ITEM 1. BUSINESS
Company Overview
We are a global provider of integrated video and voice over Internet Protocol, or VoIP, telephony services, products, hosted solutions and infrastructure. We were founded in 1996 to capitalize on the growth of the Internet as a communications tool by commercially offering Internet Protocol, or IP, telephony services, or VoIP telephony. VoIP telephony is the real-time transmission of voice communications in the form of digitized “packets” of information over the Internet or a private network, similar to the way in which e-mail and other data is transmitted. While we began as primarily a low-cost alternative source of wholesale minutes for carriers around the world, we have evolved into an international provider of next generation communication services.
Today we support tens of thousands of active users around the globe through our service provider and reseller channel and our direct-to-consumer channel. We have built a privately-managed, state-of-the-art global telecommunications platform using IP technology and we offer a broad suite of private label VoIP products and services as well as a back-office platform. Our operations management tools include, among others: account provisioning; e-commerce-based payment processing systems; billing and account management; operations management; web development; network management; and customer care. Based on our customizable VoIP solutions, these customers can offer private label video and voice-over-IP services to their own customer bases under their own brand name, a “white-label” brand (in which no brand name is indicated and different customers can offer the same product), or the deltathree brand. At the same time, our direct-to-consumer channel includes our joip Mobile application (which is a cellular phone application providing low cost mobile calls over 3G cellular networks as well as WiFi networks) and our iConnectHere offering (which provides VoIP products and services directly to consumers and small businesses online using the same primary platform). We are able to provide our services at a cost per user that is generally lower than that charged by traditional service providers because we minimize our network costs by using efficient packet-switched technology and interconnecting to a wide variety of termination options, which allows us to benefit from pricing differences between vendors to the same termination points.
Prior to 1999, we focused on building a privately-managed, global network utilizing IP technology, and our business primarily consisted of carrying and transmitting traffic for communications carriers over our network. Beginning in 1999, we began to diversify our offerings by layering enhanced IP telephony services over our network. These enhanced services were targeted at consumers and were primarily accessible through our consumer website. During 2000, we began offering services on a co-branded or private-label basis to service providers and other businesses to assist them in diversifying their product offerings to their customer bases. In 2001, we continued to enhance our unique strengths through our pioneering work with the Session Initiation Protocol, or SIP, an Internet Engineering Task Force standard that has been embraced by industry leaders such as Microsoft and Cisco. These efforts culminated in the launch of our state-of-the-art SIP infrastructure, and in doing so we became the first major VoIP service provider to deploy an end-to-end SIP network and services. In recent years, we have continued our pioneering efforts in SIP and these efforts have yielded significant new releases.
In 2009 we began the process of expanding the suite of our communications offerings into the global video phone services market. In the third quarter of 2009 we entered into an agreement with ACN Pacific Pty Ltd., a wholly-owned subsidiary of ACN, Inc., or ACN, pursuant to which we provide digital video and voice-over-IP services in Australia and New Zealand to ACN Pacific. In December 2010 we entered into an agreement with ACN Korea, a wholly-owned subsidiary of ACN, pursuant to which we provide digital video and voice-over-IP services in Korea.
In 2010 we continued to update our network by adding a video mail feature to our video phone applications and launching our joip mobile application in July 2010. Following the launch of the mobile application, in October 2010 we entered into a sales agency agreement with ACN pursuant to which ACN sells a private label version of joip Mobile under the ACN Mobile World brand in the United States and Canada. In addition, we offer the joip Mobile application on a white-label basis to other customers. Finally, we entered into affiliate agreements with different third parties pursuant to which such third parties refer potential subscribers to our joip Mobile application.
In April 2011 we entered into an introducer agreement with ACN Europe B.V., a wholly-owned subsidiary of ACN, pursuant to which ACN Europe refers potential customers in different countries in Europe to a private label version of joip Mobile sold under the ACN Mobile World brand. In November 2011 we entered into a service agreement with Momentis U.S. Corp., a multi-level marketing company, pursuant to which Momentis refers potential customers in North America to a co-branded offering of joip Mobile and other consumer VoIP products and services.
On April 3, 2012, we entered into an amendment to our sales agency agreement with ACN and our introducer agreement with ACN Europe. Pursuant to the terms of the amendment, beginning April 1, 2012, we are required to pay all then-current commissions on a timely basis as required under the agreements and a late fee in the amount of one percent per month of any past-due, unpaid commissions (which, as of December 31, 2013, was equal to approximately $1,173,000). In addition, beginning July 15, 2012, we are required to pay down any unpaid past due amounts in an amount equal to at least $15,000 per month through June 15, 2013, and at least $25,000 per month thereafter until such time as the unpaid balance is paid in full, and are required to pay in full any unpaid, past due amounts upon 30 days' notice. In July 2012 we began making the $15,000 monthly payment, however due to our financial condition we suspended making the monthly payments of the unpaid commissions and the current commissions in April 2013 with the oral consent of ACN and ACN Europe. We do not know when we will resume making such payments again, and there is no assurance that we will be able to do so in the near future (if at all) or that until such time ACN and ACN Europe will continue to consent to our not making any such required payments and not exercise any rights they may have under our respective agreements with them or under applicable law. In addition, in the event of certain insolvency-related events defined in the agreements, all unpaid amounts will become immediately due and payable effective immediately prior to such event.
As a complement to the initiatives we have taken to attempt to organically expand our businesses, we have also evaluated opportunities for growth through strategic relationships. In February 2009 we consummated a transaction with D4 Holdings pursuant to which we sold to D4 Holdings an aggregate of 39,000,000 shares of our common stock and a warrant to purchase up to an additional 30,000,000 shares of our common stock. D4 Holdings is a private investment fund whose ownership includes owners of ACN, a direct seller of telecommunications services. As a result of the transactions with D4 Holdings, we expect to continue to seek opportunities to provide services to ACN and enter into other commercial transactions that give us access to ACN’s international marketing and distribution capabilities.	
From an operational standpoint, in 2012 we continued to focus our near-term strategy and market initiatives on growing our service provider and digital next generation communications offerings while still supporting our core VoIP reseller and direct-to-consumer business segments.
Going forward, we expect to:
•actively market our products and services to those entities that wish to offer white-label digital next generation communications offerings or sell our products and services on an affiliate basis;
•pursue a targeted strategy of identifying and evaluating appropriate strategic collaborations, such as potentially engaging in commercial transactions with ACN, that we hope will continue to expand and diversify our customer base;
•market and sell our direct-to-consumer products and services through affiliates and our affiliate program; and
•support and maintain our current reseller base, as we expect our revenue from this key channel will continue to represent a significant percentage of our total revenue in the foreseeable future.
Transactions with D4 Holdings
On February 10, 2009, we entered into a Securities Purchase Agreement with D4 Holdings LLC, or D4 Holdings, pursuant to which we issued to D4 Holdings (i) 39,000,000 shares of our common stock, representing approximately 54.3% of the total number of issued and outstanding shares of common stock following the transaction, for an aggregate purchase price of $1,170,000, paid in cash, and (ii) a warrant, exercisable for ten years, to purchase up to an additional 30,000,000 shares of our common stock at an exercise price of $0.04 per share. The transaction closed on February 12, 2009.
Upon the closing of the transaction and pursuant to the terms of the Purchase Agreement, Noam Bardin resigned as a director and the board of directors appointed Robert Stevanovski and Anthony Cassara to serve on the board. In addition, Lior Samuelson resigned as Chairman of the Board and remained a director, and Robert Stevanovski was appointed to serve as Chairman. Following the closing of the transaction, our Board of Directors appointed three additional directors to serve on the Board. The appointments of the three new directors became effective on March 28, 2009.
In connection with the transaction, the parties also entered into an Investor Rights Agreement, pursuant to which we have agreed to file, upon the request of D4 Holdings, a registration statement covering the resale of any shares of our common stock held by D4 Holdings (including the shares of common stock underlying the warrant issued to D4 Holdings). Subject to our ability to suspend the effectiveness of the registration statement for a limited period of time under certain circumstances, we are required to maintain the effectiveness of any such registration statement until the earlier of (i) the date on which all shares of common stock covered by the registration statement have been sold thereunder or (ii) the date on which all such shares of common stock can be sold without registration pursuant to Rule 144 or another similar exemption under the Securities Act of 1933. Subject to certain limitations, D4 Holdings will also be entitled to “piggy-back” registration rights on all future registrations by and any registrations initiated by our other stockholders.
On March 1, 2010, we and our subsidiaries entered into a Loan and Security Agreement, or the “First Loan Agreement”, with D4 Holdings pursuant to which D4 Holdings agreed to provide us and our subsidiaries a line of credit in a principal amount of $1,200,000. On August 10, 2010, we and our subsidiaries entered into the Second Loan and Security Agreement, or the “Second Loan Agreement”, with D4 Holdings, pursuant to which D4 Holdings agreed to provide us and subsidiaries an additional line of credit in a principal amount of $1,000,000. In connection with the Second Loan Agreement, we issued D4 Holdings a warrant to purchase up to 4,000,000 shares of our common stock at an exercise price of $0.1312 per share. We have drawn down all amounts available to be borrowed under the two lines of credit.
On March 2, 2011, we and our subsidiaries entered into the Third Loan and Security Agreement, or the “Third Loan Agreement”, with D4 Holdings, pursuant to which D4 Holdings agreed to provide us and our subsidiaries an additional line of credit in a principal amount of $1,600,000. Pursuant to the terms of the Convertible Promissory Note, or the “Convertible Note”, issued by us in connection with the Third Loan Agreement, D4 Holdings may elect to convert all or any portion of the outstanding principal amount under the Convertible Note into that number of shares of our common stock determined by dividing such principal amount by $0.08 (as may be adjusted under the terms of the Convertible Note). Simultaneous with our entering into the Third Loan Agreement, D4 Holdings and we entered into an amendment of the First Loan Agreement, pursuant to which (among other things) the maturity date for repayment of principal under the First Loan Agreement was extended from March 1, 2011, to March 1, 2012, and subsequently extended by oral agreement of the parties to July 1, 2012, and then subsequently orally extended again to January 2, 2014, pending the parties finalizing and entering into a formal amendment. In connection with the Third Loan Agreement, we issued D4 Holdings a warrant to purchase up to 1,000,000 shares of our common stock at an exercise price of $0.096 per share. We have drawn down the aggregate principal amount available under the Third Loan Agreement, the principal amount of which can be converted by D4 Holdings into an aggregate of 20,000,000 shares of our common stock.
On September 12, 2011, we and our subsidiaries entered into the Fourth Loan and Security Agreement, or the “Fourth Loan Agreement”, with D4 Holdings, pursuant to which D4 Holdings agreed to provide us and our subsidiaries an additional line of credit in a principal amount of $300,000. We have drawn down all amounts available to be borrowed under the Fourth Loan Agreement.
On November 13, 2012, we and our subsidiaries entered into the Third Amendment to Loan and Security Agreements, or the "Third Amendment", and the Amendment to Warrant Agreements, or the "Warrants Amendment", with D4 Holdings. Pursuant to the Third Amendment and the Warrants Amendment:
·the maturity date for repayment of principal under the First Loan Agreement was extended to January 2, 2014;
·the maturity date for repayment of principal under the Second Loan Agreement was extended to January 2, 2015;
·the maturity date for repayment of principal under each of the Third and Fourth Loan Agreements was extended to January 2, 2016;
·all interest outstanding under each of the loan agreements was added to the principal amount outstanding under the respective loan agreement and the promissory notes issued pursuant to each respective loan agreement was increased by such amount; and
·the exercise price under each of the Warrant Agreements entered into by us and D4 Holdings as of February 12, 2009, August 10, 2010, and March 2, 2011 was amended to $0.02 per share.
In connection with the extension of the maturity dates under the Third Amendment, we issued to D4 Holdings a warrant, exercisable for ten years, to purchase up to 10,000,000 shares of our common stock at an exercise price of $0.02 per share.
Interest payments under the First, Second and Third Loan Agreements are required to be made monthly through the maturity date of each respective loan. In March 2012, D4 Holdings orally agreed to permit us to defer such monthly interest payments for periods in which our cash flows from operations were insufficient to make such payments. However, D4 Holdings has not formally agreed to defer such interest payments for future periods.
In January 2014, we failed to repay the outstanding principal and accrued interest under the First Loan Agreement on its maturity date. On March 28, 2014, we and our subsidiaries entered into a Forbearance Agreement with D4 Holdings, or the Forbearance Agreement, pursuant to which D4 Holdings agreed to forbear from taking any enforcement action under our loan agreements with D4 Holdings resulting from our failure to meet our repayment obligations under the First Loan Agreement until the earliest of (i) December 31, 2014, (ii) repayment in full of all obligations under the First Loan Agreement, (iii) the occurrence of any breach of our obligations under the Forbearance Agreement, or (iv) the occurrence of any additional default under our loan agreements with D4 Holdings. In connection with the Forbearance Agreement, we issued to D4 Holdings a warrant, exercisable for ten years, to purchase up to 10,000,000 shares of our common stock at an exercise price of $0.02 per share.
Industry Background
VoIP technology translates voice into data packets, transmits the packets over data networks such as the Internet or privately managed networks (such as our network), and reconverts them into voice at the destination. Unlike traditional telephone networks, VoIP does not use dedicated circuits for each telephone call; instead, the same VoIP network can be shared by multiple users for voice, data and video simultaneously. This type of data network is more efficient than a dedicated circuit network because the data network is not restricted by the one-call, one-line limitation of a traditional telephone network and, as a result, greater traffic can be transmitted over this data network. This improved efficiency creates cost savings that can be passed on to consumers in the form of lower rates or retained by the VoIP provider. Significant cost savings are also achieved for international telephone calls carried over data networks primarily because they bypass the international settlement process, which represents a significant portion of international long distance tariffs. Additionally, VoIP allows for features that are not available on traditional telephony networks - particularly at the consumer level - including voice mail to email forwarding, find me/follow me, web-based control of call forwarding preferences, user account review/revision and a host of other features and functions.
Beyond cost savings, we believe that VoIP telephony technologies will further the potential for the Internet to become the preferred medium of communications and commerce. As a result, VoIP has experienced significant growth in recent years due to:
•improved quality and reliability of VoIP calls due to technological advances, increased network development and greater bandwidth capacity;
•new product development that allows VoIP providers to offer services not currently offered by traditional telephone companies;
•greatly improved ease of use, whereby the end-user does not perceive a difference between use of a traditional telephone and a broadband telephone;
•increasing demand for long distance communication services driven by the increased mobility of the global workforce; and
•increasing demand for lower cost telephone service around the world..
As a result of these growth trends, various service providers, enterprises and consumers are continuing to procure offerings from VoIP providers such as deltathree. Specifically, consumers in emerging markets are increasingly using VoIP-enabled services, such as IP telephones, to realize significant cost savings on long distance and international calls, while in markets where a significant number of consumers have access to broadband internet services these consumers are increasingly viewing VoIP as a viable and more affordable substitute for their traditional voice telecommunications provider. In addition, as broadband connectivity has become more available and less expensive around the world, it is now possible for providers like us to offer video as well as voice services to businesses and residential consumers.
Our Products and Services
Products
We have built a privately-managed, global network using IP technology and offer our customers a suite of IP video and voice products. Our products include:
joip Mobile Application. Our joip Mobile application is a cellular phone application providing low cost mobile calls over 3G cellular networks as well as WiFi networks. Cellular operating systems supported by joip Mobile currently include the iPhone, Google Android, Nokia Symbian and Blackberry.
Digital Video and Voice-over-IP Services. Through the use of our network we offer a white-label solution in which our customers have the ability to customize, implement and rapidly launch digital next generation communications offerings with minimal risk and investment. For our potential partners, we offer a full spectrum of service provider back-end support services, including network management, billing, provisioning, e-commerce as well as custom web and application development.
Broadband Phone. Our Broadband Phone product is a phone replacement solution available to business and retail customers over the "last mile" through broadband connections via cable modem, DSL or fixed wireless. In addition to offering capabilities similar to those offered by traditional telephony providers and allowing users to use their existing phone, Broadband Phone enables a user to conveniently operate features and retrieve voice mail through email, web or a phone interface.
PC-to-Phone. Our PC-to-Phone offering enables a user to conveniently and inexpensively place a call to a standard telephone anywhere in the world directly from a personal computer while remaining on-line.
Services
We provide a robust set of value-added services that enables us to address the challenges that have traditionally made the provision of telecommunications services difficult. These operations management tools include the following:
•video mail: we provide a video mail feature for our video phone applications;
•account provisioning: we provide our service provider and reseller customers with a dedicated Web page through which they can order additional services or accounts, generate and activate PINs and perform other customary implementation functions;
•payment processing systems: we provide our customers with a fraud detection and prevention system to permit secure credit card transactions over the Web;
•billing and account management: we provide our customers with real-time, Web-based access to billing records to check billing and usage information or to increase prepaid accounts;
•customer care: we have moved and consolidated traditional first tier customer care functions onto the Web for ease and flexibility and support this with second tier customer care; and
•network operations care: we provide a Network Operations Center, or NOC, automated trouble ticket system, which enables our customers to submit, manage, and follow-up with technical questions and issues online.
The provision of VoIP products and services through our service provider and reseller sales channel and our direct-to-consumer channel accounted for 85.7% and 12.4% of our total revenues in 2013, respectively.
Our Distribution Channels
We market, support and distribute our products and services to tens of thousands of active users around the globe through our service provider and reseller channel and our direct-to-consumer channel.
Service Provider and Reseller Channel
We have developed high-value solutions for the large number of service providers and resellers that are focused on providing their customers with video and voice-over-IP products and services.
Our Hosted Consumer VoIP Solution leverages our VoIP experience and delivers to our service providers, resellers, and various corporate customers a customizable, private-label suite of VoIP products and services. Using our infrastructure, we enable these enterprises to offer their customers different combinations of our basic products and services, accessible through a single account.
Direct-to-Consumer Channel
Our direct-to-consumer channel includes our joip Mobile application, which is a cellular phone application providing low cost mobile calls over 3G cellular networks as well as WiFi networks, and our iConnectHere offering, which provides VoIP products and services directly to consumers and small businesses online.
joip Mobile. joip Mobile is our cellular phone application providing low cost mobile calls over 3G cellular networks as well as WiFi networks. We market and sell joip Mobile directly to consumers as well as through affiliates and our affiliate program. In addition, ACN sells a private label version of joip Mobile under the ACN Mobile World brand.
iConnectHere. iConnectHere demonstrates our products, services and hosting capabilities to our reseller customers and service providers. Through iConnectHere, an account holder can access all of our product offerings, including our mobile application, Broadband Phone and PC-to-Phone. Additionally, iConnectHere permits us to collect usage information on our products and services and enables us to provide our service provider and reseller customers with key information and recommendations regarding implementation of our products and services.
Through iConnectHere, consumer users can:
•sign up for any of our services, including our mobile application, Broadband Phone, PC-to-Phone;
•download our software and/or order IP-based Broadband Phone devices;
•recharge their accounts, either by entering their credit card information or authorizing automatic recharging;
•send a PC-to-Phone call;
•check real-time billing and usage information;
•communicate by e-mail with a customer service representative; and
•view answers to frequently-asked questions.
Our Strategy
Our strategy is to become a leading worldwide next generation service provider and enabler of video and voice-over-IP products and services, and to either sell our products and services on a white-label basis to other customers (who can then resell these products and services) or enter into affiliate agreements with different third parties pursuant to which such third parties refer potential subscribers to our products and services. The following are key elements of our strategy:
Capitalize on the Growth of the Video and Voice-over-IP Marketplace. We believe we are well positioned to take advantage of the expected growth of the video and voice-over-IP services markets. We plan to focus our efforts and resources on increasing our share of the next generation service provider and enabler market while simultaneously maintaining our reseller business. We also allow our direct consumers to sign up for one account and choose a number of next generation communication services and products linked to that account.
Offer Flexible and Modular Deployment Alternatives. We offer our service providers and resellers a choice of deployment alternatives ranging from full outsourcing to partial outsourcing through our modular offering suite. Depending on the particular needs of each of our customers, we design our offering to fit within their business objectives, available resources and desired level of participation. We can develop and integrate specific features and functions into our package, such as various network elements, access components, fulfillment, and the specific feature/functions the provider can offer to its end-users.
Pursue Strategic Relationships. In addition to our strategy and actions to grow organically as described above, we also actively evaluate and pursue appropriate strategic relationships that we believe will continue to expand our customer base and grow our revenues. As discussed above under “ - Transactions with D4 Holdings”, in February 2009 we consummated a transaction with D4 Holdings pursuant to which we sold 39,000,000 shares of our common stock and a warrant to purchase up to an additional 30,000,000 shares of our common stock. D4 Holdings is a private investment fund whose ownership includes owners of ACN, a direct seller of telecommunications services. In October 2010 we entered into a sales agency agreement with ACN pursuant to which ACN sells a private label version of joip Mobile under the ACN Mobile World brand. In December 2010 we entered into an agreement with ACN Korea, a wholly-owned subsidiary of ACN, pursuant to which we provide digital video and voice-over-IP services in Korea. In April 2011 we entered into an introducer agreement with ACN Europe B.V., a wholly-owned subsidiary of ACN, pursuant to which ACN Europe refers potential customers in different countries in Europe to a private label version of joip Mobile sold under the ACN Mobile World brand. As a result of the investment in our company by D4 Holdings, we expect to continue to seek opportunities to provide services to ACN and enter into other commercial transactions that give us access to ACN’s international marketing and distribution capabilities.
Sales and Marketing
We sell and market our products and services through our service provider and reseller channel and our direct-to-consumer channel. In general, our sales and marketing activities include:
•developing, deploying and supporting local-specific product features and services, such as multiple language capabilities, different currency capabilities, and various payment methods;
•engaging in strategic relationships with customers (including licensed providers);
•entering into relationships with affiliates that sell our products and services, generally as part of our affiliate programs; and
•using various on-line advertising and search strategies to target and optimize sales efforts.
Service Provider and Reseller Channel
Service Providers. Our experience in deploying sophisticated solutions provides us with leverage as we introduce these services to other service providers.
Reseller Program. Through our reseller program, we contract with smaller service providers and resellers around the world, which in turn sell our products and services under their own brand, a white-label brand or our deltathree brand to retailers, businesses, Internet cafés and others in their local markets. Our experience in providing differentiated VoIP solutions in the emerging international telecommunications environment enables us to effectively enter new markets as they open to competition.
Direct-to-Consumer Channel
joip Mobile. Our joip Mobile application is provided by us directly to consumers as well as through our affiliate program. In addition, ACN sells a private label version of joip Mobile under the ACN Mobile World brand through its independent sales representatives. Finally, we offer the joip Mobile application on a white-label basis to other customers.
iConnectHere. iConnectHere provides VoIP products and services directly to consumers and small businesses online. Through iConnectHere, an account holder can access all of our product offerings, including our mobile application, Broadband Phone and PC-to-Phone.
Our Infrastructure
Network
In order to deliver our products and services, we operate a privately-managed IP network. By managing our own network, we have the ability to regulate traffic volumes and to directly control the quality of service from each originating point of presence, or POP, to the termination point via a variety of termination options. Our ability to interconnect to a wide variety of termination options increases the diversity and robustness of our network, minimizes and eliminates single points of failure, and simultaneously allows us to benefit from pricing differences between vendors to the same termination points. In addition, our network allows us to avoid the significant transmission delays associated with the Internet, which may impede delivery of high quality, reliable services to our users.
In 2001, we introduced our SIP infrastructure. The SIP protocol is one of the most advanced VoIP protocols and, unlike its predecessors, which were modeled after traditional telephony protocols, SIP has the ability to scale with a distributed architecture and at a lower cost. SIP’s superior attributes also include faster and more cost effective development and lower hardware requirements, which allows us to incur lower capital expenditure costs. Our SIP network currently powers all of our offerings. In recent years, we have continued our pioneering efforts in SIP and these efforts have yielded significant new releases. For example, in 2007 we released a next generation SIP-based PC-to-Phone application, certified many new devices which function as access points to our services, and added new features and new calling plans to our offerings. In 2009 we began the process of expanding the suite of our communications offerings into the global video phone services market.
Our network is built around a high availability backbone that connects New Jersey, Atlanta, London, Seoul and Sydney. In each of, and between, these locations we maintain multiple interconnections or peering arrangements with Internet backbone and voice providers. These points are strategically located to allow access from our network to and from the Internet with a high level of performance. While operating as a private extension of the Internet, our backbone has a high level of security designed to isolate it from security threats found on the public Internet. During 2013 we migrated some of our services to the "cloud" and intend to shut down our facilities at one or more of these locations during 2014.
Access to our network is possible through several products and services. A call can originate from a mobile phone using our joip Mobile application, the PC-to-Phone product using our downloadable software application “soft-phones,” a Web browser, or Broadband Phone devices. These calls enter our network from the Internet through our interconnection points.
Our network can terminate calls through our and our termination providers’ POPs. Termination decisions are based on a sophisticated routing system that applies routing rules based on origination point, termination cost and other factors. These rules are consistently updated to ensure a high level of quality and economic efficiency. Each termination port is carefully managed with capacity planning tools and techniques to provide cost-effective service to customers, along with multiple termination options to ensure the highest possible levels of redundancy.
We are a party to service agreements with several telecommunications providers, including foreign telephone companies, Internet backbone providers and others. Pursuant to these agreements, we can transport video and voice data packets to our hubs and terminate calls throughout the world in a cost effective and efficient manner.
Support
Our NOC monitors and manages our network from a central location, seven days a week, 24 hours a day. The NOC monitors all aspects of our network, including the routers, databases, switches, leased lines, Internet connections, gatekeepers and gateways to ensure that they are functioning at optimal levels. In the event of a failure of any of these network components, NOC personnel are provided with a real time, systems-generated notification via an instant messaging system consisting of pagers, cellular phones, screen pop-ups and e-mail that identifies the malfunction so that proper measures can be taken to restore service in a timely fashion. Our NOC utilizes a combination of industry technologies as well as unique applications developed by us. The NOC serves all of the different parts of our operations environment, including network nodes, Web servers and specific applications.
We provide customer support on various levels to different customers. With respect to our service provider and reseller customers, we provide customer care and technical support directly to these customers and they in turn provide their own support directly to the end-users. Customers of joip Mobile and iConnectHere receive technical support and customer care through e-mail support.
