ITEM 1. DESCRIPTION OF BUSINESS
Small World Kids, Inc. was organized on July 28, 2001 under the name SavOn Team Sports, Inc. in the State of Utah to sell sporting goods over the Internet. On May 20, 2004, we acquired Fine Ventures, LLC, a Nevada limited liability company, and Small World Toys, a California corporation. As a result of these acquisitions, we had a change of our management, our controlling shareholders, our financial position and our business plan. Small World Kids is now a holding company and has no significant business operations or assets other than its interest in Small World Toys. Since the acquisition of Small World Toys, the Company has been engaged in the development, manufacturing, marketing and distribution of educational and developmental toys. To more accurately reflect our operations after the acquisitions, we changed our name from SavOn Team Sports, Inc. to Small World Kids, Inc. We also changed our place of incorporation from the state of Utah to the state of Nevada.
Small World Kids became a holding company as a result of the May 20, 2004 transactions and has no significant business operations or assets other than its interest in Small World Toys, the accounting predecessor company. As such, accounting guidelines dictate that the results of operations for the predecessor and successor entities be clearly segregated for financial reporting purposes. However, for the purpose of describing and analyzing the results of operations in this section, both predecessor and successor entities have been combined.
As of December 31, 2006, Small World Kids is comprised solely of Small World Toys (which includes the Neurosmith brand) and as such the balances and results for each entity are one in the same.
Overview of Small World Toys
Small World Toys has been distributing toys for 45 years. Our Small World Toys’ proprietary product lines features toys for children ages zero to ten with a focus of promoting early learning, education, discovery and imagination. Small World Toys develops, manufactures, markets and distributes toys to promote healthy minds and bodies in infant, pre-school, early learning, imaginative play and active play categories. The company distributes products in specialty, mass, chain, education, catalog, online and international channels through sales representative firms as well as in-house sales executives. Proprietary brands include IQ Baby®, IQ Preschool®, Ryan’s Room®, Gertie Ball®, Small World Living, Puzzibilities®, All About Baby®, Neurosmith® and Imagiix™. We also exclusively distribute product for several brands such as TOLO® to the specialty toy market in the United States through our “SW Express” distribution arm. Small World Toys has had acquired licenses for our developmental toy products including the works of Dr. Seuss, Eric Carle, including “The Very Hungry Caterpillar” and Karen Katz, including “Where is Baby’s Belly Button.”
Recent Developments
On February 28, 2006, the Company entered into a security agreement (the Laurus “Security Agreement”) with Laurus Master Fund, Ltd. (“Laurus”). Included in the Security Agreement is an asset-based Secured Non-Convertible Revolving Note (the “Revolving Note”) that we may borrow up to $16.5 million and a $2.0 million, two year Secured Non-Convertible Term Note (the “Term Note “). On July 26, 2006 and amended on October 19, 2006, Laurus authorized $1.5 million in excess of the maximum allowed borrowings based on a formula amount of the secured assets (the “Overadvance”) on the Revolving Note for a one year period. On January 26, 2007, the Company entered into an Omnibus Amendment No.1 with Laurus that (a) amended the Overadvance Side Letter by extending the maturity of the Overadvance of up to $1,500,000 from October 19, 2007 to February 28, 2008 and (b) increased the Concentration Limits for accounts on standard terms from 15% to 32.5%. In addition, the requirement for the listing of the Company’s shares on the NASDAQ, OTC Bulletin Board or other Principal Market and for the timely filing with the SEC of all reports required to be filed pursuant to the Exchange Act was deleted.
On January 26, 2007, the Company also entered into the Second Amendment to the Registration Rights Agreement with Laurus dated February 28, 2006, that deleted the requirement to file a Registration Statement without penalty In accordance with EITF 00-19, the value of the Warrant issued to Laurus on February 28, was subject to marked-to-market revaluation at each period end since this Warrant was subject to registration rights requiring the Company to register the underlying shares with the SEC within 60 days of the issuance of the warrant. Any change in fair value from the date of issuance to the date the underlying shares are registered was included in other (expense) income. With the Second Amendment to the Registration Rights Agreement that deleted the requirement to file a Registration Statement, the warrant liability is reclassified from a liability to equity. The change in fair value from December 31, 2006 to January 26, 2007 of $362,000 will be included in other income in January 2007. With the termination of the requirement to file a Registration Statement, the value of the warrant on the January 26, 2007 of $1,085,000 will be reclassified from a liability to equity (Note 5 of the accompanying financial statements).
On January 26, 2007, the Company issued a warrant to purchase an aggregate of 685,185 shares at an exercise price of $.01 per share to Laurus. The warrant was issued in connection with the extension of the maturity of the Overadvance to February 28, 2008 and the increase of the Concentration Limits on standard terms from 15% to 32.5%. This warrant has a relative fair value of $711,000 calculated using the Black Scholes option pricing model with the following assumptions:
The Company has determined the issuance of the warrant in connection with Omnibus Amendment No.1 and the Second Amendment to the Registration Rights has resulted in a substantial modification resulting in the net present value between the original Revolving Note and the amended Revolving Note to be greater than 10%, and in accordance with EITF Issue 96-19, Debtor’s Accounting for a Modification or Exchange of Debt, the amendments were accounted for as an extinguishment of debt and the relative fair value of the warrant will be expensed.
Strategic Plan
Our strategic plan is market expansion through both growth of existing product lines, and the acquisition of licenses, product lines and companies that create synergies in operations, production and distribution or that can add value, sales and distribution into new retain accounts. We regard product line extensions, new customer relationships, and opportunities for increased cost reductions as particularly important in our analysis of a potential acquisition’s strategic value.
The anticipated benefits of this proposed strategy include:
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Enhanced channels of distribution for products through the combination of the potential target’s alternative distribution channels with our specialty retail distribution channels.
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Diversified product lines within high growth categories to create additional in-store placement in multiple sections of the store, which we believe will increase per store orders and a greater percentage of shelf space.
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Greater number of unit sales for products that will decrease manufacturing costs, therefore increasing margins and allowing us to benefit from price breaks that vendors offer for larger quantity orders.
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Fuller utilization of operations as a percentage of sales, which will increase operating margins, combined operating departments.
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Cost improvements in production and distribution coupled with expanded and improved product lines leading to increased profitability and growth.
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Expansion into international markets through multi-country distributors.
However, acquisitions involve uncertainties, and our attempts to identify appropriate acquisitions, and finance and complete any particular acquisition, may not be successful. In addition, growth by acquisition involves risks that could adversely affect our results of operations, including difficulties in integrating and assimilating the operations and personnel, the potential loss of key employees of acquired companies, failure of an acquired business to achieve targeted financial results and potential increase of indebtedness to finance the acquisition.
Industry Overview
Consumer spending on toys, dolls and games will reach $73.3 billion by 2011, according to the statisticians at Easy Analytic Software, a 42% increase from the $51.6 billion spent in the United States on toys, dolls and games in 2006, a figure compiled by the U.S. Department of Commerce.
Management believes that the toy industry growth will be primarily driven by the following trends:
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According to Packaged Facts, the U.S. population of children under the age of 12 is at an all-time high at close to 38% of the population, or 64 million children.
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According to Packaged Facts, the U.S. birthrate is higher than it has been in 30 years due to an increase in fertility and the trend of mothers giving birth later in life.
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The last census revealed that there are over 70 million people in the United States over the age of 55. That number is expected to grow 60% by 2007, which is six times faster than the rest of the population. A vast majority of persons in this demographic are grandparents and according to Packaged Facts, grandparents currently spend more than $2 billion annually in toys for their grandchildren.
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Increase in dual income families.
Product Overview
While many of our products are evergreen brands or long life cycle products, we are continually developing new products and the refreshing of existing products. Our product offerings are a combination of proprietary products that we design, sourced product that we find in other countries, that we then purchase and package in our packaging for exclusive distribution in the United Sates specialty market, and finally a small amount of open market product that we put through our distribution chain for retailers. We have the capability to create and develop products from inception to completion as finished goods with our in house designers. Additionally, we use third-parties to provide a portion of the sculpting, sample making, illustration and package design required for our products. Typically, the development process takes from nine to eighteen months from concept to production and shipment to our customers. We have launched an electronic learning line through our 2004 acquisition of Neurosmith. We occasionally acquire other product concepts from unaffiliated third parties. If we accept and develop a third party’s concept for new toys, we generally pay a royalty on the toys developed from this concept that are sold, and may, on an individual basis, guarantee a minimum royalty. Royalties payable to inventors and developers generally range from 5% to 10% of the wholesale sales prices for each unit of a product sold by us. We believe that utilizing experienced third-party inventors gives us access to a wide range of development talent. We also have license agreements with third parties that permit us to utilize the trademark, characters or inventions of the licensor in products that we sell.
Small World Toys Brands
Small World Toys’ proprietary brands feature toys for children ages 0 - 10 years with a focus on early learning, discovery, imagination and active play. The company positioning reflects the Small World Kids “whole child” philosophy: Small World Toys provides products that nurture the whole child - mind, body and spirit - through vibrant, engaging toys that promote early learning, reward social interaction and encourage physical fitness.
Learning Brands:
IQ Baby® - Infant toys that invite exploration, encourage discovery and reward development in the critical years from birth through toddler hood. IQ baby products nurture the whole child-body, mind and spirit through vibrant, engaging toys designed to reward infant development and encourage social interaction Toys within this brand include Hickory Dickory Clock and Pillow Soft Activity Blocks.
Neurosmith® - Electronic learning toys that combine the latest child development research with fun, interactive play patterns. Research indicates that certain playtime actions, or “play patterns,” can positively affect the way a child’s brain develops. Neurosmith’s play patterns are designed with this research in mind, stimulating and developing important connections in a baby’s busy brain. These connections lay the groundwork for enhanced learning potential that lasts a lifetime. Toys within this brand include Music Block® and Touch ‘N Sing Blocks™.
Puzzibilities® - Wooden puzzles designed in four progressive levels to stimulate “piece by piece” fun learning across a range of ages and developmental skills. Our puzzles foster primary learning skills such as fine motor skills, hand eye coordination, problem solving, concentration, and abstract thinking. Finely crafted puzzles have bright colors, imaginative themes and contemporary designs. Toys within this brand include Sounds On The Farm and Bilingual Counting puzzles.
Imaginative Play Brands:
Ryan’s Room® - Classic wooden play sets and accessories that allow children to imagine, create and bring to life their very own worlds. Constructed from solid sturdy wood, hand painted, and sized for little hands, every set of Ryan’s Room toys continues to encourage imaginative play. These open floor plan toys allow for easy access showcasing a number of unique architectural details. Toys within this brand include Fairyland Forest treehouse, Sunshine Manor dollhouse, Pirate Ship and accessories.
All About Baby® - Sweet, huggable dolls to love and nurture complete with popular and imaginative accessories. These realistic baby dolls feature different sounds and interactive functions for hours of role playing fun. These dolls have interactive features that teach cause and effect, promotes social development, and develops manual dexterity. Toys within this brand include including Baby Sweet Sounds and Deluxe Baby Doll Set.
Small World Living™ - The Role play toys and environments are designed to encourage your child to play out his dreams of “what I want to be when I grow up!” These toys stir up the imagination, while promoting a constructive lifestyle and empowering children through creative role play to create their dream world. Toys within this brand include Includes Stove, BBQ Grill, utensils, bakery and cookware sets.
Imagiix™ - Award winning toys for infant, toddler & pre-school. Toys within this brand include the Piano Stepper musical toy.
Active Play Brands:
Gertie Ball® - An award-winning line of balls for all ages, designed with a wide variety of unique textures, designs and features. Designed for preschoolers, these soft, lightweight, easy-to-catch balls will not bend back a finger or hurt when they hit. Gertie balls are gummy and soft enough for kids who may be scared of big heavy balls coming toward them. Toys within this brand include Glitter, Bumpie and Glow Gertie Balls.
Active Edge® - Sports and activity toys designed to give a child a sense of mastery, empowerment, and help build a foundation for an active, fit lifestyle. These toys encourages your child to get out and play. Toys within this brand include Bounce Around, Loop-To-Loop Parachute and Tube Travel toys.
Active Edge® Extreme- Sports and activity toys designed with a twist thereby allowing your child’s play to reach the next level while building a foundation for an active, healthy and fit lifestyle. Toys within this brand include Aqua Hockey and Shoot ‘N’ Score Soccer Ball.
Distribution
Small World Toys has been distributing its products to a broad spectrum of retail and various other accounts for over 40 years. Some of these accounts include toy specialty, chain, gift, education, catalog and e-commerce. We have over 80 sales representatives, within 11 representative firms that sell to these accounts by geographic locations. The representative firms are managed in house. In addition, a five member sales team handles in house accounts as well as develops new channels of distribution. We have utilized our distribution strength to represent other, high quality companies that did not have distribution into the specialty market in the United States, such as Tolo® for example. We receive samples of their products or catalogs that show their products; then either incorporate their product pictures and pricing into our catalog or use their own catalog. We buy their product, ship it into our warehouse, and sell it to our retail and on-line customers through our in house and outside sales representatives.
SW Express is our brand name of products that include both products that we buy from manufacturers to resell instead of developing ourselves, as well as, products that we distribute for other companies such as Tolo. It is not a separate company or branch of the company; it is a brand name in which to differentiate the products that we distribute rather than those we develop ourselves. Distribution allows us to increase category presence, expand market share, limit manufacturing (tooling) risk, and sell into new channels. SW Express has been distributing Tolo Toys exclusively in the United States for over 10 years. SW Express allows us to take advantage of the relationship we have with our customers and their 6,000 stores. Product categories that SW Express distributes include Nature and Science, Outdoor, Pool and high quality Infant and Toddler toys. Toys include Preschool Laptop, Tailgate Trio Car and Wigglin’ Water sprinkler. Small World Toys has agreements with these companies and either buys the products directly from the manufacturers to distribute into its channels or receives a distribution percentage upon selling the product. Currently, most of our distributed products are sourced and produced in China.
Infant and preschool toys made of quality, bright plastic and plush, which are produced in China by British founders with a strong European market presence. Small World has distributed Tolo products in the USA for over ten years. Toys include Sneezy The Activity Dragon and First Friends and accessories.
International
Outside of the United States, our primary markets are Canada, Western Europe, and Asia. Sales of our products abroad accounted for approximately $1,037,000 or 3.7% and $1,097,000 or 3.2 % of our net sales in 2006 and 2005, respectively. We believe that foreign markets present an attractive opportunity, and we plan to intensify our marketing efforts and further expand our distribution channels abroad.
Marketing
Generally, our products and brands are promoted through local market promotions, merchandising displays and advertising print, including cooperative advertising with retail accounts. Our product launches include in-store merchandising displays, trade advertising and newspaper ads that are co-oped with our retail customers. We participate in the New York Toy Fairs in October and February. We also attend gift and juvenile shows including JPMA (Juvenile Products Manufacturers Assoc.), NSSEA (National School Supply & Education Assoc.), ASTRA (American Specialty Toy Retailing Association), ABC (All Baby’s and Children Expo) and regional gift shows. Going forward, we will maintain our trade and local marketing efforts while expanding programs to reach the consumer on a more national level, including an increased focus on public relations outreach, strengthening partnerships with key influencers in the fields of early learning and child development, participation in relevant event marketing and sponsorships, utilization of direct-to-consumer media and the establishment of consumer loyalty programs.
Manufacturing
We outsource the manufacturing of our proprietary products to vendors in Asia. We believe our outsourcing strategy enhances the scalability of our manufacturing efforts. We use numerous manufacturers to source components and build finished products to our specifications. During the year ended December 31, 2006, our top ten suppliers accounted for 74.1 % of the total product purchases. The top two suppliers accounted for 20.9% and 10% of total purchases, respectively. Our tools and dies are located at the facilities of our third-party manufacturers. Manufacturers are selected based on their technical and production capabilities and are matched to particular products to achieve cost and quality efficiencies. Employees in the Culver City office create and design product in each product category. They then send the designs to the manufacturer to get a sample product and costing done or have samples made in the United States. Once the sample and costing is approved, these product developers will work with the factories to insure the integrity and safety of the products. Small World Toys designs approximately 90 toys per year and sources approximately 40 products from Asian or European manufacturers. We have long standing relationships with our manufacturers and have been manufacturing in Asia for more than 15 years. Small World Toys works with more than 40 factories both on a manufacturing basis and to source toys to distribute exclusively in the United States. Small World Toys has credit terms with most of its manufacturers and pays upon shipping of product from Hong Kong. Small World Toys has an office in Hong Kong with five people who are responsible for inspecting factories and setting up relationships with new manufacturers. The group also inspects product and sends product to a third party for safety certification. Small World Toys also has a staff in Quality and Control in its Culver City office that works with product development and all phases of production to assure that all safety requirements are met. Small World Toys owns all of its tools for product developed internally as well as trademarks and design patents. The majority of our products are shipped directly to our warehouse in Carson, California and are later shipped to meet the demands of our retailers and distributors.
Customers and Customer Service
Our three largest customers; Costco Wholesale Corporation, Target and TJX Companies collectively represented 36.4% and 32.5 % of 2006 and 2005 sales, respectively. No other customer represents greater than 5% of our sales in 2006 or 2005. Although we do not have long term contracts with any of our customers, we believe that our ability to establish and maintain long-term relationships is substantial as many of our accounts have been buying from Small World Toys for more than 15 years. Small World Toys has consistently been in the top five vendors with almost all of its 2,500 Specialty accounts. Small World Toys sells to high end Specialty stores as well as the educational channel, the book channel, high end department stores such as Nordstroms and other high end retailers such as Learning Express and Lakeshore Learning. Small World Toys has become a vendor with other high end chains such as Target and Costco. Small World is trying to differentiate its product for each channel in order to keep product fresh in each channel. Our success with our customers, which have approximately 6,000 stores (example - one customer, Target operates over 1,300 stores), is based on providing programs and product that will help them stock and sell our product. Small World Toys has a staff of 5 customer service representatives who are supervised by a Customer Service Manager. We encourage and utilize frequent communication with and feedback from our customers and retailers to continually improve our products and service. We offer toll-free telephone support for customers who prefer to talk directly with a customer service representative. We also respond to e-mail inquiries received through our website.
Product Development
While many of our products are evergreen brands or long life cycle products, we are continually developing new products and refreshing existing products. We expensed approximately $1,743,000 and $1,972,000 in 2006 and 2005, respectively, on activities relating to the development and design of new products. Our product offerings are a combination of proprietary products that we design, sourced product that we find in other countries, purchased and packaged in our packaging for exclusive distribution in the United States specialty market and a small amount of open market product that we put through our distribution chain for retailers.
We have the capability to create and develop products from inception to completion of finished goods with our in house designers. Additionally, we use third-parties to provide a portion of the sculpting, sample making, illustration and package design required for our products. Typically, the development process takes from nine to eighteen months from concept to production and shipment to our customers.
Most of our products that we develop are sold under our trademarks and trade names, while the Neurosmith products incorporate patented devices or designs. Trade names and trademarks are significant assets in that they provide product recognition and acceptance. We customarily seek trademark and patent protection covering our products and own or have applications pending for US and foreign patents covering many of our Neurosmith products. A number of these trademarks relate to product lines that are significant to our business and operations. We believe our rights to these properties are adequately protected, but there can be no assurance that our rights can be successfully asserted in the future or will not be invalidated, circumvented or challenged.
We have launched an electronic learning line through our 2004 acquisition of Neurosmith. Small World Toys acquired the patents, designs, trademarks, copyrights and technology for over 20 Early Electronic Products in the Neurosmith brand. Small World Toys has more than 10 patent applications and patents and 100 copyrights and trademarks, including design patents in its portfolio. Small World Toys holds the licensing rights to design, manufacture, market and distribute many well known trademarks and copyrighted products based on the properties of Eric Carle, Dr. Seuss and Karen Katz.
We occasionally acquire other product concepts from unaffiliated third parties. If we accept and develop a third party’s concept for new toys, we generally pay a royalty on the toys developed from this concept that are sold, and may, on an individual basis, guarantee a minimum royalty. Royalties payable to inventors and developers generally range from 5% to 10% of the net sales prices for each unit of a product sold by us. We believe that utilizing experienced third-party inventors gives us access to a wide range of development talent.
We also have license agreements with third parties that permit us to utilize the trademark, characters or inventions of the licensor in products that we sell. Licensing fees paid to the licensor range from 8-10 percent of net sales.
Competition
Competition in the toy industry is intense. We compete with several medium and small toy companies in our product categories that distribute products into the specialty toy market such as Alex, International Playthings Inc., Melissa and Doug, Playmobil U.S.A., RC2 Corporation, and Toysmith Group. We also compete with several large toy companies such as Mattel, Hasbro and Jakks Pacific. These competitors have greater financial resources, larger sales and marketing and product development departments, stronger name recognition, longer operating histories and benefit from greater economies of scale. These factors, among others, may enable our competitors to market their products at lower prices or on terms more advantageous to customers than those we could offer for our competitive products. These competitors may have a greater ability to procure product licenses, as well as to market and distribute products and obtain shelf space. Competition may result in price reductions, reduced gross margins and loss of market share, any of which could have a material adverse effect on our business, financial condition and results of operations. We compete primarily in the infant and pre-school category and the educational toy category of the U.S. toy industry and, to some degree, in the International toy industry. Our platform company, Small World Toys, has been distributing our products into the specialty retail, catalog, education and chains for over 40 years and we believe that our relationships and quality of our product brand awareness have been critical to our penetration.
Seasonality
Our business is subject to seasonal fluctuations. In 2006 and 2005, approximately 58% and 60%, respectively of net sales were generated in the third and fourth calendar quarters. We have traditionally introduced new product catalogs in January and in July. Generally, the first quarter is the period of lowest shipments and sales and therefore the least profitable due to fixed costs. Seasonality factors may cause our operating results to fluctuate from quarter to quarter. However, we employ customer programs for retailers or “early buy” programs to lesson the seasonality. These programs provide an opportunity for our customers to purchase our products in the first and second quarters and stock through the year by offering dating programs, where they pay in their highest sales quarters, typically in the third and fourth quarters.
Employees
At December 31, 2006, we had 60 full time employees. None of our employees are covered by a collective bargaining agreement. We consider our relations with our employees to be good.
ITEM 1A.
ITEM 1A. RISK FACTORS
Our business faces many risks. The risks described below may not be the only risks we face. Additional risks that we do not yet know of, or that we currently think are material, may also impair our business operations or financial results. If any of the events or circumstances described in the following risks actually occurs, our business, financial conditions or results of operations could suffer and the trading price of our common stock could decline.
We have limited cash available for operations. We may not have sufficient liquidity to continue to meet our debt obligations.
As of December 31, 2006, we had approximately $1,169,000 of unrestricted cash and availability on our line of credit, which includes the $1,500,000 Overadvance with our senior lender, Laurus.
Cash has historically been generated from operations. Operations and liquidity needs are funded primarily through cash flows from operations, as well as, utilizing, when needed, borrowings under the Company’s secured credit facilities and short term notes. Working capital needs generally reach peak levels from August through November of each year. To gain shelf space and address the seasonality of the toy industry, we offer early buy programs that are volume related with extended payment terms. Our historical revenue pattern is one in which the second half of the year is more significant to our overall business than the first half and, within the second half of the year, the fourth quarter is the most prominent. The trend of retailers over the past few years has been to make a higher percentage of their purchases of toy and game products within or close to the fourth quarter holiday consumer buying season, which includes Christmas. We expect that this trend will continue. As such, historically, the majority of cash collections for Small World Toys occur late in the fourth quarter as the extended payment terms become due from our early buy programs. As receivables are collected, the proceeds are used to repay borrowings under the Revolving Note issued to Laurus Master Fund.
We have incurred significant losses since our purchase of Small World Toys in May 2004. As of December 31, 2006, our accumulated deficit was $22.6 million. On June 9, 2006, the Company received approximately $2.4 million from the private placement of Class A-1 Preferred Stock at $1.10 per share and subsequently received an additional $.3 million by November 2006. In addition, on June 9, 2006, the Company converted $3.0 million of debt due in 2006 and 2008 to Class A-1 Preferred Stock, and restructured a $2.5 million note due in 2006 to $250,000 due within 12 months and the balance to begin principal amortization in October 2008. On October 19, 2006, we have received an additional $200,000 from the private placement of Class A-1 Preferred Stock at $1.10 per share. On October 19, 2006, we issued an aggregate of $330,000 in principal amount of 10% Convertible Debentures. On July 26, 2006, Laurus authorized $750,000 in excess of the maximum allowed borrowings based on a formula amount of the secured assets (the “Overadvance”) on the Revolving Note. On October 19, 2006, Laurus increased to $1,500,000 the permitted Overadvance to the Company in excess of the maximum amounts available to be borrowed on our revolver loans.
