ITEM 1.
Business
Overview
We provide paid-search advertising services to local and national businesses on the Internet. Our services enable businesses to list their products and services in our distributed Internet search results. By providing listings of products and services to consumers in a targeted search context, we offer businesses an effective method of advertising to consumers during the purchasing process.
Our sponsored listings are derived from our Advertiser Network, which includes our direct advertisers as well as indirect advertisers from other paid-search and directory companies. We supply these aggregated sponsored listings to our own Local.com web site and our Distribution Network, which is a network of web sites and search engines that integrate our search results into their web sites, in response to targeted keyword searches performed by Internet users on those web sites.
We generate revenue each time an Internet user initiates a search on our own Local.com web site or on our Distribution Network and clicks-through on a sponsored listing from our Advertiser Network. We generally compile these sponsored listings according to bid price, which is the amount an advertiser is willing to pay for each click-through. Advertisers pay only when an Internet user clicks-through on the advertiser’s sponsored listing. Our distribution model is designed to provide sponsored listings from our direct advertisers as well as the advertisers of other paid-search engines to our broad Distribution Network. We also generate revenue from monthly fee arrangements and display advertising (banners).
Prior to 2005, we provided search services that benefited national advertisers. During 2005, we began to transition away from national search services and to focus on local search services.
In August 2005, we launched Local.com, a consumer facing destination web site specializing in local search. Local.com uses a combination of our proprietary Keyword DNAtm and geographic web indexing technologies to provide relevant search results for local business, products and services and sponsored listings.
Industry Overview
We believe that searches for products, services and businesses within a geographic region, or local search, will be an increasingly significant segment of the online advertising industry. Although paid-search advertising has been used primarily by businesses that serve the national market, local businesses are increasingly using online advertising to attract local customers. Local search allows consumers to search for local businesses’ products or services by including geographic area, zip code, city and other geographically targeted search parameters in their search requests. Local search is relatively new, and as a result it is difficult to determine our current market share or predict our future market share; however, The Kelsey Group estimates that the local search market in the United States will grow to $6.2 billion by 2010.
Our Solution
Prior to 2005, we provided search services that benefited national advertisers. During 2005, we began to transition our resources away from national search services in order to focus on local search. In August 2005, we launched Local.com, a consumer facing destination web site specializing in local search. We believe our Local.com web site provides the following benefits to local advertisers and consumers:
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Targeted Advertising. By bidding on relevant keywords, businesses can target consumers at the exact time a consumer has demonstrated an interest, through search, in what the business has to offer. We believe that paid-search advertising delivers a more relevant list of commercial sites for Internet users because advertisers generally only bid on keywords that are related to the products and services they offer.
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Large Number of Local Advertisers and Business Listing. When Internet users perform a search on Local.com, they are able to find sponsored listings from a large number of advertisers from other paid-search and Internet yellow pages companies. In addition, we also display relevant listings from approximately 15 million businesses in the United States from our indexed listings. The breadth of advertisers within our Advertiser Network increases the likelihood that we can provide relevant sponsored listings to consumers.
We believe that this increases the possibility that consumers will click-through on one of our sponsored listings, thereby generating revenue for us as well as our Advertiser Network partner.
Our Strategy
Our objective is to be a leader in local search by increasing the number of advertisers and consumers on Local.com, by enhancing the services we currently provide and by developing new products and services. The key elements of our strategy are to:
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Increase the Number of Advertisers on Local.com. We intend to increase the number of advertisers on Local.com by selling advertising products directly to local businesses, establishing new relationships with other paid-search companies, participating in trade shows, and strengthening our brand through other marketing activities. We also intend to pursue expansion of our business into international markets where consumers, advertisers and search providers are seeking local search technologies.
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Increase the Number of Consumers on Local.com. We intend to drive more consumers to Local.com through our marketing efforts and new business initiatives. The more searches we receive and respond to with sponsored listings, the more opportunities we have to display banner advertisements and to receive click-throughs on those sponsored listings, and therefore, to generate revenue.
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Develop New and Enhance Existing Local Search Services. We believe that the demand for search results targeted to a specific geographic region is increasing as more people have begun to rely on the Internet as their primary reference source. We further believe our local search technology will enable increasing numbers of local businesses to connect with consumers via paid-search. In 2004, we launched our local search and advertising platform, now named LocalConnect. We primarily market LocalConnect to directory web sites, newspaper publishers and city guides that generally have existing relationships with local businesses. It is our objective to continue to offer directory web sites, newspaper publishers and city guides serving local markets a growing range of advertising services that are integrated into our LocalConnect platform, which they can select to offer to their own advertisers. In March 2005, we acquired the Local.com domain name and in August 2005, we launched our Local.com web site, a consumer facing destination web site specializing in local search. We intend to commit additional resources, mainly research and development personnel to enhance and develop new features for our Local.com web site.
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International Expansion. We intend to market our local search services in foreign markets. We believe that our services, specifically Local.com, can be deployed in foreign markets. When we establish foreign operations, we may need to make capital expenditures for data centers and hire staff in various countries.
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Acquisition of Strategic Technologies and Businesses. We may acquire technologies and other businesses that enhance our ability to serve consumers, advertisers and our platform clients with our national and local search services.
Our Services
Prior to 2005, we provided search services that benefited national advertisers. During 2005, we began to transition away from national search services and to focus on local search. In August 2005, we launched Local.com, a consumer facing destination web site specializing in local search.
Local Search
Local.com is a consumer facing destination web site specializing in local search. Local.com uses a combination of our proprietary Keyword DNAtm and geographic web indexing technologies to provide relevant search results for local business, products and services and sponsored listings. We generate revenue primarily when an Internet user clicks-through on an advertiser’s sponsored listing.
LocalConnect is a search and advertising platform that we license to directory web sites and newspaper publishers. This platform enables our customers to offer local search functionality on their own web site. LocalConnect enables our partners to generate revenue from local advertisers by offering local advertiser sponsored listings on the directories’ or publishers’ web sites.
National Search
Our national paid-search services enable businesses to advertise their products and services with sponsored listings that we make available in response to relevant search requests by Internet users. Our distribution model is designed to concurrently source sponsored listings from both our direct advertisers as well as advertisers of other paid-search engines, and then distribute those listings throughout our Distribution Network of web sites and search engines in response to specific keyword searches by consumers on those sites. Advertisers pay only when an Internet user clicks-through on their sponsored listing. When an Internet user clicks-through on a sponsored listing from our Advertiser Network, we generate revenue that we then share with the applicable Distribution Network partner.
Advertiser Network. Paid-search companies join our Advertiser Network to gain access to the large number of searches originated on our Distribution Network. We believe this access to consumer search requests increases the opportunity for click-through revenue because the advertiser’s listings are distributed in response to a larger number of consumer search requests.
Our sponsored listings are derived from our direct advertisers as well as the indirect advertisers from our Advertiser Network partners, which are other paid-search and Internet yellow pages companies such as Ask.com (a division of IAC/InterActive Corp.), MIVA, Inc., and LookSmart Ltd. Our sponsored listings are distributed across our Distribution Network in response to matching keyword searches initiated by consumers on those sites. Advertisers’ listings are generally ranked according to the price they are willing to pay for a click-through.
Distribution Network. Web sites and search engines join our Distribution Network because we are a single point of contact for a large number of paid-search advertisers from our Advertiser Network. This increases our Distribution Network partners’ opportunities to generate revenue from their consumer search traffic.
Our Distribution Network consists of web sites and search engines. When a consumer initiates a search on one of those sites, we receive the search request and then deliver relevant sponsored listings from our Advertiser Network in response. Many of our Distribution Network partners combine search results from other providers with our listings in order to increase possible search results to satisfy an Internet user’s search request.
Technology, Research and Development
We make our services available to advertisers, consumers and our Advertising and Distribution Network partners through a combination of our own proprietary technology and commercially available technology from industry leading providers.
We believe that it is important that our technologies be compatible with the systems used by our Advertiser and Distribution Network partners. Our core technology platform operates on universally accepted standards such as XML and SOAP for business-to-business computing and we believe that these standards provide for platform independence and simplified integration with other systems. We rely upon third parties to provide hosting services, including hardware support and service and network coordination.
Our research and development efforts are focused on developing new services and enhancing our existing services to provide additional features and functionality that we believe will appeal to our direct advertisers, consumers and our Advertiser and Distribution Network partners. Our research and development efforts also include the development and implementation of business continuity and disaster recovery systems, improvement of data retention, backup and recovery processes. As of December 31, 2006, we had nineteen employees in product and technical development.
Our research and development expenses were $2.8 million, $3.0 million and $1.3 million for the years ended December 31, 2006, 2005 and 2004, respectively.
Keyword DNA Technology
Our patented Keyword DNA technology is our proprietary method for indexing large amounts of data, and is critical to Local.com. Keyword DNA technology enables consumers to enter into a search engine the particular product or service they are seeking and a given geographic area. Our Keyword DNA technology then attempts to locate the appropriate business listing, searching as many different data sources as directed, to find the results. Unlike other search engine technologies, Keyword DNA is designed to return only the businesses that supply, or are
likely to supply, the appropriate product or service in a given geographic area. Keyword DNA does not return results based upon information that may appear on a web site. We believe that our methodology increases the relevancy of geographically targeted search results.
Distribution Technology
A fundamental aspect of our national search business is the ability to source large volumes of sponsored listings from our Advertiser Network and distribute those listings to our Distribution Network in response to consumer search requests, and to do so in real-time. Our technology is designed to gather information from multiple data points and compile the results according to a proprietary set of rules that we have developed. Each click-through from our Distribution Network is subject to a filtering process in order to improve advertiser return on investment by minimizing such things as double-clicks and other illegitimate click-throughs. This technology incorporates a sophisticated accounting system that provides our direct advertisers and our partners with the information they need to manage their relationships with us. In addition, our bid management system creates a real-time auction among advertisers in which they are able to bid for click-throughs.
Competition
The online paid-search market is intensely competitive. Our primary current competitors include Yahoo!, Google, our own Advertiser Network partners and online directories, such as Switchboard.com, Superpages.com and Yellowpages.com. Non-paid-search engines are beginning to offer paid-search services, and we believe that additional companies will enter into the paid-search advertising market. Although we currently pursue a strategy that allows us to partner with a broad range of web sites and search engines, our current and future partners may view us as a threat to their own internal paid-search services. We believe that the principal competitive factors in our market are network size, revenue sharing arrangements, services, convenience, accessibility, customer service, quality of search tools, quality of editorial review and reliability and speed of fulfillment of paid-search listings across the Internet infrastructure.
Competition for the distribution of sponsored listings could cause us to enter into agreements with our Distribution or Advertiser Network partners with less favorable terms or to lose partners. This could reduce our number of click-throughs, reduce revenue or increase search-serving expenses, all or some of which may have a material adverse effect on our business, operating results and financial condition.
We also compete with other online advertising services as well as traditional offline media such as television, radio and print, for a share of businesses’ total advertising budgets. Nearly all of our competitors have longer operating histories, larger customer bases, greater brand recognition and significantly greater financial, marketing and other resources than we do. Our competitors may secure more favorable revenue sharing arrangements with network distributors, devote greater resources to marketing and promotional campaigns, adopt more aggressive growth strategies and devote substantially more resources to web site and systems development than we do.
The search industry has experienced consolidation, including the acquisitions of companies offering paid-search services. Industry consolidation may result in larger, more established and well-financed competitors with a greater focus on paid-search services. If this trend continues, we may not be able to compete in the paid-search market and our financial results may suffer.
Additionally, larger companies such as Google and Microsoft may implement technologies into their search engines or software that make it less likely that consumers will reach, or execute searches on, Local.com or our Distribution Network partners’ web sites and less likely to click-through on our Advertiser Network partners’ sponsored listings. If we are unable to successfully compete against current and future competitors or if our current Advertising Network partners choose to rely more heavily on their own distribution networks in the future, our operating results will be adversely affected.
Major Customers
We have two customers that represent more than 10% of our consolidated revenue. Our national Advertiser Network partner, LookSmart, Ltd., represented 15%, 30% and 35% of our consolidated revenue for the years ended December 31, 2006, 2005 and 2004, respectively. Our local Advertiser Network partner, Yahoo! Inc., represented 48%, 2%, and 0% of our consolidated revenue for the years ended December 31, 2006, 2005 and 2004, respectively.
Traffic Acquisition
We advertise on other search engine web sites, primarily google.com, but also yahoo.com, msn.com and ask.com, by bidding on certain keywords we believe will drive traffic to our Local.com web site. During the three month period ending December 31, 2006, approximately 92% of the traffic on our Local.com web site was acquired from other search engine web sites. During the year ended December 31, 2006, traffic acquisition costs (TAC) were $7.7 million of which $6.9 million was paid to Google, Inc.
Intellectual Property
Our success and ability to compete are substantially dependent upon our internally developed technology and data resources. We seek to protect our intellectual property through existing laws and regulations, as well as through contractual restrictions. We rely on trademark, patent and copyright law, trade secret protection and confidentiality and license agreements with our employees, customers, partners and others to protect our intellectual property.
We own the registered trademarks for “ePilot,” “Keyword DNA” and “Pay Per Connect,” in the United States. We may claim trademark rights in, and apply for registrations in the United States for a number of other marks.
We have patent applications pending related to a variety of business and transactional processes associated with paid-search and other cost-per-event advertising models in different environments. We may consolidate some of our current applications and expect to continue to expand our patent portfolio in the future. We cannot assure you, however, that any of these patent applications will be issued as patents, that any issued patents will provide us with adequate protection against competitors with similar technology, that any issued patents will afford us a competitive advantage, that any issued patents will not be challenged by third parties, that any issued patents will not be infringed upon or designed around by others, or that the patents of others will not have a material adverse effect on our ability to do business. Furthermore, our industry has been subject to frequent patent-related litigation by the companies and individuals that compete in it. The outcome of ongoing litigation or any future claims in our industry could adversely affect our business or financial prospects.
Government Regulation
Like many companies, we are subject to existing and potential government regulation. There are, however, comparatively few laws or regulations specifically applicable to Internet businesses. Accordingly, the application of existing laws to Internet businesses, including ours, is unclear in many instances. There remains significant legal uncertainty in a variety of areas, including, but not limited to: user privacy, the positioning of sponsored listings on search results pages, defamation, taxation, the provision of paid-search advertising to online gaming sites, the legality of sweepstakes, promotions and gaming sites generally, and the regulation of content in various jurisdictions.
Compliance with federal laws relating to the Internet and Internet businesses may impose upon us significant costs and risks, or may subject us to liability if we do not successfully comply with their requirements, whether intentionally or unintentionally. For example, the Digital Millennium Copyright Act, which is in part intended to reduce the liability of online service providers for listing or linking to third party web sites that include materials that infringe the rights of others, was adopted by Congress in 1998. If we violate the Digital Millennium Copyright Act we could be exposed to costly and time-consuming copyright litigation.
There are a growing number of legislative proposals before Congress and various state legislatures regarding privacy issues related to the Internet generally, and some of these proposals apply specifically to paid-search businesses. We are unable to determine if and when such legislation may be adopted. If certain proposals were to be adopted, our business could be harmed by increased expenses or lost revenue opportunities, and other unforeseen ways. We anticipate that new laws and regulations affecting us will be implemented in the future. Those new laws, in addition to new applications of existing laws, could expose us to substantial liabilities and compliance costs.
Employees
As of December 31, 2006 we had fifty-eight employees, all of which were full-time, nineteen of which were engaged in research and development, twenty-five in sales and marketing and fourteen in general and administration. None of our employees are represented by a labor union. We have not experienced any work stoppages, and we consider our relations with our employees to be good.
Recent Developments
On February 23, 2007, we entered into a Purchase Agreement with two investors. Pursuant to this agreement, the investors purchased an aggregate of $8.0 million of 9% senior secured convertible notes and warrants to purchase shares of our common stock. The senior secured convertible notes are secured by our assets and are due on February 23, 2009. Each senior secured convertible note holder has the right, at any time, to convert their note into shares of our common stock at an initial conversion ratio of one share of common stock for each $4.02 of principal amount of debenture. We also issued warrants to purchase an aggregate of 796,020 shares of common stock at an exercise price of $4.82 per share that expire five years from the date of issuance and warrants to purchase an aggregate of 796,020 shares of common stock at an exercise price of $5.63 per share that expire five years from the date of issuance. The relative fair value of these warrants, using the Black-Scholes model at the date of grant, was $3.1 million and will be recorded as convertible debt discount and will be amortized over the life of the debentures. The assumptions used in the Black-Scholes model were as follows: no dividend yield; 4.67% interest rate; five years contractual life; and volatility of 100%. In connection with the issuance of the convertible secured debentures, we paid $530,000 in cash for placement agent fees of which $205,000 was paid to a member of our board of directors. These fees are recorded in prepaid expenses and will be amortized over the life of the debentures. We also issued warrants to purchase an aggregate of 71,642 shares of common stock at an exercise price of $4.82 per share that expire five years from the date of issuance and warrants to purchase an aggregate of 71,642 shares of common stock at an exercise price of $5.63 per share that expire five years from the date of issuance. The fair value of these warrants, using the Black-Scholes model at the date of grant, was $458,000 and will be recorded in prepaid expenses and will be amortized over the life of the debentures.
Corporation Information
We were incorporated in Delaware in March 1999 as eWorld Commerce Corporation. In August 1999 we changed our name to eLiberation.com Corporation. In February 2003, we changed our name to Interchange Corporation. On November 2, 2006, we changed our name to Local.com Corporation.
ITEM 1A.
ITEM 1A.
Risk Factors
Investing in our common stock involves a high degree of risk. You should carefully consider the risks described below with all of the other information included in this Report before making an investment decision. If any of the possible adverse events described below actually occur, our business, results of operations or financial condition would likely suffer. In such an event, the market price of our common stock could decline and you could lose all or part of your investment. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently known to us or that we currently believe to be immaterial may also adversely affect our business, results of operations or financial condition.
If we are not successful with our Local.com initiative, our future financial performance may be affected.
In March 2005, we purchased the Local.com domain name. On August 9, 2005, we launched Local.com, a consumer facing destination web site specializing in local search. This site is our first consumer facing business and we intend to invest significant amounts of time and resources on Local.com We cannot assure you that we will be successful in growing revenue from local search, in attracting consumers or advertisers to Local.com, or in achieving a positive impact on our operational and financial performance with Local.com. If we are unable to attract consumers and/or advertisers to Local.com, our financial performance may be adversely affected.