Our services are supported by our on-line interactive customer service and billing center, which enables an end-user to set up an account, receive an account number and a PIN, pay by credit card for services, find answers to frequently asked questions and contact customer service representatives. Once a user has established an account, the user can prepay for additional usage by credit card as well as access real-time detailed information such as call logs and transaction records. Through the on-line billing system, a user can personalize the billing information to select the data most relevant to them. This on-line interactive customer service and billing center is supported by a human customer care contact center that provides voice, e-mail and instant messaging support to the customers.
Suppliers
We outsource to third-party vendors the provisioning of certain of our local telecommunications services, including local phone numbers, access to the public switched telephone network, or PSTN, operator assistance, directory listings and assistance, E-911 emergency services and local number portability. We also outsource the development of our applications and certain of the features ancillary to our services, as well as provisioning of our consumer premises equipment, such as our analog telephone adapters, IP Phones and gateways, and certain aspects of our customer care services. We do not rely on any one specific vendor for providing these services, except for E-911 emergency services and certain specific services of customer care. While we believe our relations with our suppliers are good, we believe that we could replace our suppliers if necessary and that although our ability to provide services to our customers may be impacted in such a case we do not expect that this would have a material adverse affect on our business, financial condition and results of operation.
Proprietary Rights
We rely and expect to be able to rely on trademark and trade secret laws, confidentiality agreements and other contractual arrangements with our employees, strategic partners and others to protect our proprietary rights.
We have registered trademarks for “deltathree”, “deltathree making VoIP work for you”, “the IP Communications Network”, “iConnectHere”, “joip”, “joipy”, “joip just talk”, “Click It”, “iconnecthere.com” and other trademarks in the United States and internationally. In connection with our acquisition of the Go2Call businesses, we acquired the “Go2Call” trademark and a variety of trademarked derivatives of “Go2Call”. These trademarks may not provide adequate protection against competitive technology and may not be held valid and enforceable if challenged. We do not own any registered copyrights.
To further safeguard our intellectual property, we have a policy that requires our employees and contractors to execute confidentiality and assignment of inventions agreements when they begin their relationships with us.
Regulation
Regulatory Environment Overview
The use of the Internet and private IP networks to provide VoIP service is a relatively recent market development. Although the provision of such services is currently not as regulated as traditional telephony services within the United States, the Federal Communications Commission, or FCC, has applied some regulation to certain types of VoIP services and is reviewing whether to apply additional regulations to VoIP services. In addition, several foreign governments have adopted or proposed regulations that could restrict or prohibit the provision of VoIP services. Regulation of Internet telephony providers and services may materially and adversely affect our business, financial condition, operating results and future prospects, particularly if increased numbers of governments impose regulations restricting the use and sale of IP telephony services. In addition, to the extent we become required to contribute to regulatory funds and collect and remit regulatory fees, taxes and surcharges this will increases our costs, which may result in either our increasing the retail price of our service offerings or reducing our profitability.
Federal Regulation
Regulatory Classification of VoIP Services
Although there are several regulatory proceedings currently pending before federal authorities, providers of interconnected VoIP services are lightly regulated compared to providers of traditional telecommunications services. On February 12, 2004, the FCC initiated a generic rulemaking proceeding concerning the provision of voice and other services using IP technology, including assessing whether VoIP services should be classified as information services or telecommunications services. The rulemaking is ongoing and we cannot predict the outcome of this proceeding. In November 2004, the FCC determined that certain interconnected VoIP services (meaning VoIP services that can be used to send and receive calls to or from the PSTN), including some services that are similar to ours, should be considered interstate services subject to federal rather than state jurisdiction. Although this ruling was appealed by several states, on March 21, 2007, the United States Court of Appeals for the Eighth Circuit affirmed the FCC’s determination.
The FCC’s generic rulemaking proceeding could result in the FCC determining, for instance, that certain types of Internet telephony should be regulated like basic telecommunications services. Thus, Internet telephony would no longer be exempt from more onerous telecommunications-related regulatory obligations, could potentially become subject to state telecommunications regulations, and could become subject to other economic regulations typically imposed on traditional telecommunications carriers.
VoIP E-911 Matters
On June 3, 2005, the FCC released an order and notice of proposed rulemaking concerning VoIP emergency 911 services. The order set forth two primary requirements for providers of interconnected VoIP services. The order applies to our iConnectHere and joip customers, or our direct consumers. We do not believe that we are responsible for compliance with this order when we sell our service wholesale to companies who then offer the service to retail end-users. We cannot predict whether we would be subject to any third-party litigation in connection with such customers who resell our services or whether the rules will be interpreted as applicable to those who wholesale interconnected VoIP services.
The order set forth two primary requirements for providers of interconnected VoIP services. First, the order requires providers of interconnected VoIP services like us to notify our retail customers of the differences between the emergency services available through our offerings and those available through traditional telephony providers. We also had to receive affirmative acknowledgment from some of our retail customers that they understand the nature of the emergency services available through our service. On September 27, 2005, the FCC's Enforcement Bureau released an order stating that the Enforcement Bureau will not pursue enforcement actions against interconnected VoIP providers that have received affirmative acknowledgement from at least 90% of their subscribers. We received affirmative acknowledgment from more than 95% of our relevant customers that they understand the nature of the emergency services available through our service, and thus we believe we are substantially in compliance with the first aspect of the FCC's June 3 order.
Second, the order required providers of interconnected VoIP services like us to offer enhanced emergency dialing capabilities, or E-911, to all of our retail customers by November 28, 2005. Under the terms of the order, we are required to use the dedicated wireline E-911 network to transmit customers' 911 calls, callback number and customer-provided location information to the emergency authority serving the customer's specified location. On November 7, 2005, the FCC's Enforcement Bureau issued a Public Notice with respect to that requirement. The Public Notice indicated that providers who have not fully complied with the enhanced emergency dialing capabilities requirement are not required to discontinue the provision of services to existing customers, but that the FCC expects that such providers will discontinue marketing their services and accepting new customers in areas in which the providers cannot offer enhanced emergency dialing capabilities where such capabilities are otherwise available.
Almost all of our retail customers currently receive E-911 service in conformity with the FCC’s order. Like many interconnected VoIP providers, we rely on third parties to route emergency calls originated by our customers. In certain instances and for some of our customers, the third party provider may route 911 calls to an unofficial emergency call center. Such unofficial call centers may not be able to receive appropriate call back information. To the extent that they are so able or callers provide their location information the emergency dispatchers in such call centers may not then be able to route such calls to the appropriate public safety answering point. The FCC could find that routing calls in this manner violates its rules, potentially subjecting us to enforcement actions including, but not limited to, fines, cease and desist orders, or other penalties. Moreover, some customers who were receiving service prior to the FCC’s deadline for compliance with the E-911 regulations may not receive such service. The FCC permitted service providers to continue to provide service to those existing customers rather than disconnect those customers. Pursuant to the FCC’s requirement, after the implementation of the FCC E-911 requirements, we provide services to our new retail customers only where we can provide the FCC required E-911 service. We may be required to stop serving those customers to whom we cannot provide the required enhanced emergency dialing capabilities that were being serviced prior to the issuance of the FCC’s rules at any time.
The FCC is considering modifying its VoIP E-911 rules. In June 2007, the FCC released a Notice of Proposed Rulemaking to consider whether it should impose additional obligations on interconnected VoIP providers. Specifically, the FCC considered mandating that interconnected VoIP providers implement a solution that will allow for automatically determining the location of their customers for purposes of E-911 rather than require customers to manually update their existing location information (as is the case under the current regulations). Moreover, the Notice included a tentative conclusion that interconnected VoIP providers that allow their service to be used in more than one location, like us, be required to meet the same customer location accuracy standards applicable to providers of mobile telecommunications services. In September 2010, the FCC released a Notice of Inquiry again requesting comment on, among other issues, whether interconnected VoIP providers should be required to provide automatic location information about their customers rather than requiring customers to self-report their location. Additionally, the Notice of Inquiry sought comment on whether the FCC’s rules concerning the delivery of emergency services should be extended to non-interconnected VoIP services as well as to mobile VoIP applications used on smartphones, computers and other devices. At this time we cannot predict the outcome of these proceedings or their potential impact on our business.
See “State and Local Regulation” below for a discussion of fees we may collect in the future in connection with providing E-911.
Communications Assistance for Law Enforcement Act
The Communications Assistance for Law Enforcement Act, or CALEA, requires certain communications service providers to assist law enforcement agencies in conducting lawfully authorized electronic surveillance. On September 23, 2005, the FCC released an order concluding that CALEA applies to interconnected VoIP providers. In May 2006 the FCC released an order finding that broadband Internet access service providers and interconnected VoIP providers are required to implement the same type of CALEA requirements that have been applied to wireline telecommunications carriers. These include obligations to (1) ensure that communications equipment, facilities, and services meet interception assistance capability requirements and (2) develop system security policies and procedures to define employee supervision and record retention requirements. As a result of the steps we have taken, we believe that we comply with CALEA.
Universal Service Fund
The FCC decided in June 2006 that interconnected VoIP service providers should be required to contribute to the universal service fund, or USF. The amount of universal service contribution for interconnected VoIP service providers is based on a percentage of revenues earned from end-user interstate services. The FCC developed three alternatives under which an interconnected VoIP service provider may elect to calculate its universal service contribution: (1) a safe harbor that assumes 64.9% of the provider’s end-user revenues are interstate; (2) a traffic study to determine an allocation for interstate end-user revenues; or (3) actual interstate and international end-user revenues. If an interconnected VoIP service provider calculates its universal service contributions based on its actual percentage of interstate calls, the FCC suggested that its preemption of state regulation of such services may no longer apply, in which case the interconnected VoIP service provider could be subject to regulation by each state in which it operates as well as federal regulation. In addition, the FCC is considering a number of proposals that could alter the way that the USF is assessed. For instance, the FCC is considering an assessment based on the use of telephone numbers. The U.S. Congress may also provide the FCC with additional authority to reform USF or mandate a particular methodology. At this time we cannot predict what impact, if any, USF reform may have on our business.
Numerous states may attempt to impose state universal service contribution requirements on interconnected VoIP providers such as deltathree. At this time, various states - including Kansas, Nebraska and New Mexico - claim that they have the right to require interconnected VoIP providers to contribute to their respective USF funds. On March 3, 2008, the U.S. District Court for Nebraska issued a preliminary injunction and found that Nebraska's state Public Service Commission does not have jurisdiction to require Universal Service contributions from VoIP providers. On May 1, 2009, a panel of the U.S. Circuit Court of Appeals for the Eighth Circuit affirmed the U.S. District court ruling. In response, the Nebraska and New Mexico state commissions filed a petition with the FCC seeking the authority to impose state USF contribution obligations on interconnected VoIP providers, like us, and the FCC granted the petition. As a result of this ruling, a number of other states have either stated that offerings such as ours may be subject to their respective state USF or are considering imposing such obligations on us. We would likely pass through to our customers in those states any such state USF fees, potentially making our services less competitive with offerings available from traditional providers of telecommunications services, which may cause us to lose customers in those states. In addition, in the past some states have attempted to impose retroactive application of any state USF obligations. Retroactive applicability of any state USF fees would effectively bar us from collecting such fees from our customers, reducing our future profits.
Customer Proprietary Network Information
On April 2, 2007, the FCC issued an order that tightened existing rules on protection and use of Customer Proprietary Network Information, or CPNI, and extended coverage of the CPNI rules to interconnected VoIP service providers. Among other things, the Order imposes greater obligations on us and other companies like us to protect CPNI, acquire customer consent prior to engaging in certain kinds of marketing efforts based on CPNI, train our employees concerning protecting (and the use of) CPNI and to file formal certifications with the FCC regarding procedures for protecting this information. As a result of the steps we have taken, we believe that we comply with this Order.
Access for People with Disabilities
Effective October 5, 2007, interconnected VoIP providers like us became required to, among other things, make certain that their equipment and service is accessible to and usable by individuals with disabilities, if readily achievable. In addition, interconnected VoIP providers like us became obligated to contribute to the Telecommunications Relay Services, or TRS, fund and to offer 711 abbreviated dialing for access to relay services. Following March 31, 2009, interconnected VoIP providers are required to route such 711 calls to the appropriate TRS relay center serving the state in which the caller is located or the relay center corresponding to the caller’s last registered address. As a result of the steps we have taken, we believe that we comply with the applicable requirements.
Regulatory Fees
Effective November 2007, the FCC adopted an Order concerning the collection of regulatory fees for Fiscal Year 2007 requiring the collection of such fees from interconnected VoIP providers like us. Like other interconnected VoIP providers, we now pay regulatory fees based on interstate and international revenues.
Local Number Portability
On November 8, 2007, the FCC released an Order relating to local number portability imposing local number portability, or LNP, and related obligations on interconnected VoIP Providers like us. The Order requires interconnected VoIP providers to contribute to shared numbering administration costs. Additionally, the Order mandates that we process certain kinds of telephone number porting requests within certain timeframes. As a result of the steps we have taken, we believe that we comply with this Order. Subsequently, on May 13, 2009, the FCC released another order concerning LNP that further reduces the porting timeframe for certain types of telephone number porting requests that interconnected VoIP providers, like us, have to process. Since we are not a licensed telecommunications carrier, we must rely on third parties to comply with these porting obligations. If these third parties fail to comply with these obligations we could be subject to fines, forfeitures and other penalties by the FCC or state public utilities commissions or we could face legal liability in state or federal court from customers or carriers. The FCC also released a Further Notice of Proposed Rulemaking to refresh the record on how to further improve the porting process, and how to potentially expand the new one business day porting timeframe to other kinds of ports. We cannot predict the outcome of this proceeding or its potential impact on us at this time.
Intercarrier Compensation
The FCC is actively considering reform of the intercarrier compensation system, which is a set of FCC rules and regulations by which telecommunications carriers compensate each other for the use of their respective networks. These rules and regulations affect the prices we pay to our suppliers for access to the facilities and services that they provide to us, such as termination of calls by our customers onto the public switched telephone network. At this time we cannot predict what impact, if any, new intercarrier compensation regulations would have on our business.
Discontinuance Requirements
In May 2009, the FCC extended discontinuance rules that apply to non-dominant common carriers to interconnected VoIP providers, like us. The FCC's rules require non-dominant domestic carriers to provide notice to customers at least 30 days prior to discontinuing service to a telephone exchange, toll stations serving a community in whole or in part, and other similar activities that affect a community or part of a community. Carriers must inform certain state authorities of the discontinuation, and obtain prior FCC approval before undertaking the service disruption. The FCC's rules allow for streamlined treatment for FCC discontinuance approvals and interconnected VoIP providers will be able to take advantage of the same streamlined procedures afforded to non-dominant carriers. It is not yet clear how these rules apply to interconnected VoIP providers. But in the event we discontinue one of our service offerings in its entirety or if we were to exit the market in whole we would likely have to comply with these new rules. We do not expect these new obligations to have a material impact on our business.
Katrina Reporting Requirements
In June 2007, the FCC adopted various recommendations from its Independent Panel Reviewing the Impact of Hurricane Katrina on Communications Networks Panel, including a requirement that certain interconnected VoIP providers submit reports regarding the reliability and resiliency of their 9-1-1 systems. At this time, we are not subject to these reporting requirements but may become subject in the future.
Open Internet, or “Net Neutrality”, Obligations
We rely upon providers of broadband Internet access services to offer our services to our customers. The FCC recently adopted “open Internet” rules that would, among other things, prohibit fixed providers of broadband Internet access services from blocking, impairing or downgrading such access. Wireless providers of broadband Internet access services would be prohibited from blocking VoIP applications like ours. The open Internet rules are not yet effective and, as a result of both legislative efforts to overturn the rules as well as potential appeals of the passage of the rules, it is unclear whether (and when) the rules will become effective. While we are not aware of any provider of broadband Internet access attempting to interfere with our Internet access, the lack of enforceable rules could potentially negatively impact our service offerings and impede our ability to offer new services that require significant Internet bandwidth.
State and Local Regulation
Some state and local regulatory authorities believe they retain jurisdiction to regulate the provision of, and impose taxes, fees and surcharges on, intrastate Internet and VoIP telephony services, and have attempted to impose such taxes, fees and surcharges, such as a fee for providing E-911 service. Rulings by the state commissions on the regulatory considerations affecting Internet and IP telephony services could affect our operations and revenues, and we cannot predict whether state commissions will be permitted to regulate the services we offer in the future.
We paid approximately $35,000 of state and local taxes and other fees during 2013. To the extent we increase the cost of services to our customers to recoup some of the costs of compliance this will have the effect of decreasing any price advantage we may have over traditional telecommunications companies.
In addition, it is possible that we will be required to collect and remit taxes, fees and surcharges in other states and local jurisdictions and which such authorities may take the position that we should have collected. If so, they may seek to collect those past taxes, fees and surcharges from us and impose fines, penalties or interest charges on us. Our payment of these past taxes, fees and surcharges, as well as penalties and interest charges, could have a material adverse effect on us.
International Regulation
The regulatory treatment of Internet and Internet-based voice services, including IP telephony or VoIP, outside of the United States varies widely from country to country. A number of countries may prohibit Internet and IP telephony, while other countries expressly permit but regulate Internet and IP telephony. Some countries evaluate proposed Internet and IP telephony service on a case-by-case basis to determine whether any regulation is necessary or whether it should be regulated as a voice service or as another telecommunications or data service. Finally, in many countries neither Internet nor IP telephony have been addressed by legislation or regulatory action as of the date of this filing. Although we strive to comply with applicable international IP telephony regulations, we cannot be certain that we are in compliance with all of the relevant regulations at any given point in time.
In 2002, the European Commission adopted a set of directives for a new framework (Regulatory Framework) for electronic communications regulation that, in part, attempts to harmonize the regulations that apply to services regardless of the technology used by the provider. The Regulatory Framework was further amended in November 2009. Under the Regulatory Framework, there is no distinction in regulation made based upon technology between switched or packet-based networks. As a result, some types of IP telephony and VoIP services may be regulated like traditional telephony services while others may be subject to less stringent regulation. The European Commission has published a staff working paper aimed at clarifying the conditions applicable to providers of IP-based services. The working paper identifies various issues that may arise in relation to IP-based services including the regulatory classification of Internet telephony and VoIP under the Regulatory Framework. The European Regulators Group (consisting of regulators from European Union Member States and the European Commission) has adopted a Common Statement for VoIP regulation. The European Commission currently is reviewing how IP telephony services fit into the Regulatory Framework and analyzing other issues associated with IP telephony, such as access to numbering resources and provision of emergency services. Although the European Commission has recommended that a “light touch” to regulation be taken, we cannot predict what future actions the European Commission, Member States, and courts reviewing the Regulatory Framework may take regarding IP telephony and related matters, or what impact, if any, such actions may have on our business.
Based on the European Commission's current position, we believe that most providers of IP telephony would be subjected to no more than minimal regulation such as a general authorizations or declaration requirements that may be imposed by the European Union Member States. Several Member States have issued statements or regulations concerning IP telephony and VoIP while others have issued consultations requesting industry comments on the applicability of the Regulatory Framework to various IP telephony and VoIP services in their respective countries. However, since the Commission's findings on IP telephony are not binding on the Member States, we cannot assure you that the services provided over our network will not be deemed “voice telephony” subject to heightened regulation by one or more EU Member States. Although Member States are required to adhere to the Regulatory Framework, Member States may not take a uniform approach in regulating a particular Internet-enabled service including IP telephony. We cannot predict the manner in which Member States will regulate our particular services.
As we make our services available in foreign countries, and as we facilitate sales by our network partners to end-users located in foreign countries, such countries may claim that we are required to qualify to do business in the particular foreign country. Such countries may also claim that we are subject to regulation, including requirements to obtain authorization for the provision of voice telephony or other telecommunications services, or for the operation of telecommunications networks. It is also possible that such countries may claim that we are prohibited in all cases from providing our services or conducting our business in those countries. Failure to qualify as a foreign corporation in certain jurisdictions, or to comply with foreign laws and regulations, may adversely affect our business. In addition, we cannot predict how a regulatory or policy change of a particular country might affect the provision of our services.
Our network partners may also currently be, or in the future may become, subject to requirements to qualify to do business in a particular foreign country, comply with regulations (including requirements to obtain authorizations for the provision of voice telephony or other telecommunications services or for the operation of telecommunications networks) or cease providing services or conducting their business as conducted in that country. We cannot be certain that our network partners either are currently in compliance with any such requirements, will be able to comply with any such requirements, and/or will continue in compliance with any such requirements.
Other Regulation Affecting the Internet
The European Union has also enacted several directives relating to the Internet, including regulations that address online commerce and data protection. International governments are adopting and implementing privacy and data protection regulations that establish certain requirements with respect to, among other things, the confidentiality, processing and retention of personal subscriber information. The potential effect, if any, of these data protection rules on the development of our business remains uncertain.
Competition
We compete primarily in the market for enhanced video and VoIP telephony services, products, hosted solutions and infrastructure, and specifically in the VoIP service provider and reseller markets. This VoIP market is highly competitive and there are numerous competing providers. We believe that the primary competitive factors determining our success in the VoIP telephony market are: quality of service and network capacity; the ability to meet and anticipate customer needs through multiple service offerings and feature sets; customer services; and price.
Future competition could come from a variety of companies in the video and voice-over-IP industry. This industry includes major companies who have greater resources and larger subscriber bases than we have, and have been in operation for many years. In addition, many companies provide, or are planning to provide, some of the services we offer.
Revenues and Assets by Geographic Area
For the year ended December 31, 2013, approximately $14.7 million, or 91%, of our revenue was derived from international customers, and $1.4 million, or 9%, was derived from customers in the United States. Most of our long-lived assets are located in the United States. For more detailed information concerning our geographic segments, see Note 14 to our financial statements included elsewhere in this Annual Report.
Employees
As of December 31, 2013, we had 29 employees, of which 28 were located in Israel (7 of whom were part-time employees) and one was located in the United States. We consider our relationship with our employees to be good. None of our employees is covered by collective bargaining agreements.
Customers
In 2013, two customers accounted for approximately 72.4% of our gross revenues. Any significant decline in our sales to any of our material customers would likely have a material adverse effect on our business, operating results and financial condition.
Available Information
Our Internet address is www.deltathree.com. Through a link at the Investor Relations section of our website we make available, free of charge, our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports as soon as reasonably practicable after such materials have been electronically filed with, or furnished to, the SEC. The information on our website does not constitute a part of this annual report on Form 10-K.
ITEM 1A.
ITEM 1A. RISK FACTORS
Our business, financial condition and results of operations and the trading price of our common stock could be materially adversely affected by any of the following risks as well as the other risks highlighted elsewhere in this Annual Report, particularly the discussions about regulation, competition and intellectual property. Additional risks and uncertainties not presently known to us or that we currently deem immaterial also may impair our business operations.
Risks Related to our Company
We believe it is probable that we will need additional capital to continue our operations in the near term
We sustained significant operating losses in years prior to 2013, which led to a significant reduction in our cash reserves. As of December 31, 2013, we had negative working capital of approximately $7.5 million and negative stockholders’ equity of approximately $7.4 million. We believe it is probable that we will continue to experience losses and increased negative working capital and negative stockholders’ equity in the near future, and that we will not be able to return to positive cash flow before we require additional capital in the near term.
We believe that, unless we are able to increase our revenues, we will not have sufficient funds to continue our current operations over the foreseeable future if we do not receive additional financing. We may experience difficulties accessing the equity and debt markets and raising such capital, and there can be no assurance that we will be able to raise such additional capital on favorable terms or at all. In addition, as a result of D4 Holdings’ controlling interest in our company, D4 Holdings will be able to exercise a controlling influence over future issuances of capital stock or other securities by us and a third party may be deterred from investing in us.
We have a history of losses and we are uncertain as to our future profitability.
Except for the year ended December 31, 2012, in which we reported net income from operations of approximately $88,000 but a net loss from operations of $1.6 million, we have a history of significant, recurring losses since our inception, and we may continue to incur significant losses for the foreseeable future. We reported net losses of approximately $3.1 million in 2011, $1.6 million in 2012 and $1.8 million in 2013. As of December 31, 2013, our accumulated deficit was approximately $185 million. Our revenues may not grow or even continue at their current level. Going forward, we will need to increase our revenues and/or lower our current cost structure to reach profitability. If our revenues do not increase and/or if we are unable to reduce our expenses, we may not be able to reach profitability again. We cannot assure you that we will be able to reach profitability on a quarterly or annual basis in the future. These factors raise substantial doubt about our ability to continue as a going concern.
We may not be able to expand our revenue.
Our business strategy is to expand our revenue sources and our distribution channels in order to include the provision of video and VoIP telephony services to different customer groups. We can neither assure you that we will be able to accomplish this nor that this strategy will be profitable. Currently, our revenues are primarily generated by sales of our video and VoIP telephony products and services through our service provider and reseller sales channel and our direct-to-consumer channel. VoIP telephony from these channels generated 98.7%, 96.9% and 98.2% of our total revenues in 2011, 2012 and 2013, respectively.
We expect that our revenues for the foreseeable future will be dependent on, among other factors:
•sales of our video and voice-over-IP products and services;
•the public’s acceptance and use of video and voice-over-IP services;
•expansion of our service offerings;
•the effect of competition, regulatory environment, international long distance rates and access and transmission costs on our prices; and
•continued improvement of our global network quality.
Our business strategy assumes, among other things, that the voice-over-IP market generally and such market as it applies to mobile devices specifically will expand significantly. If this market does not expand significantly we may not be able to expand our revenues and successfully carry out our business strategy.
The global financial crisis may have an impact on our business and financial condition in ways that we currently cannot predict.
The continued financial crisis and related turmoil in the global financial system may have an impact on our business and our financial condition, as well as increase the risk of uncollectible accounts receivable from our customers. For example, our ability to obtain additional financing may be severely restricted at a time when we would like, or need, to do so, which could have an impact on our flexibility to react to changing economic and business conditions.
We are substantially dependent upon a few material customers, and any significant decline in our sales to those customers could have a material adverse effect on our business.
In 2013, two customers accounted for approximately 72.4% of our annual gross revenues. Any significant decline in our sales to any of our material customers would likely have a material adverse effect on our business, operating results and financial condition.
A continuing decline in telecommunications prices may cause us to lower our prices to remain competitive, which could prevent our future profitability.