As of December 31, 2006, we had $804,000 in principal payments due during the next twelve months to Laurus, Horizon, St. Cloud and the former shareholder of Small World Toys. Of the $804,000 in principal payments due in 2007, the Company is not permitted by Laurus to pay the $152,000 in principal payments due to St. Cloud in 2007 while any amounts are outstanding on the $1,500,000 overadvance. We may not be able to generate sufficient cash flow from operations to meet our debt and operational obligations. If we are unable to generate sufficient cash flow, we would be required to seek additional financing or restructure our debt obligations. There can be no assurance that we will be able to obtain additional financing or restructure our debt obligations or that, if we were to be successful in obtaining additional financing or restructure our debt obligations, it would be on favorable terms. Failure to obtain additional financing or restructuring our debt obligations may cause us to default on these debt obligations. In addition, under cross default provisions in the Laurus Security Agreement, defaults under our debt obligations may cause the acceleration of the repayment of the Revolving and Term Notes.
We have a history of net losses.
We have incurred significant losses since our purchase of Small World Toys in May 2004. As of December 31, 2006, our accumulated deficit was $22.6 million. These losses principally resulted from the cost of being public, research and development, general and administrative, sales and marketing expenses and significant interest expense associated with our capital structure. We may continue to experience net losses in the future.
We have cross default provisions in our senior credit facility which may result in the acceleration the obligations due under the credit agreement
Under cross default provisions in the Laurus Security Agreement, defaults under our debt obligations may cause the acceleration of the repayment of the Revolving and Term Notes. Under these provisions, a default or acceleration in one of debt agreement may result in the default and acceleration of our debt agreements with Laurus (regardless of whether we were in compliance with the terms of the Laurus Security Agreement), providing Laurus with the right to accelerate the obligations due under their debt agreement.
Our business and operating results will depend on our ability to redesign, restyle and extend our existing core products and product lines as consumer preferences evolve, and to develop, introduce and gain customer acceptance of new products and product lines.
Our business and operating results depend largely upon the appeal of our products and on our ability to redesign, restyle and extend our existing core products and product lines as consumer preferences evolve, and to develop, introduce and gain customer acceptance of new products and product lines. Several trends in recent years have presented challenges for the toy industry, including:
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the phenomenon of children outgrowing toys at younger ages, particularly in favor of interactive and high technology products;
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increasing use of technology;
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higher consumer expectations for product quality, functionality and value;
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Retailers buying direct from the manufacturers in Asia; and
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Manufactureres in Asia selling direct to the retailers.
We cannot assure you that:
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our current products will continue to be popular with consumers;
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the product lines or products that we introduce will achieve any significant degree of market acceptance;
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We will be able to expand into new channels; or
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the life cycles of our products will be sufficient to permit us to recover design, manufacturing, marketing and other costs associated with those products.
Uncertainty and adverse changes in the general economic conditions of markets in which we participate may negatively affect our business.
Current and future conditions in the economy have an inherent degree of uncertainty. As a result, it is difficult to estimate the level of growth or contraction for the economy as a whole. It is even more difficult to estimate growth or contraction in various parts, sectors and regions of the economy. These changes may negatively affect the sales of our products, increase exposure to losses from bad debts, or increase costs associated with manufacturing and distributing products.
The toy industry is highly competitive.
The toy industry is highly competitive. Some of our competitors have financial and strategic advantages over us, including:
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greater financial resources;
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larger sales, marketing and product development departments;
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stronger name recognition;
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longer operating histories; and
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greater economies of scale.
In addition, the toy industry has no significant barriers to entry. Competition is based primarily on the ability to design and develop new toys, to sell the products into retail and sell through to consumers through successful marketing. Many of our competitors offer similar products or alternatives to our products. We cannot assure you that we will be able to obtain adequate shelf space in retail stores to support our existing products or to expand our products and product lines or that we will be able to continue to compete effectively against current and future competitors.
The toy industry is subject to high rates of seasonality.
Our business and the toy industry in general experience the lowest sales rates in the first quarter and second quarters of the calendar year. In 2006 and 2005, approximately 58% and 60%, respectively of net sales were generated in the third and fourth calendar quarters. Seasonality factors may cause our operating results to fluctuate significantly from quarter to quarter. In addition, our results of operations may also fluctuate as a result of the timing of new product releases.
Our growth strategy depends in part upon our ability to acquire companies, new product lines and licenses.
Future acquisitions will succeed only if we can effectively assess characteristics of potential target companies and product lines, such as:
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salability of products;
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suitability of distribution channels;
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management ability;
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financial condition and results of operations; and
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the degree to which acquired operations can be integrated with our operations.
We cannot assure you that we can identify strategic acquisition candidates or negotiate acceptable acquisition terms, and a failure to do so may adversely affect our results of operations and our ability to sustain growth. Our acquisition strategy involves a number of risks, each of which could adversely affect our results, including:
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difficulties in integrating acquired businesses, product lines or licenses
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assimilating new facilities and personnel
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harmonizing diverse business strategies and methods of operation;
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diversion of management attention from operation of the existing business;
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loss of key personnel from acquired companies; and
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failure of an acquired business to achieve targeted financial results.
A substantial reduction in or termination of orders from any of our largest customers could adversely affect our financial condition and results of operations.
Our three largest customers; Costco Wholesale Corporation, Target and TJX Companies collectively represented 36.4% and 32.5 % of 2006 and 2005 sales, respectively. No other customer represents greater than 5% of our sales in 2006 or 2005. Except for outstanding purchase orders for specific products, we do not have written contracts with or commitments from any of our customers. A substantial reduction in or termination of orders from any of our largest customers could adversely affect our business, financial condition and results of operations. In addition, pressure by large customers seeking price reductions, financial incentives, changes in other terms of sale or for us to bear the risks and the cost of carrying inventory also could adversely affect our business, financial condition and results of operations. If one or more of our major customers were to experience difficulties in fulfilling their obligations to us, cease doing business with us, significantly reduce the amount of their purchases from us, it could have a material adverse affect on our business, financial condition and results of operations.
Liquidity problems or bankruptcy of our key customers could increase our exposure to losses from bad debts and could have a material adverse effect on our business, financial condition and results of operations.
There is a risk that customers will not pay, or that payment may be delayed, because of bankruptcy or other factors beyond our control, which could increase our exposure to losses from bad debts. In addition, if these or other customers were to cease doing business as a result of bankruptcy, or significantly reduce the number of stores operated, it could have a material adverse effect on our business, financial condition and results of operations. In addition, the bankruptcy or financial difficulty of one or more of our significant retailers could negatively impact our revenues and bad debt expense.
We depend on third-party manufacturers who develop, provide and use the tools and dies that we own to manufacture our products and we have limited control over the manufacturing processes.
All of our products are manufactured by third-party manufacturers and any difficulties encountered by these third-party manufacturers that result in product defects, production delays, cost overruns or the inability to fulfill orders on a timely basis could adversely affect our business, financial condition and results of operations.
We do not have long-term contracts with our third-party manufacturers and our operations would be impaired if we lost our current suppliers.
Our operation would be impaired if we lost our current suppliers or if our current suppliers’ operations or sea or air transportation with our overseas manufacturers were disrupted or terminated even for a relatively short period of time. During the year ended December 31, 2006, our top ten suppliers accounted for 74.1 % of the total product purchases. The top two suppliers accounted for 20.9% and 10% of total purchases, respectively. Our tools and dies are located at the facilities of our third-party manufacturers. We are potentially subject to variations in the prices we pay third-party manufacturers for products, depending on what they pay for their raw materials since we do not have long-term contracts.
We have manufacturing operations outside of the United States, subjecting us to risks associated with international operations.
We utilize third-party manufacturers located principally in The People’s Republic of China, or the PRC and the Far East. Our third-party manufacturing operations are subject to the risks normally associated with international operations, including:
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currency conversion risks and currency fluctuations;
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political instability;
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civil unrest and economic instability;
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complications in complying with laws in varying jurisdictions and changes in governmental policies;
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rising cost of raw material;
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rising energy prices;
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blackouts due to energy shortages;
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transportation delays, interruptions and strikes; and
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the potential imposition of tariffs.
If we were prevented from obtaining our products due to medical, political, labor or other factors, our operations would be disrupted while alternative sources of products were secured. Also, the imposition of trade sanctions by the United States against a class of products imported by us from, or the loss of “normal trade relations” status by China, could significantly increase our cost of products imported from the PRC.
Our products sold in the United States are subject to various laws, including the Federal Hazardous Substances Act, the Consumer Product Safety Act, the Federal Hazardous Substances Act, the Flammable Fabrics Act and the rules and regulations promulgated under these acts.
These statutes are administered by the Consumer Product Safety Commission (“CPSC”), which has the authority to remove from the market products that are found to be defective and present a substantial hazard or risk of serious injury or death. The CPSC can require a manufacturer to recall, repair or replace these products under certain circumstances. Any such allegations or findings could result in:
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product liability claims;
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loss of sales;
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diversion of resources;
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damage to our reputation;
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increased warranty costs; and
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removal of our products from the market.
We could be the subject of future product liability suits, which could harm our business.
Products that have been or may be developed by us may expose us to potential liability from personal injury or property damage claims by the users of such products. There can be no assurance that a claim will not be brought against us in the future. While we currently maintain product liability insurance coverage in amounts we believe sufficient for our business risks, we may not be able to maintain such coverage or such coverage may not be adequate to cover all potential claims. Moreover, even if we maintain sufficient insurance coverage, any successful claim could significantly harm our business, financial condition and results of operations.
We have a material amount of goodwill which, if it becomes impaired, would result in a charge against our income
Goodwill is the amount by which the cost of an acquisition accounted for using the purchase method exceeds the fair value of the net assets we acquire. Current accounting standards require that goodwill be periodically evaluated for impairment based on the fair value of the operations acquired. As of December 31, 2006, approximately $2,767,000 or 13.3%, of our total assets represented goodwill. Reductions in our net income (loss) caused by the write-down of goodwill could harm our results of operations.
The Company filed a registration statement with the SEC on June 15, 2006 and Amendment No. 1 on October 4, 2006 covering, among other things, shares of common stock issuable upon exercise of certain warrants, preferred stock and debentures. As of the date of this filing, the Company is in the process of reviewing and responding to the comments received from the SEC on Amendment No.1. The exercise or conversion of the warrants, convertible preferred Class A-1 Stock and convertible debenture if the registration is declared effective, may cause significant dilution to our stockholders and the resale thereof may have an adverse impact on the market price of our common stock.
As of December 31, 2006, there are 5,410,575 shares of our common stock outstanding. Being registered in the registration statement are 14,593,380 shares of our common stock that are issuable upon exercise or conversion of the following securities: (i) 3,899,995 warrants; (ii) 10,130,885 Class A-1 Convertible Preferred shares; and (iii) the conversion of the convertible debenture into 562,500 shares. The exercise or conversion of these securities will increase the number of our publicly traded shares, which could depress the market price of our common stock.
The perceived risk of dilution may cause our stockholders to sell their shares, which would contribute to a downward movement in the stock price of our common stock. Moreover, the perceived risk of dilution and the resulting downward pressure on our stock price could encourage investors to engage in short sales of our common stock.
Because of the limited trading and because of the possible price volatility, you may not be able to sell your shares of common stock when you desire to do so.
The trading price of our common stock is not necessarily an indicator of what the trading price of our common stock might be in the future.
Because of the limited trading market for our common stock, and because of the possible price volatility, you may not be able to sell your shares of common stock when you desire to do so. The inability to sell your shares in a rapidly declining market may substantially increase your risk of loss because of such illiquidity and because the price for our common stock may suffer greater declines because of its price volatility.
Certain factors, some of which are beyond our control, that may cause our share price to fluctuate significantly include, but are not limited to, the following:
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announcement by us or our competitors of significant contracts, acquisitions, strategic partnerships, joint ventures or capital commitments;
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changes in market valuations of similar companies;
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variations in our quarterly operating results;
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inability to complete or integrate an acquisition;
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additions or departures of key personnel; and
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fluctuations in stock market price and volume.
Additionally, in recent years the stock market in general, and the Over-the-Counter Bulletin Board in particular, have experienced extreme price and volume fluctuations. In some cases, these fluctuations are unrelated or disproportionate to the operating performance of the underlying company. These market and industry factors may materially and adversely affect our stock price, regardless of our operating performance.
In the past, class action litigation has often been brought against companies following periods of volatility in the market price of those companies’ common stock. If we become involved in this type of litigation in the future, it could result in substantial costs and diversion of management attention and resources, which could have a further negative effect on your investment in our stock.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS
The Company filed a registration statement with the SEC on June 15, 2006 and Amendment No. 1 on October 4, 2006. As of the date of this filing, the Company is in the process of reviewing and responding to the comments received from the SEC on Amendment No.1..
ITEM 2.
ITEM 2. DESCRIPTION OF PROPERTIES
Our corporate headquarters are located at 5711 Buckingham Parkway, Culver City, California 90230, where we lease approximately 28,000 square feet and sublease approximately 17,000. This lease was amended to extend the term to February 28, 2009. We also lease approximately 62,000 square feet of warehouse space in Carson, California. This lease was also amended to extend the term to January 31, 2008. We also leased 1,200 square feet of office space in China in the town of ChangAn, GuangDong Province but this lease expired November 1, and was not renewed. We believe these facilities and additional or alternative space available to us will be adequate to meet our needs in the near term.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
On August 5, 2005, Gemini Partners, Inc. (“Gemini”) filed an action in the Superior Court of the State of California for the County of Los Angeles against Small World Toys, Debra Fine, and Fineline Services, LLC. On February 21, 2006, Gemini filed a second amended complaint that, among other things, named as a defendant Small World Kids, Inc. Gemini’s complaint arises out of a written consulting agreement dated as of November 10, 2003 entered into by and between Gemini and Fineline Services. On June 13, 2006, the Company and Gemini settled the suit out of court for $40,000.
On September 7, 2005, Small Play, Inc. (“Small Play”) filed an action in the United States District Court for the Southern District of New York against Small World Toys alleging $3 million in damages in connection with a supposed breach of an alleged oral licensing agreement. The suit was dismissed without prejudice by the Court on June 1, 2006 for failure of the plaintiffs to prosecute.
On April 12, 2006, Ryan Yanigihara, the Company’s former Controller, filed a complaint with the Secretary of Labor alleging violation of Section 806 of the Sarbanes-Oxley Act protecting whistleblowers. The complaint is still pending investigation and a determintation before OSHA. The Board of Directors commissioned an independent investigation of the complaint which was unable to substantiate the allegations.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year covered by this report.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITEIS
Our common stock is quoted on the OTC Bulletin Board of the National Association of Securities Dealers, Inc. (the “NASD”) under the symbol “SMWK.OB”. The following table sets forth, for the periods indicated, the high and low bid prices for the periods from January 1, 2005 through December 31, 2006. These quotations reflect inter-dealer prices, without retail mark-up, mark-down or commission, and may not represent actual transactions.
Holders
As of December 31, 2006, we currently have outstanding 5,410,575 shares of our common stock outstanding. As of December 31, 2006, our shares of common stock are held by approximately 64 stockholders of record. This does not include an indeterminate number of beneficial owners of securities whose shares are held in the names of various dealers and clearing agencies.
Dividends
We have never paid cash dividends on our common stock.
On June 9, 2006, we issued Class A-1 Convertible Preferred Stock. The holders of the outstanding Class A-1 Preferred Stock will be entitled to receive, out of funds legally available therefore, cumulative dividends at the annual rate of 6% per annum payable quarterly in shares of the Company’s Class A-1 Preferred Stock at a per share price of $1.10. As of December 31, 2006, the Company had accrued but not paid $375,000 in dividends on the Class A-1 Preferred Stock. In addition, in conjunction with the issuance of the Class A-1 Preferred Stock on June 9, 2006, a non-cash dividend of approximately $2.6 million was recorded at the time of issuance in relation to the warrants and the in-the-money conversion feature that allows for the conversion at a price lower than fair market value on the day of issuance. In addition, the repriced and additional warrants issued to the $1.5 million Convertible Debenture holders was determined to have a fair market value of approximately $1.2 million and since the warrants have no mandatory registration rights, the value of the warrants is also deemed a non-cash dividend.
The 10% Convertible Preferred Stock that we issued in August 2005 converted into the Class A-1 Convertible Preferred in June 2006 along with all accrued but unpaid dividends. Through June 9, 2006, when we converted such stock to the Class A-1 Preferred Stock, we had not paid any dividends on the 10% Convertible Preferred in either cash or stock, but had accrued $399,000 in dividends which was converted into 362,703 Class A-1 shares.
In addition, in conjunction with the issuance of the 10% Convertible Preferred Stock in August 2005, a non-cash dividend of approximately $2.2 million was recorded at the time of issuance in relation to an in-the-money conversion feature that allows for the conversion at a price lower than fair market value on the day of issuance.
Our future dividend policy will be determined by our Board of Directors and will depend upon a number of factors, including our financial condition and performance, our cash needs and expansion plans, income tax consequences, and the restrictions that applicable laws and our credit arrangements then impose.
Securities Authorized For Issuance under Equity Compensation Plans.
The following table summarizes the securities authorized for issuance as of December 31, 2006 under our 2004 Stock Compensation Plan, the number of shares of our common stock issuable upon the exercise of outstanding options, the weighted average exercise price of such options and the number of additional shares of our common stock still authorized for issuance under such plan.
ITEM 6.
ITEM 6.
CONSOLIDATED SELECTED FINANCIAL DATA
The following selected consolidated financial data is derived from our audited consolidated financial statements for the years ended December 31, 2006, 2005, 2004 and 2003 and for the eleven months ended (short year, transition period) December 31, 2002. The selected financial data may not be indicative of our future performance.
(1) Reflects the predecessor entity, Small World Toys prior to the May 20, 2004 acquisition by Small World Kids, Inc.
(2) Reflects the financial position and results of operations for the predecessor entity, Small World Toys from January 1, 2004 through May 20, 2004 and the successor entity, Small World Kids, Inc. from May 21, 2004 through December 31, 2004.
ITEM 7.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Overview
Small World Kids was organized on July 28, 2001 in the state of Utah under the name Savon Team Sports, Inc. (“SavOn”) to sell sporting goods over the Internet. The business operations generated limited revenues and operated at a loss since inception. On August 1, 2004, as a result of the May 20, 2004 transactions discussed below, we changed our name from SavOn Team Sports, Inc. to Small World Kids, Inc. We also changed our domicile from Utah to Nevada.
May 20, 2004 Transactions
Pursuant to an Exchange Agreement dated as of May 20, 2004, by and among the Company and a group of investors (“the Investors'), we issued 4,531,375 shares of its common stock, par value $0.001 per share, in exchange for all of the equity interests of Fine Ventures, LLC (“FVL”). Prior to May 20, 2004, FVL had no operating activities. As a condition to the closing of this transaction, Michael Rubin, the then-majority shareholder of the Company, sold 553,000 shares of his 618,000 shares of Small World Kids common stock for $10,000 to the Investors.
Simultaneously, pursuant to the terms of a Stock Purchase Agreement dated as of May 20, 2004, by and among Small World Kids, Debra Fine, Small World Toys, Eddy Goldwasser and Gail S. Goldwasser, Trustee of the Gail S. Goldwasser and Mark Chatinsky Family Trust (“Gail Goldwasser”; collectively with Eddy Goldwasser, (“Goldwassers”), Small World Kids acquired from the Goldwassers all of the issued and outstanding equity interests of Small World Toys (the “SWT Shares”). As consideration for the SWT Shares, Small World Kids paid an aggregate sum of $7,200,000, delivered as follows; (i) $5,000,000 in cash; and (ii) $2,200,000 in the form of a $500,000 six month promissory note, a $1,000,000 seven month promissory note, and a $700,000 two year promissory note payable in quarterly installments commencing April 2005.
As a result of the May 20, 2004 transactions, we have had a change of our management, our controlling shareholders, our financial position and our business plan. Since Small World Kids, our accounting successor, had no significant business operations or assets prior to the May 20, 2004 transactions described above, presenting comparative periods would not be meaningful. As such, the results of operations presented below for the predecessor are those of Small World Toys.
On October 14, 2005 we completed a ten for one (10:1) reverse stock split (“Reverse Split”), with rounding all fractional shares down to the next full share. After the Reverse Split, there are approximately 5,400,000 shares of common stock outstanding. The Reverse Split did not reduce the number of authorized shares of common stock, alter the par value or modify any voting rights or other terms thereof. As a result of the Reverse Split, the conversion price and/or the number of shares issuable upon the exercise of any outstanding options and warrants to purchase common stock was proportionally adjusted pursuant to the respective terms thereof. All references in this prospectus to units of securities (e.g. Common Stock shares) or per share amounts are reflective of the Reverse Split for all periods reported.
Compared to 2005
Net sales
Net sales for the year ended December 31, 2006 decreased $5,425,000 or 16.1% to $28,331,000 from $33,756,000 for the year ended December 31, 2005. The revenue decrease is mainly attributable to the decrease of $6,397,000 and $3,377,000 in sales to the specialty toy and national chain channels, respectively, over the year ended December 31, 2005. Part of this decline is attributed to the lack of the right inventory to fill orders during the third and fourth quarters. Management initiated improved demand order forecasting to increase the fill rate and as a result inventory has increased by $.2 million during 2006. Partially offsetting the decline in revenue was an increase in sales to mass retailers of $4,072,000 for the year ended December 31, 2006 over the year ended December 31, 2005. Due to the increased sales to the mass channel, Ryan’s Room product line sales more than doubled during the year ended December 31, 2006 versus the comparable prior year period. The Eric Carle licensed products which were introduced in 2006 increased over the comparable prior year period along with the All About Baby brand. All other brands suffered declines over the comparable prior year period primarily due to the supply shortages.
Gross Profit
Gross profit for the year ended December 31, 2006 decreased $2,367,000 or 18.0% to $10,770,000 from $13,137,000 for the year ended December 31, 2005 due to the decline in sales in 2006 over 2005. Gross profit margin of 38.0% decreased for the year ended December 31, 2006 as compared to 38.9% for the year ended December 31, 2005. The decrease in gross margin primarily resulted from approximately $939,000 in increased demurrage penalty costs for goods held in port in 2006 over 2005, which is approximately 3 percentage points on sales. In addition, the sales to specialty stores declined to 56.8% of net sales for the year ended December 31, 2006, as compared to 66.1% of net sales for the for the year ended December 31, 2005. Sales to the national chains and mass retailers typically have lower gross margins than sales to the specialty channel but most sales to these channels do not incur freight out or warehousing expenses and have lower commissions.
Operating Expenses
Operating expenses for the year ended December 31, 2006 decreased $1,596,000 or 9.3% to $15,622,000 from $17,218,000 but as a percentage of sales increased to 55.1% from 51.0% for the year ended December 31, 2005. The increase as a percentage of sales resulted from the 16.1% decline in sales in 2006 from 2005. Selling, general and administrative expenses for the year ended December 31, 2006 decreased $1,386,000 or 9.4% to $13,407,000 from $14,793,000 for the year ended December 31, 2005. Decreased selling, shipping and handling expenses for the year ended December 31, 2006 of $1,000,000 or 24.1% from the prior year period were driven by the higher mix of sales to the mass channel, which do not incur shipping and handling costs. Marketing and branding expenses decreased by $747,000 or 31.7% for the year ended December 31, 2006 as compared to the prior year period partly due to the write-off of $348,000 of barter credits in 2005. The non-cash consulting expenses for the year ended December 31, 2006 attributable to the issuance of stock options granted to consultants for services valued by using the Black-Scholes option-pricing model decreased by $524,000 from the comparable period. The non-cash recognition of stock compensation expense in the year ended December 31, 2006 was $547,000 resulting from the adoption of SFAS 123(R) using the modified prospective transition method in January 2006. Prior to the adoption of SFAS 123R, the Company accounted for stock-based awards to employees and directors using the intrinsic value method in accordance with APB 25 as allowed under Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (“SFAS 123”). Under the intrinsic value method, no stock-based compensation expense had been recognized in the Company’s statement of operations for the year ended December 31, 2005. As of December 31, 2006, $257,000 of unrecognized compensation costs related to non-vested stock options are expected to be recognized over the following 31 months. Partially offsetting the increase in operating expenses was the decrease in research and development costs of $229,000 or 11.6% to $1,743,000 for the year ended December 31, 2006 as compared to $1,972,000 for the year ended December 31, 2005. The Company also incurred a slight increase in amortization of intangible expenses of $19,000 for the year ended December 31, 2006 as compared to the same period of the prior year.
Other Income and Expense
Interest expense for the year ended December 31, 2006 increased $3, 419,000 or 97.1% to $6,940,000 from $3,521,000 for the year ended December 31, 2005. The increase is primarily due to: (i) the increase of $1,062,000 in non-cash interest expense resulting from the amortization of debt discounts that occurred for the year ended December 31, 2006 over the comparable prior year period; (ii) $1,077,000 in unamortized debt issuance costs related to the converted debt as a result of the conversion of $3 million of debt into Class A-1 Preferred Stock on June 9, 2006 and recorded as a non-cash expense in June 2006 (Note 5 of the accompanying financial statements); and (iii) $1,628,000 non-cash expense resulting from the repriced and additional warrants issued to the 10% Convertible Debenture holders on June 9, 2006 (Note 5 of the accompanying financial statements).