We have historically incurred losses and expect to incur losses in the future, which may impact our ability to implement our business strategy and adversely affect our financial condition.
We have a history of losses. Although we achieved a net income of $1.5 million for the year ended December 31, 2004, we have a net loss of $6.5 million for the year ended December 31, 2005 and $13.3 million for the year ended December 31, 2006. We also had an accumulated deficit of $31.0 million at December 31, 2006 and expect to have a net loss for at least the next quarter. We have significantly increased our operating expenses by expanding our operations in order to grow our business and further develop and maintain our services. Such increases in operating expense levels may adversely affect our operating results if we are unable to immediately realize benefits from such expenditures. We cannot assure you that we will be profitable or generate sufficient
profits from operations in the future. If our revenue does not grow, we may experience a loss in one or more future periods. We may not be able to reduce or maintain our expenses in response to any decrease in our revenue, which may impact our ability to implement our business strategy and adversely affect our financial condition.
We face intense competition from larger, more established companies, as well as our own Advertiser Network partners, and we may not be able to compete effectively, which could reduce demand for our services.
The online paid-search market is intensely competitive. Our primary current competitors include Yahoo! Inc., Google Inc., our own Advertiser Network partners and online directories, such as Switchboard. Although we currently pursue a strategy that allows us to partner with a broad range of web sites and search engines, our current and future partners may view us as a threat to their own internal paid-search services. Nearly all of our competitors have longer operating histories, larger customer bases, greater brand recognition and significantly greater financial, marketing and other resources than we do. Our competitors may secure more favorable revenue sharing arrangements with network distributors, devote greater resources to marketing and promotional campaigns, adopt more aggressive growth strategies and devote substantially more resources to web site and systems development than we do. In addition, the search industry has experienced consolidation, including the acquisitions of companies offering paid-search services. Industry consolidation has resulted in larger, more established and well-financed competitors with a greater focus on paid-search services. If these industry trends continue, or if we are unable to compete in the paid-search market, our financial results may suffer.
Additionally, larger companies such as Google and Microsoft Corporation may implement technologies into their search engines or software that make it less likely that consumers can reach, or execute searches on, Local.com or our Distribution Network partners’ web sites and less likely to click-through on our Advertiser Network partners’ sponsored listings. The implementation of such technologies could result in a decline in click-throughs to our advertisers’ sponsored listings, which would decrease our revenues. If we are unable to successfully compete against current and future competitors or if our current Advertising Network partners choose to rely more heavily on their own distribution networks in the future, our operating results will be adversely affected.
We rely on our Advertiser Network partners to provide us access to their advertisers, and if they do not, it could have an adverse impact on our business.
We rely on our Advertiser Network partners to provide us with advertiser listings so that we can distribute these listings to Local.com or our Distribution Network partners in order to generate revenue when a consumer click-through occurs on our Advertiser Network partners’ sponsored listings. For the year ended December 31, 2006, 79% of our revenue was derived from our Advertiser Network partners. In addition, almost 100% of our revenues from Local.com are derived from our Advertiser Network partners. Most of our agreements with our Advertiser Network partners are short-term, and, as a result, they may discontinue their relationship with us or negotiate new terms that are less favorable to us, at any time, with little or no notice. Our success depends, in part, on the maintenance and growth of our Advertiser Network partners. If we are unable to develop or maintain relationships with these partners, our operating results and financial condition will suffer.
Our executive officers and certain key personnel are critical to our success, and the loss of these officers and key personnel could harm our business.
Our performance is substantially dependent on the continued services and performance of our executive officers and other key personnel. We only have employment agreements with our three executive officers: Heath B. Clarke (Chief Executive Officer and Chairman of the Board), Stanley B. Crair (President and Chief Operating Officer) and Douglas S. Norman (Chief Financial Officer and Secretary). Each of Messrs. Clarke, Crair and Norman’s employment agreements may be terminated with 30 days notice by either the executive or us. No key man life insurance has been purchased on any of Messrs. Clarke, Crair or Norman. Our performance also depends on our ability to retain and motivate our officers and key employees. The loss of the services of any of our officers or other key employees could have a material adverse effect on our business, prospects, financial condition and results of operations. Our future success also depends on our ability to identify, attract, hire, train, retain and motivate other highly skilled technical, managerial and marketing personnel. Competition for such personnel is intense, and we cannot assure you that we will be successful in attracting and retaining such personnel. The failure to attract and
retain our officers or the necessary technical, managerial and marketing personnel could have a material adverse effect on our business, prospects, financial condition and results of operations.
The market for Internet and local search advertising services is in the early stages of development, and if the market for our services decreases it will have a material adverse effect on our business, prospects, financial condition and results of operations.
Internet marketing and advertising, in general, and paid-search, in particular, are in the early stages of development. Our future revenue and profits are substantially dependent upon the continued widespread acceptance, growth, and use of the Internet and other online services as effective advertising mediums. Many of the largest advertisers have generally relied upon more traditional forms of media advertising and have only limited experience advertising on the Internet. Local search, in particular, is still in an early stage of development and may not be accepted by consumers for many reasons including, among others, that consumers may conclude that local search results are less relevant and reliable than non-paid-search results, and may view paid-search results less favorably than search results generated by non-paid-search engines. If consumers reject our paid-search services, or commercial use of the Internet generally, and the number of click-throughs on our sponsored listings decreases, the commercial utility of our search services could be adversely affected.
We expect that our anticipated future growth, including through potential acquisitions, may strain our management, administrative, operational and financial infrastructure, which could adversely affect our business.
We anticipate that significant expansion of our present operations will be required to capitalize on potential growth in market opportunities. This expansion has placed, and is expected to continue to place, a significant strain on our management, operational and financial resources. We expect to add a significant number of additional key personnel in the future, including key managerial and technical employees who will have to be fully integrated into our operations. In order to manage our growth, we will be required to continue to implement and improve our operational and financial systems, to expand existing operations, to attract and retain superior management, and to train, manage and expand our employee base. We cannot assure you that we will be able to effectively manage the expansion of our operations, that our systems, procedures or controls will be adequate to support our operations or that our management will be able to successfully implement our business plan. If we are unable to manage growth effectively, our business, financial condition and results of operations could be materially adversely affected.
On February 28, 2005, we completed the acquisition, through a wholly owned subsidiary, of all of the outstanding capital stock of Inspire Infrastructure 2i AB, a Swedish Internet and wireless local-search technology company. In the future, we may choose to expand our operations or market presence by pursuing acquisitions of complementary business, services or technologies or engage in other strategic alliances with third parties. Any such transactions would be accompanied by the risks commonly encountered in such transactions, including, among others, the difficulty of assimilating operations, technology and personnel of the combined companies, the potential disruption of our ongoing business, the inability to retain key technical and managerial personnel, the inability of management to maximize our financial and strategic position through the successful integration of acquired businesses, additional expenses associated with amortization of acquired intangible assets, the maintenance of uniform standards, controls and policies and the impairment of relationships with existing employees and customers. We have limited experience in these types of acquisitions, and we may not be successful in overcoming these risks or any other potential problems. As a result, any acquisition may have a material adverse effect on our business, prospects, financial condition and results of operations.
We may incur impairment losses related to goodwill and other intangible assets which could have a material and adverse effect on our financial results.
As a result of our acquisition of Inspire Infrastructure 2i AB, the purchase of Local.com domain name, and the Atlocal asset purchase, we have recorded substantial goodwill and intangible assets in our consolidated financial statements. During the year ended December 31, 2005, due to the deterioration of revenues in Europe since the acquisition of Inspire in February 2005, we believed that the carrying amount for customer contracts and relationships was impaired. The carrying amount of customer contracts and relationships exceeded the sum of the undiscounted cash flows expected and as a result, we wrote-down the remaining unamortized balance of $337,000. We are required to perform impairment reviews of our goodwill and other intangible assets, which are
determined to have an indefinite life and are not amortized. Such reviews are performed annually or earlier if indicators of potential impairment exist. We performed our annual impairment analysis as of December 31, 2006 and determined that no impairment existed. Future impairment reviews may result in charges against earnings to write-down the value of intangible assets.
We may be subject to intellectual property claims that create uncertainty about ownership of technology essential to our business and divert our managerial and other resources.
There has been a substantial amount of litigation in the technology industry regarding intellectual property rights. We cannot assure you that third parties will not, in the future, claim infringement by us with respect to our current or future services, trademarks or other proprietary rights. Our success depends, in part, on our ability to protect our intellectual property and to operate without infringing on the intellectual property rights of others in the process. There can be no guarantee that any of our intellectual property will be adequately safeguarded, or that it will not be challenged by third parties. We may be subject to patent infringement claims or other intellectual property infringement claims that would be costly to defend and could limit our ability to use certain critical technologies.
We may also become subject to interference proceedings conducted in the patent and trademark offices of various countries to determine the priority of inventions. The defense and prosecution, if necessary, of intellectual property suits, interference proceedings and related legal and administrative proceedings is costly and may divert our technical and management personnel from their normal responsibilities. We may not prevail in any of these suits. An adverse determination of any litigation or defense proceedings could cause us to pay substantial damages, including treble damages if we willfully infringe, and, also, could put our patent applications at risk of not being issued.
Furthermore, because of the substantial amount of discovery required in connection with intellectual property litigation, there is a risk that some of our confidential information could be compromised by disclosure during this type of litigation. In addition, during the course of this kind of litigation, there could be public announcements of the results of hearings, motions or other interim proceedings or developments in the litigation. If investors perceive these results to be negative, it could have an adverse effect on the trading price of our common stock.
Any patent litigation could negatively impact our business by diverting resources and management attention away from other aspects of our business and adding uncertainty as to the ownership of technology and services that we view as proprietary and essential to our business. In addition, a successful claim of patent infringement against us and our failure or inability to obtain a license for the infringed or similar technology on reasonable terms, or at all, could have a material adverse effect on our business.
We may be subject to lawsuits for information displayed on our web sites and the web sites of our advertisers, which may affect our business.
Laws relating to the liability of providers of online services for activities of their advertisers and for the content of their advertisers’ listings are currently unsettled. It is unclear whether we could be subjected to claims for defamation, negligence, copyright or trademark infringement or claims based on other theories relating to the information we publish on our web sites or the information that is published across our Distribution Network. These types of claims have been brought, sometimes successfully, against online services as well as other print publications in the past. We may not successfully avoid civil or criminal liability for unlawful activities carried out by our advertisers. Our potential liability for unlawful activities of our advertisers or for the content of our advertisers’ listings could require us to implement measures to reduce our exposure to such liability, which may require us, among other things, to spend substantial resources or to discontinue certain service offerings. Our insurance may not adequately protect us against these types of claims and the defense of such claims may divert the attention of our management from our operations. If we are subjected to such lawsuits, it may adversely affect our business.
Government and legal regulations may damage our business.
We are not currently subject to direct regulation by any government agency, other than regulations generally applicable to Internet businesses, and there are currently few significant laws or regulations directly applicable to access to or commerce on the Internet. It is possible, however, that a number of laws and regulations may be adopted
with respect to the Internet, covering issues such as the positioning of sponsored listings on search results pages. For example, the Federal Trade Commission, or FTC, has recently reviewed the way in which search engines disclose paid-search practices to Internet users. In 2002, the FTC issued guidance recommending that all search engine companies ensure that all paid-search results are clearly distinguished from non-paid results, that the use of paid-search is clearly and conspicuously explained and disclosed and that other disclosures are made to avoid misleading users about the possible effects of paid-search listings on search results. The adoption of laws or regulations relating to placement of paid search advertisements or user privacy, defamation or taxation may inhibit the growth in use of the Internet, which in turn, could decrease the demand for our services and increase our cost of doing business or otherwise have a material adverse effect on our business, prospects, financial condition and results of operations. Any new legislation or regulation, or the application of existing laws and regulations to the Internet or other online services, could have a material adverse effect on our business, prospects, financial condition and results of operations.
If we do not deliver traffic that converts into revenue for advertisers, then the advertisers may pay us less for their listing or discontinue listings with us.
For our services to be successful, we need to deliver consumers to advertisers’ web sites that convert into sales for the advertiser. If we do not meet advertisers’ expectations by delivering quality traffic, then they may reduce their bid prices or cease doing business with us, which may adversely affect our business and financial results.
If we fail to detect click-through fraud, we could lose the confidence of our advertisers, thereby causing our business to suffer.
We are exposed to the risk of fraudulent or illegitimate clicks on our sponsored listings. If fraudulent clicks are not detected, the affected advertisers may experience a reduced return on their investment in our advertising programs because the fraudulent clicks will not lead to revenue for the advertisers. As a result, our advertisers may become dissatisfied with our advertising programs, which could lead to loss of advertisers and revenue.
Failure to adequately protect our intellectual property and proprietary rights could harm our competitive position.
Our success is substantially dependent upon our proprietary technology, which relates to a variety of business and transactional processes associated with our paid-search advertising model, our Keyword DNA technology and our LocalConnect search and advertising platform. We rely on a combination of patent, trademark, copyright and trade secret laws, as well as confidentiality agreements and technical measures, to protect our proprietary rights. Although we have filed patent applications on certain parts of our technology, much of our proprietary information may not be patentable, and we do not currently possess any patents. We cannot assure you that we will develop proprietary technologies that are patentable or that any pending patent applications will be issued or that their scope is broad enough to provide us with meaningful protection. We own the trademarks for ePilot, Pay Per Connect and Keyword DNA in the United States and may claim trademark rights in, and apply for trademark registrations in the United States for a number of other marks. We cannot assure you that we will be able to secure significant protection for these marks. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our services or to obtain and use information that we regard as proprietary. We cannot assure you that our means of protecting our proprietary rights will be adequate or that our competitors will not independently develop similar technology or duplicate our services or design around patents issued to us or our other intellectual property rights. If we are unable to adequately protect our intellectual property and proprietary rights, our business and our operations could be adversely affected.
We may experience downward pressure on our bid prices if advertisers do not obtain a competitive return on investment, which could have a material and adverse effect on our financial results.
We may experience downward pressure on our bid prices if advertisers do not obtain a favorable return on investment from our paid-search services in comparison to our competitors’ services or other advertising methods. We compete with other web search services, online publishers and high-traffic web sites, as well as traditional media such as television, radio and print, for a share of our advertisers’ total advertising expenditures. Many potential advertisers and advertising agencies have only limited experience advertising on the Internet and have not devoted a significant portion of their advertising expenditures to paid-search. Acceptance of paid-search marketing
among advertisers will depend, to a large extent, on its perceived effectiveness and the continued growth of commercial usage of the Internet. If we experience downward pricing pressure for our services in the future, our financial results may suffer.
Two of our Advertiser Network partners have provided a substantial portion of our revenue; the loss of either of these partners may have a material adverse effect on our operating results.
Our national Advertiser Network partner, LookSmart, Ltd., represented 15% of our total revenue for the year ended December 31, 2006. Our local Advertiser Network partner, Yahoo! Inc., represented 48% of our total revenue for the year ended December 31, 2006. It is difficult to predict whether LookSmart and Yahoo will continue to represent such a significant portion of our revenue in the future. Either partner may choose not to renew our agreement in the future or may choose to reduce the use of our paid-search services, in which case our business and financial results may be harmed.
Two customers account for a significant portion of our accounts receivable, and the failure to collect from those customers would harm our financial condition and results of operations.
While most of our customers pay for our services in advance, some do not. Two of our customers that do not pay in advance, LookSmart and Yahoo, have and will likely continue for the foreseeable future to account for a significant portion of our accounts receivable. At December 31, 2006, LookSmart represented 11% and Yahoo represented 52%, of our total accounts receivable. LookSmart’s and Yahoo’s accounts have been, and will likely continue to be, unsecured and any failure to collect on those accounts would harm our financial condition and results of operations.
A significant portion of the traffic to our local.com web site is acquired from other search engines, mainly google.com, the loss of the ability to acquire traffic could have a material and adverse effect on our financial results.
We advertise on other search engine web sites, primarily google.com, but also yahoo.com, msn.com and ask.com, by bidding on certain keywords we believe will drive traffic to our Local.com website. During the three month period ending December 31, 2006, approximately 92% of the traffic on our Local.com website was acquired from other search engine websites. During the year ended December 31, 2006, traffic acquisition costs (TAC) were $7.7 million of which $6.9 million was paid to Google, Inc. If we are unable to advertise on these web sites, or the cost to advertise on these web sites increases, our financial results may suffer.
Problems with our computer and communication systems may harm our business.
A key element of our strategy is to generate a high volume of traffic across our network infrastructure to and from our Advertiser and Distribution Network partners. Accordingly, the satisfactory performance, reliability and availability of our software systems, transaction-processing systems and network infrastructure are critical to our reputation and our ability to attract and retain advertising customers, as well as maintain adequate customer service levels. We may experience periodic systems interruptions. Any substantial increase in the volume of traffic on our software systems or network infrastructure will require us to expand and upgrade our technology, transaction-processing systems and network infrastructure. We cannot assure you that we will be able to accurately project the rate or timing of increases, if any, in the use of our network infrastructure or timely expand and upgrade our systems and infrastructure to accommodate such increases.
We rely on third party technology, server and hardware providers, and a failure of service by these providers could adversely affect our business and reputation.
We rely upon third party data center providers to host our main servers and expect to continue to do so. In the event that these providers experience any interruption in operations or cease operations for any reason or if we are unable to agree on satisfactory terms for continued hosting relationships, we would be forced to enter into a relationship with other service providers or assume hosting responsibilities ourselves. If we are forced to switch hosting facilities, we may not be successful in finding an alternative service provider on acceptable terms or in hosting the computer servers ourselves. We may also be limited in our remedies against these providers in the event of a failure of service. In the past, we have experienced short-term outages in the service maintained by one of our
current co-location providers. We also rely on third party providers for components of our technology platform, such as hardware and software providers, credit card processors and domain name registrars. A failure or limitation of service or available capacity by any of these third party providers could adversely affect our business and reputation.
State and local governments may be able to levy additional taxes on Internet access and electronic commerce transactions, which could result in a decrease in the level of usage of our services.
Beginning in 1998, the federal government imposed a moratorium on state and local governments’ imposition of new taxes on Internet access and eCommerce transactions, which has now expired. State and local governments may be able to levy additional taxes on Internet access and eCommerce transactions unless the moratorium is reinstituted. Any increase in applicable taxes may make eCommerce transactions less attractive for businesses and consumers, which could result in a decrease in eCommerce activities and the level of usage of our services.