International and domestic telecommunications prices have decreased significantly over the last few years in most of the markets in which we operate, and as a result our margins have decreased materially. We anticipate that prices will continue to be reduced in all of the markets in which we do business or expect to do business. Users who select our services (or our resellers’ or service provider customers’ services) to take advantage of the current pricing differential between traditional telecommunications prices and our (or our customers’) prices may switch to traditional telecommunications carriers as such pricing differentials diminish or disappear, and we will be unable to use such pricing differentials to attract new customers in the future. Such competition or continued price decreases may require us to lower our prices to remain competitive, may result in reduced revenue, a loss or decrease of customers and may prevent our future profitability.
Intense competition could reduce our market share and decrease our revenue.
The market for video and voice-over-IP services is extremely competitive. Our competitors include companies in the video and voice-over-IP industry. Many of our existing competitors and potential competitors have broader portfolios of services, greater financial, management and operational resources, greater brand-name recognition, larger subscriber bases and more experience than we have. In addition, our Internet competitors use the Internet instead of a private network to transmit traffic, and the operating and capital costs of these providers may be less than ours.
If we are unable to provide competitive service offerings, we may lose existing customers and be unable to attract additional customers. In addition, many of our competitors enjoy economies of scale that result in a lower cost structure for transmission and related costs, which cause significant pricing pressures within the industry. To remain competitive, we must continue to invest significant resources in research and development, sales and marketing, and customer support. We may not have sufficient resources to make these investments or to make the technical advances necessary to be competitive, which, in turn, will cause our business to suffer.
Fluctuations in our quarterly financial results may make it difficult for investors to predict our future performance.
Our quarterly operating results may fluctuate significantly in the future as a result of a variety of factors, many of which are outside our control. The factors generally within our control include:
•the rate at which we are able to attract users to purchase our video and voice-over-IP products and services;
•the amount and timing of expenses to enhance marketing and promotion efforts and to expand our infrastructure; and
•the timing of announcements or introductions of new or enhanced services by us.
The factors outside our control include:
•the timing of announcements or introductions of new or enhanced services by our competitors;
•regulations in various countries that prohibit us from providing our services cost-effectively or at all;
•technical difficulties or network interruptions in the Internet or our privately-managed network; and
•general economic and competitive conditions specific to our industry.
We face a risk of failure of computer and communications systems used in our business.
Our business depends on the efficient and uninterrupted operation of our computer and communications systems as well as those that connect to our network. We maintain communications systems in facilities in New Jersey, Atlanta, London, Seoul and Sydney. Although we have designed our network to reduce the possibility of disruptions or other outages, our systems and those that connect to our network are subject to damage or interruption from natural disasters, power loss, communications failure, hardware or software malfunction, network failures, physical or electronic break-ins, sabotage, computer viruses, intentional acts of terrorism or vandalism and other events that may be or may not be beyond our control. Any system interruptions that cause our services to be unavailable, including significant or lengthy telephone network failures or difficulties for users in communicating through our network or portal, could damage our reputation and result in a loss of users.
Our computer systems and operations may be vulnerable to security breaches.
We believe that the safety of our network and the secure transmission of confidential information over the Internet are essential to our operations and maintaining user confidence in our services. Although we have developed systems and processes that are designed to protect our network, the consumer information stored on our network, unauthorized use of our network and other security breaches, our computer infrastructure is potentially vulnerable to physical or electronic computer viruses, abuse of use, break-ins and similar disruptive problems and security breaches that could cause loss (both economic and otherwise), interruptions, delays or loss of services to our users. We rely on licensed encryption and authentication technology to effect secure transmission of confidential information, including credit card numbers. It is possible that advances in computer capabilities or new technologies could result in a compromise or breach of the technology we use to protect user transaction data. A party that is able to circumvent our security systems could misappropriate proprietary information, cause interruptions in our operations or utilize our network without authorization. Security breaches also could damage our reputation and expose us to a risk of loss, litigation and possible liability. While we have experienced isolated instances of unauthorized use of our network, and have responded to such events by taking steps to increase our network security, we cannot guarantee you that our security measures will prevent security breaches.
Operating internationally exposes us to additional and unpredictable risks.
We operate in many international markets, including the Middle East. There are certain risks inherent in doing business on an international basis, including:
•political and economic instability, including the risk of social unrest, war, civil war and armed conflict in the countries in which we operate;
•uncertainty regarding the ability of our resellers to resell our service in compliance with all laws, rules and regulations in such markets and actions by foreign governments or foreign telecommunications companies to limit access to our services;
•fluctuations in exchange rates;
•potentially adverse tax consequences;
•potentially weaker protection of intellectual property rights; and
•uncertain market acceptance and difficulties in marketing efforts due to language and cultural differences..
We need to retain key personnel to support our products and ongoing operations.
The marketing and operations of our products and services will continue to place a significant strain on our limited personnel, management, and other resources; this is particularly true following the significant decline in the number of our employees that occurred as a result of a reduction in force we effected during 2011 and an additional, smaller reduction in force that we instituted during December 2013, following which we have limited internal redundancy. Our future success depends upon the continued services of our executive officers and other key employees whom we rely upon to run our operations. Except for Mr. Effi Baruch, our Chief Executive Officer, President and Senior Vice President of Technology and Operations, none of our officers or key employees is subject to an employment agreement for any specific term. The loss of the services of any of these officers or key employees could impact our ability to run our operations and delay the development and introduction of, and negatively impact our ability to sell, our products, either of which could adversely affect our financial results. We currently do not maintain key person life insurance policies on any of our employees.
Our ability to provide our service and to comply with certain regulatory obligations is dependent in part upon third-party providers, facilities and equipment, the failure of which could cause delays or interruptions of our service, expose us to legal liability, damage our reputation, cause us to lose customers and limit our growth.
Our success depends on our ability to provide quality and reliable service, which is in part dependent upon the proper functioning of facilities and equipment owned and operated by third parties and is, therefore, beyond our control. Unlike traditional wireline telephone service or wireless service, our service requires our customers to have an operative broadband Internet connection and an electrical power supply, which are provided by the customer's Internet service provider and electric utility company, respectively, and not by us. The quality of some broadband Internet connections may be too poor for customers to use our services properly. In addition, if there is any interruption to a customer's broadband Internet service or electrical power supply, that customer will be unable to make or receive calls, including emergency calls, using our service. We also outsource several of our network functions to third-party providers. For example, we outsource the maintenance of our regional data connection points, which are the facilities at which our network interconnects with the public switched telephone network. If our third-party service providers fail to maintain these facilities properly, or fail to respond quickly to problems, our customers may experience service interruptions. We also outsource the development of several of our applications and features, and in some cases enter into license and support agreements with the applicable providers. If those providers seek to terminate our license and support agreements, we would need to find replacement providers, and our customers may experience service interruptions. In addition, our E-911 service is currently dependent upon a third-party provider. Interruptions in service from this vendor could cause failures in our customers' access to E-911 services. Finally, our service offerings that integrate with the public switched telephone network are wholly reliant on third party network service providers to originate and terminate substantially all of our calls to users of traditional telephone services. Interruptions in our service caused by third-party facilities or service providers have in the past caused and may in the future cause us to lose customers, or cause us to offer substantial customer credits, which could adversely affect our revenue and profitability. If interruptions adversely affect the perceived reliability of our service, we may have difficulty attracting new customers and our brand, reputation and growth will be negatively impacted.
Our emergency and E-911 calling services may expose us to significant liability.
Our emergency calling service and E-911 calling service are different from the corresponding services offered by traditional wireline telephone companies. These differences may lead to failures that would not occur for users of traditional telephony services. For example, providers of interconnected VoIP services, like us, must use components of both the wireline and wireless infrastructure in unique ways that can result in failure. Also, emergency services provided over the Internet can be adversely impacted by power outages and network congestion that do not necessarily have the same adverse impact on users of traditional telephone services. Emergency call centers may not be equipped with appropriate hardware or software to accurately process and respond to emergency calls received by consumers of interconnected VoIP services. Finally, users of nomadic interconnected VoIP services must manually update their location information, and failure to do so can result in dispatching of assistance to the wrong location. For these reasons, some of our customers do not receive emergency services in full compliance with the FCC rules. Any of these failures could result in enforcement action by the FCC, significant monetary penalties and restrictions on our ability to offer non-compliant services.
Third parties might infringe upon our proprietary technology.
We cannot assure you that the steps we have taken to protect our intellectual property rights will prevent misappropriation of our proprietary technology. To protect our rights to our intellectual property, we rely on a combination of trademarks and trade secret protection, confidentiality agreements and other contractual arrangements with our employees, affiliates, strategic partners and others. We may be unable to detect the unauthorized use of, or take appropriate steps to enforce, our intellectual property rights. Effective trademark and trade secret protection may not be available in every country in which we offer or intend to offer our services. Failure to adequately protect our intellectual property could materially harm our brand, devalue our proprietary content and affect our ability to compete effectively. Further, defending our intellectual property rights could result in significant financial expenses and managerial resources.
Third parties may claim that our services infringe upon their intellectual property rights.
Third parties have asserted and may assert claims that we have violated a patent or infringed a copyright, trademark or other proprietary right belonging to them and subject us to expensive and disruptive litigation. In addition, we incorporate licensed third-party technology in some of our products and services. In these license agreements, the licensors have agreed to indemnify us with respect to any claim by a third party that the licensed software infringes any patent or other proprietary right so long as we have not made changes to the licensed software. We cannot assure you that these provisions will be adequate to protect us from infringement claims. Any infringement claims and lawsuits, even if not meritorious, could be expensive and time consuming to defend; divert management’s attention and resources; require us to redesign our products, if feasible; require us to pay royalties or enter into licensing agreements in order to obtain the right to use necessary technologies; and/or may materially disrupt the conduct of our business.
Risks Related to our Industry
Government regulation and legal uncertainties relating to IP telephony could harm our business.
Historically, voice communications services have been provided by regulated telecommunications common carriers. We offer voice communications to the public for international and domestic calls using IP telephony, and we do not operate as a licensed telecommunications common carrier in many jurisdictions based on specific regulatory classifications and recent regulatory decisions. However, the growth of IP telephony has led to close examination of its regulatory treatment in many jurisdictions, making the legal status of our services uncertain and subject to change as a result of future regulatory action, judicial decisions or legislation in any of the jurisdictions in which we operate. Established regulated telecommunications carriers have sought and may continue to seek regulatory actions to restrict the ability of companies such as ours to provide services or to increase the cost of providing such services.
Application of new regulatory restrictions or requirements to us could increase our costs of doing business and prevent us from delivering our services through our current arrangements. In such event, we would consider a variety of alternative arrangements for providing our services, including obtaining appropriate regulatory authorizations for our local network partners or ourselves, changing our service arrangements for a particular country or limiting our service offerings. Such regulations could limit our service offerings, raise our costs and restrict our pricing flexibility, and potentially limit our ability to compete effectively. Furthermore, regulations and laws that affect the growth of the Internet could hinder our ability to provide our services over the Internet.
Our international operations are also subject to regulatory risks, including the risk that regulations in some jurisdictions will prohibit us from providing our services (or our resellers from reselling our services) cost-effectively or at all, which could limit our growth. Currently, there are several countries where regulations prohibit us and our resellers from offering service. We cannot assure you that these conditions will not have a material effect on our revenues and growth in the future. In addition, because customers can use our services almost anywhere that a broadband Internet connection is available, including countries where providing VoIP services is illegal, the governments of those countries may attempt to assert jurisdiction over us, which could expose us to significant liability and regulation.
We may not be able to keep pace with rapid technological changes in the communications industry.
Our industry is subject to rapid technological change, and we cannot predict the effect of technological changes on our business. We expect that new services and technologies will emerge in the market in which we compete. These new services and technologies may be superior to the services and technologies that we use and/or may render our services and technologies obsolete.
To be successful, we must adapt to our rapidly changing market by continually improving and expanding the scope of services we offer and by developing new services and technologies to meet customer needs. Our success will depend, in part, on our ability to license leading technologies and respond to technological advances and emerging industry standards on a cost-effective and timely basis. We will need to spend significant amounts of capital to enhance and expand our services to keep pace with changing technologies.
The success of our business is affected by customers' unimpeded access to broadband service. Providers of broadband services may be able to block our services, which could adversely affect our revenue and growth.
A portion of our customers must have broadband access to the Internet in order to use our service. Some providers of broadband access have taken measures that affect their customers' ability to use our service, such as downgrading the quality of the data packets we transmit over their lines, giving those packets low priority, giving other packets higher priority than ours, blocking our packets entirely or attempting to charge their customers more for also using our services. It is not clear whether suppliers of broadband access services have a legal obligation to allow their customers to access and use our service without interference. As a result of recent decisions by the U.S. Supreme Court and the FCC, providers of broadband services are subject to relatively light regulation by the FCC. Consequently, federal and state regulators might not prohibit broadband providers from limiting their customers' access to VoIP or otherwise discriminating against VoIP providers. Interference with our service or higher charges for using our service could cause us to lose existing customers, impair our ability to attract new customers, and harm our revenue and growth.
The FCC’s “open Internet” rules, which would partially address issues relating to blocking, impairing or downgrading our service by either fixed or wireless providers of broadband Internet access services, are not yet effective and, as a result of both legislative efforts to overturn the rules as well as potential appeals of the passage of the rules, it is unclear whether (and when) the rules will become effective. While we are not aware of any provider of broadband Internet access attempting to interfere with our Internet access, the lack of enforceable rules could potentially negatively impact our service offerings and impede our ability to offer new services that require significant Internet bandwidth.
We are not currently accepting customers in areas where we cannot provide E-911 service in conformity with the FCC’s rules. This has adversely impacted the ability of iConnectHere to accept new customers and may also have an adverse effect on our sales to customers who resell our service.
Various U.S. state and local fees, taxes and surcharges, as well as those for the European Union, may increase our costs and our customers' cost of using our services.
Some state and local regulatory authorities claim that they retain jurisdiction to regulate the provision of, and impose taxes, fees and surcharges on, intrastate Internet and VoIP telephony services, and have attempted to impose such taxes, fees and surcharges, such as a fee for providing E-911 service. A recent FCC ruling allows states to require providers of interconnected VoIP services, like us, to contribute to state USF programs. While the decision did not address retroactive liability, there is a possibility that certain states will seek to impose retroactive application of any state USF obligations. We would likely pass through to our customers in those states any such state USF fees, potentially making our services less competitive with offerings available from traditional providers of telecommunications services, which may cause us to lose customers in those states. In addition, it is possible that we will be required to collect and remit taxes, fees and surcharges in other states and local jurisdictions, and which such authorities may take the position that we should have collected. If so, they may seek to collect those past taxes, fees and surcharges from us and impose fines, penalties or interest charges on us. Our payment of these past taxes, fees and surcharges, as well as penalties and interest charges, could have a material adverse effect on us.
We paid approximately $35,000 of U.S. state and local taxes and other fees during 2013. To the extent we increase the cost of services to our customers to recoup some of the costs of compliance this will have the effect of decreasing any price advantage we may have over traditional telecommunications companies.
There may be risks associated with our ability to comply with funding requirements of the USF and similar state or federal funds as well as other FCC-mandated funding requirements or that our customers will cancel service due to the impact of these or other price increases to their service.
We began contributing to the USF during the fourth fiscal quarter of 2006 and began charging our customers a USF surcharge fee. In addition, we are required to collect and remit other FCC-related fees, such as the TRS fund and contributions towards local number portability, and the FCC and state public utilities commissions are considering subjecting interconnected VoIP providers like us to additional fees and surcharges. The impact of this price increase on our customers or our inability to recoup the costs or liabilities in remitting such fees as well as any future fees could have a material adverse effect on our financial position, results of operations and cash flows, or could cause some customers to cancel our service due to the loss of any price advantage we may have over traditional telecommunications companies.
Future legislation or regulation of our service offerings may increase our costs, which may result in either our increasing the retail price of our service offerings or reducing our profitability.
The FCC has several ongoing proceedings that could negatively impact us. Specifically, the FCC may reform the system of payments between companies that connect telephone companies and the methodology for contributing to the federal USF program. Such reforms may increase the charges we pay to other companies for handling our calls. The FCC may adopt more stringent E-911 obligations. This could result in us having to deploy new technologies or engage a third party to provide services in compliance with the new regulations, increasing our costs. The FCC may determine that some or all of our offerings are properly classified as “telecommunications” services subjecting our offerings to state and federal regulations, thereby increasing our compliance costs. The U.S. Congress, state legislatures, state regulatory commissions and foreign regulatory commissions could attempt to impose additional obligations on us at any time or reform existing law concerning the contribution methodology for regulatory fees and surcharges in a manner that negatively impacts us. We cannot predict the outcome of pending FCC proceedings or what actions such other governmental and regulatory bodies may take that may affect us.
Risks Related to our Relationship with D4 Holdings
D4 Holdings controls a majority of our common stock and has the ability to exercise control over all matters submitted to a stockholder vote.
D4 Holdings currently owns approximately 54.0% of the issued and outstanding shares of our common stock, holds warrants to purchase an aggregate of 55,000,000 shares of our common stock and can convert the principal outstanding under the Convertible Note into 20,000,000 shares of our common stock. Assuming the exercise of all warrants held by D4 Holdings and the conversion of outstanding principal under the Convertible Note, D4 Holdings beneficially owns 77.4% of our common stock. As long as D4 Holdings continues to beneficially own more than 50% of the voting power of our company, D4 Holdings will be able to exercise a controlling influence over decisions affecting us, including:
•composition of our board of directors and, through it, our direction and policies, including the appointment and removal of our officers;
•potential mergers, acquisitions, sales of assets and other significant corporate transactions;
•future issuances of capital stock or other securities by us;
•incurrence of debt by us;
•amendments, waivers and modifications to any agreements between us and D4 Holdings;
•payment of dividends on our capital stock; and
•approval of our business plans and general business development.
In addition, this concentration of ownership may discourage, delay or prevent a change in control of our company, which could deprive our stockholders of an opportunity to receive a premium for their common stock as part of a sale of our company or result in strategic decisions that could negatively impact the value and liquidity of our outstanding stock. D4 Holdings also has sufficient voting power to amend our organizational documents. Furthermore, conflicts of interest could arise in the future between us and D4 Holdings concerning, among other things, potential competitive business activities or business opportunities. D4 Holdings is not restricted from competitive activities or investments. We cannot provide assurance that the interests of D4 Holdings will coincide with the interests of other holders of our common stock. Also, four of our seven directors are affiliated with D4 Holdings. As a result, the ability of any of our other stockholders to influence the management of our company is limited, which could have an adverse effect on the market price of our stock.
The ownership of D4 Holdings includes owners of ACN, and we may engage in commercial transactions with ACN and its affiliated entities in the future.
D4 Holdings is a private investment fund whose ownership includes owners of ACN. Four of the members of our board of directors currently serve as officers and/or directors of ACN. Because ACN is a direct seller of telecommunications services, we may seek to engage in commercial transactions to provide services to ACN in the future. During the third quarter of 2009 we entered into an agreement with ACN Pacific Pty Ltd., a wholly-owned subsidiary of ACN, pursuant to which we provide digital video and voice-over-IP telecommunications services in Australia and New Zealand to ACN Pacific. In October 2010 we entered into a sales agency agreement with ACN pursuant to which ACN sells a private label version of joip Mobile under the ACN Mobile World brand. In December 2010 we entered into an agreement with ACN Korea, a wholly-owned subsidiary of ACN, pursuant to which we provide digital video and voice-over-IP services in Korea. In April 2011 we entered into an introducer agreement with ACN Europe B.V., a wholly-owned subsidiary of ACN, pursuant to which ACN Europe refers potential customers in different countries in Europe to a private label version of joip Mobile sold under the ACN Mobile World brand. Although we expect that the terms of any such transactions will be established based upon negotiations between employees of ACN and us and, when appropriate, subject to the approval of the independent directors on our board or a committee of disinterested directors, there can be no assurance the terms of any such transactions will be as favorable to us as might otherwise be obtained in arm’s length negotiations.
As a result of D4 Holding’s controlling interest in deltathree a third party may be deterred from attempting to acquire our company.
D4 Holding’s controlling interest in deltathree could delay, deter or prevent a third party from attempting to acquire control of us. This may have the effect of discouraging a third party from making a tender offer or otherwise attempting to obtain control of us, even though such a change in ownership would be economically beneficial to us and our stockholders.
Our stockholders may suffer dilution in the future in the event that D4 Holdings exercises any of the warrants or its right to convert outstanding principal amounts under the Convertible Note into shares of our common stock.
D4 Holdings currently holds warrants to purchase an aggregate of 55,000,000 shares of our common stock at exercise prices of $0.02 per share and can convert the principal outstanding under the Convertible Note into 20,000,000 shares of our common stock. In the event that D4 Holdings exercises any or all of the warrants or converts principal amounts outstanding under the Convertible Note into shares of our common stock, in full or in part, our existing stockholders may experience significant and immediate dilution.
Risks Related to our Common Stock
Volatility of our stock price could adversely affect our stockholders.
From the time that trading commenced in our common stock in November 1999, the market price of our common stock has been highly volatile and may continue to be volatile and could be subject to wide fluctuations in response to factors such as:
•the market price for the stock of our major competitors;
•variations in our actual or anticipated quarterly operating results or those of our competitors;
•announcements by us or our competitors of technological innovations;
•introduction of new products or services by us or our competitors;
•announcements by us or our competitors of significant acquisitions;
•our entry into strategic partnerships or joint ventures; and
•purchases and sales of our common stock by D4 Holdings.
All of these factors are, in whole or part, beyond our control and may materially adversely affect the market price of our common stock regardless of our performance.
Investors may not be able to resell their shares of our common stock following periods of volatility because of the market's adverse reaction to such volatility. In addition, the market price for shares of telecommunications, Internet-related and technology companies has dramatically decreased. We cannot assure you that our common stock will trade at the same levels of other telecommunications or Internet stocks.
Our common stock is quoted on the OTCQB, which may increase the volatility of our stock and make it harder to sell shares of our stock.
Our common stock is quoted on the OTCQB, which tends to be a highly illiquid market. There is a greater chance of market volatility for securities that trade on the OTCQB (as opposed to a national exchange or quotation system), as a result of which stockholders may experience wide fluctuations and a depressed price in the market price of our securities. Thus, stockholders may be required to either sell our securities at a market price which is lower than their purchase price or to hold our securities for a longer period of time than they planned. Because our common stock falls under the definition of “penny stock,” trading in our common stock may be limited because broker-dealers are required to provide their customers with disclosure documents prior to allowing them to participate in transactions involving our common stock. These rules impose additional sales practice requirements on broker-dealers that sell low-priced securities to persons other than established customers and institutional accredited investors; and require the delivery of a disclosure schedule explaining the nature and risks of the penny stock market. As a result, the ability or willingness of broker-dealers to sell or make a market in our common stock might decline, and stockholders could find it more difficult to sell their stock.
Risks Related to our Israel Operations
We may be negatively impacted by changes in political, military and/or economic conditions.
Since the establishment of the State of Israel in 1948, a number of armed conflicts have taken place between Israel and its Arab neighbors and a state of hostility, varying from time to time in intensity and degree, has led to security and economic problems for Israel. A peace agreement between Israel and Egypt was signed in 1979 and a peace agreement between Israel and Jordan was signed in 1994. However, as of the date hereof Israel has not entered into any peace agreement with Syria or Lebanon.
Negotiations between Israel and representatives of the Palestinian Authority in an effort to resolve the state of conflict have been sporadic and have failed to result in peace. The establishment in 2006 of a government in the Gaza territory by representatives of the Hamas militant group has created additional unrest and uncertainty in the region, and in each of December 2008 and November 2012 Hamas engaged in an armed conflict with Israel.
The recent political instability and civil unrest in the Middle East and North Africa (including the ongoing civil war in Syria) as well as the ongoing conflict between Iran and Israel have raised new concerns regarding security in the region and the potential for armed conflict or other hostilities involving Israel. We could be adversely affected by any such hostilities, the interruption or curtailment of trade between Israel and its trading partners, or a significant downturn in the economic or financial condition of Israel.
In addition, certain countries, companies and organizations continue to participate in a boycott of Israeli firms. We do not believe that the boycott has had a material adverse effect on us, but there can be no assurance that restrictive laws, policies or practices directed towards Israel or Israeli-based businesses will not have an adverse impact on our business or financial condition in the future.
Our costs of operations have at times been affected by changes in the cost of our operations in Israel resulting from changes in the value of the Israeli shekel relative to the U.S. dollar. Recently, the weakening of the dollar relative to the shekel has significantly increased the costs of our Israeli operations, stated in U.S. dollars.
Israel’s economy has been subject to numerous destabilizing factors, including a period of rampant inflation in the early- to mid-l980s, low foreign exchange reserves, fluctuations in world commodity prices and military conflicts. The Israeli Government has, for these and other reasons, intervened in the economy by utilizing, among other means, fiscal and monetary policies, import duties, foreign currency restrictions and control of wages, prices and exchange rates. The Israeli Government has periodically changed its policies in all these areas. Although we derive most of our revenues outside of Israel, a substantial portion of our expenses are incurred in Israel and are affected by economic conditions in the country.
All of these factors are, in whole or part, beyond our control and may materially adversely affect on our business, financial condition and operating results, or market price of our common stock regardless of our performance.
We may be negatively impacted by employees being called for army service.
Generally, all male adult citizens and permanent residents of Israel under the age of 45 are, unless exempt, obligated to perform up to 36 days of military reserve duty annually. Additionally, all such residents are subject to being called to active duty at any time under emergency circumstances. Furthermore, some of our officers and employees are currently obligated to perform annual reserve duty. While we have operated effectively under these requirements since we began operations, no assessment can be made as to the full impact of such requirements on our workforce or business if conditions should change, and no prediction can be made as to the effect on us of any expansion of such obligations. In addition, in the event of a military conflict or other attack on Israel, including the ongoing conflict with the Palestinians, these persons could be required to serve in the military for extended periods of time and on very short notice. The absence of a number of our officers and employees for significant periods could disrupt our operations and harm our business.
ITEM 2.
ITEM 2. PROPERTIES
We lease our executive offices at 26 Avenue at Port Imperial, West New York, New Jersey, and storage and equipment space at 117 Central Avenue, Hackensack, New Jersey. We lease each of these facilities on a month-to-month basis. The aggregate rent expense, net, for the two locations for 2013 was $6,000.
