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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-QSB
QUARTERLY OR TRANSITIONAL REPORT
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the Quarterly Period Ended September 30, 2006
[ ] TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT
Commission File Number 000-25039
BRAVO! BRANDS INC.
(Exact name of registrant as specified in its amended charter)
(Formerly BRAVO! FOODS INTERNATIONAL CORP.)
Delaware 62-1681831
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
11300 US Highway 1, North Palm Beach, Florida 33408 USA
(Address of principal executive offices)
(561) 625-1411
Registrant's telephone number
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(Former name, former address and former fiscal year
if changed since last report)
Check whether the issuer (1) filed all reports required to be filed by
Section 13 or 15(d) of the Securities Exchange Act of 1934, during the past
12 months (or for such shorter period that the registrant was required to
file such reports), and (2) has been subject to such filing requirements
for the past 90 days. Yes [X] No [ ]
Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X]
APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCY
PROCEEDINGS DURING THE PRECEDING FIVE YEARS
Check whether the registrant filed all documents and reports required to be
filed by Section 12, 13 or 15(d) of the Securities Exchange Act of 1934
after the distribution of securities under a plan confirmed by a court.
Yes [ ] No [ ]
APPLICABLE ONLY TO CORPORATE ISSUERS
The number of shares outstanding of each of the issuer's classes of common
stock, as of the latest practicable date is as follows:
Date Class Shares Outstanding
November 10, 2006 Common Stock 200,179,528
Preferred Stock 454,940
Transitional Small Business Disclosure Format (Check One) YES [ ] NO [X]
BRAVO! BRANDS INC. AND SUBSIDIARY
TABLE OF CONTENTS
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated balance sheets as of F-1
September 30, 2006 (unaudited) and December 31, 2005
Consolidated statements of operations F-3
for the three and nine months
ended September 30, 2006 and 2005 (unaudited)
Consolidated statements of cash flows F-4
for the nine months ended
September 30, 2006 and 2005 (unaudited)
Notes to consolidated financial statements (unaudited) F-5
Item 2. Management's Discussion and Analysis of Financial 44
Condition and Results of Operations
Item 3. Controls and Procedures 53
PART II - OTHER INFORMATION
Item 2. Unregistered Sales of Equity and Use of Proceeds 54
Item 6. Exhibits 54
SIGNATURES 55
DOCUMENTS INCORPORATED BY REFERENCE: See Exhibits
FORWARD-LOOKING STATEMENTS
Statements that are not historical facts, including statements about
our prospects and strategies and our expectations about growth contained in
this report are "forward-looking statements" within the meaning of Section
27A of the Securities Act of 1933, as amended, and Section 21E of the
Securities Exchange Act of 1934, as amended. These forward-looking
statements represent our present expectations or beliefs concerning future
events. We caution that such forward-looking statements involve known and
unknown risks, uncertainties and other factors which may cause our actual
results, performance or achievements to be materially different from any
future results, performance or achievements expressed or implied by such
forward-looking statements. Such factors include, among other things, the
uncertainty as to our future profitability; the uncertainty as to whether
our new business model can be implemented successfully; the accuracy of our
performance projections; and our ability to obtain financing on acceptable
terms to finance our operations until we become profitable.
BRAVO! BRANDS INC. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
September 30, December 31,
2006 2005
------------- ------------
(Unaudited)
Assets
Current assets:
Cash and cash equivalents $ 1,138,124 $ 4,947,986
Restricted cash 14,500,000 --
Accounts receivable, net of allowances for doubtful accounts of
$447,634 and $350,000 for 2006 and 2005, respectively 255,259 3,148,841
Inventories 847,428 391,145
Prepaid expenses 1,320,554 973,299
------------- -------------
Total current assets 18,061,365 9,461,271
Furniture and equipment, net 723,813 288,058
Intangible assets, net 19,002,956 18,593,560
Other assets 1,988,145 15,231
------------- -------------
Total assets $ 39,776,279 $ 28,358,120
============= =============
Liabilities, Redeemable Preferred Stock and Stockholders' Equity (Deficit)
Current liabilities:
Accounts payable $ 4,563,807 $ 5,987,219
Accrued liabilities 9,984,851 4,872,277
Current maturities of notes payable 243,627 937,743
Convertible debt 20,846,607 1,012,780
Derivative liabilities 37,075,023 35,939,235
------------- -------------
Total current liabilities 72,713,915 48,749,254
Notes payable, less current maturities 81,685 -
------------- -------------
Total liabilities 72,795,600 48,749,254
------------- -------------
F-1
BRAVO! BRANDS INC. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
September 30, December 31,
2006 2005
------------- ------------
(Unaudited)
Commitments and contingencies (Note 9) - -
Redeemable preferred stock:
Series F convertible, par value $0.001 per share, 200,000 shares
designated, Convertible Preferred Stock, stated value $10.00 per
share, 5,248 shares issued and outstanding - 52,480
Series H convertible, par value $0.001 per share, 350,000 shares
designated, 7% Cumulative Convertible Preferred Stock, stated value
$10.00 per share, 52,500 and 64,500 shares issued and outstanding 502,507 388,305
Series J, par value $0.001 per share, 500,000 shares designated, 8%
Cumulative Convertible Preferred Stock, stated value $10.00 per share,
200,000 shares issued and outstanding 1,349,614 871,043
Series K, par value $0.001 per share, 500,000 shares designated, 8%
Cumulative Convertible Preferred Stock, stated value $10.00 per share,
95,000 shares issued and outstanding 826,233 792,672
------------- -------------
Total redeemable preferred stock 2,678,354 2,104,500
------------- -------------
Stockholders' equity (deficit):
Preferred stock, 5,000,000 shares authorized
Series B Preferred, par value $0.001 per share, 1,260,000 shares
designated, 9% Convertible Preferred Stock, stated value $1.00 per
share, 107,440 shares issued and outstanding 107,440 107,440
Common stock, par value $0.001 per share, 300,000,000 shares authorized,
200,179,528 and 184,253,753 shares issued and outstanding 200,180 184,254
Additional paid-in capital 100,484,804 96,507,932
Common stock subscription receivable (10,000) (10,000)
Accumulated deficit (136,479,834) (119,254,501)
Cumulative translation adjustment (265) (30,759)
------------- -------------
Total stockholders' equity (deficit) (35,697,675) (22,495,634)
------------- -------------
Total liabilities, Redeemable Preferred Stock and Stockholders'
Equity (Deficit) $ 39,776,279 $ 28,358,120
============= =============
See accompanying notes.
F-2
BRAVO! BRANDS INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------------- ------------------------------
2006 2005 2006 2005
---- ---- ---- ----
(Unaudited) (Unaudited) (Unaudited) (Unaudited)
(Restated) (Restated)
Revenues $ 5,110,200 $ 3,245,305 $ 12,376,641 $ 6,591,693
Product costs (4,240,277) (2,360,884) (10,440,374) (4,719,011)
Shipping costs (409,453) (395,073) (1,154,089) (825,909)
------------- ------------- ------------- ------------
Gross margin 460,470 489,348 782,178 1,046,773
Operating expenses:
Selling expense 6,663,113 1,525,944 12,874,022 3,046,524
General and administrative expense 4,057,823 375,081 7,454,344 2,970,159
Product development 232,593 185,042 509,912 400,799
------------- ------------- ------------- ------------
Loss from operations (10,493,059) (1,596,719) (20,056,100) (5,370,709)
Other income (expense)
Derivative income (expense), net 11,056,420 23,321,020 10,958,409 (52,518,630)
Interest income (expense), net (1,163,599) (152,001) (1,594,860) (1,643,891)
Liquidated damages (225,938) - (4,784,213) -
Non-recurring finders' fee - (3,000,000) - (3,000,000)
Legal settlement - - (552,600) -
Loss from extinguishment of debt (425,869) - (425,869) 7,164
Other income (expense) - (893,148) - (893,148)
Income (loss) before income taxes (1,252,045) 17,679,152 (16,455,233) (63,419,214)
Provision for income taxes - - - -
------------- ------------- ------------- ------------
Net income (loss) (1,252,045) 17,679,152 (16,455,233) (63,419,214)
Preferred stock dividends and accretion (411,719) (215,689) (952,979) (1,080,399)
------------- ------------- ------------- ------------
Income (loss) applicable to common
stockholders $ (1,663,764) $ 17,463,463 $ (17,408,212) $(64,499,613)
============= ============= ============= ============
Loss per common share:
Basic income (loss) per common share $ (0.01) $ 0.15 $ (0.09) $ (0.79)
============= ============= ============= ============
Diluted income (loss) per common share $ (0.01) $ 0.00 $ (0.09) $ (0.79)
============= ============= ============= ============
Weighted average common shares outstanding 194,492,040 113,680,645 189,474,500 82,091,556
============= ============= ============= ============
Comprehensive income (loss):
Net income (loss) $ (1,252,045) $ 17,679,152 $ (16,455,233) $(63,419,214)
Foreign currency translation 9,055 (18,322) 30,494 (23,649)
------------- ------------- ------------- ------------
Comprehensive income (loss) $ (1,242,990) $ 17,660,830 $ (16,424,739) $(63,442,863)
============= ============= ============= ============
See accompanying notes.
F-3
BRAVO! BRANDS INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
Nine Months Ended September 30
2006 2005
-------------------------------
(Unaudited) (Unaudited)
(Restated)
Cash Flow from Operating Activities:
Net loss $(16,455,233) $(63,419,214)
Adjustments to net loss
Depreciation and amortization 2,504,512 1,241,959
Allowance for doubtful accounts 97,634 -
Legal settlement for Marvel warrants 552,600 -
Stock issuance for consulting expense 317,566 346,438
Derivative (gain) expense, net (10,958,409) 52,518,630
(Gain)/loss on debt extinguishment 425,869 (7,164)
Amortization of debt discount 850,000 1,335,678
Stock compensation expense 333,868 654,592
Gain/Loss on disposal of fixed assets 1,998 -
Changes in operating assets & liabilities:
Accounts receivable 2,795,948 (149,281)
Inventories (456,283) (241,173)
Prepaid expenses and other assets (353,518) (1,008,700)
Accounts payable and accrued expenses 3,748,744 5,117,240
------------ ------------
Net cash used in operating activities (16,594,704) (3,610,995)
------------ ------------
Cash Flows from Investing Activities:
Licenses and trademark costs (187,878) (789,171)
Purchases of equipment (520,166) (90,583)
------------ ------------
Net cash used in investing activities (708,044) (879,754)
------------ ------------
Cash Flows provided by financing activities:
Proceeds from exercise of warrants 700,000 2,958,509
Proceeds from convertible notes payable 31,669,323 2,350,000
Restricted cash (14,500,000)
Proceeds from sale of stock and warrants 151,951 450,000
Payments of dividends (33,771) -
Payment of notes payable (2,281,754) -
Redeem warrants - (100,000)
------------ ------------
Registration and deferred financing costs (2,243,357) (704,142)
------------ ------------
Net cash provided by financing activities 13,462,392 4,954,367
------------ ------------
Effect of changes in exchange rates on cash 30,494 (23,649)
------------ ------------
Net (decrease) increase in cash and cash equivalents (3,809,862) 439,969
Cash and cash equivalent, beginning of period 4,947,986 113,888
------------ ------------
Cash and cash equivalent, ending of period $ 1,138,124 $ 553,857
============ ============
See accompanying notes.
F-4
Note 1 - Nature of Business, Basis of Presentation and Liquidity and
Management's Plans
Nature of Business:
We are engaged in the sale of flavored and organic milk products and flavor
ingredients in the United States, the United Kingdom and the Middle East, and
we are establishing an infrastructure to conduct business in Canada.
Basis of Presentation:
The accompanying unaudited consolidated financial statements have been
prepared in accordance with generally accepted accounting principles for
interim financial information and with the instructions to Form 10QSB, Item
310(b) of Regulation S-B and Article 10 (01)(c) of Regulation S-X.
Accordingly, the accompanying financial statements do not include all the
information and footnotes required by generally accepted accounting
principles for complete financial statements. In the opinion of management,
all adjustments (consisting of normal recurring adjustments) considered
necessary for a fair presentation have been included in the accompanying
financial statements. Operating results for the three and nine-month
periods ending September 30, 2006 are not necessarily indicative of the
results that may be expected for the year ended December 31, 2006.
Liquidity and Management's Plans:
As reflected in the accompanying consolidated financial statements, we have
incurred operating losses and negative cash flow from operations and have a
working capital deficiency of $54,652,550 as of September 30, 2006. In
addition, we experienced delays in filing our financial statements and
registration statements due to errors in our historical accounting that
have now been corrected. Our inability to make these filings has resulted
in our recognition of significant penalties to the investors during the
quarter ended September 30, 2006. However, these penalties ceased on
November 7, 2006 when the Securities and Exchange Commission declared
effective our Amended Form SB-2 registration statement filed in November
2006. Finally, our revenues are significantly concentrated with one major
customer. The loss of this customer or curtailment in business with this
customer could have a material adverse effect on our business. These
conditions raise substantial doubt about our ability to continue as a going
concern.
We have been dependent upon third party financings as we execute our
business model and plans. In July 2006, we completed a $30.0 million
convertible note financing that is expected to fulfill our liquidity
requirements through the end of 2006. As of September 30, 2006, $14.5
million of the proceeds from this financing arrangement were restricted and
held in escrow, pending effectiveness of our Amended Forms SB-2
registration statement. However, such proceeds were released to us on
November 14, 2006.
We plan to increase our sales, improve our gross profit margins, augment
our international business and, if necessary, obtain additional financing.
Ultimately, our ability to continue is dependent upon the achievement of
profitable operations. There is no assurance that further funding will be
available at acceptable terms, if at all, or that we will be able to
achieve profitability.
The accompanying financial statements do not reflect any adjustments that
may result from the outcome of this uncertainty.
F-5
Note 2 - Summary of Significant Accounting Policies:
Use of Estimates
----------------
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America requires
management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and disclosure of contingent assets and
liabilities at the date of the financial statements and the reported
amounts of revenues and expenses during the reporting period. Among the
more significant estimates included in our financial statements are the
following:
- Estimating future bad debts on accounts receivable that are carried
at net realizable values.
- Estimating our reserve for unsalable and obsolete inventories that
are carried at lower of cost or market.
- Estimating the fair value of our financial instruments that are
required to be carried at fair value.
- Estimating the recoverability of our long-lived assets.
We use all available information and appropriate techniques to develop our
estimates. However, actual results could differ from our estimates.
Business Segment and Geographic Information
-------------------------------------------
We operate in one dominant industry segment that we have defined as the
single serve flavored milk industry. While our international business is
expected to grow in the future, it currently contributes less than 10% of
our revenues, and we have no physical assets outside of the United States.
Revenue Recognition
-------------------
Our revenues are derived from the sale of branded milk products to
customers in the United States of America, Great Britain and the Middle
East. Geographically, our revenues are dispersed 99% and 1% between the
United States of America and internationally, respectively. We currently
have one customer in the United States that provided 79% and 0% of our
revenue during the nine months ended September 30, 2006 and 2005,
respectively.