The agreement with Laurus and the $1.5 million 10% Convertible Debentures noteholders obligated us to file a registration statement to register the warrant shares and the common shares underlying the conversion prior to the Second Amendment to the Registration Rights Agreement dated January 26, 2007. Accordingly, pursuant to EITF 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock”, the cumulative relative net value of the warrant at the date of issuance of $3,663,000 was recorded as a warrant liability on the balance sheet. Any change in fair value from the date of issuance to the date the underlying shares were to be registered was included in other (expense) income. The change in fair market value (“FMV”) of the warrant liability is a non-cash charge determined by the difference in FMV from period to period. The Company calculates the FMV of the warrants outstanding using the Black-Scholes model. The decrease in the fair value of the warrant liability associated with Laurus and the 10% Convertible Debentures for the year ended December 31, 2006 was $1,557,000 and is a result of the decrease in the trading value of our stock during the year ended December 31, 2006. This compares to an increase of $291,000 for the year ended December 31, 2005. Since the $1.5 million 10% Convertible Debentures were converted on June 9, 2006 into Class A-1 Convertible Preferred shares, the company no longer has an obligation to file a registration statement to register the warrant shares and the common shares underlying the conversion of the 10% Convertible Debentures and the warrant liability associated with the 10% Convertible Debentures was reclassified as Equity. As of December 31, 2006, the Company had an obligation to file a registration statement with Laurus and had filed the registration statement with the SEC on June 15, 2006 and the Amendment No.1 on October 4, 2006. On January 26, 2007, the Company entered into the Second Amendment to the Registration Rights Agreement dated February 28, 2006 with Laurus that deleted the requirement to file a Registration Statement and no penalties were owed. Since the Company no longer has an obligation to file a registration statement to register the warrant shares, the warrant liability will be reclassified as Equity in January 2007 (Note 6 of the accompanying financial statements).
Lower rent and commission income accounted for the $30,000 decrease in Other for the year ended December 31, 2006 over the comparative period in 2005.
Provision for Income Tax
Small World Kids recorded no provision for income taxes for the years ended December 31, 2006 due to the net loss incurred during these periods. Income tax benefit for the year ended December 31, 2005 was $292,000, due to the benefit realized in recognizing for losses on which a valuation allowance has not been recorded.
Dividends
The 10% Class A Convertible Preferred Stock requires that we accrue a quarterly dividend at a rate of 10% per annum. The dividend is payable in cash or a combination of 50% cash and 50% Common Stock at the Company’s option, but the Company has not yet declared or paid any of the accrued dividends since the conversion to Preferred Stock on August 11, 2005. On June 9, 2006, we issued Class A-1 Convertible Preferred Stock along with converting the 10% Class A Convertible Preferred Stock along with accrued but unpaid dividends of $399,000. The holders of the outstanding Class A-1 Preferred Stock will be entitled to receive, out of funds legally available therefore, cumulative dividends at the annual rate of 6% per annum payable quarterly in shares of the Company’s Class A-1 Preferred Stock at a per share price of $1.10. The Company has accrued $375,000 in dividends for the 6% Class A-1 Preferred Stock for the year ended December 31, 2006. The Company has not yet declared or paid any of the accrued dividends for the 6% Class A-1 since the issuance of these securities.
The Class A-1 Preferred Stock has a beneficial conversion feature which allows the holders to acquire Common Stock of the Company at an effective conversion price of approximately $.25 below fair value at the date of issuance on June 9, 2006. In accordance with EITF 98-5, Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios, the Company has determined the intrinsic value of this in-the-money conversion feature accounted for it as a discount to the Preferred Stock. The fair market value of the intrinsic value of the beneficial conversion feature was determined to be approximately $2.5 million. As the Preferred Stock is immediately convertible, the full value of the conversion feature is deemed a dividend upon issuance and as such has been recorded directly to retained earnings. (Note 5 of the accompanying financial statements).
Compared to 2004
The following table provides a summary of the Company’s consolidated results of operations and the percentage of total net sales represented by the line items reflected in the Company’s consolidated statements of operations:
(1) Reflects the financial position and results of operations for the predecessor entity, Small World Toys from January 1, 2004 through May 20, 2004 and the successor entity, Small World Kids, Inc. from May 21, 2004 through December 31, 2004.
Net sales
Net sales for the year ended December 31, 2005 increased $4,263,000 or 14.5 % to $33,756,000 from $29,493,000 for the year ended December 31, 2004. The revenue increase is mainly attributable to the expansion of the Company’s product lines including brands such as Active Edge®, Small World Living™, IQ Baby®, IQ Preschool®, Gertie Balls®, and the All about Baby products. The introduction of the Neurosmith product line in the second quarter resulted in 2005 sales of approximately $1,200,000. Sales to new 2005 mass retailers, Costco Wholesale Corporation and Target Corporation resulted in an increase of $4,200,000 in 2005. Small World Express™, the Company’s distribution arm experienced over a 45% increase for the year ended December 31, 2005 over the comparable prior year period. Somewhat offsetting these increases were decreased shipments relating to the following core brands; Puzzibilities®, Ryan’s Room® and Tolo® products and the following item classes; Imaginative Play, Tub Tints, Preschool and Vehicles.
Gross Profit
Gross profit for the year ended December 31, 2005 increased $1,035,000 or 8.6% to $13,137,000 from $12,102,000 for the year ended December 31, 2004. Gross profit margin of 38.9% declined for the year ended December 31, 2005 as compared to 41.0% for the year ended December 31, 2004. The decrease in gross margin primarily resulted from a greater mix of sales to national chains and mass retailers of 33.7% of net sales for the year ended December 31, 2005, as compared to 25.5% of net sales for the year ended December 31, 2004. Sales to national chains and mass retailers typically have lower gross margins than sales to the specialty stores, but do not incur freight out or warehousing expenses and have lower commissions. In addition, there was an increase in promotional rebates and royalties for the year ended December 31, 2005 as compared to the same period of the prior year.
Operating Expenses
Operating expenses for the year ended December 31, 2005 increased approximately $3,691,000 or 27.3% and as a percentage of sales increased to 51.0% from 45.8% for the year ended December 31, 2004.
The increase in operating expenses was partly related to an increase in research and development costs of $799,000 or 68.1% incurred in the development of new products for the year ended December 31, 2005 as compared to the year ended December 31, 2004.
Selling, general and administrative expenses for the year ended December 31, 2005 increased $2,630,000 or 21.6% to $14,793,000 from $12,163,000 for the year ended December 31, 2004. Increased selling, shipping and handling expenses for the year ended December 31, 2005 of $351,000 or 5.6% over the prior year was driven by the 14.5% increase in sales in 2005 over 2004. Also, legal, auditing, insurance and investor relations expenses, driven primarily by the costs of being a public company, increased by $686,000 for the year ended December 31, 2005 as compared to the prior year. These costs were incurred for a full year in 2005 as compared to only seven months during 2004 as we became a public entity in late May 2004. Also contributing to the increase was an increase in marketing and branding expenses by approximately $291,000 for the year ended December 31, 2005 as compared to the prior year as we have introduced the following new brands since the acquisition of Small World Toys in May 2004; Small World Living™, Active Edge®, Active Edge Extreme®, IQ Baby The Softer Side®, Neurosmith® and Imagiix™. The write off of $348,000 of barter credits also contributed to the increase (Note 2 of the accompanying financial statements). Due to the amendments to our Credit Facility with PNC, our bank charges increased by $269,000 for the year ended December 31, 2005 as compared to the prior year. In addition, the Company incurred non-cash consulting expenses for the ended December 31, 2005 in the amount of $535,000 attributable to the issuance of 300,000 stock options granted to consultants for services valued by using the Black-Scholes option-pricing model. Only 16,000 of the options issued to the consultants were exercised, the balance expired or were terminated. The balance of the increase or $150,000 was attributable to increased travel and airfare expenses relating to the acquisition and fund raising activities in over prior year activities.
The Company also incurred additional costs of $262,000 for the year ended December 31, 2005 related to the amortization of intangible assets acquired in the purchase of Small World Toys, the Neurosmith product line and Imagiix as opposed to the previous year.
Other Income and Expense
Interest expense for the year ended December 31, 2005 increased $2,532,000 or 256.0% to $3,521,000 from $989,000 for the year ended December 31, 2004. The increase is partly due to the increase of $1,310,000 in non-cash interest expense resulting from the amortization of debt discounts that occurred for the year ended December 31, 2005 over the prior year. The balance of the increase resulted from the increase in the outstanding balances of the Company’s notes payable and the revolving credit line. Cash interest paid for the year ended December 31, 2005 increased by $999,000 over the prior fiscal year primarily due to the increased debt obligations.
The agreements with the $1.5 million 10% Convertible Debentures note holders obligated us to file a registration statement to register the warrant shares and the common shares underlying the conversion. Accordingly, pursuant to EITF 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock”, the relative net value of the warrants at the date of issuance of $1,077,000 was recorded as a warrant liability on the balance sheet. Any change in fair value from the date of issuance to the date the underlying shares are registered will be included in other (expense) income. The change in fair market value (“FMV”) of the warrant liability is a non-cash charge determined by the difference in FMV from period to period. The Company calculates the FMV of the warrants outstanding using the Black-Scholes model. The decrease in the fair value of the warrant liability associated with the 10% Convertible Debentures from the date of issuance to December 31, 2005 was $388,000.
Also due to fluctuations in the Company’s stock price, the Company also experienced a $97,000 increase in the FMV of the warrant liability associated with the St. Cloud Capital Partners LP Bridge Notes. As a result of the July 20, 2005 amendment to the notes held by St Cloud Capital Partners LP, the FMV of the warrant liability has been reclassified to equity.
Lower commission income accounted for the $207,000 decrease in Other.
Provision for Income Tax
Income tax benefit for the year ended December 31, 2005 was $292,000, due to the benefit realized in recognizing for losses on which a valuation allowance has not been recorded.
Liquidity and Capital Resources
Operations and liquidity needs are funded primarily through cash flows from operations, as well as utilizing, when needed, borrowings under the Company’s secured credit facilities and short and long term notes. Working capital needs generally reach peak levels from August through November of each year. To gain shelf space and address the seasonality of the toy industry, the Company offers early buy programs that are volume related with extended payment terms. The Company’s historical revenue pattern is one in which the second half of the year is more significant to the Company’s overall business than the first half and, within the second half of the year, the fourth quarter is the most prominent. The trend of retailers over the past few years has been to make a higher percentage of their purchases of toy and game products within or close to the fourth quarter holiday consumer buying season, which includes Christmas. The Company expects that this trend will continue. As such, historically, the majority of cash collections for Small World Toys occur late in the fourth quarter as the extended payment terms become due from the Company’s early buy programs. As receivables are collected, the proceeds are used to repay borrowings under the Company’s Revolving Note.
On February 28, 2006, Small World Kids, Inc. issued a Secured Non-Convertible Revolving Note (the “Revolving Note”) with Laurus Master Fund, Ltd. (“Laurus”). The term of the Revolving Note is two years and provides that we may borrow up to $16,500,000 subject to certain conditions. Interest is payable monthly, in arrears at a rate per annum equal to the Prime Rate (as published in The Wall Street Journal ) plus two percent (2.0%). The Revolving Note has no financial covenants and is collateralized by a security interest in substantially all of the assets of the Company and its subsidiaries, including its operating subsidiary, Small World Toys.
On February 28, 2006, Small World Kids, Inc., also issued pursuant to a security agreement (the Laurus “Security Agreement”) a $2.0 million, two year Secured Non-Convertible Term Note (the “Term Note “) with Laurus. Commencing April 1, 2006 and each succeeding month after, the Company will make principal payments of $33,333 with all the balance of the unpaid principal amount due upon the maturity date of February 28, 2008. Interest is payable monthly, in arrears at a rate per annum equal to the Prime Rate (as published in The Wall Street Journal ) plus three percent (3.0%). The Term Note has no financial covenants and is collateralized by the Laurus Security Agreement.
Under cross default provisions in the Laurus Security Agreement, defaults under any of our debt obligations may cause the acceleration of the repayment of the Revolving and Term Notes. Under these provisions, a default or acceleration in any of our debt agreement may result in the default and acceleration of our debt agreements with Laurus (regardless of whether we were in compliance with the terms of the Laurus Security Agreement), providing Laurus with the right to accelerate the obligations due under their debt agreement.
On March 20, 2006, The Company entered into a Purchase Order Revolving Credit Line (“PO Credit Line”) of Five Million Dollars ($5,000,000) with Horizon Financial Services Group USA to provide financing for the acquisition of product from our overseas vendors. The term of the PO Credit Line is eighteen (18) months and provides that we may borrow up to $5,000,000 subject to certain conditions including Horizon’s approval of the applicable vendors. A financing fee equal to Four and One Half Percent (4.50%) of the gross amount or face value of each Horizon financing instrument will be charged for the first forty-five (45) day period or part thereof that the financing instrument remains outstanding. An additional fee of fifty basis points (.50%) for each additional period of 15 days, or part thereof, during which the Horizon financing instrument remains outstanding will be charged. The PO Credit Line has no financial covenants and is collateralized by a security interest, junior in position to that of our senior lender, Laurus Master Fund, Ltd, to the assets related to the PO Credit Line transactions. Horizon and St. Cloud Capital Partners executed an inter-creditor agreement on the collateralized security interest on June 1, 2006.
On June 9, 2006, the Company received approximately $2.4 million from the private placement of Class A-1 Preferred Stock at $1.10 per share and binding commitments for an additional $.3 million of which $150,000 was received in September and the balance was received in November 2006. As a condition of this transaction, we converted $3 million of debt into 2,763,636 shares of the Class A-1 Convertible Preferred as follows: (i) the 24% Notes Due 2006 in principal amount of $1,000,000 with Hong Kong League Central Credit Union, PCCW Credit Union and HIT Credit Union; (ii) the $1.5 million in principal amount of the 10% Convertible Debentures due in 2008 along with accrued but unpaid interest and penalties; and (iii) the 10% Note Due 2006 - Related Party in principal amount of $500,000 in notes to various investors which included Debra Fine, the Company’s President and Chief Executive Officer who provided $175,000 of the total borrowing. We also converted the Series A Convertible Preferred Stock we issued on August 11, 2005, when we converted a $5,000,000 Bridge Note dated May 2004 held by SWT, LLC, along with accrued but unpaid dividends into 4,908,157 shares of the Class A-1 Preferred Stock. Also, as a condition of this sale, the 10% Note Due 2006 to St Cloud Capital Partners LP in the principal amount of $2.5 million was restructured as follows: the Company prepaid $50,000 of the existing note and issued to St. Cloud two new notes to replace the exiting note. The first note in the principal amount of $200,000 will be for twelve months with monthly amortization payments at a 10% interest rate; the second note will be for $2,250,000 with interest at 10% per annum with interest only payable on June 30, 2006 and September 15, 2006 and commencing September 16, 2006, payments will be interest only each month through September 15, 2008 and commencing October 15, 2008, monthly amortization payments (based on a five-year amortization) with all interest plus unpaid principal due on September 15, 2011 and the second note will be convertible into shares of the common stock of the Company at $4.00 per share.
On July 26, 2006, Laurus authorized $750,000 in excess of the maximum allowed borrowings based on a formula amount of the secured assets (the “Overadvance”) on the Revolving Note. On October 19, 2006, Laurus exercised the discretion granted to it pursuant to Section 2(a)(ii) of the Security Agreement dated February 28, 2006 with the Company to make loans to the Company in excess of the maximum amounts available to be borrowed on our revolver loans. The aggregate principal amount of the Overadvance is $1,500,000, of which amount $1,500,000 was outstanding as of December 31, 2006. The Overadvance, subject to certain restrictions, is available to the Company for a one year period. The interest applicable to the Overadvance shall be the “prime rate” published in The Wall Street Journal from time to time plus two percent (2%).
Pursuant to a Securities Purchase Agreement (the “Purchase Agreement”) dated October 19, 2006 between Small World Kids, Inc. and the following investors; Russell Fine and Debra Fine (our President and Chief Executive Officer) as trustees of the Fine Family Trust, and Vintage Filings, LLC, the Company sold in a private placement 181,818 shares of its Class A-1 Convertible Preferred Stock (the “Preferred Shares”) for $200,000. The Purchase Agreement granted to the purchasers piggyback registration rights with respect to the shares of Company Common Stock issuable upon conversion of the Preferred Shares and certain participation rights in respect of future equity financings.
On October 19, 2006, the Company issued an aggregate of $330,000 in principal amount of 10% Convertible Debentures (the “Debenture”) to Hong Kong League Central Credit Union and Kershaw Mackie & Company with net proceeds of $300,000. Interest is payable monthly in arrears and the Debentures mature on March 31, 2008. The Debentures are convertible into shares of the Registrant’s Common Stock at the option of the holder at a conversion price $1.10 (subject to normal adjustments). Since the convertible debenture has only standard adjustment features with no reset conversion price requirements nor registration rights requirements beyond piggy-back rights, the debt is considered conventional debt under FASB 133 and EITF 00-19.
On November 6, 2006, the Company entered into an amendment with the former shareholder whereas the contingent earnout for 2006 was fixed at $670,000 and a three year note for $667,619 (the unpaid principal amount of the 5% Note) was issued with monthly amortization payments at a 10% interest rate.
On January 26, 2007, the Company entered into an Omnibus Amendment No.1 with Laurus that (a) amended the Overadvance Side Letter by extended the maturity of the Overadvance of up to $1,500,000 from October 19, 2007 to February 28, 2008 and (b) increased the Concentration Limits for accounts on standard terms from 15% to 32.5%. In addition, the requirement for the listing of the Company’s shares on the NASDAQ, OTC Bulletin Board or other Principal Market and for the timely filing with the SEC of all reports required to be filed pursuant to the Exchange Act was deleted along with the requirement to file a registration statement.
As of December 31, 2006, we had approximately $155,000 of cash and unrestricted cash which compares to $524,000 at December 31, 2005. Also, as of December 31, 2006, we had approximately $1,014,000 of availability on our line of credit which includes the $1,500,000 Overadvance. This compares to $612,000 of availability on our line of credit as of December 31, 2005.
For the year ended December 31, 2006, the Company used cash for operating activities of $6,012,000 as compared to $2,760,000 for the year ended December 31, 2005. Inclusive of this increase beyond the increase in net losses and non cash charges as previously explained were the following working capital changes: (i) an increase in inventory of $442,000 in the year ended December 31, 2006, (ii) a decrease in accounts receivable of $504,000 and (iii) a decrease in prepaid expenses and other current assets of $285,000; partially offset by (iv) an increase in accounts payable of $256,000 and (v) an decrease of accrued expenses of $839,000.
Since the Company outsources manufacturing of products to Asia, the Company has historically low requirements for additions to property and equipment. For the year ended December 31, 2006, the Company spent approximately $19,000 in additions to capital equipment as compared to $214,000 for the comparable period in 2005.
All securities issuances were made pursuant to an exemption from the registration requirements of the Securities Act of 1933, as amended, pursuant to Regulation D promulgated thereunder.
We have incurred significant losses since our purchase of Small World Toys in May 2004. As of December 31, 2006, our accumulated deficit was $22.6 million. On June 9, 2006, the Company received approximately $2.4 million from the private placement of Class A-1 Preferred Stock at $1.10 per share and subsequently received an additional $.3 million by November 2006. In addition, on June 9, 2006, the Company converted $3.0 million of debt due in 2006 and 2008 to Class A-1 Preferred Stock, and restructured a $2.5 million note due in 2006 to $250,000 due within 12 months and the balance to begin principal amortization in October 2008. On October 19, 2006, we have received an additional $200,000 from the private placement of Class A-1 Preferred Stock at $1.10 per share. On October 19, 2006, we issued an aggregate of $330,000 in principal amount of 10% Convertible Debentures. On July 26, 2006, Laurus authorized $750,000 in excess of the maximum allowed borrowings based on a formula amount of the secured assets (the “Overadvance”) on the Revolving Note. On October 19, 2006, Laurus increased to $1,500,000 the permitted Overadvance to the Company in excess of the maximum amounts available to be borrowed on our revolver loans.
As of December 31, 2006, we had $804,000 in principal payments due during the next twelve months to Laurus, Horizon, St. Cloud and the former shareholder of Small World Toys. Of the $804,000 in principal payments due in 2007, the Company is not permitted by Laurus to pay the $152,000 in principal payments due to St. Cloud in 2007 while any amounts are outstanding on the $1,500,000 overadvance. We may not be able to generate sufficient cash flow from operations to meet our debt and operational obligations. If we are unable to generate sufficient cash flow, we would be required to seek additional financing or restructure our debt obligations. There can be no assurance that we will be able to obtain additional financing or restructure our debt obligations or that if we were to be successful in obtaining additional financing or restructure our debt obligations, it would be on favorable terms. Failure to obtain additional financing or restructuring our debt obligations may cause us to default on these debt obligations. In addition, under cross default provisions in the Laurus Security Agreement, defaults under any of our debt obligations may cause the acceleration of the repayment of the Revolving and Term Notes. This raises substantial doubt about the Company’s ability to continue as a going concern for a reasonable period of time. Management has and will continue to pursue the following actions: (i) reducing operating expenses; (ii) seeking to obtain new equity; and (iii) restructuring the debt obligations.
Additionally, the Company may need additional financing to fund the Company’s acquisition strategy, the amount of which will depend on the price and structure of potential acquisitions.
Contractual Obligations and Off-Balance Sheet Arrangements
As part of the purchase for SWT Shares on May 20, 2004, the Company entered into a contingent earnout with the former shareholder of Small World Toys. The Company agreed to a two year promissory note, payable in quarterly installments commencing April 2005 with a minimum payment of $700,000 and a maximum payment of $1,500,000, if certain sales targets are achieved in 2005 and 2006. In 2005, the seller earned $673,000 based on the Company obtaining $33.7 million in net sales of which $350,000 was paid in quarterly installments in 2005 and the balance due in 2006 to be paid on a $60,000 per month payment schedule commencing on April 2006. The 2006 earnout is based on 2% of 2006 net sales up to a maximum of $800,000. On November 6, 2006, the Company entered into an amendment with the former shareholder whereas the contingent earnout for 2006 was fixed at $670,000 and a three year note for $667,619 (the unpaid principal amount of the 5% Note) was issued with monthly amortization payments at a 10% interest rate.
On March 20, 2006, The Company entered into a Purchase Order Revolving Credit Line (“PO Credit Line”) of Five Million Dollars ($5,000,000) with Horizon Financial Services Group USA to provide financing for the acquisition of product from our overseas vendors. The term of the PO Credit Line is eighteen (18) months and provides that we may borrow up to $5,000,000 subject to certain conditions including Horizon’s approval of the applicable vendors. A financing fee equal to Four and One Half Percent (4.50%) of the gross amount or face value of each Horizon financing instrument will be charged for the first forty-five (45) day period or part thereof that the financing instrument remains outstanding. An additional fee of fifty basis points (.50%) for each additional period of 15 days, or part thereof, during which the Horizon financing instrument remains outstanding will be charged. The PO Credit Line has no financial covenants and is collateralized by a security interest, junior in position to that of our senior lender, Laurus Master Fund, Ltd, to the assets related to the PO Credit Line transactions. Horizon and St. Cloud Capital Partners executed an inter-creditor agreement on the collateralized security interest on June 1, 2006. As of December 31, 2006, there was $46,000 outstanding under this PO Credit Line
The following tables summarize our total contractual cash obligations by year:
(1) Prior to debt issuance costs, see Note 5 of the accompanying financial statements
The Company has no other off-balance sheet arrangements as defined by Regulation S-K that have or are reasonably likely to have a current or future effect on the Company’s financial condition, revenues or expense or liquidity.
Critical Accounting Policies and Significant Estimates
Management’s discussion and analysis of our financial condition and results of operations are based upon the consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities. On an on-going basis, management evaluates estimates, including those related to the valuation of inventory and the allowance for uncollectible accounts receivable. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. A summary of the significant accounting policies can be found in Note 2 of the Notes to Consolidated Financial Statements. The significant accounting policies which management believes are the most critical to aid in fully understanding and evaluating our reported financial results include revenue recognition and sales allowances, inventory, accounts receivable and allowances for doubtful accounts and intangible assets.
Revenue Recognition
We recognize revenue when all four revenue recognition criteria have been met: persuasive evidence of an arrangement exists, the product has been delivered or the service has been rendered, the price is fixed or determinable and collection is probable. We recognize revenue from product sales upon when all of the foregoing conditions are met which in general is at the time of shipment where the risk of loss and title has passed to the customer. However, for certain shipments such as direct shipments from our vendors to our customers or where we use consolidators to deliver our products (usually export shipments) revenue is recognized in accordance with the sales terms specified by the respective sales agreements.
Sales allowances for customer promotions, discounts and returns are recorded as a reduction of revenue when the related revenue is recognized. We routinely commit to promotional sales allowance programs with our customers. These allowances primarily relate to fixed programs, which the customer earns based on purchases of our products during the year. Discounts are recorded as a reduction of related revenue at the time of sale. Sales to customers are generally not subject to any price protection or return rights.
We offer extended terms to some of its customers in the first three quarters of the year by way of sales promotions whereby payment will not become due until the fourth quarter if a specified purchase threshold has been met. This promotion allows us to capture additional shelf space and to encumber more of the annual budgets of our retail customers. The result of this promotion gives rise to a significant increase in accounts receivable through the fourth quarter until such time that substantially all accounts become due and are collected. Based upon historically low rates of return and collection of substantially all of these extended term accounts, we have determined that revenue is appropriately recognized in accordance with its normal procedures described above.
