCME solutions. The SDM-9210 is a compact, 1 rack mount unit high device used for interconnection to the BTS. It provides high reliability features such as E1 bypass, 1:1 redundancy, and an optional high precision clock compliant with the G.823 PDH standard which is necessary to enable quality handover in high density urban areas. The SDM-9600 is a high density chassis that has been introduced with the SDM-9606 hot-swappable blade. The fully loaded chassis supports up to 30 T1/E1s. A new set of DSPs has been deployed to improve the performance in GPRS/EDGE support and enable a reduction of overall latency. Other software enhancements include SS7 call setup detection for improved compression efficiency in DCME applications and features related to better operation over satellite networks, including specific features developed in connection with partnerships with particular satellite equipment vendors.
In 2005, the Company integrated the I-Master application to the Company’s Class 4 and Class 5 softswitch and added multiple rating features to the I-Master solution. In 2006, the Company added a number of rating features to I-Master to support the competitive North American pre-paid market. These include disconnect rate plans and global rate management tools.
In 2006, the Company began an integration strategy for the Verso Verilink VoIP IAD products and the NetPerformer product family. To meet the European Union’s RoHS directive, Verso Verilink also performed a redesign of its 8000 and WanSuite products. In addition, 4 wire G.SHDSL was added to the WanSuite family for extended reach capabilities.
Employees
As of December 31, 2006, the Company had 234 domestic employees, including 99 employees located at the Company’s headquarters in Atlanta, Georgia (64 of whom work in the Advanced Applications Services Group); 35 employees at the Company’s facility in Littleton, Colorado; 36 employees at the Company’s facility in Madison,
Alabama; five employees at the Company’s office in Jacksonville, Florida; 25 employees of the Advanced Applications Service Group located throughout the country; and 34 other employees located throughout the United States. As of December 31, 2006, the Company had 66 international employees, 41 of whom are located at the Company’s NetPerformer operations in Montreal, Canada and 25 of whom conduct the Company’s sales efforts throughout the rest of the world.
Background
The Company was incorporated in Minnesota on March 20, 1984. Until 2001, the Company historically operated a value-added reseller (“VAR”) business and an associated network performance management consulting and integration practice. The Company also operated a Hospitality Services Group (“HSG”), which provided technology solutions to lodging, restaurant, and energy management customers. Over the years, the Company has moved away from these lines of business and now focuses on providing the products and services offered by its Packet-based Technologies Group and its Advanced Application Services Group. During the last six years, the Company’s business developed as described below.
Early in 2000, the Company’s Board of Directors (the “Board”) decided to explore the sale of all or a portion of the Company’s HSG, which consisted of the Company’s lodging business, its restaurant solutions business and its energy management business. Subsequently, the operations of HSG were classified as discontinued operations, and each of the operating units of HSG was sold between late 2000 and early 2001. The sale of these operating units included all of the operations of (i) Sulcus Hospitality Technologies Corp., which the Company acquired in 1999; and (ii) Encore Systems, Inc., Global Systems and Support, Inc. and Five Star Systems, Inc. (collectively, the “Encore Group”), which the Company acquired in 1998, except for the Company’s customer response center services.
In September 2000, the Company acquired Cereus Technology Partners, Inc. (“Cereus”) in a merger transaction. Cereus provided end-to-end e-business and business-to-business technology solutions, including e-business strategy, network consulting and hosting and application integration. In connection with the acquisition of Cereus, the Company changed its name to “Verso Technologies, Inc.”
In November 2000, the Company acquired MessageClick, Inc. (“MessageClick”) in a merger transaction. The acquisition of MessageClick provided the Company with a proprietary unified communications application delivered as an application service provider. In the second quarter of 2001, the Company decided to discontinue offering its MessageClick application and to refocus the development of the MessageClick application to be offered as a licensed software product. The Company has since focused its overall strategy on pursuing the market for next generation communications and, therefore, the development of the MessageClick application as a licensed product is currently dormant.
In July 2001, the Company acquired all of the outstanding capital stock of NACT Telecommunications, Inc., now known as Provo Pre-paid (Delaware) Corp. (“NACT”). The Company’s acquisition of NACT in July 2001 was the Company’s first significant investment in proprietary communications products. The acquisition of NACT and its portfolio of products and services allowed the Company to begin to offer proprietary, integrated, switching solutions for communications service providers seeking turn-key, pre-paid telecommunications solutions. The acquisition of NACT was funded by a $15 million investment by Telemate.Net, as contemplated by the Company’s merger agreement with Telemate.Net. On January 21, 2005, the Company sold substantially all of the operating assets of its NACT business. In connection with the sale, “NACT Telecommunications, Inc.” changed its name to “Provo Pre-paid (Delaware) Corp.”
On November 16, 2001, the Company acquired Telemate.Net by means of a merger, pursuant to which Telemate.Net became a wholly-owned subsidiary of the Company. Telemate.Net develops proprietary Internet access, voice and IP network usage management, and intelligence applications that enable businesses to monitor, analyze, and manage the use of their internal network resources. As a result of the acquisition of Telemate.Net, the Company added next generation applications and application development competencies to the Company’s solutions portfolio.
During the quarter ended December 31, 2001, and in keeping with the Company’s focus on providing next generation communications solutions, the Company determined that its VAR business and associated network performance management consulting and integration practice were not strategic to the Company’s ongoing objectives and, therefore, decided to discontinue capital and human resource investment in these businesses. Accordingly, the Company elected to report its VAR and associated consulting and integration operations as discontinued operations by early adoption of Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS No. 144”), which is intended to allow a company to more clearly communicate a change in its business that results from a decision to dispose of non-strategic operations.
On October 1, 2002, the Company purchased a 51% interest in Shanghai BeTrue Infotech Co., Ltd. (“BeTrue”) for $100,000, with $50,000 paid at closing, $25,000 paid on December 30, 2002, and $25,000 paid on March 30, 2003. Upon closing the transaction, the Company contributed to the joint venture certain next generation communication equipment and software valued at approximately $236,000 and $50,000, respectively. Additionally, the Company contributed to BeTrue $25,000 on December 30, 2002, and $25,000 on March 30, 2003. The remaining 49% interest in BeTrue is owned by Shanghai Tangsheng Investments & Development Co. Ltd. (“Shanghai Tangsheng”). BeTrue provides VoIP and satellite network solutions, including systems integration, project implementation, technical support, consulting and training to leading telecommunications companies in China and the Asia-Pacific region. The Company plans to leverage BeTrue’s sales channels and support infrastructure capabilities, including pre- and post- sales support. Due to shared decision-making between the Company and Shanghai Tangsheng, the results for BeTrue are recorded as an equity investment rather than consolidated in the Company’s results.
On February 12, 2003, the Company acquired substantially all operating assets and related liabilities of Clarent Corporation. The assets purchased from Clarent Corporation include the following key products: next generation switching and call control software; high density media gateways; multi-service access devices, signaling and announcement servers; network management systems; and high demand telephony applications based on packet-switched technology. Specifically, the Company acquired the Clarent Softswitch and NetPerformer products in connection with this acquisition.
On September 26, 2003, the Company acquired MCK Communications, Inc., now known as Needham (Delaware) Corp. (“MCK”), by means of a merger, pursuant to which MCK became a wholly-owned subsidiary of the Company. MCK provided products that deliver distributed voice communications by enabling businesses to extend the functionality and applications of their business telephone systems from the main office to outlying offices, remote call centers, teleworkers and mobile employees over public and private networks. On January 21, 2005, the Company sold substantially all of the operating assets of its MCK business, including (i) the assets which allow legacy digital business telephone handsets to be used in a voice network using public/private IP-based, circuit-switched, frame relay or wireless technology network and (ii) the products that enable call recording of legacy business telephone systems in non-packet environments. In connection with the sale, “MCK Communications, Inc.” changed its name to “Needham (Delaware) Corp.”
On March 31, 2005, the Company acquired substantially all of the operating assets of WSECI, a provider of an Internet protocol-based applications platform which enables the deployment of multiple voice and next generation services to the carrier market.
On October 11, 2005, the Company effected a 1-for-5 reverse stock split of the outstanding Common Stock, pursuant to which every one share of Common Stock issued and outstanding was automatically reclassified and converted into one-fifth of a share of Common Stock (the “Reverse Split”).
On June 16, 2006, the Company acquired the outstanding equity interests of Winslow Asset Holdings, LLC (now known as Verso Verilink, LLC) from Winslow Asset Group, LLC (the “Verilink Acquisition”). Winslow Asset Holdings, LLC had earlier acquired substantially all of the business assets of Verilink Corporation and Larscom Incorporated (together, the “Verilink Sellers”), other than the accounts receivable and certain fixed assets of the Verilink Sellers which were transferred to Winslow Asset Group, LLC. As a result of the Company’s equity purchase, the Company acquired the Verilink Sellers’ business of developing, manufacturing, marketing and selling broadband access solutions for computer networks.
On December 29, 2006, the Company purchased certain assets from, and assumed certain liabilities of Paradyne Networks, Inc. relating to its business of manufacturing, selling and supporting the iMarc product line, a family of ATM, IP service units, and branch monitors that provides intelligent demarcation between carrier and enterprise networks, allowing for easier management.
Item 1A.
Item 1A.
Risk Factors
The price of the Common Stock has been volatile.
The stock market in general and the market for technology companies in particular, has experienced extreme volatility that has often been unrelated to the operating performance of particular companies. From September 4, 2003 to February 18, 2007, the per share closing price of the Common Stock on The Nasdaq Capital Market (formerly known as The Nasdaq SmallCap Market) fluctuated from a high of $25.35 to a low of $0.83. The Company believes that the volatility of the price of the Common Stock does not solely relate to the Company’s performance and is broadly consistent with volatility experienced in the Company’s industry. Fluctuations may result from, among other reasons, responses to operating results, announcements by competitors, regulatory changes, economic changes, market valuation of technology firms and general market conditions.
In addition, in order to respond to competitive developments, the Company may from time to time make pricing, service or marketing decisions that could harm its business. Also, the Company’s operating results in one or more future quarters may fall below the expectations of securities analysts and investors. In either case, the trading price of the Common Stock would likely decline.
The trading price of the Common Stock could continue to be subject to wide fluctuations in response to these or other factors, many of which are beyond the Company’s control. If the market price of the Common Stock decreases, then shareholders may not be able to sell their shares of Common Stock at a profit.
The Company may be unable to fund future growth.
The Company’s business strategy calls for growth internally as well as through acquisitions. The Company has invested substantial funds in its sales and marketing efforts in order to grow revenues. This strategy to increase sales and marketing resources as well as other strategies for growth internally which the Company may implement now or in the future will require funding for additional personnel, capital expenditures and other expenses, as well as for working capital purposes. Financing may not be available to the Company on favorable terms or at all. If adequate funds are not available on acceptable terms, then the Company may not be able to meet its business objectives for expansion. This, in turn, could harm the Company’s business, results of operations and financial condition. In addition, if the Company raises additional funds through the issuance of equity or convertible debt securities, then the percentage ownership of the Company’s shareholders will be reduced, and any new securities could have rights, preferences and privileges senior to those of the Common Stock. Furthermore, if the Company raises capital or acquires businesses by incurring indebtedness, then the Company will become subject to the risks associated with indebtedness, including interest rate fluctuations and any financial or other covenants that the Company’s lender may require. Moreover, if the Company’s strategy to invest in its sales and marketing efforts in order to grow revenues does not produce the desired result, then the Company will have incurred significant expenses which it may or may not have obtained adequate funding to cover.
The Company has a history of losses and may not be profitable in the future.
The Company has a history of net losses, including net losses of $17.8 million for the 2006 fiscal year, $20.1 million for the 2005 fiscal year, $38.8 million for the 2004 fiscal year, $18.3 million for the 2003 fiscal year, $2.7 million for the 2002 fiscal year and $147.6 million for the 2001 fiscal year. As of December 31, 2006, the Company had an accumulated deficit of $350 million. Further, developing the Company’s business strategy and expanding the Company’s services will require significant additional capital and other expenditures. Accordingly, if the Company is not able to increase its revenue, then it may never generate sufficient revenues to achieve or sustain profitability.
The Common Stock may be delisted from The Nasdaq Capital Market.
The Common Stock is currently quoted on The Nasdaq Capital Market. The Company must satisfy certain minimum listing maintenance requirements to maintain such quotation, including a series of financial tests relating to shareholders equity or net income or market value, public float, number of market makers and shareholders, market capitalization, and maintaining a minimum bid price of $1.00 per share for the Common Stock. In the past, the Company has experienced periods in which the minimum bid price for the Common Stock fell below $1.00 per share.
On August 28, 2006, The Nasdaq Stock Market notified the Company that for the last 30 consecutive business days the bid price for the common stock had closed below the minimum $1.00 per share requirement for continued inclusion of the common stock on The Nasdaq Capital Market as required by Marketplace Rule 4310(c)(4) (the “Rule”). In accordance with Marketplace Rule 4310(c)(8)(D), the Company had 180 calendar days, or until February 26, 2007, to regain compliance with the Rule, which the Company did in November 2006.
If the bid price of the Common Stock were to remain below $1.00 per share for 30 consecutive trading days, or if the Company was unable to continue to meet The Nasdaq Capital Market’s other listing standards, then The Nasdaq Stock Market would notify the Company that the Common Stock could be delisted from The Nasdaq Capital Market. If the Common Stock is delisted from The Nasdaq Capital Market, then the Common Stock may trade on the Over-the-Counter-Bulletin Board, which is viewed by most investors as a less desirable and less liquid market place. Delisting from The Nasdaq Capital Market could make trading the Common Stock more difficult for the Company’s investors, leading to declines in share price. Delisting of the Common Stock would also make it more difficult and expensive for the Company to raise additional capital. Furthermore, delisting of the Common Stock is an event of default under the Company’s credit facility with the Company’s primary lender, the Company’s outstanding 6.75% senior unsecured convertible debentures and, through certain cross default provisions, the Loan and Security Agreement the Company entered into with Clarent Corporation in connection with the Company’s acquisition of substantially all of the business assets, and certain related liabilities, of Clarent Corporation on February 12, 2003.
The Company’s growth could be limited if it is unable to attract and retain qualified personnel.
The Company believes that its success depends largely on its ability to attract and retain highly skilled and qualified technical, managerial and marketing personnel. Competition for highly skilled engineering, sales, marketing and support personnel is intense because there is a limited number of people available with the necessary technical skills and an understanding of the markets which the Company serves. Workforce reductions by the Company during recent years may adversely affect the Company’s ability to retain its current employees and recruit new employees. The inability to hire or retain qualified personnel could hinder the Company’s ability to implement its business strategy and harm its business.
The Company is exposed to the general condition of the telecommunications market.
The Company’s business is subject to global economic conditions, and in particular, market conditions in the telecommunications industry. The Company’s operations could be adversely affected if capital spending from telecommunications service providers does not grow or declines. If global economic conditions worsen, or if the prolonged slowdown in the telecommunications industry continues, then the Company may experience adverse operating results.
The Company’s need to invest in research and development could harm the Company’s operating results.
The Company’s industry is characterized by the need for continued investment in research and development. If the Company fails to invest sufficiently in research and development, then the Company’s products could become less attractive to potential customers, which could have a material adverse effect on the Company’s results of operations and financial condition. As a result of the Company’s need to maintain or increase its spending levels in this area, the Company’s operating results could be materially harmed if the Company’s net sales fall below expectations. In addition, as a result of the need for research and development and technological innovation, the Company’s operating costs may increase in the future.
The market for converged communications solutions is still in its infancy and rapidly evolving. If this market does not develop and grow as expected, then it could have a material adverse effect on the Company’s business.
While the Company believes there is a significant growth opportunity in providing converged communications solutions to its customers, there can be no assurances that this technology will be widely accepted or that a viable market for the Company’s products will fully develop or be sustainable. If this market does not develop, or develops more slowly than expected, then the Company may not be able to sell its products in significant volume, or at all. Due to the intense competition in this market and the recent introduction of this technology, there can be no assurance that the Company will succeed in this evolving marketplace.
Intellectual property infringement claims against the Company, even without merit, could require the Company to enter into costly licenses or deprive the Company of the technology it needs.
The Company’s industry is technology intensive. As the number of competitors in the Company’s target markets increases and the functionality of the products produced by such competitors further overlaps, third parties may claim that the technology the Company develops or licenses infringes their proprietary rights. Any claims against the Company or any of its subsidiaries may affect the Company’s business, results of operations and financial conditions. Any infringement claims, even those without merit, could require the Company to pay damages or settlement amounts or could require the Company to develop non-infringing technology or enter into costly royalty or licensing agreements to avoid service implementation delays. Any litigation or potential litigation could result in product delays, increased costs or both. In addition, the cost of litigation and the resulting distraction of the Company’s management resources could have a material adverse effect on the Company’s results of operations and financial condition. If successful, a claim of product infringement could deprive the Company of the technology it needs altogether.
Failure to protect the Company’s intellectual property rights could have a material adverse effect on the Company’s business.
The Company’s success depends in part upon the protection of the Company’s proprietary application software and hardware products. The Company has taken steps that it believes are adequate to establish, protect and enforce its intellectual property rights. The Company cannot assure you that these efforts will be adequate. Despite the Company’s efforts to protect the Company’s proprietary rights, unauthorized parties may attempt to copy or otherwise obtain rights to use the Company’s products or technology.
The Company has pending several patent applications related to its products. There can be no assurance that these patents will be issued. Even if these patents are issued, the limited legal protection afforded by patent, trademark, trade secret and copyright laws may not be sufficient to protect the Company’s proprietary rights to the intellectual property covered by these patents.
Furthermore, the laws of many foreign countries in which the Company does business do not protect intellectual property rights to the same extent or in the same manner as do the laws of the United States. In addition, it is necessary to file for patent and trademark protection in foreign countries in order to obtain legal protection in those countries. The Company has made such filings only on a limited basis. These efforts may not be sufficient and additional filings may be cost prohibitive. Additionally, even if the Company’s domestic and international efforts are successful, the Company’s competitors may independently develop non-infringing technologies that are substantially similar or superior to the Company’s technologies.
If the Company’s products contain defects, then the Company’s sales are likely to suffer, and the Company may be exposed to legal claims.
The Company’s business strategy calls for the development of new products and product enhancements which may from time to time contain defects or result in failures that the Company did not detect or anticipate when introducing such products or enhancements to the market. In addition, the markets in which the Company’s products are used are characterized by a wide variety of standard and non-standard configurations and by errors, failures and bugs in third-party platforms that can impede proper operation of the Company’s products. Despite
product testing by the Company, defects may still be discovered in some new products or enhancements after the products or enhancements are delivered to customers. The occurrence of these defects could result in product returns, adverse publicity, loss of or delays in market acceptance of the Company’s products, delays or cessation of service to the Company’s customers or legal claims by customers against the Company.
To the extent that contractual provisions that limit the Company’s exposure to legal claims are unenforceable or are not included in contracts or such claims are not covered by insurance, a successful products liability claim could have a material adverse effect on the Company’s business, results of operations and financial condition.
The Company may be obligated to indemnify customers who purchase equipment from the Company against claims of patent infringement.
In the course of the Company’s business, the Company may sell certain equipment and license software to its customers, and in connection with such sale and license, may agree to indemnify these customers from claims made against them by third parties for patent infringement related to such equipment and software. If the Company is required to make any payments in respect of these indemnification obligations, then it could have a material adverse effect on its business, results of operations and financial condition.
The Company’s focus on emerging markets could make achievement of its sales goals more difficult.
The Company focuses a large part of its sales efforts on emerging markets, including the Middle East, Africa and Latin America. These markets can be more volatile and less predictable than more developed markets. In addition, there is less of a track record for demand for communications products in these markets and both service providers and end users tend to have less capital to spend on communications products. These elements could impact the Company’s ability to meet its sales objectives.
Sales to customers based outside the United States have accounted for a significant portion of the Company’s revenues, which exposes the Company to risks inherent in international operations.
International sales represented 49% of the revenues for the Technologies Group for the year ended December 31, 2006 and 73% of the revenues for such group for the year ended December 31, 2005. International sales are subject to a number of risks, including changes in foreign government regulations, laws, and communications standards; export license requirements; currency fluctuations, tariffs and taxes; other trade barriers; difficulty in collecting accounts receivable; longer accounts receivable collection cycles; difficulty in managing across disparate geographic areas; difficulties in hiring qualified local personnel; difficulties associated with enforcing agreements and collecting receivables through foreign legal systems; expenses associated with localizing products for foreign markets; and political and economic instability, including disruptions of cash flow and normal business operations that may result from terrorist attacks or armed conflict.
If the relative value of the U.S. dollar in comparison to the currency of the Company’s foreign customers should increase, then the resulting effective price increase of the Company’s products to these foreign customers could result in decreased sales. In addition, to the extent that general economic downturns in particular countries or regions impact the Company’s customers, the ability of these customers to purchase the Company’s products could be adversely affected especially for some of the more significant projects. Payment cycles for international customers can be longer than those for customers in the United States. The foreign markets for the Company’s products may develop more slowly than currently anticipated. Also, the Company’s ability to expand the sale of certain of its products internationally is limited by the necessity of obtaining regulatory approval in new countries. The Company anticipates that its non-Canadian, foreign sales will generally be invoiced in U.S. dollars, and does not currently plan to engage in foreign currency hedging transactions. As the Company expands its international operations, however, it may allow payment in foreign currencies, and exposure to losses in foreign currency transactions may increase. The Company may choose to limit any currency exposure through the purchase of forward foreign exchange contracts or other hedging strategies. The Company’s future currency hedging strategies if employed may not be successful.
The Company’s dependence on contract manufacturers and suppliers could result in product delivery delays.
The Company currently uses contract manufacturers to manufacture a significant portion of its NetPerformer and Verilink products. The Company also has in the past contracted with a firm in India to perform a significant portion of software development for the Company’s softswitch products. The Company’s reliance on contract manufacturers and contract software developers involves a number of risks, including the absence of adequate capacity, the unavailability of, or interruptions in access to necessary manufacturing processes and reduced control over delivery schedules. If the Company’s contract manufacturers or software development contractor are unable or unwilling to continue manufacturing the Company’s products and components in required volumes or to develop software features on the required time schedule, then the Company will have to identify one or more acceptable alternatives. The use of new manufacturers may cause significant interruptions in supply if the new manufacturers have difficulty manufacturing products to the Company’s specifications. The engagement of new software developers or a new contractor may cause delay in delivery of features while the new developers are being trained to work with the software. Further, the introduction of new manufacturers or developers may increase the variance in the quality of the Company’s products. In addition, the Company relies upon third-party suppliers of specialty components and intellectual property used in its products. It is possible that a component needed to complete the manufacture of the Company’s products may not be available at acceptable prices or on a timely basis, if at all. Inadequate supplies of components, or the loss of intellectual property rights, could affect the Company’s ability to deliver products to its customers. Any significant interruption in the supply of the Company’s products would result in the reduction of product sales to customers, which in turn could permanently harm the Company’s reputation in the industry.
The Company may be subject to litigation.