Delta Three Israel Ltd., a wholly-owned subsidiary of the Company, or the "Subsidiary", leases an office that houses the Company’s research and development facilities in Jerusalem, Israel. The term of the lease is until June 30, 2015. Rent expense, net, for our subsidiary, for 2013 was $143,000.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
On July 5, 2011, we received a notice from the New York City Department of Finance that claimed that we had not paid commercial rent tax required under the New York City Administrative Code from June 1998 through May 2008 for the two offices that we had leased during that time. The notice stated that we are obligated to pay the outstanding tax amounts, as well as significant interest and penalties that were assessed on the unpaid amounts as well as for the failure to file the applicable tax returns. We engaged outside counsel, which began discussions with the Department of Finance, and contested the assessment and simultaneously attempted to negotiate a significant reduction in the amounts to be paid. Our appeal was rejected in July 2012 by an examiner in the Department of Finance, and the Company has subsequently engaged and begun discussions with a manager in the Department of Finance and submitted additional supporting materials. The final outcome of this assessment and our negotiations with the New York City Department of Finance cannot be determined at this time. In the event that we are required to pay all or most of the amounts claimed by the New York City Department of Finance this would have a material adverse effect on our financial condition and liquidity. During 2011 we recorded $300,000 as a provision for commercial rent tax.
We are not a party to any other material pending legal proceedings, other than ordinary routine litigation incidental to the business, to which we are a party or of which any of our property is subject.
ITEM 4.
ITEM 4. (REMOVED AND RESERVED)
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Market Information
Our common stock is currently quoted and traded on the OTCQB under the symbol “DDDC”. The following table sets forth the high and low bid prices of our common stock for the periods indicated:
Holders
As of March 24, 2014, we had 119 holders of record of the 72,273,525 outstanding shares of our common stock. This does not reflect persons or entities that hold their stock in nominee or "street" name through various brokerage firms.
Dividend Policy
We have never declared or paid any cash dividends on our capital stock, and do not anticipate paying any cash dividends on our capital stock in the foreseeable future. We currently intend to retain future earnings, if any, to finance our operations and to expand our business. Any future determination to pay cash dividends will be at the discretion of our board of directors and will be dependent upon our financial condition, operating results, capital requirements and other factors that our board of directors considers appropriate.
Purchases of Equity Securities by the Issuer and Affiliated Purchasers
None.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
You should read the selected consolidated financial data together with our consolidated financial statements and related notes and the section of this Annual Report entitled “Management's Discussion and Analysis of Financial Condition and Results of Operations.” The selected financial data for each of the years in the three-year period ended December 31, 2013, and as of December 31, 2012 and 2013 is derived from our audited financial statements that have been included in this Annual Report. The selected financial data as of December 31, 2009, 2010 and 2011 and for the years ended December 31, 2009 and 2010 is derived from consolidated financial statements that have not been included in this Annual Report.
(*) reclassified
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion of our financial condition and results of operations should be read together with our consolidated financial statements and the related notes thereto included elsewhere in this Annual Report. This discussion contains certain forward-looking statements that involve substantial risks and uncertainties. When used in this report, words such as “anticipate,” “believe,” “estimate,” “expect,” “target,” “goal,” “project,” “intend,” “plan,” “believe,” “seek,” variations of such words and similar expressions as they relate to our management or us are intended to identify such forward-looking statements. Our actual results, performance or achievements could differ materially from those expressed in, or implied by, these forward-looking statements. Factors that might cause such a difference include, but are not limited to, those discussed in “Risk Factors” and other risks referenced from time to time in our filings with the SEC. Historical operating results are not necessarily indicative of the trends in operating results for any future period.
Overview
We are a global provider of integrated video and voice over Internet Protocol, or VoIP, telephony services, products, hosted solutions and infrastructure. We were founded in 1996 to capitalize on the growth of the Internet as a communications tool by commercially offering Internet Protocol, or IP, telephony services, or VoIP telephony. VoIP telephony is the real-time transmission of voice communications in the form of digitized “packets” of information over the Internet or a private network, similar to the way in which e-mail and other data is transmitted. While we began as primarily a low-cost alternative source of wholesale minutes for carriers around the world, we have evolved into an international provider of next generation communication services.
Today we support tens of thousands of active users around the globe through our service provider and reseller channel and our direct-to-consumer channel. We have built a privately-managed, state-of-the-art global telecommunications platform using IP technology and we offer a broad suite of private label VoIP products and services as well as a back-office platform. Our operations management tools include, among others: account provisioning; e-commerce-based payment processing systems; billing and account management; operations management; web development; network management; and customer care. Based on our customizable VoIP solutions, these customers can offer private label video and voice-over-IP services to their own customer bases under their own brand name, a “white-label” brand (in which no brand name is indicated and different customers can offer the same product), or the deltathree brand. At the same time, our direct-to-consumer channel includes our joip Mobile application (which is a cellular phone application providing low cost mobile calls over 3G cellular networks as well as WiFi networks) and our iConnectHere offering (which provides VoIP products and services directly to consumers and small businesses online using the same primary platform). We are able to provide our services at a cost per user that is generally lower than that charged by traditional service providers because we minimize our network costs by using efficient packet-switched technology and interconnecting to a wide variety of termination options, which allows us to benefit from pricing differences between vendors to the same termination points.
Prior to 1999, we focused on building a privately-managed, global network utilizing IP technology, and our business primarily consisted of carrying and transmitting traffic for communications carriers over our network. Beginning in 1999, we began to diversify our offerings by layering enhanced IP telephony services over our network. These enhanced services were targeted at consumers and were primarily accessible through our consumer website. During 2000, we began offering services on a co-branded or private-label basis to service providers and other businesses to assist them in diversifying their product offerings to their customer bases. In 2001, we continued to enhance our unique strengths through our pioneering work with the Session Initiation Protocol, or SIP, an Internet Engineering Task Force standard that has been embraced by industry leaders such as Microsoft and Cisco. These efforts culminated in the launch of our state-of-the-art SIP infrastructure, and in doing so we became the first major VoIP service provider to deploy an end-to-end SIP network and services. In recent years, we have continued our pioneering efforts in SIP and these efforts have yielded significant new releases.
In 2009 we began the process of expanding the suite of our communications offerings into the global video phone services market. In the third quarter of 2009 we entered into an agreement with ACN Pacific Pty Ltd., a wholly-owned subsidiary of ACN, Inc., or ACN, pursuant to which we provide digital video and voice-over-IP services in Australia and New Zealand to ACN Pacific. In December 2010 we entered into an agreement with ACN Korea, a wholly-owned subsidiary of ACN, pursuant to which we provide digital video and voice-over-IP services in Korea.
In 2010 we continued to update our network by adding a video mail feature to our video phone applications and launching our joip mobile application in July 2010. Following the launch of the mobile application, in October 2010 we entered into a sales agency agreement with ACN pursuant to which ACN sells a private label version of joip Mobile under the ACN Mobile World brand in the United States and Canada. In addition, we offer the joip Mobile application on a white-label basis to other customers. Finally, we entered into affiliate agreements with different third parties pursuant to which such third parties refer potential subscribers to our joip Mobile application.
In April 2011 we entered into an introducer agreement with ACN Europe B.V., a wholly-owned subsidiary of ACN, pursuant to which ACN Europe refers potential customers in different countries in Europe to a private label version of joip Mobile sold under the ACN Mobile World brand. In November 2011 we entered into a service agreement with Momentis U.S. Corp., a multi-level marketing company, pursuant to which Momentis refers potential customers in North America to a co-branded offering of joip Mobile and other consumer VoIP products and services.
On April 3, 2012, we entered into an amendment to our sales agency agreement with ACN and our introducer agreement with ACN Europe. Pursuant to the terms of the amendment, we are required to pay all then-current commissions on a timely basis as required under the agreements and a late fee in the amount of one percent per month of any past-due, unpaid commissions (which, as of December 31, 2013, was equal to approximately $1,173,000). In addition, beginning July 15, 2012, we were required to pay down any unpaid past due amounts in an amount equal to at least $15,000 per month through June 15, 2013, and at least $25,000 per month thereafter until such time as the unpaid balance is paid in full, and are required to pay in full any unpaid, past due amounts upon 30 days' notice. In addition, in the event of certain insolvency-related events defined in the agreements, all unpaid amounts will become immediately due and payable effective immediately prior to such event.
In July 2012 we began making the $15,000 monthly payment of unpaid commissions, however due to our financial condition we suspended making the monthly payments of the unpaid commissions and the current commissions in April 2013 with the oral consent of ACN and ACN Europe. We do not know when we will resume making such payments again, and there is no assurance that we will be able to do so in the near future (if at all) or that until such time ACN and ACN Europe will continue to consent to our not making any such required payments and not exercise any rights they may have under our respective agreements with them or under applicable law. In addition, in the event of certain insolvency-related events defined in the agreements, all unpaid amounts will become immediately due and payable effective immediately prior to such event.
As a complement to the initiatives we have taken to attempt to organically expand our businesses, we have also evaluated opportunities for growth through strategic relationships. In February 2009 we consummated a transaction with D4 Holdings pursuant to which we sold to D4 Holdings an aggregate of 39,000,000 shares of our common stock and a warrant to purchase up to an additional 30,000,000 shares of our common stock. D4 Holdings is a private investment fund whose ownership includes owners of ACN, a direct seller of telecommunications services. As a result of the transactions with D4 Holdings, we expect to continue to seek opportunities to provide services to ACN and enter into other commercial transactions that give us access to ACN’s international marketing and distribution capabilities.
From an operational standpoint, in 2012 we continued to focus our near-term strategy and market initiatives on growing our service provider and digital next generation communications offerings while still supporting our core VoIP reseller and direct-to-consumer business segments.
Going forward, we expect to:
•actively market our products and services to those entities that wish to offer white-label digital next generation communications offerings;
•pursue a targeted strategy of identifying and evaluating appropriate strategic collaborations, such as potentially engaging in commercial transactions with ACN, that we hope will continue to expand and diversify our customer base;
•market and sell our direct-to-consumer products and services through affiliates and our affiliate program; and
•support and maintain our current reseller base, as we expect our revenue from this key channel will continue to represent a significant percentage of our total revenue in the foreseeable future.
Trends in Our Industry and Business
A number of factors in our industry and business have a significant effect on our results of operations and are important to an understanding of our financial statements. These trends include:
Overall Economic Factors: Our operations and earnings are affected by local, regional and global events or conditions that affect supply and demand for telecommunications products and services. These events or conditions are generally not predictable and include, among other things, general economic growth rates and the occurrence of economic recessions; changes in demographics, including population growth rates; and consumer preferences. Our strategy and execution focus is predicated on an assumption that these factors will continue to promote strong desire for the utilization of telephony products and services and that the cost and feature advantages of VoIP alternatives will not be negatively impacted by unforeseen changes in these factors.
Industry: The telecommunications industry is highly competitive. In recent years we have seen new sources of supply for our underlying infrastructure that have reduced our overall costs of operation, including both advances in telecommunications technology and advances in technology relating to telecommunications usage, and have enjoyed the benefits of competition among these suppliers for a relatively limited amount of viable customers. A key component of our competitive position, particularly given the number and range of competing communications products, is our ability to manage operating expenses successfully, which requires continuous management focus on reducing unit costs and improving efficiency.
Consumer Demand: There is significant competition within the traditional telecommunications marketplaces (landline and wireless) and also with other emerging next generation telecommunications providers, including IP telecommunications providers, in supplying the overall telecommunications needs of businesses and individual consumers.
A key component of our competitive position, particularly given the commodity-based nature of many of our products, is our ability to sell to a growing demand base for alternative communications products, in both the developed and developing global marketplace. Within the developed global marketplace, our ability to sell broadband video and voice-over-IP products and services is directly linked to the significant growth rate of broadband adoption, and we expect this trend to continue. We benefit from this trend because our service requires a broadband Internet connection and our potential addressable market increases as broadband adoption increases. Within the developing areas of the world, our ability to sell alternative telephony products and services is linked to both the increasing baseline economic trends within these countries as well as the growing desire for individuals and businesses to communicate and do business outside of their own countries. We expect these trends to continue, and benefit from them because both the ability to afford long distance calls and the desire to make them increase as a result.
Political Factors: Our operations and earnings have been, and may in the future be, affected from time to time in varying degree by political instability, social unrest (including the recent social unrest in the Middle East) and by other political developments and laws and regulations, such as: telecommunications regulations; war, civil war, armed conflict, terrorism and other international conflicts; restrictions on production, imports and exports; price controls; tax increases and retroactive tax claims; expropriation of property; and cancellation of contract rights. Both the likelihood of such occurrences and their overall effect upon us vary greatly from country to country and are not predictable. At the same time, VoIP is becoming legal in more countries as governments seek to increase competition, and this helps us as service providers and resellers seek to meet their customers’ telecommunications needs with newly available solutions. Both the likelihood of VoIP legalization and its overall effect upon us vary greatly from country to country and are not predictable.
Regulatory Factors: Our business has developed in an environment largely free from regulation. However, the United States and other countries have begun to examine how VoIP services should be regulated and to begin instituting such regulation, and a number of initiatives could have an impact on our business. These initiatives include the assertion of state regulatory and taxing authorities over us, FCC rulemaking regarding emergency calling services, the imposition of law-enforcement obligations like the Communications Assistance for Law Enforcement Act, referred to as “CALEA”, marketing restrictions and data protection rules for Customer Proprietary Network Information, referred to as “CPNI”, access to relay services for people with disabilities, local number portability, proposed reforms for the inter-carrier compensation system, and an ongoing generic rulemaking considering the classification of interconnected VoIP services under federal law. Complying with regulatory developments will impact our business by increasing our operating expenses, including legal fees, requiring us to make significant capital expenditures or increasing the taxes and regulatory fees we pay. We may impose additional fees on our customers in response to these increased expenses. This would have the effect of increasing our revenues per customer, but not our profitability, and increasing the cost of our services to our customers, which would have the effect of decreasing any price advantage we may have over traditional telecommunications companies.
Project Factors: In addition to the factors cited above, the advancement, cost and results of particular projects depend on the outcome of: negotiations with potential partners, governments, suppliers, customers or others; changes in operating conditions or costs; and the occurrence of unforeseen technical difficulties or enhancements. The likelihood of these items occurring and its overall positive or negative effect upon us vary greatly from project to project and are not predictable.
Risk Factors: See “Item 1A. Risk Factors” for a discussion of the impact of market risks, financial risks and other risks and uncertainties that we face.
Revenues
Our revenues are derived mainly from resellers, service providers, and direct consumers of our video and voice-over-IP products and services. Revenue is recognized from these products and services as follows:
·postpaid minutes: revenue from the sale of minutes on a postpaid basis (primarily sold to our wholesale resellers) is recognized at the time such minutes are used;
·prepaid minutes: prepayments for communications services and the sale of minutes are deferred and recognized as revenue at the time communications services are provided and at the time the minutes are utilized, service charges are levied or remaining balances expire. We conduct evaluations of outstanding prepaid balances that do not have expiration dates or service fees associated with them to determine, based on terms and condition of agreements and historical data, whether such balances are likely to be utilized. If we determine that balances are unlikely to be used, the deferred revenue liability is reduced accordingly and other revenue is recognized. The outstanding prepaid balances likely to be utilized are reconciled to our deferred revenue account and deferred revenue is increased or decreased accordingly to properly reflect our estimated liability;
·monthly recurring charges: revenue from fees such as set monthly recurring charges based on the level of service or calling plans that the subscriber subscribes for is recognized as the applicable service is provided; and
·other revenues: these revenues include, but are not limited to, prepaid balances with no services fees or expiration dates that are unlikely to be utilized.
The following sets forth our revenues per segment for each of the years ended December 31, 2013 and 2012:
The provision of video and voice-over-IP products and services through our service provider and reseller channel accounted for approximately 66.2% and 85.7% of our total revenues in 2012 and 2013, respectively, while the provision of VoIP telephony through our direct-to-consumer channel accounted for approximately 30.7% and 12.4% of our total revenues in 2012 and 2013, respectively.
Costs and Operating Expenses
Costs and operating expenses consist of the following: cost of revenues; research and development expenses; selling and marketing expenses; general and administrative expenses; and depreciation and amortization.
Cost of revenues consist primarily of network, access, termination and transmission costs paid to carriers that we incur when providing services and fixed costs associated with leased transmission lines. The term of our contracts for leased transmission lines is generally one year or less, and either party can terminate with prior notice.
Research and development expenses consist primarily of costs associated with establishing our network and the initial testing of our services and compensation expenses of software developers involved in new product development and software maintenance. Since our inception, we have expensed all research and development costs in each of the periods in which they were incurred.
Selling and marketing expenses consist primarily of expenses associated with our direct sales force incurred to attract potential service provider, reseller, and corporate customers and advertising and promotional expenses incurred to attract potential consumer users to our direct-to-consumer divisions.
General and administrative expenses consist primarily of compensation and benefits for management, finance and administrative personnel, insurance premiums, occupancy costs, legal and accounting fees and other professional fees. Additionally, we incur expenses associated with our being a public company, including the costs of directors’ and officers’ insurance.
Depreciation and amortization consists of the depreciation calculated on our fixed assets for the fiscal year ended December 31, 2013.
We have not recorded any income tax benefit for net losses and credits incurred for any period from inception to December 31, 2013. The utilization of these losses and credits depends on our ability to generate taxable income in the future. Because of the uncertainty of our generating taxable income going forward, we have recorded a full valuation allowance with respect to these deferred assets.
Net Operating Losses
As of December 31, 2013, we had net operating losses, or NOLs, generated in the U.S. of approximately $23.4 million and our Subsidiary had NOLs of approximately $4.6 million. Our issuance of common stock to D4 Holdings in February 2009 constituted an “ownership change” as defined in Section 382 of the Internal Revenue Code. As a result, under Section 382 our ability to utilize NOLs generated in the U.S. prior to February 2009 (equal to approximately $156 million) to offset any income we may generate in the future will be limited to approximately $600,000 per year from February 2009. The NOLs began to expire in 2011 and will continue to expire at various dates until 2029 if not utilized. Our ability to utilize our remaining NOLs could be additionally reduced if we experience any further “ownership change,” as defined under Section 382.
Critical Accounting Policies
The SEC defines critical accounting policies as those that are, in management's view, most important to the portrayal of a company's financial condition and results of operations and most demanding on their calls on judgment, often as a result of the need to make estimates about the effect of matters that are inherently uncertain and may change in subsequent periods. We believe our most critical accounting policies relate to:
Use of estimates: Our consolidated financial statements are prepared in conformity with accounting principles generally accepted in the United States, which require management to make estimates and assumptions that affect the amounts reported and disclosed in the consolidated financial statements and the accompanying notes. Actual results could differ materially from these estimates.
On an ongoing basis, we evaluate our estimates, including those related to allowances for doubtful accounts receivable, the amortization of deferred revenue associated with customer accounts, the useful lives of property and equipment and the value of common stock, common stock options, and restricted stock for the purpose of determining stock-based compensation. We base our estimates on historical experience, available market information, appropriate valuation methodologies, including the Black Scholes option model and on various other assumptions that we believe to be reasonable, the results of which form the basis for making judgments about the carrying values of assets and liabilities.
Revenue recognition and deferred revenue: We record revenue from VoIP telephony services based on minutes (or fractions thereof) of customer usage. We record revenue from related services based on completion of the specific activities associated with the services. We record payments received in advance for prepaid services and services to be supplied under contractual agreements as deferred revenue until such related services are provided. We estimate the allowance for doubtful accounts by reviewing the status of significant past due receivables and analyzing historical bad debt trends and we then reduce accounts receivables by such allowance for doubtful accounts to expected net realizable value.
Restructured long-term debt. We regard the restructured long-term debt to D4 Holdings, under the criteria of, and have accounted for the restructured long-term debt as, a troubled debt restructuring in accordance with ASC Subtopic 470-60, “Debt - Troubled Debt Restructurings by Debtors”, or ASC 470-60, which requires that the gross future cash flows of principal and interest be reflected in the balance sheet. The long-term debt is secured by substantially all of our assets.
Results of Operations
The following table sets forth the statement of operations data presented as a percentage of revenues for the periods indicated:
Year Ended December 31, 2013 Compared to Year Ended December 31, 2012
Revenues
Revenues overall for 2013 increased by approximately $2.4 million, or 17.5%, to approximately $16.1 million from approximately $13.7 million in 2012. Revenues increased even though the number of minutes carried by our network decreased by approximately 13.5% from approximately 333 million minutes in 2012 to approximately 288 million minutes in 2013. The increase in revenues was due to a change in the relative mix of the destinations of the calls placed over our network, with a larger percentage of calls being made during 2013 compared to 2012 to destinations for which we charge significantly higher rates.
Revenues generated by our reseller division increased by approximately $4.8 million, or 60.9%, to approximately $12.7 million for 2013 from approximately $7.9 million in 2012. This was primarily due to an increase in revenues generated by our largest reseller during 2013. In 2012, this customer generated revenues of approximately $5.4 million, which accounted for approximately 39.5% of our annual gross revenues, and in 2013 this customer generated revenues of approximately $11.1 million, which accounted for approximately 68.7% of our annual gross revenues. This increase was offset by a sharp decline in the revenues generated by our second largest reseller, primarily due to a reduction of more than 50% in rates we charge for specific destinations we effected during 2013 in order to remain competitive. . In 2012, this customer generated revenues of approximately $1.3 million, which accounted for approximately 9.3% of our annual gross revenues and in 2013 this customer generated revenues of approximately $0.6 million, which accounted for approximately 3.7% of our annual gross revenues.
Our two largest resellers accounted for approximately $11.7 million, or approximately 91.8%, of the revenues generated from our reseller division in 2013, which represented approximately 72.4% of our total revenues for 2013. By comparison, in 2012 our two largest resellers accounted for approximately $6.7 million, or approximately 84.5%, of the revenues generated from our reseller division, or approximately 48.8% of our total revenues for 2012.
Revenues generated by our service provider division decreased by approximately $56,000 or 4.9%, to $1,091,000 for 2013 from $1,147,000 in 2012. This was primarily due to a decline in revenues generated from our service agreement with ACN Pacific offset by an increase in revenues generated by our service agreement with ACN Korea.
Sales to direct consumers sharply decreased by approximately $2.2 million, or 52.4%, to approximately $2.0 million in 2013 from approximately $4.2 million in 2012. Revenues generated through our iConnectHere offering declined by approximately $150,000 from approximately $560,000 in 2012 to approximately $410,000 in 2013, in addition to a decline in revenues generated by our joip Mobile offering, which decreased from approximately $3.6 million in 2012 to approximately $1.4 million in 2013.
Costs and Operating Expenses
Cost of revenues. Cost of revenues increased by approximately $4.1 million, or 46.6%, from approximately $8.8 million in 2012 to approximately $12.9 million in 2013. Our network rent cost decreased slightly by approximately $22,000, while our termination costs increased by 56.2% from $7.3 million in 2012 to $11.4 million in 2013. This was due to a change in the relative mix of the destinations of the calls placed over our network, with a larger percentage of calls being purchased during 2013 to destinations for which we pay significantly higher rates than during 2012.
Research and development expenses Research and development expenses remained constant at approximately $1.2 million for each of 2012 and 2013.
Selling and marketing expenses. Selling and marketing expenses decreased by approximately $0.7 million, or 35%, to $1.3 million in 2013 from $2.0 million in 2012. The main reason for the decrease was a decrease in sales of our joip Mobile application by ACN, ACN Europe and Momentis, as a result of which we recorded lower commissions for 2013.
General and administrative expenses. General and administrative expenses remained constant at approximately $1.4 million for each of 2012 and 2013.
Depreciation and amortization. Depreciation and amortization increased by $3,000, or 2.0%, from $148,000 in 2012 to $145,000 in 2013.
(Loss) income from operations
We reported a loss from operations of approximately $885,000 in 2013 compared to income from operations of approximately $88,000 in 2012.
Interest Expense, Net
We recorded interest expense of approximately $0.9 million in 2013 compared to $1.7 million in 2012. This was due primarily to (i) interest accrued to be paid to D4 Holdings under our loan agreements with D4 Holdings in an amount equal to $590,000, (ii) the expense recorded for the warrant we issued to D4 Holdings in connection with the Second Loan Agreement and the warrant and Convertible Note we issued to D4 Holdings in connection with the Third Loan Agreement in an aggregate amount equal to $169,000 and (iii) interest accrued to be paid to ACN Inc. for un-paid commission as described above in " - Overview" in an amount equal to $85,000.
Income Taxes, Net
We recorded net income taxes of $35,000 in 2013.
Net Loss
Net loss increased by approximately $0.2 million, or 12.5%, from approximately $1.6 million in 2012 to $1.8 million in 2013, due to the foregoing factors.
Year Ended December 31, 2012 Compared to Year Ended December 31, 2011
Revenues
Revenues overall for 2012 increased by approximately $3.2 million, or 30.5%, to approximately $13.7 million from approximately $10.5 million in 2011. Revenues increased although during this period the number of minutes carried by our network decreased by approximately 8.5% from approximately 364 million minutes in 2011 to approximately 333 million minutes in 2012. This was due to a change in the relative mix of the destinations of the calls placed over our network, with a lower percentage of calls being made during 2012 to destinations for which we charge significantly higher rates than during 2011.
Revenues generated by our reseller division increased by approximately $1.3 million, or 19.7%, to approximately $7.9 million for 2012 from approximately $6.6 million in 2011. This was primarily due to the resumption of business with our largest reseller during the fourth quarter of 2011 after such reseller had temporarily suspended operations at the beginning of February 2011. In 2011, this customer generated revenues of approximately $1.6 million, which accounted for approximately 15.6% of our annual gross revenues, and in 2012 this customer generated revenues of approximately $5.4 million, which accounted for approximately 39.5% of our annual gross revenues. This increase was offset by a sharp decline in the revenues generated by our second largest reseller, primarily due to a decline in rates we charge for specific destinations of more than 50% over a one-year period. In order be able to continue providing this reseller with competitive prices we were required to lower our prices to those provided by the rest of the market. In 2011, this customer generated revenues of approximately $2.9 million, which accounted for approximately 27.8% of our annual gross revenues and in 2012 this customer generated revenues of approximately $1.3 million, which accounted for approximately 9.3% of our annual gross revenues.