Inventory
Inventory is valued at the lower of average cost or market. Inventory costs consist of the purchases of finished goods from our vendors and the associated costs necessary to obtain those inventories. As necessary, we write down inventory to its estimated market value based on assumptions about future demand and market conditions. Failure to accurately predict and respond to consumer demand could result in the under production of popular items or overproduction of less popular items which may require additional inventory write-downs which could materially affect our future results of operations.
Long-lived Assets
We evaluate long-lived assets whenever events or changes in business circumstances or our planned use of assets indicate that their carrying amounts may not be fully recoverable or that their useful lives are no longer appropriate. Reviews are performed to determine whether the carrying values of assets are impaired based on comparison to either the discounted expected future cash flows (in the case of goodwill and intangible assets) or to the undiscounted expected future cash flows (for all other long-lived assets). If the comparison indicates that impairment exists, the impaired asset is written down to its fair value. Significant management judgment is required in the forecast of future operating results that are used in the preparation of expected discounted and undiscounted cash flows.
The total purchase price of our acquisitions are allocated to the fair value of the assets acquired and liabilities assumed in accordance with the provisions of Statements of Financial Accounting Standards (“SFAS”) No. 141, Business Combinations and No. 142, Goodwill and Other Intangible Assets. In accordance with Statement of Financial Accounting Standards No. 141, the estimated the fair value of the assets acquired for purpose of allocating the purchase price.
At December 31, 2006, we had a net amount of $5.4 million of goodwill and purchased intangible assets on our Consolidated Balance Sheet. As no impairment indicators were present during fiscal 2006, we believe our purchased intangible assets remains recoverable based on the discounted estimated future cash flows of the associated products and technologies.
Recent Accounting Pronouncements
In February 2007, the Financial Accounting Standards Board (“FASB”) issued Statement No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS No. 159”), provides companies with an option to report selected financial assets and liabilities at fair value. This Statement is effective as of the beginning of an entity’s first fiscal year beginning after November 15, 2007. Early adoption is permitted as of the beginning of the previous fiscal year provided that the entity makes that choice in the first 120 days of that fiscal year and also elects to apply the provisions of Statement 157. We are currently evaluating the potential impact of the adoption of SFAS 159 on our future consolidated financial statements.
In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans-an amendment of FASB Statements No. 87, 88, 106 and 132(R)” (“SFAS 158”). SFAS 158 requires an employer that sponsors one or more single-employer defined benefit plans to (a) recognize the overfunded or underfunded status of a benefit plan in its statement of financial position, (b) recognize as a component of other comprehensive income, net of tax, the gains or losses and prior service costs or credits that arise during the period but are not recognized as components of net periodic benefit cost pursuant to SFAS No. 87, “Employers’ Accounting for Pensions,” or SFAS No. 106, “Employers’ Accounting for Postretirement Benefits Other Than Pensions,” (c) measure defined benefit plan assets and obligations as of the date of the employer’s fiscal year-end, and (d) disclose in the notes to financial statements additional information about certain effects on net periodic benefit cost for the next fiscal year that arise from delayed recognition of the gains or losses, prior service costs or credits, and transition asset or obligation. An employer with publicly traded equity securities is required to initially recognize the funded status of a defined benefit postretirement plan and to provide the required disclosures as of the end of the fiscal year ending after December 15, 2006. The requirement to measure plan assets and benefit obligations as of the date of the employers fiscal year-end statement of financial position is effective for fiscal years ending after December 15, 2008. Since we do not have a Defined Benefit Plan, this did not have a material impact on the Company’s financial position, results of operations or cash flows.
In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 clarifies the principle that fair value should be based on the assumptions market participants would use when pricing an asset or liability and establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. SFAS 157 is effective for our fiscal year beginning January 1, 2007. We are currently evaluating the potential impact of the adoption of SFAS 157 on our future consolidated financial statements.
In September 2006, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”). SAB 108 provides interpretive guidance on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a current year misstatement. The SEC staff believes that registrants should quantify errors using both a balance sheet and an income statement approach and evaluate whether either approach results in quantifying a misstatement that, when all relevant quantitative and qualitative factors are considered, is material. SAB 108 is effective for our fiscal year ending December 31, 2006. The adoption of SAB 108 will only impact our consolidated financial statements if we have misstatements in the future.
In July 2006, the Financial Accounting Standards Board ("FASB") issued FASB Interpretation ("FIN") No. 48, Accounting for Uncertainty in Income Taxes, with respect to FASB Statement No. 109, Accounting for Income Taxes, regarding accounting for and disclosure of uncertain tax positions. FIN No. is intended to reduce the diversity in practice associated with the recognition and measurement related to accounting for uncertainty in income taxes. This interpretation is effective for fiscal years beginning after December 15, 2006. We are currently evaluating the impact this interpretation will have on our financial statements.
In March 2006, the FASB issued SFAS No. 156 “Accounting for Servicing of Financial Assets an amendment of FASB Statement No. 140”. FASB Statement No. 140, “Accounting for Transfers and servicing of Financial Assets and Extinguishments of Liabilities” establishing among other things, the accounting for all separately recognized servicing assets and servicing liabilities. This Statement amends Statement 140 to require that all separately recognized servicing assets and servicing liabilities be initially measured at fair value, if practicable. This Statement permits, but does not require, the subsequent measurement of separately recognized servicing assets and servicing liabilities at fair value. SFAS No. 156 is effective as of the beginning of the fiscal year that begins after September 15, 2006. The company will adopt SFAS 156 on January 1, 2007
In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments” (“SFAS 155”), which amends SFAS No. 133, “Accounting for Derivatives Instruments and Hedging Activities” (“SFAS 133”) and SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities” (“SFAS 140”). SFAS 155 amends SFAS 133 to narrow the scope exception for interest-only and principal-only strips on debt instruments to include only such strips representing rights to receive a specified portion of the contractual interest or principle cash flows. SFAS also amends SFAS 140 to allow qualifying special-purpose entities to hold a passive derivative financial instrument pertaining to beneficial interests that itself is a derivative instruments. The Company is currently evaluating the impact this new Standard, but believes that it will not have a material impact on the Company’s financial position, results of operations or cash flows. We will adopt SFAS 155 on January 1, 2007.
For the year ending December 31, 2007, under current rules, pursuant to Section 404 of the Sarbanes-Oxley Act, management will be required to deliver a report that assesses the effectiveness of our internal controls over financial reporting. The SEC issued a release in December 2006, however, announcing that the Commission has extended the date by which non-accelerated filers, which we currently are, must begin to comply with the Section 404(b) requirement to provide an auditor’s attestation report on internal controls over financial reporting. The deadline for the auditor’s attestation report has been moved to the first annual report for fiscal years ending on or after December 15, 2008. The SEC is considering further postponing this date.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA
Our audited Consolidated Financial Statements, including the notes thereto, appear beginning on page of this report.
ITEM 8A.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our principal financial instruments are our Secured Non-Convertible Revolving Note and Secured Non-Convertible Term Note with Laurus Master Funds, Ltd. (“Laurus”) which provides for an interest rate of Prime Rate (as published in The Wall Street Journal ) plus two percent (2.0%) for the Revolving Note and Prime Rate (as published in The Wall Street Journal ) plus three percent (3.0%) for the Term Note. We are affected by market risk exposure primarily through the effect of changes in the Prime Rate on our interest rates on our obligations under the Revolving and Term Notes. At December 31, 2006, an aggregate principal amount of $10.8 million was outstanding under the Revolving and Term Notes. If the principal amounts outstanding remained at this level for an entire year and the prime rate increased or decreased, respectively, by 0.5%, we would pay or save, respectively, an additional $54,000 in interest in that year.
Our business outside the United States is conducted in United States Dollars. Although we purchase and sell products and services in United States Dollars and do not engage in exchange swaps, futures or options contracts or other hedging techniques, fluctuations in currency exchange rates could reduce demand for products sold in United States dollars. We cannot predict the effect that future exchange rate fluctuations will have on our operating results. We may in the future engage in currency hedging transactions, which could result in our incurring significant additional losses.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCOSURES
None.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
As a result of the May 20, 2004 transactions, the internal control structure in place for Small World Toys, Inc. has succeeded to Small World Kids, Inc. Since the acquisition of Small World Toys, the Company’s system of internal controls has evolved consistent with the development of the business.
(a) Evaluation of disclosure controls and procedures: As of December 31, 2006, the end of the period covered by this report, the Company’s chief executive and the Company’s chief financial officer reviewed and evaluated the effectiveness of the Company’s disclosure controls and procedures (as defined in Exchange Act Rule 13a-15 and Rule 15d-15(e)), which are designed to ensure that material information the Company must disclose in the Company’s report filed or submitted under the Securities Exchange Act of 1934, as amended (the “Exchange Act”) is recorded, processed, summarized, and reported on a timely basis, and have concluded, based on that evaluation, that as of such date, the disclosure controls and procedures were effective to ensure that information required to be disclosed in reports filed or submitted under the Exchange Act is accumulated and communicated to the Company’s management, including its chief executive officer and chief financial officer, as appropriate to allow timely decisions regarding required disclosure. Although the evaluation did not detect any material weaknesses or significant deficiencies in the Company’s system of internal accounting controls over financial reporting, management identified certain potential deficiencies in its level of staffing. The Company is reviewing its staffing level to address this resource issue.
(b) Changes in internal control over financial reporting: There have been no changes in the Company’s internal control structure over that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
ITEM 9B.
ITEM 9B. OTHER INFORMATION
None
PART III
ITEM 10.
ITEM 10.
DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS
The following table and text set forth the names of all directors and executive officers of our Company as of December 31, 2006. The Board of Directors is comprised of only one class. All of the directors will serve until the next annual meeting of shareholders and until their successors are elected and qualified, or until their earlier death, retirement, resignation or removal. There are no family relationships between or among the directors, executive officers or persons nominated or charged by our Company to become directors or executive officers. Executive officers serve at the discretion of the Board of Directors, and are appointed to serve until the first Board of Directors meeting following the annual meeting of shareholders. Also provided herein are brief descriptions of the business experience of each director and executive officer and an indication of directorships held by each director in other companies subject to the reporting requirements under the Federal securities laws.
The directors and executive officers of the Company are as follows:
Name
Age
Position Held with the Company
Debra Fine
Chairman, CEO, President and Director
Bob Rankin
Chief Financial Officer and Secretary
Gary Adelson (b)
Director
Alex Gerstenzang (a)
Director
Eric Manlunus (b)
Director
Lane Nemeth (a)
Director
Shelly Singhal (a)
Director
David Swartz (b)
Director
(a)
Member of the Compensation Committee
(b)
Member of the Audit Committee
Biographies of Directors and Executive Officers:
Debra Fine, Chief Executive Officer, Chairman and President
Debra Fine has served as the Chief Executive Officer, Chairman and President since May 20, 2004. Fine served as a principal at EM Ventures (Venture Capital Fund) from 2002 to 2004. Prior to joining EM Ventures, she was the President and Chief Executive Officer of three consumer product companies, Fandom Media, a “tween” products company from 2000 to 2002, President of New Media for Digital Domain, an academy award winning movie production company from 1998 to 2000 and Cloud 9 Children’s products. With over 15 years of experience in consumer products, entertainment and media, Fine has developed expertise in operations, marketing, licensing and creating growth in start-up ventures. She holds a Bachelor of Arts in Journalism and Advertising from the University of Southern California and a MBA from the Anderson School, Executive Program at University of California, Los Angeles.
Robert Rankin, Chief Financial Officer and Secretary
Robert Rankin has served as the Chief Financial Officer and Secretary since May 24, 2004. From 2002 until 2004, Mr. Rankin served as a consultant including serving as an interim CFO for a semiconductor start-up company from 2003 until joining the Company. From 1992 through 2002, Mr. Rankin held positions as Chief Financial Officer of public and private, mid-cap and start-up companies in the high technology and aerospace industries. In 2000, Rankin co-founded an application service provider software company. In 2000, while serving as the Chief Financial Officer of webcasts.com a private company, Rankin directed the sale of this software start-up for a valuation over $100 million. From 1992 through 1998 under his leadership as CFO, DeCrane Aircraft Holdings, Inc. grew from a highly leveraged, VC funded, private aerospace company with sales of $13 million in 1991 to a multinational public company with sales of almost $200 million in 1998. Rankin's background also includes senior financial management positions with B.F. Goodrich and Coltec Industries. Mr. Rankin has a Bachelor of Science in Mechanical Engineering and a Master of Science in Business, both from Carnegie-Mellon University. On March 27, 2007, Mr. Rankin announced his resignation effective April 10, 2007.
Gary Adelson, Director
Gary Adelson has been a managing director of Houlihan Lokey Howard & Zukin and co-head of the firm’s Media & Entertainment Investment Banking Group since 2003. Prior to joining the firm, he was a principal of Media Connect Partners, a provider of financial and operating advisory services to media, entertainment, sports and communications companies that he co-founded in 2003 and that was acquired by Houlihan. In 1996, Adelson co-founded EastWest Venture Group, which is a private venture capital, company managing a fund of over $250 million and served until 2002. From 1990 to 1995, He co-founded and served as Chairman and Chief Executive Officer of ICS, a telephony and cable company that was acquired by MCI in 1995. He earned a Bachelor of Arts degree in Economics from the University of California, Los Angeles and has served as the chairman of UCLA’s Venture Fund. Mr. Adelson serves on the board of the Pediatric Aids Foundation and was executive director of Israel’s 50th anniversary jubilee.
Alex Gerstenzang, Director
Alex Gerstenzang has been a senior executive with a big box retailer, having been with them for the last 29 years, overseeing a diverse product sales mix of approximately $12 billion since 1997. He has managed the East Coast region for Paris Boutique Corporation and subsequently founded a consulting business serving clients as diverse as prisons to the City of Portland and Georgia Pacific Corporation. He attended Dalton School, Columbia University, Pace University and New York University. He earned a Bachelor of Specialized Studies degree in finance and a Master of Business Administration.
Eric Manlunus, Director
Eric Manlunus is the Founder and Managing Director of Frontera Group, LLC, a boutique venture capital firm focused on investing in early to mid-stage emerging companies. Previously, he was also a principal of an LA-based value hedge fund from 2002 to mid-2006. Prior to Frontera, he was the founding Chairman and CEO of Sitestar; a publicly traded technology investment company focused on the consolidation of independent and privately owned Internet service providers in the rural markets of the mid-Atlantic region of the US. During his tenure, Sitestar completed seven acquisitions and became one of the largest independent ISPs in the region. He started his career as an associate of Arthur Andersen’s retail management consulting division from 1991-1995. Eric earned an M.B.A from Pepperdine University and a B.S. in Communications from Florida International University. He is and was previously a member of the Board of Directors of Exist Global, Mobile Content Networks, Small World Kids, Brentwood Media Group, Sitestar, Sierra Madre Foods, Menu Direct and Xcel Healthcare.
Lane Nemeth, Director
Lane Nemeth has been the founder and chief executive officer of Pet Lane, a direct sales enterprise since 2003. Prior to founding Pet Lane, she was an author, speaker and consultant from 1998 to 2003. She is the founder of Discovery Toys, an educational toy company based in Livermore, California, that was acquired by Avon (NYSE:AVP) in 1997 and was with Discovery from 1978 to 1998. She has received numerous entrepreneurial awards and is a regularly featured speaker at national child development, business leadership seminars, including the Stanford Leadership Academy and the National Association of Women Business Owners. She is a member of the Women’s Executive Leadership Council. Her recent book, Discovering Another Way, Raising Brighter Children, While Having a Meaningful Career , has received national recognition. She earned a Bachelor of Arts degree from the University of Pittsburgh and a Master of Arts degree in education from Seton Hall University.
Shelly Singhal, Director
Shelly Singhal currently serves as the Chairman and Chief Executive Officer of the SBI Group, a position he has held since 2001. Prior to joining SBI, Mr. Singhal was managing director of corporate finance at a brokerage firm in Orange County, California, joining the firm in 1995. He was responsible for several areas, including its E-Commerce Group from 1995 to 2000 and serving as manager of the Firm’s Bridge Fund. He earned a Bachelor of Science degree from Seaver College at Pepperdine University.
David Swartz, Director
David Swartz is the Managing Partner of Good Swartz Brown & Berns, which is a regional accounting and business advisory firm which he joined in 1990. Prior to joining Good Swartz Brown & Berns, he served as the chief financial officer of Westfield, Inc., a publicly held shopping center development company, from 1988-1990. From 1968 to 1988, Swartz was a managing partner and on the national board of BDO Seidman, an international accounting firm. He is also a Director of Primedex Corporation, a public company. Mr. Swartz has more than thirty-five years of experience providing business advisory services to clients in several industries, including manufacturing, wholesale, retail, entertainment, real estate and professional services, and his professional experience also includes acquisitions, merger transactions, business valuations, and ESOPs. He has lectured extensively at several Southern California universities, and is a frequent speaker to trade and professional organizations. Swartz is past president of the Jewish Big Brothers of Los Angeles and serves on the boards of several other charitable foundations. Swartz earned his Bachelor of Science degree in Accounting from California State University, Northridge and is a member of the California Society of Certified Public Accountants and the American Institute of Certified Public Accountants. He also served as treasurer of the Los Angeles chapter of the California Society of Certified Public Accountants. He is now a Vice President on the California Board of Accountancy, a division of the California Department of Consumer Affairs.
Family Relationships
There are no family relationships between any of our directors or executive officers.
Code Of Ethics And Conduct
On October 15, 2004, the Board of Directors adopted a Code of Ethics and Conduct.
Audit Committee
The Company has an audit committee consisting of three independent directors David Swartz, Gary Adelson and Eric Manlunus. Our Board of Directors has determined that Mr. Swartz is an “audit committee financial expert” as that term is defined in Item 401(e) of Regulation S-B under the Exchange Act of 1934.
ITEM 11:
ITEM 11: EXECUTIVE COMPENSATION
Compensation Discussion and Analysis
Overview of Executive Compensation Program
The following discussion and analysis describes the Company’s compensation objectives and policies as applied to the named executive officers appearing in the Summary Compensation Table. This section is intended to provide a framework within which to understand the actual compensation awarded to, earned or held by each Executive Officer during 2006.
Compensation Objectives
The Compensation Committee of our Board of Directors has overall responsibility for the approval, evaluation and oversight of all of our compensation plans, policies and programs. The Compensation Committee believes that an effective executive compensation program should provide base annual compensation that is reasonable in relation to individual executive’s job responsibilities and reward the achievement of both annual and long-term strategic goals of our company. The Committee uses annual cash bonuses to reward an officer’s achievement of specific goals and stock options as a retention tool and as a means to align the executive’s long-term interests with those of our stockholders, with the ultimate objective of improving stockholder value. The Committee evaluates both performance and compensation to maintain our company’s ability to attract and retain excellent employees in key positions and to assure that compensation provided to key employees remains competitive relative to the compensation paid to similarly situated executives of comparable companies. To that end, the Committee believes executive compensation packages provided by us to our named executive officers should include both cash and share-based compensation.
Because of the size of our company, the small number of executive officers in our company, and our company’s financial priorities, the Committee has decided not to implement or offer any retirement plans, pension benefits or other similar plans for our executive officers. Accordingly, the components of the executive compensation consist of salary, year-end cash bonuses awarded based on the Company’s attainment of growth and profitability objectives and the Compensation Committee’s subjective assessment of each senior executive’s job performance during the past year, stock option grants to provide executives with longer-term incentives, and occasional special compensation awards (either cash or stock options) to reward extraordinary efforts or results.
The Compensation Committee also takes the company’s financial and working capital condition into account in its compensation decisions.
Role of our Chief Executive Officer in Compensation Decisions
The Compensation Committee on occasion meets with our Chief Executive Officer to obtain recommendations with respect to our compensation programs, practices and packages for executives, other employees and directors. Our Chief Executive Officer makes recommendations to the Compensation Committee on the executive compensation, but the Compensation Committee is not bound to and does not always accept the Chief Executive Officer’s recommendations.
The Compensation Committee makes all compensation decisions for the named executive officers and approves recommendations regarding equity awards to all of our employees. Decisions regarding the non-equity compensation of other executives are made by the Chief Executive Officer.
The Compensation Committee and the Chief Executive Officer annually review the performance of each named executive officer (other than the Chief Executive Officer, whose performance is reviewed only by the Committee). The conclusions reached and recommendations based on these reviews, including with respect to salary adjustments and annual award amounts, are presented to the Committee. The Committee can exercise its discretion in modifying any recommended adjustments or awards to executives.
Setting Executive Compensation
Based on the foregoing objectives, the Committee has structured the Company’s annual cash and incentive-based cash and non-cash executive compensation to motivate executives to achieve the business goals set by the Company, to reward the executives for achieving such goals, and to retain the executives. The Committee has not employed outside compensation consultants to assist it in executive compensation matters.
There is no pre-established policy or target for the allocation between either cash and non-cash incentive compensation.
Executive Compensation Components
For 2006, the principal components of compensation for the named executive officers were: base salary; performance-based cash compensation; and long-term equity incentive compensation.
Base Salary
The Company provides named executive officers and other employees with base salary to compensate them for services rendered during the fiscal year. Base salary ranges for the named executive officers are determined for each executive based on his or her position and responsibility. During its review of base salaries for executives, the Committee primarily considers: the negotiated terms of each executive employment agreement; internal review of the executive’s compensation, both individually and relative to other executive officers; and individual performance of the executive. Salary levels are typically considered annually as part of the company’s performance review process, as well as upon a change in job responsibility. Merit-based increases to salaries are based on the Compensation Committee’s assessment of the individual’s performance and the financial condition of the Company. The contracts for both Ms. Fine and Mr. Rankin provide that on each and every anniversary of the employment agreement effective date, the executive’s annual base salary shall be increased by the increase in the consumer price index for the Los Angeles metropolitan statistical area over what it was during the preceding one-year period.
Performance-Based Cash Compensation
The Compensation Committee has not established an incentive cash compensation program with fixed performance targets except under our employment contract with Ms. Fine. Per Ms. Fine’s contract, she may receive an annual bonus, as determined and awarded by the Board of Directors from time to time in its sole discretion, but not less than an amount equal to 5% of earning before interest and taxes if such amount for any year is in excess of $1,000,000; 4% if such amount for any year is in excess of $2,000,000; and 3% if such amount is over $3,000,000.
Due to the losses incurred and financial condition of the Company, no performance compensation was awarded to the named Executives except for the Mr. Bennett who earned a special cash bonus of $60,000 in recognition of his role in increasing our penetration into the mass channel.
Long-Term Equity Incentive Compensation
As indicated above, the Committee also aims to encourage the company’s executive officers to focus on long-term company performance by allocating to them stock options that vest over a period of several years. In 2006, the Committee did not grant any stock options to the named executives.
Retirement Plans, Perquisites And Other Personal Benefits
We currently have no retirement plan for the named executive officers or other employees. Retirement benefits to employees are currently provided through our 401(k) plan. In addition, we do not provide any of our executive officers with any perquisites or other personal benefits. We do not have in effect any change of control provisions for payment to any executive officer in the event of a change in control of Small World Kids except that our 2004 Stock Compensation Plan provides that all unvested options held by our employees, including the named executive officers, immediately vest upon a change of control.
Ownership Guidelines
The Committee has no requirement that each named executive officer maintain a minimum ownership interest in our company. Our long-term incentive compensation consists of the grant of stock options to our named executive officers. The stock option program assists the company to: establish the link between the creation of stockholder value and long-term executive incentive compensation; provide an opportunity for increased equity ownership by executives; function as a retention tool because of the vesting features included in all options granted by the Committee; and maintain competitive levels of total compensation.
We normally grant stock options to new executive officers when they join our company based upon their position with us and their relevant prior experience. The options granted by the Compensation Committee generally vest quarterly over the first three years of the ten-year option term. Vesting rights generally cease upon termination of employment and exercise rights cease three months after termination of employment. Prior to the exercise of an option, the holder has no rights as a stockholder with respect to the shares subject to such option, including voting rights and the right to receive dividends or dividend equivalents. In addition to the initial option grants, our compensation committee may grant additional options to retain our executives and reward, or provide incentive for, the achievement of corporate goals and strong individual performance. We expect that we will continue to provide new employees with initial option grants in the future to provide long-term compensation incentives and will continue to rely on performance-based and retention grants to provide additional incentives for current employees. Additionally, in the future, the Compensation Committee may consider awarding additional or alternative forms of equity incentives, such as grants of restricted stock, restricted stock units and other performance-based awards.
It is our policy to award stock options at an exercise price equal to the closing price of our common stock on the date of the grant. The Compensation Committee has never granted options with an exercise price that is less than the closing price of our common stock on the grant date, nor has it granted options which are priced on a date other than the grant date. For purposes of determining the exercise price of stock options, the grant date is deemed to be the date on which the Compensation Committee approves the stock option grant.