The Company may be subject to claims involving how the Company conducts its business or the market for or issuance of the Common Stock or other securities. Any such claims against the Company may affect its business, results of operations and financial conditions. Such claims, including those without merit, could require the Company to pay damages or settlement amounts and would require a substantial amount of time and attention from the Company’s senior management as well as considerable legal expenses. Although the Company does not anticipate that its activities would warrant such claims, there can be no assurances that such claims will not be made.
The Company derives a substantial amount of its revenues from channel distribution partners and such revenues may decline significantly if any major partner cancels or delays a purchase of its products.
The Company uses an indirect sales model to derive a substantial portion of its revenue. Failure to generate revenue as expected from this channel could have a material adverse effect on the Company’s results of operations and financial condition.
No channel partner or distributor is obligated to purchase additional products or services from the Company. Accordingly, present and future partners may terminate their purchasing arrangements with the Company or significantly reduce or delay their orders. Any termination, change, reduction or delay in orders could have a material adverse effect on the Company’s results of operations and financial condition. In addition, the Company currently has varying distribution, marketing and development arrangements with its partners. There is no assurance that the Company will continue to enjoy the support and cooperation that it has historically experienced from these parties or their associated distribution channels. Also, there is no certainty that these parties will continue to offer the Company’s products in their sales portfolio. It is possible that these vendors may seek to offer broader product lines and solutions that are competitive with the Company’s products. In addition, they may change their distribution models which could negatively impact revenues of the Company. Furthermore, the Company must correctly anticipate the price, performance and functionality requirements of these partners and must successfully develop products that meet end user requirements and make these products available on a timely basis and in sufficient quantities in order to sustain and grow its business.
The Company’s inability to develop and maintain relationships with key technology suppliers could harm its ability to sustain and grow its business.
The success of the Company depends to a significant degree upon its continued relationships with leading technology suppliers. The standards for telephony equipment and data networks are evolving, and the Company’s products may not be compatible with new technology standards that may emerge. If the Company is unable to provide its customers with interoperable solutions, then they may make purchases from vendors who provide the requisite product interoperability. This could have a material adverse effect on the Company’s results of operations and financial condition.
Compliance or the failure to comply with current and future environmental regulations could cause us significant expense.
The Company is subject to a variety of federal, state, local and foreign environmental regulations. If the Company fails to comply with any present and future regulations, it could be subject to future liabilities, the suspension of production or a prohibition on the sale of its products. In addition, such regulations could require the Company to incur other significant expenses to comply with environmental regulations, including expenses associated with the redesign of any non-compliant product. From time to time new regulations are enacted, and it is difficult to anticipate how such regulations will be implemented and enforced. For example, in 2003 the European Union enacted the Restriction on the Use of Certain Hazardous Substances in Electrical and Electronic Equipment Directive (“RoHS”) and the Waste Electrical and Electronic Equipment Directive (“WEEE”), for implementation in European Union member states. Similar legislation is currently in force or is being considered in the United States, as well as other countries, such as Japan and China. The failure to comply with any of such regulatory requirements or contractual obligations could result in the Company being liable for costs, fines, penalties and third-party claims, and could jeopardize the Company’s ability to conduct business in the jurisdictions where these regulations apply.
Item 2.
Item 2.
Properties
The Company is headquartered in Atlanta, Georgia, where the Company currently leases 49,000 square feet of space, 24,600 of which is used for the Company’s corporate offices, the Telemate.Net operations, and the Company’s Advanced Application Services Group. The Company is obligated to pay rent on this space of approximately $116,000 per month, plus a share of operating expenses, through January 2010. The Company has subleased 24,400 square feet of space at the Atlanta facility for $18,613 per month from January 2006 through July 2006, $33,224 per month from August 2006 through July 2007, $33,896 per month from August 2007 through July 2008, $34,568 per month from August 2008 through July 2009, and $35,260 from August 2009 though the end of the lease on January 31, 2010. Further, the Company is also obligated through January 2010 to pay rent of $30,000 per month with respect to an additional 13,000 square feet of space at the Atlanta facility, the cost of which is included in discontinued operations. The Company has subleased 13,000 square feet of this space at the Atlanta facility for $20,000 per month through January 2010.
Verso Verilink leases 43,750 square feet of office, manufacturing, and warehouse space in Madison, Alabama. This space was formerly used by Verilink Corporation for operation of its business. The Company uses the space for manufacturing and shipping functions related to the Verso Verilink product line. During the second and third quarters of 2007, the Company is planning to move the manufacturing and shipping functions for the softswitch, NetPerformer and iMarc product lines to the facility. The Company is obligated to pay $17,038 in monthly rent under this lease through June 30, 2006 and $17,552 in monthly rent from July 1, 2006 through the expiration of the lease term on June 30, 2010.
In connection with the Company’s disposition of its NACT business, NACT assigned to the purchaser thereof all of NACT’s interest in a lease for approximately 40,000 square feet of office space in Provo, Utah, which had been used to operate the NACT business, a component of the Company’s Packet-based Technologies Group. The purchaser has agreed to pay all amounts owed under the lease; however, NACT’s payment obligations under the lease have not been terminated and the Company’s guaranty of such obligations remains in place. The lease expires in December 2009, and the rent thereunder is $51,000 per month.
In connection with the acquisition of substantially all of the operating assets of Clarent in February 2003, the Company assumed two leases for real property located in Quebec, Canada. Pursuant to the first lease, the Company leases approximately 18,400 square feet of office and laboratory space for software research and development purposes related to the NetPerformer products. Verso Canada entered into a Lease Amending and Extension Agreement on November 29, 2006 extending the lease term from December 1, 2006 through November 30, 2009 at a base rent of 17,665 Canadian dollars per month plus a proportionate share of operating expenses and taxes for the building. Pursuant to the second lease, Verso Canada leases approximately 10,000 square feet of office, warehouse and storage space for commercial and manufacturing purposes also related to the Company’s NetPerformer products. Verso Canada is obligated to pay $4,600 per month, plus a share of operating expenses, until the lease terminates in May 2007. The Company does not plan to renew this lease due to its plan to locate the warehouse and manufacturing functions conducted in the facility to the Company’s facility in Madison, Alabama.
The Company leases 23,000 square feet of space in Littleton, Colorado which is used primarily for research and development for the Company’s softswitch solution products and technical and administrative support for the softswitch and Verso Verilink products. Pursuant to this lease, the Company is obligated to pay rent of $27,135 per month plus a share of operating expenses through January 2009. In connection with the Company’s plan to move the manufacturing and shipping functions for the softswitch product line to the Company’s Madison, Alabama facility, the Company will make available for sublease up to half of its space in the Littleton facility.
The Company leases 1,623 square feet of space in Jacksonville, Florida for research and development in connection with its pre-paid and post-paid application. The monthly rent under this lease is $1,937 plus operating expenses through March 2007 and will be $1,995 plus operating expenses from April 2007 through March 2008.
The Company believes that its leased facilities are adequate to meet its current needs and that additional facilities are available to the Company to meet its expansion needs for the foreseeable future.
Item 3.
Item 3.
Legal Proceedings
From time to time, the Company is involved in litigation with customers, vendors, suppliers and others in the ordinary course of business, and a number of such claims may exist at any given time. All such existing proceedings are not expected to have a material adverse impact on the Company’s results of operations or financial condition. In addition, the Company or its subsidiaries are a party to the proceedings discussed below.
In December 2001, a complaint was filed in the Southern District of New York seeking an unspecified amount of damages on behalf of an alleged class of persons who purchased shares of MCK’s common stock between the date of MCK’s initial public offering and December 6, 2000. The complaint named as defendants MCK and certain of its former officers and other parties as underwriters of its initial public offering (the “MCK defendants”). The plaintiffs allege, among other things, that MCK’s prospectus, contained in the Registration Statement on Form S-1 filed with the SEC, was materially false and misleading because it failed to disclose that the investment banks which underwrote MCK’s initial public offering of securities and others received undisclosed and excessive brokerage commissions, and required investors to agree to buy shares of securities after the initial public offering was completed at predetermined prices as a precondition to obtaining initial public offering allocations. The plaintiffs further allege that these actions artificially inflated the price of MCK’s common stock after the initial public offering. This case is one of many with substantially similar allegations known as the “Laddering Cases” filed before the Southern District of New York against a variety of unrelated issuers (the “Issuers”), directors and officers (the “Laddering Directors and Officers”) and underwriters (the “Underwriters”), and have been consolidated for pre-trial purposes before one judge to assist with administration. A motion to dismiss addressing issues common to the companies and individuals who have been sued in these actions was filed in July 2002. After a hearing on the motion to dismiss the Court, on February 19, 2003, denied dismissal of the claims against MCK as well as other Issuers. Although MCK believes that the claims asserted are meritless, MCK and other Issuers have negotiated a tentative settlement with the plaintiffs. The terms of the tentative settlement agreement provide, among other things, that (i) the insurers of the Issuers will deliver a surety undertaking in the amount of $1 billion payable to the plaintiffs to settle the actions against all Issuers and the Laddering Directors and Officers; (ii) each Issuer will assign
to a litigation trust, for the benefit of the plaintiffs, any claims it may have against its Underwriters in the initial public offering for excess compensation in the form of fees or commissions paid to such Underwriters by their customers for allocation of initial public offering shares; (iii) the plaintiffs will release all claims against the Issuers and the Laddering Directors and Officers asserted or which could have been asserted in the actions arising out of the factual allegations of the amended complaints; and (iv) appropriate releases and bar orders and, if necessary, judgment reductions, will be entered to preclude the Underwriters and any non-settling defendants from recovering any amounts from the settling Issuers or the Laddering Directors and Officers by way of contribution or indemnification. Prior to the Company’s acquisition of MCK, MCK’s board of directors voted to approve the tentative settlement. On February 15, 2005, the judge presiding over the Laddering Cases granted preliminary approval of the proposed settlement, subject to some changes, which were subsequently submitted. The judge issued an order on August 31, 2005, further approving modifications to the settlement and certifying the class. Notice of the settlement was distributed to the settlement class members. The deadline for filing objections to the settlement was March 24, 2006, and a fairness hearing was held April 26, 2006. On December 5, 2006, the U.S. Court of Appeals for the Second Circuit issued a ruling reversing class certification for purposes of the litigation. The plaintiffs have petitioned for rehearing and rehearing en banc, and the Second Circuit Court has requested additional briefing on certain issues. The Court has not yet ruled on the settlement approval motion, including the effect on the settlement class of the Second Circuit’s decision regarding the litigation class. No provision was recorded for this matter in the financial statements of MCK prepared prior to its acquisition by the Company because MCK believed that its portion of the proposed settlement would be paid by its insurance carrier. The Company agrees with MCK’s treatment of this matter.
MCK was named a defendant in a lawsuit filed in Norfolk County, Massachusetts by Entrata Communications, Inc. (“Entrata”) in 2002. The case arises out of a dispute between Entrata and one of its largest shareholders, Superwire.com, Inc. (“Superwire”). Pursuant to a contract with Entrata, MCK was obligated to pay Entrata $750,000 in early 2002. In order to take advantage of a $100,000 discount offered for early payment, MCK paid Entrata $650,000 in November 2001, in full satisfaction of its contractual obligations. The funds were placed in escrow with Superwire’s California law firm, Jeffers, Shaff & Falk, LLP (“JSF”), which agreed not to disburse the funds until the dispute between Entrata and Superwire had been resolved. Nevertheless, Entrata contends that it never received the funds from MCK and that the funds were diverted to Superwire and JSF. Through the lawsuit, Entrata seeks to recover from both MCK and Superwire the $750,000 that MCK would have owed in 2002. MCK has asserted counterclaims against Entrata, and cross-claims against Superwire, for fraud and breach of contract. On October 11, 2002, Superwire and Entrata filed cross-motions for summary judgment against each other. The court denied both motions on March 13, 2003. Following denial of the cross-motions for summary judgment, MCK filed a motion to add JSF and two of its partners, Barry D. Falk and Mark R. Ziebell, as third-party defendants. The court had given the parties until March 17, 2004 to complete discovery. Before the completion of the discovery period, Entrata filed a Chapter 7 bankruptcy proceeding pursuant to the United States Bankruptcy Code. Entrata did not continue prosecution of the case after the bankruptcy filing. On September 9, 2005, the case was dismissed without prejudice by the court for lack of prosecution. On September 7, 2006, Entrata’s counsel filed a motion for relief from dismissal on the grounds of excusable neglect. The court granted Entrata’s motion and set an initial trial date of July 19, 2007. The Company intends to defend the claims and prosecute its counterclaims and third-party claims. No amounts, other than the original payment, were provided for this matter in the financial statements of MCK prepared prior to its acquisition by the Company. The Company believes that the claim against MCK is without merit, and no amount has been accrued for this matter.
Item 4.
Item 4.
Submission of Matters to a Vote of Security Holders
The Annual Meeting of Shareholders of the Company was held on November 7, 2006 in Atlanta, Georgia (the “Meeting”). At the Meeting, the shareholders of the Company voted on proposals to (i) elect a Board of eight directors to serve until the Company’s next annual meeting of shareholders and until their successors are elected and qualified (“Proposal 1”); (ii) to approve an amendment to the Company’s articles of incorporation to increase the number of authorized shares of the Company’s common stock from 60,000,000 to 120,000,000 (“Proposal 2”); (iii) to approve an amendment to the Company’s 1999 Stock Incentive Plan, as amended (the “Incentive Plan”), to (a) increase the number of shares of the Company’s common stock available for issuance under the Incentive Plan
from 3,500,000 to 7,000,000 and (b) delete the provision of the Incentive Plan which limits the maximum number of shares of the Company’s common stock underlying, or with respect to, incentive awards which may be granted in any fiscal year to any participant in the Incentive Plan (“Proposal 3”); (iv) to approve an exchange program pursuant to which the Company will offer to exchange all outstanding options to purchase shares of the Company’s common stock held by the Company’s officers, directors and employees for shares of the Company’s restricted common stock (“Proposal 4”); and (v) to ratify the appointment of Tauber & Balser, P.C. as the independent registered public accountants of the Company for the year ending December 31, 2006. Each of the foregoing proposals was approved by the Company’s shareholders at the Meeting.
The results of the vote on Proposal 1 were as follows:
There were no abstentions or broker non-votes with respect to the election of any of the director nominees listed above.
The results of the vote on Proposal 2, Proposal 3, Proposal 4 and Proposal 5 were as follows:
The foregoing proposals were set forth and described in the Notice of Annual Meeting of Shareholders and Proxy Statement of the Company dated October 4, 2006.
Item 4.5 Executive Officers of the Registrant
Pursuant to General Instruction G (3) of Form 10-K under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), the information regarding the Company’s executive officers required by Item 401 of Regulation S-K is hereby included in Part I of this Annual Report.
The following table sets forth the name of each executive officer of the Company, the office held by such officer and the age, as of March 29, 2007, of such officer:
Certain additional information concerning the individuals named above is set forth below:
Montgomery L. Bannerman has served as a director and Chief Executive Officer of the Company since October 1, 2005. From August 1, 2005 to September 30, 2005, Mr. Bannerman served as President and Chief Operating Officer of the Company. From November 19, 2004 to July 31, 2005, Mr. Bannerman served as the Company’s Senior Vice President of Strategic Initiatives. From November 2003 to September 2004, Mr. Bannerman served as Vice President Strategy for Universal Access Inc., a provider of outsourced network services. From January 2000 to October 2003, Mr. Bannerman served as Senior Vice President and Chief Technology Officer of Terremark Worldwide, Inc., a network access provider of telecommunications services. Mr. Bannerman founded IXS.NET, a provider of integrated VOIP network platforms in Asia, in 1996, and DSP.NET, a commercial ISP in northern California, in 1993.
Steven A. Odom has served as the Executive Chairman of the Board since October 1, 2005. From September 29, 2000 to September 30, 2005, Mr. Odom served as the Chief Executive Officer of the Company and as Chairman of the Board from December 2000 to September 30, 2005. From January 2000 to September 2000, Mr. Odom served as the Chairman of the Board and the Chief Executive Officer of Cereus. From 1994 until June 1998, Mr. Odom served as Chief Executive Officer of World Access, Inc., a provider of voice, data and Internet products and services around the world (“World Access”). From June 1998 until June 1999, Mr. Odom also served as Chairman of the Board of World Access. From 1990 until 1994, Mr. Odom was a private investor in several companies, including World Access and its predecessor. From 1987 until 1990, he served as President of the PCS Division of Executone Information Systems in Atlanta, Georgia, a public company that manufactured and distributed telephone systems. From 1983 until 1987, Mr. Odom was Chairman and Chief Executive Officer of Data Contract Company, Inc., a manufacturer of telephone switching equipment and intelligent pay telephones, which he founded in 1983. From 1974 until 1983, he served as the Executive Vice President of Instrument Repair Service, a private company co-founded by Mr. Odom in 1974 that repaired test instruments for local exchange carriers.
Martin D. Kidder has served as Chief Financial Officer of the Company since November 1, 2006. From June 2004 to October 2006, he served as Corporate Controller of CipherTrust, Inc., a global provider of messaging security products that merged in August 2006 with Secure Computing Corporation. From August 2003 to June 2004, Mr. Kidder served as Controller of GE Energy Company’s Network Reliability Products and Services and Rentals businesses. From October 2001 to August 2003, he served as Controller of Glenayre Technologies, Inc., a global provider of next generation messaging solutions and enhanced services for wireless and wireline carriers and MSO/cable operators. From May 1992 to April 2001, Mr. Kidder served as Vice President and Controller of World Access.
Yves Desmet has served as Senior Vice President, Worldwide Sales of the Company since October 14, 2005. From January 2005 through October 2005, he served as the Company’s Vice President of Operations for Europe, Middle East and Africa (“EMEA”). From February 2003 through January 2005, he served as the Company’s Vice President of Sales for EMEA. From 1999 to February 2003, he served as Vice President of Original Equipment Manufacturer and Channel Sales for EMEA for Clarent Corporation, a then publicly-traded provider of softswitch and VoIP solutions for next generation networks and enterprise convergent solutions.
James Nevelle has served as Senior Vice President of Operations since November 3, 2006. From June 15, 2006 to November 2, 2006, he served as General Manager, North America for the Company. From February 7, 2004 to June 14, 2006, Mr. Nevelle served as Vice President of Carrier Sales and Vice President of Sales and Marketing for Verilink Corporation, a telecommunications equipment provider. From September 1998 to February 2004, he served as the Vice President of Sales and Marketing for XEL Communications, Inc., a provider of telecommunications equipment and services.
There are no family relationships among any of the executive officers or directors of the Company. Except as disclosed in the applicable employment agreements discussed in Item 11 of this Annual Report “Executive Compensation and, Director Independence” and as disclosed in Item 13 of this Annual Report “Certain Relationships and Related Transactions,” no arrangement or understanding exists between any executive officer and any other person pursuant to which any executive officer was selected to serve as an executive officer. To the best of the
Company’s knowledge, (i) there are no material proceedings to which any executive officer of the Company is a party, or has a material interest, adverse to the Company; and (ii) there have been no events under any bankruptcy act, no criminal proceedings and no judgments or injunctions that are material to the evaluation of the ability or integrity of any executive officer during the past five years. Executive officers of the Company are elected or appointed by the Board and hold office until their successors are elected and qualified, or until their death, resignation or removal, subject to the terms of applicable employment agreements.
PART II
Item 5.
Item 5.
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Market Information
The Common Stock is currently traded on The Nasdaq Capital Market under the symbol “VRSO.” Prior to September 13, 2002, the Common Stock was traded on the Nasdaq National Market under the same symbol, and from February 17, 2000 to October 1, 2000, the Common Stock was traded on The Nasdaq National Market under the symbol “ELTX.” Prior to February 17, 2000, the Common Stock was traded on The Nasdaq Capital Market under the same symbol. The following table sets forth the quarterly high and low bid prices for the Common Stock for the periods indicated below, as reported by The Nasdaq Capital Market. The stock prices set forth below do not include adjustments for retail mark-ups, markdowns or commissions, and represent inter-dealer prices and do not necessarily represent actual transactions.
The Board amended the Company’s Articles of Incorporation effective October 11, 2005 to provide for the conversion of, every one share of Common Stock issued and outstanding into one-fifth of a share of Common Stock (the “Reverse Split”). All per share information in this document has been adjusted to reflect the Reverse Split.
As of March 22, 2007, there were approximately 1,749 holders of record of the Common Stock.
The Company has never declared or paid cash dividends on the Common Stock. The Company currently intends to retain any earnings for use in its operations and does not anticipate paying cash dividends on the Common Stock in the foreseeable future. In addition, the Company’s credit facility with Laurus Master Fund, Ltd. (“Laurus”), the Company’s primary lender, and the terms of the Company’s outstanding 6.75% senior unsecured convertible debentures prohibit the payment of cash dividends on the Common Stock.
On December 1, 2006, the Company issued to an individual 25,000 shares of Common Stock in consideration of investor relations services rendered by the individual to the Company. The shares were issued without registration under the Securities Act of 1933, as amended (the “Securities Act”), in reliance upon the exemptions from
registration set forth in Section 4(2) of the Securities Act (“Section 4(2)”) and Regulation D promulgated thereunder (“Regulation D”). The Company based such reliance upon factual representations made to the Company by the individual regarding the individual’s investment intent, sophistication, and status as an “accredited investor” (as defined in Regulation D), among other things.
As previously reported in the Current Report on Form 8-K filed by the Company on February 12, 2007, the Company conducted a private placement of Common Stock and warrants which closed on February 9, 2007. After such closing, the Company determined that in connection therewith the Company was obligated to issue warrants to purchase shares of Common Stock to a placement agent in exchange for services rendered with respect to such closing. After February 12, 2007, the Company issued to the placement agent a five-year warrant to purchase 30,000 shares of Common Stock at an exercise price of $1.25 per share. The warrant was issued without registration, in reliance upon the exception from registration set forth in Section 4(2). The Company based such reliance upon representations made by the placement agent regarding its investment intent, sophistication and status as an “accredited investor,” as defined in Rule 501(a)(1), (a)(2), (a)(3), (a)(7) or (a)(8) of Regulation D.
Performance Graph
Set forth below is a line graph comparing the cumulative total shareholder return for the Common Stock, against the cumulative total return for (i) the NASDAQ Composite Index and (ii) the Company’s Peer Group. This graph assumes the investment of $100 on December 31, 2001 in the Common Stock, the NASDAQ Composite Index, and the Company’s Peer Group and assumes dividends are reinvested (to date, the Company has not declared any dividends). The Company’s Peer Group consists of Vocaltec Communications Limited, Sonus Networks Inc., and Nortel Networks Corp. The comparisons in the graph below are based on historical data and are not intended to forecast the possible future performance of the Common Stock.
Pursuant to the regulations of the Sec, this performance graph is not “soliciting material,” is not filed with the SEC and shall not be deemed to be incorporated by reference by means of any general statement incorporating by reference this Form 10-K into any filing under the Securities Act or the Exchange Act, except to the extent that the Company specifically incorporates such information by reference.
Item 6.
Item 6.