The market price of our common stock has been and is likely to continue to be highly volatile, which could cause investment losses for our stockholders and result in stockholder litigation with substantial costs, economic loss and diversion of our resources.
Prior to our initial public offering, which was completed on October 22, 2004, there was no public trading market for our common stock. We cannot predict the extent to which investor interest will support an active and liquid trading market for our common stock.
In addition, the trading price of our common stock has been and is likely to continue to be highly volatile and could be subject to wide fluctuations as a result of various factors, many of which are beyond our control, including:
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developments concerning proprietary rights, including patents, by us or a competitor;
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market acceptance of our new and existing services and technologies;
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announcements by us or our competitors of significant contracts, acquisitions, commercial relationships, joint ventures or capital commitments;
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actual or anticipated fluctuations in our operating results;
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continued growth in the Internet and the infrastructure for providing Internet access and carrying Internet traffic;
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introductions of new services by us or our competitors;
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enactment of new government regulations affecting our industry;
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changes in the number of our Advertising and Distribution Network partners;
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seasonal fluctuations in the level of Internet usage;
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loss of key employees;
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institution of intellectual property litigation by or against us;
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success of our international expansion;
•
changes in the market valuations of similar companies; and
•
changes in our industry and the overall economic environment.
Due to the short-term nature of our Advertiser Network and Distribution Network partner agreements and the emerging nature of the paid-search market, we may not be able to accurately predict our operating results on a quarterly basis, if at all, which may lead to volatility in the trading price of our common stock. In addition, the stock market in general, and the Nasdaq Capital Market and the market for online commerce companies in particular, have experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of the listed companies. These broad market and industry factors may seriously harm the market price of our common stock, regardless of our operating performance. In the past, following periods of volatility in the market, securities class action litigation has often been instituted against these companies. Litigation against us, whether or not a judgment is entered against us, could result in substantial costs, and
potentially, economic loss, and a diversion of our management’s attention and resources. As a result of these and other factors, you may not be able to resell your shares above the price you paid and may suffer a loss on your investment.
Future sales of shares of our common stock that are eligible for sale by our stockholders may decrease the price of our common stock.
We had 9,297,502 shares of common stock outstanding on December 31, 2006. Of these shares, 340,866 are held by directors, executive officers and other affiliates and will be subject to volume limitations under Rule 144 under the Securities Act. In addition, there were outstanding options to purchase 1,933,363 shares of our common stock and warrants to purchase 1,043,664 shares of our common stock. Actual sales, or the prospect of sales by our present stockholders or by future stockholders, may have a negative effect on the market price of our common stock.
Anti-takeover provisions may limit the ability of another party to acquire us, which could cause our stock price to decline.
Our amended and restated certificate of incorporation, our amended and restated bylaws and Delaware law contain provisions that could discourage, delay or prevent a third party from acquiring us, even if doing so may be beneficial to our stockholders. In addition, these provisions could limit the price investors would be willing to pay in the future for shares of our common stock. The following are examples of such provisions in our amended and restated certificate of incorporation and in our amended and restated bylaws:
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special meetings of our stockholders may be called only by our Chief Executive Officer, by a majority of the members of our board of directors or by the holders of shares entitled to cast not less than 10% of the votes at the meeting;
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stockholder proposals to be brought before any meeting of our stockholders must comply with advance notice procedures;
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our board of directors is classified into three classes, as nearly equal in number as possible;
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newly-created directorships and vacancies on our board of directors may only be filled by a majority of remaining directors, and not by our stockholders;
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a director may be removed from office only for cause by the holders of at least 75% of the voting power entitled to vote at an election of directors;
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our amended and restated bylaws may be further amended by our stockholders only upon a vote of at least 75% of the votes entitled to be cast by the holders of all outstanding shares then entitled to vote generally in the election of directors, voting together as a single class; and
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our board of directors is authorized to issue, without further action by our stockholders, up to 10,000,000 shares of undesignated preferred stock with rights and preferences, including voting rights, designated from time to time by our board of directors.
We are also subject to Section 203 of the Delaware General Corporation Law, which provides, subject to enumerated exceptions, that if a person acquires 15% or more of our voting stock, the person is an “interested stockholder” and may not engage in “business combinations” with us for a period of three years from the time the person acquired 15% or more of our voting stock.
Our ability to utilize our net operating loss carryforwards and certain other tax attributes may be limited.
Under Section 382 of the Internal Revenue Code, if a corporation undergoes an “ownership change” (generally defined as a greater than 50% change (by value) in its equity ownership over a three-year period), the corporation’s ability to use its pre-change net operating loss carryforwards and other pre-change tax attributes against its post-change income may be limited. We believe that with our initial public offering, our recent private placement and other transactions that have occurred over the past three years, we have triggered an “ownership change” limitation. We have performed an analysis to determine to what extent our ability to utilize our net operating loss carryforwards is limited. We determined that our Section 382 limitation is $1.1 million a year. We may also experience ownership change in the future as a result of subsequent shifts in our stock ownership. As of December 31, 2006 we have net
operating loss carryforwards of approximately $26.8 million and $28.0 million for federal and state income tax purposes, respectively.
Item 1B.
Item 1B.
Unresolved Staff Comments
None
Item 2.
Item 2.
Properties
Our executive and administrative offices are located at One Technology Drive, Building G, Irvine, California, where we lease approximately 23,352 square feet of space in a two-story office building. Our current monthly rent is $28,723, subject to annual increases. Our lease for this space ends in June 2010.
Item 3.
Item 3.
Legal Proceedings
We are not currently a party to any material legal proceedings. From time to time, however, we may be subject to a variety of legal proceedings and claims in the ordinary course of business, including claims of alleged infringement of intellectual property rights and claims arising in connection with our services.
Item 4.
Item 4.
Submission of Matters to a Vote of Securities Holders
None
PART II
Item 5.
Item 5.
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Market information
Our common stock commenced trading on the Nasdaq Capital Market on October 19, 2004 under the symbol “INCX.” On November 2, 2006, in connection with our company name change, the ticker symbol of our common stock changed to “LOCM.” The following table sets forth the range of reported high and low bid quotations for our common stock as reported on the Nasdaq Capital Market. These prices reflect inter-dealer prices without retail markup, markdown or commissions and may not represent actual transactions.
Holders
On December 31, 2006, the closing price of our common stock, as reported by the Nasdaq Capital Market, was $4.05 per share and the number of stockholders of record of our common stock was 110.
Dividends
We have never declared or paid any cash dividends on our capital stock. We currently intend to retain any future earnings to finance the growth and development of our business and therefore do not anticipate paying any cash dividends in the foreseeable future. Any future determination to pay cash dividends will be at the discretion of our board of directors and will depend upon our financial condition, operating results, capital requirements, and such other factors as our board of directors deems relevant.
Performance graph
The following graph compares the cumulative 26-month total return to shareholders on Local.com Corporation’s common stock relative to the cumulative total returns of the NASDAQ Composite index and the RDG Internet Composite index. An investment of $100 (with reinvestment of all dividends) is assumed to have been made in the company’s common stock on 10/19/04 and its relative performance is tracked through 12/31/2006.
COMPARISON OF 26 MONTH CUMULATIVE TOTAL RETURN*
Among Local.com Corporation, The NASDAQ Composite Index
And The RDG Internet Composite Index
*
$100 invested on 10/19/04 in stock or on 9/30/04 in index-including reinvestment of dividends.
The stock price performance included in this graph is not necessarily indicative of future stock price performance.
Recent sales of unregistered securities
In October 2006, we issued 9,734 shares of common stock for the net issuance exercise of 67,500 warrants held by various accredited and sophisticated investors.
In November 2006, we issued 2,527 shares of common stock for the net issuance exercise of 21,250 warrants held by an accredited and sophisticated investor.
The issuance of securities in the transactions described above was deemed exempt from registration under the Securities Act in reliance on Section 4(2).
ITEM 6.
ITEM 6.
Selected Financial Data
Consolidated Statement of Operations Data (in thousands, except per share amounts):
Consolidated Balance Sheet Data (in thousands):
(1)
We adopted Statement of Financial Accounting Standards (SFAS) No. 123R, Share-Based Payment, in January 2006. Our operating loss and net loss for the year ended December 31, 2006 was higher by $2.5 million than if we had continued to account for stock-based employee compensation under the recognition and measurement principles of Accounting Principles Board Opinion (APB) No. 25, Accounting for Stock Issued to Employees. Basic and diluted net loss per share for the year ended December 31, 2006 was $0.27 higher as a result of the adoption of SFAS No. 123R.
(2)
We completed our initial public offering in October 2004 in which we sold 3.2 million shares of our common stock that resulted in net proceeds of $21.7 million. In December 2004, we completed a private placement in which we sold 822,000 shares of our common stock that resulted in net proceeds of $14.0 million.
ITEM 7.
ITEM 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operation
The following discussion and analysis of financial condition and results of operations should be read in conjunction with our financial statements and related notes included elsewhere in this Report. This discussion contains forward-looking statements that involve risks, uncertainties and assumptions. Our actual results could differ materially from those anticipated in the forward-looking statements as a result of certain factors discussed in “Risk Factors” and elsewhere in this Report.
Overview
We provide paid-search services that enable businesses to reach consumers through targeted online advertising. Our services enable businesses to advertise their products and services by listing them in our distributed Internet search results. We supply these sponsored listings to our Distribution Network in response to targeted keyword searches performed by Internet users. Sponsored listings are generally compiled according to the advertiser’s bid price for a click-through in connection with a specific keyword search.
We generate revenue each time an Internet user initiates a search on our Local.com web site, or on our Distribution Network, and clicks-through on a sponsored listing from our Advertiser Network. We also generate revenue each time we display a banner advertisement on our Local.com web site. If applicable, we share this
revenue with the Distribution Network partner that provided the related search. We only recognize as revenue the portion of advertisers’ bid prices that the applicable Advertiser Network partner pays us for providing a click-through to its advertisers, as compared to the entire amount of advertisers’ bid prices from our direct advertisers. As a result, we typically generate higher revenue per click-through from our direct advertisers than from the indirect advertisers of other paid-search engines. However, due to the broad range of advertisers and related sponsored listings from our Advertiser Network partners, we tend to receive a greater volume of click-throughs on such listings. As we add additional Advertiser Network partners, we increase our opportunity to generate incremental revenue with little additional cost or effort.
We currently sell our national paid-search services directly to advertisers through our direct sales force. Our business development department focuses on expanding the number of our Advertiser and Distribution Network partners. Although we have long-standing relationships with most of our Advertiser and Distribution Network partners, our contracts with such partners are non-exclusive and generally cancelable upon 30 days prior notice.
Prior to 2005, we provided services that benefited national advertisers. During 2005, we began to transition away from national search services and to focus on local search.
In August 2005, we launched Local.com, a consumer facing destination web site specializing in local search. Local.com uses a combination of our proprietary Keyword DNAtm and geographic web indexing technologies to provide relevant search results for local business, products and services and sponsored listings.
On November 2, 2006, we changed our name from Interchange Corporation to Local.com Corporation. We amended our Amended and Restated Certificate of Incorporation in connection with a merger of our wholly-owned subsidiary with and into us in accordance with Section 253 of the Delaware General Corporation Law.
Outlook for Our Business
We believe that searches for products, services and businesses within a geographic region, or local search, will be an increasingly significant segment of the online advertising industry. Although paid-search advertising has been used primarily by businesses that serve the national market, local businesses are increasingly using online advertising to attract local customers. Local search allows consumers to search for local businesses’ products or services by including geographic area, zip code, city and other geographically targeted search parameters in their search requests. Local search is relatively new, and as a result it is difficult to determine our current market share or predict our future market share.
We believe the market for Internet advertising and specifically paid-search services will continue to grow. The Kelsey Group estimates that the local search market in the United States will grow to $6.2 billion by 2010 and reports that there are approximately 10 million small and medium sized enterprises in the United States and that there may be as many as 25 to 30 million more around the globe, but that only approximately 350,000 businesses advertise online. As a result, we believe that local businesses, those that principally serve consumers within a fifty mile radius of their location, many of which are small and medium sized enterprises, have not been adequately served by the paid-search industry. Our Local.com web site is designed to address this market, which we believe will provide an opportunity for increased revenue from click-throughs on the sponsored listings of local businesses.
Although we have provided services for both local and national advertisers, our focus is transitioning away from the national market and towards the local search market. Our resources are currently being utilized almost entirely on developing our products and services to address the needs of the local search market.
We have increased our operating expenses, mainly sales and marketing and research and development, to support the development and launch of our Local.com web site. We intend to commit additional research and development resources to enhance and develop new features for our Local.com web site. We will also continue to increase our sales and marketing expenses to promote our Local.com web site. Search serving, which has been our largest expense in the past, will significantly decrease as our national search business decreases and we focus our efforts on local search.
Our revenue, profitability and future growth depend not only on our ability to execute our business plan, but also, among other things, on customer acceptance of our services, the growth of the paid-search market and competition from other providers of paid-search technologies and services. See “Risk Factors” for a more detailed discussion of these and other risks.
Sources of Revenue
We generate revenue primarily from click-throughs on the sponsored listings provided by our Advertiser Network, which consists of our national direct advertisers and local and national indirect advertisers from our Advertiser Network partners. For 2004 and 2005, approximately half of our revenue was derived from our direct advertisers and approximately half was derived from indirect advertisers from our Advertiser Network partners. In 2006, 73% of our revenue was derived from indirect advertisers from our Advertiser Network partners and 27% of our revenue was derived from our direct advertisers. In 2004, our national business accounted for 100% of our revenue. In 2005, our national business accounted for 93% of our revenue and our local business accounted for 7% of our revenue. In 2006, our national business accounted for 42% of our revenue and our local business accounted for 58% of our revenue. With our transition to local search and away from national search, we expect our revenue from our local search to substantially increase and our revenue from national search to substantially decrease.
Advertiser Network Partners
We have contracts with other paid-search and Internet yellow pages companies, our Advertiser Network partners, to provide these partners with consumer search traffic. These partners have their own advertisers who have paid-search campaigns and who have agreed to pay these partners for each click-through on a sponsored listing. Our Advertiser Network partners have agreed to pay us a portion of the revenue that they earn as a result of the click-throughs that we provide to their advertisers from our Distribution Network including our own destination web site, Local.com. We recognize our portion of the bid price as revenue at the time of a click-through. Our Advertiser Network partners generally have credit terms with us of net 30 days.
National Direct Advertisers
When businesses set up advertising campaigns with us, they set the bid price they are prepared to pay us each time an Internet user clicks-through on the businesses’ sponsored listings. We recognize the bid amount as revenue when a click-through occurs. For 2004, 2005 and 2006, more than 80% of our revenue from direct advertisers was paid in advance of our delivery of click-throughs. These advance payments are recorded as deferred revenue until a click-through occurs.
Operating Expenses
Search Serving
Search serving expenses consist primarily of revenue-sharing payments that we make to our Distribution Network partners, and to a lesser extent, royalties, Internet connectivity costs, data center costs, amortization of certain software license fees and maintenance and depreciation of computer equipment used in providing our paid-search services. Because the majority of these costs are revenue-sharing payments, we expect our search serving costs will decrease as revenue from our national Distribution Network decreases.
Sales and Marketing
Sales and marketing expenses largely consist of traffic acquisition, sales commissions, salaries and other costs of employment for our sales force, customer service staff and marketing personnel, advertising and promotional expenses. When an advertiser makes a deposit into its account with us, our applicable salesperson earns a commission. We record sales commission expense in the period the deposit is received. We expect our sales and marketing expenses will continue to increase in absolute dollars as we continue to increase the advertising and traffic acquisition for our Local.com web site.
General and Administrative
General and administrative expenses consist of salaries and other costs of employment of our executive, finance and information technology staff, along with legal, tax and accounting, and professional service fees. We expect that our general and administrative expenses will decrease in absolute dollars as a result of lower stock option expense.
Research and Development
Research and development expenses consist of salaries and other costs of employment of our development staff, outside contractor costs and amortization of capitalized web site development costs. We expect research and development expenses to continue at the same level for the next year.
Critical Accounting Policies
The preparation of our consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities and equity and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenue and expenses during the reported period. We review our estimates on an ongoing basis. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the result of which forms the basis for making judgments about the carrying values of assets and liabilities and the reported amounts of revenue and expenses. Actual results may differ from these estimates under different assumptions or conditions. Our significant accounting policies described in more detail in Note 1 to our consolidated financial statements included in this Report, involve judgments and estimates that are significant to the presentation of our consolidated financial statements.
Revenue Recognition
We recognize revenue when all of the following conditions are satisfied: (1) there is persuasive evidence of an arrangement; (2) the service has been provided to the customer; (3) the amount of fees to be paid by the customer is fixed or determinable; and (4) the collection of our fees is probable.
We generate revenue when it is realizable and earned, as evidenced by click-throughs occurring on our advertisers’ sponsored listings or display of a banner advertisement. Prior to supplying a click-through, we enter into a contractual arrangement to distribute sponsored listings from an advertiser or an Advertiser Network partner. The advertisers provide sponsored listings along with bid prices (what the advertisers are willing to pay for each click-through on those listings) to us. These sponsored listings are then included as search results that we distribute in response to keyword searches performed by consumers on our Distribution Network, including our own Local.com web site. Depending on the source of the advertiser, we recognize an applicable portion of the bid price for each click-through we deliver on advertisers’ sponsored listings. We recognize revenue when earned based on click-through activity to the extent that the direct advertiser has deposited sufficient funds with us or collection is reasonably assured from credit worthy direct advertisers and Advertiser Network partners.
We distribute sponsored listings to our Distribution Network partners in response to consumer national search requests and share a portion of revenue generated with these partners. In accordance with Emerging Issue Task Force No. 99-19, Reporting Revenue Gross as a Principal Versus Net as an Agent, revenue is reported gross of the payment to Distribution Network partners because we act as the primary obligor and are responsible for the fulfillment of services. For local searches, we show business listings and sponsored listings on our Local.com web site and as a result, we do not share a portion of revenue generated on click-throughs.
We do not record an allowance for refunds due to click-fraud since we have developed filtering technology designed to identify click-fraud, double-clicks and other types of illegitimate click-throughs. Our system is designed to automatically detect and void these illegitimate click-throughs daily, prior to billing or charging advertisers. Although we have no means of calculating the exact number of illegitimate click-throughs that are not automatically detected and voided, we believe such amounts are immaterial.