Revenues are recognized pursuant to formal revenue arrangements with our
customers, at contracted prices, when our product is delivered to their
premises and collectibility is reasonably assured. We extend
merchantability warranties to our customers on our products, but otherwise
do not afford our customers with rights of return. Warranty costs have
historically been insignificant.
Our revenue arrangements often provide for industry-standard slotting fees
where we make cash payments to the respective customer to obtain rights to
place our products on their retail shelves for a stipulated period of time.
We also engage in other promotional discount programs in order to enhance
our sales activities. We believe our participation in these arrangements is
essential to ensuring continued volume and revenue growth in the
competitive marketplace. These payments, discounts and allowances are
recorded as reductions to our reported revenue. Unamortized slotting fees
are recorded in prepaid expenses.
F-6
Principles of Consolidation
---------------------------
Our consolidated financial statements include the accounts of Bravo! Brands
Inc (the "Company"), and its wholly-owned subsidiary Bravo! Brands (UK)
Ltd. All material intercompany balances and transactions have been
eliminated.
Recent Accounting Pronouncements:
---------------------------------
SEC Staff Accounting Bulletin 108 ("SAB 108"), Considering the Effects of
Prior Year Misstatements when Qualifying Misstatements in Current Year
Financial Statements
In September 2006, the SEC staff issued Staff Accounting Bulletin No. 108,
"Considering the Effects of Prior Year Misstatements when Quantifying
Misstatements in Current Year Financial Statements." SAB 108 was issued in
order to eliminate the diversity of practice surrounding how public
companies quantify financial statement misstatements.
Traditionally, there have been two widely-recognized methods for
quantifying the effects of financial statement misstatements: the "roll-
over" method and the "iron curtain" method. The roll-over method focuses
primarily on the impact of a misstatement on the income statement-including
the reversing effect of prior year misstatements-but its use can lead to
the accumulation of misstatements in the balance sheet. The iron-curtain
method, on the other hand, focuses primarily on the effect of correcting
the period-end balance sheet with less emphasis on the reversing effects of
prior year errors on the income statement.
In SAB 108, the SEC staff established an approach that requires
quantification of financial statement misstatements based on the effects of
the misstatements on each of the company's financial statements and the
related financial statement disclosures. This model is commonly referred to
as a "dual approach" because it requires quantification of errors under
both the iron curtain and the roll-over methods.
SAB 108 permits existing public companies to initially apply its provisions
either by (i) restating prior financial statements as if the "dual
approach" had always been used or (ii) recording the cumulative effect of
initially applying the "dual approach" as adjustments to the carrying
values of assets and liabilities as of January 1, 2006 with an offsetting
adjustment recorded to the opening balance of retained earnings.
We will adopt the provisions of SAB 108 in connection with the preparation
of our annual financial statements for the year ending December 31, 2006.
We are in the process of evaluating the impact, if any, on our financial
statements of initially applying the provisions of SAB 108.
Statement of Financial Accounting Standard 158, Fair Value Measurements
("SFAS 158")
On September 15, 2006, the Financial Accounting Standard Board issued a
standard that provides enhanced guidance for using fair value to measure
assets and liabilities. The standard applies whenever other standards
require (or permit) assets or liabilities to be measured at fair value. The
standard does not expand the use of fair value in any new circumstances.
This Statement is effective for financial statements issued for fiscal
years beginning after November 15, 2007, and interim periods within those
fiscal years. Earlier application is encouraged, provided that the
reporting entity has not yet issued financial statements for that fiscal
year, including financial statements for an interim period within that
fiscal year. The Company will adopt this pronouncement effective January 1,
2007. We are currently evaluating the impact of adopting this pronouncement
on our financial statements.
F-7
FSP FAS 123(R )-5, Amendment of FASB Staff Position FAS 123(R)-1
FSP FAS 123(R )-5 was issued on October 10, 2006. The FSP provides that
instruments that were originally issued as employee compensation and then
modified, and that modification is made to the terms of the instrument
solely to reflect an equity restructuring that occurs when the holders are
no longer employees, no change in the recognition or the measurement (due
to a change in classification) of those instruments will result if both of
the following conditions are met: (a). There is no increase in fair value
of the award (or the ratio of intrinsic value to the exercise price of the
award is preserved, that is, the holder is made whole), or the antidilution
provision is not added to the terms of the award in contemplation of an
equity restructuring; and (b). All holders of the same class of equity
instruments (for example, stock options) are treated in the same manner.
The provisions in this FSP shall be applied in the first reporting period
beginning after the date the FSP is posted to the FASB website. We will
adopt this FSP from its effective date. We currently do not believe that
its adoption will have any impact on our financial statements.
Shipping and Handling Costs
---------------------------
Shipping and handling costs incurred to deliver products to our customers
are included as a component of cost of sales. These costs amounted to
$409,453 and $395,073 for the three months ended September 30, 2006 and
2005, respectively; $1,154,089 and $825,909 for the nine months ended
September 30, 2006 and 2005, respectively.
Cash and Cash Equivalents
-------------------------
We consider all highly liquid investments purchased with a remaining
maturity of three months or less to be cash equivalents.
Accounts Receivable
-------------------
Our accounts receivable are exposed to credit risk. During the normal
course of business, we extend unsecured credit to our customers with normal
and traditional trade terms. Typically credit terms require payments to be
made by the thirtieth day following the sale. We regularly evaluate and
monitor the creditworthiness of each customer. We provide an allowance for
doubtful accounts based on our continuing evaluation of our customers'
credit risk and our overall collection history. As of September 30, 2006
and December 31, 2005, the allowance of doubtful accounts aggregated
$447,634 and $350,000, respectively.
Inventories
-----------
Inventories, which consist primarily of finished goods, are stated at the
lower of cost on the first in, first-out method or market. Our inventories
at September 30, 2006 have substantially increased from levels at December
31, 2005 in order to support our contractual arrangement with a significant
customer. Further, our inventories are perishable. Accordingly, we estimate
and record lower-of-cost or market and unsalable-inventory reserves based
upon a combination of our historical experience and on a specific
identification basis. During the nine months ended September 30, 2006, we
provided reserves for unsalable inventories amounting to $44,601.
In November 2004, the FASB issued Financial Accounting Standard No. 151,
Inventory Costs, an amendment of ARB No. 43 Chapter 4 (FAS 151), which
clarifies that inventory costs that are "abnormal" are required to be
charged to expense as incurred as opposed to being capitalized into
inventory as a product cost. FAS 151 provides examples of "abnormal" costs
to include costs of idle facilities, excess freight and handling costs and
spoilage. FAS 151 became effective for our fiscal year beginning January 1,
2006.
F-8
Furniture and Equipment
-----------------------
Furniture and equipment are stated at cost. Depreciation is computed using
the straight-line method over a period of seven years for furniture and
five years for equipment. Maintenance, repairs and minor renewals are
charged directly to expenses as incurred. Additions and betterments to
property and equipment are capitalized. When assets are disposed of, the
related cost and accumulated depreciation thereon are removed from the
accounts, and any resulting gain or loss is included in the statement of
operations.
Intangible Assets
-----------------
Our intangible assets as of September 30, 2006 and December 31, 2005
consist of our distribution agreement with Coca-Cola Enterprises ("CCE"),
our manufacturing agreements with Jasper Products, Inc. and HP Hood, LLC,
and license and trademark costs. Estimated useful lives range from one to
ten years. The following table illustrates information about our intangible
assets:
September 30, 2006 December 31, 2005
----------------------------------------
Distribution agreement $15,960,531 $15,960,531
Manufacturing agreements 5,084,055 2,700,000
Licenses and trademarks 450,825 1,315,958
Less accumulated amortization (2,492,455) (1,382,929)
----------------------------------------
$19,002,956 $18,593,560
========================================
Amortization expense amounted to $618,251 and $2,167,540 for the three and
nine months ended September 30, 2006 and $402,812 and $729,775 for the
three and nine months ended September 30, 2005.
Estimated future amortization of our intangible assets is as follows as of
September 30, 2006:
Three months ended December 31, 2006 $ 660,026
==========
Year ended:
December 31, 2007 $2,600,290
==========
December 31, 2008 $2,583,684
==========
December 31, 2009 $2,583,187
==========
December 31, 2010 $2,430,632
==========
December 31, 2011 $1,994,934
==========
Impairment of Long-Lived Assets
-------------------------------
We evaluate the carrying value and recoverability of our long-lived assets
when circumstances warrant such evaluation by applying the provisions of
Financial Accounting Standard No. 144, Accounting for the Impairment or
Disposal of Long-Lived Assets ("FAS 144"). FAS 144 requires that long-lived
assets be reviewed for impairment whenever events or changes in
circumstances indicate that the carrying amount of an asset may not be
recoverable through the estimated undiscounted cash flows expected to
result from the use and eventual disposition of the assets. Whenever any
such impairment exists, an impairment loss will be recognized for the
amount by which the carrying value exceeds the fair value.
F-9
Financial Instruments
---------------------
Financial instruments, as defined in Financial Accounting Standard No. 107
Disclosures about Fair Value of Financial Instruments (FAS 107), consist of
cash, evidence of ownership in an entity and contracts that both (i) impose
on one entity a contractual obligation to deliver cash or another financial
instrument to a second entity, or to exchange other financial instruments
on potentially unfavorable terms with the second entity, and (ii) conveys
to that second entity a contractual right (a) to receive cash or another
financial instrument from the first entity, or (b) to exchange other
financial instruments on potentially favorable terms with the first entity.
Accordingly, our financial instruments consist of cash and cash
equivalents, accounts receivable, accounts payable, accrued liabilities,
notes payable, derivative financial instruments, convertible debt and
redeemable preferred stock that we have concluded is more akin to debt than
equity.
We carry cash and cash equivalents, accounts receivable, accounts payable
and accrued liabilities at historical costs; their respective estimated
fair values approximate carrying values due to their current nature. We
also carry notes payable, convertible debt and redeemable preferred stock
at historical cost; however, fair values of debt instruments and redeemable
preferred stock are estimated for disclosure purposes (below) based upon
the present value of the estimated cash flows at market interest rates
applicable to similar instruments.
As of September 30, 2006, estimated fair values and respective carrying
values of our notes payable, convertible debt and redeemable preferred
stock are as follows:
Instrument Note Fair Value Carrying Value
------------------------------------------------------------------------------
$600,000 Convertible Note Payable 5(c) $ 501,000 $ 450,000
===========================
$168,000 Convertible Note Payable 5(g) 172,000 168,000
===========================
$30,000,000 Convertible Note Payable 5(i) 20,142,000 20,228,608
===========================
Series H Preferred Stock 6(a) 570,000 502,507
===========================
Series J Preferred Stock 6(b) 1,811,000 1,349,614
===========================
Series K Preferred Stock 6(c) 713,000 826,233
===========================
As of December 31, 2005, estimated fair values and respective carrying
values of our notes payable, convertible debt and redeemable preferred
stock were as follows:
Instrument Fair Value Carrying Value
--------------------------------------------------------------------
$200,000 Convertible Note Payable $ 190,000 $187,934
==========================
$15,000 Convertible Note Payable 13,300 1,620
==========================
$600,000 Convertible Notes Payable 668,000 600,000
==========================
$6,250 Convertible Note Payable 6,375 5,188
==========================
$25,000 Convertible Note Payable 25,500 30,278
==========================
$187,760 Convertible Note Payable 187,760 187,760
==========================
Series F Preferred Stock 46,000 52,480
==========================
Series H Preferred Stock 525,000 388,305
==========================
Series J Preferred Stock 1,731,000 871,043
==========================
Series K Preferred Stock 881,000 792,672
==========================
Derivative financial instruments, as defined in Financial Accounting
Standard No. 133, Accounting for Derivative Financial Instruments and
Hedging Activities (FAS 133), consist of financial instruments or other
contracts that contain a notional amount and one or more underlying (e.g.
interest rate, security price or other variable), require no initial net
investment and permit net settlement. Derivative financial instruments may
be free-standing or embedded in other financial instruments. Further,
derivative financial
F-10
instruments are initially, and subsequently, measured at fair value and
recorded as liabilities or, in rare instances, assets.
We generally do not use derivative financial instruments to hedge exposures
to cash-flow, market or foreign-currency risks. However, we have entered
into certain other financial instruments and contracts, such as debt
financing arrangements, redeemable preferred stock arrangements, and
freestanding warrants with features that are either (i) not afforded equity
classification, (ii) embody risks not clearly and closely related to host
contracts, or (iii) may be net-cash settled by the counterparty. As
required by FAS 133, these instruments are required to be carried as
derivative liabilities, at fair value, in our financial statements.
The following table summarizes the components of derivative liabilities as
of September 30, 2006 and December 31, 2005:
Note 2006 2005
--------------------------------------
Compound derivative financial instruments that have been
bifurcated from the following financing arrangements:
--------------------------------------------------------
$2,500,000 Note Financing 4(a) $ -- $ --
$400,000 Convertible Note Financing 5(a) -- (1,311,000)
$2,300,000 Convertible Note Financing 5(b) -- (4,867)
$600,000 Convertible Note Financing 5(c) (620,100) (153,700)
$693,000 Convertible Note Financing 5(e) -- (42,878)
$660,000 Convertible Note Financing 5(f) -- (159,250)
$1,080,000 Convertible Note Financing 5(g) (580,986) (564,735)
$30,000,000 Convertible Note Financing 5(i) (4,705,317) -
Series H Preferred Stock Financing 6(a) (549,576) (381,377)
Series J Preferred Stock Financing 6(b) (4,452,000) (5,628,000)
Series K Preferred Stock Financing 6(c) (276,864) (206,200)
Series F Preferred Stock Financing 6(d) -- (25,632)
Freestanding derivative contracts arising from financing
and other business arrangements:
--------------------------------------------------------
Warrants issued with $2,500,000 Note Financing 4(a) (119,466) --
Warrants issued with $693,000 Convertible Notes 5(e) -- (924,120)
Warrants issued with $30,000,000 Convertible Notes 5(i) (5,853,857) --
Warrants issued with Series D Preferred Stock 7(d) -- (400,214)
Warrants issued with Series H Preferred Stock 6(a) (359,907) (1,264,109)
Warrants issued with Series F Preferred Stock 6(d) -- (563,096)
Other warrants 8(b) (19,556,950) (24,310,057)
-----------------------------
Total derivative liabilities $(37,075,023) $(35,939,235)
=============================
See the notes referenced in the table for details of the origination and
accounting for these derivative financial instruments. We estimate fair
values of derivative financial instruments using various techniques (and
combinations thereof) that are considered to be consistent with the
objective measuring fair values. In selecting the appropriate technique, we
consider, among other factors, the nature of the instrument, the market
risks that it embodies and the expected means of settlement. For less
complex derivative instruments, such as free-standing warrants, we
generally use the Black-Scholes-Merton option valuation technique because
it embodies all of the requisite assumptions (including trading volatility,
estimated terms and risk free rates) necessary to fair value these
instruments. For complex derivative instruments, such as embedded
conversion options, we generally use the Flexible Monte Carlo valuation
technique because it embodies all of the requisite assumptions (including
credit risk, interest-rate risk and exercise/conversion behaviors) that are
necessary to fair value these more complex instruments. For forward
contracts that contingently require net-cash settlement as the principal
means of settlement, we project and discount future cash flows applying
probability-weightage to multiple possible outcomes. Estimating fair values
of derivative financial instruments requires the development of significant
and
F-11
subjective estimates that may, and are likely to, change over the duration
of the instrument with related changes in internal and external market
factors. In addition, option-based techniques are highly volatile and
sensitive to changes in the trading market price of our common stock, which
has a high-historical volatility. Since derivative financial instruments
are initially and subsequently carried at fair values, our income will
reflect the volatility in these estimate and assumption changes.