Selected Financial Data
The following selected financial data should be read in conjunction with the Company’s financial statements and related notes thereto, set forth in Item 15 hereof, and “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” set forth in Item 7
Item 7 hereof. The statement of operations data and the balance sheet data have been derived from the audited consolidated financial statements of the Company. The historical results are not necessarily indicative of future results. All amounts in thousands except per share data.
(1)
Includes the continuing operations of assets acquired by the Company from Clarent Corporation since its acquisition on February 12, 2003, the continuing operations of substantially all the operating assets of WSECI beginning October 1, 2004 and the continuing operations of substantially all of the operations assets of Verilink Corporation since their acquisition on June 16, 2006.
(2)
The fiscal year 2006 loss from continuing operations includes $1.1 million of intangibles amortization and $3.9 million in non-cash interest related to the amortization of the discount on notes payable and convertible subordinated debentures and loan fees.
(3)
The fiscal year 2005 loss from continuing operations includes $809,000 of intangibles amortization, $7,000 in amortization of deferred compensation, $2.9 million in non-cash interest related to the amortization of the discount on notes payable and convertible subordinated debentures and loan fees and $2.6 million of reorganization costs - loss on sublease.
(4)
The fiscal year 2004 loss from continuing operations includes $514,000 of intangibles amortization, $435,000 in amortization of deferred compensation and $517,000 in non-cash interest related to the amortization of the discount on notes payable and convertible subordinated debentures and loan fees.
(5)
The fiscal year 2003 loss from continuing operations includes $407,000 of intangibles amortization, $780,000 in amortization of deferred compensation and $561,000 in non-cash interest related to the amortization of the discount on notes payable and convertible subordinated debentures and loan fees.
(6)
The fiscal year 2002 loss from continuing operations includes $1.2 million in amortization of deferred compensation and $601,000 in non-cash interest expense related to the amortization of the discount on convertible subordinated debentures and loan fees.
(6)
The fiscal year 2001 loss from continuing operations includes $1.3 million of intangibles amortization, $1.8 million in amortization of deferred compensation and $606,000 in non-cash interest expense related to the amortization of the discount on convertible subordinated debentures and loan fees, and a $1,640,000 loss on debt conversion.
(7)
Includes $2.1 million and $3.4 million of notes receivable as of December 31, 2006 and 2005, respectively related to the sale of assets of discontinued operations. Includes $9.0 million, $33.4 million and $27.4 million of assets of discontinued operations, as of December 31, 2004, 2003 and 2002, respectively. The assets of discontinued operations as of December 31, 2004 were reduced by the loss on disposal of discontinued operations totaling $14.8 million.
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Overview
The Company is a global technology company providing next generation communications network solutions offering a core-to-edge product portfolio to service providers and enterprises. The Company’s product offerings include WiMAX, cellular backhaul, VoBB, VoIP, IAD, and internet usage solutions which are enabled by the Company’s hardware and software. These products enable customers to reduce communication costs, generate additional revenue, secure and optimize network bandwidth. The Company manufactures, delivers, and supports these hardware, software, and service solutions primarily to wireline, cellular, wireless and satellite carriers and other customers. The Company’s solutions are used by companies in several industries, government and government related businesses, including mission critical satellite and wireless communications of all kinds. The Company’s technologies optimize bandwidth for customers using proprietary and other technology utilizing the latest industry protocols such as internet protocol multimedia subsystem (“IMS”), VoIP, VoBB as well as other advanced protocols. The Company owns open and scalable solutions that are compatible with industry standards.
The Company’s operations include two separate business segments: (i) the Technologies Group, which includes the Company’s softswitching, I-Master, and NetPerformer divisions, and the Company’s Telemate.Net, and Verso Verilink subsidiaries; and (ii) the Advanced Applications Services Group, which includes the Company’s technical applications support group and customer care center. The Technologies Group includes domestic and international sales of hardware and software, integration, applications and technical training and support. The Technologies Group offers software-based solutions (which include hardware) for customers seeking to build converged packet-based voice and data networks. In addition, the Technologies Group offers software-based solutions for Internet access and usage management that include call accounting and usage reporting for Internet protocol network devices. In 2006, the Technologies Group added the product suites from the Verilink Acquisition and the iMarc Acquisition (each defined below). These products provide access, multiplexing and transport of voice and data services and enhanced the Company’s technology offerings, and delivered two Tier 1 North American customers. The Advanced Applications Services Group includes outsourced technical application services and application installation and training services to both customers of the Technologies Group and outside customers.
Since 2001, the Company has been selling products to the carrier market and focusing its strategic direction on developing and marketing next generation communications products. The Company’s current business was built on acquisitions made by the Company by leveraging the economic downturn in the telecommunications area. In the first quarter of 2003, the Company acquired substantially all of the operating assets of Clarent Corporation, which provided the Company with VoIP technologies primarily serving international markets and significantly increased the Company’s market share in the worldwide softswitch market.
The Company’s strategy through 2003 was to add next generation communications products to its suite of products through strategic acquisitions and to leverage these operations through cost reductions to enhance cash flow. With the acquisition of substantially all of the operating assets of Clarent Corporation, the Company moved its growth strategy toward international markets. International revenue increased from 0% of the Company’s consolidated revenues in 2002 to 53% of the Company’s consolidated revenues for 2005. As the acquisition of substantially all of the operating assets of Clarent Corporation was funded primarily by short-term seller financing, generating cash flow from operations during 2003 was required to meet the debt repayment obligations. As such, the Company leveraged its combined operations, reducing sales, general and administrative costs (as compared to costs prior to the acquisition), while preserving the research and development expenditures which are vital to the Company’s long-term growth and viability.
In 2004, the Company began moving toward an open standards platform. In 2004 and 2005, the Company significantly increased its expenditures for research and development and sales and marketing to focus on long-term sustainable revenue growth. In the first quarter of 2004, the Company completed a private placement raising approximately $16.5 million, net of expenses, to fund the increased research and development efforts and expanded sales and marketing programs. In the first quarter of 2005, the Company completed a private placement of senior unsecured convertible debentures raising an additional $12.8 million. As expected, these additional expenditures significantly increased the operating loss from continuing operations in 2005 and 2004 as compared to 2003.
In January 2005, the Company sold substantially all of the operating assets of its NACT and MCK businesses to better focus the Company’s capital and management resources on areas which the Company believes have greater potential given its strategy to focus on next generation network and solutions. In addition, the Company disposed of its NACT business because the Company wanted to move toward an open-standards, pre-paid next generation solution that could better address growing market opportunities and enable the Company to offer a competitive product for Tier 1 and Tier 2 carriers. The Company believes that the I-Master platform, which the Company acquired in March 2005 after forming a strategic partnership with WSECI in the latter half of 2004, permits the Company to offer a more robust next generation solution. Further, the Company disposed of its MCK business because the Company intends to focus on next generation solutions for service providers and the products of the MCK business did not fit that profile. The operations of the NACT and MCK businesses have been reclassified as discontinued operations in the Company’s consolidated financial statements.
On June 16, 2006, the Company acquired all of the outstanding equity interests (the “Verilink Acquisition”) of Winslow Asset Holdings, LLC (“Holdings”), now known as Verso Verilink, LLC from Winslow Asset Group, LLC (“Group”) pursuant to that certain Securities Purchase Agreement dated as of June 15, 2006 among Verso, Holdings and Group. At the time of the Acquisition, Holdings’ assets consisted of substantially all of the business assets of Verilink Corporation and Larscom Incorporated (together, the “Verilink Sellers”), other than the accounts receivable and certain fixed assets of the Verilink Sellers which were transferred to Group prior to the Acquisition. Holdings’ assets were used by the Verilink Sellers in their business of developing, manufacturing, marketing and selling broadband access solutions for computer networks. The Verilink Acquisition has provided substantial revenues to the Company which have improved its operating performance during the second half of 2006.
On December 29, 2006, the Company purchased certain assets of Paradyne Networks, Inc. related to the business of manufacturing, selling and supporting the iMarc product line (the “iMarc Acquisition”). The iMarc product line is a family of ATM, IP service units, and branch monitors that provides intelligent demarcation between carrier and enterprise networks, allowing for easier management. The iMarc product line is complementary to the Verilink product line and is being integrated into the Verilink business.
On October 11, 2005, the Company effected the Reverse Split of the outstanding Common Stock, pursuant to which every five (5) shares of common stock outstanding on such date were converted into one (1) share of common stock. The Reverse Split enabled the Company to regain compliance with the minimum bid price requirement for continued inclusion on the Nasdaq SmallCap Market.
The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. The Company does not engage in off-balance sheet activities and therefore none are disclosed in the financial statements. The Company believes that the foregoing events significantly affect the comparability of the Company’s results of operations from year to year. You should read the following discussion of the Company’s results of operations and financial condition in conjunction with the Company’s consolidated financial statements and related notes thereto included in Item 15 of this Annual Report.
Results of Operations
Fiscal Year 2006 Compared with Fiscal Year 2005
For the year ended December 31, 2006, the Company’s net loss totaled $17.8 million, or $0.51 per share, compared with a net loss of $20.1 million, or $0.74 per share, for the same period in 2005. The 2006 results included $674,000 in reorganization costs. The 2005 results included $3.0 million in reorganization costs and a loss from discontinued operations of $566,000.
Continuing Operations
For the year ended December 31, 2006, the Company’s net loss from continuing operations totaled $17.8 million, or $0.51 per share, compared with a net loss of $19.5 million, or $0.72 per share, for 2005. The 2006 results included $674,000 in reorganization costs. The 2005 results included $3.0 million in reorganization costs.
Total revenue was $42.5 million for the year ended December 31, 2006, reflecting a 29% increase from 2005. Product revenue increased from $18.3 million in 2005 to $27.9 million in 2006. The increase in product revenue in
the Packet-based Technologies Group was attributable to the addition of the Verilink product revenue, which was acquired by the Company on June 16, 2006, and increase in revenue associated with the I-Master product partially offset by declines in the sales of the Company’s other products. Services revenue was $14.7 million for the year ended December 31, 2006, basically flat with the same period in 2005, primarily due to revenue from the Verilink professional services group, net of declines primarily in the Advanced Application Services Group. The decrease in revenue from the Advanced Application Services Group was attributable primarily to a decline in revenue from its largest customer due to that customer’s conversion to a new software platform, the support of which is primarily handled by the software vendor.
Gross profit increased by $2.5 million in the year ended December 31, 2006, and was 40% of revenue in 2006, compared with 45% of revenue for 2005. The increase in gross profit is attributable to the increase in revenues. The decline in gross margin percentage was primarily attributable to the decline in the margin for the Advanced Application Services Group and in the Technologies Group. The decrease in Advanced Application Services Group gross margin is due to decreased revenues and a change in revenue mix from support revenue related to a proprietary software product to general call center support. The lower margin in the Technologies Group is primarily as a result of the lower margins from the primarily hardware based Verilink product suite.
Total operating expenses incurred in continuing operations for the year ended December 31, 2006 were $29.3 million, a decrease of $917,000 compared to the same period in 2005. The decrease is primarily attributable to the following items: decreases in reorganization costs of $2.3 million and depreciation and amortization of $340,000 offset by increases in general and administrative expense of $825,000 and research and development expense of $973,000.
The increase in general and administrative expenses for the year ended December 31, 2006 is primarily from stock-based compensation expense related to stock awards granted to the non-employee members of the Board of Directors and stock options for executives in 2006 and the additional cost from the Verilink Acquisition in 2006, net of the reduction in audit and professional fees primarily due to the Company not being required to comply with reporting requirements of Section 404 of the Sarbanes-Oxley Act of 2002 and reduced corporate office rent.
The increase in research and development costs were primarily attributable to the additional costs from the Verilink acquisition in 2006 and additional costs for the NetPerformer product as a result of restructuring and changes in product design to obtain compliance with the European Union’s RoHS directive, offset by a reduction in development resources related to the softswitch product.
The decrease in depreciation and amortization expense is comprised of a decrease in depreciation expense of $508,000 and a decrease in amortization of deferred compensation of $7,000 net of an increase in amortization expense. The decrease in depreciation expense is related to lower capital expenditures during 2006 as well as fully- depreciated assets partially offset by additional depreciation related to the Verilink Acquisition. The increase in amortization of $175,000 is related to the amortization of Verilink intangibles and additional intangibles related to the contingent purchase price issued related to WSECI.
In the fourth quarter of 2006, the Company terminated a senior executive. As a result of this action, the Company recorded reorganization costs of $674,000 during the year ended December 31, 2006.
In the second quarter of 2005, the Company entered into a sublease agreement with an unrelated party to sublease excess office space at the Company’s facility in Atlanta, Georgia. The excess space arose primarily due to reductions in corporate staffing over the past year. As a result of the sublease, the Company recorded an accrual of $1.7 million, equaling the difference between the remaining payments due on this lease ($3.3 million) and the amounts to be paid by the sublessor ($1.6 million). The Company recorded reorganization costs of $2.6 million during the year ended December 31, 2005, which included the $1.7 million difference between the lease and the sublease for the entire remaining term, as well as write-offs for furniture and leasehold improvements. The Company expects to save approximately $1.2 million over the remaining term of the original lease, which expires January 31, 2010.
As a percentage of revenue, operating expenses from continuing operations were 69% during the year ended December 31, 2006, down from 92% for the same period in 2005.
Other expense was $22,000 during the year ended December 31, 2006, compared with $58,000 for the same period in 2005.
Equity in loss of investment was $1,000 during the year ended December 31, 2006, compared to equity in income of investment of $17,000 in 2005. These amounts represent the Company’s portion of BeTrue’s income for each of these years. Due to the shared decision making between the Company and its equity partner, the results of BeTrue are treated as an equity investment rather than being consolidated.
Net interest expense was $5.6 million during the year ended December 31, 2006, an increase of $1.7 million compared to the same period in 2005. Included in net interest expenses was amortization of loan fees and discount on convertible debentures which were $3.9 million for the year ended December 31, 2006 as compared to $2.9 million for the year ended December 31, 2005. The increase in the interest expenses was primarily attributable to interest and amortization of the loan costs and fees associated with the new credit facility with Laurus and the termination of the line of credit with Silicon Valley Bank (“Silicon”).
Business Unit Performance
Technologies Group
Total revenue from the Company’s Technologies Group was $35.2 million in the year ended December 31, 2006, a 49% increase from the same period in 2005. The increase in product revenue in the Technologies Group was primarily attributable to the Verilink Acquisition which occurred on June 16, 2006, and increase in revenue associated with the I-Master product partially offset by declines in the sales of the Company’s other products.
Gross profit increased by $3.9 million in the year ended December 31, 2006, and was 46% of revenue, a decrease from 51% of revenue in the same period in 2005. The increase in gross profit dollars is attributable to the
increase in revenue. The decrease in gross margin percentage is due to the lower margins from the primarily hardware based Verilink product.
Allocated operating expenses incurred in the Technologies Group for the year ended December 31, 2006 were $18.5 million, an increase of $1.6 million compared to the same period in 2005. The increase in general and administrative expenses is due to the expenses related to the Verilink Acquisition. The increase in research and development costs were primarily attributable to the additional costs from the Verilink Acquisition in 2006 and additional costs for the NetPerformer product as a result of restructuring and changes in product design to obtain compliance with the European Union’s RoHS directive, offset by a reduction in development resources related to the Softswitch.
As a percent of revenue, operating expenses for the Technologies Group were 53% during the year ended December 31, 2006, down from 71% during the same period in 2005. The decrease in the percentage is primarily attributable to the higher revenue.
Advanced Applications Services Group
Total revenue for the Company’s Advanced Applications Services Group was $7.3 million for the year ended December 31, 2006, a 20% decrease from the same period in 2005. The decrease in revenue from the Advanced Application Services Group was attributable primarily to a decline in revenue from its largest customer due to that customer’s conversion to a new software platform, the support of which is primarily handled by the software vendor, net of new customers added.
Gross profit decreased by $1.4 million in the year ended December 31, 2006, and was 16% of revenue, compared with 28% of revenue in the same period in 2005. The decrease in gross profit dollars and gross margin percentage is due to decreased revenues and a change in revenue mix from support revenue related to a proprietary software product to general call center support.
Allocated operating expenses incurred in Advanced Applications Services Group for the year ended December 31, 2006 were $781,000, a decrease of $60,000 compared to the same period in 2005. The decrease in general and administrative expenses primarily relates to a decrease in personnel and related costs and occupancy costs.
Discontinued Operations
In January 2005, the Company sold substantially all of the operating assets of its NACT and MCK businesses to better focus the Company’s capital and management resources on areas which the Company believes have greater potential given its strategy to focus on next generation network and solutions to improve cash utilization. In addition, the Company disposed of its NACT business because the Company wanted to move toward an open-standards, pre-paid next generation solution that could better address growing market opportunities and enable the Company to offer a competitive product for Tier 1 and Tier 2 carriers. The Company believes that the I-Master platform, which the Company acquired from WSECI in March 2005, permits the Company to offer a better solution. Further, the Company disposed of its MCK business because it intends to focus on next generation solutions for service providers and the products of the MCK business did not fit that profile. The operations of the NACT and MCK businesses have been reclassified as discontinued operations in the Company’s consolidated financial statements.
Summary operating results of the discontinued operations (in thousands) are as follows:
The operating loss from discontinued operations for the year ended December 31, 2005 includes depreciation and amortization of $114,000.
Fiscal Year 2005 Compared with Fiscal Year 2004
For the year ended December 31, 2005, the Company’s net loss totaled $20.1 million, or $0.74 per share, compared with a net loss of $38.8 million, or $1.47 per share, for the same period in 2004. The 2005 results included $3.0 million in reorganization costs and a loss from discontinued operations of $566,000. The 2004 results included $1.4 million in reorganization costs and a loss from discontinued operations of $20.0 million.
Continuing Operations
For the year ended December 31, 2005, the Company’s net loss from continuing operations totaled $19.5 million, or $0.72 per share, compared with a net loss of $18.8 million, or $0.71 per share, for 2004. The 2005 results included $3.0 million in reorganization costs. The 2004 results included $1.4 million in reorganization costs.
Total revenue was $32.9 million in the year ended December 31, 2005, reflecting a 2% increase from 2004. Product revenue increased from $15.5 million in 2004 to $18.3 million in 2005. The increase in product revenue in the Technologies Group was attributable to the addition of the I-Master platform product revenue related to WSECI, which was acquired by the Company on March 31, 2005, as well as an increase in the Company’s NetPerformer product sales. In 2005, the increase in product revenue came from five new products, most notably the I-Master server and the NetPerformer GSM A.bis product. Services revenue was $14.6 million in the year ended December 31, 2005, reflecting a 13% decrease from the same period in 2004, primarily due to revenue from the Advanced Application Services Group. The decrease in revenue from the Advanced Application Services Group was attributable primarily to a decline in revenue from its largest customer due to that customer’s conversion to a new software platform, the support of which is primarily handled by the software vendor.
Gross profit decreased by $261,000 in the year ended December 31, 2005, and was 45% of revenue in 2005, compared with 47% of revenue for 2004. The decrease in gross profit percentage resulted from the increase in amortization of intangibles related to the acquisition of WSECI in March 2005 and lower margin in the Advanced Application Services Group.
Total operating expenses incurred in continuing operations for the year ended December 31, 2005 were $30.4 million, a decrease of $2.8 million compared to the same period in 2004. The decrease is primarily attributable to the following items: decreases in general and administrative expenses of $2.2 million, sales and marketing expenses of $1.4 million and depreciation and amortization expense of $683,000 offset by an increase in reorganization costs of $1.6 million.
The decrease in general and administrative expenses resulted from a decrease in professional fees, the vast majority of which related to the elimination of non-recurring costs incurred in 2004 related to the implementation of Section 404 of the Sarbanes-Oxley Act of 2002, reduction of bad debt expense primarily in the Advanced Application Services Group, reduction in rent and occupancy costs related to the sublease (see reorganization costs - loss on sublease discussion below), and reductions of corporate personnel and related costs associated with the disposal of NACT and MCK in January 2005.
The decrease in sales and marketing expenses resulted from the reduction of personnel costs primarily for sales management overhead and marketing and personnel related costs, including travel.
The decrease in depreciation and amortization expense is comprised of a decrease in depreciation expense of $255,000 and a decrease in amortization of deferred compensation of $428,000. The decrease in depreciation expense is related to lower capital expenditures during 2005 of approximately $1.2 million compared to 2004 and decreases related to fully-depreciated assets. Capital expenditures are primarily depreciated on a straight-line basis over an estimated useful life of three years. The decrease in amortization of deferred compensation primarily related to the final vesting of options outstanding since the Company’s acquisitions of Telemate.Net in November 2001 and Cereus in September 2000.
In the third quarter of 2005, the Company terminated a senior executive. As a result of this action, the Company recorded reorganization costs of $340,000 during the year ended December 31, 2005.
In the second quarter of 2005, the Company entered into a sublease agreement with an unrelated party to sublease excess office space at its facility in Atlanta, Georgia. The excess space arose primarily due to reductions in corporate staffing over the past year. As a result of the sublease, the Company recorded an accrual of $1.7 million, equaling the difference between the remaining payments due on this lease ($3.3 million) and the amounts to be paid by the sublessor ($1.6 million). The Company recorded reorganization costs of $2.6 million during the year ended December 31, 2005, which included the $1.7 million difference between the lease and the sublease for the entire remaining term, as well as write-offs for furniture and leasehold improvements. The Company expects to save approximately $1.2 million over the remaining term of the original lease, which expires January 31, 2010.
In the first quarter of 2005, as a result of the sale of substantially all of the operating assets of the MCK and NACT businesses, the Company initiated a reorganization and eliminated six corporate positions. As a result of these actions, the Company recorded reorganization costs of $124,000 during the year ended December 31, 2005.
In the first quarter of 2004, the Company terminated the employment of a senior executive. In the fourth quarter of 2004, the Company initiated a restructuring plan to improve operational efficiencies and financial performance and eliminated 20 positions held by employees. As a result of these actions, the Company recorded reorganization costs of $1.4 million during the year ended December 31, 2004, including $570,000 of non-cash stock compensation expense. Annualized savings beginning in the first quarter of 2005 were expected to be approximately $1.9 million.
As a percentage of revenue, operating expenses from continuing operations were 92% during the year ended December 31, 2005, down from 103% for the same period in 2004.
Other expense was $58,000 during the year ended December 31, 2005, compared with other income of $259,000 for the same period in 2004. Other expense during the year ended December 31, 2005 was primarily related to expenses paid to third parties associated with the restructuring of the Company’s 7.5% convertible debentures. Other income during the year ended December 31, 2004 was primarily related to the sale of non-operating assets.
Equity in income of investment was $17,000 during the year ended December 31, 2005, compared to $56,000 in 2004. These amounts represent the Company’s portion of BeTrue’s income for each of these years. Due to the shared decision making between the Company and its equity partner, the results of BeTrue are treated as an equity investment rather than being consolidated.
Net interest expense was $3.9 million during the year ended December 31, 2005, an increase of $2.9 million compared to the same period in 2004. The increase was primarily attributable to interest on the $13.5 million senior unsecured convertible debentures issued in February 2005, the amortization of the discount and loan origination fees on the $13.5 million senior unsecured convertible debentures, as well as increased amortization of the discount on the 7.5% convertible subordinated debentures that were restructured during the year ended December 31, 2005.