Allowance for Doubtful Accounts
Our management estimates the uncollectability of our accounts receivable for losses that may result from the inability of our customers to make required payments. Management specifically analyzes accounts receivable and historical bad debt, customer concentration, customer credit-worthiness, current economic trends and changes in customer payment terms when evaluating the adequacy of the allowance for doubtful accounts. If we believe that our customers’ financial condition has deteriorated such that it impairs their ability to make payments to us,
additional allowances may be required. We review past due accounts on a monthly basis and record an allowance for doubtful accounts generally equal to any accounts receivable that are over 90 days past due.
As of December 31, 2006, one customer represented 52% and another customer represented 11% of our total accounts receivable. These customers have historically paid within the payment period provided for under the contract and management believes these customers will continue to do so.
Stock Based Compensation
In December 2004, the Financial Accounting Standard Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 123R, Share-Based Payment, which addresses the accounting for employee stock options. SFAS No. 123R requires that the cost of all employee stock options, as well as other equity-based compensation arrangements, be reflected in the financial statements based on the estimated fair value of the awards. That cost will be recognized over the period during which an employee is required to provide service in exchange for the award - the requisite service period (usually the vesting period).
We adopted SFAS No. 123R on January 1, 2006, the beginning of our first quarter of fiscal 2006, using the modified-prospective transition method. Under the modified-prospective transition method prior periods of our financial statements are not restated for comparison purposes. In addition, the measurement, recognition and attribution provisions of SFAS No. 123R apply to new grants and grants outstanding on the adoption date. Estimated compensation expense for outstanding grants at the adoption date will be recognized over the remaining vesting period using the compensation expense calculated for the pro forma disclosure purposes under SFAS No. 123, Accounting for Stock-Based Compensation.
Total stock-based compensation expense recognized for the year ended December 31, 2006 is as follows (in thousands, except per share amount):
Results of Operations
The following table sets forth our historical operating results as a percentage of revenue for the years ended December 31, 2006, 2005 and 2004:
Years ended December 31, 2006 and 2005
Revenue
Revenue was $14.2 million and $18.1 million for 2006 and 2005, respectively, representing a decrease of $3.9 million or 21.6%. The decrease in our total revenue was primarily due to a decreased number of revenue-generating click-throughs from our national business as a result of national advertisers reducing overall spending with us. The decrease was partially offset by an increase in click-throughs from our local business as a result of our launch of Local.com in August 2005. We expect revenue from our local business to continue to increase and revenues from our national business to decline as we continue to transition away from national services in order to focus on local search.
Revenue from our local business was $8.1 million or 57.0% of our total revenue, revenue from our local international business was $144,000 or 1.0% of our total revenue and revenue from our national business was $6.0 million or 42.0% of our total revenue for the year ended December 31, 2006. Revenue from our local business was $856,000 or 4.7% of our total revenue, revenue from our local international business was $476,000 or 2.6% of our total revenue and revenue from out national business was $16.8 million or 92.7% of our total revenue for the year ended December 31, 2005.
We derived 26.7% of our revenue from direct advertisers and 73.3% of our revenue from our Advertiser Network partners during 2006 as compared to 56.7% of our revenue from direct advertisers and 43.3% of our revenue from our Advertiser Network partners during 2005. Our national Advertiser Network partner, LookSmart, Ltd. represented 15.1% and 29.6% of our revenue for the years ended December 31, 2006 and 2005, respectively, and our local Advertising Network partner, Yahoo! Inc., represented 39.5% and 2.4% of our total revenue for the years ended December 31, 2006 and 2005.
Search serving
Search serving expenses were $5.0 million and $10.7 million for 2006 and 2005, respectively, representing a decrease of $5.7 million or 53.7%. As a percentage of revenue, search serving expenses were 34.9% and 59.0% for 2006 and 2005, respectively. The decrease in absolute dollars was due to decreased payments to our Distribution Network partners associated with our lower national business revenue in the current period. The decrease in percentage was due to a greater portion of our revenue being generating from our local search business which has minimal search serving expense associated with it.
Sales and marketing
Sales and marketing expenses were $13.1 million and $6.0 million for 2006 and 2005, respectively, representing an increase of $7.1 million or 118.6%. As a percentage of revenue, sales and marketing expenses were 92.7% and 33.2% for 2006 and 2005, respectively. The increase in absolute dollars was primarily due to an increase in advertising expenses and traffic acquisition costs (TAC) for our Local.com web site, along with the non-cash stock based compensation expense as a result of the adoption of SFAS No. 123R. We expect sales and marketing expenses to increase as we increase our TAC for our Local.com web site.
General and administrative
General and administrative expenses were $5.9 million and $4.0 million for 2006 and 2005, respectively, representing an increase of $1.9 million or 46.1%. As a percentage of revenue, general and administrative expenses were 41.4% and 21.7% for 2006 and 2005, respectively. The increase in absolute dollars was primarily due to the non-cash stock based compensation expense as a result of the adoption of SFAS No. 123R.
Research and development
Research and development expenses were $2.8 million and $3.0 million for 2006 and 2005, respectively, representing a decrease of $152,000 or 5.1%. As a percentage of revenue, research and development expenses were 20.0% and 16.5% for 2006 and 2005, respectively. The decrease in absolute dollars was primarily due to the capitalization of website development costs partially offset by an increase in salaries and related personnel costs as a result of an increase in research and development headcount to develop our local search services along with the non-cash stock based compensation expense as a result of the adoption of SFAS No. 123R. We capitalized an additional
$392,000 of research and development expenses for website development and amortized $174,000 during the year ended December 31, 2006. We capitalized $244,000 of research and development expenses for website development and amortized $34,000 during the year ended December 31, 2005.
Amortization and write-down of intangibles
Amortization and write-down of intangibles expense was $947,000 and $1.1 million for 2006 and 2005, respectively. This includes the amortization of developed technology, customer contracts and relationships, and non-compete agreements associated with the Inspire acquisition, along with the amortization of purchase technology and non-compete agreement associated with the Atlocal asset purchase. Also, during the fourth quarter of 2005, we determined that the remaining carrying value of customer contracts and relationships of $337,000 was not supported by the expected present value of discounted cash flows and as a result recorded a write-down of $337,000.
Interest and other income (expense)
Interest and other income (expense) was $288,000 and $680,000 for 2006 and 2005, respectively, representing a decrease in net interest and other income of $392,000. This decrease was due to lower interest income as a result of less cash available to invest.
Provision (benefit) for income taxes
Provision (benefit) for income taxes was $1,000 and $498,000 for 2006 and 2005 respectively. During the quarter ended September 30, 2005, we revised our allowance to provide a full valuation allowance against our deferred income tax assets. Based on available evidence, both positive and negative, we feel it is “more likely than not” that all of our deferred tax assets will not be realized. We evaluate, at least quarterly, the realizability of our deferred income tax assets and assess the need for a valuation allowance. Examples of evidence considered in our periodic assessments include, but are not limited to, our historical operating performance, future earnings projections and possible tax-planning strategies. If sufficient positive evidence becomes apparent, we may be required to reduce our valuation allowance, in whole or in part, resulting in income tax benefits reflected in our statement of operations.
Net income (loss)
We had a net loss of $13.3 million and $6.5 million for 2006 and 2005, respectively.
Years ended December 31, 2005 and 2004
Revenue
Revenue was $18.1 million and $19.1 million for 2005 and 2004, respectively, representing a decrease of $933,000 or 4.9%. The decrease was primarily due to a decreased number of revenue-generating click-throughs as a result of our efforts to improve traffic quality by applying more stringent filtering criteria to click-through from our Distribution Network. Additionally, advertisers have reduced overall spending with us resulting in lower revenue for the year ended December 31, 2005.
Revenue from our national business was $16.8 million or 92.7% of our total revenue, revenue from our local business was $856,000 or 4.7% of our total revenue and revenue from our local international business was $476,000 or 2.6% of our total revenue for the year ended December 31, 2005. Our national business comprised 100% of our total revenue for the year ended December 31, 2004.
We derived 56.7% of our revenue from direct advertisers and 43.3% of our revenue from our Advertiser Network partners during 2005 as compared to 55.6% of our revenue from direct advertisers and 44.4% from our Advertiser Network partners during 2004. One of our Advertiser Network partners, LookSmart, Ltd. represented 29.6% and 34.9% of our revenue for the years ended December 31, 2005 and 2004, respectively.
No Distribution Network partner represented greater than 10% of our revenue for the years ended December 31, 2005 or 2004.
Search serving
Search serving expenses were $10.7 million and $9.7 million for 2005 and 2004, respectively, representing an increase of $1.0 million or 10.4%. As a percentage of revenue, search serving expenses were 59.0% and 50.8% for 2005 and 2004, respectively. The increase in search serving expense and search serving expense as a percentage of revenue was due to increased revenue sharing arrangements with our Distribution Network partners along with a one-time expense of $664,000 for a license fee due to Overture. We will continue to pay Overture a percentage of our gross revenue from our direct advertisers. However, we expect our search serving expense to decrease as our revenue from our national business decreases.
Sales and marketing
Sales and marketing expenses were $6.0 million and $3.8 million for 2005 and 2004, respectively, representing an increase of $2.3 million or 59.6%. As a percentage of revenue, sales and marketing expenses were 33.2% and 19.8% for 2005 and 2004, respectively. The increase in absolute dollars was primarily due to an increase in salaries and related personnel costs as a result of an increase in sales and marketing headcount and an increase in advertising expense for the launch of our local.com web site.
General and administrative
General and administrative expenses were $4.0 million and $2.6 million for 2005 and 2004, respectively, representing an increase of $1.4 million or 52.1%. As a percentage of revenue, general and administrative expenses were 22.2% and 13.9% for 2005 and 2004, respectively. The increase in absolute dollars was primarily due to and increase in consulting, legal and accounting fees, recruiting fees for our chief operating officer, and a one-time expense for severance pay.
Research and development
Research and development expenses were $3.0 million and $1.3 million for 2005 and 2004, respectively, representing an increase of $1.7 million or 133.1%. As a percentage of revenue, research and development expenses were 16.5% and 6.7% for 2005 and 2004, respectively. The increase in absolute dollars was primarily due to an increase in salaries and related personnel costs as a result of an increase in research and development headcount and consulting fees to improve our national search filtering.
Amortization and write-down of intangibles
Amortization and write-down of intangibles expense was $1.1 million and zero for 2005 and 2004, respectively. This includes the amortization of developed technology, customer contracts and relationships, and non-compete agreements associated with the Inspire acquisition, along with the amortization of purchase technology and non-compete agreement associated with the Atlocal asset purchase. Also, during the fourth quarter of 2005, we determined that the remaining carrying value of customer contracts and relationships of $337,000 was not supported by the expected present value of discounted cash flows and as a result recorded a write-down of $337,000.
Interest and other income (expense)
Interest and other income (expense) was $680,000 and $(656,000) for 2005 and 2004, respectively, representing an increase in net interest and other income of $1.3 million. This increase was due to interest income from cash we raised in our initial public offering and our private placement in the fourth quarter of 2004, along with a one-time abatement of penalties and interest from the IRS relating to our payroll tax liability and the elimination of interest expense relating to the convertible secured debentures and convertible secured promissory notes.
Provision (benefit) for income taxes
Provision (benefit) for income taxes was $498,000 and $(521,000) for 2005 and 2004 respectively. During the fourth quarter of 2004, we released a portion of our valuation allowance for our deferred income tax assets due to our operating performance and forecasted operating results. As a result, we recorded deferred income tax assets of $678,000 and deferred income tax liabilities of $151,000. During the quarter ended September 30, 2005, we revised our allowance to provide a full valuation allowance against our deferred income tax assets. Based on available
evidence, both positive and negative, we feel it is “more likely than not” that all of our deferred tax assets will not be realized. We evaluate, at least quarterly, the realizability of our deferred income tax assets and assess the need for a valuation allowance. Examples of evidence considered in our periodic assessments include, but are not limited to, our historical operating performance, future earnings projections and possible tax-planning strategies. If sufficient positive evidence becomes apparent, we may be required to reduce our valuation allowance, in whole or in part, resulting in income tax benefits reflected in our statement of operations.
Net income (loss)
We had net income (loss) of $(6.5 million) and $1.5 million for 2005 and 2004, respectively. Our net loss for the year ended December 31, 2005 includes material expenses with no comparative effects in 2004 of $1.6 million which consists of: $664,000 for a license fee; $527,000 for the non-cash income tax provision; $337,000 for the write-down of customer contracts and relationships; $53,000 for fixed asset disposals relating to the move of our corporate office; and $50,000 rent expense for the sublet of our old office.
Liquidity and Capital Resources
We have funded our business, to date, primarily from the issuance of equity and debt securities. Cash and cash equivalents were $3.3 million as of December 31, 2006. Marketable securities were $2.0 million as of December 31, 2006. We had positive working capital of $3.4 million at December 31, 2006.
Years ended December 31, 2006 and 2005
Net cash used in operations was $9.2 million and $3.4 million in 2006 and 2005, respectively. The increase in cash used in operations was primarily due to an increased net loss and an increase in accounts receivable partially offset by higher depreciation and amortization, a decrease in cash received for lease incentive and a decrease in deferred tax assets.
Net cash provided by (used in) investing activities was $11.1 million and $(22.4 million) in 2006 and 2005, respectively. In 2006, we received $11.4 million in proceeds from the sale of marketable securities and paid $487,000 for capital expenditures. In 2005, we paid $15.3 million in cash for our acquisition of Inspire Infrastructure 2i AB and $4.0 million for capital expenditures. We expect cash provided by investing activities to decrease substantially in 2007 as a result of less marketable securities available to sell and an increase in planned acquisition activity.
Net cash provided by financing activities was $310,000 and $2.3 million in 2006 and 2005, respectively. In 2006, we raised $77,000 from the exercise of warrants and $344,000 from the exercise of stock options. In 2005, we raised $1.1 million from the exercise of warrants and $1.4 million from the exercise of stock options.
Inspire Infrastructure 2i AB Acquisition
On February 28, 2005, we completed the acquisition, through a wholly owned subsidiary, of all of the outstanding capital stock of Inspire Infrastructure 2i AB (Inspire), a Swedish Internet and wireless local-search technology company. Under the terms of the acquisition, Inspire shareholders received $15.0 million in cash and cash acquisition costs of $409,000. Under the terms of the acquisition, Inspire shareholders could have received additional consideration consisting of up to 447,067 shares of our common stock, valued at $7.5 million based upon a 30-day moving average at the date of acquisition, which was payable upon the achievement of certain future business performance criteria.
On May 15, 2006, we entered into a Share Purchase Termination Agreement with Interchange Europe Holding Corporation, our wholly owned subsidiary, and the five former shareholders of Inspire Infrastructure 2i AB (Sellers) to terminate all provisions of the Share Purchase Agreement dated February 2, 2005, except for Provision 10 - Non-Compete and Section 11.7 - Confidentiality. As a result of this termination, $232,000 of the cash escrow was returned to us which reduced goodwill. In addition, the Sellers will not earn or receive the additional consideration of 447,067 shares of our common stock.
On December 20, 2006, we entered into a Share Purchase Agreement with Starboard Finans AB to sell all of the outstanding capital stock of Interchange Europe AB (formerly Inspire Infrastructure 2i AB) we owned (1,000 shares) for $140 (SEK 1,000).
Private Placement
On February 23, 2007, we entered into a Purchase Agreement with two investors. Pursuant to this agreement, the investors purchased an aggregate of $8.0 million of 9% senior secured convertible notes and warrants to purchase shares of our common stock. The senior secured convertible notes are secured by our assets and are due on February 23, 2009. Each senior secured convertible note holder has the right, at any time, to convert their note into shares of our common stock at an initial conversion ratio of one share of common stock for each $4.02 of principal amount of debenture. We also issued warrants to purchase an aggregate of 796,020 shares of common stock at an exercise price of $4.82 per share that expire five years from the date of issuance and warrants to purchase an aggregate of 796,020 shares of common stock at an exercise price of $5.63 per share that expire five years from the date of issuance. The relative fair value of these warrants, using the Black-Scholes model at the date of grant, was $3.1 million and will be recorded as convertible debt discount and will be amortized over the life of the debentures. The assumptions used in the Black-Scholes model were as follows: no dividend yield; 4.67% interest rate; five years contractual life; and volatility of 100%.
In connection with the issuance of the convertible secured debentures, we paid $530,000 in cash for placement agent fees of which $205,000 was paid to a member of our board of directors. These fees are recorded in prepaid expenses and will be amortized over the life of the debentures. We also issued warrants to purchase an aggregate of 71,642 shares of common stock at an exercise price of $4.82 per share that expire five years from the date of issuance and warrants to purchase an aggregate of 71,642 shares of common stock at an exercise price of $5.63 per share that expire five years from the date of issuance. The fair value of these warrants, using the Black-Scholes model at the date of grant, was $458,000 and will be recorded in prepaid expenses and will be amortized over the life of the debentures.
Management believes, based upon projected operating needs and our recent financing, our working capital is sufficient to fund our operations for at least the next 12 months.
Contractual Obligations
The following table sets forth certain payments due under contractual obligations with minimum firm commitments as of December 31, 2006 (in thousands):
(1)
Represents a non-cancelable operating lease agreement for our office that expires in June 2010.
Off-Balance Sheet Arrangements
We do not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that are material to our investors.
New Accounting Pronouncements
In June 2006, FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes (FIN48), which defines the threshold for recognizing the benefits of tax return positions in the financial statements as “more-likely-than-not”to be sustained by the taxing authority. A tax position that meet the “more-likely-than-not” criterion shall be measured at the largest amount of benefit that is more than 50% likely of being realized upon ultimate settlement. FIN48 applies to all tax positions accounted for under SFAS No. 109, Accounting for Income Taxes. FIN48 is effective for fiscal years beginning after December 15, 2006. Upon adoption, we will adjust our financial statements to reflect only those tax positions that are more-likely-than-not to be sustained as of the adoption date. Any adjustment will be recorded directly to our beginning retained earnings balance in the period of adoption and reported as a change in accounting principle. We are currently analyzing the effect of adopting FIN48.
In September 2006, FASB issued SFAS No. 157, Fair Value Measurements which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands
disclosures about fair value measurements. This statement does not require any new fair value measurements; rather, it applies under other accounting pronouncements that require or permit fair value measurements. The provisions of SFAS No. 157 are effective for fiscal years beginning after November 15, 2007. We are currently assessing SFAS No. 157 and have not yet determined the impact, if any, that its adoption will have on our results of operations or financial condition.