The following table summarizes the effects on our income (loss) associated
with changes in the fair values of our derivative financial instruments by
type of financing for the three and nine months ended September 30, 2006
and 2005.
Three months Three months Nine months Nine months
ended ended ended ended
September 30, September 30, September 30, September 30,
2006 2005 2006 2005
----------------------------------------------------------------
Derivative income (expense):
Convertible note and warrant financings $ 338,406 $14,161,562 $ (622,453) $(38,746,429)
Preferred stock and warrant financings 2,471,296 10,485,803 2,332,192 (10,637,376)
Other warrants and derivative contracts 8,246,718 (1,326,345) 9,248,670 (3,134,825)
----------------------------------------------------------------
$11,056,420 $23,321,020 $10,958,409 $(52,518,630)
================================================================
Additional information related to individual financings can be found in
notes 5, 6 and 8.
Our derivative liabilities as of September 30, 2006 and December 31, 2005,
and our derivative losses during the three and nine months ended September
30, 2006 and 2005 are significant to our consolidated financial statements.
The magnitude of the derivative income (expense) amounts for each of the
periods reflect the following:
(a) During the quarters ended September 30, 2006 and September 30, 2005,
the trading price of our common stock, which significantly affects the fair
value of our derivative financial instruments, experienced material price
declines. To illustrate, the closing price of our common stock decreased
from $0.61 to $0.51 during the quarter ended September 30, 2006 and from
$0.93 to $0.61 during the quarter ended September 30, 2005. The lower stock
prices had the effect of significantly decreasing the fair value of our
derivative liabilities and, accordingly, we were required to adjust the
derivatives to these lower values with credits to our income. The price of
the common stock also declined during the nine months ended September 30,
2006, from $0.58 to $0.51, thereby contributing to the derivative income
impact for this period. In contrast, during the nine months ended September
30, 2005, the price of our common stock increased significantly, from $0.17
at January 3, 2005 to $0.61 at September 30, 2005. As a result, a
significant charge was recorded to our income.
(b) During the nine months ended September 30, 2005, we entered into a
$2,300,000 debt and warrant financing arrangement, more fully discussed in
Note 5(b). In connection with our accounting for this financing we
encountered the unusual circumstance of a day-one loss related to the
recognition of derivative instruments arising from the arrangement. That
means that the fair value of the bifurcated compound derivative and
warrants exceeded the proceeds that we received from the arrangement and we
were required to record a loss to record the derivative financial
instruments at fair value. The loss that we recorded amounted to
$8,663,869. We did not enter into any other financing arrangements during
the periods reported that reflected day-one losses.
F-12
The following table summarizes the number of common shares indexed to the
derivative financial instruments as of September 30, 2006:
Conversion
Financing or other contractual arrangement: Note Features Warrants Total
------------------------------------------
$2,500,000 Note Financing 4(a) -- 300,000 300,000
$600,000 Convertible Note Financing 5(c) 3,075,000 -- 3,075,000
$1,080,000 Convertible Note Financing 5(g) 1,722,000 -- 1,722,000
$30,000,000 Convertible Note Financing 5(i) 50,840,336 12,857,143 63,697,479
Series H Convertible Preferred Stock (a) 6(a) -- 3,137,500 3,137,500
Series J Convertible Preferred Stock 6(b) 20,000,000 -- 20,000,000
Other warrants and contracts 8(b) -- 54,574,688 54,574,688
-------------------------------------------
75,637,336 70,869,331 146,506,667
===========================================
(a) As more fully described in Notes 6(a) and 6(c) these instruments were
afforded the conventional convertible exemption, which means we did
not have to bifurcate the embedded conversion feature. However, we
were required to bifurcate certain other embedded derivatives as
discussed in the notes. Although the conversion features did not
require derivative accounting, we are required to also consider the
1,312,500 and 9,500,000 common shares, respectively, into which these
instruments are convertible in determining whether we have sufficient
authorized and unissued common shares for all of our share-settled
obligations.
During October 2006, the Financial Accounting Standards Board exposed for
public comment FASB Staff Position 00-19(b), Accounting for Registration
Payment Arrangements, which, if promulgated in its current form would amend
Financial Accounting Standard No. 133 Accounting for Derivative Financial
Instruments and Hedging Activities. Generally, the proposed amendment will
provide for the exclusion of registration payments, such as the liquidated
damages that we have incurred, from the consideration of classification of
financial instruments. Rather, such registration payments would be
accounted for pursuant to Financial Accounting Standard No. 5 Accounting
for Contingencies, which is our current accounting practice. That is, all
registration payments will require recognition when they are both probable
and reasonably estimable. Our current financial arrangements result in
liability classification because of registration payments and variable-
priced instruments that cause share settlement of all of our derivative
instruments to be beyond our control. Until we can amend or redeem the
variable-indexed instruments, we will not receive the benefit of equity
reclassification. Upon amendment or redemption, substantially all of our
derivative financial instruments will be reclassified to stockholders'
equity at their adjusted fair value and we will no longer be required to
reflect fair value changes in our earnings.
Advertising and Promotion Costs
-------------------------------
Advertising and promotion costs, which are included in selling expenses,
are expensed as incurred and aggregated $3,190,312 and $626,843 for the
three months ended September 30, 2006 and 2005, respectively. Advertising
and Promotion costs were $5,377,445 and $1,138,397 for the nine months
ended September 30, 2006 and 2005, respectively.
Share-based payments
--------------------
Effective January 1, 2005, we adopted the fair value recognition provisions
of Financial Accounting Standards No. 123 Accounting for Stock-Based
compensation. Effective January 1, 2006 we adopted
F-13
Financial Accounting Standards No. 123(R), Share-Based Payments (FAS123R).
Under the fair value method, we recognize compensation expense for all
share-based payments granted after January 1, 2005, as well as all share-
based payments granted prior to, but not yet vested, as of January 1, 2005,
in accordance with SFAS No. 123. Under the fair value recognition
provisions of FAS 123(R), we recognize share-based compensation expense,
net of an estimated forfeiture rate, over the requisite service period of
the award. Prior to the adoption of FAS 123 and FAS 123(R), the Company
accounted for share-based payments under Accounting Principles Board
Opinion No. 25 Accounting for Stock Issued to Employees and the disclosure
provisions of SFAS No. 123. For further information regarding the adoption
of SFAS No. 123(R), see Note 7 to the consolidated financial statements.
Income Taxes
------------
We account for income taxes using the liability method, which requires an
entity to recognize deferred tax liabilities and assets. Deferred income
taxes are recognized based on the differences between the tax bases of
assets and liabilities and their reported amounts in the financial
statements that will result in taxable or deductible amounts in future
years. Further, the effects of enacted tax laws or rate changes are
included as part of deferred tax expense or benefit in the period that
covers the enactment date. A valuation allowance is recognized if it is
more likely than not that some portion, or all, of a deferred tax asset
will not be realized.
Income (Loss) Per Common Share
------------------------------
Our basic income (loss) per common share is computed by dividing income
(loss) applicable to common stockholders by the weighted average number of
common share outstanding during the reporting period. Diluted income (loss)
per common share is computed similar to basic income (loss) per common
share except that diluted income (loss) per common share includes dilutive
common stock equivalents, using the treasury stock method, and assumes that
the convertible debt instruments were converted into common stock upon
issuance, if dilutive. For the three and nine months ended September 30,
2006 potential common shares arising from our stock options, stock
warrants, convertible debt and convertible preferred stock amounting to
115,339,001 and 122,567,616 shares, respectively, were not included in the
computation of diluted earnings per share because their effect was
antidilutive. For the three and nine months ended September 30, 2005
potential common shares arising from our stock options, stock warrants,
convertible debt and convertible preferred stock amounting to 139,575,171
and142,611,032 shares, respectively, were not included in the computation
of diluted earnings per share because their effect was antidilutive.
Note 3 - Accrued liabilities
Accrued liabilities consist of the following as of September 30, 2006 and
December 31, 2005:
2006 2005
--------------------------
Liquidated damages due to late registration (a) $3,143,331 $ 303,750
Investor relations liability (b) 1,372,000 1,545,565
Production processor liability (c) 1,183,557 182,814
Accrued payroll and related taxes 351,527 636,757
Accrued interest 559,358 376,198
Marketing and promotion accrual (d) 2,099,495 --
Accrued finance fees for July 2006 financing 975,000 --
Discontinued products (e) -- 1,710,734
Other 300,583 116,459
--------------------------
$9,984,851 $4,872,277
==========================
F-14
(a) Certain of our financing arrangements provide for penalties in the
event of non-registration of securities underlying the financial
instruments. Generally, these penalties are calculated as a percentage of
the financing proceeds, usually between 1.0% and 3.0% each month. We record
these liquidated damages when they are probable and estimable pursuant to
FAS 5.
(b) We entered into a contract with an investor relations firm during 2005
that required payment in our equity securities. This liability represents
the cost of the shares, which have not yet been issued.
(c) Represents amounts owed to our 3rd party production processor.
Approximately $1.1 million of this balance relates to penalties incurred as
a result of not meeting minimum monthly production requirements (idle
capacity costs).
(d) Represents liability associated with nationwide sales and marketing
program that was launched during the quarter ended September 30, 2006.
(e) During our year ended December 31, 2005, we discontinued certain
product lines and, as a result, incurred certain penalties under purchase
commitments with our manufacturing vendors. We accrued these penalties upon
our decision to discontinue the products.
Note 4 - Notes Payable
Notes payable consist of the following as of September 30, 2006 and
December 31, 2005:
2006 2005
------------------------
$2,500,000 face value note payable, due November 12, 2006 (a) $ -- $ --
$ 750,000 face value note payable, due September 3, 2004 (b) -- 750,000
$ 187,743 face value note payable, due December 31, 2005 (c) 187,743 187,743
Other notes payable 137,569 --
------------------------
Total notes payable 325,312 937,743
Less current maturities (243,627) (937,743)
------------------------
Long-term notes payable $ 81,685 $ --
========================
(a) $2,500,000 Note Payable, due November 12, 2006:
---------------------------------------------------
On May 12, 2006, we issued $2,500,000 of six-month, 10% notes payable plus
detachable warrants to purchase 1,500,000 shares of our common stock with a
strike price of $0.80 for a period of five-years. Net proceeds from this
financing transaction amounted to $2,235,000. The holder has the option to
redeem the notes for cash in the event of default and certain other
contingent events, including events related to the common stock into which
the instrument is convertible, registration and listing (and maintenance
thereof) of our common stock and filing of reports with the Securities and
Exchange Commission (the "Default Put"). We evaluated the terms and
conditions of the notes and warrants and determined that (i) the Default
Put required bifurcation because it did not meet the "clearly and closely
related" criteria of FAS 133 and (ii) the warrants did not meet all of the
requisite conditions for equity classification under FAS 133. As a result,
the net proceeds from the arrangement were first allocated to the Default
Put ($87,146) and the warrants ($901,665) based upon their fair values,
because these instruments are required to be initially and subsequently
carried at fair values.
On July 26, 2006, $1,000,000 of the outstanding note balance and 1,200,000
of the warrants were included in a debt exchange with a new convertible
debt financing which occurred on July 26, 2006 (See Note 5(i)). The terms
of the exchange resulted in the treatment of the transaction as a debt
F-15
extinguishment, resulting in a loss of $357,054. The remaining balance of
$1,500,000 was repaid on July 31, 2006 resulting in an extinguishment gain
of approximately $485,000.
At September 30, 2006, there was a warrant liability for the remaining
300,000 warrants which will continue to be recorded at fair value until the
warrants are either exercised or expire.
The following table illustrates fair value adjustments that we have
recorded related to the derivative financial instruments associated with
the $2,500,000 Note Payable.
Three months Three months Nine months Nine months
ended ended Ended ended
September 30, September 30, September 30, September 30,
2006 2005 2006 2005
----------------------------------------------------------------
Derivative income (expense):
Default Put $180,905 -- $(35,831) --
=======================================================
Warrant derivative $135,804 -- $298,239 --
=======================================================
We estimated the fair value of the put on the inception date using a cash
flow technique that involves probability weighting multiple outcomes. We
estimated the warrant value using the Black Scholes-Merton valuation
technique. Significant assumptions included in our valuation models are as
follows:
Inception September 30, 2006
---------------------------------
Trading value of common stock $0.75 $0.51
Warrant strike price $0.80 $0.80
Volatility 133.00% 133.00%
Risk free rate 5.08% 5.04%
Expected term Stated term Remaining term
Discount rate used for cash flows 13.75% 14.00%
The fair value of the warrants declined principally due to the decline in
our common stock trading price. Since these instruments are measured at
fair value, future changes in assumptions, arising from both internal
factors and general market conditions, may cause further variation in the
fair value of these instruments. Changes in fair values of derivative
financial instruments are reflected as charges and credits to income.
The above allocations resulted in a discount to the carrying value of the
notes amounting to approximately $1,246,000. This discount, along with
related deferred finance costs and future interest payments were amortized
through periodic charges to interest expense using the effective method
until the date of the repayment and the debt exchange. Interest expense
during the nine months ended September 30, 2006 amounted to approximately
$351,000.
(b) On May 9, 2004 we received the proceeds of a $750,000 loan from Mid-Am
Capital, payable September 3, 2004, with an interest rate of 8%. This loan
was secured by a general security interest in all of our assets. The loan
was repaid in full during the quarter ended September 30, 2006.
(c) In 1999, we issued a promissory note to assume existing debt owed by
our then Chinese joint venture subsidiary to a supplier, International
Paper. The face value of that unsecured note was $282,637 at an annual
interest rate of 10.5%. The note originally required 23 monthly payments of
$7,250 and a balloon payment of $159,862 due on July 15, 2000. During 2000,
we negotiated an extension of this note to July 1, 2001. International
Paper imposed a charge of $57,000 to renegotiate the note, which amount
represents interest due through the extension date. The balance due on this
note is $187,743 at September 30, 2006 and December 31, 2005, all of which
is delinquent.