Business Unit Performance
Technologies Group
Total revenue from the Company’s Technologies Group was $23.7 million in the year ended December 31, 2005, a 15% increase from the same period in 2004. The increase in product revenue in the Technologies Group was attributable to the addition of the I-Master platform product revenue related to the assets acquired from WSECI, which occurred on March 31, 2005, as well as an increase in the Company’s NetPerformer product sales. In 2005, the increase in product revenue came from five new products, most notably the I-Master server and the NetPerformer GSM A.bis product.
Gross profit increased by $1.2 million in the year ended December 31, 2005, and was 51% of revenue, a decrease from 53% of revenue in the same period in 2004. The increase in gross profit dollars is attributable to the increase in revenue. The decrease in gross margin percentage is due to an increase in amortization of intangibles related to the acquisition of substantially all of the operating assets of WSECI in March 2005 and increased costs relative to revenue.
Allocated operating expenses incurred in the Technologies Group for the year ended December 31, 2005 were $16.9 million, a decrease of $1.1 million compared to the same period in 2004. The increase in general and administrative expenses is due to the expenses related to the WSECI acquisition. The decrease in sales and marketing expenses resulted from the reduction of personnel costs primarily for sales management overhead and marketing and personnel related costs including travel. Research and development cost remained relatively constant compared to 2004. As a percent of revenue, operating expenses for the Technologies Group were 71% during the
year ended December 31, 2005, down from 88% during the same period in 2004. The decrease in the percentage is attributable to the decrease in sales and marketing spending coupled with higher revenue.
Advanced Applications Services Group
Total revenue for the Company’s Advanced Applications Services Group was $9.2 million in the year ended December 31, 2005, a 22% decrease from the same period in 2004. The decrease in revenue from the Advanced Application Services Group was attributable primarily to a decline in revenue from its largest customer due to that customer’s conversion to a new software platform, the support of which is primarily handled by the software vendor, net of new customers added.
Gross profit decreased by $1.4 million in the year ended December 31, 2005, and was 28% of revenue, compared with 34% of revenue in the same period in 2004. The decrease in gross profit dollars and gross margin percentage is due to decreased revenues and a change in revenue mix from support revenue related to a proprietary software product to general call center support.
Allocated operating expenses incurred in Advanced Applications Services Group for the year ended December 31, 2005 were $841,000, a decrease of $344,000 compared to the same period in 2004. The decrease in general and administrative expenses primarily relates to a decrease in personnel and related costs, occupancy costs and bad debt expense.
Discontinued Operations
In January 2005, the Company sold substantially all of the operating assets of its NACT and MCK businesses to better focus the Company’s capital and management resources on areas which the Company believes have greater potential given its strategy to focus on next generation network and solutions to improve cash utilization. In addition, the Company disposed of its NACT business because the Company wanted to move toward an open-standards, pre-paid next generation solution that could better address growing market opportunities and enable the Company to offer a competitive product for Tier 1 and Tier 2 carriers. The Company believes that the I-Master platform, which the Company acquired from WSECI in March 2005, permits the Company to offer a better solution. Further, the Company disposed of its MCK business because it intends to focus on next generation solutions for service providers and the products of the MCK business did not fit that profile. The operations of the NACT and MCK businesses have been reclassified as discontinued operations in the Company’s consolidated financial statements.
Summary operating results of the discontinued operations (in thousands) are as follows:
The operating loss from discontinued operations for the year ended December 31, 2005 includes depreciation and amortization of $114,000. The operating loss from discontinued operations for the year ended December 31, 2004 includes depreciation and amortization of $2.6 million.
Critical Accounting Policies
The preparation of financial statements and related disclosures in conformity with U.S. generally accepted accounting principles requires management to make judgments, assumptions and estimates that affect the amounts reported in the consolidated financial statements and accompanying notes. Factors that could affect the Company’s
future operating results and cause actual results to vary from expectations include, but are not limited to, lower than anticipated growth from existing customers, an inability to attract new customers, an inability to successfully integrate acquisitions and technology changes, or a decline in the financial stability of the Company’s customers. Negative developments in these or other risk factors could have a material adverse affect on the Company’s financial position and results of operations.
A summary of the Company’s critical accounting policies follows:
Revenue Recognition
The Company recognizes revenue when persuasive evidence of an agreement exists, delivery has occurred, the fee is fixed and determinable, and collection of the resulting receivable is reasonably assured. The determination of whether the collectibility is reasonably assured is based upon an assessment of the creditworthiness of the customers. In instances where the collection of a receivable is not reasonably assured, the revenue and related costs are deferred.
Deferred revenue generally represents amounts collected for which revenue has not yet been recognized. It is principally comprised of deferred maintenance revenue.
The Company recognizes revenue in accordance with Staff Accounting Bulletin (“SAB”) No. 101, “Revenue Recognition in Financial Statements” as updated by SAB No. 104 and in accordance with Emerging Issues Task Force (“EITF”) 00-21, “Revenue Arrangements with Multiple Deliverables”, Statement of Position (“SOP”) No. 97-2, “Software Revenue Recognition” (“SOP No. 97-2”) and SOP No. 98-9, “Software Revenue Recognition with Respect to Certain Transactions” (“SOP No. 98-9”).
SOP No. 97-2 generally requires revenue earned on software arrangements involving multiple elements to be allocated to each element based on the relative fair values of the elements. The fair value of an element must be based on the evidence that is specific to the vendor. License revenue allocated to software products generally is recognized upon delivery of the products or deferred and recognized in future periods to the extent that an arrangement includes one or more elements to be delivered at a future date and for which fair values have not been established. Revenue allocated to maintenance is recognized ratably over the maintenance term which is typically twelve months and revenue allocated to training and other service elements, such as implementation and training, are recognized as the services are performed.
Under SOP No. 98-9 if evidence of fair value of all undelivered elements exists but evidence does not exist for one or more delivered elements, then revenue is recognized using the residual method. Under the residual method, the fair value of the undelivered elements is deferred and the remaining portion of the arrangement fee is allocated to the delivered element and recognized as revenue.
As a consequence of the acquisition of the business assets of the Verilink Sellers on June 16, 2006, the Company now has certain distributors who have the right to return product for stock rotation purposes. Every quarter, stock rotation rights are limited to a percentage of invoiced sales to the distributor in the prior quarter. The percentage of sales used to determine the stock rotation right is based upon the terms of the executed distributor agreements with the Company. The Company reduces revenue and maintains a reserve for an estimate of potential stock rotation returns related to the current period product revenue. Management analyzes historical returns, channel inventory levels, current economic trends and changes in customer demand for the Company’s products when evaluating the adequacy of the reserve for stock rotation returns.
The Company routinely analyzes and establishes, as necessary, reserves at the time of shipment for product returns and allowances and warranty costs.
Allowance for Doubtful Accounts
The Company is required to estimate the collectibility of its trade receivables. Considerable judgment is required in assessing the ultimate realization of these receivables, including the creditworthiness of each customer. The evaluation is based on credit information and collection history concerning the customer up and through the
determination date. The Company determines the allowance for doubtful accounts based on a specific review of outstanding customer balances and a general reserve based upon aging of customer accounts and write-off history.
Inventory Obsolescence
The Company is required to state its inventories at the lower of cost or market. In assessing the ultimate realization of inventories, the Company makes judgments as to future demand requirements and compares that with the current and committed inventory levels. The Company has recorded changes in net realizable values in recent periods due to the impact of current and future technology trends and changes in strategic direction, such as discontinuances of product lines, as well as, changes in market conditions due to changes in demand requirements. Estimates of the future demand for inventory are based on historical usage for different products, as well as estimates of inventory required to fulfill maintenance requirements for products previously sold. It is possible that changes in the net realizable value of inventory may continue to occur in the future due to the current market conditions.
Liabilities of Discontinued Operations
In January 2005, the Company disposed of substantially all of the operating assets of its NACT and MCK businesses. As a result of these sales, certain liabilities of MCK are now classified as discontinued operations. Offsetting these liabilities is a receivable of $359,000 related to a sublease for which all the lease payments have been made by the company.
During 2001, the Company initiated certain restructuring plans and discontinued operations of its VAR business. In conjunction with these restructuring plans, the Company established a restructuring reserve account for the estimated costs related to the plans. These costs primarily related to facilities closings, severance costs and other business exiting costs. For the facilities closings cost, a reserve was established for all remaining lease payments due on buildings and equipment that were no longer being utilized in continuing operations, less assumptions for sub-leases. The accrual for one of the leases with total payments remaining through January 31, 2010 of $1.2 million is offset by sublease receipts totaling $722,000 through the end of the lease term and assumes an amount of $240,000 for the extension of one of the subleases through the end of the lease term.
As of December 31, 2006, the Company had a remaining balance of approximately $1.4 million in liabilities of discontinued operations. The Company currently believes that this remaining balance is sufficient to cover estimated future obligations associated with the restructurings; however, changes in these estimates could occur based on changes in the financial condition of the subleases.
Deferred Tax Asset Valuation Allowance
The Company currently has significant deferred tax assets, which are subject to periodic recoverability assessment. Realization of the Company’s deferred tax assets is principally dependant upon achievement of projected future taxable income. The Company’s judgments regarding future profitability may change due to market conditions, its ability to continue to successfully execute its strategic plan and other factors. These changes, if any, may require possible material adjustments to these deferred tax asset balances. Due to the uncertainty of the Company’s ability to recognize the entire tax benefit of the deferred tax assets, the Company has established an offsetting provision.
Litigation and Related Contingencies
The Company is subject to proceedings, lawsuits and other claims related to labor, product and other matters. The Company is required to assess the likelihood of any adverse judgments or outcomes to these matters, as well as, potential ranges of probable losses. A determination of the amount of reserves required, if any, for these contingencies is made by the Company with assistance of its legal counsel after careful analysis of each individual issue based upon the then-current facts and circumstances and discussions with legal counsel. The required reserves may change in the future due to new developments in each matter or changes in approach such as a change in settlement strategy in dealing with these matters.
Goodwill, Intangible Assets and Long-Lived Assets
Goodwill represents the excess of costs over fair value of assets of businesses acquired. Goodwill and intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but instead are tested for impairment at least annually in accordance with provisions of SFAS No. 142. Significant estimates are made with respect to the impairment testing. SFAS No. 142 also requires that intangible assets with estimable useful lives be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with SFAS No. 144.
In accordance with SFAS No. 144, long-lived assets, such as property, plant and equipment and purchased assets subject to amortization are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized by the amount by which the carrying amount of the asset exceeds the fair value of the asset. Significant estimates are made with respect to recoverability and fair value assessments.
Liquidity and Capital Resources
Summary
Liquidity is the measurement of the Company’s ability to have adequate cash or access to cash at all times in order to meet financial obligations when due, as well as to fund corporate expansion and other activities. Historically, the Company has met its liquidity requirements through a combination of cash provided by debt from third party lenders, issuances of debt and equity securities, purchases of other businesses and the sale of discontinued businesses.
At December 31, 2006, the Company had a negative working capital position (excess of current liabilities over current assets) of $38,000 compared to a positive working capital position (excess of current assets over current liabilities) of $1,887,000 at December 31, 2005. The Company’s cash and restricted cash totaled $2,175,000 at December 31, 2006, and $2,735,000 at December 31, 2005. Total long-term debt, net of discount and current-portion, was $11,500,000 at December 31, 2006 and $8,412,000 at December 31, 2005.
On September 20, 2006, the Company entered into the Security Agreement with Laurus which provides for a three-year, $14.0 million revolving credit facility with Laurus. The credit facility with Laurus replaces the Company’s prior $10.0 million credit facility with Silicon.
The credit facility with Laurus consists of two tranches: (i) Tranche A, an $8.0 million tranche, the availability of which is subject to a borrowing base; and (ii) Tranche B a $6.0 million tranche, of which $4.0 million was immediately available, of which an additional $1.0 million was made available in connection with the iMarc Acquisition at December 29, 2006 and the remaining $1.0 million of which will be available when the Company generates EBITDA (earnings before interest, income taxes, depreciation and amortization and non-cash stock compensation expense) in excess of $500,000 in any one fiscal quarter. Borrowing availability under Tranche B is not subject to a borrowing base. Borrowing ability under Tranche A is determined pursuant to a formula which is based on the value of the Company’s eligible accounts receivables and inventory and borrowings under Tranche A accrue interest at a rate of prime rate plus 2%, provided that the interest rate shall not be less than 9% (10.25% at September 30, 2006). Borrowing ability under Tranche B is available immediately but the $6.0 million availability limit under Tranche B will be reduced by $187,500 per month beginning February 1, 2007, and borrowings under Tranche B accrue interest at a fixed rate of 15%. Borrowings under the credit facility shall be made first under Tranche B to the extent of availability thereunder and then under Tranche A to the extent of availability thereunder.
As of December 31, 2006, the Company had outstanding borrowings under Tranche A and Tranche B of $2,883,000 and $5,000,000, respectively. The remaining borrowing availability under the credit facility at December 31, 2006 was $3.0 million under Tranche A and there were no amounts available under Tranche B.
On February 12, 2003, the Company acquired substantially all the business assets and assumed certain related liabilities of Clarent Corporation for $9,800,000 in notes. At December 31, 2006, a $3,000,000 secured note due
February 12, 2008 remains outstanding which bears interest at 5% per annum. The assets the Company purchased from Clarent Corporation secure the note.
On February 4, 2005, the Company completed a private placement of senior unsecured convertible debentures and warrants pursuant to a securities purchase agreement with certain institutional investors. The Company issued $13,500,000 of senior unsecured convertible debentures, Series A warrants exercisable for 2,200,000 shares of the Company’s common stock and Series B warrants exercisable for 2,000,000 shares of the Company’s common stock. The senior unsecured convertible debentures bear interest at 6.75% per annum and are due February 2009 and are convertible into approximately 5,400,000 shares of the Company’s common stock at an initial conversion price of $2.50 per share, subject to anti-dilution adjustments and certain limitations. Interest is payable on a quarterly basis and principal became payable on a quarterly basis beginning August 2006. The Series A warrants issued in connection with the private placement are exercisable for a period of five years commencing on February 4, 2005 and at an exercise price of $3.60 per share. The Series B warrants issued in connection with the private placement were exercisable for a period of 90 days, commencing on June 16, 2005 and had an exercise price of $3.90 per share. The Series B warrants expired in September 2005. The Company received net proceeds of approximately $12,500,000, including $1,600,000 in restricted cash, net of expenses.
On February 17, 2006, the Company issued, in a private placement, 5,400,000 shares of its common stock and warrants to purchase 5,400,000 shares of its common stock for an aggregate purchase price of approximately $7,100,000, or $1.30 per share. The warrants issued in connection with the private placement are exercisable, after six months, for a period of five years and at an exercise price of $1.56 per share. The Company received proceeds from the private placement of approximately $6,800,000, net of expenses.
On June 30, 2006 in connection with the completion of the admission of Citel U.K.’s entire issued share capital to AIM, the Company and Citel amended the original $3.0 million note receivable such that the principal balance of the note became due and payable as follows: $870,000 to be paid within one business day of such admission; followed by 6 monthly installments of $75,000 commencing 12 months from the date of Admission; and all remaining outstanding principal and accrued interest under this note will be due from Citel on January 21, 2008. In July 2006, the Company received the $870,000 as contemplated by the amendment to the note.
On July 18, 2006, the Company entered into an agreement (the “CM Agreement”) with CM Solutions, Inc. (“CM”), the Company’s contract manufacturer of its Verilink product line. Pursuant to the CM Agreement, CM has purchased certain electrical components valued at $2.0 million from the Company for use in the manufacture of finished goods to be purchased by the Company. In addition, the Company has agreed to assign to CM an additional amount of unused electrical components valued at $2.0 million for which title will remain with the Company. The Company has an obligation under the CM Agreement to purchase during the first two years, products assembled by CM using electrical components valued at $2.0 million (the “Assembled Products”). Furthermore, the Company has agreed to submit purchase orders to CM in a minimum amount of $2.0 million per quarter for the next three years or until the obligation to purchase the Assembled Products has been satisfied.
In connection with executing the CM Agreement, the Company and CM entered into a three-year Manufacturing Agreement which sets forth the terms and conditions under which CM shall manufacture the Assembled Products. As of December 31, 2006, CM had used $966,000 of electrical components in the manufacture of the Assembled Products, reduced the outstanding commitment to utilize $2.0 million of electrical components in the first two years of the agreements to approximately $1.0 million which reduced the inventory currently assigned to CM to approximately $1.0 million. The remaining assigned inventory is reflected as inventory on the balance sheet as of December 31, 2006. The assigned inventory is not eligible for inclusion in the borrowing base under the Company’s credit agreement with Laurus, which the Company entered into on September 20, 2006.
Cash Flow
Cash used in the Company’s continuing operations in the year ended December 31, 2006 totaled approximately $9.0 million compared with cash used by continuing operations of $14.9 million for 2005. The Company’s use of cash in continuing operations during 2006 resulted primarily from cash used by continuing operations of $9.0 million (net loss from continuing operations of $17.8 million reduced by non-cash charges totaling $8.8 million, including amortization of loan fees and discount on convertible subordinated debentures of
$3.9 million, depreciation and amortization of $2.6 million, stock based compensation of $930,000, stock issuance for services $174,000, stock issuance for interest $675,000 and provision for doubtful accounts of $513,000), cash used for net changes in current operating assets and liabilities of approximately $76,000. The Company’s use of cash in continuing operations during 2005 resulted primarily from cash used for changes in current operating assets and liabilities of approximately $4.2 million and cash used by continuing operations of $10.7 million (net loss from continuing operations of $19.5 million reduced by non-cash charges totaling $8.8 million, including depreciation and amortization of $5.8 million, provision for doubtful accounts of $463,000 and reorganization costs - loss on sublease of $2.6 million).
Cash used in the Company’s discontinued operations in the year ended December 31, 2006, totaled $1.3 million compared with $1.6 million for 2005.
Cash used in investing activities for continuing operations totaled approximately $1.1 million in the year ended December 31, 2006, compared to cash provided by investing activities for continuing operations of $2.7 million in the year ended December 31, 2005. During the year ended December 31, 2006 restricted cash decreased by $615,000 compared to an increase of $1.7 million for 2005. The Company spent $351,000 and $820,000 on capital expenditures in the year ended December 31, 2006 and 2005, respectively. In 2006, the Company spent $338,000 related to the acquisition of Verilink and $1.0 million on the iMarc Acquisition. In 2005, the Company spent $273,000 related to the acquisition of substantially all of the operating assets of WSECI.
Cash provided by investing activities for discontinued operations totaled approximately $1.4 million and $4.3 million in the year ended December 31, 2006 and 2005, respectively. The Company received $1.4 million from the notes receivable during the year ended December 31, 2006. The Company received $4.0 million from the sale of discontinued operations and $300,000 from notes receivable during the year ended December 31, 2005.
Cash provided by financing activities totaled approximately $9.9 million in the year ended December 31, 2006, compared to $11.8 million for 2005. In 2006 net proceeds from a private placement of $6.7 million, borrowing under the Company’s line of credit of $6.6 million and proceeds from the issuance of the Common Stock related to the exercise of options of $24,000 were offset by a payment of $2.3 million on the Company’s 7.5% convertible debentures and debt issue costs of $1.1 million. Net proceeds from convertible debentures of $12.8 million, net borrowings on the line of credit of $1.3 million and proceeds from the issuance of the Common Stock related to the exercise of options of $65,000 were offset by a payment of $2.3 million on the Company’s 7.5% convertible debentures for 2005.
Contractual Obligations and Commercial Commitments
The following summarizes the Company’s future contractual obligations at December 31, 2006 (in thousands):
This foregoing table excludes interest expense and sublease rentals and assumes that leases are not renewed. The Company remains a guarantor on a lease through December 2009 used in the operations of the NACT business, which the Company sold in January 2005. The total commitment related to this lease is approximately $1.9 million.
Sources of Cash
For 2007, the Company expects that its primary sources of cash will be from issuances of equity or debt securities, cash on hand, borrowings under its credit facility with Laurus and other sources. The Company expects that its current operations will not generate positive income from operations before interest, taxes, depreciation and amortization (EBITDA) for the first six months of 2007 but should generate positive EBITDA during the last six months of 2007. The Company is currently working on several initiatives to reduce the cash used in continuing operations and to ensure that it has sufficient liquidity to cover its needs for the next twelve months.
During January and February 2007, the Company issued in private placements an aggregate 5.0 million shares of the Company’s common stock and warrants to acquire 2.5 million shares of Common Stock for an aggregate purchase price of $5.0 million. The Investor Warrants are exercisable over a 5-year period commencing with their issuance at a per share exercise price equal to $1.25. The Company received approximately $4.6 million, net of expenses.
As previously mentioned, on September 20, 2006, the Company entered into a new credit facility with Laurus which provides for a three-year, $14.0 million revolving credit facility. The credit facility with Laurus replaced the Company’s prior $10.0 million credit facility with Silicon and thus increased the Company’s availability of working capital. As of December 31, 2006, the Company had outstanding borrowings under Tranche A and Tranche B of $2,883,000 and $5,000,000, respectively. The remaining borrowing availability under the credit facility at September 30, 2006 was $3.0 million under Tranche A and none under Tranche B.
Availability for borrowings under Tranche A of the Company’s credit facility with Laurus is subject to limitations as determined pursuant to a formula which is based on the value of the Company’s eligible accounts receivables and inventory. If the Company does not have sufficient eligible accounts receivable and inventories to support the level of borrowings it may need, then the Company may be unable to draw on the credit facility to the extent necessary. To the extent the Company does not have borrowing availability under the credit facility, the Company may be required to obtain additional sources of capital, sell assets, obtain an amendment to the Security Agreement or otherwise restructure its outstanding indebtedness.
Additional borrowings other than pursuant to the credit facility must be approved by Laurus and may have to be approved by the holders of the secured note issued by the Company in connection with the acquisition of substantially all of the operating assets of Clarent Corporation, which note is due in 2008, and the holders of the $13,500,000 senior unsecured convertible debentures. If the Company is unable to obtain additional capital, sell assets, obtain an amendment to the Security Agreement or otherwise restructure its outstanding indebtedness, then the Company may not be able to meet its obligations.
The Company has taken steps that the Company believes could not only increase revenues and gross margins but also could make the Company more efficient on the expense side. The acquisition of Verilink, completed in June 2006, has contributed significantly to increased revenues, gross margin and reduced operating losses. In December 2006, the Company acquired the iMarc product line which is being integrated into the Verilink operations which is expected to contribute to continued reduced operating losses. These acquisitions have provided the Company with two new U.S. based Tier 1 carrier customers. In addition, the Company’s sources of revenues have transitioned from a majority of revenues being from international sources to a mix which is approximately equal between U.S. and international sources. This transition has substantially improved the Company’s cash flow through a reduction in days sales outstanding in receivables. Revenue growth is viewed as the key driver to continue the improvement in the reduction of the operating losses and cash used from operations. During late 2005 and 2006, the Company introduced new products including product bundles comprised of two or more of the Company’s proprietary technology products; and shifted resources to focus on fewer but larger and more strategic OEM and distributor relationships. The reconstruction of the Company’s sales and distribution network is expected contribute to the Company’s future revenue growth as well as business acquisitions and strategic partnerships. Although gross margins are dependent on many different factors, including revenue volume, product mix and discounting, the
Company believes that in general, gross margins should improve with revenue increases by leveraging departmental and other non-variable costs. In addition, it anticipates improved margins from higher value solution sales such as the product bundles. The Company intends to continue its on-going review and diligence on controlling operating expenses. Based on the Company’s current financial plan for 2007, management believes that it will have sufficient liquidity from its cash on-hand, the cash raised in the recent $5.0 million private placement and its unused credit facility to meet its current financial obligations, excluding the impact of any prospective businesses to be acquired, during 2007.