ITEM 7A.
ITEM 7A.
Quantitative and Qualitative Disclosures About Market Risk
We are exposed to market risk relating to interest rate changes relating to our marketable securities. We invest our excess cash in debt instruments of the U.S. government.
Investments in fixed rate and floating rate interest earning instruments carry a degree of interest rate risk. Fixed rate securities may have their fair market value adversely impacted due to a rise in interest rates, while floating rate securities may produce less income than expected if interest rates fall. Due to these factors, our future investment income may fall short of expectations due to changes in interest rates or we may suffer losses in principal if forced to sell securities which have declined in market value due to changes in interest rates. A hypothetical 1.00% (100 basis-point) increase in interest rates would have resulted in a decrease in the fair values of our marketable securities of approximately $405,000 and $3.2 million at December 31, 2006 and 2005, respectively.
ITEM 8.
ITEM 8.
Financial Statements and Supplemental Data
Our consolidated financial statements, including the report of our independent registered public accounting firm, are included beginning at page immediately following the signature page of this Report.
ITEM 9.
ITEM 9.
Changes In and Disagreements with Accountants on Accounting Issues and Financial Disclosure
None
ITEM 9A.
ITEM 9A.
Controls and Procedures
We maintain disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended) that are designed to ensure that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.
In designing and evaluating the disclosure controls and procedures, our management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and that our management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
As required by Rule 13a-15(b) and 15d-15(b) under the Exchange Act, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the fiscal quarter covered by this Report. Based upon the foregoing, the Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective in reaching a level of reasonable assurance in achieving our desired control objectives.
There have been no significant changes in our internal control over financial reporting during the last fiscal year that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
ITEM 9B.
ITEM 9B.
Other Information
None
PART III
ITEM 10.
ITEM 10.
Directors, Executive Officers and Corporate Governance
Directors, Executive Officers and Key Employees
The following table sets forth, as of February 28, 2007, certain information concerning our executive officers, other key employees and directors:
(1)
Executive officer.
Heath B. Clarke has served as our Chairman of the Board since March 1999, as our President from March 1999 to December 2000 and as our Chief Executive Officer since January 2001. From 1998 to February 1999, Mr. Clarke was the Vice President of eCommerce for LanguageForce, Inc., a language translation software company. Prior to that time, he was a Marketing Manager for Starnet International (Canada), an Internet company. From 1995 to 1998 he held managerial positions with the Berg Group of Companies (Australia), and from 1988 to 1995 he was founder and Chief Executive Officer of Australian Fibre Packaging.
Stanley B. Crair has served as our Chief Operating Officer since July 2005 and as our President since April 2006. From 2003 to April 2005 Mr. Crair was the COO of ZeroDegrees, Inc., an internet company that provided online social networking services to business professionals, which he co-founded. The company was purchased by IAC/InterActiveCorp in 2004 and Crair remained active in the company until April 2005. From 2001 to 2003, Mr. Crair was the principal of Technology Transformation, a consulting company he founded providing strategic consulting and interim CEO/COO services. Mr. Crair received a Masters of Business Administration degree in Corporate Strategy and International Business from the University of California, Berkeley and a Bachelor of Science degree in Physics from the United States Naval Academy.
Douglas S. Norman has served as our Chief Financial Officer since February 2003 and as our Secretary since July 2003. From February 2000 through December 2002, Mr. Norman was Chief Financial Officer at Starbase Corporation, a software company that he co-founded. Mr. Norman received a Masters of Business Administration degree from Loyola Marymount University and a Bachelor of Science degree in Business Administration from California State University, Long Beach.
Jennifer R. Black has served as our Vice President of Marketing since April 2006. From May 2005 to April 2006, Ms. Black was the Director of Online Marketing at Autobytel, Inc., an Internet company that connects buyers and sellers of autos through a content and pricing lead system. From May 2004 to May 2005, Ms. Black was eCommerce Director at Teleflora, LLC, a provider of florist products and services. From December 1999 to March 2004, Ms. Black was Director of Online Marketing at FranklinCovey Corporation, an organizational improvement company. Ms. Black received a Bachelors of Arts degree in Business Management from the University of Utah.
Heather A. Dilley has served as our Vice President of Human Resources since January 2007. From October 2005 to January 2007, Ms. Dilley served as our Director of Human Resources. From June 2004 to October 2005, Ms. Dilley was the Manager of Human Resources for Paciolan, Inc. an online ticketing software company. From December 2002 to June 2004, Ms. Dilley was the Senior Human Resources Generalist for Rainbow Technologies. From June 2002 to November 2002, Ms. Dilley was the Regional Human Resources Manager for New Horizons Computer Learning Center. From May 2001 to February 2002, Ms. Dilley was a Recruiting Consultant for
Washington Mutual Bank. Ms. Dilley received a Master’s of Science degree in Human Resource Management and a Bachelor of Arts degree in Sociology from Chapman University.
Peter S. Hutto has served as our Vice President of Business Development and Sales since October 2005. From July 2005 to October 2005, Mr. Hutto was an independent contractor acting as Vice President of Development for us. From January 2003 to July 2005, Mr. Hutto was co-founder and Vice President of Business Development and Marketing for Zero Degrees, Inc., an operating unit of IAC/Interactive Corporation. From June 2002 to December 2002, Mr. Hutto was Vice President of Sales and Business Development of Celcorp Inc. From June 2001 to December 2001, Mr. Hutto was Business Strategy and Startup Advisor to Octane Ventures. Mr. Hutto received a Bachelor of Arts degree in Political Science from the University of North Carolina, Chapel Hill.
Ralph N. Kravitz has served as our Vice President of Operations since April 2004. From December 2001 to April 2004, Mr. Kravitz served as our Director of Operations and from January 2001 to December 2001 he served as our Technical Operations Manager. Mr. Kravitz received a Bachelor of Arts degree in Business Management from California State University, Fullerton.
John L. Siegfried has served as our Vice President of Engineering since April 2006. From July 2004 to April 2006, Mr. Siegfried was COO/CIO of Future Trade Corporation, a web-based electronic stock brokerage firm. From July 2001 to July 2004, Mr. Siegfried was Vice President of eCommerce and Business Development at DHL Corporation, an international shipping and logistics company. From February 1993 to February 2001, Mr. Siegfried was Senior Vice President of Technology and Client Services at Instinet Corporation, an electronic stock brokerage firm. Mr. Siegfried received a Business Administration degree in Computer MIS from California State University, Hayward.
Norman K. Farra Jr. has served as a director since August 2005. Mr. Farra is currently an independent contractor acting as Managing Director of Investment Banking for GunnAllen Financial Inc. From June 1999 to June 2001, Mr. Farra was President of Next Millennium Capital Holdings LLC, a financial advisory company. Mr. Farra received a Bachelor of Science degree in Accounting from Widener University.
Philip K. Fricke has served as a director since October 2003. Mr. Fricke is currently President of PKF Financial Consultants, Inc., a private company he founded in March 2001, which provides financial communications services and advisory services to public and private companies. Mr. Fricke also serves as director of Mi Developments Inc. Mr. Fricke received a Bachelor of Science degree and a Master of Science degree in Psychology, as well as a Master of Business Administration degree in Finance and Economics, from Fairleigh Dickinson University.
Theodore E. Lavoie has served as a director since April 1999. Mr. Lavoie is currently Chief Executive Officer of Greenline Industries, a biodiesel production equipment manufacturer. From January 2005 to May 2006, Mr. Lavoie was an independent financial consultant. From October 2003, to January 2004, Mr. Lavoie served as Vice President of Marsh Inc., a global risk and insurance services firm. From October 2002 to September 2003, Mr. Lavoie served as an independent financial consultant with Montgomery Financial Services, a financial services company. From August 1999 to May 2002, Mr. Lavoie served as Chief Financial Officer of eBuilt Inc., a software company. Mr. Lavoie also serves as a director of Financial Executives International, San Francisco. Mr. Lavoie received a Masters of Business Administration degree and a Bachelor of Science degree in Business Administration from Loyola Marymount University.
John E. Rehfeld has served as a director since August 2005 and our lead director since December 2005. Mr. Rehfeld is currently the adjunct professor of marketing for the Executive MBA Program at Pepperdine University. During 2001, Mr. Rehfeld served as Chairman and Chief Executive Officer of Spruce Technologies, Inc., a DVD authoring software company. From 1997 to 2001, Mr. Rehfeld served as Chairman and Chief Executive Officer of ProShot Golf, Inc., a privately-held company providing GPS distance measuring computers on golf carts. Mr. Rehfeld also serves as director of ADC Telecommunication, Inc., Primal Solutions, Inc., and Island Data Corporation. Mr. Rehfeld received a Masters of Business Administration degree from Harvard University and a Bachelor of Science degree in Chemical Engineering from the University of Minnesota.
Board of Directors
Our board of directors currently consists of the following five members: Heath B. Clarke (Chairman), Norman K. Farra Jr., Philip K. Fricke, Theodore E. Lavoie and John E. Rehfeld. There are no family relationships among any of our current directors and executive officers.
The number of authorized members of our board of directors is determined by resolution of our board of directors. In accordance with the terms of our amended and restated certificate of incorporation, our board of directors is divided into three classes, with each class serving staggered three-year terms. The membership of each of the three classes is as follows:
•
the class I directors are Messrs. Fricke and Farra, and their term will expire at the annual meeting of stockholders to be held in 2008;
•
the class II directors are Messrs. Lavoie and Rehfeld, and their term will expire at the annual meeting of stockholders to be held in 2009; and
•
the class III director is Mr. Clarke, and his term will expire at the annual meeting of stockholders to be held in 2007.
Our amended and restated bylaws provide that the authorized number of directors may be changed only by resolution of our board of directors. Any additional directorships resulting from an increase in the number of directors will be distributed between the three classes so that, as nearly as possible, each class will consist of one-third of our directors. This classification of our board of directors may have the effect of delaying or preventing changes in control or management of our company.
Our board of directors has designated an audit committee and a nominating, compensation and governance committee, and may establish other committees as it deems necessary or appropriate.
Audit Committee
Our audit committee consists of Messrs. Lavoie, Fricke and Farra. Messrs. Lavoie, Fricke and Farra all qualify as independent and meet the financial literacy requirements under applicable Nasdaq rules and are audit committee financial experts. Our independent auditors and our internal financial personnel regularly meet privately with and have unrestricted access to our audit committee. Our audit committee operates pursuant to a written charter that satisfies applicable SEC and Nasdaq rules. Our audit committee charter is available on our web site, www.local.com.
Our audit committee oversees our corporate accounting and financial reporting processes. The functions and responsibilities of our audit committee are to, among other things:
•
evaluate our independent auditors’ qualifications, independence and performance;
•
determine the engagement of our independent auditors;
•
approve the retention of our independent auditors to perform any proposed, permissible non-audit services;
•
monitor the rotation of partners of the independent auditors on our engagement team as required;
•
review our financial statements;
•
review our critical accounting policies and estimates; and
•
discuss with our management and our independent auditors the results of our annual audit and the review of our quarterly financial statements.
REPORT OF THE AUDIT COMMITTEE
The following Report of the Audit Committee does not constitute soliciting material and should not be deemed filed or incorporated by reference into any other Company filing under the Securities Act of 1933 or the Securities Exchange Act of 1934, except to the extent we specifically incorporate this Report by reference therein.
The Audit Committee of the Board of Directors operates pursuant to a written charter. The Committee met five times during fiscal 2006 to fulfill its responsibilities. To ensure independence, the Audit Committee also meets separately with the Company’s independent registered public accounting firm and members of management. All members of the Audit Committee are non-employee directors and satisfy the current Nasdaq Stock Market listing standards and SEC requirements with respect to independence, financial sophistication and experience.
The role of the Audit Committee is to oversee the Company’s financial reporting process on behalf of the Board of Directors. Management of the Company has the primary responsibility for the Company’s consolidated financial statements as well as the Company’s financial reporting process, principles and internal controls. The independent registered public accounting firm is responsible for performing an audit of the Company’s financial statements and expressing an opinion as to the conformity of such consolidated financial statements with generally accepted accounting principles.
In this context, the Audit Committee has reviewed and discussed the audited financial statements of the Company as of and for the year ended December 31, 2006, with management and the independent registered public accounting firm (Auditors). These reviews included discussion with the outside Auditors of matters required to be discussed pursuant to Statement on Auditing Standards No. 61 (Communication with Audit Committees). In addition, the Audit Committee has received the written disclosures and the letter from the independent Auditors required by Independence Standards Board Standard No. 1 (Independence Discussions with Audit Committees), as currently in effect, and it has discussed with the Auditors their independence from the Company.
Based on the reports and discussions described above, the Audit Committee recommended to the Board of Directors that the audited financial statements be included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2006, for filing with the Securities and Exchange Commission.
Theodore E. Lavoie, Chairman
Norman K. Farra Jr.
Philip K. Fricke
March 12,
Nominating, Compensation and Governance Committee
Our nominating, compensation and governance committee consists of Messrs. Rehfeld, Lavoie and Fricke. Our nominating, compensation and governance committee charter is available on our web site, www.local.com.
The purpose of our nominating, compensation and governance committee is to assist our board of directors in discharging the board’s responsibilities regarding, among other things:
•
the identification of qualified candidates to become board members;
•
the selection of nominees for election as directors at the next annual meeting of stockholders (or special meeting of stockholders at which directors are to be elected);
•
the selection of candidates to fill any vacancies on the board;
•
the compensation of our executives, including by designing (in consultation with management or the board), recommending to the board for approval, and evaluating our compensation plans, policies and programs;
•
producing an annual report on executive compensation for inclusion in our proxy materials in accordance with applicable rules and regulations;
•
the development and recommendation to the board of a set of corporate governance guidelines and principles applicable to us; and
•
oversight of the evaluation of the board.
Code of Business Conduct and Ethics
We have adopted a code of business conduct and ethics that applies to our officers, directors and employees. Our code of business conduct and ethics, as applied to our Chief Executive Officer, senior executive officers, principal accounting officer, controller and other senior financial officers complies with the requirements of Section 406 of the Sarbanes-Oxley Act. Our code of business conduct and ethics is available on our web site at www.local.com. In addition, a copy of the code of business conduct and ethics will be provided without charge upon request to Douglas S. Norman, Local.com Corporation, One Technology Drive, Building G, Irvine, CA 92618. We intend to timely disclose any amendments to or waivers of certain provisions of our code of business conduct and ethics that apply to our Chief Executive Officer, senior executive officers, principal accounting officer, controller
and other senior financial officers on our web site within five business days of such amendment or waiver or as otherwise required by the SEC or Nasdaq.
Section 16(a) Beneficial Ownership Reporting Compliance
Section 16(a) of the Exchange Act requires our directors and officers, and persons who own more than 10% of a registered class of our equity securities, to file with the SEC initial reports of ownership and reports of changes in ownership of equity securities of our common stock. Theses people are required by SEC regulations to furnish us with copies of all such reports they file. To our knowledge, based solely on our review of the copies of such reports furnished to us and written representations from certain insiders that no other report were required, all Section 16(a) filing requirements applicable to our insiders were complied with, except that Philip K. Fricke filed a late Form 4 relating to two transactions of common shares pledged as collateral for a personal loan with a third party (sale).
ITEM 11.
ITEM 11.
Executive Compensation
Compensation Discussion and Analysis
Philosophy and Review
Our compensation philosophy for executive officers is intended to:
•
Provide compensation that will attract, retain and motivate a superior executive team;
•
Motivate our executives to achieve important performance goals; and
•
Align the interests of our executive officers with those of our stockholders.
When determining compensation levels, our Nominating, Compensation and Governance Committee (Committee) considers compensation levels of executives at comparably-sized public high-tech companies in California along with our financial position and our performance. The Committee has retained independent consultants to advise the Committee on compensation matters. Executive compensation consists primarily of base salary, bonus and stock option grants.
Elements of Executive Officer Compensation
Base Salary
The Committee annually reviews the base salary for all executive officers, including the Chief Executive Officer. Base salary levels for our executives are targeted to be approximately the median of base salaries paid to comparably-sized public high-tech companies located in California. The Committee believes that this strategy is representative of companies similar to our company. The base salaries for the “named executive officers” for 2006 were maintained at the 2005 levels.
Bonus
The Committee annually establishes an annual target bonus for all executive officers, including the Chief Executive Officer. Bonus levels for our executives are targeted to be approximately the median of bonuses paid to comparably-sized public high-tech companies located in California. Twenty-five percent of the annual bonus is earned and paid each quarter based on targets approved by the full Board of Directors. The Committee meets quarterly to approve the pay-out of bonuses. The target bonuses for the Named Executive Officers for 2006 were maintained at the 2005 levels.
Stock Option Grants
Awards under the our stock option plans are designed to encourage long-term investment in our company, more closely align executive and stockholder interests and reward executives for enhancing stockholder value. The Committee believes stock ownership by management has been demonstrated to be beneficial to stockholders.
Under our stock option plans, the Committee may grant stock options to executives. The Committee generally grants incentive stock options within the meaning of the Internal Revenue Code. Under the terms and conditions of the plan, the Committee may, however, grant nonqualified options with an exercise price above or at the market
price on the date of grant. Generally, thirty-three percent of the options granted are available for exercise at the end of one year, while the remainder of the grant is exercisable ratably each quarter over the next eight quarters. The grants are generally for a term of ten years from the date of grant.
Stock options grants for our executives are targeted to be slightly above the median of stock options grants to executives of comparably-sized public high-tech companies located in California.
Section 162(m) Policy
Section 162(m) of the Internal Revenue Code limits the tax deductibility by a corporation of compensation in excess of $1 million paid to its Chief Executive Officer and any other of its four most highly compensated executive officers. However, compensation which qualifies as “performance-based” is excluded from the $1 million limit if, among other requirements, the compensation is payable only upon attainment of pre-established, objective performance goals under a plan approved by the corporation’s stockholders. It is our policy to qualify, to the extent reasonable, our executive officers’ compensation for deductibility under applicable tax law. However, we intend to retain the flexibility necessary to provide total cash compensation in line with competitive practice, our compensation philosophy, and our best interests. It therefore may from time to time pay compensation to our executive officers that may not be deductible.
Summary Compensation
The following table provides information regarding the compensation earned during the fiscal years ended December 31, 2006, 2005 and 2004 by our Chief Executive Officer and our two other executive officers. We refer to our Chief Executive Officer and these other executive officers as the named executive officers in this Report.