F-16
Note 5 - Convertible Debt
Convertible debt carrying values consist of the following as of September
30, 2006 and December 31, 2005:
2006 2005
------------------------
$ 200,000 Convertible Note Payable, due November 2006 (a) $ -- $ 187,934
$ 15,000 Convertible Note Payable, due May 2007 (b) -- 1,620
$ 600,000 Convertible Note Payable, due December 2005 (c) 450,000 600,000
$ 6,250 Convertible Note Payable, due April 30, 2006 (e) -- 5,188
$ 25,000 Convertible Note Payable, due October 1, 2006 (f) -- 30,278
$ 168,000 Convertible Note Payable, due December 1, 2005(g) 168,000 187,760
$30,000,000 Convertible Note Payable, due July 31, 2010 (i) 20,228,607 --
---------------------------
$20,846,607 $1,012,780
===========================
(a) $400,000 Convertible Note Financing
---------------------------------------
On November 20, 2003, we issued $400,000 of 8.0% convertible notes payable,
due November 20, 2005 plus warrants to purchase 14,000,000 shares of our
common stock with a strike prices ranging from $0.05 to $1.00 for a period
of three years. In November 2005, the underlying note agreement was
modified to extend the maturity date to November 2006. As of December 31,
2005, this note had an outstanding face value of $200,000, which was fully
converted by September 30, 2006. The convertible notes were convertible
into a variable number of our common shares based upon a variable
conversion price of the lower of $0.05 or 75% of the closing market price
near the conversion date. The holder had the option to redeem the
convertible notes payable for cash at 130% of the face value in the event
of defaults and certain other contingent events, including events related
to the common stock into which the instrument was convertible, registration
and listing (and maintenance thereof) of our common stock and filing of
reports with the Securities and Exchange Commission (the "Default Put"). In
addition, we extended registration rights to the holder that required
registration and continuing effectiveness thereof; we would be required to
pay monthly liquidating damages of 2.0% for defaults under this provision.
In our evaluation of this instrument, we concluded that the conversion
feature was not afforded the exemption as a conventional convertible
instrument due to variable conversion feature; and it did not otherwise
meet the conditions for equity classification. Since equity classification
is not available for the conversion feature, we were required to bifurcate
the embedded conversion feature and carry it as a derivative liability, at
fair value. We also concluded that the Default Put required bifurcation
because, while puts on debt instruments are generally considered clearly
and closely related to the host, the Default Put is indexed to certain
events, noted above, that are not associated debt instruments. We combined
all embedded features that required bifurcation into one compound
instrument that is carried as a component of derivative liabilities. We
also determined that the warrants did not meet the conditions for equity
classification because, as noted above, share settlement and maintenance of
an effective registration statement are not within our control. Therefore,
the warrants are also required to be carried as a derivative liability, at
fair value.
We estimated the fair value of the compound derivative on the inception
dates, and subsequently, using the Monte Carlo valuation technique, because
that technique embodies all
F-17
of the assumptions (including credit risk, interest risk, stock price
volatility and conversion estimates) that are necessary to fair value
complex derivative instruments. We estimated the fair value of the warrants
on the inception dates, and subsequently, using the Black-Scholes-Merton
valuation technique, because that technique embodies all of the assumptions
(including, volatility, expected terms, and risk free rates) that are
necessary to fair value freestanding warrants. As a result of these
estimates, our valuation model resulted in compound derivative balances
associated with this financing arrangement of $-0- and $1,311,000 as of
September 30, 2006 and December 31, 2005, respectively. These amounts are
included in Derivative Liabilities on our balance sheet. Warrants related
to the financing were fully converted prior to December 31, 2005.
The following table illustrates fair value adjustments that we have
recorded related to the derivative financial instruments associated with
the $400,000 convertible note financing.
Three months Three months Nine months Nine months
ended ended Ended ended
September 30, September 30, September 30, September 30,
2006 2005 2006 2005
----------------------------------------------------------------
Derivative income (expense)
Compound derivative $ (196,200) $864,000 $ (551,400) $(1,878,000)
=============================================================
Warrant derivative $ -- $ -- $ -- $(5,733,700)
=============================================================
Changes in the fair value of the compound derivative and, therefore,
derivative income (expense) related to the compound derivative is
significantly affected by changes in our trading stock price and the credit
risk associated with our financial instruments. The fair value of the
warrant derivative is significantly affected by changes in our trading
stock prices.
The aforementioned allocations to the compound and warrant derivatives
resulted in the discount in the carrying value of the notes to zero. This
discount, along with related deferred finance costs and future interest
payments, are amortized through periodic charges to interest expense using
the effective method. Interest expense during the nine months ended
September 30, 2006 and 2005 amounted to approximately $22,000 and $74,000,
respectively.
As noted in the introductory paragraph of this section, the holders
extended the notes one additional year to November 2006. This modification
was accounted for as an extinguishment because the present value of the
amended debt was significantly different than the present value immediately
preceding the modification. As a result of the extinguishment, the existing
debt carrying value was adjusted to fair value using projected cash flows
at market rates for similar instruments. This extinguishment resulted in
our recognition of a gain on extinguishment of $22,733 in the fourth fiscal
quarter of our year ended December 31, 2005.
(b) $2,300,000 Convertible Note Financing:
------------------------------------------
On January 28, 2005, May 23, 2005 and August 18, 2005, we issued
$1,150,000, $500,000 and $650,000, respectively of 8.0% convertible notes
payable, due January 28, 2007 plus warrants to purchase 9,200,000,
4,000,000 and 5,200,000, respectively, shares of our common stock with a
strike price of $0.129 for a period of five years. At December 31, 2005,
this note had an outstanding face value of $15,000, which was fully
converted by August 30, 2006. The reduction in face value resulted from
conversions to common stock. The convertible notes were convertible into a
fixed number of our common shares based upon a conversion price of $0.125
with anti-dilution protection for sales of securities below the fixed
conversion price. We had the option to redeem the convertible notes for
cash at 120% of the face value. The holder had the option to redeem the
convertible notes payable for cash at 120% of the face value in the event
of defaults and certain other contingent events, including events related
to the common stock into which the instrument was convertible, registration
and listing (and maintenance thereof) of our common stock and filing of
reports with the Securities and Exchange Commission (the "Default Put").
F-18
In our evaluation of this instrument, we concluded that the conversion
feature was not afforded the exemption as a conventional convertible
instrument due to the anti-dilution protection; and it did not otherwise
meet the conditions for equity classification. Since equity classification
was not available for the conversion feature, we were required to bifurcate
the embedded conversion feature and carry it as a derivative liability, at
fair value. We also concluded that the Default Put required bifurcation
because, while puts on debt instruments are generally considered clearly
and closely related to the host, the Default Put is indexed to certain
events, noted above, that are not associated debt instruments. We combined
all embedded features that required bifurcation into one compound
instrument that is carried as a component of derivative liabilities. We
also determined that the warrants did not meet the conditions for equity
classification because these instruments did not meet all of the criteria
necessary for equity classification. Therefore, the warrants were also
required to be carried as a derivative liability, at fair value.
We estimated the fair value of the compound derivative on the inception
dates, and subsequently, using the Monte Carlo valuation technique, because
that technique embodies all of the assumptions (including credit risk,
interest risk, stock price volatility and conversion estimates) that are
necessary to fair value complex derivative instruments. We estimated the
fair value of the warrants on the inception dates, and subsequently, using
the Black-Scholes-Merton valuation technique, because that technique
embodies all of the assumptions (including, volatility, expected terms, and
risk free rates) that are necessary to fair value freestanding warrants. As
a result of these estimates, our valuation model resulted in compound
derivative balances associated with this financing arrangement of $-0- and
$4,867 as of September 30, 2006 and December 31, 2005, respectively.
The following table illustrates fair value adjustments that we have
recorded related to the derivative financial instruments associated with
the $2,300,000 convertible note financing:
Three months Three months Nine months Nine months
ended ended Ended ended
September 30, September 30, September 30, September 30,
2006 2005 2006 2005
----------------------------------------------------------------
Derivative income (expense)
Compound derivative $ (24,278) $4,167,234 $(24,868) $(6,791,319)
=============================================================
Warrant derivative $ -- $ -- $ -- $(8,189,280)
=============================================================
Changes in the fair value of the compound derivative and, therefore,
derivative income (expense) related to the compound derivative is
significantly affected by changes in our trading stock price and the credit
risk associated with our financial instruments. The fair value of the
warrant derivative is significantly affected by changes in our trading
stock prices.
The aforementioned allocations to the compound and warrant derivatives
resulted in the discount in the carrying value of the notes. This discount,
along with related deferred finance costs and future interest payments, are
amortized through periodic charges to interest expense using the effective
method. Interest expense during the nine months ended September 30, 2006
and 2005 amounted to approximately $38,500 and $244,800, respectively.
(c) $600,000 Convertible Note Financing:
----------------------------------------
On June 29, 2004, we issued $600,000 of 10.0% convertible notes payable,
due December 31, 2005, plus warrants to purchase 2,000,000 and 5,000,000
shares of our common stock with strike prices of $0.25 and $1.00,
respectively, for a periods of five and two years, respectively. Net
proceeds from this financing arrangement amounted to $500,000. As of
September 30, 2006 and December 31, 2005, the outstanding principal balance
on this note was $450,000 and $600,000, respectively. The reduction in
principal was due to note conversions. As of September 30, 2006, this debt
is past due and the outstanding carrying
F-19
value of $450,000 does not include $51,000 of capitalized interest, which
is being reflected in accrued liabilities. The convertible note is
convertible into a fixed number of our common shares based upon a
conversion price of $0.15 with anti-dilution protection for sales of
securities below the fixed conversion price. We have the option to redeem
the convertible notes for cash at 120% of the face value. The holder has
the option to redeem the convertible notes payable for cash at 130% of the
face value in the event of defaults and certain other contingent events,
including events related to the common stock into which the instrument is
convertible, registration and listing (and maintenance thereof) of our
common stock and filing of reports with the Securities and Exchange
Commission (the "Default Put"). In addition, we extended registration
rights to the holder that required registration and continuing
effectiveness thereof; we are required to pay monthly liquidating damages
of 2.0% for defaults under this provision.
In our evaluation of this instrument, we concluded that the conversion
feature was not afforded the exemption as a conventional convertible
instrument due to the anti-dilution protection; and it did not otherwise
meet the conditions for equity classification. Since equity classification
is not available for the conversion feature, we were required to bifurcate
the embedded conversion feature and carry it as a derivative liability, at
fair value. We also concluded that the Default Put required bifurcation
because, while puts on debt instruments are generally considered clearly
and closely related to the host, the Default Put is indexed to certain
events, noted above, that are not associated debt instruments. We combined
all embedded features that required bifurcation into one compound
instrument that is carried as a component of derivative liabilities. We
also determined that the warrants did not meet the conditions for equity
classification because these instruments did not meet all of the criteria
necessary for equity classification. Therefore, the warrants are also
required to be carried as a derivative liability, at fair value.
We estimated the fair value of the compound derivative on the inception
dates, and subsequently, using the Monte Carlo valuation technique, because
that technique embodies all of the assumptions (including credit risk,
interest risk, stock price volatility and conversion estimates) that are
necessary to fair value complex derivative instruments. We estimated the
fair value of the warrants on the inception dates, and subsequently, using
the Black-Scholes-Merton valuation technique, because that technique
embodies all of the assumptions (including, volatility, expected terms, and
risk free rates) that are necessary to fair value freestanding warrants. As
a result of these estimates, our valuation model resulted in compound
derivative balances associated with this financing arrangement of $620,100
and $153,700 as of September 30, 2006 and December 31, 2005, respectively.
These amounts are included in Derivative Liabilities on our balance sheet.
As of December 31, 2005, all warrants related to the financing had been
converted.
The following table illustrates fair value adjustments that we have
recorded related to the derivative financial instruments associated with
the $600,000 convertible note financing:
Three months Three months Nine months Nine months
ended ended Ended ended
September 30, September 30, September 30, September 30,
2006 2005 2006 2005
----------------------------------------------------------------
Derivative income (expense)
Compound derivative $5,300 $110,100 $(466,400) $(1,472,067)
===========================================================
Warrant derivative $ -- $ -- $ -- $(5,478,300)
===========================================================
Changes in the fair value of the compound derivative and, therefore,
derivative income (expense) related to the compound derivative is
significantly affected by changes in our trading stock price and the credit
risk associated with our financial instruments. The fair value of the
warrant derivative is significantly affected by changes in our trading
stock prices. Future changes in these underlying market conditions will
have a continuing effect on derivative income (expense) associated with
these instruments.
F-20
The aforementioned allocations to the compound and warrant derivatives
resulted in the discount in the carrying value of the notes. This discount,
along with related deferred finance costs and future interest payments, are
amortized through periodic charges to interest expense using the effective
method. Interest expense during the nine months ended September 30, 2006
and 2005 amounted to approximately $-0- and $350,000, respectively.
(d) $240,000 Convertible Note Financing:
----------------------------------------
On December 22, 2004, we issued $240,000 of 10.0% convertible notes
payable, due April 30, 2006, plus warrants to purchase 800,000 shares of
our common stock at $0.15 for five years. Net proceeds from this financing
arrangement amounted to $196,500. As of June 30, 2005, this debt had been
fully converted. The convertible notes were convertible into a fixed number
of our common shares based upon a conversion price of $0.10 with anti-
dilution protection for sales of securities below the fixed conversion
price. We had the option to redeem the convertible notes for cash at 120%
of the face value. The holder had the option to redeem the convertible
notes payable for cash at 130% of the face value in the event of defaults
and certain other contingent events, including events related to the common
stock into which the instrument was convertible, registration and listing
(and maintenance thereof) of our common stock and filing of reports with
the Securities and Exchange Commission (the "Default Put"). In addition, we
extended registration rights to the holder that required registration and
continuing effectiveness thereof; we were required to pay monthly
liquidating damages of 2.0% for defaults under this provision.
In our evaluation of this instrument, we concluded that the conversion
feature was not afforded the exemption as a conventional convertible
instrument due to the anti-dilution protection and it did not otherwise
meet the conditions for equity classification. Since equity classification
was not available for the conversion feature, we were required to bifurcate
the embedded conversion feature and carry it as a derivative liability, at
fair value. We also concluded that the Default Put required bifurcation
because, while puts on debt instruments are generally considered clearly
and closely related to the host, the Default Put was indexed to certain
events, noted above, that are not associated debt instruments. We combined
all embedded features that required bifurcation into one compound
instrument that is carried as a component of derivative liabilities. We
also determined that the warrants did not meet the conditions for equity
classification because these instruments did not meet all of the criteria
necessary for equity classification. Therefore, the warrants were also
required to be carried as a derivative liability, at fair value.
We estimated the fair value of the compound derivative on the inception
dates, and subsequently, using the Monte Carlo Valuation technique, because
that technique embodies all of the assumptions (including credit risk,
interest risk, stock price volatility and conversion estimates) that are
necessary to fair value complex derivative instruments. These amounts are
included in Derivative Liabilities on our balance sheet. We estimated the
fair value of the warrants on the inception dates, and subsequently, using
the Black-Scholes-Merton valuation technique, because that technique
embodies all of the assumptions (including, volatility, expected terms, and
risk free rates) that are necessary to fair value freestanding warrants. As
of September 30, 2005 all warrant liabilities related to the financing had
been fully converted.