The Company’s short-term cash needs are for working capital, including cash operating losses, scheduled payments for the iMarc acquisition, capital expenditures, payments on the 6.75% senior unsecured convertible debentures of $4.1 million in the next twelve months, to the extent that the Company does not elect to make these payments in stock, interest payments on debt outstanding, payments of the accrued loss on sublease and payments related to discontinued operations as well as payments related to prospective businesses to be acquired, if any. In addition the Company has scheduled payments of approximately $1.1 million on the Tranche B of the credit facility to be made in the second half of 2007. The scheduled payments for the iMarc acquisition are; $1.0 million which was paid January 31, 2007, $250,000 which was paid on March 29, 2007 and $250,000 which is due no later than June 29, 2007. At December 31, 2006, accrued loss on sublease totaled $1.2 million. The Company expects to pay out approximately $1.9 million related to lease payments, net of sublease rental, in the next twelve months
The Company’s long-term cash needs are related to the costs of growing its current business as well as prospective businesses to be acquired, including capital expenditures and working capital. In addition, the Company will make required payments on its senior unsecured convertible debentures, to the extent that the Company does not elect to make these payments in stock, payments on Tranche B of its credit facility, the accrued loss on sublease, liabilities of discontinued operations and the secured note payable made by the Company in connection with the acquisition of substantially all of the operating assets of Clarent Corporation which is due February 2008. The Company expects to meet these cash needs through cash from operations, if any, cash on hand, borrowings under the credit facility or other debt facilities, if available, as well as through possible issuances of equity or debt securities. If sufficient borrowing capacity under a working capital line of credit is unavailable (or if the Company is unable to restructure its existing credit facility in the event that the Company requires additional borrowing capacity), or if the Company is otherwise unable to obtain additional capital or sell assets, then the Company may not be able to meet its obligations and growth plans.
Item 7A.
Item 7A.
Quantitative and Qualitative Disclosures About Market Risk
Market Risk
The Company is exposed to various market risks, including changes in interest rates and foreign currency exchange rates. Market risk is the potential loss arising from adverse changes in market rates and prices, such as interest rates and foreign currency exchange rates. The Company does not enter into derivatives or other financial instruments for trading or speculative purposes. The Company has also not entered into financial instruments to manage and reduce the impact of changes in interest rates and foreign currency exchange rates although the Company may enter into such transactions in the future.
Interest Rate Risks
The Company’s notes payable and convertible subordinated debentures at December 31, 2006, carry interest rates which are fixed. Tranche A of the Company’s line of credit with Laurus carries interest rates which vary with the prime rate. Accordingly, if the Company has any indebtedness outstanding under Tranche A of this line, then any increases in the prime rate will reduce the Company’s earnings. A 1% increase in the prime rate on the $2.9 million outstanding under the Company’s line of credit at December 31, 2006 would result in an annual interest expense increase of approximately $290,000.
Foreign Currency Risks
Products sold outside of the United States of America are transacted in U.S. dollars and, therefore, the Company is not exposed to foreign currency exchange risk. Transactions with Verso Canada and Verso
Technologies (UK) Limited, an indirect, wholly owned subsidiary of the Company, present foreign currency exchange risk. The principal transactions are personnel and related costs. The intercompany balance is denominated in U.S. dollars and changes in foreign currency rates would result in foreign currency gains and losses. Using the intercompany balance at December 31, 2006, a 10% strengthening of the U.S. dollar against the Canadian dollar and the British pound would result in a foreign currency transaction loss of approximately $33,000. To date, foreign exchange gains and losses have not been significant.
Item 8.
Item 8.
Financial Statements and Supplementary Data
The financial statements required to be filed with this Annual Report are filed under Item 15 hereof and are listed on the “Index to Consolidated Financial Statements” on page hereof.
Quarterly Financial Data (Unaudited)
The following table presents unaudited quarterly statements of operations data for each quarter of the Company’s last two completed fiscal years. The unaudited quarterly financial statements have been prepared on substantially the same basis as the audited financial statements contained elsewhere in this Annual Report. In the opinion of the Company’s management, the unaudited financial statements include all adjustments, consisting only of normal recurring adjustments that management considers to be necessary to fairly present this information when read in conjunction with the Company’s consolidated financial statements and related notes appearing elsewhere in
this Annual Report. The results of operations for any quarter are not necessarily indicative of the results to be expected for any future period.
(1)
Second quarter 2005 net loss included reorganization costs - loss on sublease totaling $2.6 million included in loss from continuing operations.
(2)
Per common share amounts for the quarters and full years have been calculated separately. Accordingly, quarterly amounts may not add to the annual amounts because of differences in the average common shares outstanding during each period.
Item 9.
Item 9.
Changes in and Disagreements With Accountants on Accounting and Financial Disclosure
None.
Item 9A.
Item 9A.
Controls and Procedures
The Company’s Chief Executive Officer and Chief Financial Officer have evaluated the Company’s disclosure controls and procedures (as such term is defined in Rules 13a-15(e) or 15d-15(e) of the Exchange Act), as of the end of the period covered by this Annual Report, as required by paragraph (b) of Rules 13a-15 or 15d-15 of the Exchange Act. Based on such evaluation, such officers have concluded that, as of the end of the period covered by this Annual Report, the Company’s disclosure controls and procedures are effective.
During the quarter ended December 31, 2006, there was not any change in the Company’s internal control over financial reporting identified in connection with the evaluation required by paragraph (d) of Rules 13a-15 or 15d-15 of the Exchange Act that has materially affected, or is reasonably likely to materially affect, the Company’s control over financial reporting.
Item 9B.
Item 9B.
Other Information
On March 7, 2006, the Canada Revenue Agency (the “CRA”) notified 38098 Yukon Inc. (formerly known as MCK Telecommunications Inc.), a corporation organized under the laws of the Yukon Territory (“MCK Canada”) and an indirect wholly owned subsidiary of the Company, that the CRA had completed its international income tax audit of MCK Canada for the period from May 1, 1998 to April 30, 2000 (the “Audit”). As a result of the Audit, the CRA has issued income tax reassessments to MCK Canada. In addition, the Alberta Tax and Revenue Administration (the “ATR”’) has issued reassessments for each year of the Audit.
The key issue under dispute in the audit is the valuation of certain intellectual property that was transferred from MCK Canada to its U.S. parent company, MCK Communications, Inc. (“MCK US”’) in fiscal 1998. MCK US consulted with outside valuation advisors to establish the value of the intellectual property transferred. The CRA and the ATR disagree with such value. The Company and its advisors disagree with the reassessments, and the Company has filed notices of objection with respect thereto with the CRA and the ATR and intends, if necessary, to exhaust all of its rights of appeal in connection therewith.
The Company estimates that, as of March 31, 2007, (i) the amount of taxes allegedly due in respect of the CRA reassessments was approximately U.S. $7.7 million (plus penalties and interest thereon of approximately U.S. $9.1 million); and (ii) the amount of taxes allegedly due in respect of the ATR reassessments was approximately U.S. $3.5 million (plus penalties and interest thereon of approximately U.S. $3.8 million). The Company has been advised by its Canadian and U.S. counsel that no such amounts should be collectible by the CRA or the ATR against the Company or any of its other subsidiaries (other than MCK Canada) and that the ability of the CRA and the ATR to collect such amounts should be limited to the assets of MCK Canada, which have little or no value. Accordingly, no provision for this matter has been recorded in the Company’s financial statements because the Company believes that it will not have a financial statement impact.
On March 29, 2007, the Company paid $250,000 to Paradyne Networks, Inc. (“Paradyne”), which represents the last installment payment to paid by the Company with respect to the intellectual property to be acquired by the Company from Paradyne in connection with the iMarc Acquisition, pursuant to that certain Asset Purchase Agreement, dated as of December 29, 2006, among the Company, Paradyne and, for certain limited purposes, Zhone Technologies, Inc., Paradyne’s parent, as amended by Amendment No. 1 and Amendment No. 2 thereto entered into on January 25, 2007 and February 7, 2007, respectively. In connection with making such payment, Paradyne assigned such intellectual property to the Company.
On March 23, 2007, the Company entered into an Exclusive License Agreement (the “License Agreement”) with Acacia Patent Acquisition Corporation (“APAC”). Under the License Agreement, the Company granted APAC a world-wide, exclusive right and license with respect to the Company’s U.S. Patent No. 6,292,801 and related patent applications (the “Technology”) to license the Technology to third parties and to undertake any enforcement or infringement actions against third parties related to the Technology. The ‘801 patent pertains to a system and method for tracking data resources on a network. Under the License Agreement, the Company will receive a portion of the proceeds resulting from any infringement action or further license of the Technology. Pursuant to the License Agreement, the Company is entitled to continue to use the Technology in its products without charge. APAC may terminate the License Agreement at any time within 60 days of the execution thereof and, in the event of such termination, all rights to the Technology will revert back to the Company.
PART III
Item 10.
Item 10.
Directors, Executive Officers and Corporate Governance
The information required by Item 10 of Form 10-K will be set forth in the Company’s Proxy Statement for the Annual Meeting of Shareholders to be held in 2007 (the “Proxy Statement”) under the captions titled “Proposal I: Election of Directors,” “Audit Committee Report,” “Corporate Governance” and “Section 16(a) Beneficial Ownership Reporting Compliance” and such information is incorporated herein by reference.
Item 11.
Item 11.
Executive Compensation
The information required by Item 11 of Form 10-K will be set forth in the Proxy Statement under the caption titled “Executive Compensation” and such information is incorporated herein by reference.
Item 12.
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
The information required by Item 12 of Form 10-K will be set forth in the Proxy Statement under the captions titled “Security Ownership of Certain Beneficial Owners and Management” and “Executive Compensation - Equity Compensation Plans” and such information is incorporated herein by reference.
Item 13.
Item 13.
Certain Relationships and Related Transactions, and Director Independence
The information required by Item 13 of Form 10-K will be set forth in the Proxy Statement under the captions titled “Certain Relationships and Related Transactions” and “Proposal 1: Election of Directors” and such information is incorporated herein by reference.
Item 14.
Item 14.
Principal Accountant Fees and Services
The information required by Item 14 of Form 10-K will be set forth in the Proxy Statement under the captions titled “Proposal 2: Ratification of Independent Public Accountants” and such information is incorporated herein by reference.
Item 15.
Item 15.
Exhibits and Financial Statement Schedules
Lists of certain documents filed herewith as part of this Annual Report may be found as follows:
(i) A list of the consolidated financial statements required to be filed as a part of this Annual Report is shown in the “Index to Consolidated Financial Statements” on page.
(ii) Except for Financial Statement Schedule II, “Valuation and Qualifying Accounts,” which is filed herewith, the financial statement schedules required to be filed as a part of this Annual Report are omitted from this Annual Report because the information required by such schedules is either not applicable or is included in the consolidated financial statements and notes thereto, which statements and notes are listed on the “Index to Consolidated Financial Statements” on page and filed herewith.
(iii) A list of the exhibits required by Item 601 of Regulation S-K to be filed as a part of this Annual Report is shown on the “Exhibit Index” filed herewith.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND RELATED REPORTS
The following consolidated financial statements, financial statement schedule and reports of independent registered public accounting firm are included herein on the pages indicated:
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Stockholders
Verso Technologies, Inc.
We have audited the accompanying consolidated balance sheet of Verso Technologies, Inc. and subsidiaries (the “Company”) as of December 31, 2006, and the related consolidated statements of operations, shareholders’ equity and cash flows for the year then ended. Our audit also included the financial statement schedule listed at Item 15. These financial statements and the financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and the financial statement schedule based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of their internal control over financial reporting. Our audit included consideration of internal controls over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management as well as evaluating the overall presentation of the financial statements. We believe that our audit provides 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 Verso Technologies, Inc. and subsidiaries at December 31, 2006, and the results of their operations and cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respect the information set forth therein.
As discussed in Note 2 to the consolidated financial statements, the Company adopted Statement of Financial Accounting Standards No. 123(R), Share Based Payments, effective January 1, 2006.
/s/ Tauber & Balser, P.C.
Atlanta, Georgia
March 28, 2007
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors
Verso Technologies, Inc.
We have audited the accompanying consolidated balance sheets of Verso Technologies, Inc. as of December 31, 2005 and 2004, and the related consolidated statements of operations, stockholders’ equity and cash flows for each of the two years then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Verso Technologies, Inc. as of December 31, 2005 and 2004 and the results of their operations and their cash flows for each of the two years then ended in conformity with accounting principles generally accepted in the United States of America.
Our audit was conducted for the purpose of forming an opinion on the basic financial statements taken as a whole. The Schedule II for the years ended December 31, 2005 and 2004, is presented for purposes of additional analysis and is not a required part of the basic financial statements. This schedule has been subjected to the auditing procedures applied in the audits of the basic consolidated financial statements and, in our opinion, is fairly stated in all material respects in relation to the basic financial statements taken as a whole.
/s/ Grant Thornton LLP
Atlanta, Georgia
March 3, 2006
VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
The accompanying notes are an integral part of these consolidated financial statements.
VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
The accompanying notes are an integral part of these consolidated financial statements.
VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
FOR THE YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004
The accompanying notes are an integral part of these consolidated financial statements.
VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
The accompanying notes are an integral part of these consolidated financial statements.
VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS - (Continued)
The accompanying notes are an integral part of these consolidated financial statements.
VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Business and Basis of Presentation
Verso Technologies, Inc., a Minnesota corporation (the “Company”), is a global technology company providing next generation communications network solutions offering a core-to-edge product portfolio to service providers and enterprises. The Company’s product offerings include WiMAX, cellular backhaul, voice over broadband (“VoBB”), voice over internet protocol (“VoIP”), internet access devices (“IAD”), and internet usage solutions which are enabled by the Company’s hardware and software. These products enable customers to reduce communications costs, generate additional revenue and secure and optimize network bandwidth. The Company manufactures, delivers, and supports these hardware, software, and service solutions primarily to large wireline, cellular, wireless and satellite carriers and other customers. The Company’s solutions are used by companies in several industries and government, including mission critical satellite and wireless communications of all kinds.
The Company’s operations include two separate business segments: (i) the Technologies Group, which includes the Company’s softswitching, I-Master, and NetPerformer divisions, the Company’s Telemate.Net Software, Inc. subsidiary (“Telemate.Net”), and the Company’s Verso Verilink, LLC subsidiary (“Verso Verilink”); and (ii) the Advanced Applications Services Group, which includes the Company’s technical applications support group and customer care center. The Technologies Group includes domestic and international sales of hardware and software, integration, applications and technical training and support. The Technologies Group offers software-based solutions (which include hardware) for customers seeking to build converged packet-based voice and data networks. In addition, the Technologies Group offers software-based solutions for Internet access and usage management that include call accounting and usage reporting for Internet protocol network devices. In 2006, the Technologies Group added the product suites from the Verilink Acquisition and the iMarc Acquisition (each defined below). These products provide access, multiplexing and transport of voice and data services. They have enhanced the Company’s technology offerings, provided substantial revenue to the Company, and delivered two large tier 1 North American customers in ATT and Lucent. The Advanced Applications Services Group includes outsourced technical application services and application installation and training services to both customers of the Technologies Group and outside customers.
On December 29, 2006, the Company purchased certain assets of Paradyne Networks, Inc. (“Paradyne”) related to the business of manufacturing, selling and supporting the iMarc product line (the “iMarc Acquisition”). The iMarc product line is a family of asynchronous transfer mode (ATM), IP service units, and branch monitors that provide intelligent demarcation between carrier and enterprise networks, allowing for easier management. The assets and liabilities related to this acquisition are reflected on the balance sheet as of December 31, 2006 but there are no results of operations included for the year ended December 31, 2006 since the acquisition did not occur until December 29, 2006.
On June 16, 2006, the Company acquired all of the outstanding equity interests (the “Verilink Acquisition”) of Winslow Asset Holdings, LLC (“Holdings”), now known as Verso Verilink, LLC from Winslow Asset Group, LLC (“Group”) pursuant to that certain Securities Purchase Agreement dated as of June 15, 2006 among Verso, Holdings and Group (the “Securities Purchase Agreement”). At the time of the Acquisition, Holdings’ assets consisted of substantially all of the business assets of Verilink Corporation and Larscom Incorporated (together, the “Verilink Sellers”), other than the accounts receivable and certain fixed assets. Holdings’ assets were used by the Verilink Sellers in their business of developing, manufacturing, marketing and selling broadband access solutions for computer networks. The assets and liabilities related to this acquisition are reflected on the balance sheet as of December 31, 2006 and the results of operations since June 16, 2006 are included.
In January 2005, the Company sold substantially all of the operating assets of its NACT Telecommunications, Inc., now known as Provo Pre-Paid (Delaware) Corp. (“NACT”) and MCK Communications, Inc., now known as Needham (Delaware) Corp. (“MCK”) businesses to better focus the Company’s capital and management resources on areas which the Company believes have greater potential given its strategy to focus on next-generation network and solutions and to improve cash utilization. In addition, the Company disposed of its NACT business because the Company wanted to move toward an open-standards, pre-paid next-generation solution that could better address
VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
1. Business and Basis of Presentation - (Continued)
growing market opportunities and enable the Company to offer a competitive product for Tier 1 and Tier 2 carriers. The Company acquired the I-Master platform from WSECI, Inc., a Delaware corporation formerly known as Jacksonville Technology Associates, Inc. (“WSECI”), in March 2005 after forming a strategic partnership with WSECI in the latter half of 2004. The Company believes that this platform permits it to offer a better solution.
On October 11, 2005, the Company effected a 1-for-5 reverse stock split of the Company’s outstanding common stock, pursuant to which every five (5) shares of the Company’s common stock outstanding on such date were converted into one (1) share of the Company’s common stock (the “Reverse Split”). This Reverse Split has been reflected retroactively throughout the Company’s Form 10-K.
The consolidated financial statements include the accounts of Verso Technologies, Inc. and its wholly-owned subsidiaries, including Telemate.net; Clarent Canada Ltd., now known as Verso Technologies Canada Inc. (“Verso Canada”), Verilink, MCK and NACT. MCK and NACT are reflected in discontinued operations. These subsidiaries were acquired and were all accounted for as purchases (see Note 5).
Certain prior year amounts in the consolidated financial statements have been reclassified to conform to the current year presentation. These reclassifications had no effect on previously reported net loss.
2. Summary of Significant Accounting Policies and Practices
Principles of Consolidation
The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. Investments in joint ventures, where the Company does not exercise control, are accounted for on the equity method. All significant intercompany accounts and transactions have been eliminated in consolidation.
Use of Estimates
The preparation of consolidated financial statements in conformity with U.S. generally accepted accounting principles requires management of the Company 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 consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Revenue Recognition
The Company recognizes revenue when persuasive evidence of an agreement exists, delivery has occurred, the fee is fixed and determinable, and collection of the resulting receivable is reasonably assured. The determination of whether the collectibility is reasonably assured is based upon an assessment of the creditworthiness of the customers. In instances where the collection of a receivable is not reasonably assured, the revenue and related costs are deferred.
Unearned revenue generally represents amounts collected for which revenue has not yet been recognized. It is principally comprised of deferred maintenance revenue.
The Company recognizes revenue in accordance with Staff Accounting Bulletin (“SAB”) No. 101, “Revenue Recognition in Financial Statements” as updated by Staff Accounting Bulletin No. 104 and in accordance with Emerging Issues Task Force (“EITF”) 00-21, “Revenue Arrangements with Multiple Deliverables”, Statement of Position (“SOP”) No. 97-2, “Software Revenue Recognition” (“SOP No. 97-2”) and SOP No. 98-9, “Software Revenue Recognition with Respect to Certain Transactions” (“SOP No. 98-9”).
SOP No. 97-2 generally requires revenue earned on software arrangements involving multiple elements to be allocated to each element based on the relative fair values of the elements. The fair value of an element must be
VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
2. Summary of Significant Accounting Policies and Practices - (Continued)
based on the evidence that is specific to the vendor. License revenue allocated to software products generally is recognized upon delivery of the products or deferred and recognized in future periods to the extent that an arrangement includes one or more elements to be delivered at a future date and for which fair values have not been established. Revenue allocated to maintenance is recognized ratably over the maintenance term which is typically twelve months and revenue allocated to training and other service elements, such as implementation and training, are recognized as the services are performed.
Under SOP No. 98-9 if evidence of fair value of all undelivered elements exists but evidence does not exist for one or more delivered elements, then revenue is recognized using the residual method. Under the residual method, the fair value of the undelivered elements is deferred and the remaining portion of the arrangement fee is allocated to the delivered element and recognized as revenue.
The Company routinely analyzes and establishes, as necessary, reserves at the time of shipment for product returns and allowances and warranty costs.
Cash Equivalents
The Company considers all investments purchased with an original maturity of three months or less to be cash equivalents. Cash equivalents at December 31, 2006 and 2005 of approximately $1,530,000 and $642,000, respectively, consist primarily of money market investments, which are recorded at cost, which approximates market.
The Company had $1.0 million and $1.7 million of restricted cash as December 31, 2006 and 2005, respectively. At December 31, 2006, the restricted cash is equal to the aggregate amount of the interest originally scheduled to accrue through the two year anniversary date of the senior unsecured convertible debentures less amounts paid through December 31, 2006 and the restricted cash is being released as quarterly interest payments are made, which began April 2006.
Accounts Receivable and Allowance for Doubtful Accounts
Accounts receivable are stated at the amounts that management expects to collect. The Company is required to estimate the collectibility of its trade receivables. Considerable judgment is required in assessing the ultimate realization of these receivables, including the creditworthiness of each customer. Significant changes in required reserves have been recorded in recent periods and may occur in the future due to the current telecommunications and general economic environments. The Company determines the allowance for doubtful accounts based on a specific review of outstanding customer balances plus a general reserve based on the aging of customer accounts and write-off history. An account is written off once all reasonable collection efforts have been exhausted.
Credit, Customer and Vendor Concentrations
The Company’s accounts receivable potentially subjects the Company to credit risk. While the Company has purchase-money-security-interests in its equipment sold on credit terms, the Company does not seek to perfect or claim a security interest in international or small dollar value equipment sales and services.
As of December 31, 2006, the Company’s Technologies Group had two customers that accounted for 12% and 13%, respectively, of the Company’s gross accounts receivable. During the year ended December 31, 2006, one of the Company’s customers accounted for greater than 10% of the Company’s revenue.