Summary Compensation Table
(1)
The value of option awards granted to our named executive officers has been estimated pursuant to SFAS 123R using the Black-Scholes option pricing model with the following weighted average assumptions: expected life: 7.5 years; volatility: 102 74%; risk free interest rate: 4.39%; and dividend yield: none.
(2)
Mr. Crair joined us on July 6, 2005 and we paid him his salary from that date. During 2005, Mr. Crair received other compensation of $2,350 for car allowance and $30,387 for relocation.
Employment Agreements and Change in Control Arrangements
Employment Agreement with Heath B. Clarke
We entered into an employment agreement with Heath B. Clarke, our Chairman and Chief Executive Officer, on January 2, 2003. The employment agreement has a term of two years and automatically renews for additional one year terms unless either party terminates it with at least 30 days notice to the other party.
If we terminate Mr. Clarke’s employment agreement without cause, or if Mr. Clarke terminates the agreement with good reason, each as defined in the agreement, we are obligated to pay Mr. Clarke: (i) his annual salary and other benefits earned prior to termination, (ii) the greater of his annual salary for the remaining term of the agreement or his annual salary payable over one year, (iii) the average of all bonuses earned by Mr. Clarke during the term of the agreement, payable in accordance with our standard bonus payment practices or immediately if and to the extent such bonus will be used by Mr. Clarke to exercise his stock options, (iv) benefits for 12 months following the date of termination, and (v) the right for 12 months from the date of termination to exercise all vested options granted to him prior to that time; provided that in the event the termination occurs within 120 days of the execution of an agreement which results in a change of control, as described below, vesting of all options will be accelerated and in the event the termination occurs outside of such 120 day period, all unvested options that would have vested had Mr. Clarke’s employment agreement remained in force through the end of the initial term will be fully vested immediately prior to such termination.
Employment Agreement with Stanley B. Crair
We entered into an employment agreement with Stanley B. Crair, our President and Chief Operating Officer, on July 6, 2005. The employment agreement has a term of one year and automatically renews for additional one year terms unless either party terminates it with at least 30 days notice to the other party.
If we terminate Mr. Crair’s employment agreement without cause, or if Mr. Crair terminates the agreement with good reason, each as defined in the agreement, we are obligated to pay Mr. Crair: (i) his annual salary and other benefits earned prior to termination, (ii) the greater of his annual salary for the remaining term of the agreement or his annual salary payable over one year, (iii) the average of all bonuses earned by Mr. Crair during the term of the agreement, payable in accordance with our standard bonus payment practices or immediately if and to the extent such bonus will be used by Mr. Crair to exercise his stock options, (iv) benefits for 12 months following the date of termination, and (v) the right for 12 months from the date of termination to exercise all vested options granted to him prior to that time; provided that in the event the termination occurs within 120 days of the execution of an agreement which results in a change of control, as described below, vesting of all options will be accelerated and in the event the termination occurs outside of such 120 day period, all unvested options that would have vested had Mr. Crair’s employment agreement remained in force through the end of the initial term will be fully vested immediately prior to such termination.
Employment Agreement with Douglas S. Norman
We entered into an employment agreement with Douglas S. Norman, our Chief Financial Officer and Secretary, on February 3, 2003. The employment agreement has a term of two years and automatically renews for additional one year terms unless either party terminates it with at least 30 days notice to the other party.
If we terminate Mr. Norman’s employment agreement without cause, or if Mr. Norman terminates the agreement with good reason, each as defined in the agreement, we are obligated to pay Mr. Norman: (i) his annual salary and other benefits earned prior to termination, (ii) the greater of his annual salary for the remaining term of the agreement or his annual salary payable over one year, (iii) an amount equal to 30% of his then current annual salary, payable in accordance with our standard bonus payment practices or immediately if and to the extent such bonus will be used by Mr. Norman to exercise his stock options, (iv) benefits for 12 months following the date of termination, and (v) the right for 12 months from the date of termination to exercise all vested options granted to him prior to that time; provided that in the event the termination occurs within 120 days of the execution of an agreement which results in a change of control, as described below, vesting of all options will be accelerated and in the event the termination occurs outside of such 120 day period, all unvested options that would have vested had Mr. Norman’s employment agreement remained in force through the end of the initial term will be fully vested immediately prior to such termination.
Each of the employment agreements discussed above provide for the immediate vesting of stock options granted pursuant thereto upon (i) a change in control of us or (ii) a termination of the executive’s employment without cause or for good reason within 120 days prior to the execution and delivery of an agreement which results in a change in control. Additionally, a change in control constitutes “good reason” under the terms of each of the agreements, thus permitting each of Messrs. Clarke, Crair and Norman to terminate his respective employment and receive the severance benefits discussed above. Under the terms of each employment agreement, a change in control
is deemed to have occurred if, as a result of a tender offer, other acquisition, merger, consolidation or sale or transfer of assets, any person(s) (as used in Sections 13(d) or 14(d) of the Securities Exchange Act of 1934) becomes the beneficial owner (as defined in regulations promulgated under the Exchange Act) of a total of fifty percent (50%) or more of either our outstanding common stock or our assets; provided, however, that a change of control is not deemed to have occurred if a person who beneficially owned fifty percent (50%) or more of our common stock as of the effective date of the respective employment agreement continued to do so during the term the employment agreement.
The employment agreements with Messrs. Clarke, Crair and Norman also contain standard confidentiality provisions that apply indefinitely and non-solicitation provisions that will apply during the term of the employment agreements and for a 12-month period thereafter.
Grants of Plan-Based Awards
The following table provides information regarding grants of plan-based awards that we granted to the named executive officers during the fiscal year ended December 31, 2006. Except for options granted to Heath B. Clarke, who is a 10% stockholder, all options were granted at the fair market value of our common stock on the date of grant, as determined by our board of directors. All options granted to Heath B. Clarke were granted at 110% of the fair market value of our common stock on the date of grant, as determined by our board of directors. Each option represents the right to purchase one share of our common stock. Generally, none of the shares subject to options are vested at the time of grant and 33.33% of the shares subject to such option grants vest on the date which is one year from the date of grant. The remainder of the shares vests in equal quarterly installments over the eight quarters thereafter.
Grants of Plan-Based Awards
Outstanding Equity Awards at Fiscal Year-End
The following table sets forth the number of shares of common stock subject to exercisable and unexercisable stock options held as of December 31, 2006 by each of the named executive officers.
Outstanding Equity Awards at Fiscal Year-End
(1)
1,848 options vested on January 28, 2007.
(2)
1/36th of total grant vests each month.
(3)
33.33% of total grant vests one year from the date of grant and the remainder vests quarterly over the next eight quarters.
Equity Incentive Plans
Our board of directors administers our 1999 Equity Incentive Plan, 2000 Equity Incentive Plan, 2004 Equity Incentive Plan, as amended, and 2005 Equity Incentive Plan. The board may elect to appoint a committee to administer any or all of such incentive plans. Each of these plans provide for the grant of incentive stock options to employees and non-qualified stock options to our employees, directors and consultants. These plans are provided to
attract and retain the best available personnel for positions of substantial responsibility and to provide additional incentive for employees, directors and consultants to promote our business. Stock purchase rights may also be granted under the plans.
No awards may be issued under the plans after the 10th anniversary of the earlier of (i) the date upon which the applicable plan was adopted by the board, or (ii) the date the applicable plan was approved by our stockholders.
The plans provide that the plan administrator has the authority to designate recipients of awards and to determine the terms and provisions of awards, including the exercise or purchase price, expiration date, vesting schedule and terms of exercise. The plans provide that the maximum number of shares which may be subject to awards granted to any individual in any calendar year will not exceed 300,000 shares in the case of our 1999 and 2000 Equity Incentive Plans and 600,000 shares in the case of our 2004 Equity Incentive Plan, as amended, and 2005 Equity Incentive Plan. However, this limit will not apply until the earliest of (i) the first material modification of the applicable plan, (ii) the issuance of all of the shares reserved for issuance under the applicable plan, (iii) the expiration of the applicable plan, (iv) the first meeting of our stockholders at which directors are to be elected that occurs more than three years after the completion of the offering, or (v) such other date required by Section 162(m) of the Internal Revenue Code and the rules and regulations promulgated thereunder.
The exercise price of nonqualified stock options and incentive stock options granted under the plans must be at least 85% and 100%, respectively, of the fair market value of our common stock on the date of grant. Nonqualified stock options and incentive stock options granted to optionees who own more than 10% of our outstanding common stock on the date of grant must have an exercise price that is at least 110% of the fair market value of our common stock on the grant date. Stock options granted under the plans will expire no later than ten years after the date of grant, or five years after the date of grant with respect to incentive stock options granted to individuals who own more than 10% of our outstanding common stock on the grant date. The purchase price, if any, of stock purchase rights will be determined by the plan administrator.
Our board has the discretion to grant options to our independent directors under each of our 1999 Equity Incentive Plan and 2000 Equity Incentive Plan. The board has the discretion as to the number of options granted, the number of shares subject to such options, and the terms and provisions of such options. Our 1999 Equity Incentive Plan and 2000 Equity Incentive Plan provide that the exercise price of each option granted to an independent director must be at least 100% of the fair market value of our common stock on the date of grant. Such options will be exercisable in cumulative monthly installments of 1/36th of the shares subject to such option on each of the monthly anniversaries of the date of grant, commencing with the first such monthly anniversary, such that each option will be 100% vested on the third anniversary of its date of grant. The options will have a ten year term. Our 2004 Equity Incentive Plan, as amended and 2005 Equity Incentive Plan provide that with respect to options granted to independent directors, the plans will be administered by our board.
The plans also provide for the issuance of stock purchase rights to eligible individuals. Stock purchase rights will generally be subject to such transferability and vesting restrictions as the plan administrator shall determine.
In the event of certain corporate transactions and changes in our corporate structure or capitalization, the plan administrator may make appropriate adjustments to (i) the aggregate number and kind of shares issuable under the plans, (ii) the number and kind of shares subject to outstanding awards, and (iii) the grant or exercise price of each outstanding award. In addition, in the event of an acquisition, each outstanding award may be assumed or substituted by the surviving corporation. In the event the surviving corporation does not assume or substitute such outstanding awards, the vesting of awards held by participants in the applicable plan whose status as a service provider has not terminated prior to such event will be accelerated and made fully exercisable and all restrictions thereon will lapse at least ten days prior to the closing of the acquisition. In the case of awards under our 2004 Equity Incentive Plan, immediately prior to the closing of the acquisition and with respect to any other awards outstanding under the applicable plan, such awards will be terminated if not exercised prior to the closing of the acquisition. The plan administrator also has the authority under the plans to take certain other actions with respect to outstanding awards in the event of certain transactions, including provision for the cash-out, termination, assumption or substitution of such awards.
Our board may at any time amend, alter, suspend or terminate any of the plans. However, no amendment may increase the maximum number of shares issuable under the applicable plan or extend the term of the applicable plan
without the approval of our stockholders. Any amendment, alteration, suspension or termination of any of the plans which impairs the rights of any holder of an outstanding award requires the written consent of the affected holder.
On November 19, 2004, we filed with the SEC a registration statement on Form S-8 covering the shares of common stock issuable under the 1999 Equity Incentive Plan, 2000 Equity Incentive Plan and 2004 Equity Incentive Plan, as amended.
On August 24, 2005, we filed with the SEC a registration statement on Form S-8 covering the shares of common stock issuable under the 2005 Equity Incentive Plan.
Equity Incentive Plan
In March 1999, our board of directors adopted and our stockholders approved our 1999 Equity Incentive Plan. An aggregate of 500,000 shares of our common stock are reserved for issuance under the 1999 Equity Incentive Plan. At December 31, 2006, options granted under the 1999 Plan to purchase an aggregate of 208,680 shares of our common stock, at a weighted average exercise price of approximately $2.89 per share, were outstanding.
Equity Incentive Plan
In March 2000, our board of directors adopted and our stockholders approved our 2000 Equity Incentive Plan. An aggregate of 500,000 shares of our common stock are reserved for issuance under the 2000 Equity Incentive Plan. At December 31, 2006, options granted under the 2000 Equity Incentive Plan to purchase an aggregate of 365,180 shares of our common stock, at a weighted average exercise price of approximately $3.26 per share, were outstanding.
Equity Incentive Plan
In January 2004, our board of directors adopted our 2004 Incentive Equity Plan. In August 2004, our board of directors amended our 2004 Equity Incentive Plan and adopted our Amended and Restated 2004 Equity Incentive Plan which our stockholders approved in September 2004. An aggregate of 600,000 shares of our common stock are reserved for issuance under the 2004 Equity Incentive Plan. At December 31, 2006, options granted under the 2004 Equity Incentive Plan to purchase an aggregate of 493,092 shares of our common stock, at a weighted average exercise price of approximately $8.07 per share, were outstanding.
Equity Incentive Plan
In August 2005, our board of directors adopted and our stockholders approved our 2005 Equity Incentive Plan. An aggregate of 1,000,000 shares of our common stock are reserved for issuance under the 2005 Equity Incentive Plan. At December 31, 2006, option granted under the 2005 Equity Incentive Plan to purchase an aggregate of 866,411 shares of our common stock, at a weighted average exercise price of approximately $4.71 per share, were outstanding.
Option Exercises and Stock Vested
None of our named executive officers exercised any stock options nor had any vesting of stock during the fiscal year ended December 31, 2006.
Director Compensation
The following table provides information regarding the compensation earned during the fiscal year ended December 31, 2006 by members of our Board or Directors unless the director is also a named executive officer:
2006 Director Compensation
(1)
The value of option awards granted to our directors has been estimated pursuant to SFAS 123R using the Black-Scholes option pricing model with the following weighted average assumptions: expected life: 7.3 years; volatility: 117.1%; risk free interest rate: 4.32%; and dividend yield: none.
(2)
65,000 aggregate stock options outstanding as of December 31, 2006.
(3)
55,000 aggregate stock options outstanding as of December 31, 2006.
(4)
55,794 aggregate stock options outstanding as of December 31, 2006.
Non-employee members of the Board of Directors receive an annual retainer of $20,000 plus $1,500 for each meeting attended in person and $750 for each meeting attended telephonically. The Lead Director receives and annual fee of $12,500. The Chairman of the Audit Committee receives an annual fee of $10,000. The Chairman of the Nominating, Compensation and Governance Committee receives an annual fee of $7,500. Board of Directors committee members receive $1,200 for each committee meeting attended. In addition, all members of the Board of Directors receive an annual grant of an option to purchase 15,000 shares of Local.com Corporation common stock. New members to the Board of Directors receive a grant of an option to purchase 20,000 shares of our common stock and a pro-rata amount of the regular annual grant amount of an option to purchase 15,000 shares of our common stock. One-half of each of the options granted to the member of the Board of Directors are vested at the time of the grant, and the remaining portions vest in equal monthly installments over the following twelve months.
Compensation Committee Interlocks and Insider Participation
None of our executive officers serves as a member of the board of directors or compensation committee of any entity that has one or more executive officers serving on our board of directors.
COMPENSATION COMMITTEE REPORT
The Nominating, Compensation and Governance Committee operates under a written charter adopted by the Board of Directors on October 14, 2005. The Committee is responsible for the Company’s executive compensation philosophy and major compensation policies. The Committee also determines all aspects of the compensation paid to our executive officers including the Company’s Chief Executive Officer. The Committee met seven times and acted once by unanimous written consent during fiscal 2006 to fulfill its responsibilities. All members of the Committee are non-employee directors and satisfy the current Nasdaq Stock Market listing standards and SEC requirements with respect to independence.
The Nominating, Compensation and Governance Committee has reviewed and discussed the Compensation Discussion and Analysis section of this Report with management and based on the review and discussion recommended to the Board of Directors that the Compensation Discussion and Analysis be included in this Report.
John E. Rehfeld, Chairman
Philip K. Fricke
Theodore E. Lavoie
March 12, 2007
ITEM 12.
ITEM 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
The following table sets forth the beneficial ownership of shares of our common stock as of February 28, 2007 and as adjusted to reflect the sale of common stock offered by us for:
•
each person (or group of affiliated persons) known by us to beneficially own more than 5% of our common stock;
•
each of our directors;
•
each named executive officer; and
•
all of our directors and executive officers as a group.
Information with respect to beneficial ownership has been furnished by each director, officer or beneficial owner of more than 5% of our common stock. Beneficial ownership is determined in accordance with the rules of the SEC and generally requires that such person have voting or investment power with respect to securities. In computing the number of shares beneficially owned by a person listed below and the percentage ownership of such person, shares of common stock underlying options, warrants or convertible securities held by each such person that are exercisable or convertible within 60 days of February 28, 2007 are deemed outstanding, but are not deemed outstanding for computing the percentage ownership of any other person.
The percentage of beneficial ownership is based on 9,298,419 shares of common stock outstanding.
Except as otherwise noted below, and subject to applicable community property laws, the persons named have sole voting and investment power with respect to all shares of common stock shown as beneficially owned by them. Unless otherwise indicated, the address of the following stockholders is c/o Local.com Corporation, One Technology Drive, Building G, Irvine, California 92618.
(1)
Includes 1,492,537 shares issuable upon the conversion of senior secured convertible notes. Hearst Communications, Inc. is a subsidiary of Hearst Magazines Property, Inc. (Hearst Magazines) and Hearst Holdings, Inc (Hearst Holdings). Hearst Magazines is a wholly-owned subsidiary of Communications Data Services Inc (CDS). CDS is a wholly-owned subsidiary of Hearst Holdings. Hearst Holdings is a wholly-owned subsidiary of The Hearst Corporation (Hearst). Hearst is owned by The Hearst Family Trust (Hearst Trust). The address for Hearst, Hearst Holdings, and Hearst Communications Inc. is 300 West 57th Street, New York, New York 10019. The address for the Hearst Trust is 888 Seventh Avenue, New York, New York 10106. The address for CDS is 1901 Bell Avenue, Des Moines, Iowa 50315. The address for Hearst Magazines is 2 Sound View Drive, Greenwich, Connecticut 06830.
(2)
Includes 497,513 shares issuable upon the conversion of senior secured convertible notes. Steven R. Becker is the sole principal of BC Advisors, LLC (BCA) which acquired the senior secured convertible notes and
warrants for the account of SRB Greenway Capital, L.P. (SRBGC), SRB Greenway Capital (Q.P.), L.P. (SRBQP) and SRB Greenway Offshore Operating Fund, L.P (SRB Offshore). BCA is the general partner of SRB Management, L.P. which is the general partner of SRBGC, SRBQP and SRB Offshore. The address of Steven R. Becker, BCA, SRBGC, SRBQP, SRB Offshore and SRB Management, L.P. is 300 Crescent Court, Suite 1111, Dallas, Texas 75201.