Tax and Accounting Implications
Deductibility of Executive Compensation
As part of its role, the Compensation Committee reviews and considers the deductibility of executive compensation under Section 162(m) of the Internal Revenue Code, which provides that corporations may not deduct compensation of more than $1,000,000 that is paid to certain individuals. We believe that compensation paid to our executive officers generally is fully deductible for federal income tax purposes.
Accounting for Share-Based Compensation
Beginning on January 1, 2006, the company began accounting for share-based compensation in accordance with the requirements of FASB Statement 123(R). This accounting treatment has not significantly affected our compensation decisions.
Compensation Committee
No member of our Compensation Committee participates in any of our employee compensation programs, and our Board has determined that none of our Compensation Committee members has any material business relationship with us. The members of the Compensation Committee are: Lane Nemeth; Alex Gerstenzang and Shelly Singhal and are considered independent.
Summary Compensation Table
The following table presents summary information concerning all compensation paid or accrued by us for services rendered in all capacities during 2006 by Debra Fine and Robert Rankin, who are the only individuals who served as our principal executive and financial officers, respectively during the year ended December 31, 2006, and our two other most highly compensated executive officers who were serving as executive officers as of December 31, 2006. Also listed is our former Chief Operating Officer, Mr. Nelson who resigned on March 27, 2006 but continued to receive his monthly salary until the end of his employment contract on September 22, 2006. No other executive officer earned over $100,000 in 2006.
(1) Ms. Fine was paid $250,000 in 2006 with the balance accrued that relates to the contractual CPI increase for 2005 and 2006 provided for in her contract. Per Ms.Fine’s employment contract she is entitled to car allowance however, this has not been paid since she her employment date, but was accrued in 2006 and included in Other Compensation.
(2) Mr. Matise was the Chief Operating Officer was from March 27, 2006 to December 31, 2006. Prior to joining the Company on March 27, 2006, Mr. Matise served as a Director and Consultant and whose 2006 Consulting and Director fees are included in Other Compensation.
(3) Mr. Nelson was the Chief Operating Officer prior to resigning on March 27, 2006.
(4) Mr. Rankin was paid $190,000 in 2006 with the balance accrued that relates to the contractual CPI increase for 2006 provided for in his contract. On March 27, 2007, Mr. Rankin announced his resignation effective April 10, 2007.
Option Grants of Plan-Based Awards
No options were granted during the fiscal year ended December 31, 2006 to any of the Named Executive Officers.
Stock Compensation Plan
The purpose of our 2004 Stock Compensation Plan (the “Plan”) is to promote our success and enhance our value by linking the personal interests of our employees, officers, consultants, advisors and directors to those of our stockholders, and by providing our employees, officers, consultants and directors with an incentive for outstanding performance. We adopted the Plan on September 22, 2004 under which 780,000 shares of common stock are available for issuance with respect to awards granted to our officers, directors, management and other employees. On January 25, 2005, the Board approved an amendment to the Plan to increase the number of shares of common stock reserved for issuance by an additional 600,000 shares of common stock bringing the total number of shares of common stock reserved for issuance under the Plan to 1,380,000. As of December 31, 2006, options to purchase 722,000 shares of common stock have been issued and are outstanding under the Plan.
The Plan authorizes the granting of awards to our employees, officers, consultants and directors and to employees, officers, consultants and directors of our subsidiaries. The following awards are available under the Plan:
·
Incentive stock options to purchase shares of common stock;
·
stock appreciation rights;
·
restricted stock; and
·
performance shares.
The aggregate Fair Market Value (determined at the time an ISO is granted) of the Common Stock covered by ISOs exercisable for the first time by an employee during any calendar year (under all plans of the Company) may not exceed $100,000.
Administration
The Plan is administered by the Compensation Committee of our Board of Directors. The Compensation Committee has the power, authority and discretion to make awards, to set administrative rules, guidelines and practices relating to the Plan as it shall deem advisable from time to time, and to interpret the provisions of the Plan. In determining the persons to whom awards shall be made, the number of shares to be covered by each award and the terms thereof (including the restriction, if any, which shall apply to the Common Stock subject to an award), the Committee shall take into account the duties of the respective persons, their present and potential contributions to the success of the Company and such other factors as the Committee, in its discretion, shall deem relevant in connection with accomplishing the purposes of the Plan.
Awards
Stock Options. The Compensation Committee is authorized to grant both incentive stock options. The terms of any incentive stock option must meet the requirements of Section 422 of the Internal Revenue Code. The exercise price of an option is equal to the closing price of our common stock on the date of the grant, and no option may have a term of more than 10 years from the grant date.
Stock Appreciation Rights. The Compensation Committee may grant stock appreciation rights to participants. Upon the exercise of a stock appreciation right, the participant has the right to receive the excess, if any, of (1) the fair market value of one share of common stock on the date of exercise, over (2) the grant price of the stock appreciation right as determined by the Compensation Committee, which will not be less than the fair market value of one share of common stock on the date of grant.
Restricted Stock. The Compensation Committee may grant Restricted Stock Awards entitling recipients to acquire shares of Stock, subject to the right of the Company to repurchase all or part of such shares at their purchase price (or to require forfeiture of such shares if purchased at no cost) from the recipient in the event that conditions specified by the Board in the applicable award are not satisfied prior to the end of the applicable Restricted Period or Restricted Periods established by the Board for such award. Conditions for repurchase (or forfeiture) may be based on continuing employment or service or achievement of pre-established performance or other goals and objectives. Shares of Restricted Stock may not be sold, assigned, transferred, pledged or otherwise encumbered, except as permitted by the Board during the applicable Restricted Period.
Performance Shares. The Compensation Committee may grant performance shares entitling recipients to acquire shares of Stock upon the attainment of specified performance goals or on such terms and conditions as may be selected by the Compensation Committee. The Compensation Committee may make Performance Share Awards independent of or in connection with the granting of any other Award under the Plan. The Committee in its sole discretion shall determine the performance goals applicable under each such Award, the periods during which performance is to be measured, and all other limitations and conditions applicable to the awarded Performance Shares.
Limitations on Transfer; Beneficiaries. Awards under the Plan may not be sold, pledged, assigned or transferred in any manner other than by will or by the laws of intestate succession, and may be exercised during the lifetime of Optionee only by Optionee.
Acceleration Upon Change in Control. In the event that the Company or the division, subsidiary or other affiliated entity for which a Participant performs services is sold, merged, consolidated, reorganized or liquidated, all unvested options immediately vest.
Other Adjustments. In the event that the Company or the division, subsidiary or other affiliated entity for which a Participant performs services is sold, merged, consolidated, reorganized or liquidated, the Board may take any one or more of the following actions as to outstanding Awards: (i) provide that such Awards shall be assumed, or substantially equivalent Awards shall be substituted, by the acquiring or succeeding corporation (or an affiliate thereof) on such terms as the Board determines to be appropriate, (ii) upon written notice to Participants, provide that all unexercised Options or SARs shall terminate immediately prior to the consummation of such transaction unless exercised by the Participant within a specified period following the date of such notice, (iii) in the event of a sale or similar transaction under the terms of which holders of the Common Stock of the Company receive a payment for each share surrendered in the transaction (the “Sales Price”), make or provide for a payment to each Option and/or SAR holder equal to the amount by which (A) the Sales Price times the number of shares of Common Stock subject to Participant’s outstanding, vested Options or SARs exceeds (B) the aggregate exercise price of all such outstanding, vested Options or SARs, in exchange for the termination of such Options or SARs, (iv) or make such other adjustments, if any, as the Board determines to be necessary or advisable to provide each Participant with a benefit substantially similar to that to which the Participant would have been entitled had such event not occurred.
Termination and Amendment. The Board may amend, modify or terminate any outstanding Award, including substituting therefor another Award of the same or a different type, changing the date of exercise or realization and converting an Incentive Stock Option to a Nonstatutory Stock Option, provided that the Participant’s consent to such action shall be required unless the Board determines that the action, taking into account any related action, would not materially and adversely affect the Participant.
Holdings of Previously Awarded Equity
Equity awards held as of December 31, 2006 by each of our named executive officers were issued under our 2004 Stock Incentive Plan. The following table sets forth outstanding equity awards held by our named executive officers as of December 31, 2006:
Outstanding Equity Awards at Fiscal Year-End
Option Awards
(1) Mr. Matise was the Chief Operating Officer was from March 27, 2006 to December 31, 2006. Prior to joining the Company on March 27, 2006, Mr. Matise served as a Director and Consultant.
(2) Mr. Nelson was the Chief Operating Officer prior to resigning on March 27, 2006.
(3) On March 27, 2007, Mr. Rankin announced his resignation as Chief Financial Officer effective April 10, 2007.
Option Exercises
None of our named executive officers exercised any stock options in 2006.
Employment Agreements
We entered into an employment agreement with Debra Fine, our Chairman, CEO and President on May 20, 2004 for a three-year term, which may continue upon the mutual agreement of the parties thereto except the employment relationship will be on an “at will” basis. The employment agreement provides compensation of a base salary of $250,000 per annum, an annual bonus, as determined and awarded by the Board from time to time in its sole discretion, but not less than an amount equal to 5% of EBIT, meaning earnings before interest and taxes, if such amount for any year is in excess of $1,000,000; 4% if such amount for any year is in excess of $2,000,000; and 3% if such amount is over $3,000,000, and 2,600,000 stock options at the exercise price of $.25 per share of which 650,000 vested immediately and the balance vesting on a quarterly basis in equal amounts of 162,500 shares each over the course of her agreement. The contract also provides that on each and every anniversary of the effective date of the employment agreement, the executive’s annual base salary shall be increased by the increase in the consumer price index for the Los Angeles metropolitan statistical area over what it was during the preceding one-year period. The employment agreement also provides that during each year of the Term, the Company shall, at its cost, furnish the executive with the full time use of a then-current year model Lexus automobile and automobile liability insurance coverage on such automobile. The employment agreement provides that in the event that Ms. Fine is terminated prior to the end of the initial three (3) year term, other than for cause, we will pay her salary for the remainder of the three (3) year term without any deduction or offset for any compensation earned or received from any other sources. In addition, we will pay any earned, but unpaid, bonus for the prior year, any unused vacation or other time-off benefits and any unpaid reimbursable business expenses incurred through the last day of her services. For an additional one (1) year after the termination, we shall continue benefits, at our expense. All unvested portion(s) of the options granted to her pursuant to her employment agreement shall vest and immediately become exercisable upon the effective date of such termination.
We entered into an employment agreement with John Matise, our Chief Operating Officer on March 27, 2006 for a two-year term, which may continue upon the mutual agreement of the parties thereto except the employment relationship will be on an “at will” basis. On October 19, 2006, Mr. Matise announced that he was reducing his involvement with the company to a part-time basis (approximately 25%) through the end of the year and then will leave the Company. His employment contract with the Company terminated on December 31, 2006.
We entered into an employment agreement with Robert Rankin, our Chief Financial Officer on May 24, 2004 for a two-year term, which may continue upon the mutual agreement of the parties thereto except the employment relationship will be on an “at will” basis. On April 6, 2006, the employment agreement was amended to extend the term to terminate on May 24, 2007. The employment agreement provides compensation of a base salary of $190,000 per annum, an annual bonus, as determined and awarded by the Board from time to time in its sole discretion and 520,000 stock options at the exercise price of $.38 per share of which 130,000 vested immediately and the balance vesting on a quarterly basis in equal amounts of 48,750 shares each over the course of his agreement. The contract also provides that on each and every anniversary of the effective date of the employment agreement, the executive’s annual base salary shall be increased by the increase in the consumer price index for the Los Angeles metropolitan statistical area over what it was during the preceding one-year period. The employment agreement provides that in the event that Mr. Rankin is terminated prior to the end of the term, other than for cause, we will pay his salary for an additional six months without any deduction or offset for any compensation earned or received from any other sources. In addition, we will pay any earned, but unpaid, bonus for the prior year, any unused vacation or other time-off benefits and any unpaid reimbursable business expenses incurred through the last day of his services. For an additional six months, we shall continue benefits, at our expense. All unvested portion(s) of the options granted to him pursuant to his employment agreement shall expire and be null and void upon the effective date of his termination.
Director Compensation
The following table sets forth certain information concerning the compensation earned in 2006 by our non-employee directors who served in 2006
(1) Mr. Lautz was a Director from January 1, 2006 to October 27, 2006 when he resigned.
(2) Mr. Matise was a Director from January 1, 2006 to July 18, 2006 when he resigned.
(3) We adopted the fair value recognition provisions of SFAS No. 123(R) effective January 1, 2006. Under the SFAS No. 123(R), we recorded compensation expense in our financial statements as of and for the year ended December 31, 2006 with respect to the awards included in this table. See Note 3 of the accompanying financial statements.
Prior to October 2006, the Directors who are not employees received $1,500 for each meeting attended, $1,000 for each committee meeting attended and 40,000 stock options per year. Further, the chairman of the audit committee receives an additional $5,000 annually. On October 19, 2006, the Board changed the compensation for attending meetings to
$1,500 for each meeting attended in person or telephonically that lasts over one hour, $500 for each meeting attended telephonically that lasts less than one hour, $1,000 for each committee meeting attended in person or telephonically that lasts over one hour and $500 for each committee meeting attended telephonically that lasts less than one hour.
Compensation Committee Interlocks and Insider Participation
The compensation committee is composed entirely of directors who are not our current or former employees, each of who meets the applicable definition of “independent” in the current rules of the under the listing standards of SEC rules and regulations. The compensation committee is responsible for establishing and administering our executive compensation policies. Our compensation committee does not have any interlocks with other companies.
Compensation Committee Report
The compensation committee has reviewed and discussed with the Company’s management the Compensation Discussion & Analysis contained in this annual report on Form 10-K. Based on these discussions, and the committee’s review of the Compensation Discussion & Analysis contained in this annual report, the compensation committee recommended to the Board of Directors the inclusion of the Compensation Discussion & Analysis in the Company’s annual report on Form 10-K for the year ended December 31, 2006.
Compensation Committee
Alex Gerstenzang
Lane Nemeth
Shelly Singhal
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
The following table sets forth, as of April 9, 2007 certain information regarding beneficial ownership of our common stock by (i) each person or entity who is known by us to own beneficially more than 5% of the outstanding shares of common stock, (ii) each of our directors, (iii) each of the Named Executive Officers, and (iv) all directors and executive officers as a group. As of April 9, 2007, there were 5,410,575 shares of our common stock issued and outstanding. In computing the number and percentage of shares beneficially owned by a person, shares of common stock that a person has a right to acquire within sixty (60) days of April 9, 2007, pursuant to options, warrants or other rights are counted as outstanding, while these shares are not counted as outstanding for computing the percentage ownership of any other person. Unless otherwise indicated, the address for each shareholder listed in the following table is c/o Small World Kids, Inc., 5711 Buckingham Parkway, Culver City, California 90230. This table is based upon information supplied by directors, officers and principal shareholders and reports filed with the Securities and Exchange Commission.
* Less than 1%
(1) Based on 5,410,575 shares outstanding as of April 9,2007.
(2) Debra Fine is the Chief Executive Officer, and President of the Company. Her shares are held indirectly by the Fine Family Trust of which she is the Co-Trustee which is the owner of 1,721,543 shares of our common stock, 3,063 shares underlying warrants, 227,500 shares underlying stock options that may be exercisable within 60 days of April 9,2007 and 477,273 shares issuable upon conversion of the Series Class A-1 Preferred Stock. Does not include the shares issuable upon conversion of the Series Class A-1 Preferred Stock and underlying warrants owned by SWT, LLC of which The Fine Family Trust is a member.
(3) Robert Rankin is the Chief Financial Officer and Secretary. Consists of 52,000 shares underlying stock options that may be exercisable within 60 days of the date of April 9,2007.
(4) Gary Adelson is a director of the Company. Consists of 44,000 shares underlying stock options, which are exercisable within 60 days of April 9,2007.
(5) Alex Gerstenzang is a director of the Company. Consists of 44,000 shares underlying stock options, which are exercisable within 60 days of April 9,2007.
(6) Eric Manlunus is a director of the Company and Managing Director of Frontera Group, LLC, which is the beneficial owner of 64,077 shares of our common stock, 875 shares underlying warrants and 500,000 shares issuable upon conversion of the Series Class A-1 Preferred Stock. Does not include the shares issuable upon conversion of the Series Class A-1 Preferred Stock and underlying warrants owned by SWT, LLC of which Frontera Group is a member. Includes 40,000 shares underlying stock options, which are exercisable within 60 days of April 9,2007.
(7) Lane Nemeth is a director of the Company. Consists of 44,000 shares underlying stock options, which are exercisable within 60 days of April 9,2007.
(8) Shelly Singhal is a director of the Company. Of the shares beneficially owned by Mr. Singhal, 1,297,673 common shares are owned by SWT Investments, LLC, a Delaware limited liability company, of which Mr. Singhal owns 100%; 193,678 shares are owned by SBI Holdings of which he is a managing director and consists of 93,678 common shares and 237,500 shares underlying warrants; 249,809 common shares are owned by Curried Clover LLC in which he has beneficial ownership; and 44,000 shares underlying stock options which are exercisable within 60 days of April 9,2007.The address for Mr. Singhal is 610 Newport Center Drive, Suite 1205 Newport Beach, CA 92660. Does not include the shares issuable upon conversion of the Series A-1 Preferred Stock and underlying warrants owned by SWT, LLC of which SWT Investments, LLC is a member.
(9) David Swartz is a director of the Company. Consists of 44,000 shares underlying stock options, which are exercisable within 60 days of April 9,2007.
(10) Consists of 830,970 shares underlying warrants and 927,273 shares issuable upon conversion of the Series Class A-1 Preferred Stock. The address for Bushido Capital Partners, Ltd is 275 Seventh Ave., Suite 2000, New York, NY 10001.
(11) Consists of 454,545 shares issuable upon conversion of the Series Class A-1 Preferred Stock and 100,000 shares underlying warrants. The address for C.E. Unterberg, Towbin Capital Partners 1, L.P. is 350 Madison Ave., New York, NY 10017.
(12) Consists of 1,146,718 shares of our common stock held by David Marshall, Inc. which is beneficially owned by David Marshall, an investor. The address for David Marshall, Inc. is 9229 Sunset Boulevard, Suite 505 Los Angeles, CA 90009. Does not include the shares issuable upon conversion of the Series Class A-1 Preferred Stock and underlying warrants held by SWT, LLC of which David Marshall, Inc. is a member.
(13) Consists of 206,500 common shares and 3,500 shares issuable upon exercise of warrants and 181,818 shares issuable upon conversion of the Series Class A-1 Preferred Stock and is beneficially owned by David Marshall’s father, Sid Marshall. The address for Sid Marshall is 9229 Sunset Boulevard, Suite 505 Los Angeles, CA 90009.
(14) Frontera Group, LLC which Eric Manlunus is the Managing Director and is a director of the Company. Consists of 64,077 shares of our common stock, 875 shares underlying warrants and 500,000 shares issuable upon conversion of the Series Class A-1 Preferred Stock. Does not include the shares issuable upon conversion of the Series Class A-1 Preferred Stock and underlying warrants owned by SWT, LLC of which Frontera Group is a member. The address for Frontera Group, LLC is 15303 Ventura Boulevard, Suite 1510, Sherman Oaks, CA 91403.
(15) Consists of 415,485 shares underlying warrants and 350,000 shares issuable upon conversion of the Series Class A-1 Preferred Stock. The address for Gamma Opportunity Capital Partners LP Class A is 1967 Longwood Lake Mary Road, Longwood, Fla 32750.
(16) Consists of 415,485 shares underlying warrants and 350,000 shares issuable upon conversion of the Series Class A-1 Preferred Stock. The address for Gamma Opportunity Capital Partners LP Class C is 1967 Longwood Lake Mary Road, Longwood, Fla 32750.
(17) Consists of 290,909 shares issuable upon conversion of the Series Class A-1 Preferred Stock. The address for HIT Credit Union is 610 Newport Center Drive, Suite 1205, Newport Beach, CA 92660.
(18) Consists of 513,636 shares issuable upon conversion of the Series Class A-1 Preferred Stock and 275,000 shares issuable upon conversion of the $300,000 convertible note. The address for Hong Kong League Credit Union is 610 Newport Center Drive, Suite 1205, Newport Beach, CA 92660.
(19) Consists of 1,036,000 shares underlying warrant. The address for Laurus Master Fund, Ltd is 825 Third Ave., 14 th Floor, New York, NY 10022.
(20) Consists of 81,250 shares of our common stock, 118,750 shares underlying warrants and 562,500 shares issuable upon conversion of the $2,225,000 convertible note.. The address of St. Cloud is 10866 Wilshire Boulevard, Suite 1450, Los Angeles, CA 90024.
(21) Consists of 204,082 shares underlying warrants and 4,908,157 shares issuable upon conversion of the Series Class A-1 Preferred Stock. Members of SWT, LLC include Russell Fine and Debra Fine as trustees of the Fine Family Trust, SWT Investments, LLC, which is 100% owned by Shelly Singhal who is a director of the Company, and David Marshall; Inc.. Glenhaven Corporation manages SWT, LLC, and is owned by David Marshall. The address for SWT,LLC is 9229 Sunset Boulevard, Suite 505, Los Angeles, California 90069.
(22) SWT Investments, LLC, which is 100% owned by Shelly Singhal who is a director of the Company. Consists of 1,297,673 shares of our common stock. Does not include the shares issuable upon conversion of the Series Class A-1 Preferred Stock and underlying warrants owned by SWT, LLC of which SWT Investments, LLC is a member. The address for SWT Investments, LLC is 610 Newport Center,Suite 1205,Newport Beach, CA 92660.
(23) Consists of 454,545 shares issuable upon conversion of the Series Class A-1 Preferred Stock. The address for Trinad Capital Master Fund Ltd is 2121 Avenue of the Stars, Suite 1650, Los Angeles, CA 90067.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED PARTY TRANSACTIONS
This section describes the transactions since January 1, 2005 to which we or any of our subsidiaries were or are to be a party in which the amount exceeds $60,000 and in which any director, officer, or person known by us to be the beneficial owners of 5% or more of our common stock (or any family member of the foregoing).
On June 9, 2006, the Note due 2006 in the principal amount of $2,500,000 to St. Cloud Capital Partners LP, of which Robert Lautz, who was a director of the Company at the time of the restructure, is a Managing Director, was restructured as a condition of the sale of Class A-1 Convertible Preferred Stock on June 9, 2006 as follows: the Company prepaid $50,000 of the existing note and issued to St. Cloud two new notes to replace the exiting note: the first note in the principal amount of $200,000 will be for twelve months with monthly amortization payments at a 10% interest rate; the second note will be for $2,250,000 with interest at 10% per annum with interest only payable on June 30, 2006 and September 15, 2006, and, commencing September 16, 2006, payments will be interest only each month through September 15, 2008, and commencing October 15, 2008, monthly amortization payments (based on a five-year amortization) with all interest plus unpaid principal due on September 15, 2011. The second note will be convertible into shares of the common stock of the Company at $4.00 per share. The original loan of $2,000,000 to St. Cloud was made on September 15, 2004. On July 20, 2005, St. Cloud agreed to advance an additional $500,000 for an aggregate loan of $2.5 million. On November 11, 2005, we entered into a second amendment with St. Cloud pursuant to which we issued to St. Cloud a new promissory note replacing the existing note to St. Cloud in the principal amount of $2,500,000 and extended the maturity date of the loan to September 15, 2006. Pursuant to the terms of the note agreement with St. Cloud, during the period that notes are outstanding, Mr. Lautz will be appointed to the Company’s Board of Directors. On October 27, 2006, Mr. Lautz resigned as a Director from the Company’s Board. In addition, as long as St. Cloud owns in excess of 300,000 shares, a designee of St. Cloud reasonably acceptable to us is entitled to an observer seat on the Board of Directors.
On June 9, 2006, the 24% Notes issued to Hong Kong League Central Credit Union, PCCW Credit Union and HIT Credit Union (collectively the “Lenders”) and due 2006 in the principal amount of $1,000,000 were converted into 909,091 shares of Class A-1 Convertible Preferred Stock. The Notes were issued as follows: (i) On April 28, 2005 we had entered into Term Credit Agreements (“Credit Agreements”) with Hong Kong League Central Credit Union and PCCW Credit Union for unsecured loans totaling $750,000 due on or before August 31, 2005; and (ii) On June 10, 2005 we entered into additional Credit Agreements with Hong Kong League Central Credit Union and HIT Credit Union for unsecured loans totaling $250,000 due on or before September 30, 2005. Effective August 31, 2005, the maturity dates of all outstanding unsecured loans with the Lenders were extended to the earlier of the closing of a financing transaction with net proceeds of at least $20 million or March 1, 2006. In consideration for this extension, we issued a four-year warrant to purchase up to 100,000 shares of the common stock exercisable at $5.00 per share to SBI Advisors, LLC, of which Shelly Singhal, one of our directors, is Chairman and Chief Executive Officer. On February 28, 2006, the maturity dates of all outstanding unsecured loans with the Lenders were extended to the earlier of the closing of a financing transaction with net proceeds of at least $20 million or August 11, 2006.