As of December 31, 2005, the Company’s Technologies Group had two customers that accounted for 13% and 10%, respectively, of the Company’s gross accounts receivable. During the year ended December 31, 2005, none of the Company’s customers accounted for greater than 10% of the Company’s revenue.
VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
2. Summary of Significant Accounting Policies and Practices - (Continued)
During the year ended December 31, 2004, one customer from the Company’s Advanced Application Services Group accounted for 17% of the Company’s total revenue and one customer from the Company’s Technologies Group accounted for 14% of the Company’s total revenue.
Inventories
Inventories consist primarily of purchased electronic components, and are stated at the lower of cost or market. Cost is determined by using average cost.
Inventories as of December 31, 2006 and 2005 are comprised of the following (in thousands):
The inventory amounts noted are net of excess and obsolete allowances of $1.7 million and $1.2 million for the years ended December 31, 2006 and 2005, respectively.
On July 18, 2006, the Company entered into an agreement (the “CM Agreement”) with CM Solutions, Inc. (“CM”), the Company’s contract manufacturer of its Verilink product line. Pursuant to the CM Agreement, CM has purchased certain electrical components valued at $2.0 million from the Company for use in the manufacture of finished goods to be purchased by the Company. In addition, the Company has agreed to assign to CM an additional amount of unused electrical components valued at $2.0 million for which title will remain with the Company. The Company has an obligation under the CM Agreement to purchase during the first two years, products assembled by CM using electrical components valued at $2.0 million (the “Assembled Products”). Furthermore, the Company has agreed to submit purchase orders to CM in a minimum amount of $2.0 million per quarter for the next three years or until the obligation to purchase the Assembled Products has been satisfied.
In connection with executing the CM Agreement, the Company and CM entered into a three-year Manufacturing Agreement which sets forth the terms and conditions under which CM shall manufacture the Assembled Products. As of December 31, 2006, CM had used $966,000 of electrical components in the manufacture of the Assembled Products, reduced the outstanding commitment to utilize $2.0 million of electrical components in the first two years of the agreements to approximately $1.0 million which reduced the inventory currently assigned to CM to approximately $1.0 million. The remaining assigned inventory is reflected as inventory on the balance sheet as of December 31, 2006. The assigned inventory is not eligible for inclusion in the borrowing base under the Company’s credit agreement with Laurus Master Fund, Ltd. (“Laurus”), which the Company entered into on September 20, 2006.
Property and Equipment
Property and equipment, consisting principally of computer equipment, are stated at cost or, if acquired through a business acquisition, at fair value. Depreciation is computed using the straight-line method over estimated useful lives, ranging from two to ten years. Upon retirement or disposal of property and equipment, the cost and accumulated depreciation are removed from the accounts, and any gain or loss is included in operating loss from continuing operations. Maintenance and repairs are charged to expense as incurred.
VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
2. Summary of Significant Accounting Policies and Practices - (Continued)
Property and equipment are summarized as follows (in thousands):
Depreciation expense for the year ended December 31, 2006, 2005 and 2004 were $1.5 million $2.1 million and $2.3 million, respectively.
Purchased software represents the cost of purchased integration software tools and the cost of internal use software acquired in connection with business combinations. It also includes the cost of licenses to use, embed and sell software tools developed by others. These costs are being amortized ratably based on the projected revenue associated with these purchased or licensed tools and products or based on the straight-line method over three years, whichever method results in a higher level of annual amortization. Amortization expense related to purchased software amounted to approximately $304,000, $412,000 and $404,000 in 2006, 2005 and 2004, respectively. Accumulated amortization related to purchased software totaled approximately $1.1 million and $1.4 million at December 31, 2006 and 2005, respectively.
Goodwill and Other Intangibles
Intangible assets represent the excess of cost over the fair value of net assets acquired and identified other intangible assets which consist of current technology and customer relationships. The current technology is amortized on a straight-line basis over its estimated useful life of three years. The customer relationships are amortized on a straight-line basis over their estimated useful life of three to ten years. Goodwill associated with acquisitions is not being amortized in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets” (SFAS No. 142”).
VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
2. Summary of Significant Accounting Policies and Practices - (Continued)
Goodwill and other intangible assets consist of the following (in thousands):
Other intangibles- current technology increased by $143,000 attributable to additional contingent consideration per the Asset Purchase Agreement for the WSECI acquisition during the year ended December 31, 2006. Other intangibles- customer relationship increased by $1,258,000 and $1,900,000 for the Verilink and iMarc acquisitions, respectively, during the year ended December 31, 2006.
Goodwill increased $710,000 attributable to the iMarc acquisition during the year ended December 31, 2006. There was no change in the Company’s goodwill during the year ended December 31, 2005. Under the provisions of SFAS No. 142, goodwill is no longer subject to amortization.
Estimated annual amortization expense is as follows (in thousands):
Impairment of Long-Lived Assets
SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS No. 144”), provides a single accounting model for long-lived assets to be disposed of. SFAS No. 144 also changes the criteria for classifying an asset as held for sale, broadens the scope of businesses to be disposed of that qualify for reporting as discontinued operations, and changes the timing of recognizing losses on such operations.
In accordance with SFAS No. 144, long-lived assets, such as property, plant, and equipment, and purchased intangibles subject to amortization, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an
VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
2. Summary of Significant Accounting Policies and Practices - (Continued)
impairment charge is recognized by the amount by which the carrying amount of the asset exceeds the fair value of the asset.
Goodwill not subject to amortization is tested annually for impairment, and is tested for impairment more frequently if events and circumstances indicate that the asset might be impaired. An impairment loss is recognized to the extent that the carrying amount exceeds the asset’s fair value. The annual impairment test was conducted as of December 31, 2006 and 2005 and no impairment was indicated.
Warranties
The Company provides a basic limited warranty for its products for one year except for certain product families which provide a warranty period of 3 years, 5 years or as required by specific contract. The Company estimates the costs that may be incurred under its basic limited warranty and for extension thereof and records a liability in the amount of such costs at the time product revenue is recognized. Factors that affect the Company’s warranty liability include the number of installed units, historical and anticipated rates of warranty claims and cost per claim. The Company periodically assesses the adequacy of its recorded warranty liabilities and adjusts the amounts as necessary.
Warranty liability activity for the years ended December 31, 2006, 2005 and 2004 is as follows (in thousands):
Fair Value of Financial Instruments
Estimates of fair value of financial instruments are made at a specific point in time, based on relevant market prices and information about the financial instrument. The estimated fair values of financial instruments are not necessarily indicative of the amounts the Company might realize in actual market transactions. The following methods and assumptions were used by the Company in estimating its fair value disclosures for financial instruments:
Cash and cash equivalents, restricted cash, accounts receivable, investment and notes receivable, accrued expenses, accounts payable: The carrying amounts reported in the consolidated balance sheets approximate their fair value.
Short and long-term debt: The carrying amount of the Company’s borrowings under floating rate debt approximates its fair value. The carrying amount of the Company’s notes payable has been discounted to approximate its fair value in connection with the accounting for the acquisition of substantially all of the operating assets of Clarent. The carrying amount of convertible subordinated debentures under fixed rate debt approximates its fair value because it approximates the Company’s estimated long-term borrowing rate.
Research and development costs
Research and development costs are expensed as incurred.
VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
2. Summary of Significant Accounting Policies and Practices - (Continued)
Legal costs
Legal costs associated with litigation and loss contingencies other than those associated with discontinued operations are charged to expense as services are rendered.
Stock-Based Compensation Plan
On December 31, 2005, the Board of Directors approved the accelerated vesting of unvested stock options granted to substantially all employees. The Board of Directors did not accelerate the vesting of unvested options for certain officers and directors. Accordingly, options to purchase approximately 637,000 shares became fully-vested immediately. The closing price of the Company’s stock on December 31, 2005 was $1.00. The accelerated options, which are considered fully-vested as of December 31, 2005, have exercise prices ranging from $1.03 to $23.45 and therefore there was no expense associated with any intrinsic value associated with these options. The vesting acceleration for these certain options enables the Company to avoid recognizing in its income statement compensation expense in future periods.
Effective January 1, 2006, the Company adopted Statement 123(R) using the modified prospective method and, therefore, reflect compensation expense in accordance with the SFAS 123(R) transition provisions. Under the modified prospective method, prior periods are not restated to reflect the impact of adopting the new standard at earlier dates.
As a result of the adoption of Statement 123(R), the Company recorded $352,000 of stock-based compensation expense for the year ended December 31, 2006 related to our employee stock options. Had the Company continued to account for these options under APB 25 the Company would have recorded no such expense. After recording the expense through December 31, 2006, there remained approximately $2,421,000 of unrecognized compensation cost related to unvested employee stock options to be recognized over the next 2.8 years.
The Company used the Black-Scholes method (which models the value over time of financial instruments) to estimate the fair value at grant date of the options. The Black-Scholes method uses several assumptions to value an option. The Company used the following assumptions:
•
Expected Dividend Yield - because we do not currently pay dividends, our expected dividend yield is zero.
•
Expected Volatility in Stock Price - reflects the historical change in our stock price over the expected term of the stock option.
•
Risk-free Interest Rate - reflects the average rate on a United States Treasury bond with maturity equal to the expected term of the option.
•
Expected Life of Stock Option - reflects the simplified method to calculate an expected life based on the midpoint between the vesting date and the end of the contractual term of the stock award.
The weighted-average assumptions used in the option pricing model for stock option grants were as follows:
If the Company had used the fair value-based method of accounting for its stock option and incentive plans and charged compensation cost against income, over the vesting period, based on the fair value of options at the date of
VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
2. Summary of Significant Accounting Policies and Practices - (Continued)
grant, then the net loss and net loss per common share would have been increased to the following pro forma amounts (in thousands, except for per share amounts):
Income Taxes
Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled.
Net Loss Per Share
Basic and diluted net loss per share are computed in accordance with SFAS No. 128, “Earnings Per Share,” using the weighted average number of common shares outstanding. The diluted net loss per share for the twelve-month periods ended December 31, 2006, 2005 and 2004 does not include the effect of the common stock equivalents, calculated by the treasury stock method, as their impact would be antidilutive. Using the treasury stock method, excluded common stock equivalents are as follows:
See Notes 6,7,10 and 11 for disclosure of all warrants to purchase common stock and shares issuable under stock options.
Comprehensive Income (Loss)
SFAS No. 130, “Reporting Comprehensive Income,” establishes standards for reporting and presentation of comprehensive income (loss) and its components in a full set of financial statements. The statement requires additional disclosures in the consolidated financial statements; it does not affect the Company’s financial position or results of operations. Comprehensive loss has been included in the Consolidated Statements of Shareholders’ Equity for the three-year period ended December 31, 2006.
VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
2. Summary of Significant Accounting Policies and Practices - (Continued)
Segment and Geographic Information
In accordance with the provisions of SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information”, the Company has two reportable operating segments, the Technologies Group and the Advanced Application Services Group. Following the acquisition of substantially all the operating assets of Clarent in February 2003, the Company began conducting research and development in Canada. International sales of the Company’s products and services continue to originate only from the United States.
Recent Accounting Pronouncements
In July 2006, the FASB issued Interpretation No. 48 (FIN 48), “Accounting for Uncertainty in Income Taxes, an Interpretation of SFAS No. 109.” FIN 48 creates a single model to address accounting for uncertainty in tax positions and clarifies the accounting for income taxes by prescribing the minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. Specifically under FIN 48, the tax benefits from an uncertain tax position may be recognized only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based upon the technical merits of the position. FIN 48 also provides guidance on de-recognition, measurement, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. As prescribed in the interpretation, the cumulative effect of applying the provisions of FIN 48 will be reported as an adjustment to the opening balance of retained earnings at January 1, 2007. We will adopt FIN 48 effective January 1, 2007 as required. We are presently evaluating whether the adoption of this interpretation will have a material impact on our financial statements.
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.” SFAS No. 157 establishes a framework for measuring fair value in generally accepted accounting principles, clarifies the definition of fair value within that framework, and expands disclosures about the use of fair value measurements. SFAS No. 157 is intended to increase consistency and comparability among fair value estimates used in financial reporting. As such, SFAS No. 157 applies to all other accounting pronouncements that require (or permit) fair value measurements, except for the measurement of share-based payments. SFAS No. 157 does not apply to accounting standards that require (or permit) measurements that are similar to, but not intended to represent, fair value. Fair value, as defined in SFAS No. 157, is the price to sell an asset or transfer a liability and therefore represents an exit price, not an entry price. The exit price is the price in the principal market in which the reporting entity would transact. Further, that price is not adjusted for transaction costs. SFAS No. 157 is effective For fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. SFAS No. 157 will be applied prospectively as of the beginning of the fiscal year in which it is initially applied. We are currently assessing the impact of adoption of SFAS No. 157.
3.
Mergers and Acquisitions
Acquisition of iMarc product line business
On December 29, 2006, the Company entered into an Asset Purchase Agreement (the “Purchase Agreement”) with Paradyne and, for certain limited purposes, Zhone Technologies, Inc., Paradyne’s parent (“Zhone”), pursuant to which the Company has (i) purchased certain assets from, and assumed certain liabilities of, Paradyne relating to its business (the “Business”) of manufacturing, selling and supporting the iMarc product line for an aggregate purchase price of $2.5 million and (ii) agreed to purchase certain other remaining assets relating to the Business as provided in the Purchase Agreement (collectively the transactions described in subclauses (i) and (ii) above, the “Acquisition”). Since July 1, 2006, Verso Verilink, LLC, a wholly-owned subsidiary of the Company, has served pursuant to a Reseller Agreement (the “Reseller Agreement”) as a non-exclusive reseller within the United States for certain Zhone products. The amount of consideration paid or to be paid by the Company pursuant to the
VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
3.
Mergers and Acquisitions - (Continued)
Purchase Agreement was determined as a result of arms’ length negotiations between the Company and Zhone and Paradyne.
The iMarc product line is closely aligned with the Verso portfolio and distribution model, which Verso recently expanded as a result of the June 2006 acquisition of the assets of Verilink Corporation. In particular, the iMarc product line strengthens Verso’s access offerings, substantially expands its Tier-1 customer base, and is complementary to the Verso Verilink WanSuite® product line. Prior to the acquisition of the iMarc product line, Verso served as a reseller of Zhone products and therefore has strong existing knowledge of the products and market, as well as long-term relationships with relevant senior management.
Pursuant to the Purchase Agreement, on December 29, 2006 (the “Closing Date”), the Company acquired from Paradyne certain engineering equipment and service contracts relating to the Business, assumed from Paradyne certain liabilities relating to the Business as specified in the Purchase Agreement and paid to Paradyne $1.0 million in cash in connection with the foregoing. The Company utilized its borrowing availability under its existing Credit Facility with Laurus to fund the $1.0 million paid on the Closing Date.
On the Closing Date, the Company and Paradyne also entered into (i) a License Agreement pursuant to which Paradyne has licensed to the Company rights to certain intellectual property relating to the Business on an exclusive basis (the “Transferred IP”) through January 19, 2007 and rights to certain other intellectual property relating to the Business on a non-exclusive basis for perpetuity (provided that the Company completes the purchase of the Transferred IP from Paradyne as provided in the Purchase Agreement); and (ii) an Adaptation of Reseller Agreement which modifies and supplements the Reseller Agreement to provide that Paradyne shall provide certain contract manufacturing services to the Company with respect to the iMarc products through June 30, 2007.
The Purchase Agreement provides that (i) on January 19, 2007, the Company shall acquire from Paradyne the Transferred IP for a cash purchase price of $1.5 million payable on such date; and (ii) no later than July 3, 2007, the Company shall acquire from Paradyne certain inventory and manufacturing equipment relating to the Business for a cash purchase price equal to the value of the inventory payable no later than the date of such acquisition.
The $1.5 million purchase price which was unpaid as of December 31, 2006 is reflected as purchase price payable for acquisition in the consolidated balance sheet at December 31, 2006.
On January 25, 2007, the Company entered into Amendment No. 1 (the “Amendment”) to the Purchase Agreement. The principal purpose of the Amendment was to extend to January 31, 2007 the date on which the Company is required to pay the additional $1.5 million in exchange for the assignment to the Company of certain intellectual property that Paradyne had theretofore licensed to the Company (the “Intellectual Property”), all as contemplated by the Purchase Agreement. Previously, the Company was obligated to make such payment on January 19, 2007, but Paradyne and Zhone waived compliance with the obligation as part of the Amendment. The Amendment also amends (i) the terms of the covenant not to compete to which Zhone and Paradyne (and their respective controlled affiliates) are subject, and (ii) certain exhibits and schedules to the Asset Purchase Agreement, although the Company does not believe that any such amendments are material to the Company.
After January 25, 2007, the Company, Paradyne and Zhone agreed in principle to further amend the Purchase Agreement, as modified by the Amendment, to provide that (i) the $1.5 million otherwise payable by the Company to Paradyne on January 31, 2007 in exchange for the assignment to the Company of the Intellectual Property will be payable by the Company in three installments of $1.0 million, $250,000 and $250,000 on January 31, 2007, March 31, 2007 and June 30, 2007, respectively; (ii) Paradyne will continue to license the Intellectual Property to the Company, subject to the payment of each such installment; and (iii) Paradyne will assign the Intellectual Property to the Company on June 30, 2007, subject to the receipt of the final payment (collectively, the “Further
VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
3.
Mergers and Acquisitions - (Continued)
Agreement”). The Company Paradyne and Zhone documented this Further Agreement on February 7, 2007 as described below.
On February 7, 2007, the Company entered into Amendment No. 2 (“Amendment No. 2”), effective as of January 31, 2007, to the Purchase Agreement, as previously amended by Amendment No. 1 thereto, which Amendment No. 2 memorialized, with some modification, the parties agreement in principle on January 31, 2007 as described above. The original Purchase Agreement, as amended by Amendment No. 1, required the Company to pay Paradyne by January 31, 2007 $1.5 million in exchange for the assignment to the Company of certain intellectual property. As a result of entering into Amendment No. 2, the Company is obligated to pay Paradyne $1,250,000 in exchange for the assignment to the Company of the intellectual property, of which $1.0 million was paid on January 31, 2007 and $250,000 is payable on March 30, 2007, and upon such payment Paradyne will so assign such intellectual property. In addition, pursuant to Amendment No. 2, the Company is obligated to pay to Paradyne $250,000 no later than June 29, 2007 in exchange for Paradyne’s sale to the Company upon receipt of such payment of certain manufacturing equipment previously required to be sold in connection with the payment for the intellectual property. Amendment No. 2 also amends the terms of the covenant not to compete to which Zhone and Paradyne (and their respective controlled affiliates) are bound in light of the amended payment terms described above.
The iMarc Acquisition was recorded under the purchase method of accounting, and the estimated purchase price was allocated based on the fair value of the assets acquired and liabilities assumed. The total purchase price of $2,575,000 consisted of (i) $1 million in cash at closing; (ii) three installments of $1.0 million, $250,000 and $250,000 paid January 31, 2007 and due March 31, 2007 and June 29, 2007, respectively; and (iii) direct transaction costs of approximately $75,000. A summary of the total purchase consideration is as follows (in thousands):
Under the purchase method of accounting, the total estimated purchase price is allocated to the net tangible and intangible assets based on their estimated fair values as of the date of acquisition. Based on management’s estimate of fair values, the estimated purchase price was allocated as follows (in thousands):
Acquisition of Business Assets of Verilink
On June 16, 2006, the Company acquired substantially all of the business assets of the Verilink Sellers other than accounts receivable and certain fixed assets, and assumed certain liabilities, and issued (i) 2,900,000 shares of the Company’s common stock, par value $.01 per share, and (ii) 8,766 shares of its newly-designated Series C preferred stock, which was subsequently converted in November 2006 into 2,900,000 shares of common stock as
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
3.
Mergers and Acquisitions - (Continued)
described in Note 10 - Shareholders’ Equity. The Verilink Acquisition bolsters the Company’s product offerings and adds several domestic Tier-1 relationships. The Verilink product suite includes products that provide access, multiplexing and transport of voice and data services that extend legacy networks as well as next generation converged access solutions that deliver voice, data and video to business customers.
The Verilink Acquisition was recorded under the purchase method of accounting, and the estimated purchase price was allocated based on the fair value of the assets acquired and liabilities assumed. The total purchase price of $5,906,000 consisted of (a) 2,900,000 shares of the Company’s common stock issued upon consummation of the Verilink Acquisition and valued at approximately $2,784,000, using a fair value per share of $0.96; (b) 8,766 shares of the Company’s Series C preferred stock issued upon consummation of the Verilink Acquisition and valued at approximately $2,784,000, which equals the fair value of the common stock since the preferred shares were automatically convertible into 2,900,000 common shares; and (c) direct transaction costs of approximately $338,000. The fair value of the Company’s common stock issued was determined using the eleven-trading-day average price surrounding the date the assets were sold by the Verilink Sellers (June 15, 2006). A summary of the total purchase consideration is as follows (in thousands):
The Company acquired the Verilink business assets as a result of the acquisition of Holdings, which acquired the business assets directly from Verilink Sellers on June 15, 2006. In connection with the acquisition, Group appointed the Company as sole collection agent for the Verilink receivables that Group retained. In connection with this collection arrangement, the Company receives a collection fee equal to 50% of the initial $750,000 of Verilink receivables it collects and 25% of the remaining Verilink. As of December 31, 2006, the Company had earned approximately $629,000 in collection fees upon collection of Verilink receivables. Such collection fees have been recorded as part of the net assets acquired. Under the purchase method of accounting, the total estimated purchase price is allocated to the net tangible and intangible assets based on their estimated fair values as of the date of acquisition. Based on management’s estimate of fair values, the estimated purchase price was allocated as follows (in thousands):
WSECI, Inc.
On March 31, 2005, the Company acquired substantially all of the operating assets of WSECI pursuant to the Asset Purchase Agreement (“WSECI Asset Purchase Agreement”) dated as of February 23, 2005 by and among the Company, WSECI and all of the shareholders of WSECI. WSECI is a provider of an internet protocol-based,
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
3.
Mergers and Acquisitions - (Continued)
revenue assurance platform which enables the deployment of multiple voice and next-generation services to the carrier market. The fair value of the initial acquisition cost was approximately $1.1 million, consisting of 190,000 shares of the Company’s common stock with a fair value of $331,000, $50,000 in cash, the payment of certain liabilities of approximately $613,000 and acquisition costs of approximately $114,000. The acquisition was accounted for as a purchase.
Pursuant to the WSECI Asset Purchase Agreement, the Company may become obligated to issue to WSECI additional contingent consideration of up to $5.0 million based on the sales of certain WSECI products and services. The initial $500,000 of such contingent consideration was earned by WSECI based upon specific customer transactions the Company completed, and the remaining $4.5 million of the contingent consideration may be earned by WSECI based on the revenue generated from the WSECI assets during the 18-month period following the acquisition, which revenue must equal a minimum of $88.0 million during such period in order for all of such remaining contingent consideration to be earned. The contingent consideration is payable in cash or shares of the Company’s common stock at the election of the Company. During the year ended December 31, 2005, under this provision, the Company issued an additional 277,099 shares of the Company’s common stock with a fair value of $396,000. In addition, during the year ended December 31, 2006, under this provision, the Company issued an additional 113,997 shares of the Company’s common stock with a fair value of $143,000. The additional shares issued were recorded as an increase in other intangibles-current technology which is being amortized over the remaining estimated life of the original purchased technology. In accordance with the terms of the agreement, the only additional stock payment that would be due as additional contingent consideration has been determined to be 62,950 shares of the Company’s common stock with a fair value of $70,504. These shares were issued in February 2007. This will further increase the amount of the purchase price allocated to other intangible assets and will be amortized over the remaining useful life of the asset in 2007.