Our two largest resellers accounted for approximately $6.9 million, or approximately 84.5%, of the revenue generated from our reseller division in 2012, which represented approximately 48.8% of our total revenue for 2012. By comparison, in 2011 our two largest resellers accounted for approximately $4.6 million, or approximately 69.7%, of the revenue generated from our reseller division, or approximately 43.4% of our total revenue for 2011.
Revenues generated by our service provider division decreased by approximately $231,000 or 16.8%, to $1.1 million for 2012 from $1.4 million in 2011. This was primarily due to a decline in revenues generated from our service agreement with ACN Pacific offset by an increase generated by our service agreement with ACN Korea.
Sales to direct consumers sharply increased by approximately $1.7 million, or 68%, to approximately $4.2 million in 2012 from approximately $2.5 million in 2011. Revenues generated through our iConnectHere offering declined by approximately $275,000 from approximately $835,000 for 2011 to approximately $560,000 for 2012. This was offset by the revenues generated by our joip Mobile offering, which increased from approximately $1.5 million for 2011 to approximately $3.6 million for 2012, primarily as a result of the sales agency agreement we entered into with ACN and the introducer agreement we entered into with ACN Europe and the sales agreement with Momentis during the fourth quarter of 2011.
Costs and Operating Expenses
Cost of revenues. Cost of revenues increased by approximately $1.5 million, or 20.5%, from approximately $7.3 million in 2011 to approximately $8.8 million in 2012. Our network rent cost decreased slightly by approximately $120,000, from approximately $1.2 million in 2011 to approximately $1.0 million in 2012, while our termination costs increased by 30.3% from $5.6 million in 2011 to $7.3 million in 2012. The main cause of the increase in cost of revenues was the resumption of the operations of our largest reseller in the fourth quarter of 2011.
Research and development expenses. Research and development expenses decreased by approximately $300,000, or 20%, to $1.2 million in 2012 from $1.5 million in 2011. The main reason for the decrease was the reduction in force and resulting reduction in salary expenses.
Selling and marketing expenses. Selling and marketing expenses remained constant at approximately $2.0 million for each of 2011 and 2012. Due to an increase in sales of joip Mobile by ACN, ACN Europe and Momentis we recorded higher commissions for 2012, however this was offset by the reduction in force of members of our sales department and other related expenses during 2011.
General and administrative expenses. General and administrative expenses increased by approximately $198,000, or 16.3%, to $1.4 million in 2012 from $1.2 million in 2011. During 2011 we recorded a reversal of an accrual of $706,000 for expected legal expenses and a reversal of an accrual for tax liability of $158,000. Excluding these onetime expenses, our general and administrative expenses decreased by approximately $666,000 during 2012, primarily due to a reduction in expenses for professional services and other steps to minimize our expenses, such as office and rent expenses.
Accrual for contingency. As discussed below under “ - Liquidity and Capital Resources”, on August 31, 2010, the DHS seized approximately $176,000 held in our bank accounts in connection with its investigation into the activities of certain of our resellers. In accordance with FASB Statement 5, “Loss Contingencies” [ASC 450-20], we accounted for the seizure as a loss contingency that is probable of occurrence and recognized a loss in the entire amount seized, and recognized the return of $52,804 to us as a reversal of the loss recognized.
Accrual for commercial rent tax. During 2011 we recorded $300,000 as a provision for commercial rent tax. As discussed above under Item 3 - "Legal Proceedings", on July 5, 2011, we received a notice from the New York City Department of Finance, or the Department, which claimed that we had not paid commercial rent tax, required under the New York City Administrative Code from June 1998 through May 2008 for the two offices that we had leased during that time. The notice stated that we are obligated to pay the outstanding tax amounts, as well as significant interest and penalties that were assessed on the unpaid amounts as well as for the failure to file the applicable tax returns.
Depreciation and amortization. Depreciation and amortization decreased by $31,000, or 17.2%, from $180,000 in 2011 to $149,000 in 2012 due to a decline in the value of our fixed assets during this period.
Income (loss) from Operations
We reported income from operations of approximately $88,000 in 2012 compared to a loss from operations of approximately $1.9 million in 2011.
Interest Expense, Net
We recorded interest expense of approximately $1.7 million in 2012 compared to $1.2 million in 2011. This was due primarily to interest accrued to be paid to D4 Holdings under our loan agreements with D4 Holdings in an amount equal to $551,000, and the expense recorded for the warrant we issued to D4 Holdings in connection with the Second Loan Agreement and the warrant and Convertible Note we issued to D4 Holdings in connection with the Third Loan Agreement in an aggregate amount equal to $905,000.
Income Taxes, Net
We recorded net income taxes of $11,000 in each of 2012 and 2011.
Net Loss
Net loss decreased by approximately $1.5 million, or 48.4%, from approximately $3.1 million in 2011 to $1.6 million in 2012, due to the foregoing factors.
Liquidity and Capital Resources
Since our inception in June 1996, we have incurred significant operating and net losses due in large part to the start-up and development of our operations and losses from operations. For the year ended December 31, 2013, we reported a loss from operations of approximately $0.8 million compared to income from operations of approximately $0.1 million in 2012. To date, we have an accumulated deficit of approximately $7.4 million.
As of December 31, 2013, we had cash and cash equivalents of approximately $158,000 and restricted cash and short-term investments of approximately $34,000, or a total of cash, cash equivalents and restricted cash of $192,000, a decrease of approximately $226,000 from December 31, 2012. The decrease in cash, restricted cash, and short and long term investments was primarily caused by the net cash used in investing activities during the year ended December 31, 2013, of approximately $329,000.
Cash used in or provided by operating activities is net income adjusted for certain non-cash items and changes in assets and liabilities. We had negative cash flow from operating activities of approximately $262,000 during 2013 compared with negative cash flow from operating activities of approximately $90,000 million during 2012. The increase in our cash used in operating activities was primarily driven by accumulated interest on short-term loan of approximately $590,000 and increase in accounts payable of approximately $697,000.
Net cash used in investing activities is generally driven by our capital expenditures and changes in our short and long-term investments. In 2013 and 2012 we expensed approximately $64,000 and $58,000, respectively, for the purchase of new equipment. In addition, during the year ended December 31, 2013, restricted cash equal to $22,000 that was held by some of our credit card processors was released. During 2012 we have succeeded to release $296,000 held by these credit card processors.
Net cash used in or provided by financing activities is generally driven by drawing down amounts available under lines of credit available to us, issuing shares of our capital stock and receiving cash that we had previously pledged or otherwise deposited as security for our lenders and creditors. For the year ended December 31, 2013, we drew down $100,000 under our loan agreements with D4 Holdings.
Financing cash flows have historically consisted primarily of payments of capital leases and proceeds from the exercise of options we have granted to our employees and directors. As discussed above under “Item 1. Business - Transactions with D4 Holdings”, in February 2009 we consummated a transaction with D4 Holdings pursuant to which we sold to D4 Holdings an aggregate of 39,000,000 shares of our common stock and a warrant to purchase up to an additional 30,000,000 shares of our common stock for an aggregate purchase price of $1.2 million. In addition, on March 1, 2010, we and our subsidiaries entered into the First Loan Agreement with D4 Holdings pursuant to which D4 Holdings agreed to provide us and our subsidiaries a line of credit in a principal amount of $1,200,000. On August 10, 2010, we and our subsidiaries entered into the Second Loan Agreement with D4 Holdings, pursuant to which D4 Holdings agreed to provide us and subsidiaries an additional line of credit in a principal amount of $1,000,000. In connection with the Second Loan Agreement, we issued D4 Holdings a warrant to purchase up to 4,000,000 shares of our common stock at an exercise price of $0.1312 per share. We have drawn down all amounts available to be borrowed under the two lines of credit.
On March 2, 2011, we and our subsidiaries entered into the Third Loan Agreement with D4 Holdings, pursuant to which D4 Holdings agreed to provide us and our subsidiaries an additional line of credit in a principal amount of $1,600,000. Pursuant to the terms of the Convertible Note issued by us in connection with the Third Loan Agreement, D4 Holdings may elect to convert all or any portion of the outstanding principal amount under the Convertible Note into that number of shares of our common stock determined by dividing such principal amount by $0.08 (as may be adjusted under the terms of the Convertible Note). Simultaneous with our entering into the Third Loan Agreement, D4 Holdings and we entered into an amendment of the First Loan Agreement, pursuant to which (among other things) the maturity date for repayment of principal under the First Loan Agreement was extended from March 1, 2011, to March 1, 2012, and then subsequently extended by oral agreement of the parties to July 1, 2012, and then subsequently orally extended again to January 2, 2014, pending the parties’ finalizing and entering into a formal amendment. In connection with the Third Loan Agreement, we issued D4 Holdings a warrant to purchase up to 1,000,000 shares of our common stock at an exercise price of $0.096 per share. We have drawn down the aggregate principal amount available under the Third Loan Agreement, the principal amount of which can be converted by D4 Holdings into an aggregate of 20,000,000 shares of our common stock.
On September 12, 2011, we and our subsidiaries entered into the Fourth Loan Agreement with D4 Holdings, pursuant to which D4 Holdings agreed to provide us and our subsidiaries an additional line of credit in a principal amount of $300,000. As of December 31, 2013, we have drawn down all amounts available to be borrowed under the Fourth Loan Agreement.
On November 13, 2012, we and our subsidiaries entered into the Third Amendment to Loan and Security Agreements, or the "Third Amendment", and the Amendment to Warrant Agreements, or the "Warrants Amendment", with D4 Holdings. Pursuant to the Third Amendment and the Warrants Amendment:
·the maturity date for repayment of principal under the First Loan Agreement was extended to January 2, 2014;
·the maturity date for repayment of principal under the Second Loan Agreement was extended to January 2, 2015;
·the maturity date for repayment of principal under each of the Third and Fourth Loan Agreements was extended to January 2, 2016;
·all interest outstanding under each of the loan agreements was added to the principal amount outstanding under the respective loan agreement and the promissory notes issued pursuant to each respective loan agreement was increased by such amount; and
·the exercise price under each of the Warrant Agreements entered into by us and D4 Holdings as of February 12, 2009, August 10, 2010, and March 2, 2011 was amended to $0.02 per share.
In connection with the extension of the maturity dates under the Third Amendment, we issued to D4 Holdings a warrant, exercisable for ten years, to purchase up to 10,000,000 shares of our common stock at an exercise price of $0.02 per share.
There were no options exercised by our employees or directors during the year ended December 31, 2013.
Interest payments under the First, Second and Third Loan Agreements are required to be made monthly through the maturity date of each respective loan. In March 2012, D4 Holdings orally agreed to permit us to defer such monthly interest payments for periods in which our cash flows from operations were insufficient to make such payments. However, D4 Holdings has not formally agreed to defer such interest payments for future periods.
In January 2014, we failed to repay the outstanding principal and accrued interest under the First Loan Agreement on its maturity date. On March 28, 2014, we and our subsidiaries entered into the Forbearance Agreement with D4 Holdings, pursuant to which D4 Holdings agreed to forbear from taking any enforcement action under our loan agreements with D4 Holdings resulting from our failure to meet our repayment obligations under the First Loan Agreement until the earliest of (i) December 31, 2014, (ii) repayment in full of all obligations under the First Loan Agreement, (iii) the occurrence of any breach of our obligations under the Forbearance Agreement, or (iv) the occurrence of any additional default under our loan agreements with D4 Holdings. In connection with the Forbearance Agreement, we issued to D4 Holdings a warrant, exercisable for ten years, to purchase up to 10,000,000 shares of our common stock at an exercise price of $0.02 per share.
On July 5, 2011, we received a notice from the New York City Department of Finance that claimed that we had not paid commercial rent tax required under the New York City Administrative Code from June 1998 through May 2008 for the two offices that we had leased during that time. The notice stated that we are obligated to pay the outstanding tax amounts, as well as significant interest and penalties that were assessed on the unpaid amounts as well as for the failure to file the applicable tax returns. We engaged outside counsel, which began discussions with the Department of Finance, and contested the assessment and simultaneously attempted to negotiate a significant reduction in the amounts to be paid. Our appeal was rejected in July 2012 by an examiner in the Department of Finance, and we have subsequently engaged and begun discussions with a manager in the Department of Finance and submitted additional supporting materials. The final outcome of this assessment and our negotiations with the New York City Department of Finance cannot be determined at this time. In the event that we are required to pay all or most of the amounts claimed by the New York City Department of Finance this would have a material adverse effect on our financial condition and liquidity. During 2011 we recorded $300,000 as a provision for commercial rent tax.
We experience fluctuations in our cash cycle, as we generally make payments to our termination suppliers more frequently (often on a weekly basis) than we receive payments from our customers (often on a monthly basis). In the event one of our customers did not pay us, we would experience a direct loss of the amounts we had already paid to our termination suppliers. We maintain our free cash in accounts with major banks located in the United States, and generally do not invest such cash in short or long-term investments. As a way to try to offset our declining cash position we generally seek to extend payment terms to our suppliers other than our termination providers.
We have historically obtained our funding from our utilization of the remaining proceeds from our initial public offering, offset by positive or negative cash flow from our operations, and most recently from the sale of shares of our common stock to D4 Holdings in February 2009 and borrowings under our loan agreements with D4 Holdings. These proceeds are maintained as cash, restricted cash, and short and long term investments. We have sustained significant operating losses in recent periods, which have led to a significant reduction in our cash reserves.
On April 3, 2012, we entered into an amendment to our sales agency agreement with ACN and our introducer agreement with ACN Europe. Pursuant to the terms of the amendment, beginning April 1, 2012, we are required to pay all current commissions on a timely basis as required under the agreements and a late fee in the amount of one percent per month of any past-due, unpaid commissions (which, as of December 31, 2013, was equal to approximately $1,173,000. In addition, beginning July 15, 2012, we are required to pay down any unpaid past due amounts in an amount equal to at least $15,000 per month through June 15, 2013, and at least $25,000 per month thereafter until such time as the unpaid balance is paid in full, and are required to pay in full any unpaid, past due amounts upon 30 days' notice.
In July 2012 we began making the $15,000 monthly payment, however due to our financial condition we suspended making the monthly payments of the unpaid commissions and the current commissions in April 2013 with the oral consent of ACN and ACN Europe. We do not know when we will resume making such payments again, and there is no assurance that we will be able to do so in the near future (if at all) or that until such time ACN and ACN Europe will continue to consent to our not making any such required payments and not exercise any rights they may have under our respective agreements with them or under applicable law. In addition, in the event of certain insolvency-related events defined in the agreements, all unpaid amounts will become immediately due and payable effective immediately prior to such event.
As of December 31, 2013, we had negative working capital equal to approximately $7.5 million as well as negative stockholders’ equity equal to approximately $7.4 million. We believe it is probable that we will continue to experience losses and increased negative working capital and negative stockholders’ equity in the near future and will not be able to return to positive cash flow before we require additional cash in the near term.
We believe that, unless we are able to increase revenues and generate additional cash, our current cash and cash equivalents will not satisfy our current projected cash requirements beyond the foreseeable future. As a result, there is substantial doubt about our ability to continue as a going concern.
In addition, unless we are able to increase revenues and generate additional cash, based on currently projected cash flows we believe that we will be unable to pay future scheduled interest and/or principal payments under the various loan agreements with D4 Holdings as these obligations become due, and beginning January 2013 we suspended making scheduled interest payments with the oral consent of D4 Holdings. On January 2, 2014, we did not repay to D4 Holdings the outstanding principal and interest due under the First Loan Agreement, which constituted an event of default thereunder and a cross-default under all our other loan agreements with D4 Holdings, following which we and our subsidiaries entered into the Forbearance Agreement with D4 Holdings. In the event we are unable to resume making interest payments and to pay the outstanding principal when due following the termination of the Forbearance Agreement, if D4 Holdings is not willing to waive compliance or otherwise modify our obligations such that we are able to avoid defaulting on such obligations, because D4 Holdings has a lien on all of our assets to secure our obligations under the loan agreements it could take actions under the loan agreements and seek to take possession of or sell our assets to satisfy our obligations thereunder. Any of these actions would likely have an immediate material adverse effect on our business, financial condition or results of operations.
Due to our ongoing losses and reduction in cash, we initiated restructuring activities beginning in the second quarter of 2011 in an effort to cut operating costs significantly and better align our operations with our current business model. In accordance with the restructuring, we instituted a reduction in force and decreased the number of full time employees from approximately 53 to 32, reduced the salaries of all remaining employees by five percent, and decreased non-material expenses as well as payments to be made to vendors and other third parties. In addition, in December 2013 we instituted an additional, smaller reduction in force. As of December 31, 2013, we had 22 full time employees.
In view of our current cash resources, nondiscretionary expenses, debt and near term debt service obligations, we may begin to explore all strategic alternatives available to us, including, but not limited to, a sale or merger of our company, a sale of our assets, recapitalization, partnership, debt or equity financing, voluntary deregistration of our securities, financial reorganization, liquidation and/or ceasing operations. In the event that we require but are unable to secure additional funding, we may determine that it is in our best interests to voluntarily seek relief under Chapter 11 of the U.S. Bankruptcy Code. Seeking relief under the U.S. Bankruptcy Code, even if we are able to emerge quickly from Chapter 11 protection, could have a material adverse effect on the relationships between us and our existing and potential customers, employees, and others. Further, if we were unable to implement a successful plan of reorganization, we might be forced to liquidate under Chapter 7 of the U.S. Bankruptcy Code. There can be no assurance that exploration of strategic alternatives will result in our pursuing any particular transaction or, if we pursue any such transaction, that it will be completed.
Obligations and Commercial Commitments
The following table sets forth our future contractual obligations and commercial commitments in total, for each of the next five years and thereafter:
Off-Balance Sheet Arrangements
None.
Certain Factors That May Affect Future Results of Operations
The SEC encourages companies to disclose forward-looking information so that investors can better understand a company's future prospects and make informed investment decisions. This Annual Report contains such "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995, as amended.
Words such as "may," "anticipate," "estimate," "expects," "projects," "intends," "plans," "believes" and words and terms of similar substance used in connection with any discussion of future operating or financial performance, identify forward-looking statements. All forward-looking statements are management's present expectations of future events and are subject to a number of risks and uncertainties that could cause actual results to differ materially and adversely from those described in the forward-looking statements. These risks include, but are not limited to, those set forth under the heading "Risk Factors" contained in Item 1A of this Annual Report.
In light of these assumptions, risks and uncertainties, the results and events discussed in the forward-looking statements contained in this Annual Report or in any document incorporated by reference might not occur. Stockholders are cautioned not to place undue reliance on the forward-looking statements, which speak only as of the date of this Annual Report. We are not under any obligation, and we expressly disclaim any obligation, to update or alter any forward-looking statements, whether as a result of new information, future events or otherwise. All subsequent forward-looking statements attributable to deltathree or to any person acting on our behalf are expressly qualified in their entirety by the cautionary statements contained or referred to in this section.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The Company's Consolidated Financial Statements required by this Item are set forth in Item 15 of this Annual Report.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
(a) Evaluation of Disclosure Controls and Procedures. Each of our principal executive officer and principal financial officer, after evaluating the effectiveness of our disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) as of the end of the period covered by this Annual Report, has concluded that, based on such evaluation, our disclosure controls and procedures were adequate and effective to ensure that material information required to be disclosed by us in the reports that we file and submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.
(b) Management’s Report on Internal Control over Financial Reporting. Management is responsible for establishing and maintaining adequate internal control over financial reporting of the Company. We maintain internal control over financial reporting designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. Therefore, internal control over financial reporting determined to be effective provides only reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.
Under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, management has evaluated internal control over financial reporting by the Company using the framework for effective internal control established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Management assessed the effectiveness of our internal control over financial reporting as of December 31, 2013.
Based on this assessment, management concluded that internal controls over financial reporting were effective as of December 31, 2013. In connection with this assessment, no material weaknesses in the Company’s internal control over financial reporting were identified by management. This Annual Report does not include an attestation report of our registered public accounting firm regarding internal control over financial reporting, as management's report is not subject to attestation by our registered public accounting firm pursuant to the rules of the SEC that permit us to provide only management's report in this Annual Report.
(c) Changes in Internal Controls. There were no changes in our internal control over financial reporting that occurred during the fourth quarter of 2013 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
ITEM 9B.
ITEM 9B. OTHER INFORMATION
On March 28, 2014, we and our subsidiaries entered into the Forbearance Agreement with D4 Holdings, pursuant to which D4 Holdings agreed to forbear from taking any enforcement action under our loan agreements with D4 Holdings resulting from our failure to meet our repayment obligations under the First Loan Agreement until the earliest of (i) December 31, 2014, (ii) repayment in full of all obligations under the First Loan Agreement, (iii) the occurrence of any breach of our obligations under the Forbearance Agreement, or (iv) the occurrence of any additional default under our loan agreements with D4 Holdings. In connection with the Forbearance Agreement, we issued to D4 Holdings a warrant, exercisable for ten years, to purchase up to 10,000,000 shares of our common stock at an exercise price of $0.02 per share.
Our company is majority-owned by D4 Holdings. The ultimate ownership of D4 Holdings includes owners of ACN. Each of Robert Stevanovski, Anthony Cassara and David Stevanovski, members of our Board of Directors, is a principal of D4 Holdings. Colleen Jones, a member of our Board of Directors, serves as general counsel to D4 Holdings and is an officer of ACN. As a result, each of these individuals and D4 Holdings may be deemed to have a direct or indirect interest in the transactions contemplated by the Forbearance Agreement and the warrant. In accordance with our Audit Committee Charter, the Forbearance Agreement and the warrant and the transactions contemplated thereby were approved by the Audit Committee, which includes those directors who are not affiliated with D4 Holdings.
The foregoing description of the Forbearance Agreement and the warrant does not purport to be a complete summary and is qualified in its entirety by reference to the full texts of the Forbearance Agreement and the warrant, each of which is filed as an exhibit to this Annual Report.
PART III
ITEM 10.
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
Directors
Our Amended and Restated Certificate of Incorporation provides that a director shall hold office until the annual meeting for the year in which his or her term expires except in the case of elections to fill vacancies or newly created directorships. Each director is elected for a one-year term. Set forth below are the name, age and the positions and offices held by each of our current directors, his or her principal occupation, business experience and public company board experience during at least the past five years, and the experience, qualifications, attributes or skills that qualify such person to serve on our Board of Directors.
Robert Stevanovski, 50. Mr. Stevanovski has served as a director and Chairman of the Board since February 2009. He is one of the co-founders of ACN and has served as Chairman of ACN since its founding in 1993. Mr. Stevanovski has served as a director of WorldGate since April 2009. He is the brother of David Stevanovski, also a member of the Board. Mr. Robert Stevanovski’s areas of relevant experience, qualifications, attributes or skills include sales and marketing expertise generally, extensive knowledge of the telecommunications and multi-level marketing industries, outside board experience with WorldGate and extensive business and management experience as co-founder and Chairman of ACN.
Anthony J. Cassara, 59. Mr. Cassara has served as a director since February 2009. Mr. Cassara founded and has served as President of Cassara Management Group, Inc., a privately held business counseling practice focused on the telecommunications industry, since October 2000. Prior to founding Cassara Management Group, Mr. Cassara was President of the Carrier Services division at Frontier Corporation and later at Global Crossing Ltd. from October 1999 to December 2000. Mr. Cassara served as a member of the board of directors of MPower Holding Corporation from May 2002 to August 2006; Teleglobe International Holdings Ltd. from February 2004 to February 2006; Eschelon Telecom Inc. from November 2002 to December 2004; and has served as a director of WorldGate since April 2009. Mr. Cassara’s areas of relevant experience, qualifications, attributes or skills include telecommunications and information services; senior leadership roles in global telecommunications companies; public company board experience, corporate finance, and financial reporting.
David Stevanovski, 47. Mr. Stevanovski has served as a director since March 2009. He has served in a number of positions at ACN, and currently serves as Vice President. Mr. Stevanovski has served as a director of WorldGate since April 2009. Mr. Stevanovski is the brother of Robert Stevanovski. Mr. David Stevanovski’s areas of relevant experience, qualifications, attributes or skills include sales and marketing expertise generally, extensive knowledge of the telecommunications and multi-level marketing industries, outside board experience with WorldGate, and extensive business and management experience at ACN.
Colleen R. Jones, 52. Ms. Jones has served as a director since February 2011. She has served as ACN's chief legal officer since 2003, and is presently its executive Vice President, Global Counsel and Secretary. She has served as general counsel to D4 Holding since its formation in 2009. Ms. Jones has served as a director of WorldGate since February 2011. Ms. Jones has practiced law for over 25 years, serving as chief legal officer in corporations and as a partner at large international law firms. Her areas of relevant experience, qualifications, attributes or skills include legal expertise in general corporate and commercial domestic and international transactional work for both publicly- and privately-held companies, extensive knowledge of the telecommunications and technology sectors, management experience at ACN, and public company corporate governance.
Lior Samuelson, 65. Mr. Samuelson served as Chairman of the Board from January 2008 until February 2009, and has served as a director of deltathree since August 2001. Mr. Samuelson has served as the Chairman of the Board of Commtouch Software Ltd., a provider of internet security technology, since January 1, 2011, and as a director at Commtouch since August 2, 2010. Since August 1999, Mr. Samuelson has served as a Co-Founder and Principal of Mercator Capital, and served as a director of Mercator Partners Acquisition Corp. from January 2005 to December 2007. His experience includes advising clients in the technology, communications and consumer sectors on mergers, acquisitions and private placements. From March 1997 to August 1999, Mr. Samuelson was the President and Chief Executive Officer of PricewaterhouseCoopers Securities. Prior to that, he was the President and Chief Executive Officer of The Barents Group, a merchant bank specializing in advising and investing in companies in emerging markets. Mr. Samuelson was also the Co-Chairman of Peloton Holdings, a private equity management company. Before that, he was a managing partner with KPMG and a senior consultant at Booz, Allen & Hamilton. Mr. Samuelson’s areas of relevant experience, qualifications, attributes or skills include extensive experience in finance and investment banking, public company board experience, financial reporting, and his long history of service to deltathree and knowledge of its operations.
J. Lyle Patrick, 61. Mr. Patrick has served as a director since March 2009. Mr. Patrick is currently a financial consultant and has served as chief financial officer of a number of telecommunications companies, including, most recently, First Communications, Inc., a provider of high-capacity metro and long-haul fiber network services as well as voice and data services across the Midwest and Mid-Atlantic United States, from March 2009 to December 2011, US LEC, a competitive telecommunications company, from June 2005 to March 2007, and MetroPCS, a wireless communications provider, from May 2004 to March 2005. Mr. Patrick is a Certified Public Accountant. Mr. Patrick’s areas of relevant experience, qualifications, attributes or skills include extensive accounting for public companies, with particular experience in the telecommunications industry, and financial reporting.