(3)
Includes 418,375 shares issuable upon the exercise of options that are exercisable within 60 days of February 28, 2007. Does not include 44,700 shares which were pledged as collateral for a personal loan with a third party. The pledge included the transfer of beneficial ownership of these shares during the time that the loan is outstanding. Following repayment of the loan, Mr. Clarke will once again have beneficial ownership of the shares.
(4)
Includes 90,776 shares issuable upon the exercise of options that are exercisable within 60 days of February 28, 2007.
(5)
Includes 5,000 shares issuable upon the exercise of warrants and 148,511 shares issuable upon the exercise of options that are exercisable within 60 days of February 28, 2007.
(6)
Includes 55,422 shares issuable upon the exercise of warrants and 59,999 shares issuable upon the exercise of options that are exercisable within 60 days of February 28, 2007.
(7)
Includes 49,999 shares issuable upon the exercise of options that are exercisable within 60 days of February 28, 2007. Does not include 67,000 shares which were pledged as collateral for personal loans with a third party. The pledge included the transfer of beneficial ownership of these shares during the time that the loans are outstanding. Following repayment of the loans, Mr. Fricke will once again have beneficial ownership of the shares.
(8)
Includes 49,999 shares issuable upon the exercise of options that are exercisable within 60 days of February 28, 2007.
(9)
Includes 50,793 shares issuable upon the exercise of options that are exercisable within 60 days of February 28, 2007.
(10)
Includes 60,422 shares issuable upon the exercise of warrants and 868,452 shares issuable upon the exercise of options that are exercisable within 60 days of February 28, 2007.
Securities authorized for issuance under equity compensation plans
The following table provides information as of December 31, 2006, with respect to our compensation plans including our 1999 Equity Incentive Plan, 2000 Equity Incentive Plan, 2004 Equity Incentive Plan, as amended, and 2005 Equity Incentive Plan under which we may issue shares of our common stock.
Equity Compensation Plan Information
ITEM 13.
ITEM 13.
Certain Relationships and Related Transactions, and Director Independence
Certain Relationships and Related Transactions
None
Director Independence
(1)
As defined by applicable SEC rule and the listing standards of the Nasdaq Capital Market.
ITEM 14.
ITEM 14.
Principal Accountant Fees and Services
The following table sets forth the aggregate fees for professional audit services rendered by Haskell & White LLP for audit of our annual financial statements for the years ended December 31, 2006 and 2005, and fees billed for other services provided by Haskell & White LLP for the years ended December 31, 2006 and 2005.
Audit Fees
The aggregate fees for the annual audit of our financial statements and review of our quarterly financial statements.
Audit-Related Fees
The aggregate fees for the auditor’s consent for use of our audited financial statements in our SB-2, S-3 and S-8 registration statements.
Tax Fees
The aggregate fees for tax preparation, tax advice and tax planning.
All Other Fees
The aggregate fees for services related to our acquisitions.
Our audit committee pre-approves all services provided by Haskell & White LLP.
PART IV
ITEM 15.
ITEM 15.
Exhibits, Financial Statement Schedules
*
Filed herewith.
(1)
Incorporated by reference from the Registrant’s Registration Statement on Form SB-2, Amendment No. 2, filed with the Securities and Exchange Commission on September 16, 2004.
(2)
Incorporated by reference from the Registrant’s Current Report on Form 8-K, filed with the Securities and Exchange Commission on May 19, 2006.
(3)
Incorporated by reference from the Registrant’s Current Report on Form 8-K/A, filed with the Securities and Exchange Commission on November 2, 2006.
SIGNATURES
In accordance with Section 13 or 15 (d) of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized as of the 15th day of March, 2007.
LOCAL.COM CORPORATION
By:
/s/ Heath B. Clarke
Heath B. Clarke
Chief Executive Officer and Chairman
POWER OF ATTORNEY
KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below hereby severally constitutes and appoints Heath B. Clarke and Douglas S. Norman and each of them, his or her true and lawful attorney-in-fact and agent, with full power of substitution and resubstitution for him or her and in his or her name, place and stead, in any and all capacities to sign any and all amendments to this Report on Form 10-K, and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Commission, granting unto said attorney-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite or necessary fully to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that each said attorneys-in-fact and agents or any of them or their or his or her substitute or substitutes, may lawfully do or cause to be done by virtue hereof.
In accordance with the Exchange Act, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
LOCAL.COM CORPORATION
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of
Local.com Corporation
We have audited the accompanying consolidated balance sheets of Local.com Corporation (the “Company”) as of December 31, 2006 and 2005, and the related consolidated statements of operations, stockholders’ equity and cash flows for each of the years in the three-year period ended December 31, 2006. Our audit also included the financial statement schedule listed in the index at . These financial statements are the responsibility of the company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor have we been 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 of the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Local.com Corporation as of December 31, 2006 and 2005, and the results of its consolidated operations and its cash flows for each of the years in the three-year period ended December 31, 2006 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
As discussed at Note 1, “Stock-based Compensation,” to the consolidated financial statements, during the year ended December 31, 2006, the Company changed the manner in which it accounts for stock compensation costs.
As discussed in Note 10 to the financial statements, subsequent to the year ended December 31, 2006, the Company issued $8 million of 9% convertible notes payable and warrants.
/s/ HASKELL & WHITE LLP
Irvine, California
March 15, 2007
LOCAL.COM CORPORATION
CONSOLIDATED BALANCE SHEETS
The accompanying notes are an integral part of the consolidated financial statements.
LOCAL.COM CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
The accompanying notes are an integral part of the consolidated financial statements.
LOCAL.COM CORPORATION
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
The accompanying notes are an integral part of the consolidated financial statements.
LOCAL.COM CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
The accompanying notes are an integral part of the consolidated financial statements.
LOCAL.COM CORPORATION
Notes to Consolidated Financial Statements
1.
Nature of operations and summary of significant accounting policies
Nature of operations
Local.com Corporation, a Delaware corporation (the Company), is a provider of paid-search services on the Internet. The Company provides advertisers’ sponsored listings in response to searches on the Company’s Distribution Network, a network of web sites and search engines that have integrated the Company’s search service into their sites and the Company’s own web site, Local.com. The Company’s sponsored listings are comprised of the Company’s own direct advertisers and the advertisers of other paid-search companies, which make up the Company’s Advertiser Network. The search listings are generally ranked by the advertisers’ bid. Advertisers pay a specified bid price for each click-through on the advertisers’ sponsored listing. The Company operates in one reportable business segment.
On November 2, 2006, the Company changed its name from Interchange Corporation to Local.com Corporation. The Company amended its Amended and Restated Certificate of Incorporation in connection with a merger of a wholly-owned subsidiary of the Company with and into the Company in accordance with Section 253 of the Delaware General Corporation Law.
Certain reclassifications have been made to the prior year’s consolidated financial statements to conform to current year’s presentation. Non-cash equity based expense of $95,000 for the year ended December 31, 2005 and $13,000 for the year ended December 31, 2004 are included in general and administrative expense for the corresponding periods. Payroll taxes payable of $34,000 as of December 31, 2005, is included in accrued compensation.
Principles of consolidation
The Company’s consolidated financial statements include the accounts of Local.com Corporation, its wholly owned subsidiaries, Interchange Europe Holding Corporation, Interchange Internet Search GmbH, Inspire Infrastructure 2i AB, and Inspire Infrastructure (UK) Limited, along with its majority owned subsidiary Inspire Infrastructure Espana SL. All intercompany balances and transactions have been eliminated. Effective December 31, 2006, the Company no longer has operations in its subsidiaries.
Foreign currency translation
The Company measures the financial statements for its foreign subsidiaries using the local currency as the functional currency. Current assets and current liabilities of these subsidiaries are translated at the exchange rate as of the balance sheet date, while long-term items are translated at historical rates. Revenues, costs and expenses are translated at the rates prevailing during the year. Translation adjustments from this process are included in stockholders’ equity. Any gains or losses from foreign currency transactions are included in other income.
Use of estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.
Cash and cash equivalents
The Company considers all highly liquid investments with an original maturity of three months or less to be cash equivalents. Deposits held with banks may exceed the amount of insurance provided on such deposits. Generally, these deposits may be redeemed upon demand and therefore bear minimal risk.
LOCAL.COM CORPORATION
Notes to Consolidated Financial Statements - (Continued)
Restricted cash
On June 26, 2002, the Company pledged $100,000 of cash for an irrevocable letter of credit related to the lease of office space that is classified as restricted cash on the balance sheet. The letter of credit was reduced to $40,960 on April 1, 2006. The letter of credit will expire on April 1, 2007.
On April 22, 2005, the Company pledged $125,129 of cash for an irrevocable letter of credit related the lease of new office space that is classified as restricted cash on the balance sheet. The letter of credit will be reduced to $96,397 on July 31, 2007, $66,506 on July 31, 2008, and $35,448 on July 31, 2009. The letter of credit will expire on July 31, 2010.
Marketable securities
The Company carries marketable securities at fair value, with unrealized gains and losses, net of any tax, reported as a separate component of stockholders’ equity. The amortized cost of debt securities is adjusted for amortization of premiums and accretion of discounts to maturity. Such amortization is included in interest income. Realized gains and losses and declines in value judged to be other-than-temporary on short-term investments are included in interest and other income (expense). The cost of securities sold is based on the specific identification method. Interest and dividends on securities classified as available-for-sale are included in interest income.
Accounts receivable
The Company’s accounts receivable are due primarily from customers located in the United States and are typically unsecured. Management specifically analyzes accounts receivable and historical bad debt, customer concentration, customer credit-worthiness, current economic trends and changes in customer payment terms when evaluating the adequacy of the allowance for doubtful accounts. If management believes that a customer’s financial condition has deteriorated such that it impairs its ability to make payments, additional allowances may be required. A significant portion of the Company’s direct advertisers pay in advance. In addition, the Company grants its Advertiser Network partners net 30 terms. Of the customers that do not pay in advance, as of December 31, 2006 and 2005, one customer represented 52% and 37% of total accounts receivable, respectively and one additional customer represented 11% and 27% of total accounts receivable as of December 31, 2006 and 2005, respectively.
Property and equipment
Property and equipment are stated at cost, net of accumulated depreciation and amortization. Depreciation and amortization are calculated under the straight-line basis over the shorter of the estimated useful lives or the respective assets as follows:
Repairs and maintenance expenditures that do not significantly add to the value of the property, or prolong its life, are charged to expense, as incurred. Gains and losses on dispositions of property and equipment are included in the operating results of the related period.
Intangible assets
Developed technology arising from acquisitions is recorded at cost and amortized on a straight-line basis over five years. Accumulated amortization at December 31, 2006 was $818,767.
Customer contracts and relationships arising from acquisitions are recorded at cost and amortized on a straight-line basis over five years. During the year ended December 31, 2005, due to the deterioration of revenues in
LOCAL.COM CORPORATION
Notes to Consolidated Financial Statements - (Continued)
Europe since the acquisition of Inspire in February 2005, management believed that the carrying amount for customer contracts and relationships was impaired. The carrying amount of customer contracts and relationships exceeded the sum of the undiscounted cash flows expected and as a result, the Company wrote-down the remaining unamortized balance of $337,000.
Non-compete agreement arising from acquisitions is recorded at cost and amortized on a straight-line basis over three years. Accumulated amortization at December 31, 2006 was $158,400.
Purchased technology arising from acquisitions is recorded at cost and amortized on a straight-line basis over three years. Accumulated amortization at December 31, 2006 was $643,715.
The estimated total amortization expense for intangible asset over the next five years is as follows (in thousands):
Impairment of long-lived assets
The Company accounts for the impairment and disposition of definite life intangible and long-lived assets in accordance with Statement of Financial Accounting Standards (SFAS) No. 144, Accounting for the Impairment of Disposal of Long-Lived Assets (SFAS No. 144). In accordance with SFAS No. 144, such assets to be held are reviewed for events, or changes in circumstances, which indicate that their carrying value may not be recoverable. The Company periodically reviews related carrying values to determine whether or not impairment to such value has occurred. During the year ended December 31, 2005, due to the deterioration of revenues in Europe since the acquisition of Inspire in February 2005, management believed that the carrying amount for customer contracts and relationships was impaired. The carrying amount of customer contracts and relationships exceeded the sum of the undiscounted cash flows expected and as a result, the Company wrote-down the remaining unamortized balance of $337,000. For the years ended December 31, 2006 and 2004, management had no evidence of impairment.
Goodwill and other intangible assets
Goodwill representing the excess of the purchase price over the fair value of the net tangible and intangible assets arising from acquisitions and purchased domain name are recorded at cost. Intangible assets, such as goodwill and domain name, which are determined to have an indefinite life, are not amortized in accordance with SFAS No. 142, Goodwill and Other Intangible Assets. The Company performs annual impairment reviews during the fourth fiscal quarter of each year, or earlier if indicators of potential impairment exist. For goodwill, the Company engages an independent appraiser to assist management in the determination of the fair value of its reporting unit and compares the resulting fair value to the carrying value of the reporting unit to determine if there is goodwill impairment. For other intangible assets with indefinite lives, the Company compares future undiscounted cash flow forecasts prepared by management to the carrying value of the related intangible asset group to determine if there is impairment. The Company performed its annual impairment analysis as of December 31, 2006 and determined that no impairment existed. Future impairment reviews may result in charges against earnings to write-down the value of intangible assets.
Fair value of financial instruments
The Company’s balance sheets include the following financial instruments: cash and cash equivalents, restricted cash, accounts receivable, accounts payable and accrued liabilities. The Company considers the carrying
LOCAL.COM CORPORATION
Notes to Consolidated Financial Statements - (Continued)
value of cash and cash equivalents, accounts receivable, accounts payable and accrued liabilities in the financial statements to approximate fair value for these financial instruments because of the relatively short period of time between origination of the instruments and their expected realization.
Deferred revenue
Deferred revenue represents deposits from direct advertisers for their advertising campaigns and is recognized as revenue upon a click-through.
Sales commissions
When an advertiser makes a deposit into its account with the Company, the Company’s applicable salesperson earns a commission, subject to certain criteria. The Company records sales commission expense in the period the deposit is received.
Refunds
Refunds of any remaining deposits paid by direct advertisers are available to those advertisers upon written request submitted between 30 and 90 days from the date of deposit.
Revenue recognition
Revenue is recognized when all of the following conditions are satisfied: (1) there is persuasive evidence of an arrangement; (2) the service has been provided to the customer; (3) the amount of fees to be paid by the customer is fixed or determinable; and (4) the collection of the Company’s fees is probable. The Company generates revenue when it is realizable and earned, as evidenced by click-throughs occurring on advertisers’ sponsored listings or display of a banner advertisement. As a result of each click-through, management believes all four revenue recognition criteria are met. Prior to supplying a click-through, the Company enters into a contractual arrangement to distribute sponsored listings from an advertiser or an Advertiser Network partner. The advertisers provide sponsored listings along with bid prices (what the advertisers are willing to pay for each click-through on those listings) to the Company. These sponsored listings are then included as search results that the Company distributes in response to keyword searches performed by consumers on the Company’s Distribution Network. Depending on the source of the advertiser, the Company recognizes an applicable portion of the bid price for each click-through the Company delivers on advertisers’ sponsored listings. Revenue is recognized when earned based on click-through activity to the extent that the direct advertiser has deposited sufficient funds with the Company or collection is reasonably assured from credit worthy direct advertisers and Advertiser Network partners.
The Company distributes sponsored listings to its Distribution Network in response to consumer search requests and shares a portion of revenue generated with these partners. In accordance with Emerging Issue Task Force No. 99-19, Reporting Revenue Gross as a Principal Versus Net as an Agent, revenue is reported gross of the payment to Distribution Network partners because the Company acts as the primary obligor and is responsible for the fulfillment of services.
The Company derived 27%, 57% and 56% of its total revenue from direct advertisers and 73%, 43% and 44% of its total revenue from its advertising network partners during the years ended December 31, 2006, 2005 and 2004, respectively. One national advertising network partner represented 15%, 30% and 35% of the Company’s total revenue for the years ended December 31, 2006, 2005 and 2004, respectively and one local advertising network partner represented 48%, 2% and 0% for the years ended December 31, 2006, 2005 and 2004, respectively . No distribution network partner provided consumer search requests resulting in click-throughs representing more than 10% of the Company’s total revenue in the years ended December 31, 2006, 2005 and 2004.
Search serving
Search serving expenses consist primarily of revenue-sharing payments that the Company makes to its Distribution Network partners, and to a lesser extent, royalties, Internet connectivity costs, data center costs,
LOCAL.COM CORPORATION
Notes to Consolidated Financial Statements - (Continued)
amortization of certain software license fees and maintenance and depreciation of computer equipment used in providing the Company’s paid-search services.
Web site development costs and computer software developed for internal use
Statement of Position 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use (SOP 98-1), requires that costs incurred in the preliminary project and post-implementation stages of an internal use software project be expensed as incurred and that certain costs incurred in the application development stage of a project be capitalized. Emerging Issues Task Force Issue No. 00-02 Accounting for Web Site Development Costs (EITF 00-02), requires that costs incurred in the preliminary project and operating stage of web site development be expensed as incurred and that certain costs incurred in the development stage of web site development be capitalized and amortized over the useful its useful life. During the year ended December 31, 2006, the Company capitalized $392,000 related to the web site development with a useful life of three years. During the year ended December 31, 2006, amortization of capitalized web site costs was $174,000. During the year ended December 31, 2005, the Company capitalized $244,000 related to the web site development with a useful life of three years. During the year ended December 31, 2005, amortization of capitalized web site costs was $34,000. Capitalized web site costs are included in property and equipment, net. There were no capitalized costs prior to 2005.
Research and development
Research and development expenses consist of expenses incurred by the Company in the development, creation and enhancement of its paid-search services. Research and development expenses include salaries and other costs of employment of the Company’s development staff as well as outside contractors and the amortization of capitalized web site development costs.
Traffic acquisition cost
The Company advertises on other search engine web sites, primarily google.com, but also yahoo.com, msn.com and ask.com, by bidding on certain keywords it believes will drive traffic to its Local.com web site. During the three month period ending December 31, 2006, approximately 92% of the traffic on our Local.com web site was acquired from other search engine web sites. During the year ended December 31, 2006, traffic acquisition costs (TAC) were $7.7 million of which $6.9 million was paid to Google, Inc and such amounts are included in sales and marketing in accompanying consolidated statements of operations.