On June 9, 2006, the 10% Notes due 2006 in the principal amount of $500,000 were converted into 454,546 shares of Class A-1 Convertible Preferred Stock. On August 11, 2005, we had issued an aggregate of $500,000 in notes to various accredited investors including Russell Fine and Debra Fine ( our President and Chief Executive Officer) , as trustees of the Fine Family Trust , who provided $175,000 of the total borrowing. The notes had a maturity of one year from the date of execution with interest payable monthly in arrears at a rate of 10% per annum and were secured by certain assets including receivables, inventory, equipment and other assets.
On June 9, 2006, the 2,500,000 shares of Class A Convertible Preferred Stock owned by SWT, LLC in the amount of $5,000,000 along with $398,973 in accrued dividends were converted into 4,908,157 shares of Class A-1 Convertible Preferred Stock a s a condition of the sale of Class A-1 Convertible Preferred Stock on June 9, 2006. On August 11, 2005, we had converted the $5 million Bridge Note dated May 21, 2004 issued to SWT, LLC, into 10% Class A Convertible Preferred Stock. The Class A Preferred stock was convertible at the option of the holder into the common stock at an initial fixed conversion price of $4.00 subject to adjustment based on the terms of future financings should they occur and accrued a quarterly dividend at a rate of 10% per annum and was payable in cash or a combination of 50% cash and 50% common stock at our option. In connection with the conversion of the $5 million Bridge Note, we issued on August 11, 2005, a three-year immediately exercisable warrant to purchase up to 204,082 shares of the common stock exercisable at $4.90 per share. Each of Russell Fine and Debra Fine (our President and Chief Executive Officer) as trustees of the Fine Family Trust, SWT Investments, LLC, which is wholly owned by Shelly Singhal, a director of the Company, and David Marshall; Inc. are members of SWT, LLC. Glenhaven Corporation manages SWT, LLC, and is owned by David Marshall who is the beneficially owner of more than 20% of our common stock.
On May 20, 2004, the Company entered into a $72,000 per annum three-year consulting agreement with David Marshall, Inc., a related party. On each anniversary date, the fee shall be increased by the increase in the consumer index for the Los Angeles metropolitan statistical area. During the term, David Marshall, Inc. will provide consulting services relating to business plan development, strategic planning, public relations, investor relations, acquisitions and financing activities.
Since February 2006, Russell Fine, the spouse of Debra Fine (our President and Chief Executive Officer), has been providing operational and system consulting services on a month to month basis for $11,000 per month.
Since September 2006, the Company has retained Kershaw Mackie & Company to provide management consulting services to the Company at a weekly consulting charge of $4,000 per week. After 45 days, the weekly charge decreased to $3,000 for 90 days and thereafter the weekly charge will be $2,000 until the consulting services are terminated. On October 19, 2006, the Company issued an aggregate of $27,500 in principal amount of 10% Convertible Debentures to Kershaw Mackie & Company. In consideration for the Convertible Debenture, the Company issued warrants to purchase an aggregate of 12,500 shares at an exercise price of $1.10 per share to Kershaw Mackie & Company.
Since July 2006, the Company has been using the services of Vintage Filings, LLC to provide EDGAR filing services for the filing for our SEC filing requirments. On October 19, 2006, the Company sold in a private placement 90,909 shares of its Class A-1 Convertible Preferred Stock for $100,000 to Vintage Filings, LLC.
All related party transactions have been and will continue to be approved by the majority of our directors who do not have an interest in the transactions being approved.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
Audit Fees: The aggregate fees billed for the year ended December 31, 2006 for professional services rendered by the Stonefield Josephson, Inc. (“Stonefield”) for the audit of our annual financial statements and the quarterly review of financial statements for the Quarters ended March 31, 2006, June 30, 2006 and September 30, 2006 was $246,000 as compared to $113,000 for the aggregate fees billed for the year ended December 31, 2005 for professional services rendered by the Stonefield for the audit of our annual financial statements and the quarterly review of financial statements for the Quarters ended March 31, 2005, June 30, 2005 and September 30, 2005
Tax Fees: The aggregate fees billed for the years ended December 31, 2006 and 2005 for professional services rendered by the Grant Thornton LLP for tax compliance and tax planning was approximately $41,000 and $33,000, respectively.
All Other Fees: The aggregate fees billed for the years ended December 31, 2006 and 2005 for products and services provided by Stonefield other than the services reported above was approximately $61,000 and $19,000, respectively. The Company also paid $16,000 to Grobstein Horwath and Company for a valuation of an embedded derivative.
Audit Committee Pre-Approval Policies and Procedures
Our Audit Committee’s policy is to pre-approve all audit and permissible non-audit services provided by our independent auditors. These services may include audit services, audit-related services, tax services and other services. Pre-approval is generally provided for up to one year and any pre-approval is detailed as to the particular service or category of services. The independent auditor and management are required to periodically report to the Audit Committee regarding the extent of services provided by the independent auditor in accordance with this pre-approval.
ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a) Exhibits
Exhibits are numbered in accordance with the Exhibit Table of Item 601 of Regulation S-K:
Exhibit No.
Exhibit Description
3.1
Articles of Incorporation incorporated by reference from the Form SB-2 filed with the SEC on August 28, 2001. File No. 333-68532.
3.2
Bylaws incorporated by reference from the Form SB-2 filed with the SEC on August 28, 2001. File No. 333-68532.
4.1
Pledge Agreement, dated as of May 20, 2004 incorporated by reference from the Form 8-K filed with the SEC on June 4, 2004. File No. 333-68532.
4.2
Stock Pledge Agreement, dated as of May 20, 2004 incorporated by reference from the Form 8-K filed with the SEC on June 4, 2004. File No. 333-68532.
4.3
Registration Rights Agreement, dated as of May 20, 2004 incorporated by reference from the Form 8-K filed with the SEC on June 4, 2004. File No. 333-68532.
4.4
Exchange Agreement, dated as of May 20, 2004 incorporated by reference from the Form 8-K filed with the SEC on June 4, 2004. File No. 333-68532.
4.5
Stock Purchase Agreement, dated as of May 20, 2004 incorporated by reference from the Form 8-K filed with the SEC on June 4, 2004. File No. 333-68532.
4.6
Stock Compensation Plan incorporated by reference from the Form S-8 filed with the SEC on February 4, 2005. File No. 333-68532.
4.7
Common Stock Purchase Warrant incorporated by reference from the Form 8-K filed with the SEC on October 4, 2005. File No. 333-68532.
4.8
Common Stock Purchase Warrant incorporated by reference from the Form 8-K filed with the SEC on October 11, 2005. File No. 333-68532.
4.9
Certificate of Designation of Class A-1 Convertible Preferred Stock dated as of June 9, 2006 incorporated by reference from the Form 8-K filed with the SEC on June 15, 2006. File No. 333-68532.
5.1
Legal Opinion of Troy & Gould and consent.
10.1
$700,000 Promissory Note incorporated by reference from the Form 8-K filed with the SEC on June 4, 2004. File No. 333-68532.
10.2
Employment Agreement (Fine) incorporated by reference from the Form 10KSB filed with the SEC on March 28, 2005. File No. 333-68532.
10.3
Employment Agreement (Rankin) incorporated by reference from the Form 10KSB filed with the SEC on March 28, 2005. File No. 333-68532.
10.4
Lock-up Agreement incorporated by reference from the Form 8-K filed with the SEC on November 18, 2005. File No. 333-68532.
10.5
Secured Non-Convertible Revolving Note dated February 28, 2006 (Laurus Master Fund, LTD) incorporated by reference from the Form 8-K filed with the SEC on March 3, 2006. File No. 333-68532.
10.6
Secured Non-Convertible Term Note dated February 28, 2006 (Laurus Master Fund, LTD) incorporated by reference from the Form 8-K filed with the SEC on March 3, 2006. File No. 333-68532.
10.7
Security Agreement dated February 28, 2006 (Laurus Master Fund, LTD) incorporated by reference from the Form 8-K filed with the SEC on March 3, 2006. File No. 333-68532.
10.8
Common Stock Purchase Warrant dated February 28, 2006 (Laurus Master Fund, LTD) incorporated by reference from the Form 8-K filed with the SEC on March 3, 2006. File No. 333-68532.
10.9
Financing Agreement, dated as of March 20, 2006 Horizon Financial Services Group USA) incorporated by reference from the Form 8-K filed with the SEC on March 23, 2006. File No. 333-68532.
10.10
Employment Agreement (Matise) dated March 27, 2006 incorporated by reference from the Form 8-K filed with the SEC on March 30, 2006. File No. 333-68532.
10.11
Securities Purchase Agreement dated as of June 9, 2006 by and between Small World Kids, Inc. and Purchasers of the Company’s Class A-1 Convertible Preferred Stock incorporated by reference from the Form 8-K filed with the SEC on June 14, 2006. File No. 333-68532.
10.12
Registration Rights Agreement dated as of June 9, 2006 by and between Small World Kids, Inc. and Purchasers of the Company’s Class A-1 Convertible Preferred Stock incorporated by reference from the Form 8-K filed with the SEC on June 14, 2006. File No. 333-68532.
10.13
Third Amendment to the Note Purchase Agreement dated June 9, 2006 by and between Small World Kids, Inc. and St. Cloud Capital Partners L.P. incorporated by reference from the Form 8-K filed with the SEC on June 14, 2006. File No. 333-68532.
10.14
Conversion Agreement dated as of May 26, 2006 between the Company and HIT Credit Union incorporated by reference from the Form 8-K filed with the SEC on June 14, 2006. File No. 333-68532.
10.15
Conversion Agreement dated as of May 26, 2006 between the Company and PCCW Credit Union incorporated by reference from the Form 8-K filed with the SEC on June 14, 2006. File No. 333-68532.
10.16
Conversion Agreement dated as of May 26, 2006 between the Company and Hong Kong League Central Credit Union incorporated by reference from the Form 8-K filed with the SEC on June 14, 2006. File No. 333-68532.
10.17
Conversion Agreement dated as of May 26, 2006 between the Company and certain lenders ($500,000) incorporated by reference from the Form 8-K filed with the SEC on June 14, 2006. File No. 333-68532.
10.18
Conversion Agreement dated as of May 26, 2006 between the Company and SWT, LLC incorporated by reference from the Form 8-K filed with the SEC on June 14, 2006. File No. 333-68532.
10.19
Conversion Agreement dated as of May 26, 2006 between the Company and certain lenders ($1,500,000) incorporated by reference from the Form 8-K filed with the SEC on June 14, 2006. File No. 333-68532.
10.20
Note Purchase Agreement dated as October 19, 2006 between the Company and certain lenders ($330,000) incorporated by reference from the Form 8-K filed with the SEC on October 23, 2006. File No. 333-68532.
10.21
Secured Convertible Note dated October 19, 2006 (Hong Kong League Central Credit Union) incorporated by reference from the Form 8-K filed with the SEC on October 23, 2006. File No. 333-68532.
10.22
Secured Convertible Note dated October 19, 2006 (Kershaw Mackie) incorporated by reference from the Form 8-K filed with the SEC on October 23, 2006. File No. 333-68532.
10.23
Common Stock Purchase Warrant dated October 19, 2006 (SBI Advisors) incorporated by reference from the Form 8-K filed with the SEC on October 23, 2006. File No. 333-68532.
10.24
Registration Rights Agreement dated as of October 19, 2006 by and between Small World Kids, Inc. and Purchasers of the Secured Convertible Note incorporated by reference from the Form 8-K filed with the SEC on October 23, 2006. File No. 333-68532.
10.25
Overadvance Side Letter dated October 19, 2006 (Laurus Master Fund, LTD) incorporated by reference from the Form 8-K filed with the SEC on October 23, 2006. File No. 333-68532.
10.26
Common Stock Purchase Warrant dated October 19, 2006 (Cambria LLC) incorporated by reference from the Form 8-K filed with the SEC on October 23, 2006. File No. 333-68532.
10.27
Common Stock Purchase Warrant dated October 19, 2006 (David Fuchs) incorporated by reference from the Form 8-K filed with the SEC on October 23, 2006. File No. 333-68532.
10.28
Amendment to Promissory Note to Former Shareholder dated November 6, 2006 by and between Small World Kids, Inc. and former shareholder of Small World Toys incorporated by reference from the Form 8-K filed with the SEC on November 9, 2006. File No. 333-68532.
10.29
Omnibus Amendment No. 1, dated as of January 26, 2007 by and between Small World Kids, Inc. and Small World Toys, Inc. and Laurus Master Fund, Ltd. incorporated by reference from the Form 8-K filed with the SEC on January 30, 2006. File No. 333-68532.
10.30
Second Amendment to Registration Rights Agreement, dated as of January 26, by and between Small World Kids, Inc. and Small World Toys, Inc. and Laurus Master Fund, Ltd. incorporated by reference from the Form 8-K filed with the SEC on January 30, 2006. File No. 333-68532.
10.32
Common Stock Purchase Warrant Agreement dated as of January 26, 2007 by and between Small World Kids, Inc. and Laurus Master Fund, Ltd. incorporated by reference from the Form 8-K filed with the SEC on January 30, 2006. File No. 333-68532.
16.1
Letter regarding change of certifying accountant incorporated by reference from the Form 8-K filed with the SEC on July 23, 2004. File No. 333-68532.
31.1
Certification of the Chief Executive pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2
Certification of the Chief Financial pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1
Certification of the Chief Executive under Section 906 of the Sarbanes-Oxley Act of
32.2
Certification of the Chief Financial Officer under Section 906 of the Sarbanes-Oxley Act of 2002
Each person whose signature appears below, constitutes and appoints Debra Fine with full power to act without the other, such person’s true and lawful attorney-in-fact, with full power of substitution and resubstitution, for him and in his name, place and stead, in any and all capacities, to sign this Annual Report on Form 10-K and any and all amendments to such report and other documents in connection therewith, and to file the same, and all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact, and each of them, full power and authority to do and perform each and every act and thing necessary or desirable to be done in and about the premises, as fully to all intents and purposes as he or she might or could do in person, thereby ratifying and confirming all that said attorneys-in-fact, or any of them, or their or his or her substitute or substitutes, may lawfully do or cause to be done by virtue hereof.
SIGNATURES
In accordance with the requirements of the Securities Act of 1933, the Company certifies that it has reasonable grounds to believe that it meets all of the requirements for filing this Annual Report on Form 10-K and has authorized this registration statement to be signed on its behalf by the undersigned, thereunto duly authorized, in Culver City, State of California on April 11, 2007.
Pursuant to the requirements of the Securities Act of 1933, this report has been signed by the following persons in the capacities and on the dates indicated.
Signature
Title
Date
/s/ Debra Fine
Chairman, Chief Executive Officer and
April 11, 2007
Debra Fine
Director (Principal Executive Officer)
/s/ Robert Rankin
Chief Financial Officer (Principal Financial
April 11, 2007
Robert Rankin
and Accounting Officer)
/s/ Gary Adelson
Director
April 11, 2007
Gary Adelson
/s/ Alex Gerstenzang
Director
April 11, 2007
Alex Gerstenzang
/s/ Eric Manlunus
Director
April 11, 2007
Eric Manlunus
/s/ Lane Nemeth
Director
April 11, 2007
Lane Nemeth
/s/ Shelly Singhal
Director
April 11, 2007
Shelly Singhal
/s/ David Swartz
Director
April 11, 2007
David Swartz
SMALL WORLD KIDS, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
SMALL WORLD KIDS, INC.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To: The Board of Directors and Stockholders of Small World Kids, Inc.
Culver City, California
We have audited the accompanying consolidated balance sheets of Small World Kids, Inc. and subsidiaries as of December 31, 2006 and 2005, and the related consolidated statements of income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2006. 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. We were not engaged to perform an audit of the Company’s internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Small World Kids, Inc. and subsidiaries as of December 31, 2006 and 2005, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2006 in conformity with accounting principles generally accepted in the United States of America.
The accompanying financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America, which contemplate continuation of the company as a going concern. As discussed in Note 2, the Company has incurred significant net losses since its inception and has an accumulated deficit of $22,957,661, and used cash from operating activities of $6,011,955 during the year ended December 31, 2006. The company has $804,000 in principal debt obligations due in 2007, of which $152,000 in principal payments are not permitted to be paid while any amounts are outstanding of the Company’s $1,500,000 over advance. Failure to obtain additional financing or restructure the Company’s debt obligations may cause a default on these obligations, cross default obligations may cause acceleration of payments on the Company’s debt obligations. The foregoing matters raise substantial doubt about the ability of the Company to continue as a going concern. Management's plans in regard to these matters are described in Note 2 of the accompanying financial statements. These financial statements do not include any adjustments that might result from the outcome of these uncertainties.
As discussed in Note 3 to the consolidated financial statements, in 2006 the Company adopted Statement of Financial Accounting Standards No. 123 (Revised 2004), Share-Based Payments
/s/ Stonefield Josephson, Inc.
Los Angeles, California
April 10,
SMALL WORLD KIDS, INC.
CONSOLIDATED BALANCE SHEETS
See Accompanying Notes to Consolidated Financial Statements.
SMALL WORLD KIDS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
See Accompanying Notes to Consolidated Financial Statements.
SMALL WORLD KIDS, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY
See Accompanying Notes to Consolidated Financial Statements.
SMALL WORLD KIDS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
See Accompanying Notes to Consolidated Financial Statements.
SMALL WORLD KIDS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 BASIS OF CONSOLIDATION
As a result of the May 20, 2004 transactions described in the following paragraph, the Company had a change in management, controlling shareholders, financial position and business plan.
On May 20, 2004, Small World Kids, Inc., formerly SavOn Team Sports, Inc. (“Small World”, “SWK” or the “Company”) executed an Exchange Agreement (the “Agreement”) whereby SWK issued common stock in exchange for all of the equity interests of Fine Ventures, LLC (“FVL”). Prior to the Agreement, SWK was considered a shell company as it had minimal net assets and operations. As the shareholders of FVL control the Company subsequent to the transaction, the Agreement was accounted for as a purchase by FVL of SWK and the financial statements presented for the Company are a continuation of FVL. Simultaneously SWK acquired all of the issued shares of Small World Toys, Inc. (“SWT”) in a transaction accounted for as a purchase resulting in a change in management, controlling shareholders, financial position and business plan of SWT. As such, SWT is considered to be the predecessor business and SWK the successor for accounting purposes. As SWK is considered a holding company because it currently has no significant business operations or assets other than SWT, the predecessor company’s results of operations are also presented for comparative purposes.
On October 14, 2005 the Company completed a ten for one (10:1) reverse stock split (“Reverse Split”). As of the date of the Reverse Split, there were 54,105,750 shares of the Company’s Common Stock outstanding. Immediately after the split there were 5,410,575 Common shares outstanding. Accordingly, all references to units of securities (e.g. shares of Common Stock) or per share amounts are reflective of the Reverse Split for all periods reported.
NOTE 2 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
These financial statements have been prepared in accordance with U.S. GAAP, assuming that the Company will continue as a going concern. As such, the financial statements do not include any adjustments to reflect possible future effects of the recoverability and classification of assets or the amounts and classification of liabilities that may result from liquidity uncertainties or any future decisions made with respect to the Company’s strategic alternatives.
As of December 31, 2006, we had $804,000 in principal payments due during the next twelve months to Laurus, Horizon, St. Cloud and the former shareholder of Small World Toys. Of the $804,000 in principal payments due in 2007, the Company is not permitted by Laurus to pay the $152,000 in principal payments due to St. Cloud in 2007 while any amounts are outstanding on the $1,500,000 overadvance. We may not be able to generate sufficient cash flow from operations to meet our debt and operational obligations. If we are unable to generate sufficient cash flow, we would be required to seek additional financing or restructure our debt obligations. There can be no assurance that we will be able to obtain additional financing or restructuring our debt obligations or that, if we were to be successful in obtaining additional financing or restructure our debt obligations, it would be on favorable terms. Failure to obtain additional financing or restructuring our debt obligations may cause us to default on these debt obligations. In addition, under cross default provisions in the Laurus Security Agreement, defaults under our debt obligations may cause the acceleration of the repayment of the Revolving and Term Notes. This raises substantial doubt about the Company’s ability to continue as a going concern for a reasonable period of time. Management has and will continue to pursue the following actions: (i) reducing operating expenses; (ii) seeking to obtain new equity; and (iii) restructuring the debt obligations.
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and the accompanying notes during the reporting period. Estimates in these financial statements may include but are not limited to inventory valuations, sales returns reserves, allowance for doubtful accounts receivable, income taxes and other contingent liabilities. Actual results could differ from those estimates.
Segments of an Enterprise and Related Information
The Company follows SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information.” SFAS No. 131 requires that a public business enterprise report financial and descriptive information about its reportable operating segments on the basis that is used internally for evaluating segment performance and deciding how to allocate resources to segments. We sell developmental toys including over 800 toy products for the baby to approximately 7 years old including blocks, balls, sorters, regular and bilingual puzzles, doll houses and castles with accessories, wooden appliances with bakery, utensil and realistic food replication, dolls and outdoor sports equipment and activities. We have one segment which meets the quantitative thresholds for reportable segments. Our international sales accounted for approximately $1,037,000 or 3.7% and $1,097,000 or 3.2 % of our net sales in 2006 and 2005, respectively
Revenue Recognition
We recognize revenue when all four revenue recognition criteria have been met: persuasive evidence of an arrangement exists, the product has been delivered or the service has been rendered, the price is fixed or determinable and collection is probable. We recognize revenue from product sales upon when all of the foregoing conditions are met which in general is at the time of shipment where the risk of loss and title has passed to the customer. However, for certain shipments such as direct shipments from our vendors to our customers or where we use consolidators to deliver our products (usually export shipments) revenue is recognized in accordance with the sales terms specified by the respective sales agreements.
Sales allowances for customer promotions, discounts and returns are recorded as a reduction of revenue when the related revenue is recognized. We routinely commit to promotional sales allowance programs with our customers. These allowances primarily relate to fixed programs, which the customer earns based on purchases of our products during the year. Discounts are recorded as a reduction of related revenue at the time of sale. Sales to customers are generally not subject to any price protection or return rights.
We offer extended terms to some of our customers in the first three quarters of the year by way of sales promotions whereby payment will not become due until the fourth quarter if a specified purchase threshold has been met. This promotion allows us to capture additional shelf space and to capture more of the annual budgets of our retail customers. The result of this promotion gives rise to a significant increase in accounts receivable through the fourth quarter until substantially all accounts become due and are collected. Based upon historically low rates of return and collection of substantially all of these extended term accounts, we have determined that revenue is appropriately recognized in accordance with its normal procedures described above.
Advertising Costs
All advertising costs are expensed as incurred and charged to operations within Selling, General and Administrative expenses. Such costs were $176,000, $137,000 and $129,000 for the years ended December 31 2006, December 31, 2005 and December 31 2004, respectively.
Shipping and Handling
All shipping and handling costs related to sales to customers are expensed as incurred and charged to Selling, General and Administrative expenses. These expenses were $2.6 million and $3.1 million for the years ended December 31 2006 and December 31 2005, respectively. We typically charge customers for freight out, except those vendors who qualify under the dating promotional programs, for orders over $1,000 or under fixed terms.
Barter Transaction
In fiscal year 2004, the Company exchanged $351,000 of excess inventory for advertising, travel and other barter credits valued by the barter provider at the cost of inventory. The Company recorded the barter credits as a prepaid expense at the $351,000 market value of the inventory exchanged. Additionally, in accordance with Emerging Issues Task Force No. 99-17, “Accounting for Advertising Barter Transactions,” the Company accounted for this transaction as a sale, recording revenue and cost of sales of $351,000 leaving no net impact to income. The Company did not use any credits in 2005 and only $3,000 of barter credits for travel in 2004. Since there were no assurances that the company would utilize these credits before they expired at the end of 2006, the Company determined that the realizability of the credits could not be assured and therefore wrote off the credits in 2005.
Foreign Currency and International Operations
The Company has no significant foreign assets. Almost all of our purchases are in US dollar denominations. Our nominal foreign currency transaction exposures include gains and losses realized on unhedged inventory purchases that are denominated in a currency other than the applicable functional currency.
Cash and Cash Equivalents, Short and Long-Term Investments
For purposes of cash flows, the Company considers all highly liquid investments purchased with a maturity of three months or less to be cash equivalents, those with original maturities not greater than three months and current maturities less than twelve months from the balance sheet date are considered short-term investments, and those with maturities greater than twelve months from the balance sheet date are considered long-term investments. The Company maintains bank accounts with balances which, at times, may exceed federally insured limits. The Company has not experienced any losses on such accounts. The Company believes it is not exposed to any significant risk on bank deposit accounts. As of December 31, 2006, the Company had cash balances of $155,000, of which individual bank accounts over $100,000 were not insured by the FDIC.
Accounts Receivable
The Company’s receivables are recorded when billed and represent claims against third parties that will be settled in cash. The carrying value of the Company’s receivables, net of the allowance for doubtful accounts, represents their estimated net realizable value. The Company evaluates the collectibility of accounts receivable on a customer-by-customer basis. The Company records a reserve for bad debts against amounts due to reduce the net recognized receivable to an amount the Company believes will be reasonably collected. The reserve is a discretionary amount determined from the analysis of the aging of the accounts receivables, historical experience and knowledge of specific customers.