Donna Reeves-Collins, 53. Ms. Reeves-Collins has served as a director since October 2012. Ms. Reeves-Collins has served as Managing Director at Rich Products Corporation since December 2007, and as the Chairwoman of the Board of Directors of Axcess Ontario since February 2013. She joined Rich Products following its signing of a joint venture development agreement with Cole & Parks, a bakery café restaurant which develops unique food products that was founded by Ms. Reeves-Collins in November 2003 and where Ms. Reeves-Collins has served as CEO since its inception. Prior to founding Cole & Parks, Ms. Reeves-Collins served in a number of positions at Frontier Corporation, including Senior Vice President of Sales, President of Sales for the Western Region and President and COO of a joint venture with Verizon Wireless. Following Frontier's acquisition by Global Crossing in 1999, Ms. Reeves-Collins served as the Senior Vice President of Sales - Media & Entertainment for Global Crossing through 2001.
Executive Officers and Key Employees
Set forth below is a brief description of the present and past business experience of each of the persons who currently serve as our executive officers or key employees.
Efraim Baruch, 38, Chief Executive Officer, President and Senior Vice President of Operations and Technology. In October 2010, Mr. Baruch became our Chief Executive Officer and President, having been named our interim Chief Executive Officer and President in December 2008. In January 2007, Mr. Baruch became our Senior Vice President of Operations and Technology. Mr. Baruch has been with deltathree since 1998. Mr. Baruch began working in deltathree as an engineer in the Network Operations Center, and soon after specialized in the management of data networks and security in our Wide Area Network department.
Yochai Ozeri, 37, Director of Finance and Treasurer. Prior to assuming the positions of Director of Finance and Treasurer in January 2012, Mr. Ozeri served as our Assistant Controller from July 2007 to March 2008, as Finance Manager from April 2008 to July 2009 and as Controller from August 2009 until the present. Prior to joining our company, Mr. Ozeri served as a senior auditor at Kost, Forer, Gabbay & Kasierer, a member firm of Ernst & Young International, in its technology practice group. Mr. Ozeri is a Certified Public Accountant.
Board of Directors and Committees of the Board
Our Amended and Restated Certificate of Incorporation provides that the number of members of our Board of Directors shall be not less than three and not more than thirteen. There are currently seven directors on the Board. At each annual meeting of stockholders, directors are elected to hold office for a term of one year and until their respective successors are elected and qualified.
The Board had four regular meetings during 2013. Each incumbent member of the Board participated in at least 75% of the aggregate of all Board and committee (for such committees on which the director served) meetings held during the period for which he was a director or member of such committee. None of our directors attended our 2013 Annual Stockholder Meeting. The Board has established an Audit Committee and a Compensation Committee. The functions of the committees and their current members are set forth below.
Director Nominations. Due to a decrease in the number of members of the Board after our 2006 Annual Stockholders Meeting, our Board members determined that it is efficient and important for each member to actively participate in all matters that were previously the responsibility of the Nominating and Governance Committee and dissolved the Nominating and Governance Committee as of September 11, 2006. As such, each of our Board members is expected to take part in, among other matters, the following nominating and governance-related matters:
•identifying and recommending qualified candidates for director, and recommending the director nominees for our annual meetings of stockholders;
•conducting an annual review of the Board’s performance;
•recommending the director nominees for each of the Board committees; and
•developing and recommending our company’s corporate governance guidelines.
Furthermore, our Board adopted a nominating and governance policy that was based on the former Nominating and Governance Committee Charter. This policy outlines our Board’s goals, responsibilities, and procedures related to nominating and governance matters. In this regard, our Board may consider candidates recommended by stockholders as well as from other sources such as other directors or officers, third party search firms or other appropriate sources.
For all potential candidates, the Board considers a number of factors, such as the extent to which the candidate’s knowledge and experience would fill a need in the Board and help complement the other directors, a candidate’s personal integrity and sound judgment, independence, knowledge of the industry in which we operate, possible conflicts of interest, and concern for the long-term interests of our stockholders. In addition, although the Company does not have a formal policy regarding the consideration of diversity in identifying and evaluating potential director candidates, the Board will consider diversity in the context of the Board as a whole and takes into account the personal characteristics (gender, ethnicity and age), skills and experience, qualifications and background of current and prospective directors diversity as one factor in identifying and evaluating potential director candidates. In general, persons recommended by stockholders will be considered on the same basis as candidates from other sources. If a stockholder wishes to nominate a candidate to be considered for election as a director at our 2014 Annual Meeting of Stockholders using the procedures set forth in the Company's Amended and Restated By-laws, it must follow the procedures described under “Nomination of Directors” in our Amended and Restated By-laws. If a stockholder wishes simply to propose a candidate for consideration as a nominee by our Board, it should submit any pertinent information regarding the candidate to the Chairman of the Board by mail care of our Secretary at 26 Avenue at Port Imperial, Suite #407, West New York, New Jersey 07093.
Compensation Committee. The Compensation Committee is responsible for:
•evaluating our compensation policies;
•determining executive compensation, and establishing executive compensation policies and guidelines; and
•administering our stock option and compensation plans.
As part of these responsibilities, the Compensation Committee determines the compensation of our Chief Executive Officer, and conducts its decision making process with respect to this issue without the presence of the Chief Executive Officer. The Compensation Committee had one formal meeting and additional informal meetings and discussions during 2013. The Compensation Committee has a charter, a copy of which is available to our stockholders at the Corporate Governance section of our website located at www.deltathree.com. The Compensation Committee is composed of Lior Samuelson (Chairman), J. Lyle Patrick and Donna Reeves-Collins.
Audit Committee. The Audit Committee is responsible for:
•recommending to the Board the appointment of the firm selected to serve as our independent auditors and monitoring the performance of such firm;
•reviewing and approving the scope of the annual audit and evaluating with the independent auditors our annual audit and annual financial statements;
•reviewing with management the status of internal accounting controls;;
•evaluating issues having a potential financial impact on us which may be brought to the Audit Committee’s attention by management, the independent auditors or the Board;
•evaluating our public financial reporting documents; and
•reviewing the non-audit services to be performed by the independent auditors, if any, and considering the effect of such performance on the auditor's independence.
The Audit Committee had four meetings during 2013. The Audit Committee has a charter, a copy of which is available to our stockholders at the Corporate Governance section of our website located at www.deltathree.com. The Audit Committee is composed of J. Lyle Patrick (Chairman), Lior Samuelson and Donna Reeves-Collins. The Board of Directors has determined that each of Mr. Patrick, Mr. Samuelson and Ms. Reeves-Collins meets the requirements of the applicable Securities and Exchange Commission rules for membership on the Audit Committee, including Rule 10A-3(b) under the Exchange Act and is “independent” as defined in Rule 5605(a)(2) of the Nasdaq Marketplace Rules. The Board has also determined that Mr. Patrick qualifies as an “audit committee financial expert” as defined in Item 407 of Regulation S-K.
Board Leadership Structure
The Board has no policy regarding the need to separate or combine the offices of Chairman of the Board and Chief Executive Officer and remains free to make this determination from time to time in a manner that the Board deems most appropriate for our company. Currently, we have separated the positions of CEO and Chairman of the Board in recognition of the differences between the two roles. The CEO is responsible for the day to day leadership and performance of the Company, while the Chairman of the Board (in collaboration with other members of the Board) sets the strategic direction of the Company, provides guidance to the management, sets the agenda for the Board meetings (in collaboration with the other members of the Board) and presides over meetings of the Board. We believe that separating these positions allows the Chairman of the Board to lead the board in its fundamental role of providing direction and guidance to management, while allowing our Chief Executive Officer to focus on our day-to-day operations. In addition, we believe that the current separation provides a more effective monitoring and objective evaluation of the performance of the CEO.
Risk Management
The Board is actively involved in the oversight and management of risks that could affect our company. This oversight and management is conducted primarily through committees of the Board, as disclosed in the descriptions of each of the committees above and in the charters of each of the committees, but the full Board has retained responsibility for general oversight of risks. The Board regularly receives reports from members of senior management on areas of material risk to the company, including operational, financial, regulatory and legal. The Audit Committee oversees management of financial risks (including liquidity and credit) and approves all transactions with related persons. The Compensation Committee is responsible for overseeing the management of risks relating to the Company’s executive compensation plans and arrangements. The Board satisfies its oversight responsibility through full reports by each committee chair regarding the committee’s considerations and actions, as well as through regular reports directly from officers responsible for oversight of particular risks within the Company.
Legal Proceedings
None.
Section 16(a) Beneficial Ownership Reporting Compliance
Section 16(a) of the Exchange Act requires that the Company’s directors, executive officers and persons who own more than 10% of the outstanding common stock of the Company file initial reports of ownership and reports of changes in ownership in such common stock with the SEC. Officers, directors and stockholders who own more than 10% of the outstanding common stock are required by the SEC to furnish the Company with copies of all Section 16(a) reports they file.
To our knowledge, based solely upon our review of the copies of such reports furnished to us, we believe that all of our directors, officers and holders of more than 10% of any class of our equity securities have complied with the applicable Section 16(a) reporting requirements.
Code of Conduct and Ethics
On March 25, 2004, we adopted a Corporate Code of Conduct and Ethics applicable to all employees and directors of deltathree, including our principal executive officer, principal financial and accounting officer and controller. There were no changes made to the Corporate Code of Conduct and Ethics during 2013. The text of the Corporate Code of Conduct and Ethics is posted on the Corporate Governance section of our website at www.deltathree.com and will be made available to stockholders without charge, upon request, in writing to the Secretary at 26 Avenue at Port Imperial, Suite #407, West New York, New Jersey 07093. We intend to post on our website any amendments to, or waivers from, our Code of Conduct and Ethics that apply to our principal executive officer, principal financial and accounting officer and controller. We have all of our new employees certify that they have read and understand our Corporate Code of Conduct and Ethics, and, periodically, we also ask our existing employees to certify that they have reviewed our Corporate Code of Conduct and Ethics.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Summary Compensation Table
The following table shows the total compensation accrued during the fiscal years ended December 31, 2012 and 2013 to (1) all individuals who served as our Chief Executive Officer during any part of 2013 and (2) one executive officer whose total compensation exceeded $100,000 during the fiscal year ended December 31, 2013. These executive officers are referred to in this Annual Report as our “named executive officers”. We did not have any other executive officer whose total compensation exceeded $100,000 during the fiscal year ended December 31, 2013.
(1)Represents the aggregate grant date fair value calculated in accordance with ASC 718-10 in connection with the issuance of the applicable restricted stock or restricted unit award or option award. For a detailed discussion of the assumptions made in the valuation of stock awards, please see the Notes to the Consolidated Financial Statements included in this Annual Report.
Employment Agreement with Mr. Effi Baruch
We currently have an employment agreement with Mr. Baruch, our Chief Executive Officer, President and Senior Vice President of Operations and Technology. The agreement became effective on December 9, 2008, and was amended as of March 17, 2009, October 20, 2009, October 27, 2010, and August 17, 2011. Mr. Baruch receives a base salary of $180,735.60 per year, which is adjusted as of January 15 each year by the percentage change in the Cost of Price Index during the preceding year. Mr. Baruch is entitled to receive an annual bonus under our then-applicable bonus plan equal to up to three (3) months’ salary based on performance criteria that will be agreed upon by him and the Board of Directors. In the event of termination of the agreement, the terminating party is required to provide the other party 90 days’ written notice unless the Company terminates the agreement for cause, in which case the Company is required to provide such written notice required by applicable law. In the event the Company terminates the agreement without cause, Mr. Baruch shall be entitled to receive a lump sum payment equal to his then-current monthly base salary multiplied by three, subject to Mr. Baruch executing a general release of all claims to the maximum extent permitted by law. However, if Mr. Baruch is offered and accepts employment in any other position with our company or any subsidiary or affiliate, we will not be required to make any such severance payment.
Outstanding Equity Awards at Fiscal Year-End
The following table shows certain information with respect to stock options and unvested stock awards outstanding as of December 31, 2013, for each of the named executive officers.
(1)For a better understanding of this table, we have included an additional column showing the grant date of the stock options. Subject to the terms and conditions contained in any award agreement between the Company and the holder of any such award, in the event of a change of control of the Company the outstanding stock options granted under our 2009 Stock Incentive Plan or our Amended and Restated 2004 Stock Incentive Plan, as applicable, will not accelerate and become immediately vested and exercisable unless otherwise determined by the Compensation Committee.
(2)Options to purchase 125,000 shares vested and became exercisable on each of September 15, 2010, 2011, 2012 and 2013.
(3)Options to purchase 81,250 shares vested and became exercisable on October 19, 2011, 2012 and 2013, and options to purchase 81,250 shares vest and become exercisable on October 19, 2014.
(4)Options to purchase 125,000 shares vested and became exercisable on each of September 15, 2012 and 2013, and options to purchase 125,000 shares vest and become exercisable on each of September 15, 2014 and 2015.
(5)Options to purchase 125,000 shares vested and became exercisable on May 24, 2013, and options to purchase 125,000 shares vest and become exercisable on each of May 24, 2014, 2015 and 2016.
(6)Options to purchase 37,500 shares vested and became exercisable on each of September 15, 2010, 2011, 2012 and 2013.
(7)Options to purchase 25,000 shares vested and became exercisable on each of October 19, 2011, 2012 and 2013, and options to purchase 25,000 shares vest and become exercisable on October 19, 2014.
(8)Options to purchase 37,500 shares vested and became exercisable on each of September 26, 2012 and 2013, and options to purchase 37,500 shares vest and become exercisable on each of September 26, 2014 and 2015.
(9)Options to purchase 37,500 shares vested and became exercisable on May 24, 2013, and options to purchase 37,500 shares vest and become exercisable on each of May 24, 2014, 2015 and 2016.
Director Compensation
The following table shows the total compensation earned for services performed for us by each member of our Board of Directors during the fiscal year ended December 31, 2013.
(1)Represents the aggregate grant date fair value, calculated in accordance with ASC 718-10, of options to purchase shares of the Common Stock that were granted in prior years to each of Lior Samuelson, Anthony Cassara, J. Lyle Patrick and Colleen Jones. The grants were made pursuant to the 2009 Stock Incentive Plan. Each of Robert Stevanovski and David Stevanovski elected to waive their right to receive such grant. For a detailed discussion of the assumptions made in the valuation of stock awards, please see the Notes to the Consolidated Financial Statements included in this Annual Report.
(2)Each of Robert Stevanovski and David Stevanovski elected to waive their right to receive compensation for their services to the Company. This election is revocable by each of Messrs. R. Stevanovski and D. Stevanovski at any time.
(3)Represents $20,000 earned by each of Mr. Cassara, Ms. Jones for their respective service as a director.
(4)Represents $20,000 earned by Mr. Samuelson for his services as a director, $5,000 for his services as a member of the Audit Committee and, $15,000 for his services as the Chairman of the Compensation Committee.
(5)Represents $20,000 earned by Mr. Patrick for his services as a director, $20,000 for his services as Chairman of the Audit Committee and $5,000 for his services as a member of the Compensation Committee
(6)Represents $20,000 earned by Ms. Reeves-Collins for her services as a director, $5,000 for her services as member of the Audit Committee and $5,000 for her services as a member of the Compensation Committee.
Director Compensation Policy
In May 2009, the Board of Directors approved the following annual cash compensation for our directors effective as of April 1, 2009:
•each director receives cash compensation of $20,000;
•the Chairman of the Audit Committee receives additional cash compensation of $20,000;
•the Chairman of the Compensation Committee receives additional cash compensation of $15,000 and
•each non-Chairman committee member receives additional cash compensation of $5,000.
We reimburse each member of our Board of Directors for reasonable travel and other expenses in connection with attending meetings of the Board of Directors.
Each of our directors has the right to elect to convert the total cash compensation that such director is eligible to receive into shares of our common stock at the then-applicable market price. Directors have the right to make this election only during such times as the employees and directors of the company are not in a black-out period in trading in securities of the company and such director is not in possession of material, non-public information about the company. Any such shares so acquired by a director are restricted and vest only after a period of one year from the date of grant, following which the director is able to sell such shares in accordance with Rule 144 under the Securities Act of 1933.
At this time each of Robert Stevanovski and David Stevanovski has elected to waive their right to receive compensation for their services to the company. This election is revocable by each of Messrs. R. Stevanovski and D. Stevanovski at any time.
On December 31, 2013, each of our directors who have not elected to waive their right to receive compensation for their services to the company executed a letter agreement with us. Pursuant to the letter agreement each of those directors agreed, effective January 1, 2014, to defer receipt of payment of fifty percent of the amounts otherwise payable to them in cash by us in connection with their respective service as a member of our Board of Directors and chairmanship or membership fees otherwise payable in connection with their respective service on the committees of our Board during the period covered by the agreement. The deferred payments do not include stock-based compensation paid or payable to them or reimbursement for expenses incurred by them, and are to be paid by us to them in a lump sum by December 31, 2014. In the event of a Change of Control (as defined in our 2009 Stock Incentive Plan), we are required to pay the deferred payments in a lump sum within 30 days thereafter. Each of the letter agreements is terminable by either us or the respective directors upon 30 days written notice.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
As of March 24, 2014, there were 72,311,025 shares of our common stock issued and outstanding. Each share of common stock entitles the holder thereof to one vote with respect to each item to be voted on by holders of the shares of common stock. We have no other securities, voting or nonvoting, outstanding.
The following table sets forth information with respect to the beneficial ownership of shares of our common stock as of March 12, 2014, by:
•each person whom we know beneficially owns more than 5% of the common stock;
•each of our directors individually;
•each of our named executive officers individually; and
•all of our current directors and executive officers as a group.
Unless otherwise indicated, to our knowledge, all persons listed below have sole voting and investment power with respect to their shares of common stock. Each person listed below disclaims beneficial ownership of their shares, except to the extent of their pecuniary interests therein. Shares of common stock that an individual or group has the right to acquire within 60 days of March 12, 2014, pursuant to the exercise of options or the vesting of restricted stock or restricted units are deemed to be outstanding for the purpose of computing the percentage ownership of such person or group, but are not deemed outstanding for the purpose of calculating the percentage owned by any other person listed.
*Less than 1%.
(1)Percentage of beneficial ownership is based on 72,311,025 shares of common stock outstanding as of March 24, 2014.
(2)Ownership is based on a Schedule 13D/A filed November 19, 2012, by D4 Holdings, Manna Holdings, Praescient, LLC (“Praescient”) and Robert Stevanovski and includes (a) 39,000,000 shares of common stock, (b) 55,000,000 shares of common stock issuable under warrants held by D4 Holdings and (c) 20,000,000 shares of common stock issuable upon conversion of outstanding principal under the Convertible Note held by D4 Holdings. For a description of the Convertible Note, see Part I, Item 1. “Business - Transactions with D4 Holdings.” Robert Stevanovski is the manager of Praescient, which serves as the sole manager of D4 Holdings and as the managing member of Manna Holdings. Manna Holdings is the sole member of D4 Holdings. As such, Mr. Stevanovski, Praescient and Manna Holdings may be deemed to beneficially own the securities reported in the table. Each of Mr. Stevanovski, Praescient and Manna Holdings disclaims beneficial ownership of such securities, and the information reported herein shall not be deemed an admission that such reporting person is the beneficial owner of the securities for any purpose, except to the extent of such person’s pecuniary interest therein.
(3)Ownership is based on a Form 4 filed April 1, 2011.
(4)Includes (a) options to purchase 1,468,750 shares of common stock and (b) 55,000 shares of common stock.
(5)Includes (a) options to purchase 372,500 shares of common stock and (b) 6,000 shares of common stock.
(6)Includes the following securities: (a) 39,000,000 shares of common stock, (b) warrants to purchase 55,000,000 shares of common stock and (c) 20,000,000 shares of common stock issuable upon conversion of outstanding principal under the Convertible Note. Each of Anthony Cassara and David Stevanovski beneficially owns a membership interest in Manna Holdings, which is the sole member of D4 Holdings. As such, each of Messrs. Cassara and Stevanovski may be deemed to beneficially own the securities reported herein and owned directly by D4 Holdings. Each of Messrs. Cassara and Stevanovski disclaims beneficial ownership of such securities, and the information reported herein shall not be deemed an admission that such reporting person is the beneficial owner of the securities for any purpose, except to the extent of his pecuniary interest therein.
(7)Includes options to purchase 250,000 shares of common stock.
(8)Includes (a) options to purchase 590,000 shares of common stock and (b) 152,000 shares of common stock.
(9)Includes options to purchase 125,000 shares of common stock.
(10)Includes options to purchase 25,000 shares of common stock.
(11)Includes (a) 39,207,000 shares of common stock, (b) options to purchase 2,831,250 shares of common stock, (c) warrants to purchase 55,000,000 shares of common stock and (d) 20,000,000 shares of common stock issuable upon conversion of outstanding principal under the Convertible Note held directly (or deemed to be beneficially owned) by all of our current directors and executive officers as a group.
Equity Compensation Plan Information
The following table provides certain aggregate information with respect to shares of our common stock that may be issued under our equity compensation plans in effect as of December 31, 2013.
(1)These plans consist of our Amended and Restated 2004 Stock Incentive Plan and Amended and Restated 2006 Non-Employee Director Stock Plan, which were terminated except with respect to outstanding options previously granted thereunder, and our 2009 Stock Incentive Plan.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
Certain Relationships and Related Transactions
As described above under “Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters”, D4 Holdings beneficially owns an aggregate of approximately 77.4% of our common stock (which includes 39,000,000 shares of common stock, warrants to purchase 55,000,000 shares of our common stock, and 20,000,000 shares of common stock issuable upon conversion of outstanding principal under the Convertible Note. The ultimate ownership of D4 Holdings includes owners of ACN, Inc. Each of Robert Stevanovski, Anthony Cassara and David Stevanovski, members of the Company’s Board of Directors, is a principal of D4 Holdings. As a result, each of these individuals and D4 Holdings may be deemed to have a direct or indirect interest in the transactions contemplated by the Purchase Agreement and the Investor Rights Agreement, and the Loan Agreements, described above under “Item 1. Business - Transactions with D4 Holdings”.
During the third quarter of 2009 we entered into an agreement with ACN Pacific Pty Ltd., a wholly-owned subsidiary of ACN, pursuant to which we provide digital video and voice-over-IP telecommunications services in Australia and New Zealand to ACN Pacific. In October 2010 we entered into a sales agency agreement with ACN pursuant to which ACN sells a private label version of joip Mobile under the ACN Mobile World brand. In December 2010 we entered into an agreement with ACN Korea, a wholly-owned subsidiary of ACN, pursuant to which we provide digital video and voice-over-IP services in Korea. In April 2011 we entered into an introducer agreement with ACN Europe B.V., a wholly-owned subsidiary of ACN, pursuant to which ACN Europe refers potential customers in different countries in Europe to a private label version of joip Mobile sold under the ACN Mobile World brand.
The following table sets forth the revenue we recognized from the agreements described above, for the periods presented:
The following table details the commission paid and accrued to our affiliates in connection with our sales agreements, for the periods presented:
Each of Robert Stevanovski, Anthony Cassara and David Stevanovski has an ownership interest in, and a director, officer and/or advisory position with, ACN. As a result of their relationship with ACN, each of these individuals may be deemed to have a direct or indirect interest in the transactions contemplated by our agreements with ACN and ACN Korea.
All transactions between us and our officers, directors, principal stockholders and affiliates must be reviewed and approved in advance by the Audit Committee. To the extent that any member of the Audit Committee has an interest in any such transaction, the member will recuse himself from considering and voting on the matter.
Director Independence
Our common stock is currently quoted on the OTCQB and is not listed on the Nasdaq Stock Market or any other national securities exchange. Accordingly, we are not currently subject to the Nasdaq continued listing requirements or the requirements of any other national securities exchange. Nevertheless, in determining whether a director or nominee for director should be considered “independent” the board utilizes the definition of independence set forth in Rule 5605(a)(2) of the Nasdaq Marketplace Rules. The board has determined that J. Lyle Patrick qualifies as “independent” under this rule.
Our company also would qualify as a “controlled company” under Rule 5615(c)(2) of the Nasdaq Marketplace Rules because D4 Holdings holds more than 50% of the voting power of our company. Accordingly, we would have the option to be exempt from the requirements under Rule 5605 to have:
•a majority of independent directors;
•a compensation committee composed solely of independent directors;
•compensation of our executive officers determined by a majority of independent directors or a compensation committee composed solely of independent directors;
•a nominating committee composed solely of independent directors; and
•director nominees selected, or recommended for the Board's selection, either by a majority of the independent directors or a nominating committee composed solely of independent directors.
Because we are not currently subject to the Nasdaq continued listing requirements we have not determined to what extent we would rely on the “controlled company” exemption from any of the foregoing requirements if we were subject to these requirements.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
The following table presents fees for professional audit services rendered by Brightman Almagor Zohar & Co. for the audit of the Company's annual financial statements for the years ended December 31, 2013 and 2012, and fees billed for other services rendered by Brightman Almagor Zohar & Co. during those periods.
In the above table, in accordance with the SEC’s definitions and rules, “audit fees” are fees we paid Brightman Almagor Zohar & Co. for professional services for the audit of our annual financial statements and review of financial statements included in our quarterly reports filed with the SEC, as well as for work generally only the independent auditor can reasonably be expected to provide, such as statutory audits and consultation regarding financial accounting and/or reporting standards; “audit-related fees” are fees billed by Brightman Almagor Zohar & Co. for assurance and related services that are reasonably related to the performance of the audit or review of our financial statements; “tax fees” are fees for tax compliance, tax advice and tax planning; and “all other fees” are fees billed by Brightman Almagor Zohar & Co. for any services not included in the first three categories.
Policy on Audit Committee Pre-Approval of Audit and Permissible Non-Audit Services of Independent Auditors
Consistent with SEC policies regarding auditor independence, the Audit Committee has responsibility for appointing, setting compensation and overseeing the work of the independent auditor. In recognition of this responsibility, the Audit Committee has established a policy to pre-approve all audit and permissible non-audit services provided by the independent auditor.