The adjusted allocation of the costs of the acquisition of WSECI (initial cost plus contingent payments) is as follows (in thousands):
The following unaudited pro forma information presents the results of continuing operations of the Company as if the Verilink Acquisition and the iMarc Acquisition had taken place on January 1, 2005 (in thousands, except per share amounts). Certain adjustments have been made to reflect the impact of the purchase transaction. These pro forma results have been prepared for comparative purposes only and are not indicative of what would have occurred had the acquisition been made at the beginning of the respective periods, or of the results which may occur in the future (in thousands, except per share amounts):
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
4.
Unconsolidated Affiliates
Shanghai BeTrue Infotech Co., Ltd.
On October 1, 2002, the Company acquired a 51% ownership interest but a minority voting interest in Shanghai BeTrue Infotech Co., Ltd. (“BeTrue”). The remaining 49% interest in BeTrue is owned by Shanghai Tangsheng Investments & Development Co. Ltd (“Shanghai Tangsheng”). The joint venture provides the Company with a distribution channel in the China and Asia-Pacific region for the Company’s application-based Voice over Internet Protocol gateway solutions, billing systems, value-added applications and web filtering solutions. Due to the shared decision making between the Company and its equity partner, the results of BeTrue are treated as an equity investment rather than being consolidated. The Company determined that since BeTrue was a business, BeTrue did not fall under the scope of the Financial Accounting Standards Board Interpretation No. 46, “Consolidation of Variable Interest Entities” and there was no impact on the Company’s financial position or results of operations.
The Company purchased the 51% interest in BeTrue for $100,000 from NeTrue Communications, Inc., Shanghai Tangsheng’s former joint venture partner. The Company also contributed to the joint venture certain next-generation communication equipment and software valued at approximately $236,000 and cash in the amount of $100,000.
Summarized financial information reported by this affiliate for the years ended December 31, 2006, 2005 and 2004 (in thousands) are as follows:
5.
Discontinued Operations
In January 2005, the Company sold substantially all of the operating assets of its NACT and MCK businesses to better focus the Company’s capital and management resources on areas which the Company believes have greater potential given its strategy to focus on next-generation network and solutions to improve cash utilization. In addition, the Company disposed of its NACT business because the Company wanted to move toward an open-standards, pre-paid next-generation solution that could better address growing market opportunities and enable the Company to offer a competitive product for Tier 1 and Tier 2 carriers. The Company believes that the I-Master platform which the Company acquired from WSECI in March 2005, after forming a strategic partnership with WSECI in the latter half of 2004, permits the Company to offer a better solution. Further, the Company disposed of its MCK business because the Company intends to focus on next-generation solutions for service providers and the products of MCK business did not fit that profile. The operations of NACT and MCK businesses have been reclassified as discontinued operations in the Company’s consolidated financial statements.
The loss on the sale of the NACT business recorded in 2004 totaled $11.4 million. The loss includes a reduction in net asset values of approximately $10.9 million and a provision for estimated closing costs and expenses of approximately $500,000. The loss on the sale of the MCK business recorded in 2004 totaled $3.4 million. The loss includes a reduction in net asset values of approximately $2.9 million and a provision for estimated closing costs and expenses of approximately $500,000.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
5.
Discontinued Operations - (Continued)
Summary operating results of the discontinued operations (in thousands) are as follows:
The operating loss from discontinued operations in 2005 includes general and administrative costs of $97,000, sales and marketing costs of $104,000, research and development costs of $275,000 and depreciation and amortization of $61,000.
The operating loss from discontinued operations in 2004 includes general and administrative costs of $2.9 million, sales and marketing costs of $4.0 million, research and development costs of $5.0 million, depreciation of $979,000, amortization of intangibles of $1.6 million, reorganization costs of $140,000 and other income of $27,000.
Assets and liabilities of discontinued operations (in thousands) are as follows:
In connection with the disposition of the MCK business, CITEL Technologies Limited (“Citel U.K.”) and CITEL Technologies, Inc. (“Citel U.S.” and together with CITEL U.K., “CITEL”) issued to the Company a convertible secured promissory note in principal amount of $3.5 million (the “Note”). The outstanding principal under the Note accrues interest at an annual rate of 6% and has remaining payments with all interest accrued thereon of eight monthly payments of $60,000 followed by sixteen monthly payments of $75,000, with all remaining outstanding principal and interest under the Note payable on January 21, 2008. Under certain circumstances described in the Note, all or any portion of the principal outstanding under the Note may be converted at the Company’s option into shares of the capital stock of Citel U.K. Citel U.K.’s and Citel U.S.’ obligations under the Note are secured by a security interest in certain assets sold to CITEL.
On June 30, 2006, in connection with the completion of the admission (“Admission”) of Citel U.K.’s entire issued share capital to the AIM market of the London Stock Exchange plc (“AIM”), the Company and Citel amended the Note such that the principal balance of the Note becomes due and payable as follows: $870,000 to be paid within one business day of Admission, followed by six monthly installments of $75,000 commencing 12 months from the date of Admission, and all remaining outstanding principal and accrued interest under the Note being due and payable on January 21, 2008. The $870,000 was received in July 2006. The Company agreed to irrevocably waive its rights to be prepaid the Note in accordance with the terms of the Note as a result of (and limited
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
5.
Discontinued Operations - (Continued)
to the transactions associated with) the Admission; however the waiver given by the Company does not waive any subsequent right to be prepaid under the Note in accordance with its terms.
Accrued rent relates primarily to several leases for buildings and equipment that are no longer being utilized in continuing operations. The accrual is for all remaining payments due on these leases less estimated amounts to be paid by any sublessors. The accrual contains one lease with total payments remaining through January 31, 2010 of $1.2 million and assumes that the building will be sub-leased for approximately 58% of the total lease liability over the remaining term of the lease.
In the second quarter of 2006, the Company prepaid the remaining lease obligations through March 31, 2007 totaling $1,223,000 for the lease related to the former MCK headquarters lease in order to release a $1,551,000 letter of credit which was reducing the Company’s borrowing capacity by the same amount. Sublease payments of $114,000 will continue on this facility remaining through March 2007.
The activity in the liabilities of discontinued operations (in thousands) was as follows:
6.
Financing Arrangements
On September 20, 2006, the Company entered into a Security Agreement (the “Security Agreement”) with Laurus which provides for a three-year, $14.0 million revolving credit facility (the “Credit Facility”). The Credit Facility with Laurus replaces the Company’s prior $10.0 million credit facility with Silicon Valley Bank (“Silicon”).
The Credit Facility with Laurus consists of two tranches: (i) an $8.0 million tranche, the availability of which is subject to a borrowing base (“Tranche A”); and (ii) a $6.0 million tranche, of which $4.0 million was immediately available, of which an additional $1 million was made available in connection with the iMarc acquisition at December 31, 2006 and the remaining $1 million of which will be available when the Company generates EBITDA (earnings before interest, income taxes, depreciation and amortization and non-cash stock compensation expense) in excess of $500,000 in any one fiscal quarter (“Tranche B”). Borrowing availability under Tranche B is not subject to a borrowing base. Borrowing ability under Tranche A is determined pursuant to a formula which is based on the value of the Company’s eligible accounts receivables and inventory. Borrowings under Tranche A accrue interest at a rate of prime rate plus 2%, provided that the interest rate shall not be less than 9% (10.25% at December 31, 2006). Borrowing ability under Tranche B is available immediately but the $6.0 million availability limit under Tranche B will be reduced by $187,500 per month beginning February 1, 2007, and borrowings under Tranche B accrue interest at a fixed rate of 15%. Borrowings under the Credit Facility shall be made first under Tranche B to the extent of availability thereunder and then under Tranche A to the extent of availability thereunder.
The Company’s obligations under the Credit Facility are secured by a first priority security interest in all of the Company’s assets and a pledge of all of the outstanding equity interests of Telemate.net and Verilink. Under the terms of the Security Agreement, the Company may not declare dividends or incur any additional indebtness without the consent of Laurus.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
6.
Financing Arrangements - (Continued)
In connection with the Credit Facility, the Company issued to Laurus (i) a perpetual warrant to purchase 600,000 shares of the Company’s common stock, at an exercise price of $.01 per share; and (ii) a five-year warrant to purchase 1,321,877 shares of the Company’s common stock at an exercise price of $0.91 per share, which was the average closing price of the common stock for the ten-trading day period immediately prior to the closing of the Credit Facility. The exercise price of the warrants and the number of shares of common stock issuable upon exercise of the warrants are subject to adjustment for stock splits, stock dividends, recapitalizations and similar corporate events but not for any other dilutive events.
The value of the warrants issued to Laurus to purchase 600,000 shares and 1,321,877 shares of common stock was $554,000 and $958,000, respectively, and such amounts plus fees and expenses of $548,000 have been recorded as loan issuance costs. In connection with the Credit Facility, on September 20, 2006, the Company issued a placement agent (“Agent”) a five-year warrant to purchase 192,000 shares of common stock at an exercise price of $1.25 per share as partial consideration for business advisory services rendered to the Company (the “Placement Agent Warrant”). The value of the Placement Agent Warrant issued was $132,000 and was recorded as loan origination fees and is being amortized over the term of the Credit Facility. Pursuant to the Security Agreement, the Company paid Laurus Capital Management, LLC, an affiliate of Laurus, a fee of 3.5% of the total facility amount, or $490,000, plus expenses. The fees were recorded as loan origination fees and is being amortized over the term of the Credit Facility.
The Company has also agreed to issue to Laurus a five-year warrant to purchase 660,939 shares of common stock at an exercise price of $0.91 per share (the “Additional Warrant”) upon the earlier of (i) the date which is 18 months after the date of the closing of the Credit Facility and (ii) the date upon which the borrowing availability under Tranche B equals $6.0 million (without regard to the monthly deductions thereto commencing on February 1, 2007). The Additional Warrant is on substantially the same terms as the warrant to purchase 1,321,877 shares of common stock.
In connection with the iMarc Acquisition, the Company obtained from Laurus its consent to the iMarc Acquisition and its waiver of certain conditions under the Credit Facility which the Company would otherwise have been required to satisfy before having access to additional borrowing availability under the Credit Facility. In exchange for such consent and waiver, the Company issued to Laurus on December 29, 2006 a perpetual warrant to purchase 150,000 shares of the Company’s common stock (the “Common Stock”) at an exercise price of $.01 per share (the “Penny Warrant”). In addition, the Company issued to Laurus a five-year warrant to purchase 330,470 shares of Common Stock at an exercise price of $0.91 per share, which warrant the Company was obligated to issue under the Credit Facility upon the increase in borrowing availability thereunder (the “Additional Warrant” and, together with the Penny Warrant, the “Warrants”). The Warrants are subject to adjustment for stock splits, stock dividends, recapitalizations and similar corporate events but not for any other dilutive events.
The total loan issuance costs for the Laurus Credit Facility in 2006 was $3.0 million including the value of the warrants issued to Laurus and to the Placement Agent of $2.1 million. Loan issuance costs are recognized in accordance with APB 21, “Interest on Receivable and Payables,” and are recorded as a deferred charge on the Company’s balance sheet. The Company amortizes these costs over the original term of the notes. Amortization is calculated based on the interest method for Tranche B or straight line method for Tranche A based on an allocation of the costs over the relative fair values of the line of credit and term debt.
During the years ended December 31, 2006, 2005 and 2004, the Company recorded interest expense from the amortization of the loan issuances costs of approximately $528,000, $134,000 and $338,000, respectively. In 2006 in connection with the termination of the Silicon Credit Agreement, the Company expensed the unamortized portion of the loan origination fees of approximately $101,000. The unamortized loan origination fees associated with the Laurus Credit Facility totaled approximately $2.7 million at December 31, 2006.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
6.
Financing Arrangements - (Continued)
In connection with the Credit Facility and to evidence the transactions contemplated thereby, the Company also entered into an Intellectual Property Security Agreement, a Stock Pledge Agreement, a Secured Non-Convertible Tranche A Revolving Note and a Secured Non-Convertible Tranche B Revolving Note, as well as a Registration Rights Agreement.
Prior to the completion of the Credit Facility with Laurus, the Company had a line of credit with Silicon Valley Bank (“Silicon”). The Company’s line of credit with Silicon (the “Silicon Credit Agreement”) was terminated in September 2006.
As of December 31, 2006, the Company had outstanding borrowings under Tranche A and Tranche B of the Laurus credit facility of $2,883,000 and $5,000,000, respectively. The remaining borrowing availability under the credit facility at December 31, 2006 was $3 million under Tranche A and $0 under Tranche B. The $5 million will be amortized as follows: $1,063,000 in 2007; $2,250,000 in 2008 and $1,687,000 in 2009.
7.
Convertible Debentures
Senior Unsecured Convertible Debentures
On February 4, 2005, the Company completed a private placement of senior unsecured convertible debentures and warrants pursuant to a securities purchase agreement with certain institutional investors. The Company issued $13.5 million of senior unsecured convertible debentures, Series A warrants exercisable for 2.2 million shares of the Company’s common stock and Series B warrants exercisable for 2.0 million shares of the Company’s common stock. The debentures have been discounted to reflect the fair value of the warrants issued, totaling approximately $4.5 million. In addition, after allocation of the fair value of the warrants issued, the remaining fair value of the debentures resulted in a computed beneficial conversion feature with a fair value of $3.6 million. The amount was recorded as a discount in the third quarter as a result of additional analysis of the calculation of the beneficial conversion feature.
The discount is being amortized to interest expense over the life of the senior unsecured convertible debentures. The unamortized discount totaled approximately $4.0 million at December 31, 2006 and approximately $6.5 million at December 31, 2005. The senior unsecured convertible debentures bear interest at a rate of 6% per annum increasing to 6.75% at February 4, 2006, and are due February 2009 and are convertible into approximately 5.4 million shares of the Company’s common stock at an initial conversion price of $2.50 per share, subject to anti-dilution adjustments and certain limitations. Interest is payable on a quarterly basis beginning April 2005 and principal is payable on a quarterly basis beginning August 2006. The Series A warrants issued in connection with the private placement are exercisable for a period of five years commencing on February 4, 2005 and at an initial exercise price, subject to anti-dilution adjustments of $3.60 per share.
The Series B warrants issued in connection with the private placement were exercisable for a period of 90 days, commencing on June 16, 2005, and had an exercise price of $3.90 per share. The Series B warrants expired in September 2005. The Company paid certain private placement fees and attorney’s fees totaling $993,000 and issued Series A warrants, on the same terms as disclosed above, exercisable for 302,400 shares of the Company’s stock with a value of $561,000, in connection with the private placement. The fees were recorded as loan origination fees and are being amortized to interest expense over the term of the debentures. The unamortized fees totaled approximately $1.2 million at December 31, 2005. In connection with the private placement, the Company received net proceeds of approximately $12.5 million, including $1.6 million in restricted cash, net of expenses.
VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
7.
Convertible Debentures - (Continued)
Convertible Subordinated Debentures
On July 25, 2005, the Company announced that it had restructured its outstanding 7.5% convertible debenture with an aggregate principal amount of $4,500,000 due November 22, 2005. Pursuant to the restructuring, the entire aggregate principal amount outstanding has been paid as of October, 2006.
In connection with the restructuring, the Company issued warrants to purchase an aggregate of 800,000 shares of the Company’s common stock at an initial exercise price of $2.50 per share exercisable beginning on November 22, 2005. Of these warrants, 600,000 expire in July 2007. The remaining 200,000 expire in February 2011. The fair value of the warrants issued totaled approximately $877,000 and was recorded as additional discount on the debentures. As of December 31, 2006, the discount was fully amortized to interest expense.
8.
Notes Payable
On February 12, 2003, the Company acquired substantially all the operating assets and certain related liabilities of Clarent. At the closing of the acquisition, the Company issued a $3.0 million secured note due February 12, 2008, which bears interest at 5% per annum, discounted at 7.5% per annum. The unamortized discount totaled approximately $138,000 at December 31, 2006. The assets the Company purchased from Clarent secure the secured notes; this note payable is subordinate to the Laurus debt.
9.
Reorganization Costs
In the fourth quarter of 2006, the Company terminated a senior executive. As a result of this action, the Company recorded reorganization costs of $674,000, consisting of severance costs of $596,000 and non-cash stock compensation expense of $78,000.
In the first quarter of 2005, the Company disposed of substantially all of the operating assets of NACT and MCK, which resulted in six corporate positions being eliminated. In the third quarter of 2005, the Company terminated a senior executive. As a result of these actions, the Company recorded reorganization costs of $464,000, consisting of severance costs, during the year ended December 31, 2005.
In the second quarter of 2005, the Company entered into a sublease agreement with an unrelated party to sublease excess office space at its facility in Atlanta, Georgia. The excess space was primarily due to reductions in the corporate staffing over the past several years. As a result of these actions, the Company recorded an accrual for all remaining payments due on this lease, less amounts to be paid by the sublessor. Total payments remaining through January 31, 2010 are $3.1 million and the sublease total payments are $836,000 over the remaining term of the lease. The Company recorded reorganization costs of $2.6 million during the year ended December 31, 2005. The charge represents the difference between the lease and the sublease for the entire remaining term, as well as write-offs for furniture and leasehold improvements. The Company expects to save approximately $1.6 million over the term of the sublease, which expires January 31, 2010.
In the first quarter of 2004, the Company terminated a senior executive. In the fourth quarter of 2004, the Company initiated certain restructuring plans to improve operational efficiencies and financial performance and eliminated 20 positions held by employees. As a result of these actions, the Company recorded reorganization costs of $1.4 million during the year ended December 31, 2004, which included severance costs of $830,000 and non-cash stock compensation of $570,000.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
10.
Shareholders’ Equity
Preferred Stock
The Company has 200,000 shares of authorized preferred stock, 6,000 of which were designated as Series A Convertible Preferred Stock (“Series A Preferred Stock”) and 10,000 of which has been designated as Series C Preferred Stock. All 6,000 shares of the Series A Preferred Stock have been converted into 60,000 shares of the Company’s common stock.
As described in Note 3- Mergers and Acquisitions: Business Assets of Verilink, as part of the purchase price, the Company issued 8,766 shares of its newly-designated Series C preferred stock. The shares of preferred stock automatically converted into 2,900,000 shares of common stock upon the effectiveness of an amendment to the Company’s articles of incorporation to increase the number of authorized shares of common stock as specified in the Statement of Rights of the Series C Preferred Stock. Such amendment was effective on November 7, 2006, and the shares of preferred stock have converted into 2,900,000 shares of common stock.
Private Placement
On February 17, 2006, the Company issued, in a private placement, 5.4 million shares of its common stock and warrants to purchase 5.4 million shares of its common stock for an aggregate purchase price of approximately $7.1 million, or $1.30 per share. The warrants issued in connection with the private placement are exercisable, after six months, for a period of five years and at an exercise price of $1.56 per share. The Company received approximately $6.8 million, net of expenses.
On February 24, 2004, the Company completed a private placement of securities pursuant to which it issued 2.0 million shares of its common stock and warrants to purchase 491,505 shares of its common stock for an aggregate purchase price of $17.7 million, or $9.00 per share. The warrants issued in connection with the private placement are exercisable for a period of seven years at an exercise price of $11.50 per share. The Company received approximately $16.5 million, net of expenses, from the private placement of these securities.
Stock Warrants
In connection with various financing and acquisition transactions, and related services provided to the Company, the Company has issued warrants to purchase the Company’s common stock.
On September 20, 2006, the Company entered into a Security Agreement (the “Security Agreement”) with Laurus which provides for a three-year, $14.0 million revolving credit facility (the “Credit Facility”). The Credit Facility with Laurus replaces the Company’s prior $10.0 million credit facility with Silicon. In connection with the Credit Facility, the Company issued to Laurus (i) a perpetual warrant to purchase 600,000 shares of the Company’s common stock, at an exercise price of $.01 per share; and (ii) a five-year warrant to purchase 1,321,877 shares of the Company’s common stock at an exercise price of $0.91 per share, which was the average closing price of the common stock for the ten-trading day period immediately prior to the closing of the Credit Facility. The exercise price of the warrants and the number of shares of common stock issuable upon exercise of the warrants are subject to adjustment for stock splits, stock dividends, recapitalizations and similar corporate events but not for any other dilutive events.
The value of the warrants issued to Laurus to purchase 600,000 shares and 1,321,877 shares of common stock was $554,000 and $958,000, respectively, and such amounts plus fees and expenses of $548,000 have been recorded as loan issuance costs. In connection with the Credit Facility, on September 20, 2006, the Company issued a placement agent (“Agent”) a five-year warrant to purchase 192,000 shares of common stock at an exercise price of $1.25 per share as partial consideration for business advisory services rendered to the Company (the “Placement Agent Warrant”). The value of the Placement Agent Warrant issued was $132,000 and was recorded as loan issuance costs and are being amortized over the term of the Credit Facility. Pursuant to the Security Agreement, the
VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
10.
Shareholders’ Equity - (Continued)
Company paid Laurus Capital Management, LLC, an affiliate of Laurus, a fee of 3.5% of the total facility amount, or $490,000, plus expenses. The fee was recorded as loan issuance costs and are being amortized over the term of the Credit Facility.
The Company has also agreed to issue to Laurus a five-year warrant to purchase 660,939 shares of common stock at an exercise price of $0.91 per share (the “Additional Warrant”) upon the earlier of (i) the date which is 18 months after the date of the closing of the Credit Facility and (ii) the date upon which the borrowing availability under Tranche B equals $6.0 million (without regard to the monthly deductions thereto commencing on February 1, 2007). When issued, the Additional Warrant shall be on substantially the same terms as the warrant to purchase 1,321,877 shares of common stock. The Company also agreed to file no later than 60 days after the closing of the Credit Facility a registration statement with the Securities and Exchange Commission to register pursuant to the Securities Act of 1933, as amended (the “Securities Act”), the resale of the shares common stock issuable upon exercise of the warrants issued to Laurus. This registration statement was filed on November 3, 2006, but has not yet been declared effective.
In connection with the iMarc acquisition, the Company obtained from Laurus its consent to the acquisition and its waiver of certain conditions under the Credit Facility which the Company would otherwise have been required to satisfy before having access to additional borrowing availability under the Credit Facility. In exchange for such consent and waiver, the Company issued to Laurus on December 29, 2006 a perpetual warrant to purchase 150,000 shares of the Company’s common stock (the “Common Stock”) at an exercise price of $.01 per share (the “Penny Warrant”). In addition, the Company issued to Laurus a five-year warrant to purchase 330,470 shares of Common Stock at an exercise price of $0.91 per share, which warrant the Company was obligated to issue under the Credit Facility upon the increase in borrowing availability thereunder (the “Additional Warrant” and, together with the Penny Warrant, the “Warrants”). The Warrants are subject to adjustment for stock splits, stock dividends, recapitalizations and similar corporate events but not for any other dilutive events. The value of the Penny Warrant and Additional Warrant issued to Laurus was $173,000 and $304,000, respectively and the amounts have been recorded as loan issuance costs and are being amortized over the remaining term of the Credit Facility.