Inventory
Inventory is valued at the lower of average cost or market. Inventory costs consist of the purchases of finished goods from our vendors and the associated costs necessary to obtain those inventories. As necessary, we write down inventory to its estimated market value based on assumptions about future demand and market conditions. Failure to accurately predict and respond to consumer demand could result in the under production of popular items or overproduction of less popular items which may require additional inventory write-downs which could materially affect our future results of operations.
Property and Equipment
Property and equipment are recorded at cost and are depreciated over the estimated useful lives of the assets using the straight-line method. Estimated useful lives for financial reporting purposes are as follows: furniture and fixtures, five to seven years; computer hardware and software, three years; leasehold improvements, over the shorter of five years or the lease term. The cost and related accumulated depreciation of all property and equipment retired or otherwise disposed of are removed from the accounts. Any gain or loss is recognized in the current period. Various accelerated methods are used for tax purposes.
Maintenance and repair costs are charged to expense as incurred, and renewals and improvements that extend the useful lives of the assets are capitalized and added to the property and equipment.
Property and equipment consist of the following:
Depreciation expense for the years ended December 31, 2006 and 2005 was approximately $177,000 and $228,000 respectively.
Intangible Assets
We evaluate long-lived assets whenever events or changes in business circumstances or our planned use of assets indicate that their carrying amounts may not be fully recoverable or that their useful lives are no longer appropriate. Reviews are performed to determine whether the carrying values of assets are impaired based on comparison to either the fair value in the case of goodwill or to the undiscounted expected future cash flows for all other long-lived assetsand amortizable intangible assets. If the comparison indicates that impairment exists, the impaired asset is written down to its fair value. Significant management judgment is required in the forecast of future operating results that are used in the preparation of expected discounted and undiscounted cash flows.
In accordance with SFAS 142, goodwill shall be at a minimum, tested for impairment annually. The first of the impairment tests consists of a comparison of the total fair value of the Company based upon the closing stock price and the Company’s net assets on the date of the test. If the fair value is in excess of the net assets, there is no indication of impairment and no need to perform the second tier impairment test. The Company performed this test as of the end of the Second Quarter, the second year mark of the purchase of Small World Toys which resulted in the recording of the goodwill carried on the Company’s books. As the market value of the Company significantly exceeded the net assets of the Company, there is no indication of impairment and no adjustment was required to be made.
All other intangible assets are to be tested for impairment when a triggering event has occurred. In accordance with SFAS 142, the Company reviewed for impairment the fair value of the intangible assets acquired from Imagiix in June 2005. In 2006, the Company shipped approximately $331,000 in Imagiix products and approximately met the projections used for the valuation of the assets acquired. As such, there is no indication of impairment and no adjustment was required to be made.
The Company also performed an impairment test as of September 2006 for the fair value of the assets acquired from Neurosmith LLC in September 2004. The Company sold $1.1 million and $1.2 million in Neurosmith products in 2006 and 2005, respectively. These sales approximately meet the projections used for the valuation of the assets acquired. As such, there is no indication of impairment and no adjustment was required to be made.
Components of the Company’s identifiable amortizable intangible assets are as follows (in thousands):
Amortization expense of intangible assets for the years ended December 31, 2006 and 2005 was approximately $472,000 and $452,000 respectively. Estimated amortization expense for the next five succeeding fiscal years and all years thereafter are as follows:
At December 31, 2006, the weighted average amoritization period remaining for the intangible assets was 6.6 years.
Prepaid expenses and other current assets
Prepaid expenses and other current assets include prepaid material, insurance, marketing and other prepaid expenses and miscellaneous items as follows:
Major Vendors
During the year ended December 31, 2006, our top ten suppliers accounted for 74.1 % of the total product purchases. The top two suppliers accounted for 20.9% and 10% of total purchases, respectively. Our tools and dies are located at the facilities of our third-party manufacturers.
During the year ended December 31, 2005, our top ten suppliers accounted for 64.7% of the total product purchases. The top two suppliers accounted for 11% and 9% of total purchases, respectively.
Recent Accounting Pronouncements
In February 2007, the Financial Accounting Standards Board (“FASB”) issued Statement No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS No. 159”), provides companies with an option to report selected financial assets and liabilities at fair value. This Statement is effective as of the beginning of an entity’s first fiscal year beginning after November 15, 2007. Early adoption is permitted as of the beginning of the previous fiscal year provided that the entity makes that choice in the first 120 days of that fiscal year and also elects to apply the provisions of Statement 157. We are currently evaluating the potential impact of the adoption of SFAS 159 on our future consolidated financial statements.
In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans-an amendment of FASB Statements No. 87, 88, 106 and 132(R)” (“SFAS 158”). SFAS 158 requires an employer that sponsors one or more single-employer defined benefit plans to (a) recognize the overfunded or underfunded status of a benefit plan in its statement of financial position, (b) recognize as a component of other comprehensive income, net of tax, the gains or losses and prior service costs or credits that arise during the period but are not recognized as components of net periodic benefit cost pursuant to SFAS No. 87, “Employers’ Accounting for Pensions,” or SFAS No. 106, “Employers’ Accounting for Postretirement Benefits Other Than Pensions,” (c) measure defined benefit plan assets and obligations as of the date of the employer’s fiscal year-end, and (d) disclose in the notes to financial statements additional information about certain effects on net periodic benefit cost for the next fiscal year that arise from delayed recognition of the gains or losses, prior service costs or credits, and transition asset or obligation. An employer with publicly traded equity securities is required to initially recognize the funded status of a defined benefit postretirement plan and to provide the required disclosures as of the end of the fiscal year ending after December 15, 2006. The requirement to measure plan assets and benefit obligations as of the date of the employers fiscal year-end statement of financial position is effective for fiscal years ending after December 15, 2008. The Company is assessing the impact the adoption will have, but since we do not have a Defined Benefit Plan, we do not believe it will have a material impact on the Company’s financial position, results of operations or cash flows.
In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 clarifies the principle that fair value should be based on the assumptions market participants would use when pricing an asset or liability and establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. SFAS 157 is effective for our fiscal year beginning January 1, 2007. We are currently evaluating the potential impact of the adoption of SFAS 157 on our future consolidated financial statements.
In September 2006, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”). SAB 108 provides interpretive guidance on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a current year misstatement. The SEC staff believes that registrants should quantify errors using both a balance sheet and an income statement approach and evaluate whether either approach results in quantifying a misstatement that, when all relevant quantitative and qualitative factors are considered, is material. SAB 108 is effective for our fiscal year ending December 31, 2006. The adoption of SAB 108 will only impact our consolidated financial statements if we have misstatements in the future.
In July 2006, the Financial Accounting Standards Board ("FASB") issued FASB Interpretation ("FIN") No. 48, Accounting for Uncertainty in Income Taxes, with respect to FASB Statement No. 109, Accounting for Income Taxes, regarding accounting for and disclosure of uncertain tax positions. FIN No. is intended to reduce the diversity in practice associated with the recognition and measurement related to accounting for uncertainty in income taxes. This interpretation is effective for fiscal years beginning after December 15, 2006. We are currently evaluating the impact this interpretation will have on our financial statements.
In March 2006, the FASB issued SFAS No. 156 “Accounting for Servicing of Financial Assets an amendment of FASB Statement No. 140”. FASB Statement No. 140, “Accounting for Transfers and servicing of Financial Assets and Extinguishments of Liabilities” establishing among other things, the accounting for all separately recognized servicing assets and servicing liabilities. This Statement amends Statement 140 to require that all separately recognized servicing assets and servicing liabilities be initially measured at fair value, if practicable. This Statement permits, but does not require, the subsequent measurement of separately recognized servicing assets and servicing liabilities at fair value. SFAS No. 156 is effective as of the beginning of the fiscal year that begins after September 15, 2006. The company will adopt SFAS 156 on January 1, 2007
In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments” (“SFAS 155”), which amends SFAS No. 133, “Accounting for Derivatives Instruments and Hedging Activities” (“SFAS 133”) and SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities” (“SFAS 140”). SFAS 155 amends SFAS 133 to narrow the scope exception for interest-only and principal-only strips on debt instruments to include only such strips representing rights to receive a specified portion of the contractual interest or principle cash flows. SFAS also amends SFAS 140 to allow qualifying special-purpose entities to hold a passive derivative financial instrument pertaining to beneficial interests that itself is a derivative instruments. The Company is currently evaluating the impact this new Standard, but believes that it will not have a material impact on the Company’s financial position, results of operations or cash flows. We will adopt SFAS 155 on January 1, 2007.
For the year ending December 31, 2007, under current rules, pursuant to Section 404 of the Sarbanes-Oxley Act, management will be required to deliver a report that assesses the effectiveness of our internal controls over financial reporting. The SEC issued a release in December 2006, however, announcing that the Commission has extended the date by which non-accelerated filers, which we currently are, must begin to comply with the Section 404(b) requirement to provide an auditor’s attestation report on internal controls over financial reporting. The deadline for the auditor’s attestation report has been moved to the first annual report for fiscal years ending on or after December 15, 2008. The SEC is considering further postponing this date.
NOTE STOCK BASED COMPENSATION
The Company’s 2004 Stock Compensation Plan (“Plan”) provides for grants of options up to 780,000 shares of common stock, and was amended on January 25, 2005 to provide grants of options up to 1,380,000. Pursuant to the Plan, the Company may grant options to any directors, officers, employees and independent contractors of the Company or of any subsidiary of the Company. Stock options are granted at, or above, the fair market value of our stock. As of December 31, 2006, there were 658,000 options available for grant.
The following table summarizes the activity of stock options under the Plan:
Effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment , (“SFAS 123R”) which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors, including employee stock options, based on estimated fair values. SFAS 123R supersedes the Company’s previous accounting under Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”) for periods beginning on or after January 1, 2006.
The Company adopted SFAS 123R using the modified prospective transition method, which requires the application of the accounting standard as of January 1, 2006, the first day of the Company’s fiscal year 2006. The Company’s financial statements as of and for the year ended December 31, 2006 reflect the impact of SFAS 123R. In accordance with the modified prospective transition method, the Company’s financial statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123R.
The Company uses the Black-Scholes option-pricing model (“Black-Scholes model”) for the determination of fair value of share-based payment awards on the date of grant. Using an option-pricing model is affected by the Company’s stock price as well as assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to the Company’s expected stock price volatility over the term of the awards, and actual and projected employee stock options exercise behaviors.
There were 350,000 options granted during the year ended December 31, 2006 of which 280,000 were granted to the Directors and vested immediately. The fair value of the Company’s options granted during the year ended December 31, 2006 was estimated at the grant date using the Black-Scholes option pricing model with the following the weighted average assumptions:
In accordance with SFAS 123R stock-based compensation expense recognized in the statements of operations for the year ended December 31, 2006 is based on awards ultimately expected to vest. Based on historical experiences, the Company expects 10% per year forfeitures of its prior option grants and therefore the compensation expense has been reduced for estimated forfeitures. SFAS 123R requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. In the Company’s pro forma information required under SFAS 123 for the periods prior to fiscal 2006, the Company adjusted the expected forfeitures for actual as they occurred.
Stock-based compensation expense recognized under SFAS 123R for the year ended December 31, 2006, was approximately $547,000. There were 350,000 options granted during the year ended December 31, 2006. The weighted average fair value of options granted during the year ended December 31, 2006 was $1.34 with an aggregate total value of $469,000. As of December 31, 2006, $257,000 of unrecognized compensation costs related to non-vested stock options are expected to be recognized over the following 31 months. Since the Company adopted SFAS 123R as of January 1, 2006, there was no stock-based compensation expense related to employee stock options recognized during the year ended December 31, 2005.
Prior to the adoption of SFAS 123R, the Company accounted for stock-based awards to employees and directors using the intrinsic value method in accordance with APB 25 as allowed under Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (“SFAS 123”). Under the intrinsic value method, no stock-based compensation expense had been recognized in the Company’s statement of operations for the year ended December 31, 2005.
The following pro forma net loss and loss per share information is presented as if the Company accounted for stock-based compensation awarded using the fair value recognition provisions of SFAS 123 for the year ended December 31, 2005:
During the year ended December 31, 2005, the Company granted 48,000 options, respectively at an exercise price equal to the fair market value of our stock at the time of the grant.
The Company also granted 50,000 stock options to a consultant in the first quarter of 2005. These options vest quarterly over a three year period beginning in the second quarter ended June 30, 2005. Any unexercised options expire three months after the completion or termination of the consulting agreement. The value of the options was determined using the Black-Scholes option-pricing model and was recorded as non-cash compensation expense during the service period of the consulting agreement. The consulting agreement was terminated June 30, 2006. No options were exercised and the options expired on September 30, 2006. The Company recorded compensation expense of $11,000 and $48,000 related to these options for the year ended December 31, 2006 and 2005, respectively.
NOTE 4 INCOME TAXES
The Company accounts for its income taxes using the Financial Accounting Standards Board Statements of Financial Accounting Standards No. 109, “Accounting for Income Taxes,” which requires the establishment of a deferred tax asset or liability for the recognition of future deductible or taxable amounts and operating loss and tax credit carryforwards. Deferred tax expense or benefit is recognized as a result of timing differences between the recognition of assets and liabilities for book and tax purposes during the year.
Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Deferred tax assets are recognized for deductible temporary differences and operating loss, and tax credit carryforwards. A valuation allowance is established to reduce that deferred tax asset if it is “more likely than not” that the related tax benefits will not be realized.
The provision (benefit) for income taxes for the years ended December 31, 2006 and 2005
The reconciliation of income tax provision computed at federal statutory rates to income tax expense is as follows
Net deferred tax assets at December 31, 2006 and 2005 are as follows:
The Company has loss carryforwards of approximately $13,498,000 and $6,220,765 for the years ended December 31, 2006 and 2005, respectively, from continuing operations, which may be used to offset future United States federal taxes, which begin to expire in 2024 and state income taxes, which begin to expire in 2014.
NOTE 5 LONG-TERM DEBT
Components of long-term debt are as follows (net of discounts):
Laurus Security Agreement
On February 28, 2006, the Company entered into a security agreement (the Laurus “Security Agreement”) with Laurus Master Fund, Ltd. (“Laurus”). Included in the Security Agreement is an asset-based Secured Non-Convertible Revolving Note (the “Revolving Note”). The term of the Revolving Note is two years and provides that we may borrow up to $16,500,000 subject to certain conditions. Interest is payable monthly, in arrears at a rate per annum equal to the Prime Rate (as published in The Wall Street Journal ) plus two percent (2.0%). The Revolving Note has no financial covenants and is collateralized by a security interest in substantially all of the assets of the Company and its subsidiaries, including its operating subsidiary, Small World Toys. Proceeds from the Revolving Note were used to repay funds borrowed under the secured asset-based revolving credit facility with PNC Bank (“PNC”) and the PNC facility was terminated.
The Company also has a $2.0 million, two year Secured Non-Convertible Term Note (the “Term Note “) with Laurus. Commencing April 1, 2006 and each succeeding month after, the Company will make principal payments of $33,333 with all the balance of the unpaid principal amount due upon the maturity date of February 28, 2008. Interest is payable monthly, in arrears at a rate per annum equal to the Prime Rate (as published in The Wall Street Journal ) plus three percent (3.0%). The Term Note has no financial covenants and is collateralized by the Laurus Security Agreement.
In consideration for the Revolving Note and the Term Note, the Company issued to Laurus a warrant (“Warrant”) to purchase 1,036,000 shares of common stock at a $0.001 per share exercise price. This Warrant has a fair value of $2,586,000 calculated using the Black Scholes option pricing model with the following assumptions:
The value of the Warrant of $2,586,000 was recorded as an asset as debt issuance costs to be amortized over the life of the loan.
This Warrant is subject to registration rights requiring the Company to register the underlying shares with the SEC within 60 days of the issuance of the Warrant. The deadline to register the underlying shares has been subsequently amended to June 15, 2006. The Company filed the registration statement with the SEC on June 15, 2006 and Amendment No. 1 on October 4, 2006. As of the date of this filing, the Company was in the process of reviewing and responding to the comments received from the SEC on Amendment No.1. The registration statement must be declared effective within 180 days of the issuance of the Warrant or Laurus may impose a default interest rate equal to two percent (2%) per month interest on the outstanding Revolving and Term Notes until the registration statement is declared effective.
It has been determined that the default interest rate is in effect liquidated damages, and therefore, in accordance with EITF 00-19, the Company determined that the maximum liquidated damages exceeds the difference between the fair value of a registered share of common stock and unregistered share of common stock on the date of the transaction and therefore the value of the Warrant has been recorded as a liability subject to marked-to-market revaluation at each period end. The decrease in the fair value of the warrant liability associated with Laurus from the date of issuance of February 28, to December 31, 2006 was $1,139,000 and is a result of the decrease in the trading value of our stock during this period.
In connection with the Security Agreement, the Company paid broker and management fees of $833,000 and was recorded as an asset as debt issuance costs to be amortized over the life of the loan.
On July 26, 2006, Laurus authorized $750,000 in excess of the maximum allowed borrowings based on a formula amount of the secured assets (the “Overadvance”) on the Revolving Note. On October 19, 2006, Laurus exercised the discretion granted to it pursuant to Section 2(a)(ii) of the Security Agreement dated February 28, 2006 with the Company to make loans to the Company in excess of the maximum amounts available to be borrowed on our revolver loans. The aggregate principal amount of the Overadvance is $1,500,000, of which amount $486,000 was outstanding as of December 31, 2006. The Overadvance, subject to certain restrictions, is available to the Company for a one year period. The interest applicable to the Overadvance shall be the “prime rate” published in The Wall Street Journal from time to time plus two percent (2%).
The Company had $1,014,000 of availability on the Revolving Note as of December 31, 2006 including $1,014,000 from the overadvance.
On January 26, 2007, the Company entered into an Omnibus Amendment No.1 with Laurus that (a) amended the Overadvance Side Letter by extended the maturity of the Overadvance of up to $1,500,000 from October 19, 2007 to February 28, 2008 and (b) increased the Concentration Limits for accounts on standard terms from 15% to 32.5%. In addition, the requirement for the listing of the Company’s shares on the NASDAQ, OTC Bulletin Board or other Principal Market and for the timely filing with the SEC of all reports required to be filed pursuant to the Exchange Act was deleted.
On January 26, 2007, the Company also entered into the Second Amendment with Laurus, to the Registration Rights Statement dated February 28, 2006, that deleted the requirement to file a Registration Statement and no penalties were owed. In accordance with EITF 00-19, the value of the Warrant issued to Laurus on February 28, 2006 was subject to marked-to-market revaluation at each period end since this Warrant was subject to registration rights requiring the Company to register the underlying shares with the SEC within 60 days of the issuance of the Warrant.. Any change in fair value from the date of issuance to the date the underlying shares are registered was included in other (expense) income. With the Second Amendment with Laurus, to the Registration Rights Statement dated February 28, 2006, that deleted the requirement to file a Registration Statement, the warrant liability is reclassified from a liability to equity. The change in fair value from December 31, 2006 to January 26, 2007 of $362,000 will be included in other income in January 2007. With the termination of the requirement to file a Registration Statement, the value of the warrants on the January 26, 2007 of $1,085,000 will be reclassified from a liability to equity.
On January 26, 2007, the Company issued a warrant to purchase an aggregate of 685,185 shares at an exercise price of $.01 per share to Laurus. The warrant was issued in connection with the extension of the maturity of the Overadvance to February 28, 2008 and the increase of the Concentration Limits on standard terms from 15% to 32.5%. This warrant has a relative fair value of $711,000 calculated using the Black Scholes option pricing model with the following assumptions:
The Company has determined the issuance of the warrant in connection with Omnibus Amendment No.1 and the Second Amendment to the Registration Rights has resulted in a substantial modification resulting in the net present value between the original Revolving Note and the amended Revolving Note to be greater than 10%, and in accordance with EITF Issue 96-19, Debtor’s Accounting for a Modification or Exchange of Debt, the amendments were accounted for as an extinguishment of debt and the relative fair value of the warrant will be expensed.
Purchase Order Financing Facility
On March 20, 2006, The Company entered into a Purchase Order Revolving Credit Line (“PO Credit Line”) of Five Million Dollars ($5,000,000) with Horizon Financial Services Group USA to provide financing for the acquisition of product from our overseas vendors. The term of the PO Credit Line is eighteen (18) months and provides that we may borrow up to $5,000,000 subject to certain conditions including Horizon’s approval of the applicable vendors. A financing fee equal to Four and One Half Percent (4.50%) of the gross amount or face value of each Horizon financing instrument will be charged for the first forty-five (45) day period or part thereof that the financing instrument remains outstanding. An additional fee of fifty basis points (.50%) for each additional period of 15 days, or part thereof, during which the Horizon financing instrument remains outstanding will be charged. The PO Credit Line has no financial covenants and is collateralized by a security interest, junior in position to that of our senior lender, Laurus Master Fund, Ltd, to the assets related to the PO Credit Line transactions. As of December 31, 2006, $46,000 were due under this facility.
10% Bridge Notes - St Cloud Capital Partners LP
On September 15, 2004, we entered into a Note Purchase Agreement with St. Cloud Capital Partners L.P. (“St. Cloud”), pursuant to which we issued to St. Cloud a 10% Convertible Promissory Note in the aggregate amount of $2,000,000, due September 15, 2005. The Company also was required to pay a closing fee of $80,000 and a management fee of $80,000 to St. Cloud. In connection with the issuance of the note, we issued St. Cloud 65,000 shares of common stock and warrants to purchase an additional 35,000 shares of common stock. The warrants are exercisable at an exercise price per share equal to $5.00 per share. The warrants expire in September 2008. The Company also granted certain registration rights whereby the Company agreed to include the common stock and warrants in a registration statement filed by the Company with the Securities and Exchange Commission (the “SEC”).
On July 20, 2005 the Company amended the Agreement (the “Amendment”) pursuant to which St. Cloud agreed to advance to the Company an additional $500,000 for an aggregate loan of $2.5 million at an interest rate of 10% per annum payable monthly in arrears. The aggregate loan is secured by certain Company assets including Receivables, Inventory, Equipment and other assets. In consideration for the advance, the Company issued to St. Cloud an additional 16,250 shares of the Company’s Common Stock and four year immediately exercisable warrants for the right to acquire 8,750 shares (“Warrant Shares”) of the Company’s Common Stock. The aggregate Warrants underlying 43,750 shares of Common Stock are exercisable at an exercise price per share equal to the lowest of (a) $4.00 per share or; (b) the per share price (or conversion price if a derivative security) of the next financing of the Company with gross proceeds of at least $5 million. The Amendment also provides piggyback registration rights with respect to the shares of Common Stock and Warrant Shares in the event the Company files a qualified Registration Statement with the SEC.
On November 11, 2005, the Company entered into a Second Amendment to the Agreement with St. Cloud pursuant to which the Company issued to St. Cloud a new promissory note (the “Replacement Note”) replacing the existing note to St. Cloud in the principal amount of $2,500,000 (the “Loan Amount”). Under the Replacement Note, the maturity date of the Loan Amount was extended to September 15, 2006. The Replacement Note is convertible into shares of the Common Stock of the Company at $4.00 per share (subject to adjustment) or, as to up to 50% of the Loan Amount, into securities issued by the Company in a financing with gross proceeds of at least $12,500,000. As the Replacement Note is convertible at a price below the fair market value on the date of issuance, it is deemed to have a beneficial conversion feature with an intrinsic value of $912,000. In consideration of the agreement of St. Cloud to accept the Replacement Note, the Company issued to St. Cloud two warrants to purchase an aggregate of 75,000 shares of Common Stock (the “New Warrant Shares”) as follows: a First Warrant for 50,000 shares at $6.00 per share exercisable for a number of New Warrant Shares (each, a “Tranche”) in accordance with the following: 12,500 shares to be vested at Closing and 12,500 shares (or the prorated portion thereof as provided in the Warrant) to be vested on January 1, 2006, April 1, 2006 and July 1, 2006 (a “Vesting Date”); and a Second Warrant for 25,000 shares at $7.50 per share, 6,250 shares to be is vested at Closing and 6,250 shares (or the prorated portion thereof as provided in the Warrant) to be vested on each Vesting Date, provided that the applicable Warrant may not be exercised for a specific Tranche if the Replacement Note is not outstanding on the applicable Vesting Date. The number of New Warrant Shares is proportionally reduced, as of a Vesting Date, if the principal amount of the Note is less than the Loan Amount. The Company determined the Replacement Note resulted in a substantial modification due to the new maturity date and the conversion feature, and in accordance with EITF Issue 96-19, Debtor’s Accounting for a Modification or Exchange of Debt, the exchange transaction was accounted for as an extinguishment of debt. As such, the relative fair market value was deemed to be fees paid associated with the extinguishment of the old debt instrument and included as debt extinguishment loss to be recognized in the current period.