F-21
The following table illustrates fair value adjustments that we have
recorded related to the derivative financial instruments associated with
the $240,000 convertible note financing:
Three months Three months Nine months Nine months
ended ended Ended ended
September 30, September 30, September 30, September 30,
2006 2005 2006 2005
----------------------------------------------------------------
Derivative income (expense)
Compound derivative $ -- $ -- $ -- $(55,604)
===========================================================
Warrant derivative $ -- $265,740 $ -- $ 55,540
===========================================================
Changes in the fair value of the compound derivative and, therefore,
derivative income (expense) related to the compound derivative is
significantly affected by changes in our trading stock price and the credit
risk associated with our financial instruments. The fair value of the
warrant derivative is significantly affected by changes in our trading
stock prices.
The aforementioned allocations to the compound and warrant derivatives
resulted in the discount in the carrying value of the notes. This discount,
along with related deferred finance costs and future interest payments,
were amortized through periodic charges to interest expense using the
effective method. Interest expense during the nine months ended September
30, 2006 and 2005 amounted to approximately $-0- and $90,000, respectively.
(e) $693,000 Convertible Note Financing:
----------------------------------------
On October 29, 2004, we issued $693,000 of 10.0% convertible notes payable,
due April 30, 2006, plus warrants to purchase 2,200,000 shares of our
common stock at $0.15 for five years. Net proceeds from this financing
arrangement amounted to $550,000. As of December 31, 2005, this debt had
face value $6,250 outstanding which amount had been fully converted by
April 30, 2006. The convertible notes were convertible into a fixed number
of our common shares based upon a conversion price of $0.10 with anti-
dilution protection for sales of securities below the fixed conversion
price. We had the option to redeem the convertible notes for cash at 120%
of the face value. The holder had the option to redeem the convertible
notes payable for cash at 130% of the face value in the event of defaults
and certain other contingent events, including events related to the common
stock into which the instrument was convertible, registration and listing
(and maintenance thereof) of our common stock and filing of reports with
the Securities and Exchange Commission (the "Default Put"). In addition, we
extended registration rights to the holder that required registration and
continuing effectiveness thereof; we were required to pay monthly
liquidating damages of 2.0% for defaults under this provision.
In our evaluation of this instrument, we concluded that the conversion
feature was not afforded the exemption as a conventional convertible
instrument due to the anti-dilution protection; and it did not otherwise
meet the conditions for equity classification. Since equity classification
was not available for the conversion feature, we were required to bifurcate
the embedded conversion feature and carry it as a derivative liability, at
fair value. We also concluded that the Default Put required bifurcation
because, while puts on debt instruments are generally considered clearly
and closely related to the host, the Default Put is indexed to certain
events, noted above, that are not associated debt instruments. We combined
all embedded features that required bifurcation into one compound
instrument that is carried as a component of derivative liabilities. We
also determined that the warrants did not meet the conditions for equity
classification because these instruments did not meet all of the criteria
necessary for equity classification. Therefore, the warrants were also
required to be carried as a derivative liability, at fair value.
We estimated the fair value of the compound derivative on the inception
dates, and subsequently, using the Monte Carlo valuation technique, because
that technique embodies all of the assumptions (including credit risk,
interest risk, stock price volatility and conversion estimates) that are
necessary to fair value complex derivative instruments. We estimated the
fair value of the warrants on the inception dates, and subsequently, using
the Black-Scholes-Merton valuation technique, because that technique
embodies all of the assumptions (including, volatility, expected terms, and
risk free rates) that are necessary to fair value freestanding warrants. As
a result of these estimates, our valuation model resulted in compound
derivative balances of $-0- and $42,878 as of September 30, 2006 and
December 31, 2005, respectively. Our valuation model resulted in warrant
derivative balances associated arising from the convertible note
F-22
financing of $-0- and $924,120 as of September 30, 2006 and December 31,
2005, respectively. These amounts are included in Derivative Liabilities on
our balance sheet.
The following table illustrates fair value adjustments that we have
recorded related to the derivative financial instruments associated with
the $693,000 convertible note financing:
Three months Three months Nine months Nine months
ended ended Ended ended
September 30, September 30, September 30, September 30,
2006 2005 2006 2005
----------------------------------------------------------------
Derivative income (expense)
Compound derivative $ -- $ 22,625 $(6,143) $(2,611,650)
============================================================
Warrant derivative $ -- $538,220 $ -- $ (707,880)
=============================================================
Changes in the fair value of the compound derivative and, therefore,
derivative income (expense) related to the compound derivative is
significantly affected by changes in our trading stock price and the credit
risk associated with our financial instruments. The fair value of the
warrant derivative is significantly affected by changes in our trading
stock prices.
The aforementioned allocations to the compound and warrant derivatives
resulted in the discount in the carrying value of the notes. This discount,
along with related deferred finance costs and future interest payments,
were amortized through periodic charges to interest expense using the
effective method. Interest expense during the nine months ended September
30, 2006 and 2005 amounted to approximately $3,711 and $253,000,
respectively.
(f) $660,000 Convertible Note Financing:
----------------------------------------
On April 2, 2004, we issued $660,000 of 10.0% convertible notes payable,
due October 1, 2005, plus warrants to purchase 3,000,000 shares of our
common stock at $0.15 for five years. Net proceeds from this financing
arrangement amounted to $493,000. As of December 31, 2005, this debt had a
face value $25,000 outstanding which amount had been fully converted by
June 30, 2006. The convertible notes were convertible into a fixed number
of our common shares based upon a conversion price of $0.10 with anti-
dilution protection for sales of securities below the fixed conversion
price. We had the option to redeem the convertible notes for cash at 120%
of the face value. The holder had the option to redeem the convertible
notes payable for cash at 130% of the face value in the event of defaults
and certain other contingent events, including events related to the common
stock into which the instrument is convertible, registration and listing
(and maintenance thereof) of our common stock and filing of reports with
the Securities and Exchange Commission (the "Default Put"). In addition, we
extended registration rights to the holder that required registration and
continuing effectiveness thereof; we were required to pay monthly
liquidating damages of 2.0% for defaults under this provision.
In our evaluation of this instrument, we concluded that the conversion
feature was not afforded the exemption as a conventional convertible
instrument due to the anti-dilution protection, and it did not otherwise
meet the conditions for equity classification. Since equity classification
is not available for the conversion feature, we were required to bifurcate
the embedded conversion feature and carry it as a derivative liability, at
fair value. We also concluded that the Default Put required bifurcation
because, while puts on debt instruments are generally considered clearly
and closely related to the host, the Default Put is indexed to certain
events, noted above, that are not associated debt instruments. We combined
all embedded features that required bifurcation into one compound
instrument that is carried as a component of derivative liabilities. We
also determined that the warrants did not meet the conditions for equity
classification because these instruments did not meet all of the criteria
necessary for equity classification. Therefore, the warrants are also
required to be carried as a derivative liability, at fair value.
F-23
We estimated the fair value of the compound derivative on the inception
dates, and subsequently, using the Monte Carlo valuation technique, because
that technique embodies all of the assumptions (including credit risk,
interest risk, stock price volatility and conversion estimates) that are
necessary to fair value complex derivative instruments. We estimated the
fair value of the warrants on the inception dates, and subsequently, using
the Black-Scholes-Merton valuation technique, because that technique
embodies all of the assumptions (including, volatility, expected terms, and
risk free rates) that are necessary to fair value freestanding warrants. As
a result of these estimates, our valuation model resulted in compound
derivative balances of $-0- and $159,250 as of September 30, 2006 and
December 31, 2005, respectively. These amounts are included in Derivative
Liabilities on our balance sheet. As of September 30, 2005, all warrants
related to the financing had been fully converted.
The following table illustrates fair value adjustments that we have
recorded related to the derivative financial instruments associated with
the $660,000 convertible note financing:
Three months Three months Nine months Nine months
ended ended Ended ended
September 30, September 30, September 30, September 30,
2006 2005 2006 2005
----------------------------------------------------------------
Derivative income (expense)
Compound derivative $ -- $(435,861) $(3,250) $(2,793,746)
=============================================================
Warrant derivative $ -- $ -- $ -- $ 61,800
=============================================================
Changes in the fair value of the compound derivative and, therefore,
derivative income (expense) related to the compound derivative is
significantly affected by changes in our trading stock price and the credit
risk associated with our financial instruments. The fair value of the
warrant derivative is significantly affected by changes in our trading
stock prices.
The aforementioned allocations to the compound and warrant derivatives
resulted in the discount in the carrying value of the notes. This discount,
along with related deferred finance costs and future interest payments,
were amortized through periodic charges to interest expense using the
effective method. Interest expense during the nine months ended September
30, 2006 and 2005 amounted to approximately $-0- and $111,465, respectively.
(g) $1,008,000 Convertible Note Financing:
------------------------------------------
On June 29, 2004, we issued $1,008,000 of 10.0% convertible notes payable,
due April 30, 2006, plus warrants to purchase 3,200,000 and 8,000,000
shares of our common stock at $0.25 and $2.00, respectively, for a periods
of five years. Net proceeds from this financing arrangement amounted to
$679,000. We had an outstanding balance of $168,000 and $187,760 as of
September 30, 2006 and December 31, 2005, respectively on this note. The
convertible notes were convertible into a fixed number of our common shares
based upon a conversion price of $0.15 with anti-dilution protection for
sales of securities below the fixed conversion price. We had the option to
redeem the convertible notes for cash at 120% of the face value. The holder
has the option to redeem the convertible notes payable for cash at 130% of
the face value in the event of defaults and certain other contingent
events, including events related to the common stock into which the
instrument is convertible, registration and listing (and maintenance
thereof) of our common stock and filing of reports with the Securities and
Exchange Commission (the "Default Put"). In addition, we extended
registration rights to the holder that required registration and continuing
effectiveness thereof; we are required to pay monthly liquidating damages
of 2.0% for defaults under this provision.
F-24
In our evaluation of this instrument, we concluded that the conversion
feature was not afforded the exemption as a conventional convertible
instrument due to the anti-dilution protection; and it did not otherwise
meet the conditions for equity classification. Since equity classification
is not available for the conversion feature, we were required to bifurcate
the embedded conversion feature and carry it as a derivative liability, at
fair value. We also concluded that the Default Put required bifurcation
because, while puts on debt instruments are generally considered clearly
and closely related to the host, the Default Put is indexed to certain
events, noted above, that are not associated debt instruments. We combined
all embedded features that required bifurcation into one compound
instrument that is carried as a component of derivative liabilities. We
also determined that the warrants did not meet the conditions for equity
classification because these instruments did not meet all of the criteria
necessary for equity classification. Therefore, the warrants are also
required to be carried as a derivative liability, at fair value.
We estimated the fair value of the compound derivative on the inception
dates, and subsequently, using the Monte Carlo valuation technique, because
that technique embodies all of the assumptions (including credit risk,
interest risk, stock price volatility and conversion estimates) that are
necessary to fair value complex derivative instruments. We estimated the
fair value of the warrants on the inception dates, and subsequently, using
the Black-Scholes-Merton valuation technique, because that technique
embodies all of the assumptions (including, volatility, expected terms, and
risk free rates) that are necessary to fair value freestanding warrants.
These amounts are included in Derivative Liabilities on our balance sheet.
As of December 31, 2005, all warrants related to the financing had been
fully converted.
The following table illustrates fair value adjustments that we have
recorded related to the derivative financial instruments associated with
the $1,008,000 convertible note financing:
Three months Three months Nine months Nine months
ended ended Ended ended
September 30, September 30, September 30, September 30,
2006 2005 2006 2005
----------------------------------------------------------------
Derivative income (expense)
Compound derivative $53,424 $ 644,804 $(16,251) $(2,531,373)
===========================================================
Warrant derivative $ -- $ 7,361,600 -- $ 220,800
===========================================================
Changes in the fair value of the compound derivative and, therefore,
derivative income (expense) related to the compound derivative is
significantly affected by changes in our trading stock price and the credit
risk associated with our financial instruments. The fair value of the
warrant derivative is significantly affected by changes in our trading
stock prices. Future changes in these underlying market conditions will
have a continuing effect on derivative income (expense) associated with
these instruments.
The aforementioned allocations to the compound and warrant derivatives
resulted in the discount in the carrying value of the notes. This discount,
along with related deferred finance costs and future interest payments,
were amortized through periodic charges to interest expense using the
effective method. Interest expense during the nine months ended September
30, 2006 and 2005 amounted to approximately $0 and $485,000, respectively.
(h) $360,000 Convertible Note Financing:
----------------------------------------
On April 21, 2005, we issued $360,000, nine-month-term, 10% convertible
notes payable, due October 31, 2005. Net proceeds for this financing
transaction amounted to $277,488. The notes were convertible into shares of
common stock at a fixed conversion rate of $0.20, with anti-dilution
protection for sales of securities below the fixed conversion price. The
holder converted the notes on September 30, 2005. We had the option to
redeem the notes payable for cash at 120% of the face value. The holder had
the option to redeem the convertible notes payable for cash at 130% of the
face value in the event of defaults and
F-25
certain other contingent events, including events related to the common
stock into which the instrument is convertible, registration and listing
(and maintenance thereof) of our common stock and filing of reports with
the Securities and Exchange Commission (the "Default Put").
In our evaluation of this instrument, we concluded that the conversion
feature was not afforded the exemption as a conventional convertible
instrument due to the anti-dilution protection afforded the holder and it
did not otherwise meet the conditions for equity classification. Therefore,
we were required to bifurcate the embedded conversion feature and carry it
as a derivative liability. We also concluded that the Default Put required
bifurcation because, while puts on debt instruments are generally
considered clearly and closely related to the host, the Default Put is
indexed to certain events, noted above, that are not associated debt
instruments. We combined all embedded features that required bifurcation
into one compound instrument that was carried as a component of derivative
liabilities through the date of conversion.
We allocated the initial proceeds from the financing first to the compound
derivative instrument in the amount of $113,925 and the balance to the debt
host instrument. We estimated the fair value of the compound derivative on
the inception dates, and subsequently, using the Monte Carlo valuation
technique, because that technique embodies all of the assumptions
(including credit risk, interest risk, stock price volatility and
conversion estimates) that are necessary to fair value complex derivative
instruments.
The following table illustrates fair value adjustments that we have
recorded related to the compound derivative arising from the $360,000
convertible notes payable.
Three months Three months Nine months Nine months
ended ended Ended ended
September 30, September 30, September 30, September 30,
2006 2005 2006 2005
----------------------------------------------------------------
Derivative income (expense)
Compound derivative $ -- $623,100 $ -- $(841,650)
============================================================
Changes in the fair value of the compound derivative and, therefore,
derivative income (expense) related to the compound derivative is
significantly affected by changes in our trading stock price and the credit
risk associated with our financial instruments. Since the instrument was
converted on September 30, 2005, there will be no future charges or credits
to derivative income (expense) associated with this instrument.
The above allocations resulted in a discount to the carrying value of the
notes amounting to approximately $173,925. This discount, along with
related deferred finance costs and future interest payments, are being
amortized through periodic charges to interest expense using the effective
method. Interest expense during the nine months ended September 30, 2005
amounted to approximately $163,000.