On February 17, 2006, the Company issued, in a private placement, 5.4 million shares of its common stock and warrants to purchase 5.4 million shares of its common stock for an aggregate purchase price of approximately $7.1 million, or $1.30 per share. The warrants issued in connection with the private placement are exercisable, after six months, for a period of five years and at an exercise price of $1.56 per share.
In February 2005, the Company issued 2.2 million Series A warrants with an exercise price of $3.60 and 2.0 million Series B warrants with an exercise price of $3.90 in connection with the Company’s private placement on February 4, 2005 (see Note 7). The Series B warrants issued in connection with the private placement were exercisable for a period of 90 days after the effective date of a registration statement and expired in September 2005. The Company also issued 302,400 Series A warrants with an exercise price of $3.60 to pay certain private placement fees.
In July 2005, the Company issued 800,000 warrants with an exercise price of $0.50 in connection with the restructuring of its outstanding 7.5% convertible debenture with an aggregate principal amount of $4.5 million due November 22, 2005 (see Note 7). Of these warrants, 600,000 expire July 1, 2007 and the remaining 200,000 have a five year term.
During 2005, 2,506 warrants with an exercise price of $0.05 were exercised and 3.4 million expired with an exercise price range of $3.90 - $28.25.
During 2004, the Company issued 491,505 warrants in connection with the Company’s private placement on February 24, 2004, as discussed above.
VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
10.
Shareholders’ Equity - (Continued)
A summary of warrants outstanding as of December 31, 2006, is as follows:
As of December 31, 2006, all of the warrants are vested.
The exercise price and number of outstanding warrants for certain warrants previously issued have been adjusted according to their antidilution provisions.
11.
Stock Incentive Plan
The Company has a stock incentive plan for employees, consultants, and other individual contributors to the Company which enables the Company to grant up to 7.0 million qualified and nonqualified incentive stock options as well as other stock-based awards (the “1999 Plan”). In 2004, the 1999 Plan was amended to increase the number of shares of the Company’s stock underlying the 1999 Plan from 3.0 million to 3.5 million and in 2007 the 1999 Plan was amended to increase the number of shares of the Company’s stock underlying the 1999 Plan from 3.5 million to 7.0 million. The Company adopted the 1999 Plan which aggregates the Company’s prior stock option plans, in the second quarter of 1999. The qualified options granted under the 1999 Plan must be granted at an exercise price not less than the fair market value at the date of grant. The compensation committee of the Company’s board of directors determines the period within which options may be exercised, but no option may be exercised more than ten years from the date of grant.
The 1999 Plan also provides for stock purchase authorizations, stock bonus awards and issuance of restricted stock. Stock awards totaling 486,936, 39,521 and 9,988 have been granted under the 1999 Plan for the years ended December 31, 2006, 2005 and 2004, respectively. The stock awards for 2006 include 420,000 shares granted the Company’s board of directors in November 2006 for their board services during 2006. The shares were immediately vested upon issuance and the Company recorded $500,000 of stock-based compensation. In December 2006, a former senior executive was issued 66,936 shares in connection with a separation arrangement which resulted in $78,000 of stock-based compensation which was classified as reorganization costs in the consolidated statement of operations. Total awards remaining available for grant under the 1999 Plan as of December 31, 2006 were 1,573,787.
Upon the acquisition of Cereus Technology Partners, Inc. (“Cereus”) in September 2000, the Company assumed the Cereus Technology Partners, Inc. 1997 Stock Option Plan (the “Cereus Plan”), and the options outstanding thereunder. The options outstanding under the Cereus Plan were converted at a rate of 1.75 shares of the Company’s common stock per share of Cereus’ common stock at the time of the acquisition and totaled 275,342. These options, at the time of acquisition, had an estimated fair value of $2.8 million using the Black-Scholes option pricing model based on the following weighted-average assumptions: expected volatility - 88%; expected life - five years; risk-free interest rate - 5.5%; and expected dividend yield - 0%, was included in the cost of the acquisition. The Company does not plan to issue any additional shares under the Cereus Plan.
In connection with the acquisition of Cereus, the Company recorded deferred compensation of approximately $6.9 million for the aforementioned options granted by Cereus prior to the acquisition which were exchanged for
VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
11.
Stock Incentive Plan - (Continued)
options to purchase the Company’s common stock. The Company amortized deferred compensation over four years, the vesting period of the options. The Company amortized to non-cash compensation expense approximately $7,000 and $435,000 of the deferred compensation related to these option grants for the years ended December 31, 2005 and 2004, respectively. They were fully amortized in 2005. The Company accelerated vesting and extended the exercise date on an option grant for a terminated senior executive (see Note 9). As a result, the Company recorded a non-cash charge of approximately $570,000 for the year ended December 31, 2004, representing the value of the accelerated vesting and extended exercise date. The expense is included in reorganization costs.
A summary of the status of the Company’s stock options granted to employees as of December 31, 2006, December 31, 2005, and December 31, 2004 and the changes during the years ended on these dates is presented below:
The Company defines in-the-money stock options at December 31, 2006 as options that had exercise prices that were lower than the $1.16 market price of our common stock at that date. The aggregate intrinsic value of options outstanding at December 31, 2006 is calculated as the difference between the exercise price of the underlying options and the market price of our common stock. As of December 31, 2006, there were 2,269,008 stock options outstanding that were in-the- money of which 64,008 of these were exercisable. The aggregate intrinsic value of stock options outstanding and stock options exercisable as of December 31, 2006 was $26,000 and $4,000, respectively. The aggregate intrinsic value of options exercised during 2006 was $1,000.
A summary of the status of nonvested stock options at December 31, 2006, and the changes during the year ended December 31, 2006 is presented below:
VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
11.
Stock Incentive Plan - (Continued)
The following table summarizes information about employee stock options and the above warrants granted by Cereus prior to its acquisition by the Company, outstanding at December 31, 2006:
12.
Stock Option Exchange Program
Effective November 7, 2006, the shareholders and board of directors approved a voluntary exchange of options for shares of restricted common stock “Exchange Program” that, if and when implemented, will permit the current officers, non-employee directors and employees of the Company and its subsidiaries, (“Eligible Holders”), to exchange all outstanding options to purchase shares of Common Stock held by them (“Eligible Options”) for a lesser number of shares of Common Stock to be granted as a restricted stock award under, and subject to the terms of, the Incentive Plan. For every Eligible Option to purchase four shares of Common Stock surrendered by an Eligible Holder in the Exchange Program, the Company will grant to such holder one share of restricted Common Stock pursuant to the Incentive Plan (the “Exchange Ratio”). The Exchange Ratio is intended to result in the grant of restricted Common Stock awards having an aggregate value much lower than the aggregate value of the Eligible Options surrendered, determined using the Black-Scholes option valuation model. Each award of restricted Common Stock granted in the Exchange Program to any Eligible Holder other than a non-employee director of the Company will vest in two equal installments on each of the four-month anniversary and the 12-month anniversary of the date of grant of such award. Each award of restricted Common Stock granted in the Exchange Program to any non-employee director of the Company will be vested in its entirety on the date of grant. Notwithstanding the foregoing, an award of restricted Common Stock will terminate and will not vest if the grantee of such award is not an employee or director of the Company or one of its subsidiaries as of the date such award is granted and on each date on which it vests.
The Company expects that 2,047,931 Eligible Options will be eligible for exchange, and approximately 511,983 shares of restricted Common Stock will be issued if all Eligible Options are surrendered in the Exchange Program. The exercise prices of such Eligible Options range from $1.00 to $90.00 per share, and these options are held by 168 Eligible Holders.
It is currently anticipated that the Exchange Program will commence in the first half of 2007. The Board of Directors will retain the authority, in its discretion, to terminate or postpone the Exchange Program at any time prior to the expiration of the election period under the Exchange Program (provided, however, in no event will the Exchange Program permit the issuance of restricted Common Stock awards having a greater aggregate value than the aggregate value of the stock options surrendered, as estimated using the Black-Scholes option valuation model).
VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
13.
Income Taxes
The components of loss from continuing operations, before income taxes were (in thousands):
A reconciliation of the statutory U.S. federal income tax rate to the Company’s effective tax was as follows:
Deferred income taxes are recognized to reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the Company’s net deferred tax assets are as follows (in thousands):
The valuation allowance for deferred tax assets as of December 31, 2006, was approximately $74.7 million. The decrease of $10.1 million, the increases of $11.4 million and $13.5 million in the total valuation allowance for 2006, 2005 and 2004, respectively, are due to changes in the above described temporary differences on which a valuation allowance was provided.
VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
13.
Income Taxes - (Continued)
A portion of the Company’s deferred tax assets are attributable to acquisitions accounted for as purchase transactions. The valuation allowances associated with these deferred assets will be credited to goodwill if and when realized. Based on the level of historical taxable income and projections for future taxable income over the periods in which the deferred tax assets are deductible, the Company’s management believes it is more likely than not that the Company will not realize the benefits of the deferred tax assets as of December 31, 2006 and 2005.
At December 31, 2006, the Company had net operating loss (“NOL”) carry-forwards of approximately $166.2 million and other business tax credits of approximately $1.2 million, a substantial portion of which are subject to certain limitations under the Internal Revenue Code Section 382. If not utilized, the NOLs will continue to expire through the year 2026. In addition the Company had foreign investment tax credits totaling approximately $729,000 which begin expiring in years 2014 through 2026.
14.
Savings and Retirement Plan
The Company sponsors a 401(k) savings and retirement plan which is available to all eligible employees. Under the plan, the Company may make a discretionary matching contribution. Discretionary matching contributions less forfeitures from continuing operations were approximately $157,000, $89,000 and $244,000 for the years ended December 31, 2006, 2005 and 2004, respectively.
15.
Employee Stock Purchase Plan
On November 16, 1999, the Company adopted the Verso Technologies, Inc. 1999 Employee Stock Purchase Plan (the “Stock Purchase Plan”). Under the Stock Purchase Plan, full-time or part-time employees, except persons owning 5% or more of the Company’s common stock, who have worked for the Company for at least 15 consecutive days before the beginning of the offering period are eligible to participate in the Stock Purchase Plan. Employees may elect to have withheld up to 10% of their annual salary up to a maximum of $25,000 per year to be applied to the purchase of the Company’s unissued common stock. The purchase price was generally equal to 85% of the lesser of the market price on the beginning or ending date of the offering periods up until December 31, 2005 at which time the Stock Purchase Plan was amended. The amended plan called for the purchase price to be 95% of the market price on the ending date of the offering period. In 2004, the Stock Purchase Plan was amended to increase the amount of shares of the Company’s common stock underlying the plan from 200,000 to 300,000. Shares of the Company’s common stock issued under the Stock Purchase Plan were 17,916, 50,103 and 35,468 for the years ended December 31, 2006, 2005 and 2004, respectively.
16.
Other Commitments and Contingencies
Leases
The Company leases office space and certain equipment under operating leases which expire at various dates through 2010 with some leases containing options for renewal. Rent expense for continuing operations under these leases was $2.3 million, $2.0 million and $2.2 million for the years ended December 31, 2006, 2005 and 2004, respectively.
VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
16.
Other Commitments and Contingencies - (Continued)
As of December 31, 2006, approximate future commitments under operating leases and future minimum rentals to be received under noncancelable subleases in excess of one year are as follows (in thousands):
The Company remains a guarantor on a lease through December 2009 used in the operations of the NACT business, which the Company sold in January 2005. The total remaining commitment related to this lease is approximately $1.9 million.
Canadian Tax Audit
On March 7, 2006, the Canada Revenue Agency (the “CRA”) notified 38098 Yukon Inc. (formerly known as MCK Telecommunications Inc.), a corporation organized under the laws of the Yukon Territory (“MCK Canada‘’) and an indirect wholly owned subsidiary of the Company, that the CRA had completed its international income tax audit of MCK Canada for the period from May 1, 1998 to April 30, 2000 (the “Audit‘’). As a result of the Audit, the CRA has issued income tax reassessments to MCK Canada. In addition, the Alberta Tax and Revenue Administration (the “ATR”’) has issued reassessments for each year of the Audit.
The key issue under dispute in the audit is the valuation of certain intellectual property that was transferred from MCK Canada to its U.S. parent company, MCK Communications, Inc. (“MCK US”’) in fiscal 1998. MCK US consulted with outside valuation advisors to establish the value of the intellectual property transferred. The CRA and the ATR disagree with such value. The Company and its advisors disagree with the reassessments, and the Company has filed notices of objection with respect thereto with the CRA and the ATR and intends, if necessary, to exhaust all of its rights of appeal in connection therewith.
The Company estimates that, as of March 31, 2007, (i) the amount of taxes allegedly due in respect of the CRA reassessments was approximately U.S. $7.7 million (plus penalties and interest thereon of approximately U.S. $9.1 million); and (ii) the amount of taxes allegedly due in respect of the ATR reassessments was approximately U.S. $3.5 million (plus penalties and interest thereon of approximately U.S. $3.8 million). The Company has been advised by its Canadian and U.S. counsel that no such amounts should be collectible by the CRA or the ATR against the Company or any of its other subsidiaries (other than MCK Canada) and that the ability of the CRA and the ATR to collect such amounts should be limited to the assets of MCK Canada, which have little or no value. Accordingly, no provision for this matter has been recorded in the Company’s financial statements because the Company believes that it will not have a financial statement impact.
17.
Segment Information
The Company reports information for two segments, the Technologies Group and the Advanced Applications Services Group. Previously the Company reported two segments, the Carrier Solutions Group and the Enterprise Solutions Group. Following the dispositions of the NACT and MCK businesses, the Company re-evaluated its internal reporting and decision-making and segregated the activity of the Advanced Applications Services Group and combined the remaining operations of the Carrier Solutions Group and Enterprise Solutions Group into the
VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
17.
Segment Information - (Continued)
Packet-based Technologies Group. Management evaluates the business segment performance based on contributions before unallocated items. Inter-segment sales and transfers are not significant.
Technologies Group:
The Technologies Group includes the Company’s softswitching, I-Master, and NetPerformer divisions, the Company’s Telemate.Net Software, Inc. subsidiary (“Telemate.Net”), and the Company’s Verso Verilink, LLC subsidiary (“Verso Verilink”). The Technologies Group includes domestic and international sales of hardware and software, integration, applications and technical training and support. The Technologies Group offers software-based solutions (which include hardware) for companies seeking to build private, converged packet-based voice and data networks. In addition, the Technologies Group offers software-based solutions for Internet access and usage management that include call accounting and usage reporting for Internet protocol network devices. In 2006, the Technologies Group added the product suites from the Verilink Acquisition and the iMarc Acquisition. These products provide access, multiplexing and transport of voice and data services.
Advanced Applications Services Group:
The Company’s Advanced Applications Services Group, consists of the Company’s technical applications support group which was previously included as part of the Enterprise Solutions Group, and includes outsourced technical application services and application installation and training services to both customers of the Technologies Group and outside customers.
Summarized financial information concerning the Company’s reportable segments is shown in the following table (in thousands):
VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
17.
Segment Information - (Continued)
The following table reconciles the contribution before unallocated items to the loss before discontinued operations (in thousands):
The following table reconciles the segment total assets to the Company’s total assets:
VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
17.
Segment Information - (Continued)
Following the acquisition of substantially all the operating assets along with certain liabilities of Clarent in February 2003, the Company began conducting research and development in Canada. International sales of the Company’s products and services continue to originate only from the United States. The geographic distribution of the Company’s revenue and contribution before unallocated items (in thousands) are as follows:
18.
Litigation
From time to time, the Company is involved in litigation with customers, vendors, suppliers and others in the ordinary course of business, and a number of such claims may exist at any given time. All such existing proceedings are not expected to have a material adverse impact on the Company’s results of operations or financial condition. In addition, the Company or its subsidiaries are a party to the proceedings discussed below.
In December 2001, a complaint was filed in the Southern District of New York seeking an unspecified amount of damages on behalf of an alleged class of persons who purchased shares of MCK’s common stock between the date of MCK’s initial public offering and December 6, 2000. The complaint named as defendants MCK and certain of its former officers and other parties as underwriters of its initial public offering (the “MCK defendants”). The plaintiffs allege, among other things, that MCK’s prospectus, contained in the Registration Statement on Form S-1 filed with the SEC, was materially false and misleading because it failed to disclose that the investment banks which underwrote MCK’s initial public offering of securities and others received undisclosed and excessive brokerage commissions, and required investors to agree to buy shares of securities after the initial public offering was completed at predetermined prices as a precondition to obtaining initial public offering allocations. The plaintiffs further allege that these actions artificially inflated the price of MCK’s common stock after the initial public offering.
This case is one of many with substantially similar allegations known as the “Laddering Cases” filed before the Southern District of New York against a variety of unrelated issuers (the “Issuers”), directors and officers (the “Laddering Directors and Officers”) and underwriters (the “Underwriters”), and have been consolidated for pre-trial purposes before one judge to assist with administration. A motion to dismiss addressing issues common to the companies and individuals who have been sued in these actions was filed in July 2002. After a hearing on the motion to dismiss the Court, on February 19, 2003, denied dismissal of the claims against MCK as well as other Issuers.
VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
18.
Litigation - (Continued)
Although MCK believes that the claims asserted are meritless, MCK and other Issuers have negotiated a tentative settlement with the plaintiffs. The terms of the tentative settlement agreement provide, among other things, that (i) the insurers of the Issuers will deliver a surety undertaking in the amount of $1 billion payable to the plaintiffs to settle the actions against all Issuers and the Laddering Directors and Officers; (ii) each Issuer will assign to a litigation trust, for the benefit of the plaintiffs, any claims it may have against its Underwriters in the initial public offering for excess compensation in the form of fees or commissions paid to such Underwriters by their customers for allocation of initial public offering shares; (iii) the plaintiffs will release all claims against the Issuers and the Laddering Directors and Officers asserted or which could have been asserted in the actions arising out of the factual allegations of the amended complaints; and (iv) appropriate releases and bar orders and, if necessary, judgment reductions, will be entered to preclude the Underwriters and any non-settling defendants from recovering any amounts from the settling Issuers or the Laddering Directors and Officers by way of contribution or indemnification.
Prior to the Company’s acquisition of MCK, MCK’s board of directors voted to approve the tentative settlement. On February 15, 2005, the judge presiding over the Laddering Cases granted preliminary approval of the proposed settlement, subject to some changes, which were subsequently submitted. The judge issued an order on August 31, 2005, further approving modifications to the settlement and certifying the class. Notice of the settlement has been distributed to the settlement class members. The deadline for filing objections to the settlement was March 24, 2006, and a fairness hearing was held April 26, 2006. On December 5, 2006, the U.S. Court of Appeals for the Second Circuit issued a ruling reversing class certification for purposes of the litigation.
The plaintiffs have petitioned for rehearing and rehearing en banc, and the Second Circuit Court has requested additional briefing on certain issues. The Court has not yet ruled on the settlement approval motion, including the effect on the settlement class of the Second circuit’s decision regarding the litigation class. No provision was recorded for this matter in the financial statements of MCK prepared prior to its acquisition by the Company because MCK believed that its portion of the proposed settlement would be paid by its insurance carrier. The Company agrees with MCK’s treatment of this matter.
MCK was named a defendant in a lawsuit filed in Norfolk County, Massachusetts by Entrata Communications, Inc. (“Entrata”) in 2002. The case arises out of a dispute between Entrata and one of its largest shareholders, Superwire.com, Inc. (“Superwire”). Pursuant to a contract with Entrata, MCK was obligated to pay Entrata $750,000 in early 2002. In order to take advantage of a $100,000 discount offered for early payment, MCK paid Entrata $650,000 in November 2001, in full satisfaction of its contractual obligations. The funds were placed in escrow with Superwire’s California law firm, Jeffers, Shaff & Falk, LLP (“JSF”), which agreed not to disburse the funds until the dispute between Entrata and Superwire had been resolved. Nevertheless, Entrata contends that it never received the funds from MCK and that the funds were diverted to Superwire and JSF.
Through the lawsuit, Entrata seeks to recover from both MCK and Superwire the $750,000 that MCK would have owed in 2002. MCK has asserted counterclaims against Entrata, and cross-claims against Superwire, for fraud and breach of contract. On October 11, 2002, Superwire and Entrata filed cross-motions for summary judgment against each other. The court denied both motions on March 13, 2003. Following denial of the cross-motions for summary judgment, MCK filed a motion to add JSF and two of its partners, Barry D. Falk and Mark R. Ziebell, as third-party defendants. The court had given the parties until March 17, 2004 to complete discovery. Before the completion of the discovery period, Entrata filed a Chapter 7 bankruptcy proceeding pursuant to the United States Bankruptcy Code. Entrata did not continue prosecution of the case after the bankruptcy filing. On September 9, 2005, the case was dismissed without prejudice by the court for lack of prosecution.
On September 7, 2006, Entrata’s counsel filed a motion for relief from dismissal on the grounds of excusable neglect. The court granted Entrata’s motion and set an initial trial date of July 19, 2007. The Company intends to defend the claims and prosecute its counterclaims and third-party claims. No amounts, other than the original
VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
18.
Litigation - (Continued)
payment, were provided for this matter in the financial statements of MCK prepared prior to its acquisition by the Company. The Company believes that the claim against MCK is without merit, and no amount has been accrued for this matter.
19.
Subsequent Events
On January 30, 2007, February 2, 2007, February 5, 2007, and February 9, 2007, the Company entered into Securities Purchase Agreements with certain purchasers with substantially the same terms (the “Purchase Agreements”) pursuant to which the Company agreed to sell in private placements to such purchasers an aggregate of 5 million shares of the Company’s common stock (the “Common Stock”) and warrants to acquire 2.5 million shares of Common Stock (the “Investor Warrants”) for an aggregate purchase price of $5 million.
The Investor Warrants are exercisable over a 5-year period commencing with their issuance at a per share exercise price equal to $1.25. The exercise price of the Investor Warrants, but not the number of shares of Common Stock issuable upon exercise thereof, is subject to adjustment in the event of certain dilutive issuances.
In connection with the Purchase Agreements, the Company also entered into Registration Rights Agreement with the purchaser parties to the Purchase Agreements pursuant to which the Company granted to such purchaser certain registration rights with respect to the shares of Common Stock sold (including the shares of Common Stock issuable upon exercise of the Investor Warrants) under the Purchase Agreements.
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
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.
Verso Technologies, Inc.
By:
/s/ Steven A. Odom
Steven A. Odom
Executive Chairman of the Board
Date: April 2, 2007
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
EXHIBIT INDEX
E-1
E-2
E-3
E-4
E-5
E-6
E-7
E-8
E-9
E-10
E-11
E-12
E-13
E-14
E-15
E-16
E-17
E-18
E-19
E-20
E-21