Prior to engagement of the independent auditor for the next year's audit, management will submit an aggregate of services expected to be rendered during that year for each of four categories of services to the Audit Committee for approval.
1. Audit services include audit work performed in the preparation of financial statements, as well as work that generally only the independent auditor can reasonably be expected to provide, including comfort letters, statutory audits, and attest services and consultation regarding financial accounting and/or reporting standards.
2. Audit-related services are for assurance and related services that are traditionally performed by the independent auditor, including due diligence related to mergers and acquisitions, employee benefit plan audits, and special procedures required to meet certain regulatory requirements.
3. Tax services include all services performed by the independent auditor's tax personnel except those services specifically related to the audit of the financial statements, and includes fees in the areas of tax compliance, tax planning, and tax advice.
4. Other services are those associated with services not captured in the other categories. The Company generally does not request such services from the independent auditor.
Prior to engagement, the Audit Committee pre-approves these services by category of service. The fees are budgeted and the Audit Committee requires the independent auditor and management to report actual fees versus the budget periodically throughout the year by category of service. During the year, circumstances may arise when it may become necessary to engage the independent auditor for additional services not contemplated in the original pre-approval. In those instances, the Audit Committee requires specific pre-approval before engaging the independent auditor.
The Audit Committee may delegate pre-approval authority to one or more of its members. The member to whom such authority is delegated must report, for informational purposes only, any pre-approval decisions to the Audit Committee at its next scheduled meeting.
PART IV
ITEM 15.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES
(a)(1) Financial Statements.
The Consolidated Financial Statements filed as part of this Annual Report are identified in the Index to Consolidated Financial Statements on page hereto.
(a)(2) Financial Statement Schedules.
Financial Statement Schedules have been omitted because the information required to be set forth therein is not applicable or is shown on the financial statements or notes thereto.
(a)(3) Exhibits.
We hereby file, as exhibits to this Annual Report, those exhibits listed on the Exhibit Index immediately following the signature page hereto.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this Annual Report on Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized, on March 31, 2014.
DELTATHREE, INC.
By: /s/ Effi Baruch
Effi Baruch
Chief Executive Officer, President and Senior Vice
President of Operations and Technology
(Principal Executive Officer)
KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Effi Baruch his true and lawful attorney-in-fact, acting alone, with full power of substitution, for and in the name, place and stead of the undersigned, in any and all capacities to sign any and all amendments to this Annual Report on Form 10-K, and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, and hereby grants to such attorney-in-fact and agents full power and authority to do and perform each and every act and thing requisite and necessary to be done, as fully to all intents and purposes as the undersigned might or could do in person, hereby ratifying and confirming all that said attorney-in-fact and agent or his substitutes, may lawfully do or cause to be done by virtue thereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this Annual Report on Form 10-K has been signed by the following persons on behalf of the registrant and in the capacities and on the dates indicated:
Signature
Title
Date
/s/ Effi Baruch
Chief Executive Officer, President and Senior
March 31,
Effi Baruch
Vice President of Operations and Technology
(Principal Executive Officer)
/s/ Yochai Ozeri
Director of Finance and Treasurer (Principal
March 31,
Yochai Ozeri
Financial Officer and Principal Accounting Officer)
/s/ Robert Stevanovski
Chairman of the Board of Directors
March 31,
Robert Stevanovski
/s/ Anthony Cassara
Director
March 31,
Anthony Cassara
/s/ David Stevanovski
Director
March 31,
David Stevanovski
/s/ Colleen Jones
Director
March 31,
Colleen Jones
/s/ Lior Samuelson
Director
March 31,
Lior Samuelson
/s/ J. Lyle Patrick
Director
March 31,
J. Lyle Patrick
/s/ Donna Reeves-Collins
Director
March 31, 2014
Donna Reeves-Collins
EXHIBIT INDEX
The following documents are filed as exhibits to this Annual Report on Form 10-K or incorporated by reference to exhibits previously filed with the Securities and Exchange Commission.
Exhibit
Number
Description
3.1
Form of the Company’s Amended and Restated Certificate of Incorporation (incorporated by reference from our Annual Report on Schedule 14A filed on April 30, 2002).
3.2
Form of the Company’s Amended and Restated By-laws (incorporated by reference from our registration statement on Form S-1 (Registration No. 333-122242)).
3.3
Certificate of Amendment to the Company’s Amended and Restated Certificate of Incorporation (incorporated by reference from our Quarterly Report on Form 10-Q filed on August 14, 2009).
4.1
Specimen Certificate of Common Stock (incorporated by reference from our registration statement on Form S-1 (Registration No. 333-122242)).
4.2
Convertible Promissory Note, dated March 2, 2011, by deltathree, Inc., Delta Three Israel, Ltd. and DME Solutions, Inc. in favor of D4 Holdings, LLC in a principal amount of $1,600,000 (incorporated by reference from our Current Report on Form 8-K filed on March 3, 2011).
4.3
Promissory Note, dated September 12, 2011, by deltathree, Inc., Delta Three Israel, Ltd. and DME Solutions, Inc. in favor of D4 Holdings, LLC in a principal amount of $300,000 (incorporated by reference from our Current Report on Form 8-K filed on September 12, 2011).
10.1
2004 Non-Employee Director Stock Option Plan (incorporated by reference from our registration statement on Form S-8 (Registration No. 333-122242)).+
10.2
First Amendment to the deltathree, Inc. 2004 Non-Employee Director Stock Option Plan, dated as of December 20, 2005 (incorporated by reference from Exhibit 10.2 of our Current Report on Form 8-K filed on December 21, 2005).+
10.3
Form of Option Agreement Pursuant to 2004 Non-Employee Director Stock Option Plan (incorporated by reference from our Annual Report on Form 10-K filed on March 31, 2005).+
10.4
deltathree, Inc. Amended and Restated 2004 Stock Incentive Plan (incorporated by reference from our Definitive Proxy Statement on Schedule 14A filed on June 19, 2008).+
10.5
deltathree, Inc. Amended and Restated 2006 Non-Employee Director Stock Plan (incorporated by reference from our Definitive Proxy Statement on Schedule 14A filed on June 19, 2008).+
10.6
Form of Option Agreement Pursuant to 2004 Stock Incentive Plan (incorporated by reference from our Annual Report on Form 10-K filed on March 31, 2005).+
10.7
Form of Restricted Unit Agreement Pursuant to 2004 Stock Incentive Plan (incorporated by reference from our Annual Report on Form 10-K filed on March 31, 2008).+
10.8
deltathree, Inc. 2009 Stock Incentive Plan (incorporated by reference from our Definitive Proxy Statement on Schedule 14A filed on June 22, 2009).+
10.9
Form of deltathree, Inc. 2009 Stock Incentive Plan Incentive Stock Option Grant Agreement (incorporated by reference from our Quarterly Report on Form 10-Q filed on August 14, 2009).
10.10
Form of deltathree, Inc. 2009 Stock Incentive Plan Nonstatutory Stock Option Grant Agreement (for U.S. taxpayers) (incorporated by reference from our Quarterly Report on Form 10-Q filed on August 14, 2009).+
10.11
Form of deltathree, Inc. 2009 Stock Incentive Plan Nonstatutory Stock Option Grant Agreement under Section 102(b)(2) of the Israeli Income Tax Ordinance (for Israeli taxpayers) (incorporated by reference from our Quarterly Report on Form 10-Q filed on August 14, 2009).+
10.12
Form of deltathree, Inc. 2009 Stock Incentive Plan Nonstatutory Stock Option Grant Agreement under Section 3(i) of the Israeli Income Tax Ordinance (for Israel taxpayers) (incorporated by reference from our Quarterly Report on Form 10-Q filed on August 14, 2009).+
10.13
Form of deltathree, Inc. 2009 Stock Incentive Plan Restricted Stock Award Agreement (for U.S. taxpayers) (incorporated by reference from our Quarterly Report on Form 10-Q filed on August 14, 2009).+
10.14
Form of deltathree, Inc. 2009 Stock Incentive Plan Restricted Stock Award Agreement (for Israeli taxpayers) (incorporated by reference from our Quarterly Report on Form 10-Q filed on August 14, 2009).+
10.15
Letter Amendment, dated as of April 1, 2012, between deltathree, Inc., Delta Three Israel, Ltd. and DME Solutions, Inc. and LKN Communications, Inc., doing business as ACN, Inc. (incorporated by reference from our Current Report on Form 8-K filed on April 4, 2012).
10.16
Third Amendment to Loan and Security Agreements, dated as of November 13, 2012, by and among deltathree, Inc., Delta Three Israel, Ltd., DME Solutions, Inc. and D4 Holdings, LLC. (incorporated by reference from our Quarterly Report on Form 10-Q filed on November 14, 2012).
10.17
Amendment to Warrant Agreements, dated as of November 13, 2012, by and among deltathree, Inc. and D4 Holdings, LLC. (incorporated by reference from our Quarterly Report on Form 10-Q filed on November 14, 2012).
10.18
Warrant, dated November 13, 2012, between deltathree, Inc., and D4 Holdings, LLC. (incorporated by reference from our Quarterly Report on Form 10-Q filed on November 14, 2012).
10.19*
Assignment and Assumption of Rights, Duties and Interests Agreement, dated as of February 7, 2013 between deltathree, Inc. and ACN Digital Phone Services, Inc.
10.20*
Form of Letter Agreement regarding deferral of certain cash compensation between deltathree, Inc. and certain of its directors.
10.21*
Forbearance Agreement, dated as of March 28, 2014, by and among deltathree, Inc., Delta Three Israel, Ltd., DME Solutions, Inc. and D4 Holdings, LLC.
10.22*
Warrant, dated March 28, 2014, between deltathree, Inc., and D4 Holdings, LLC.
21.1*
Subsidiaries of deltathree, Inc.
23.1*
Consent of Brightman Almagor Zohar & Co.
31.1*
Certification of the Chief Executive Officer, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2*
Certification of the Chief Financial Officer, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1*
Certification of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2*
Certification of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
101.INS*
XBRL Instance Document.**
101.SCH*
XBRL Taxonomy Extension Schema Document.**
101.CAL*
XBRL Taxonomy Extension Calculation Linkbase Document.**
101.DEF*
XBRL Taxonomy Extension Definition Linkbase Document.**
101.LAB*
XBRL Taxonomy Extension Label Linkbase Document.**
101.PRE*
XBRL Taxonomy Extension Presentation Linkbase Document.**
*Filed herewith.
+Indicates management contract or compensatory plan, contract or arrangement.
**Pursuant to Rule 406T of Regulation S-T, these interactive data files are deemed not “filed” for purposes of Section 18 of the Exchange Act, or otherwise subject to the liability of that section and shall not be deemed to be incorporated by reference into any filing under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, except to the extent that the Company specifically incorporates such information by reference.
Index to Consolidated Financial Statements
Brightman Almagor Zohar
1 Azrieli Center
Tel Aviv 67021
P.O.B. 16593,
Tel Aviv 61164
Israel
Tel: +972 (3) 608 5555
Fax: +972 (3) 609 4022
info@deloitte.co.il
www.deloitte.co.il
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and
Shareholders of deltathree, Inc.
We have audited the accompanying consolidated balance sheets of deltathree, Inc. ("the Company") and its subsidiary as of December 31, 2013 and 2012, and the related consolidated statements of operations, changes in stockholders' deficiency and cash flows for each of the three years in the period ended December 31, 2013. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit 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, such consolidated financial statements, present fairly, in all material respects, the financial position of the Company and its subsidiary as of December 31, 2013 and 2012, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2013 in conformity with accounting principles generally accepted in the United States of America.
The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the financial statements, the Company's recurring losses from operations and deficiency in stockholders' equity raise substantial doubt about its ability to continue as a going concern. Management's plans concerning these matters are also discussed in Note 1 to the financial statements. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.
/s/ Brightman Almagor Zohar & Co.
Brightman Almagor Zohar & Co.
Certified Public Accountants
A member firm of Deloitte Touche Tohmatsu Limited
Tel Aviv, Israel
March 30, 2014
DELTATHREE, INC.
CONSOLIDATED BALANCE SHEETS
($ in thousands)
The accompanying notes are an integral part of these consolidated financial statements.
DELTATHREE, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
($ in thousands, except share and per share data)
The accompanying notes are an integral part of these consolidated financial statements.
DELTATHREE, INC.
STATEMENTS OF STOCKHOLDERS’ DEFICIENCY
($ in thousands, except share data)
* Less than $1.
The accompanying notes are an integral part of these consolidated financial statements.
DELTATHREE, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
($ in thousands)
The accompanying notes are an integral part of these consolidated financial statements.
DELTATHREE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1 - The Company
deltathree, Inc. (the “Company”) is a global provider of integrated Voice over Internet Protocol, or VoIP, digital video and voice-over-IP services, products, hosted solutions and infrastructure. The Company was founded in 1996 to capitalize on the growth of the Internet as a communications tool by commercially offering Internet Protocol, or IP, telephony services, or VoIP telephony. While the Company began as primarily a low-cost alternative source of wholesale minutes for carriers around the world, it has evolved into an international provider of next generation communication services.
Going Concern
The Company has sustained significant operating losses in recent periods, which has resulted in a significant reduction in its cash reserves. The Company and its subsidiaries have entered into four loan agreements with D4 Holdings, LLC, its majority stockholder, pursuant to which D4 Holdings has agreed to provide the Company with loans in the aggregate principal amount of $4,100,000. The initial Loan and Security Agreement was entered into on March 1, 2010, and the Company has drawn the maximum principal amount available under the initial Loan and Security Agreement. On August 10, 2010, the Company and its subsidiaries entered into the Second Loan and Security Agreement, or the “Second Loan Agreement”, with D4 Holdings with a maximum principal amount of $1,000,000, and the Company has drawn the maximum principal amount available under the Second Loan Agreement. In connection with the Second Loan Agreement, the Company issued D4 Holdings a warrant to purchase up to 4,000,000 shares of the Company's common stock at an exercise price of $0.1312 per share. On March 2, 2011, the Company and its subsidiaries entered into the Third Loan and Security Agreement, or the “Third Loan Agreement”, with D4 Holdings, pursuant to which D4 Holdings agreed to provide the Company and its subsidiaries an additional line of credit in a principal amount of $1,600,000. Pursuant to the terms of the Convertible Promissory Note, or the “Convertible Note”, issued by the Company in connection with the Third Loan Agreement, D4 Holdings may elect to convert all or any portion of the outstanding principal amount under the Convertible Note into that number of shares of the Company’s common stock determined by dividing such principal amount by $0.08 (as may be adjusted under the terms of the Convertible Note). Simultaneous with the Company’s entering into the Third Loan Agreement, D4 Holdings and the Company entered into an amendment of the First Loan Agreement, pursuant to which (among other things) the maturity date for repayment of principal under the First Loan Agreement was extended from March 1, 2011, to March 1, 2012, and then subsequently extended by oral agreement of the parties to July 1, 2012, and subsequently orally extended again to January 2, 2014, pending the parties finalizing and entering into a formal amendment. In connection with the Third Loan Agreement, the Company issued D4 Holdings a warrant to purchase up to 1,000,000 shares of the Company’s common stock at an exercise price of $0.096 per share. The Company has drawn the aggregate principal amount available under the Third Loan Agreement, the principal amount of which can be converted by D4 Holdings into an aggregate of 20,000,000 shares of the Company’s common stock. On September 12, 2011, the Company and its subsidiaries entered into the Fourth Loan and Security Agreement, or the “Fourth Loan Agreement”, with D4 Holdings, pursuant to which D4 Holdings agreed to provide the Company and its subsidiaries an additional line of credit in a principal amount of $300,000. As of December 31, 2013, the Company had received advances in the aggregate amount of $300,000 from D4 Holdings pursuant to notices of borrowing under the Fourth Loan Agreement.
On November 13, 2012, the Company and its subsidiaries entered into the Third Amendment to Loan and Security Agreements, or the "Third Amendment", and the Amendment to Warrant Agreements, or the "Warrants Amendment", with D4 Holdings. Pursuant to the Third Amendment and the Warrants Amendment:
· the maturity date for repayment of principal under the First Loan Agreement was extended to January 2, 2014;
· the maturity date for repayment of principal under the Second Loan Agreement was extended to January 2, 2015;
· the maturity date for repayment of principal under each of the Third and Fourth Loan Agreements was extended to January 2, 2016;
· all interest outstanding under each of the loan agreements was added to the principal amount outstanding under the respective loan agreement and the promissory notes issued pursuant to each respective loan agreement was increased by such amount; and
· the exercise price under each of the Warrant Agreements entered into by us and D4 Holdings as of February 12, 2009, August 10, 2010, and March 2, 2011 was amended to $0.02 per share.
In connection with the extension of the maturity dates under the Third Amendment, the Company issued to D4 Holdings a Warrant, exercisable for ten years, to purchase up to 10,000,000 shares of the Company's common stock at an exercise price of $0.02 per share.
Interest payments under the First, Second and Third Loan Agreements are required to be made monthly through the maturity date of each respective loan. In March 2012, D4 Holdings orally agreed to permit the Company to defer such monthly interest payments for periods in which its cash flows from operations were insufficient to make such payments. However, D4 Holdings has not formally agreed to defer such interest payments for future periods.
In January 2014, the Company failed to repay the outstanding principal and accrued interest under the First Loan Agreement on its maturity date. On March 28, 2014, the Company and its subsidiaries entered into a Forbearance Agreement with D4 Holdings, or the Forbearance Agreement, pursuant to which D4 Holdings agreed to forbear from taking any enforcement action under the Company's loan agreements with D4 Holdings resulting from the Company's failure to meet its repayment obligations under the First Loan Agreement until the earliest of (i) December 31, 2014, (ii) repayment in full of all obligations under the First Loan Agreement, (iii) the occurrence of any breach of our obligations under the Forbearance Agreement, or (iv) the occurrence of any additional default under the Company's loan agreements with D4 Holdings. In connection with the Forbearance Agreement, the Company issued to D4 Holdings a warrant, exercisable for ten years, to purchase up to 10,000,000 shares of the Company's common stock at an exercise price of $0.02 per share.
As of December 31, 2013, the Company had negative working capital equal to approximately $7.5 million as well as negative stockholders’ equity equal to approximately $7.4 million. The Company believes it is probable that it will continue to experience losses and increased negative working capital and negative stockholders’ equity in the near future and will not be able to return to positive cash flow before it requires additional cash in the near term. The Company may experience difficulties accessing the equity and debt markets and raising additional capital, and there can be no assurance that the Company will be able to raise such additional capital on favorable terms or at all. If additional funds are raised through the issuance of equity securities, the Company’s existing stockholders will experience significant further dilution. Because of the Company’s significant losses to date and the Company’s limited tangible assets, the Company does not fit traditional credit lending criteria, which could make it difficult for the Company to obtain loans or to access the capital markets. If the Company issues additional equity or convertible debt securities to raise funds, the ownership percentage of the Company’s existing stockholders would be reduced and they may experience significant dilution. New investors may demand rights, preferences or privileges senior to those of existing holders of the Company’s common stock.
The Company believes that, unless it is able to increase revenues and generate additional cash flows, its current cash and cash equivalents will not satisfy its current projected cash requirements beyond the foreseeable future. As a result, there is substantial doubt about the Company’s ability to continue as a going concern.
In addition, unless the Company is able to increase revenues and generate additional cash flows, based on currently projected cash flows the Company believes that it will be unable to pay future scheduled interest and/or principal payments under the various loan agreements with D4 Holdings as these obligations become due, and beginning January 2013 the Company suspended making scheduled interest payments with the oral consent of D4 Holdings. On January 2, 2014, the Company did not repay to D4 Holdings the outstanding principal and interest due under the First Loan Agreement, which constituted an event of default thereunder and a cross-default under all its other loan agreements with D4 Holdings, following which the Company and its subsidiaries entered into the Forbearance Agreement with D4 Holdings. In the event the Company is unable to resume making interest payments and to pay the outstanding principal when due following the termination of the Forbearance Agreement, if D4 Holdings is not willing to waive compliance or otherwise modify the Company’s obligations such that the Company is able to avoid defaulting on such obligations, because D4 Holdings has a lien on all of the Company’s assets to secure the Company’s obligations under the loan agreements it could take actions under the loan agreements and seek to take possession of or sell the Company’s assets to satisfy the Company’s obligations thereunder. Any of these actions would likely have an immediate material adverse effect on the Company’s business, financial condition or results of operations.
Due to the Company’s ongoing losses and reduction in cash, the Company initiated restructuring activities beginning in the second quarter of 2011 in an effort to cut operating costs significantly and better align the Company’s operations with its current business model. In accordance with the restructuring, the Company instituted a reduction in force and decreased the number of full time employees from approximately 53 to 32, reduced the salaries of all remaining employees by five percent, and decreased non-material expenses as well as payments to be made to vendors and other third parties. In addition, in December 2013 the Company instituted an additional, smaller reduction in force. As of December 31, 2013, the Company had 22 full-time employees.
In view of the Company’s current cash resources, nondiscretionary expenses, debt and near term debt service obligations, the Company may begin to explore all strategic alternatives available to it, including, but not limited to, a sale or merger of the Company, a sale of its assets, recapitalization, partnership, debt or equity financing, voluntary deregistration of its securities, financial reorganization, liquidation and/or ceasing operations. In the event that the Company requires but is unable to secure additional funding, the Company may determine that it is in its best interests to voluntarily seek relief under Chapter 11 of the U.S. Bankruptcy Code. Seeking relief under the U.S. Bankruptcy Code, even if the Company is able to emerge quickly from Chapter 11 protection, could have a material adverse effect on the relationships between the Company and its existing and potential customers, employees, and others. Further, if the Company was unable to implement a successful plan of reorganization, the Company might be forced to liquidate under Chapter 7 of the U.S. Bankruptcy Code. There can be no assurance that exploration of strategic alternatives will result in the Company pursuing any particular transaction or, if the Company pursues any such transaction, that it will be completed.
Note 2 - Summary of significant accounting policies
a. Basis of presentation
The financial statements have been prepared in conformity with U.S. generally accepted accounting principles.
b. Principles of consolidation
The consolidated financial statements include the accounts of the Company and Delta Three Israel Ltd., the Company's Israeli subsidiary (the “Subsidiary”). All significant inter-company accounts and transactions have been eliminated.
c. Financial statements in U.S. dollars
The reporting currency of the Company is the U.S. dollar ("dollar"). The dollar is the functional currency of the Company and its subsidiary. Transactions and balances originally denominated in dollars are presented at their original amounts. Non-dollar transactions and balances are re-measured into dollars in accordance with the principles set forth in “Foreign Currency Matters” [ASC 830]. All exchange gains and losses from translation of monetary balance sheet items resulting from transactions in non-dollar currencies are recorded in the statement of operations as they arise.
d. Use of estimates
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported and disclosed in the consolidated financial statement and the accompanying notes. Actual results could differ from those estimates.
e. Cash and cash equivalents
Cash held in U.S. banks are subject to U.S. Federal Depository Insurance Corporation (“FDIC”) limits of $250,000 and cash held in foreign accounts are unprotected. Due to the Company’s cash needs, management has generally held and continues to hold the majority of its cash in U.S. banks that are insured under the FDIC.
f . Restricted cash
Restricted cash represents amounts held in cash, money market funds and certificates of deposit to support stand-by-letters of credit used as security for third party vendors, as well as amounts deposited as guarantees for the Company’s office in Jerusalem and for currency hedging transactions in which the Company engages.
g. Inventory
Inventory consists of the cost of customer equipment and is at the lower of cost (principally on a standard cost basis that approximates the “first-in-first-out”, or FIFO, standard) or market.
h. Property and equipment
Property and equipment are stated at cost. Depreciation is calculated using the straight-line method over the estimated useful lives of the depreciable assets, which range from two to five years. Leasehold improvements are amortized based on the straight-line method over the shorter of the term of the lease, or the estimated useful life of the improvements.
i. Revenue recognition
The Company recognizes revenues from VoIP telephony services based on minutes (or fractions thereof) of customer usage. The Company records payments received in advance for prepaid services and services to be supplied under contractual agreements as deferred revenue until such related services are provided.
j. Cost of revenues
Cost of revenues consists primarily of direct costs that the Company pays to third parties in order to provide telephony services. These costs include access, transmission and interconnection charges that the Company pays to other access providers to terminate domestic and international phone calls on the public switched telephone network. In addition, these costs include the cost to lease phone numbers and to co-locate in other telephone companies' facilities, as well as to purchase equipment. These costs also include taxes that the Company pays on telecommunications services from its suppliers.
k. Research and development expenses
Research and development expenses are expensed as incurred and consist primarily of payroll and facilities charges associated with the research and development of our current and future products.
l. Income taxes
The Company provides for income taxes using the liability approach defined by “Accounting for Income Taxes” [ASC 740-10]. Deferred tax assets and liabilities are recognized for the expected tax consequences between the tax bases of the assets and liabilities and their reported amounts. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized and are reversed at such time that realization is believed to be more likely than not.
m. Stock-based compensation
The following assumptions were used for the fiscal year 2013: dividend yield of 0.00% for all periods; risk-free interest rate of 1.2%; an expected life of 3-4 years for all periods; and a volatility rate of 200%.
n. Restricted shares and restricted units
The Company has granted restricted shares and restricted units to purchase shares of the Company’s common stock to retain, reward and motivate those employees who are deemed critical to the future success of the Company. The stock incentive plan under which the Company grants restricted share and restricted units was approved by the Board of Directors. The Company values restricted shares and restricted units to purchase shares of its common stock at the aggregate grant date fair value in accordance with ASC 718-10.
o. Net income (loss) per share
Basic and diluted net income (loss) per share have been computed in accordance with “Earnings Per Share” [ASC 260-10] using the weighted average number of shares of common stock outstanding. Diluted earnings per share give effect to all potential dilutive issuances of shares of common stock that were outstanding during the period.
p. Concentration of credit and business risk
The Company is subject to concentrations of credit risk, which consist principally of cash and cash equivalents, short-term investments and trade accounts receivable.
The Company maintains its cash balances at various financial institutions. The Company performs periodic evaluations of the relative credit standing of these institutions.
The majority of the Company's non-carrier customers prepay for their services. The Company establishes an allowance for doubtful accounts based upon factors surrounding the credit risk of customers, historical trends and other information.