(i) $30,000,000 Convertible Note Financing:
-------------------------------------------
On July 26, 2006, we issued $30,000,000 of 9.0% convertible notes payable,
due January 27, 2010, plus warrants to purchase 12,857,143 shares of our
common stock at $0.73, for a period of five years. Net proceeds from this
financing arrangement amounted to approximately $15,000,000 (net of
approximately $1,090,000 in financing costs) and $15,000,000 to be held in
escrow for future release, pending the occurrence of certain defined
events. There was a $1,000,000 note balance related to the May 2006
financing that was exchanged for an equal amount of convertible notes from
this financing (See Note 4(a) for our accounting for that exchange). We had
a carrying value on this note of $20,229,000 as of September 30, 2006. The
convertible notes are
F-26
convertible into a fixed number of our common shares based upon a
conversion price of $0.70 with anti-dilution protection for sales of
securities below the fixed conversion price. We have the option to redeem
the convertible notes for cash at an amount equal to the note balance plus
accrued interest including the amount of unpaid interest that would have
been paid through the third anniversary of the note. The holder has the
option to redeem the convertible notes payable for cash at 125% of the face
value in the event of default and certain other contingent events,
including events related to the common stock into which the instrument is
convertible, registration and listing (and maintenance thereof) of our
common stock and filing of reports with the Securities and Exchange
Commission (the "Default Put"). We have the option to redeem the notes
payable at a date earlier than maturity (the "call option"). If we exercise
the call option, the holders will have the right to exercise an additional
42,857,142 warrants and receive common shares to which the contingent
warrants are indexed to. Absent the Company's exercise of its call option
to redeem the convertible notes, the holders have no rights to exercise the
warrants and receive common shares to which the contingent warrants are
indexed. The Company currently has no plans in the foreseeable future to
exercise its call option. If the Company does exercise its call option,
however, the number of our common shares that are issuable upon the
exercise of the contingent warrants is limited to the number of our common
shares underlying the convertible notes that have been redeemed. In
addition, we extended registration rights to the holder that required
registration and continuing effectiveness thereof; we are required to pay
monthly liquidating damages of 3.0% for defaults under this provision.
In our evaluation of this instrument, we concluded that the conversion
feature was not afforded the exemption as a conventional convertible
instrument due to the anti-dilution protection; and it did not otherwise
meet the conditions for equity classification. Since equity classification
is not available for the conversion feature, we were required to bifurcate
the embedded conversion feature and carry it as a derivative liability, at
fair value. We also concluded that the Default Put required bifurcation
because, while puts on debt instruments are generally considered clearly
and closely related to the host, the Default Put is indexed to certain
events, noted above, that are not associated debt instruments. We combined
all embedded features that required bifurcation into one compound
instrument that is carried as a component of derivative liabilities. We
also determined that the warrants did not meet the conditions for equity
classification because these instruments did not meet all of the criteria
necessary for equity classification. Therefore, the warrants are also
required to be carried as a derivative liability, at fair value.
We estimated the fair value of the compound derivative on the inception
dates, and subsequently, using the Monte Carlo valuation technique, because
that technique embodies all of the assumptions (including credit risk,
interest risk, stock price volatility and conversion estimates) that are
necessary to fair value complex derivative instruments. We estimated the
fair value of the warrants on the inception dates, and subsequently, using
the Black-Scholes-Merton valuation technique, because that technique
embodies all of the assumptions (including, volatility, expected terms, and
risk free rates) that are necessary to fair value freestanding warrants.
These amounts are included in Derivative Liabilities on our balance sheet.
On August 31, 2006, the Company entered into Amendment Agreements in which
the investors agreed to release the Company from events of default that
occurred under the terms of the original July 26, 2006 financing. In
exchange, Amended and Restated Notes were issued in which the conversion
price on the $15,000,000 financing, which was held in escrow, was reduced
from $0.70 to $0.51. In addition, the holder could require the Company to
redeem any portion of the Amended and Restated Note in cash or common stock
at 125% from October 10, 2006 through December 31, 2006. This debt
modification was deemed to be a modification rather than a debt
extinguishment since it did not rise to the requirements of EITF 96-19 to
be deemed a debt extinguishment. The change in the conversion price caused
an additional embedded conversion feature liability of approximately
$646,000 which was also recorded as a reduction in the carrying amount of
the debt.
The following table illustrates fair value adjustments that we have
recorded related to the derivative financial instruments associated with
the $30,000,000 convertible note financing:
Three months Three months Nine months Nine months
ended ended Ended ended
September 30, September 30, September 30, September 30,
2006 2005 2006 2005
----------------------------------------------------------------
Derivative income (expense)
Compound derivative $(478,692) $ -- $(478,692) $ --
============================================================
Warrant derivative $ 662,143 $ -- $ 662,143 $ --
============================================================
F-27
Changes in the fair value of the compound derivative and, therefore,
derivative income (expense) related to the compound derivative is
significantly affected by changes in our trading stock price and the credit
risk associated with our financial instruments. The fair value of the
warrant derivative is significantly affected by changes in our trading
stock prices. Future changes in these underlying market conditions will
have a continuing effect on derivative income (expense) associated with
these instruments.
The aforementioned allocations to the compound and warrant derivatives
resulted in the discount in the carrying value of the notes. This discount,
along with related deferred finance costs and future interest payments,
were amortized through periodic charges to interest expense using the
effective method. Interest expense during the nine months ended September
30, 2006 amounted to approximately $97,000.
Derivative warrant fair values are calculated using the Black-Scholes-
Merton valuation technique. Significant assumptions as of September 30,
2006, corresponding to each of the series of warrants are as follows:
Series A
--------
Trading market price $0.51
Strike price $0.73
Volatility 94.25%
Risk-free rate 5.02%
Remaining term/life (years) 4.75
Our stock prices have been highly volatile. Future fair value changes are
significantly influenced by our trading common stock prices. As previously
discussed herein, changes in fair value of derivative financial instruments
are reflected in earnings.
Note 6 - Preferred Stock
Our articles of incorporation authorize the issuance of 5,000,000 shares of
preferred stock. We have designated this authorized preferred stock, as
follows:
(a) Series H Preferred Stock:
-----------------------------
We have designated 350,000 shares of our preferred stock as Series H
Cumulative Convertible Preferred Stock with a stated and liquidation value
of $10.00 per share. Series H Preferred Stock has cumulative dividend
rights at 7.0% of the stated amount, ranks senior to common stock and is
non-voting. As of September 30, 2006 and December 31, 2005, the preferred
stock liability was $502,507 and $388,305, respectively. The Series H
preferred stock is convertible into our common stock at a fixed conversion
price of $0.40 per common share. The Series H Preferred Stock is
mandatorily redeemable for common stock on the fifth anniversary of its
issuance. We have the option to redeem the Series H Preferred Stock for
cash at 135% of the stated value. The holder has the option to redeem the
Series H Preferred Stock for cash at 140% of the stated value in the event
of defaults and certain other contingent events, including events related
to the common stock into which the instrument is convertible, listing of
our common stock and filing of reports with the Securities and Exchange
Commission (the "Default Put").
Based upon our evaluation of the terms and conditions of the Series H
Preferred Stock, we concluded that it was more akin to a debt instrument
than an equity instrument, which means that our accounting conclusions are
based upon those related to a traditional debt security, and that it should
afforded the conventional convertible exemption regarding the embedded
conversion feature because the conversion
F-28
price is fixed. Therefore, we are not required to bifurcate the embedded
conversion feature and carry it as a liability. However, we concluded that
the Default Put required bifurcation because, while puts on debt-type
instruments are generally considered clearly and closely related to the
host, the Default Put is indexed to certain events, noted above, that are
not associated with debt-type instruments. In addition, due to the default
and contingent redemption features of the Series H Preferred Stock, we
classified this instrument as redeemable preferred stock, outside of
stockholders' equity.
Between December 2001 and March 2002, we issued 175,500 shares of Series H
Preferred Stock for cash of $1,755,000, plus warrants to purchase an
aggregate of 4,387,500 shares of common stock at $0.50 for five years. As
of September 30, 2006 and December 31, 2005, shares of preferred stock
outstanding were 52,500 and 64,500, respectively, and warrants outstanding
were 3,379,435 and 4,387,500, respectively. We initially allocated
$1,596,228 of the proceeds from the Series H Preferred financings to the
warrants at their fair values because the warrants did not meet all of the
conditions necessary for equity classification and, accordingly, are
carried as derivative liabilities, at fair value. We also allocated
$134,228 to the Default Puts which, as described above are carried as
derivative liabilities, at fair value. Finally, we recorded derivative
expense of $9,666 because one of the financings did not result in
sufficient proceeds to record the derivative financial instruments at fair
values on the inception date.
We estimated the fair value of the derivative warrants on the inception
dates, and subsequently, using the Black-Scholes-Merton valuation
technique. As a result of applying this technique, our valuation of the
derivative warrants amounted to $359,907 and $1,264,109 as of September 30,
2006 and December 31, 2005, respectively. We estimated the fair value of
the Default Puts on the inception dates, and subsequently, using a cash
flow technique that involves probability-weighting multiple outcomes at net
present values. Significant assumptions underlying the probability-weighted
outcomes included both our history of similar default events, all available
information about our business plans that could give rise to or risk
defaults and the imminence of impending or current defaults. As a result of
these subjective estimates, our valuation model resulted in Default Put
balances associated with the Series H Preferred Stock of $549,576 and
$381,377 as of September 30, 2006 and December 31, 2005, respectively.
These amounts are included in Derivative Liabilities on our balance sheet.
The following table illustrates fair value adjustments that we have
recorded related to the Default Puts on the Series H Preferred Stock.
Three months Three months Nine months Nine months
ended ended Ended ended
September 30, September 30, September 30, September 30,
Derivative income (expense) 2006 2005 2006 2005
----------------------------------------------------------------
Default Put $(47,124) $ (2,064) $(168,198) $ (6,191)
=============================================================
Derivative Warrants $480,363 $1,346,635 $ 904,202 $(1,361,786)
=============================================================
Derivative income (expense) related to the Default Put includes changes to
the fair value arising from changes in our estimates about the probability
of default events and amortization of the time-value element embedded in
our calculations. Higher derivative expense in the three and nine months
ended September 30, 2006, when compared to the same periods of 2005,
reflected the increased probability that the Default Put would become
exercisable because we would not timely file certain reports with the
Securities and Exchange Commission. While the Default Put became
exercisable at that time, the holders of the Series H Preferred Stock did
not exercise their right prior to curing the event. There can be no
assurances that the holders of the Series H Preferred Stock would not
exercise their rights should further defaults arise.
F-29
The discounts to the Series H Preferred Stock that resulted from the
aforementioned allocations are being accreted through periodic charges to
paid-in capital using the effective method. The following table illustrates
the components of preferred stock dividends and accretions for the three
and nine months ended September 30, 2006 and 2005:
Three months Three months Nine months Nine months
ended ended Ended ended
September 30, September 30, September 30, September 30,
2006 2005 2006 2005
----------------------------------------------------------------
Cumulative dividends at 7% $ 35,100 $35,100 $105,300 $105,300
Accretions 144,640 16,298 224,202 518,915
-----------------------------------------------------------
$179,740 $51,398 $329,502 $624,215
===========================================================
As of September 30, 2006, $421,200 of cumulative dividends are in arrears
on Series H Preferred Stock.
(b) Series J Preferred Stock:
-----------------------------
We have designated 500,000 shares of our preferred stock as Series J
Cumulative Convertible Preferred Stock with a stated and liquidation value
of $10.00 per share. Series J Preferred Stock has cumulative dividend
rights at 8.0% of the stated amount, ranks senior to common stock and is
non-voting. It is also convertible into our common stock at a conversion
price of $0.20 per common share. The Series J Preferred Stock is
mandatorily redeemable for common stock on the fifth anniversary of its
issuance. We have the option to redeem the Series J Preferred Stock for
cash at 135% of the stated value. The holder has the option to redeem the
Series J Preferred Stock for cash at 140% of the stated value in the event
of defaults and certain other contingent events, including events related
to the common stock into which the instrument is convertible, registration
and listing (and maintenance thereof) of our common stock and filing of
reports with the Securities and Exchange Commission (the "Default Put").
Based upon our evaluation of the terms and conditions of the Series J
Preferred Stock, we concluded that its features were more akin to a debt
instrument than an equity instrument, which means that our accounting
conclusions are generally based upon standards related to a traditional
debt security. Our evaluation concluded that the embedded conversion
feature was not afforded the exemption as a conventional convertible
instrument due to certain variability in the conversion price, and it
further did not meet the conditions for equity classification. Therefore,
we are required to bifurcate the embedded conversion feature and carry it
as a liability. We also concluded that the Default Put required bifurcation
because, while puts on debt-type instruments are generally considered
clearly and closely related to the host, the Default Put is indexed to
certain events, noted above, that are not associated debt-type instruments.
We combined all embedded features that required bifurcation into one
compound instrument that is carried as a component of derivative
liabilities. In addition, due to the default and contingent redemption
features of the Series J Preferred Stock, we classified this instrument as
redeemable preferred stock, outside of stockholders' equity.
In September 2002, February 2003 and May 2003 we issued 100,000 shares,
50,000 shares and 50,000 shares, respectively, of Series J Preferred Stock
for cash of $2,000,000. We also issued warrants for an aggregate of
14,000,000 shares of our common stock in connection with the financing
arrangement. The warrants have terms of five years and an exercise price of
$0.25. We initially allocated proceeds of $658,000 and $1,190,867 from the
financing arrangements to the compound derivative discussed above and to
the warrants, respectively. Since these instruments did not meet the
criteria for classification, they are required to be carried as derivative
liabilities, at fair value.
We estimated the fair value of the compound derivative on the inception
dates, and subsequently, using the Monte Carlo valuation technique, because
that technique embodies all of the assumptions (including credit risk,
interest risk, stock price volatility and conversion estimates) that are
necessary to fair value complex derivative instruments. We estimated the
fair value of the warrants on the inception dates, and
F-30
subsequently, using the Black-Scholes-Merton valuation technique, because
that technique embodies all of the assumptions (including, volatility,
expected terms, and risk free rates) that are necessary to fair value
freestanding warrants. As a result of these estimates, our valuation model
resulted in compound derivative balances associated with the Series J
Preferred Stock of $4,452,000 and $5,628,000 as of September 30, 2006 and
December 31, 2005, respectively. These amounts are included in Derivative
Liabilities on our balance sheet.
The following table illustrates fair value adjustments that we have
recorded related to the derivative financial instruments associated with
the Series J Preferred Stock.
Three months Three months Nine months Nine months
ended ended Ended ended
September 30, September 30, September 30, September 30,
2006 2005 2006 2005
----------------------------------------------------------------
Derivative income (expense)
Compound derivative $1,652,000 $3,584,000 $1,176,000 $(4,452,000)
=============================================================
Warrant derivative $ -- $2,515,200 $ -- $(3,136,000)
=============================================================
Changes in the fair value of the compound derivative and, therefore,
derivative income (expense) related to the compound derivative is
significantly affected by changes in our trading stock price and the credit
risk associated with our financial instruments. The fair value of the
warrant derivative is significantly affected by changes in our trading
stock prices. Future changes in these underlying market conditions will
have a continuing effect on derivative income (expense) associated with
these instruments.