On June 9, 2006, the Company received approximately $2.4 million from the private placement of Class A-1 Preferred Stock at $1.10 per share and binding commitments for an additional $.3 million of which $150,000 was received in September and the balance was received in November 2006. As a condition of this sale, the Company entered into a Third Amendment to the Agreement with St. Cloud whereas the 10% Note Due 2006 to St Cloud in the principal amount of $2.5 million was restructured as follows: the Company prepaid $50,000 of the existing note and issued to St. Cloud two new notes to replace the exiting note. The first note in the principal amount of $200,000 will be for twelve months with monthly amortization payments at a 10% interest rate; the second note (the first and second notes in aggregate “Notes”) will be for $2,250,000 with interest at 10% per annum with interest only payable on June 30, 2006 and September 15, 2006 and commencing September 16, 2006, payments will be interest only each month through September 15, 2008 and commencing October 15, 2008, monthly amortization payments (based on a five-year amortization) with all interest plus unpaid principal due on September 15, 2011 and the second note will be convertible into shares of the common stock of the Company at $4.00 per share. The Company determined the Notes resulted in a substantial modification since the effective interest rate of the Replacement Note included warrants issued while there were no warrants issued with the Notes resulting in the net present value between the two notes to be greater than 10%, and in accordance with EITF Issue 96-19, Debtor’s Accounting for a Modification or Exchange of Debt, the exchange transaction was accounted for as an extinguishment of debt. The relative fair market value of the Replacement Note and the Notes were deemed to be equal since the principal and interest of the two notes are equal and therefore there was no gain or loss associated with the extinguishment of the old debt instrument to be recognized in the current period.
Per the subordination agreement signed between St Cloud and Laurus on February 28, 2006, principal payments on either of the two notes with St Cloud are not allowed to be made while any amounts are open under the Overadvance. The aggregate principal amount of the Overadvance is $1,500,000, of which $486,000 was outstanding as of December 31, 2006.
10% Notes Due 2008
On October 19, 2006, the Company issued an aggregate of $330,000 in principal amount of 10% Convertible Debentures (the “Debenture”) to Hong Kong League Central Credit Union and Kershaw Mackie & Company, who are also providing management consulting services to the Company, with net proceeds of $300,000. Interest is payable monthly in arrears and the Debentures mature on March 31, 2008. Per the Intercreditor and Subordination Agreement dated March 2007 between St. Cloud and Hong Kong League Central Credit Union and Kershaw Mackie & Company, no principal payments can be made on the Debenture until all notes between the Company and St. Cloud have been paid in full. The Debenture is convertible into shares of the Registrant’s Common Stock at the option of the holder at a conversion price $1.10 (subject to normal adjustments). Since the Debenture has only standard adjustment features with no reset conversion price requirements nor registration rights requirements beyond piggy-back rights, the debt is considered conventional debt under FASB 133 and EITF 00-19. As the Debenture is convertible at a price below the fair market value on the date of issuance, it is deemed to have a beneficial conversion feature with an intrinsic value of $29,000 and recorded as adebt issuance expense to be amortized over the remaining life of the loan.
In consideration for the Debenture, the Company issued Warrants (“SBI Warrants”) to purchase an aggregate of 137,500 and 12,500 shares, respectively, at an exercise price of $1.10 per share, to SBI Advisors LLC, a placement agent and which is beneficially owned by Shelly Singhal, a director of the Small World Kids , and Kershaw Mackie & Company. These warrants have a relative fair value of $150,000 calculated using the Black Scholes option pricing model with the following assumptions:
The relative fair value of the warrants will be recorded as a discount to the debt issuance to be amortized over the life of the Convertible Debenture. The Company also entered into a Registration Rights Agreement in connection with the Debentures and Warrants on October 19, 2006 to provide piggy-back registration rights for the common shares issuable upon conversion of the Debentures or exercise of the Warrants.
10% Note Due 2009 - Former shareholder
As part of the purchase for SWT Shares on May 20, 2004, the Company entered into a contingent earnout with the former shareholder of Small World Toys. The Company agreed to a two year promissory note, payable in quarterly installments commencing April 2005 with a minimum payment of $700,000 and a maximum payment of $1,500,000, if certain sales targets are achieved in 2005 and 2006. In 2005, the seller earned $673,000 based on the Company obtaining $33.7 million in net sales of which $350,000 was paid in quarterly installments in 2005 and the balance and interest due in 2006 to be paid on a $60,000 per month payment schedule commencing on April 2006 at 10% interest on the unpaid balance. The 2006 earnout is based on 2% of 2006 net sales up to a maximum of $800,000. If the certain sales targets are achieved, as allowed by SFAS 141, “Business Combinations”, and in accordance with paragraph 28, the contingent payout of up to a maximum of $800,000 will be considered additional cost of acquiring Small World Toys and recorded as goodwill. Of the 2006 earnout, a minimum quarterly payment of $87,500 will be paid with the balance earned due January 2007.
On November 6, 2006, the Company entered into an amendment with the former shareholder whereas the contingent earnout for 2006 was fixed at $670,000 and a three year note for $667,619 (the unpaid principal amount of the 5% Note) was issued with monthly amortization payments at a 10% interest rate. A default interest rate of 15% will be incurred on the unpaid scheduled interest and principal payments if not cured within 5 days. The Company has determined the amendment has resulted in a substantial modification resulting in the net present value between the two notes to be greater than 10%, and in accordance with EITF Issue 96-19, Debtor’s Accounting for a Modification or Exchange of Debt, the amendment was accounted for as an extinguishment of debt.
24% Notes Due 2006
On April 28, 2005 the Company entered into Term Credit Agreements (“Credit Agreements”) with Hong Kong League Central Credit Union and PCCW Credit Union (collectively the “Lenders”) for unsecured loans totaling $750,000 due on or before August 31, 2005. Interest is charged at a rate of 2% per month and is payable monthly in arrears. On June 10, 2005 the Company entered into additional Credit Agreements with Hong Kong League Central Credit Union and HIT Credit Union for unsecured loans totaling $250,000 due on or before September 30, 2005. Effective August 31, 2005 the maturity dates of all outstanding unsecured loans with the Lenders were extended to the earlier of the closing of a financing transaction with net proceeds of at least $20 million or March 1, 2006. In consideration of the extension, the Company agreed to issue four year immediately exercisable warrants to purchase 100,000 shares of the Company’s Common Stock exercisable at $5.00 per share to SBI Advisors, a related party, as a placement fee. At inception the fair value was determined to be $325,000 using the Black-Scholes option pricing model and applied to the principal as a discount to be accreted over the expected life of the unsecured loans. In connection with the Security Agreement with Laurus, the maturity date of all outstanding unsecured loans with the Lenders were extended to the earlier to occur of (a) the closing of a financing with net proceeds of at least $20,000,000 or (b) August 11, 2006.
On June 9, 2006, the Company received approximately $2.4 million from the private placement of Class A-1 Preferred Stock at $1.10 per share and binding commitments for an additional $.3 million of which $150,000 was received in September and the balance was received in November 2006. As a condition of this sale, the 24% Notes Due 2006 in the aggregate principal amount of $1,000,000 with Hong Kong League Central Credit Union, PCCW Credit Union and HIT Credit Union were converted into 909,091 shares of the Class A-1 Preferred Stock.
10% Convertible Debentures Due 2008
On September 30, 2005 the Company completed the issuance of an aggregate of $1.5 million in principal amount of 10% Convertible Debentures (the “Debentures”) and entered into a Securities Purchase Agreement (“Stock Purchase Agreement”) with Gamma Opportunity Capital Partners LP and Bushido Capital Master Fund LP. The Debentures will mature on September 30, 2008 and bear an interest rate of 10% per annum payable quarterly in arrears. The Company may make interest payments in cash or shares of its Common Stock, subject, in the case of payment in shares, to satisfaction of certain conditions. The Debentures are immediately convertible to the Company’s Common Stock at the option of the holder. The conversion price is $4.00, subject to adjustments for stock splits, stock dividends or rights offerings combinations, recapitalization, reclassifications, extraordinary distributions and similar events and certain subsequent equity sales. As the Debentures are convertible at a price below the fair market value on the date of issuance, they are deemed to have a beneficial conversion feature with an intrinsic value of $425,000.
In consideration for the issuance of the Debentures, the Company issued five year immediately exercisable warrants to purchase an aggregate of 281,250 shares of the Company’s Common Stock. Of the shares underlying the warrants, 93,750 have an exercise price of $7.50 per share (subject to adjustment) and 187,550 have an exercise price of $6.00 per share. These warrants have a fair value of $1.1 million calculated using the Black Scholes option pricing model. These warrants are subject to registration rights requiring the Company to register the underlying shares with the SEC within 120 days of the issuance of the Debentures. In connection with the Security Agreement with Laurus, the registration rights were amended to require the Company to register the underlying shares with the SEC when the Company registers the underlying shares of the Warrant issued with the Security Agreement with Laurus. In accordance with EITF 00-19, the value of the warrants has been recorded as a liability subject to marked-to-market revaluation at each period end. The decrease in the fair value of the warrant liability associated with the 10% Convertible Debentures from December 31, 2005 to June 9, 2006 was $418,000 and is a result of the decrease in the trading value of our stock during this period.
On June 9, 2006, the Company received approximately $2.4 million from the private placement of Class A-1 Preferred Stock at $1.10 per share and binding commitments for an additional $.3 million of which $150,000 was received in September and the balance was received in November 2006. As a condition of this sale, the $1.5 million in principal amount of the 10% Convertible Debentures due in 2008 along with accrued but unpaid interest and penalties were converted into 1,400,000 shares of the Class A-1 Preferred Stock. As a result of this transaction, the Company no longer has an obligation to register the underlying shares with the SEC and as such the warrant liability of $271,000 was reclassified to equity. Also, as a result of this conversion, $1,062,000 of unamortized debt discount was charged to interest expense. Per the warrant agreement, because the price per share of the Class A-1 Preferred Stock $1.10 was less than the exercise price of the 93,750 warrants with an exercise price of $7.50 per share and 187,550 warrants with an exercise price of $6.00 per share, the 93,750 and 187,500 warrants were repriced to $1.10 and an additional 1,380,688 warrants were issued at $1.10. Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment, (“SFAS 123R”) addresses modifications to equity instruments. In accordance with SFAS 123R, the modification of the exercise price resulted in an expense of $80,000.
The fair market value of the additional 1,380,688 warrants was $1,549,000 and calculated using the Black Scholes option pricing model with the following assumptions:
10% Note Due 2006 - Related Party
Effective August 11, 2005, the Company completed the issuance of an aggregate of $500,000 in Notes to various investors which included Debra Fine, the Company’s President and Chief Executive Officer who provided $175,000 of the total borrowing. The Notes mature one year from the date of execution with interest payable monthly in arrears at a rate of 10% per annum. The Notes are secured by certain Company assets including Receivables, Inventory, Equipment and other assets. The Notes also provide piggyback registration rights in the event the Company files a qualified Registration Statement with the SEC. In consideration for the loans, the Company agreed to issue an aggregate of 16,250 shares of the Company’s Common Stock and four year immediately exercisable warrants to purchase an aggregate of 8,750 shares of the Company’s Common Stock. The Warrants are exercisable at an exercise price per share equal to the lowest of (a) $4.00 per share, or (b) the per share price (or conversion price if a derivative security) of the next financing of the Company with gross proceeds of at least $5 million. At inception the fair value of these warrants was determined to be $100,000 using the Black-Scholes option pricing model and applied to the principal as a discount to be accreted as a non-cash interest cost over the life of the loan.
On June 9, 2006, the Company received approximately $2.4 million from the private placement of Class A-1 Preferred Stock at $1.10 per share and binding commitments for an additional $.3 million of which $150,000 was received in September and the balance was received in November 2006. As a condition of this sale, the $500,000 in principal amount of the 10% Note due 2006 was converted into 455,000 shares of the Class A-1 Preferred Stock. As a result of this conversion, $15,000 of unamortized debt discount was charged to interest expense.
Accretion of Debt Discounts
For the years ended December 31, 2006 and 2005, aggregate accretion of debt discounts were $2,586,000 and $1,524,216, respectively and included in interest expense. In addition, as a result of the conversion of $3 million of debt into Class A-1 Preferred Stock on June 9, 2006, $1,077,000 in unamortized debt issuance costs related to the converted debt were recorded as a non-cash expense in June 2006.
NOTE 6: WARRANT LIABILITY
In consideration for the Revolving Note and the Term Note, the Company issued to Laurus a warrant (“Warrant”) to purchase 1,036,000 shares of common stock at a $0.001 per share exercise price. These warrants are subject to registration rights requiring the Company to register the underlying shares with the SEC within 60 days of the issuance of the warrant. The deadline to register the underlying shares has been subsequently amended to June 15, 2006. The Company filed the registration statement with the SEC on June 15, 2006 and Amendment No. 1 on October 4, 2006. As of the date of this filing, the Company was in the process of reviewing and responding to the comments received from the SEC on Amendment No.1. Per the Registration Rights Statement dated February 28, 2006, the registration statement must be declared effective within 180 days of the issuance of the warrant or Laurus may impose a default interest rate equal to two percent (2%) per month interest on the outstanding Revolving and Term Notes until the registration statement is declared effective. In accordance with EITF 00-19, the value of the warrants of $2,586,000 has been recorded as a liability subject to marked-to-market revaluation at each period end. Any change in fair value from the date of issuance to the date the underlying shares are registered will be included in other (expense) income. The change in fair value from the date of issuance to December 31, 2006 of $1,139,000 has been included in other income.
On June 9, 2006, the Company received approximately $2.4 million from the private placement of Class A-1 Preferred Stock at $1.10 per share and binding commitments for an additional $.3 million of which $150,000 was received in September and the balance was received in November 2006. As a condition of this sale, the $1.5 million in principal amount of the 10% Convertible Debentures due in 2008 along with accrued but unpaid interest and penalties were converted into 1,400,000 shares of the Class A-1 Preferred Stock. As a result of this transaction, the Company no longer has an obligation to register the underlying shares with the SEC and as such the warrant liability of $271,000 associated with the 10% Convertible Debentures due in 2008 was reclassified to equity.
On January 26, 2007, the Company entered into the Second Amendment with Laurus, to the Registration Rights Statement, that deleted the requirement to file a Registration Statement and no penalties were owed. The change in fair value from December 31, 2006 to January 26, 2007 of $362,000 will be included in other income in January 2007. With the termination of the requirement to file a Registration Statement, the value of the warrants on the January 26, 2007 of $1,085,000 will be reclassified from a liability to equity.
NOTE ISSUANCE OF CLASS A-1 PREFERRED STOCK
On June 9, 2006, the Company received approximately $2.4 million from the private placement of Class A-1 Preferred Stock at $1.10 per share and binding commitments for an additional $.3 million of which $150,000 was received in September and the balance was received in November 2006. As a condition of this transaction, we converted an aggregate of $3 million of debt (plus a portion accrued interest) into 2,763,636 shares of the Class A-1 Convertible Preferred as follows: (i) the 24% Notes Due 2006 in principal amount of $1,000,000 with Hong Kong League Central Credit Union, PCCW Credit Union and HIT Credit Union; (ii) the $1.5 million in principal amount of the 10% Convertible Debentures due in 2008 along with accrued but unpaid interest and penalties; and (iii) the 10% Note Due 2006 - Related Party in principal amount of $500,000 in notes to various investors which included Debra Fine, the Company’s President and Chief Executive Officer who provided $175,000 of the total borrowing. We also converted the shares of Series A Convertible Preferred Stock we issued to SWT, LLC on August 11, 2005, when we converted a $5,000,000 Bridge Note dated May 2004 held by SWT, LLC, along with accrued but unpaid dividends, into 4,908,157 shares of the Class A-1 Preferred Stock.
Pursuant to a Securities Purchase Agreement (the “Purchase Agreement”) dated October 19, 2006 between Small World Kids, Inc. and the following investors; Russell Fine and Debra Fine (our President and Chief Executive Officer) as trustees of the Fine Family Trust, and Vintage Filings, LLC, the Company sold in a private placement 181,818 shares of its Class A-1 Convertible Preferred Stock (the “Preferred Shares”) for $200,000. The Purchase Agreement granted to the purchasers piggyback registration rights with respect to the shares of Company Common Stock issuable upon conversion of the Preferred Shares and certain participation rights in respect of future equity financings.
The Company issued 100,000 warrants on June 9, 2006 with an exercise price of $2.00 to C.E.Unterberg, Towbin Capital Partners1, L.P. in connection with the private placement of Class A-1 Preferred Stock. The warrants have a fair value of $11,000 calculated using the Black Scholes option pricing model with the following assumptions:
The fair value of the warrants was recorded as a reduction to the net proceeds from the private placement of Class A-1 Preferred Stock.
The Class A-1 Preferred has an adjustment of the conversion price upon issuance of additional equity at a price lower than the conversion which causes the Class A-1 Preferred to be treated as an unconventional preferred instrument. Upon evaluation under FASB Statement No. 133, “Accounting for Derivative Instruments and Hedging Activities” and EITF 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock”, it was determined that the embedded derivative would be classified as equity and as such, the Company did not bifurcate the conversion feature. The Class A-1 Preferred Stock has a beneficial conversion feature which allows the holders to acquire Common Stock of the Company at an effective conversion price of $.25 below fair value at the date of issuance. In accordance with EITF 98-5, Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios , the Company has determined the intrinsic value of this in-the-money conversion feature be accounted for it as a discount to the Preferred Stock. The intrinsic value of the beneficial conversion feature was determined to be approximately $2.5 million. As the Preferred Stock is immediately convertible, the full value of the conversion feature is deemed a dividend upon issuance and as such have been recorded directly to accumulated deficit.
On October 19, 2006, the Company issued warrants to purchase 91,477 and 67,614 shares at an exercise price of $1.10 per share to Cambria Capital LLC and David Fuchs, respectively. The warrants were issued in connection with the conversion of the $1.5 million debentures and the sale on June 9, 2006 in a private placement of 227,727 shares of its Class A-1 Convertible Preferred Stock for $250,000 as referenced in the Company’s Form 8-K filed June 14, 2006 and have piggy-back registration rights for the common shares issuable upon the exercise of the warrants. The warrants have a fair value of $293,000 calculated using the Black Scholes option pricing model with the following assumptions:
The fair value of the warrants was recorded as a reduction to the net proceeds from the private placement of Class A-1 Preferred Stock.
NOTE 8: COMMITMENTS AND CONTINGENCIES
As part of the purchase for SWT Shares on May 20, 2004, the Company entered into a contingent earnout with the former shareholder of Small World Toys. The Company agreed to a two year promissory note, payable in quarterly installments commencing April 2005 with a minimum payment of $700,000 and a maximum payment of $1,500,000, if certain sales targets are achieved in 2005 and 2006. In 2005, the seller earned $673,000 based on the Company obtaining $33.7 million in net sales of which $350,000 was paid in quarterly installments in 2005 and the balance due in 2006. The 2006 earnout is based on 2% of 2006 net sales up to a maximum of $800,000. Of the 2006 earnout, a minimum quarterly payment of $87,500 will be paid with the balance earned due January 2007. On November 6, 2006, the Company entered into an amendment with the former shareholder whereas the contingent earnout for 2006 was fixed at $670,000 and a three year note for $667,619 (the unpaid principal amount of the 5% Note) was issued with monthly amortization payments at a 10% interest rate (Note 5).
On May 20, 2004, the Company entered into a $72,000 per annum three-year consulting agreement with David Marshall, Inc., a related party. On each anniversary date, the fee shall be increased by the increase in the consumer index for the Los Angeles metropolitan statistical area. During the term, David Marshall, Inc. will provide consulting services relating to business plan development, strategic planning, public relations, investor relations, acquisitions and financing activities.
On August 5, 2005, Gemini Partners, Inc. (“Gemini”) filed an action in the Superior Court of the State of California for the County of Los Angeles against Small World Toys, Debra Fine, and Fineline Services, LLC. On February 21, 2006, Gemini filed a second amended complaint that, among other things, named as a defendant Small World Kids, Inc. Gemini’s complaint arises out of a written consulting agreement dated as of November 10, 2003 entered into by and between Gemini and Fineline Services. On June 13, 2006, the Company and Gemini settled the suit out of court for $40,000.
On September 7, 2005, Small Play, Inc. (“Small Play”) filed an action in the United States District Court for the Southern District of New York against Small World Toys alleging $3 million in damages in connection with a supposed breach of an alleged oral licensing agreement. The suit was dismissed without prejudice by the Court on June 1, 2006 for failure of the plaintiffs to prosecute.
On April 12, 2006, Ryan Yanigihara, the Company’s former Controller, filed a complaint with the Secretary of Labor alleging violation of Section 806 of the Sarbanes-Oxley Act protecting whistleblowers. The complaint is still pending investigation and a determintation before OSHA.The Board of Directors commissioned an independent investigation of the complaint which was unable to substantiate the allegations.
Additionally, the Company is subject to legal proceedings and claims which arise in the ordinary course of business. In the opinion of management, such matters are without merit and are of such kind that if disposed of unfavorably, would not have a material adverse effect on the Company’s consolidated financial position or results of operations or liquidity.
Our corporate headquarters are located at 5711 Buckingham Parkway, Culver City, California 90230, where we lease approximately 28,000 square feet and sublease approximately 17,000. This lease was amended to extend the term to February 28, 2009. We also lease approximately 62,000 square feet of warehouse space in Carson, California. This lease was also amended to extend the term to January 31, 2008. We also leased 1,200 square feet of office space in China in the town of ChangAn, GuangDong Province but this one year lease expired in November 1, 2006 and was not renewed. We believe these facilities and additional or alternative space available to us will be adequate to meet our needs in the near term. The aggregate future rental rates are:
The Company is party to several license agreements for the acquisition and development of certain toys and related manufacturing, licensing and distribution rights. Royalties range from 3% to 10% of various categories of sales. The agreements remain in effect for as long as the Company manufactures and sells the toys.
NOTE 9: EARNINGS (LOSS) PER SHARE
Basic earnings per share are computed by dividing income or loss available to common shareholders by the weighted average number of common shares outstanding during the reporting period. Diluted earnings per share is computed based on the weighted average number of shares outstanding during the period increased by the effect of the potential dilution that could occur if securities or other contracts, such as stock options and stock purchase contracts, were exercised or converted into common stock using the treasury stock method.
For the years ended December 31, 2006, 2005 and 2004, there were a total of 15,468,000, 3,521,000 and 360,000, respectively, potentially dilutive securities based on outstanding stock options, warrants, convertible preferred stock and convertible debentures during the period reported considered to be anti-dilutive which due to the net loss from operations were not included in the calculations of earnings per share. For the year ended December 31, 2003, the predecessor had no dilutive securities since there were no outstanding options or warrants.
NOTE 10: PROFIT SHARING PLAN
The Company has a qualified 401(k) profit sharing plan in effect for eligible employees. The plan provides for pre-tax employee contributions. A portion of the pre-tax employee contributions will be matched by the Company on a discretionary basis. The plan also provides for annual contributions at the discretion of the Company. Total contributions are not to exceed annual amounts deductible under Internal Revenue Service regulations. No contributions were made for the years ended December 31, 2006 and December 31, 2005.
NOTE 11: SELECTED QUARTERLY FINANCIAL DATA (Unaudited)
(1) Per share amounts are reflective of the Reverse Split for all periods reported.
NOTE 12: VALUATION
(1) Includes recovery of $141,000 that was written off in 2003.
NOTE 13: SUBSEQUENT EVENTS
On January 26, 2007, the Company entered into an Omnibus Amendment No.1 with Laurus that (a) amended the Overadvance Side Letter by extended the maturity of the Overadvance of up to $1,500,000 from October 19, 2007 to February 28, 2008 and increased the Concentration Limits for accounts on standard terms from 15% to 32.5%. In addition, the requirement for the listing of the Company’s shares on the NASDAQ, OTC Bulletin Board or other Principal Market and for the timely filing with the SEC of all reports required to be filed pursuant to the Exchange Act was deleted.
On January 26, 2007, the Company also entered into the Second Amendment with Laurus, to the Registration Rights Statement dated February 28, 2006, that deleted the requirement to file a Registration Statement and no penalties were owed. In accordance with EITF 00-19, the value of the Warrant issued to Laurus on February 28, 2006 were subject to marked-to-market revaluation at each period end since this Warrant was subject to registration rights requiring the Company to register the underlying shares with the SEC within 60 days of the issuance of the Warrant.. Any change in fair value from the date of issuance to the date the underlying shares are registered was included in other (expense) income. With the Second Amendment with Laurus, to the Registration Rights Statement dated February 28, 2006, that deleted the requirement to file a Registration Statement, the warrant liability is reclassified from a liability to equity. The change in fair value from December 31, 2006 to January 26, 2007 of $362,000 will be included in other income in January 2007. With the termination of the requirement to file a Registration Statement, the value of the Warrant on the January 26, 2007 of $1,085,000 will be reclassified from a liability to equity (Note 5).
On January 26, 2007, the Company issued a warrant to purchase an aggregate of 685,185 shares at an exercise price of $.01 per share to Laurus. The warrant was issued in connection with the extension of the maturity of the Overadvance to February 28, 2008 and the increase of the Concentration Limits on standard terms from 15% to 32.5%. This warrant has a relative fair value of $711,000 calculated using the Black Scholes option pricing model with the following assumptions:
The relative fair value of the warrant will be recorded as a discount to the debt issuance to be amortized over the remaining life of the credit facility with Laurus.