Income taxes
The Company follows the provisions of SFAS No. 109, Accounting for Income Taxes, which requires recognition of deferred income tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements and tax returns. Deferred income tax assets and liabilities are determined based upon the difference between the financial statement and tax bases of assets and liabilities, using the enacted tax rates in effect for the year in which the differences are expected to reverse. A valuation allowance is provided when it is more likely than not that deferred income tax assets will not be realized.
Comprehensive income (loss)
The Company accounts for comprehensive income (loss) using SFAS No. 130, Reporting Comprehensive Income (SFAS No. 130). SFAS No. 130 establishes standards for reporting comprehensive income (loss) and its components in financial statements. Comprehensive income (loss), as defined therein, refers to revenue, expenses, gains and losses that are not included in net income (loss) but rather are recorded directly in shareholders’ equity. For the years ended December 31, 2006 and 2005, comprehensive loss consisted of net loss plus net unrealized gain/loss on marketable securities and foreign currency translation adjustments. For the year ended December 31, 2004, comprehensive income consisted of net income plus unrealized loss on marketable securities.
LOCAL.COM CORPORATION
Notes to Consolidated Financial Statements - (Continued)
Supplemental comprehensive income (loss) information (in thousands):
Stock-based compensation
In December 2004, the Financial Accounting Standard Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 123R, Share-Based Payment, which addresses the accounting for employee stock options. SFAS No. 123R requires that the cost of all employee stock options, as well as other equity-based compensation arrangements, be reflected in the financial statements based on the estimated fair value of the awards. That cost will be recognized over the period during which an employee is required to provide service in exchange for the award - the requisite service period (usually the vesting period).
The Company adopted SFAS No. 123R on January 1, 2006, the beginning of its first quarter of fiscal 2006, using the modified-prospective transition method. Under the modified-prospective transition method prior periods of the Company’s financial statements are not restated for comparison purposes. In addition, the measurement, recognition and attribution provisions of SFAS No. 123R apply to new grants and grants outstanding on the adoption date. Estimated compensation expense for outstanding grants at the adoption date will be recognized over the remaining vesting period using the compensation expense calculated for the pro forma disclosure purposes under SFAS No. 123, Accounting for Stock-Based Compensation.
Total stock-based compensation expense recognized for the year ended December 31, 2006 is as follows (in thousands, except per share amount):
The fair values of these options were estimated at the date of grant using a Black-Scholes option pricing model with the following weighted-average assumptions:
As of December 31, 2006, there was $1.8 million of unrecognized stock-based compensation expense related to outstanding stock options, net of forecasted forfeitures. This amount is expected to be recognized over a weighted average period of 1.3 years. The stock-based compensation expense for these awards will be different if the actual forfeiture rate is different from the Company’s forecasted rate.
LOCAL.COM CORPORATION
Notes to Consolidated Financial Statements - (Continued)
Prior to the adoption of SFAS No. 123R the Company accounted for stock-based employee compensation under the recognition and measurement principles of Accounting Principles Board Opinion (APB) No. 25, Accounting for Stock Issued to Employees and the disclosure requirements of SFAS No. 123 and related SFAS No. 148, Accounting for Stock-Based Compensation - Transition and Disclosure.
The following table illustrates the pro forma effect of the fair value recognition of stock-based compensation on net income (loss) and net income (loss) per share for the years ended December 31, 2005 and 2004 (in thousands, except per share amounts):
The fair value of these options was estimated at the date of grant using a Black-Scholes option pricing model with the following assumptions:
Net income (loss) per share
SFAS No. 128, Earnings per Share, establishes standards for computing and presenting earnings per share. Basic net income (loss) per share is calculated using the weighted average shares of common stock outstanding during the periods. Diluted net income (loss) per share is calculated using the weighted average number of common and potentially dilutive common shares outstanding during the period, using the treasury stock method for options and warrants.
For the year ended December 31, 2006, potentially dilutive securities, which consist of options to purchase 1,933,363 share of common stock at prices ranging from $0.40 to $16.59 and warrants to purchase 1,043,664 shares of common stock at prices ranging from $3.00 to $25.53 were not included in the computation of diluted net income per share because such inclusion would be antidilutive.
For the year ended December 31, 2005, potentially dilutive securities, which consist of options to purchase 1,339,360 shares of common stock at prices ranging from $0.40 to $16.59 and warrants to purchase 1,279,575 shares of common stock at prices ranging from $2.00 to $25.53 were not included in the computation of diluted net income per share because such inclusion would be antidilutive.
LOCAL.COM CORPORATION
Notes to Consolidated Financial Statements - (Continued)
For the year ended December 31, 2004, potentially dilutive securities, which consist of warrants to purchase 195,650 shares of common stock at prices ranging from $20.00 to $25.53 were not included in the computation of diluted net income per share because such inclusion would be antidilutive.
The following table sets forth the computation of basic and diluted net income (loss) per share for the periods indicated (in thousands, except per share amounts):
New accounting pronouncements
In June 2006, FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes (FIN48), which defines the threshold for recognizing the benefits of tax return positions in the financial statements as “more-likely-than-not” to be sustained by the taxing authority. A tax position that meet the “more-likely-than-not” criterion shall be measured at the largest amount of benefit that is more than 50% likely of being realized upon ultimate settlement. FIN48 applies to all tax positions accounted for under SFAS No. 109, Accounting for Income Taxes. FIN48 is effective for fiscal years beginning after December 15, 2006. Upon adoption, the Company will adjust its financial statements to reflect only those tax positions that are more-likely-than-not to be sustained as of the adoption date. Any adjustment will be recorded directly to its beginning retained earnings balance in the period of adoption and reported as a change in accounting principle. The Company is currently analyzing the effect of adopting FIN48.
In September 2006, FASB issued SFAS No. 157, Fair Value Measurements which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. This statement does not require any new fair value measurements; rather, it applies under other accounting pronouncements that require or permit fair value measurements. The provisions of SFAS No. 157 are effective for fiscal years beginning after November 15, 2007. The Company is currently assessing SFAS No. 157 and has not yet determined the impact, if any, that its adoption will have on its results of operations or financial condition.
LOCAL.COM CORPORATION
Notes to Consolidated Financial Statements - (Continued)
2.
Composition of certain balance sheet captions
Property and equipment consisted of the following (in thousands):
Intangible assets consisted of the following (in thousands):
3.
Marketable securities
The following is a summary of marketable securities all of which are classified as available for sale (in thousands):
LOCAL.COM CORPORATION
Notes to Consolidated Financial Statements - (Continued)
The contractual maturities of marketable securities are as follows (in thousands):
4.
Income taxes
The Company’s provision (benefit) for income taxes consists of the following (in thousands):
The provision (benefit) for income taxes differs from the amount computed by applying the federal income tax rate as follows:
LOCAL.COM CORPORATION
Notes to Consolidated Financial Statements - (Continued)
Deferred income taxes reflect the tax effect of temporary differences between the carrying amounts of assets and liabilities for reporting purposes and the amounts used for income tax purposes. The components of deferred tax assets and liabilities are as follows (in thousands):
As of December 31, 2006, the Company has approximately $1.7 million of valuation allowance attributable to the tax benefit of exercised stock options and warrants issued for services, which will be credited directly to paid-in capital when the related deferred tax assets are realized.
As of December 31, 2006, the Company had $26.8 million and $28.0 million in net operating loss carryforwards for federal and state income tax purposes, respectively. The credits begin to expire in 2020 for federal and 2012 for state income tax purposes.
5.
Commitments and contingencies
Lease Commitments
The Company leases office space under an operating lease agreement that expires in June 2010. The future minimum lease payments under non-cancelable operating leases at December 31, 2006 are as follows (in thousands):
The Company recognizes rent expense on a straight-line basis over the life of the operating lease as the lease contains a fixed escalation rent clause. Rent expense for the years ended December 31, 2006, 2005 and 2004 was $336,000, $407,000 and $210,000, respectively.
LOCAL.COM CORPORATION
Notes to Consolidated Financial Statements - (Continued)
401(k) Plan
The Company maintains a 401(k) plan for eligible employees. Employees become eligible to participate in the plan at the beginning of each calendar quarter (January, April, July, October) following their hire date. Employees may contribute amounts ranging from 1% to 15% or their annual salary, up to maximum limits set by the Internal Revenue Service. The Company may make matching contributions at its own discretion. Employees immediately vest 100% of their own contributions and 20% of the Company’s matching contributions for each year of service. Through December 31, 2006, the Company has made no matching contributions.
Employment Agreements
The Company has signed employment agreements with its three executive officers and five of its key employees. The agreements provide for the payments of annual salaries totaling $1.4 million and annual bonuses of up to $552,000 in the aggregate. The agreements have a term of one year and automatically renew for one year terms unless terminated on at least 30 days notice by either party. If the Company terminates one of these officers or key employees without cause, the Company is obligated to pay the terminated officer or key employee (i) his annual salary and other benefits earned prior to termination, (ii) the greater of such officer’s or key employee’s annual salary for the remaining term of the agreement or such officer’s or key employee’s annual salary, (iii) the average of all bonuses during the term of the employment agreement, (iv) the same benefits that such officer or key employee received prior to termination, for a period of 12 months following termination, and (v) the right to exercise all options, including any as yet unvested options, for a period of 12 months following termination.
Legal Proceedings
The Company is not currently a party to any material legal proceedings. From time to time, however, the Company may be subject to a variety of legal proceedings and claims in the ordinary course of business.
6.
Stockholders’ equity
The Company has authorized 30,000,000 shares of common stock and 10,000,000 shares of convertible preferred stock.
Warrants
Warrant activity for the years ended December 31, 2004, 2005 and 2006 was as follows:
The weighted average fair value at grant date of the warrants granted during the year ended December 31, 2004 was $1.99. No warrants were issued during the years ended December 31, 2005 and 2006.
LOCAL.COM CORPORATION
Notes to Consolidated Financial Statements - (Continued)
The following table summarizes information regarding warrants outstanding and exercisable at December 31, 2006:
7.
Stock plans
In March 1999, the Company adopted the 1999 Equity Incentive Plan (1999 Plan). The 1999 Plan provides for the grant of non-qualified and incentive stock options to employees, directors and consultants of options to purchase shares of the Company’s stock. Options are granted at exercise prices equal to the fair market value of the common stock on the date of grant. Prior to 2006, 25% of the options were available for exercise at the end of nine months, while the remainder of the grant were exercisable ratably over the next 27 month period, provided the optionee remained in service to the Company. For options granted in 2006, 33.33% of the options are available for exercise at the end of one year, while the remainder of the grant is exercisable ratably over the next 8 quarters, provided the optionee remains in service to the Company. The options generally expire ten years from the date of grant. The Company has reserved 500,000 shares for issuance under the 1999 Plan, and as of December 31, 2006, a total of 499,977 shares were subject to options granted and outstanding under the 1999 Plan.
In March 2000, the Company adopted the 2000 Equity Incentive Plan (2000 Plan). The 2000 Plan provides for the grant of non-qualified and incentive stock options to employees, directors and consultants of options to purchase shares of the Company’s stock. Options are granted at exercise prices equal to the fair market value of the common stock on the date of grant. Prior to 2006, 25% of the options were available for exercise at the end of nine months, while the remainder of the grant were exercisable ratably over the next 27 month period, provided the optionee remained in service to the Company. For options granted in 2006, 33.33% of the options are available for exercise at the end of one year, while the remainder of the grant is exercisable ratably over the next 8 quarters, provided the optionee remains in service to the Company. The options generally expire ten years from the date of grant. The Company has reserved 500,000 shares for issuance under the 2000 Plan, and as of December 31, 2006, a total of 499,957 shares were subject to options granted and outstanding under the 2000 Plan.
In January 2004, the Company adopted the 2004 Equity Incentive Plan (2004 Plan), in August 2004, the Company amended the 2004 Plan and in September 2004, the stockholders of the Company approved the 2004 Plan, as amended. The 2004 Plan provides for the grant of non-qualified and incentive stock options to employees, directors and consultants of options to purchase shares of the Company’s stock. Options are granted at exercise prices equal to the fair market value of the common stock on the date of grant. Prior to 2006, 25% of the options were available for exercise at the end of nine months, while the remainder of the grant were exercisable ratably over the next 27 month period, provided the optionee remained in service to the Company. For options granted in 2006, 33.33% of the options are available for exercise at the end of one year, while the remainder of the grant is exercisable ratably over the next 8 quarters, provided the optionee remains in service to the Company. The options generally expire ten years from the date of grant. The Company has reserved 600,000 shares for issuance under the 2004 Plan and as of December 31, 2006, a total of 599,852 shares were subject to options granted and outstanding under the 2004 Plan.
LOCAL.COM CORPORATION
Notes to Consolidated Financial Statements - (Continued)
In August 2005, the Company adopted and the stockholders of the Company approved the 2005 Equity Incentive Plan (2005 Plan). The 2005 Plan provides for the grant of non-qualified and incentive stock options to employees, directors and consultants of options to purchase shares of the Company’s stock. Options are granted at exercise prices equal to the fair market value of the common stock on the date of grant. Prior to 2006, 25% of the options were available for exercise at the end of nine months, while the remainder of the grant were exercisable ratably over the next 27 month period, provided the optionee remained in service to the Company. For options granted in 2006, 33.33% of the options are available for exercise at the end of one year, while the remainder of the grant is exercisable ratably over the next 8 quarters, provided the optionee remains in service to the Company. The options generally expire ten years from the date of grant. The Company has reserved 1,000,000 shares for issuance under the 2005 Plan and as of December 31, 2006, a total of 904,911 shares were subject to options granted and outstanding under the 2005 Plan.
Stock option activity under the plans for the years ended December 31, 2004, 2005 and 2006 is as follows:
The weighted-average fair value at grant date for the options granted during the years ended December 31, 2004, 2005 and 2006 was $1.59, $9.01, and $3.50 per option, respectively.
The aggregate intrinsic value of all options exercised during the years ended December 31, 2005 and 2006 was $2.1 million and $122,000, respectively. There were no options exercised during the year ended December 31, 2004.
LOCAL.COM CORPORATION
Notes to Consolidated Financial Statements - (Continued)
The following table summarizes information regarding options outstanding and exercisable at December 31, 2006:
8.
Operating segment information
SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information (SFAS No. 131), requires that public business enterprises report certain information about operating segments. The Company has one reporting segment: paid-search. The following table presents summary operating geographic information as required by SFAS No. 131 (in thousands):
LOCAL.COM CORPORATION
Notes to Consolidated Financial Statements - (Continued)
9.
Inspire Infrastructure 2i AB acquisition
On February 28, 2005, the Company completed the acquisition, through a wholly owned subsidiary, of all of the outstanding capital stock of Inspire Infrastructure 2i AB (Inspire), a Swedish Internet and wireless local-search technology company for $15.0 million in cash and cash acquisition costs of $409,000. Under the terms of the acquisition, Inspire shareholders could have received additional consideration consisting of up to 447,067 shares of Local.com common stock, valued at $7.5 million based upon a 30-day moving average at the date of acquisition, which was payable upon the achievement of certain future business performance criteria.
On May 15, 2006, the Company entered into a Share Purchase Termination Agreement with Interchange Europe Holding Corporation, a wholly owned subsidiary of the Company, and the five former shareholders of Inspire Infrastructure 2i AB (Sellers) to terminate all provisions of the Share Purchase Agreement dated February 2, 2005, except for Provision 10 - Non-Compete and Section 11.7 - Confidentiality. As a result of this termination, $232,000 of the cash escrow was returned to the Company which reduced goodwill. In addition, the Sellers will not earn or receive the additional consideration of 447,067 shares of Local.com common stock.
On December 20, 2006, the Company entered into a Share Purchase Agreement with Starboard Finans AB to sell all of the outstanding capital stock of Interchange Europe AB (formerly Inspire Infrastructure 2i AB) it owns (1,000 shares) for $140 (SEK 1,000).
10.
Subsequent events
On February 23, 2007, the Company entered into Purchase Agreement with two investors. Pursuant to this agreement, the investors purchased an aggregate of $8.0 million of 9% senior secured convertible notes and warrants to purchase shares of the Company’s common stock. The senior secured convertible notes are secured by the Company’s assets and are due on February 23, 2009. Each senior secured convertible note holder has the right, at any time, to convert their note into shares of the Company’s common stock at an initial conversion ratio of one share of common stock for each $4.02 of principal amount of debenture. The Company also issued warrants to purchase an aggregate of 796,020 shares of common stock at an exercise price of $4.82 per share that expire five years from the date of issuance and warrants to purchase an aggregate of 796,020 shares of common stock at an exercise price of $5.63 per share that expire five years from the date of issuance. The relative fair value of these warrants, using the Black-Scholes model at the date of grant, was $3.1 million will be recorded as convertible debt discount and will be amortized over the life of the debentures. The assumptions used in the Black-Scholes model were as follows: no dividend yield; 4.67% interest rate; five years contractual life; and volatility of 100%.
In connection with the issuance of the convertible secured debentures, the Company paid $530,000 in cash for placement agent fees of which $205,000 was paid to a director of the Company. These fees are recorded in prepaid expenses and will be amortized over the life of the debentures. The Company also issued warrants to purchase an aggregate of 71,642 shares of common stock at an exercise price of $4.82 per share that expire five years from the date of issuance and warrants to purchase an aggregate of 71,642 shares of common stock at an exercise price of $5.63 per share that expire five years from the date of issuance. The fair value of these warrants, using the Black-Scholes model at the date of grant, was $458,000 and will be recorded in prepaid expenses and will be amortized over the life of the debentures.
Schedule II - Valuation and Qualifying Accounts
Years ended December 31, 2006, 2005 and 2004
SELECTED QUARTERLY FINANCIAL DATA
(in thousands, except per share amounts)
(Unaudited)
INDEX TO EXHIBITS
*
Filed herewith.
(1)
Incorporated by reference from the Registrant’s Registration Statement on Form SB-2, Amendment No. 2, filed with the Securities and Exchange Commission on September 16, 2004.
(2)
Incorporated by reference from the Registrant’s Current Report on Form 8-K, filed with the Securities and Exchange Commission on May 19, 2006.
(3)
Incorporated by reference from the Registrant’s Current Report on Form 8-K/A, filed with the Securities and Exchange Commission on November 2, 2006.