The discounts to the Series J Preferred Stock that resulted from the
aforementioned allocations are being accreted through periodic charges to
paid-in capital using the effective method. The following table illustrates
the components of preferred stock dividends and accretions for the three
and nine months ended September 30, 2006 and 2005:
Three months Three months Nine months Nine months
ended ended Ended ended
September 30, September 30, September 30, September 30,
2006 2005 2006 2005
----------------------------------------------------------------
Cumulative dividends at 8% $ 40,000 $ 40,000 $120,000 $120,000
Accretions 183,289 102,229 478,570 266,923
-----------------------------------------------------------
$223,289 $142,229 $598,570 $386,923
===========================================================
As of September 30, 2006, $600,000 of cumulative dividends are in arrears
on Series J Preferred Stock.
(c) Series K Preferred Stock:
-----------------------------
We have designated 500,000 shares of our preferred stock as Series K
Cumulative Convertible Preferred Stock with a stated and liquidation value
of $10.00 per share. Series K Preferred Stock has cumulative dividend
rights at 8.0% of the stated amount, ranks senior to common stock and is
non-voting. It is also convertible into our common stock at a fixed
conversion price of $0.10 per common share. The Series K Preferred Stock is
mandatorily redeemable for common stock on the fifth anniversary of its
issuance. We have the option to redeem the Series K Preferred Stock for
cash at 120% of the stated value. The holder has the option to redeem the
Series K Preferred Stock for cash at 140% of the stated value in the event
of defaults and certain other contingent events, including events related
to the common stock into which the instrument is convertible, listing of
our common stock and filing of reports with the Securities and Exchange
Commission (the "Default Put").
F-31
Based upon our evaluation of the terms and conditions of the Series K
Preferred Stock, we concluded that it was more akin to a debt instrument
than an equity instrument, which means that our accounting conclusions are
based upon those related to a traditional debt security, and that it should
afforded the conventional convertible exemption regarding the embedded
conversion feature because the conversion price is fixed. Therefore, we are
not required to bifurcate the embedded conversion feature and carry it as a
liability. However, we concluded that the Default Put required bifurcation
because, while puts on debt-type instruments are generally considered
clearly and closely related to the host, the Default Put is indexed to
certain events, noted above, that are not associated debt-type instruments.
In addition, due to the default and contingent redemption features of the
Series K Preferred Stock, we classified this instrument as redeemable
preferred stock, outside of stockholders' equity.
In March 2004, we issued 80,000 shares of Series K Preferred Stock for cash
of $800,000. In April 2004, we issued 15,000 shares of Series K Preferred
Stock to extinguish debt with a carrying value of $150,000. At the time of
these issuances, the trading market price of our common stock exceeded the
fixed conversion price and, as a result, we allocated $160,000 and $60,000
from the March and April issuances, respectively, to stockholders' equity
which amount represented a beneficial conversion feature. In addition, we
recorded a debt extinguishment loss of $60,000 in connection with the April
exchange of Series K Preferred Stock for debt because we estimated that it
had a fair value that exceeded the carrying value of the extinguished debt
by that amount. Finally, we allocated approximately $59,000 and $11,000 to
the Default Puts, representing fair values, in connection with the March
and April issuances, respectively.
We estimated the fair value of the Default Puts on the inception dates, and
subsequently, using a cash flow technique that involves probability-
weighting multiple outcomes at net present values. Significant assumptions
underlying the probability-weighted outcomes included both our history of
similar default events, all available information about our business plans
that could give rise to or risk defaults, and the imminence of impending or
current defaults. As a result of these subjective estimates, our valuation
model resulted in Default Put balances associated with the Series K
Preferred Stock of $276,864 and $206,200 as of September 30, 2006 and
December 31, 2005, respectively. These amounts are included in Derivative
Liabilities on our balance sheet. The following table illustrates fair
value adjustments that we have recorded related to the Default Puts on the
Series K Preferred Stock.
Three months Three months Nine months Nine months
ended ended Ended ended
September 30, September 30, September 30, September 30,
2006 2005 2006 2005
----------------------------------------------------------------
Derivative income (expense) $(4,614) $(1,256) $(70,664) $(3,769)
==========================================================
Derivative income (expense) related to the Default Put includes changes to
the fair value arising from changes in our estimates about the probability
of default events and amortization of the time-value element embedded in
our calculations. Higher derivative expense in the three and nine months
ended September 30, 2006, when compared to the same periods of 2005,
reflected the increased probability that the Default Put would become
exercisable because we would not timely file certain reports with the
Securities and Exchange Commission. While the Default Put became
exercisable at that time, the holders of the Series K Preferred Stock did
not exercise their right prior to curing the event. There can be no
assurances that the holders of the Series K Preferred Stock would not
exercise their rights should further defaults arise.
F-32
The discounts to the Series K Preferred Stock that resulted from the
aforementioned allocations are being accreted through periodic charges to
paid-in capital using the effective method. The following table illustrates
the components of preferred stock dividends and accretions for the three
and nine months ended September 30, 2006 and 2005:
Three months Three months Nine months Nine months
ended ended Ended ended
September 30, September 30, September 30, September 30,
2006 2005 2006 2005
----------------------------------------------------------------
Cumulative dividends at 8% $19,000 $19,000 $57,000 $57,000
Accretions 11,360 10,682 33,561 31,560
----------------------------------------------------------
$30,360 $29,682 $90,561 $88,560
==========================================================
As of September 30, 2006, $190,000 of cumulative dividends are in arrears
on Series K Preferred Stock.
(d) Other Preferred Stock Designations and Financings:
------------------------------------------------------
Series A Preferred: We have designated 500,000 shares of our preferred
stock as Series A Convertible Preferred Stock. There were no Series A
Preferred Stock outstanding during the periods presented.
Series B Preferred: We have designated 1,260,000 shares of our preferred
stock as Series B Convertible Preferred Stock with a stated and liquidation
value of $1.00 per share. Series B Preferred has cumulative dividend rights
of 9.0%, ranks senior to common stock and has voting rights equal to the
number of common shares into which it may be converted. Series B Preferred
is convertible into common on a share for share basis. Based upon our
evaluation of the terms and conditions of the Series B Preferred Stock, we
have concluded that it meets all of the requirements for equity
classification. We have 107,440 shares of Series B Preferred outstanding as
of September 30, 2006 and December 31, 2005.
Series D Preferred: We have designated 165,000 shares of our preferred
stock as Series D Cumulative Convertible Preferred Stock with a stated and
liquidation value of $10 per share. Series D Preferred has cumulative
dividend rights of 6.0%, ranks senior to common stock and is non-voting.
There are no shares of Series D Preferred Stock outstanding during any of
the periods reported in this quarterly report.
Series F Preferred: We have designated 200,000 shares of our preferred
stock as Series F Convertible Preferred Stock with a stated and liquidation
value of $10 per share. There were 5,248 shares of Series F Preferred Stock
outstanding as of December 31, 2005. The shares were fully converted by
September 30, 2006. Series F Preferred is non-voting and convertible into
common stock at a variable conversion price equal to the lower of $0.60 or
75% of the trading prices near the conversion date. In addition, the holder
had the option to redeem the convertible notes payable for cash at 125% of
the face value in the event of defaults and certain other contingent
events, including events related to the common stock into which the
instrument is convertible, registration and listing (and maintenance
thereof) of our common stock and filing of reports with the Securities and
Exchange Commission (the "Default Put"). We concluded that the conversion
feature was not afforded the exemption as a conventional convertible
instrument due to variable conversion feature and it did not otherwise meet
the conditions for equity classification. Since equity classification is
not available for the conversion feature, we were required to bifurcate the
embedded conversion feature and carry it as a derivative liability, at fair
value. We also concluded that the Default Put required bifurcation because,
while puts on debt-type instruments are generally considered clearly and
closely related to the host, the Default Put is indexed to certain events,
noted above, that are not associated debt-type instruments. These two
derivative features were combined into one compound derivative instrument.
In addition, due to the default and contingent redemption features of the
Series F Preferred Stock, we classified this instrument as redeemable
preferred stock, outside of stockholders' equity.
F-33
Series I Preferred: We have designated 200,000 shares of our preferred
stock as Series I Convertible Preferred Stock with a stated and liquidation
value of $10.00 per share. Series I Preferred has cumulative dividend
rights at 8.0% of the stated value, ranks senior to common stock and is
non-voting. Series I Preferred is convertible into a variable number of
common shares at the lower conversion price of $0.40 or 75% of the trading
market price. There were no Series I Preferred Stock outstanding as of
September 30, 2006 and December 31, 2005. We accounted for Series I
Preferred Stock while it was outstanding as an instrument that was more
akin to a debt instrument. We also bifurcated the embedded conversion
feature and freestanding warrants issued with the financing and carried
these amounts as derivative liabilities, at fair value. The table below
reflects derivative income and (expense) associated with changes in the
fair value of this derivative financial instrument.
The following table summarizes derivative income (expense) related to
compound derivatives and freestanding warrant derivatives that arose in
connection with the preferred stock transactions discussed above.
Three months Three months Nine months Nine months
ended ended Ended ended
September 30, September 30, September 30, September 30,
Derivative income (expense) 2006 2005 2006 2005
----------------------------------------------------------------
Series D Preferred:
Warrant derivative $337,714 $ 823,734 $ 331,509 $ (153,788)
Series F Preferred:
Compound derivative 31,819 (1,198,083) (403,753) (1,269,520)
Warrant derivative 21,138 3,417,637 563,096 65,780
Series I Preferred:
Compound derivative -- -- -- (69,620)
Warrant derivative -- -- -- (250,482)
-----------------------------------------------------------
$390,671 $ 3,043,288 $ 490,852 $(1,677,630)
===========================================================
Note 7 - Share Based Payments
We have adopted certain incentive share-based plans that provide for the
grant of up to 10,397,745 stock options to our directors, officers and key
employees. As of September 30, 2006, there were 660,655 shares of common
stock reserved for issuance under our stock plans. Options granted under
plans prior to May, 2005 are fully vested. Subsequent options granted are
under plans which become exercisable over two years in equal annual
installments with the first third exercisable on grant date, provided that
the individual is continuously employed by us. We did not grant options
during the nine months ended September 30, 2006.
On January 1, 2006, we adopted Financial Accounting Standard 123 (revised
2004), Share-Based Payments ("FAS 123(R)") which is a revision of FAS No.
123, using the modified prospective method. Under this method, compensation
cost recognized for the nine months ended September 30, 2006 includes
compensation cost for all share-based payments modified or granted prior to
but not yet vested as of, January 1, 2006, based on the grant date fair
value estimated in accordance with the original provisions of FAS No. 123.
Compensation cost is being recognized on a straight-line basis over the
requisite service period for the entire award in accordance with the
provisions of SFAS 123R.
F-34
As we had previously adopted the fair-value provisions of FAS No. 123,
effective January 1, 2005, the adoption of FAS 123(R) had a negligible
impact on our earnings. We recorded compensation costs of $110,911 and
$333,868 for the three and nine months ended September 30, 2006,
respectively, and $102,782 and $654,592 for the three and nine months ended
September 30, 2005. We recognized no tax benefit for share-based
compensation arrangements due to the fact that we are in a cumulative loss
position and recognize no tax benefits in our Consolidated Statement of
Operations.
As required by FAS 123(R), we estimate forfeitures of employee stock
options and recognize compensation cost only for those awards expected to
vest. Forfeiture rates are determined for two groups of employees -
directors / officers and key employees based on historical experience. We
adjust estimated forfeitures to actual forfeiture experience as needed. The
cumulative effect of adopting FAS 123(R) of $17,000, which represents
estimated forfeitures for options outstanding at the date of adoption, was
not material and therefore has been recorded as a reduction of our stock-
based compensation costs in Selling and General and Administrative expenses
expense rather than displayed separately as a cumulative change in
accounting principle in the Consolidated Statement of Operations. The
adoption of SFAS No. 123(R) had no effect on cash flow from operating
activities or cash flow from financing activities for the nine months ended
September 30, 2006.
We estimate the fair value of each stock option on the date of grant using
a Black-Scholes-Merton (BSM) option-pricing formula, applying the following
assumptions and amortize that value to expense over the option's vesting
period using the straight-line attribution approach:
Third Nine months Third Nine months
Quarter ended Quarter ended
2006 * 2006 * 2005 * 2005
------------------------------------------------
Expected Term (in years) n/a n/a n/a 6
Risk-free rate n/a n/a n/a 5.01%
Expected volatility n/a n/a n/a 141%
Expected dividends n/a n/a n/a 0%
* No options were granted for the respective periods.
Expected Term: The expected term represents the period over which the
share-based awards are expected to be outstanding. It has been determined
as the midpoint between the vesting date and the end of the contractual
term.
Risk-Free Interest Rate: We based the risk-free interest rate used in our
assumptions on the implied yield currently available on U.S. Treasury zero-
coupon issues with a remaining term equivalent to the stock option award's
expected term.
Expected Volatility: The volatility factor used in our assumptions is based
on the historical price of our stock over the most recent period
commensurate with the expected term of the stock option award.
Expected Dividend Yield: We do not intend to pay dividends on our common
stock for the foreseeable future. Accordingly, we use a dividend yield of
zero in our assumptions.
F-35
A summary of option activity under the stock incentive plans for the nine
months ended September 30, 2006 is presented below:
Average
Weighted- Remaining
Average Contractual Aggregate
Exercise Term Intrinsic
Options Shares Price (in years) Value
------------------------------------------------ --------- --------- ----------- ---------
Outstanding at December 31, 2005 9,600,422 $0.32
Granted - -
Exercised - -
Forfeited (41,667) $0.25
Expired (155,000) $0.75
Outstanding at September 30, 2006 9,403,755 $0.31 8.61 $2,234,945
========= ===== ==== ==========
Vested or expected to vest at September 30, 2006 9,114,991 $0.31 8.61 $2,161,956
========= ===== ==== ==========
Exercisable at September 30 , 2006 6,470,283 $0.33 8.61 $1,492,908
========= ===== ==== ==========
No options were granted during the nine months ended September 30, 2006.
There were no options granted during the third quarter of 2005. The
weighted-average fair value of options granted during the nine months ended
September 30, 2005 was $0.15. There were no exercises of options during the
nine months ended September 30, 2006 and the same period in 2005.
At September 30, 2006, the Company had $311,904 of total unrecognized
compensation expense related to non-vested stock options, which is expected
to be recognized over a weighted-average period of one year.
Note 8 - Other Stockholders' Equity
(a) Issuances of Common Stock During the Three Month Period Ended
-----------------------------------------------------------------
September 30, 2006
------------------
On July, 6, 2006, we issued 83,121 shares of our common stock in a private
placement, pursuant to Section 4(2) of the Securities Act of 1933, to an
accredited investor.
On July, 14, 2006, we issued 436,388 shares of common stock upon the
cashless exercise of a warrant associated with our Series D convertible
preferred stock. These shares were issued to an accredited investor
pursuant to Regulation D and Section 4(2) of the Securities Act of 1933.
On July 14, August 14 and August 31, 2006, we issued, in the aggregate,
275,000 shares of common stock pursuant to a conversion of our Series H
preferred stock. The shares of common stock underlying the preferred were
issued pursuant to Regulation D.