Sales to material customers representing ten percent or more of total revenues for each of the twelve months ended December 31, 2013 and 2012, and accounts receivable as of December 31, 2013, and December 31, 2012, were as follows:
q. Fair value of financial instruments
The financial instruments of the Company consist mainly of cash and cash equivalents, short-term investments, current accounts receivable, accounts payable and long-term liabilities. In view of their nature, the fair value of the financial instruments included in working capital of the Company is usually identical or close to their carrying amounts.
r. Derivatives
The Company applies the provisions of “Accounting for Derivative Instruments and Hedging Activities,” [ASC 815-10], as amended. The standard requires the Company to recognize all derivatives on the balance sheet at fair value. Derivatives that are not hedges must be adjusted to fair value through the statement of operations. If the derivative is a hedge, depending on the nature of the hedge, changes in the fair value of derivatives will either be offset against the change in fair value of the hedged assets, liabilities or firm commitments through earnings, or recognized in other comprehensive income (loss) until the hedged item is recognized in earnings. The ineffective portion of a derivative’s change in fair value will be immediately recognized in earnings. The Company use of derivatives is immaterial.
s. Long-term loan from a related party
The Second Loan Agreement and the Third Loan Agreement as described in Note 1 above are accounted for in accordance with "Debt with Conversion and Other Options" [ASC 470-20-25].
The Second Loan Agreement was accounted as a debt instrument with stock warrants. Under ASC 470-20-25, issuers of certain debt instruments with stock purchase warrants are required to separately account for the liability components and the equity components, based on the relative fair value of the debt instrument without the warrants and of the warrants themselves at time of issuance. The Company separated it accordingly.
The Third Loan Agreement was accounted as a convertible debt instrument with stock warrants and a beneficial conversion features. Under ASC 470-20-25, as a first step the Company separated the debt instruments and the warrants based on their relative fair value for the liability components and for the equity components. In addition, as a second step the Company concluded that the liability component includes beneficial conversion features. Under ASC 470-20-25, issuers of certain debt instruments with beneficial conversion features need to allocate to an equity component an amount based on the amount the feature is in-the-money at the commitment date. The Company separated it accordingly.
On November 13, 2012, we and our subsidiaries entered into the Third Amendment to Loan and Security Agreements, or the "Third Amendment", and the Amendment to Warrant Agreements, or the "Warrants Amendment", with D4 Holdings. Pursuant to the Third Amendment and the Warrants Amendment, we have regarded the restructured long-term debt to D4 Holdings, under the criteria of, and have accounted for the restructured long-term debt as, a troubled debt restructuring in accordance with ASC Subtopic 470-60, “Debt - Troubled Debt Restructurings by Debtors”, which requires that the gross future cash flows of principal and interest be reflected in the balance sheet.
The following is a summary of the long-term loans and the equity components:
The interest expenses relating to both the contractual interest coupon and amortization of the discount on the liability component are as follows:
Note 3 - Restricted cash and short-term investments
As of December 31, 2013 and 2012, our total restricted cash and short-term investments was approximately $34,000 and $56,000, respectively. Restricted cash represents amounts held in certificates of deposit and money market funds to support stand-by letters of credit used as security for third party vendors as well as amounts deposited as guarantees for the Subsidiary’s office in Jerusalem and for currency hedging transactions in which the Company engages.
Note 4 - Accounts receivable, net
Accounts receivable are stated net of an allowance for doubtful accounts of approximately $508,000 at December 31, 2013 and $535,000 at December 31, 2012. Accounts receivable, net includes $142,000 and $159,000 as of December 31, 2013 and 2012, respectively, for related parties.
Note 5 - Prepaid expenses and other current assets
Prepaid expenses and other current assets consist of the following:
Note 6 - Property and equipment, net
Note 7 - Other current liabilities
Other current liabilities consist of the following:
Note 8 - Severance pay obligations
The Subsidiary is subject to certain Israeli laws and labor agreements that determine the obligations of the Subsidiary to make severance payments to employees who have been terminated and who are leaving the employment of the Subsidiary under certain other circumstances. The amount of severance pay benefits requirement to be paid is determined based upon the employee’s length of service and the employee's salary at the time of termination. This obligation is partially funded through regular deposits made by the Subsidiary into accounts maintained by unaffiliated third party insurance company funds for managers' insurance policies. Amounts deposited are controlled by the fund trustees and insurance companies and are not under the control and management of the Subsidiary.
Expenses relating to employee termination benefits were $113,745, $107,689 and $196,567 for the years ended December 31, 2013, 2012 and 2011, respectively.
The aggregate value of the insurance policies as of December 31, 2013 and 2012 was $901,362 and $697,113, respectively.
Note 9 - Commitments and contingencies
a. Lease commitments
The Company leases its executive offices at 26 Avenue at Port Imperial, West New York, New Jersey, and storage and equipment space at 117 Central Avenue, Hackensack, New Jersey. The Company leases each of these facilities on a month-to-month basis. The aggregate rent expense, net, for the two locations for 2013 was $6,000.
The Subsidiary leases an office that houses the Company’s research and development facilities in Jerusalem, Israel. The term of the lease is until June 30, 2015. Rent expense, net, for the Subsidiary, for 2013 was $143,000.
b.Legal proceedings
On August 31, 2010, the U.S. Department of Homeland Security, or the DHS, seized approximately $176,000 held in the Company’s bank accounts in connection with its investigation into the activities of certain of the Company’s resellers. In subsequent conversations with the Assistant United States Attorney for the Eastern District of New York, or the U.S. Attorney, which is assisting the DHS in the investigation, the Company was informed that the government suspects that these resellers were engaged in money laundering activities. In addition, the U.S. Attorney stated that the Company failed to file certain reports of cash payments under applicable law. The Company is opposing this seizure, and on October 12, 2010, it filed a petition with the DHS for the return of the money. On February 4, 2011, the Company’s petition was denied, and on February 22, 2011, the Company presented an offer of compromise. On November 1, 2011, the Company was notified by the DHS that its offer of compromise had been denied. In March 2012, the Company signed a Stipulation of Settlement with the U.S. Customs and Border Protection, or the CBP, pursuant to which, amongst other things, the Company agreed to a forfeiture of the seized funds and the CBP agreed to return and remit $52,804 to the Company following completion of the forfeiture proceedings. In accordance with FASB Statement 5, “Loss Contingencies” [ASC 450-20], the Company accounted for the seizure as a loss contingency that is probable of occurrence and recognized a loss in the entire amount seized, and recognized the recovery of the amount to be returned to the Company as a reversal of the loss recognized.
On July 5, 2011, the Company received a notice from the New York City Department of Finance that claimed that the Company had not paid commercial rent tax required under the New York City Administrative Code from June 1998 through May 2008 for the two offices that the Company had leased during that time. The notice stated that the Company is obligated to pay the outstanding tax amounts, as well as significant interest and penalties that were assessed on the unpaid amounts as well as for the failure to file the applicable tax returns. The Company engaged outside counsel, which began discussions with the Department of Finance, and contested assessment and simultaneously attempted to negotiate a significant reduction in the amounts to be paid. The Company’s appeal was rejected in July 2012 by an examiner in the Department of Finance, and the Company has subsequently engaged and begun discussions with a manager in the Department of Finance and submitted additional supporting materials. The final outcome of this assessment and the Company’s negotiations with the New York City Department of Finance cannot be determined at this time. In the event that the Company is required to pay all or most of the amounts claimed by the New York City Department of Finance this would have a material adverse effect on the Company’s financial condition and liquidity. During 2011 the Company recorded $300,000 as a provision for commercial rent tax.
In addition, from time to time the Company is a party to legal proceedings, much of which is ordinary routine litigation incidental to the business, and is regularly required to expend time and resources in connection with such proceedings. Accordingly, the Company, in consultation with its legal advisors, accrues amounts that management believes it is probable the Company will be required to expend in connection with all legal proceedings to which it is a party.
c. Regulation
Although there are several regulatory proceedings currently pending before federal authorities, providers of interconnected VoIP services are lightly regulated compared to providers of traditional telecommunications services. On February 12, 2004, the FCC initiated a generic rulemaking proceeding concerning the provision of voice and other services using IP technology, including assessing whether VoIP services should be classified as information services or telecommunications services. The rulemaking is ongoing and we cannot predict the outcome of this proceeding. In November 2004, the FCC determined that certain interconnected VoIP services (meaning VoIP services that can be used to send and receive calls to or from the PSTN), including some services that are similar to ours, should be considered interstate services subject to federal rather than state jurisdiction. Although this ruling was appealed by several states, on March 21, 2007, the United States Court of Appeals for the Eighth Circuit affirmed the FCC’s determination.
The FCC’s generic rulemaking proceeding could result in the FCC determining, for instance, that certain types of Internet telephony should be regulated like basic telecommunications services. Thus, Internet telephony would no longer be exempt from more onerous telecommunications-related regulatory obligations, could potentially become subject to state telecommunications regulations, and could become subject to other economic regulations typically imposed on traditional telecommunications carriers.
On June 3, 2005, the FCC released an order and notice of proposed rulemaking concerning VoIP emergency 911 services. The order set forth two primary requirements for providers of interconnected VoIP services. The order applies to our iConnectHere and joip customers, or our “direct customers”. We do not believe that we are responsible for compliance with this order when we sell our service wholesale to companies who then offer the service to retail end-users. We cannot predict whether we would be subject to any third-party litigation in connection with such customers who resell our services or whether the rules will be interpreted as applicable to those who wholesale interconnected VoIP services.
The order set forth two primary requirements for providers of interconnected VoIP services. First, the order requires providers of interconnected VoIP services like us to notify our retail customers of the differences between the emergency services available through our offerings and those available through traditional telephony providers. We also had to receive affirmative acknowledgment from some of our retail customers that they understand the nature of the emergency services available through our service. On September 27, 2005, the FCC's Enforcement Bureau released an order stating that the Enforcement Bureau will not pursue enforcement actions against interconnected VoIP providers that have received affirmative acknowledgement from at least 90% of their subscribers. We received affirmative acknowledgment from more than 95% of our relevant customers that they understand the nature of the emergency services available through our service, and thus we believe we are substantially in compliance with the first aspect of the FCC's June 3 order.
Second, the order required providers of interconnected VoIP services like us to offer enhanced emergency dialing capabilities, or E-911, to all of our retail customers by November 28, 2005. Under the terms of the order, we are required to use the dedicated wireline E-911 network to transmit customers' 911 calls, callback number and customer-provided location information to the emergency authority serving the customer's specified location. On November 7, 2005, the FCC's Enforcement Bureau issued a Public Notice with respect to that requirement. The Public Notice indicated that providers who have not fully complied with the enhanced emergency dialing capabilities requirement are not required to discontinue the provision of services to existing customers, but that the FCC expects that such providers will discontinue marketing their services and accepting new customers in areas in which the providers cannot offer enhanced emergency dialing capabilities where such capabilities are otherwise available.
Almost all of our retail customers currently receive E-911 service in conformity with the FCC’s order. Like many interconnected VoIP providers, we rely on third parties to route emergency calls originated by our customers. In certain instances and for some of our customers, the third party provider may route 911 calls to an unofficial emergency call center. Such unofficial call centers may not be able to receive appropriate call back information. To the extent that they are so able or callers provide their location information the emergency dispatchers in such call centers may not then be able to route such calls to the appropriate public safety answering point. The FCC could find that routing calls routed in this manner violates its rules, potentially subjecting us to enforcement actions including, but not limited to, fines, cease and desist orders, or other penalties. Moreover, some customers who were receiving service prior to the FCC’s deadline for compliance with the E-911 regulations may not receive such service. The FCC permitted service providers to continue to provide service to those existing customers rather than disconnect those customers. Pursuant to the FCC’s requirement, after the implementation of the FCC E-911 requirements, we provide services to our new retail customers only where we can provide the FCC required E-911 service. We may be required to stop serving those customers to whom we cannot provide the required enhanced emergency dialing capabilities that were being serviced prior to the issuance of the FCC’s rules at any time.
The FCC is considering modifying its VoIP E-911 rules. In June, 2007, the FCC released a Notice of Proposed Rulemaking to consider whether it should impose additional obligations on interconnected VoIP providers. Specifically, the FCC considered mandating that interconnected VoIP providers implement a solution that will allow for automatically determining the location of their customers for purposes of E-911 rather than require customers to manually update their existing location information (as is the case under the current regulations). Moreover, the Notice included a tentative conclusion that interconnected VoIP providers that allow their service to be used in more than one location, like us, be required to meet the same customer location accuracy standards applicable to providers of mobile telecommunications services. In September 2010, the FCC released a Notice of Inquiry again requesting comment on, among other issues, whether interconnected VoIP providers should be required to provide automatic location information about their customers rather than requiring customers to self-report their location. Additionally, the Notice of Inquiry sought comment on whether the FCC’s rules concerning the delivery of emergency services should be extended to non-interconnected VoIP services as well as to mobile VoIP applications used on smartphones, computers and other devices. At this time we cannot predict the outcome of these proceedings or their potential impact on our business.
The Communications Assistance for Law Enforcement Act, or CALEA, requires certain communications service providers to assist law enforcement agencies in conducting lawfully authorized electronic surveillance. On September 23, 2005, the FCC released an order concluding that CALEA applies to interconnected VoIP providers. In May 2006 the FCC released an order finding that broadband Internet access service providers and interconnected VoIP providers are required to implement the same type of CALEA requirements that have been applied to wireline telecommunications carriers. These include obligations to (1) ensure that communications equipment, facilities, and services meet interception assistance capability requirements and (2) develop system security policies and procedures to define employee supervision and record retention requirements. As a result of the steps the Company has taken, we believe that we comply with CALEA.
The FCC decided in June 2006 that interconnected VoIP service providers should be required to contribute to the universal service fund, or USF. The amount of universal service contribution for interconnected VoIP service providers is based on a percentage of revenues earned from end-user interstate services. The FCC developed three alternatives under which an interconnected VoIP service provider may elect to calculate its universal service contribution: (1) a safe harbor that assumes 64.9% of the provider’s end-user revenues are interstate; (2) a traffic study to determine an allocation for interstate end-user revenues; or (3) actual interstate and international end-user revenues. If an interconnected VoIP service provider calculates its universal service contributions based on its actual percentage of interstate calls, the FCC suggested that its preemption of state regulation of such services may no longer apply, in which case the interconnected VoIP service provider could be subject to regulation by each state in which it operates as well as federal regulation. In addition, the FCC is considering a number of proposals that could alter the way that the USF is assessed. For instance, the FCC is considering an assessment based on the use of telephone numbers. The U.S. Congress may also provide the FCC with additional authority to reform USF or mandate a particular methodology. At this time we cannot predict time what impact, if any, USF reform, may have on our business.
Numerous states may attempt to impose state universal service contribution requirements on interconnected VoIP providers such as deltathree. At this time, various states - including Kansas, Nebraska and New Mexico - claim that they have the right to require interconnected VoIP providers to contribute to their respective USF funds. On March 3, 2008, the U.S. District Court for Nebraska issued a preliminary injunction and found that Nebraska's state Public Service Commission does not have jurisdiction to require Universal Service contributions from VoIP providers. On May 1, 2009, a panel of the U.S. Circuit Court of Appeals for the Eighth Circuit affirmed the U.S. District court ruling. In response, the Nebraska and New Mexico state commissions filed a petition with the FCC seeking the authority to impose state USF contribution obligations on interconnected VoIP providers, like us, and the FCC granted the petition. As a result of this ruling, a number of other states have either stated that offerings such as ours may be subject to their respective state USF or are considering imposing such obligations on us. We would likely pass through to our customers in those states any such state USF fees, potentially making our services less competitive with offerings available from traditional providers of telecommunications services, which may cause us to lose customers in those states. In addition, in the past some states have attempted to impose retroactive application of any state USF obligations. Retroactive applicability of any state USF fees would effectively bar us from collecting such fees from our customers, s reducing our future profits.
On April 2, 2007, the FCC issued an order that tightened existing rules on protection and use of Customer Proprietary Network Information, or CPNI, and extended coverage of the CPNI rules to interconnected VoIP service providers. Among other things, the Order imposes greater obligations on us and other companies like us to protect CPNI, acquire customer consent prior to engaging in certain kinds of marketing efforts based on CPNI, train our employees concerning protecting (and the use of) CPNI and to file formal certifications with the FCC regarding procedures for protecting this information. As a result of the steps we have taken, we believe that we comply with this Order.
On June 15, 2007, and effective October 5, 2007, interconnected VoIP providers, like us, became required to, among other things, make certain that their equipment and service is accessible to and usable by individuals with disabilities, if readily achievable. In addition, interconnected VoIP providers like us became obligated to contribute to the Telecommunications Relay Services, or TRS, fund and to offer 711 abbreviated dialing for access to relay services. Following March 31, 2009, interconnected VoIP providers are required to route such 711 calls to the appropriate TRS relay center serving the state in which the caller is located or the relay center corresponding to the caller’s last registered address. As a result of the steps we have taken, we believe that we comply with the applicable requirements.
On August 6, 2007 and effective November 2007, the FCC adopted an Order concerning the collection of regulatory fees for Fiscal Year 2007 requiring the collection of such fees from interconnected VoIP providers like us. Like other interconnected VoIP providers, we now pay regulatory fees based on interstate and international revenues.
On November 8, 2007, the FCC released an Order relating to local number portability imposing local number portability, or LNP, and related obligations on interconnected VoIP Providers like us. The Order requires interconnected VoIP providers to contribute to shared numbering administration costs. Additionally, the Order mandates that we process certain kinds of telephone number porting requests within certain timeframes. As a result of the steps we have taken, we believe that we comply with this Order. Subsequently, on May 13, 2009, the FCC released another order concerning LNP that further reduces the porting timeframe for certain types of telephone number porting requests that interconnected VoIP providers, like us, have to process. Since we are not a licensed telecommunications carrier, we must rely on third parties to comply with these porting obligations. If these third parties fail to comply with these obligations we could be subject to fines, forfeitures and other penalties by the FCC or state public utilities commissions or we could face legal liability in state or federal court from customers or carriers. The FCC also released a Further Notice of Proposed Rulemaking to refresh the record on how to further improve the porting process, and how to potentially expand the new one business day porting timeframe to other kinds of ports. We cannot predict the outcome of this proceeding or its potential impact on us at this time.
The FCC is actively considering reform of the intercarrier compensation system, which is a set of FCC rules and regulations by which telecommunications carriers compensate each other for the use of their respective networks. These rules and regulations affect the prices we pay to our suppliers for access to the facilities and services that they provide to us, such as termination of calls by our customers onto the public switched telephone network. At this time we cannot predict what impact, if any, new intercarrier compensation regulations would have on our business.
In May 2009, the FCC extended to interconnected VoIP providers like us the discontinuance rules that previously applied only to non-dominant common carriers. The FCC's rules require non-dominant domestic carriers to provide notice to customers at least 30 days prior to discontinuing service to a telephone exchange, toll stations serving a community in whole or in part, and other similar activities that affect a community or part of a community. Carriers must inform certain state authorities of the discontinuation, and obtain prior FCC approval before undertaking the service disruption. The FCC's rules allow for streamlined treatment for FCC discontinuance approvals and interconnected VoIP providers will be able to take advantage of the same streamlined procedures afforded to non-dominant carriers. It is not yet clear how these rules apply to interconnected VoIP providers. But in the event we discontinue one of our service offerings in its entirety or if we were to exit the market in whole we would likely have to comply with these new rules. We do not expect these new obligations to have a material impact on our business.
In June 2007, the FCC adopted various recommendations from its Independent Panel Reviewing the Impact of Hurricane Katrina on Communications Networks Panel, including a requirement that certain interconnected VoIP providers submit reports regarding the reliability and resiliency of their 9-1-1 systems. At this time, we are not subject to these reporting requirements but may become subject in the future.
We rely upon providers of broadband Internet access services to offer our services to our customers. The FCC recently adopted “open Internet” rules that would, among other things, prohibit fixed providers of broadband Internet access services from blocking, impairing or downgrading such access. Wireless providers of broadband Internet access services would be prohibited from blocking VoIP applications like ours. The open Internet rules are not yet effective and, as a result of both legislative efforts to overturn the rules as well as potential appeals of the passage of the rules, it is unclear whether (and when) the rules will become effective. While we are not aware of any provider of broadband Internet access attempting to interfere with our Internet access, the lack of enforceable rules could potentially negatively impact our service offerings and impede our ability to offer new services that require significant Internet bandwidth.
In addition, some state and local regulatory authorities believe they retain jurisdiction to regulate the provision of, and impose taxes, fees and surcharges on, intrastate Internet and VoIP telephony services, and have attempted to impose such taxes, fees and surcharges, such as a fee for providing E-911 service. Rulings by the state commissions on the regulatory considerations affecting Internet and IP telephony services could affect our operations and revenues, and we cannot predict whether state commissions will be permitted to regulate the services we offer in the future.
The Company paid approximately $35,000 of state and local taxes and other fees during 2013. To the extent we increase the cost of services to its customers to recoup some of the costs of compliance; this will have the effect of decreasing any price advantage we may have over traditional telecommunications companies.
In addition, it is possible that we will be required to collect and remit taxes, fees and surcharges in other states and local jurisdictions where we have not done so, and which such authorities may take the position that we should have collected. If so, they may seek to collect those past taxes, fees and surcharges from us and impose fines, penalties or interest charges on us. Our payment of these past taxes, fees and surcharges, as well as penalties and interest charges, could have a material adverse effect on us.
Note 10 - Stockholders' equity
a.Share capital
The Company’s common stock is currently listed on the OTCQB under the symbol “DDDC”.
b.Change in Control
On February 10, 2009, the Company entered into the Purchase Agreement with D4 Holdings pursuant to which the Company issued to D4 Holdings the Shares, representing approximately 54.3% of the total number of issued and outstanding shares of Common Stock following the transaction, for an aggregate purchase price of $1,170,000, payable in cash, and the Warrant, exercisable for ten years, to purchase up to an additional 30,000,000 shares of Common Stock at an exercise price of $0.04 per share. The transaction closed on February 12, 2009.
In connection with the closing of the transaction and pursuant to the terms of the Purchase Agreement, Noam Bardin resigned as a director and the board of directors appointed Robert Stevanovski and Anthony Cassara to serve on the board. In addition, Lior Samuelson resigned as Chairman of the Board and remained a director, and Robert Stevanovski was appointed to serve as Chairman. Under the terms of the Purchase Agreement, D4 Holdings had the right to nominate for appointment by the board one director in addition to Messrs. Stevanovski and Cassara, and it nominated David Stevanovski. In addition, on March 4, 2009, the Board of Directors of the Company increased the size of the board from five to seven members and filled the two vacancies remaining on the board by appointing Gregory Provenzano and J. Lyle Patrick as directors. The appointments of the three new directors to serve on the board became effective on March 28, 2009.
As a result of the transaction between the Company and D4 Holdings, D4 Holdings obtained a controlling interest in the Company.
c . Stock Options
At our Annual Meeting on August 6, 2009, upon the recommendation of our Board of Directors our stockholders approved the adoption of our 2009 Stock Incentive Plan (the “2009 Plan”). Upon the adoption of the 2009 Plan, our 2004 Stock Incentive Plan and 2006 Non-Employee Director Stock Plan were terminated except with respect to outstanding awards previously granted under those plans and no additional awards will be made under those plans. Under the 2009 Plan, the Compensation Committee is authorized to grant awards, either in the form of incentive or non-incentive stock options or restricted stock.
As of December 31, 2013, options to purchase 6,492,500 shares of Common Stock granted under the Company’s stock incentive plans were exercisable with exercise prices ranging between $0.02 and $3.20 per share.
A summary of the status of the Company’s stock incentive plans as of December 31, 2013, 2012 and 2011 and changes during the years then-ended is presented below:
Additional information regarding options outstanding as of December 31, 2013, is as follows:
As of December 31, 2013, outstanding options to purchase 5,970,000 shares of Common Stock and options to purchase 2,355,000 shares of Common Stock exercisable were “in-the-money” with aggregate intrinsic values of $64,700 and $24,800, respectively.
The unrecognized compensation expense calculated under the fair value method for stock options expected to vest as of December 31, 2013, was approximately $44,000 and is expected to be recognized over a weighted-average period of two years.
c. Restricted shares of the Company’s Common Stock
During the year ended December 31, 2013, the Company did not grant restricted shares of the Company’s common stock or restricted units to purchase shares of the Company’s common stock.
Note 11 - Research and development expenses
Research and development expenses consist of the following:
Note 12 - Interest expense, net
Interest expense consists of the following:
Note 13 - Income taxes
a.Provision for income taxes
No provision for income taxes was required for the years ended December 31, 2013, 2012 and 2011 due to net losses in these periods.
b.Net operating losses
As of December 31, 2013, the Company had net operating losses generated in the U.S. and Israel of approximately $23.4 million and $4.6 million, respectively.
The Company’s issuance of common stock to D4 Holdings in February 2009 constituted an “ownership change” as defined in Section 382 of the Internal Revenue Code. As a result, under Section 382 the Company’s ability to utilize NOLs generated in the U.S. prior to February 2009 (equal to approximately $156 million) to offset any income it may generate in the future will be limited to approximately $600,000 per year from February 2009. The NOLs began expiring in 2011 and will expire at various dates until 2029 if not utilized. The Company’s ability to utilize its remaining NOLs could be additionally reduced if it experiences any further “ownership change,” as defined under Section 382.
The Company's net operating losses generated in Israel may be carried forward indefinitely. The Subsidiary received final tax assessments through the tax year ended December 31, 2008.
c.In accordance with ASC 740-10, the components of deferred income taxes are as follows:
A valuation allowance of $9.4 million and $8.8 million is provided as of December 31, 2013 and 2012, respectively, as the realization of the deferred tax assets are not assured.
d.Income/(Loss) before income tax for each entity:
Note 14 - Segment reporting, geographical information and major customers
The Company operates in one business segment, VoIP Telephony services, and makes business decisions and allocates resources accordingly.
The following table summarizes the Company’s revenues and long-lived assets by country. Revenue is attributed to geographic region based on the location of the customers. Long-lived assets are attributed to geographic region based on the country in which the assets are located.
Note 15 - Related Party Transaction
The following tables below summarize our related party transactions, in thousands of dollars:
Related parties involved in these transactions:
·D4 Holdings, LLC.
·Affiliates of D4 Holdings, LLC.
Selected Quarterly Financial Information (Unaudited)