On July, 19, 2006, we issued 1,008,065 shares of common stock upon the
cashless exercise of a warrant associated with our Series H convertible
preferred stock. These shares were issued to an accredited investor
pursuant to Regulation D and Section 4(2) of the Securities Act of 1933.
On August 24, 2006, we issued 168,937 shares of common stock pursuant to a
conversion of our May 2005 convertible note. The shares of common stock
underlying the convertible note were
F-36
issued pursuant to a registration statement declared effective by the
Securities and Exchange Commission on August 2, 2005.
On September 13, 2006, we issued, in the aggregate, 161,527 shares of
common stock pursuant to a conversion of our Series F preferred stock. The
shares of common stock underlying the preferred were issued pursuant to
Regulation D.
On September 28, 2006, we issued 4,000,000 shares of common stock pursuant
to a conversion of our November 2003 convertible note. The shares of common
stock underlying the convertible note were issued pursuant to a
registration statement declared effective by the Securities and Exchange
Commission on August 3, 2004.
On September 28, 2006, we issued 1,000,000 shares of common stock pursuant
to a conversion of our June 2004 convertible note. The shares of common
stock underlying the convertible note were issued pursuant to a
registration statement declared effective by the Securities and Exchange
Commission on April 18, 2005.
(b) Outstanding Warrants
------------------------
As of September 30, 2006, we had the following outstanding warrants:
Warrants/
Expiration Options Exercise
Warrants Grant date date Granted Price
Series H Preferred Stock Financing 12/5/2001 12/4/2006 2,637,500 0.500
Series H Preferred Stock Financing 1/30/2002 1/30/2007 375,000 0.500
Series H Preferred Stock Financing 2/15/2002 2/14/2007 125,000 0.500
Warrant to Licensor 6/20/2005 6/19/2007 1,000,000 0.050
Warrant to Consultant 4/8/2005 4/7/2007 1,000,000 0.250
Warrant to Distributor 8/30/2005 8/29/2008 30,000,000 0.360
November 2005 Common Stock Financing 11/28/2005 11/27/2010 15,667,188 0.800
November 2005 Common Stock Financing 11/28/2005 11/27/2010 1,012,500 0.500
Warrant to Distributor 9/19/2006 9/19/2012 5,870,000 0.730
May 2006 Debt Financing 5/12/2006 5/11/2011 300,000 0.800
Other Financings 12/27/2001 2/28/2007 25,000 0.400
July 2006 Senior Convertible Notes Financing 7/27/2006 7/26/2012 12,857,143 0.730
----------
Total Warrants 70,869,331
==========
The table above excludes contingent warrants to purchase 42,857,142 shares of
the Company's common stock. These contingent warrants were issued in
connection with the convertible debt and warrant arrangement discussed in Note
5(i). The warrant holders' ability to exercise these warrants is contingent
upon the Company's exercise of its call option to redeem the specified
convertible notes payable at a date earlier than maturity. Absent the
Company's exercise of its call option to redeem the convertible notes, the
holders have no rights to exercise the warrants and receive common shares to
which the contingent warrants are indexed. The Company currently has no
plans in the foreseeable future to exercise its call option. If the Company
does exercise its call option, however, the number of our common shares that
are issuable upon the exercise of the contingent warrants is limited to the
number of our common shares underlying the convertible notes that have been
redeemed.
Derivative income (expense) associated with these other warrants are
summarized in the table below.
F-37
Three months Three months Nine months Nine months
ended ended Ended ended
September 30, September 30, September 30, September 30,
Derivative income (expense) 2006 2005 2006 2005
----------------------------------------------------------------
Warrant derivative $8,246,718 $(1,326,345) $9,248,670 $(3,134,825)
=============================================================
Note 9 - Commitments and Contingencies
Lease of Office
---------------
We lease office space, used for our corporate offices in Florida, under an
operating lease that expires October 31, 2015. Future non-cancelable
minimum rental payments required under the operating lease as of September
30, 2006 are as follows:
Amount
-------
Three months ending December 31, 2006 $23,217
Years ending December 31,
2007 92,868
2008 92,868
2009 92,868
2010 92,868
Total rent expense, including expenses related to common area maintenance
and parking, for the three and nine months ended September 30, 2006
amounted to $44,116 and $113,877; rent expense for the three and nine
months ended September 30, 2005 amounted to $22,662 and $67,366.
Royalties:
----------
We license trademarks and trade dress from certain Licensors for use on our
products. Royalty advances are payable against earned royalties on a
negotiated basis for these licensed intellectual property rights. The table
below identifies each Licensor to which our licenses require advance
payments and, in addition, reflects the term of the respective licenses as
well as the advance royalties remaining to be paid on such negotiated
advance royalty payments, as of September 30, 2006. We currently are in
default of our guaranteed royalty payments to Marvel Enterprises on our
license for the United Kingdom by the aggregate advance remaining listed
below for Marvel (UK).
Aggregate Advance
Licensor: Term Remaining
-------------------------------------------------------------
Marvel (UK) Two years $ 120,960
Masterfoods Six years 2,430,000
Diabetes Research Institute One year 7,500
Employment Contacts
-------------------
Our Chief Executive Officer, Mr. Warren, has a two-year employment
contract, expiring October 2007, that provides a base salary of $300,000,
plus a bonus of one quarter percent (0.25%) of net revenue and normal
corporate benefits. This contract has a minimum two-year term plus a
severance package upon change of control based on base salary.
F-38
Officers Toulan, Patipa, Edwards and Kee have employment contracts with
base salaries aggregating $710,000 annually, plus discretionary bonuses and
normal corporate benefits. These contracts have minimum two-year terms plus
severance packages upon change of control based on base salary.
Our Chief Financial Officer, Mr. Kaplan, has an employment contract,
expiring November 2008, that provides a base salary of $180,000 for year
one, $200,000 for year two and $220,000 for year three, plus discretionary
bonuses and normal corporate benefits. This contract has a minimum three-
year term plus a severance package upon change of control based on base
salary
Marketing Commitments
---------------------
Coca-Cola Enterprises ("CCE"). In August 2005, we executed a Master
Distribution Agreement with CCE. Pursuant to this agreement, we are
contractually obligated to spend an aggregate of $5,000,000 on marketing
activities in 2005 and 2006 for our products that are distributed by CCE.
Beginning in 2007, we are further obligated to spend an amount annually in
each country within a defined territory equal or greater than 3% of our
total CCE revenues in such territory (on a country by country basis). Such
national and local advertising for our products includes actively marketing
the Slammers mark, based on a plan to be mutually agreed each year. We are
required to maintain our intellectual property rights necessary for the
production, marketing and distribution of our products by CCE.
During the period commencing at the inception of the CCE agreement through
the period ended September 30, 2006, we have spent approximately $4.2
million on marketing activities pursuant to our agreement with CCE.
Production Agreements
---------------------
Jasper Products LLC
-------------------
On December 27, 2005, we executed a multi-year non-exclusive production
agreement with Jasper Products, L.L.C. of Joplin Missouri for the
production of our products through 2011. Under the terms of the agreement,
the parties have agreed to annual volume commitments for the ordering and
production of our various lines of shelf stable single serve flavored milk
beverages. To secure the production commitments, as well as the right of
first refusal for Jasper's additional production capacity going forward, we
paid a one time equipment mobilization payment of $2.7 million to Jasper.
The agreement incorporates per unit (single bottle) monetary penalties for
both unused capacity by us and any production shortfall by Jasper.
HP Hood LLC
-----------
On September 19, 2006, we executed a six-year non-exclusive production
agreement with HP Hood LLC of Chelsea, Massachusetts, for the production of
our products through 2012. Under the terms of the agreement, the parties
have agreed to annual volume commitments for the ordering and production of
our various lines of shelf-stable, single-serve flavored milk beverages.
The agreement incorporates per unit monetary penalties for unused capacity
by us. The penalty shall be adjusted annually based upon a formula indexed
to a defined series of the Producer Price Index for Total Manufacturing
Industries. In connection with the agreement, we issued a six year warrant
to HP Hood for the purchase of 5,870,000 shares of our common stock at an
exercise price of $0.73 per share. We have a conditional right to call the
exercise of the warrant.
Note 10 - Restatements
Our statements of operations for the three and nine months ended September
30, 2005 and our balance sheet as of December 31, 2005 have been restated
as illustrated in the following tables:
Condensed Consolidated Statements of Operations
Three and Nine Months Ended September 30, 2005
Three months Three months Nine months Nine months
ended ended ended ended
Sept. 30, 2005 Sept. 30, 2005 Sept. 30, 2005 Sept. 30, 2005
(As Restated) (As Reported) (As Restated) (As Reported)
--------------------------------------------------------------------
Revenues $ 3,245,305 $ 3,245,305 $ 6,591,693 $ 6,591,693
Product costs (2,755,957) (2,360,884) (5,544,920) (4,719,011)
Operating expenses (2,439,020) (2,717,708) (6,417,482) (6,064,998)
Other income (expense) 19,628,824 (3,073,169) (58,048,505) (3,293,415)
-----------------------------------------------------------------
Net (loss) 17,679,152 (4,906,456) (63,419,214) (7,485,731)
=================================================================
Loss applicable to common 17,463,463 (4,994,496) (64,499,613) (7,748,732)
=================================================================
Loss per common share 0.15 (0.04) (0.79) (0.09)
=================================================================
Comprehensive loss $17,660,830 $(4,912,126) $(63,442,863) $(7,509,380)
=================================================================
F-39
The following tables reflect the individual components of our restatements
and a description of the nature of the adjustment:
Quarter ended
Sept. 30, 2005
--------------
Net income (loss), as reported $(4,906,456)
Share-based payments (102,782)
Deferred development costs (128,711)
Derivative income (expense) 23,321,020
Amortization of debt discount (73,864)
Investor relations charges (634,541)
Other 204,486
-----------
Net income (loss), as restated $17,679,152
===========
Share-based payments: We improperly measured and deferred share-based
payment expense related to employee stock options that were issued
commencing in the second quarter of the year ended quarter ended September
20, 2005. These adjustments, which are reflected in operating expenses,
reflect the effects of re-measurement of the stock options and the
elimination of previously deferred compensation amounts.
Deferred development costs: We improperly capitalized development costs on
our balance sheet. These adjustments reflect our revised policy that
requires development costs to be expensed as they are incurred. We record
development costs as a component of operating expenses.
Derivative income (expense): Derivative income (expense) arises from
adjustments to our derivative liabilities to carry these instruments at
fair value at the end of each reporting period. Our derivative financial
instruments consist of compound and freestanding instruments. These
derivative financial instruments arose from (i) our notes payable,
convertible notes payable and preferred stock financing transactions and
(ii) the reclassification of non-exempt warrants from stockholders' equity
to derivative liabilities because share settlement is presumed not to be
within our control. We previously did not properly allocate proceeds from
our financing transactions to derivative liabilities where applicable; nor
did we reclassify our other warrants to derivative liabilities when we
presumably lost our ability to share settle such instruments.
Amortization of debt discounts and other charges: We have adjusted our
notes payable and convertible notes payable to reflect the allocation of
proceeds to derivative liabilities. These allocations have resulted in
discounts to the face value of the debt, and we are required to amortize
these discounts through periodic charges to interest expense using the
effective method. The adjustments reflect the difference between our
previous method of recognizing interest expense based upon the stated
interest rate and amounts derived from the application of the effective
interest method. Other charges include gains and losses on extinguishments
of our debt instruments that have arisen when modifications to such
instruments were considered to be significant.
Investor relations charges: We entered into a contract with an investor
relations firm during 2005 that required payment in our equity securities.
We incorrectly did not recognize the value of these services until the
securities were issued. This adjustment reflects the proper recognition of
the consulting cost in general and administrative expenses and a reciprocal
amount in accrued liabilities.
F-40
Quarter ended
Sept. 30, 2005
--------------
Loss applicable to common
stockholders, as reported $(4,994,496)
Adjustments to net loss 22,585,608
Preferred stock accretion (127,649)
-----------
Loss applicable to common stockholders, as restated $17,463,463
===========
Preferred stock accretions: We did not allocate proceeds from certain of
our preferred stock financings to derivative financial instruments
(warrants and compound derivatives) and stockholders' equity (beneficial
conversion features). These adjustments reflect the accretion of discounts
to the preferred stock carrying values, which are reductions to net income
(loss) to arrive at income (loss) applicable to common shareholders. We
have accreted these discounts in our restated financial statements through
periodic charges to retained earnings using the effective method.
Quarter ended
Sept. 30, 2005
--------------
Loss per common share, as reported $(0.04)
Share-based payments (0.00)
Deferred development costs (0.00)
Derivative income (expense) 0.20
Amortization of debt discount (0.00)
Liquidated damages expense --
Investor relations charges (0.01)
Preferred stock accretions/dividends (0.00)
------
Net income (loss) per common share, as restated $ 0.15
------
Diluted income per common share, as restated $ 0.00
======
See descriptions that we have provided under the tables for net income
(loss) and income (loss) applicable to common stockholders. Our restated
income (loss) per common share reflects the application of the treasury
stock method and the if-converted methods where those methods are
appropriate.
Quarter ended
Sept. 30, 2005
--------------
Comprehensive loss, as reported $(4,912,126)
-----------
Comprehensive loss, as restated $17,660,830
===========
Our restated comprehensive income (loss) reflects the adjustments
attributable to net income (loss), above.
Note 11 - Subsequent Events
On October 11, 2006, a Special Meeting of Stockholders of the Company was
convened pursuant to written notice in accordance with the Company's By-
laws. At that meeting, the stockholders by proxy and in person voted (i) to
amend Article IV of the Company's Articles of Incorporation to increase the
F-41
Company's capital stock from 300,000,000 to 500,000,000 shares of common
stock and (ii) to amend Article I of the Company's Articles of
Incorporation to change the name of the Company to Bravo! Brands Inc.
The votes received by the Company in favor of the increase in its capital
stock represented 95.55% of the Company's shares of common stock issued and
outstanding on the record date for the vote. The votes received by the
Company in favor of the name change represented 98.75% of the Company's
shares of common stock issued and outstanding on the record date for the
vote.
On November 7, 2006, the Securities and Exchange Commission declared
effective the Form SB - 2 registration statement filed by the company in
December 2005. The registration statement included amended and restated
financial statements for the fiscal year ended December 31, 2005 and for
the quarterly period ending June 30, 2006. The restated financial
statements reflect the reclassification of certain of the company's
financial instruments and the implementation of a new valuation methodology
for derivatives associated with certain of its past and current financial
instruments. The restatements resulted in non-cash adjustments to the
financial statements and did not impact the operating results of the
company.
In July 2006, the Company sold $30 million of Senior Convertible Notes due
2010. Of the $30 million raised by the company, $15 million was released to
the Company upon closing the transaction in July and the remaining $15
million was held in escrow, pending effectiveness of the Form SB-2. The
Company had previously satisfied the other escrow release condition by
having shareholders approve an increase in authorized shares at a
shareholder meeting on October 11, 2006. On November 10, 2006, the balance
of the proceeds from the Company's July 2006 sale of the $30 million of
Senior Convertible Notes was released to the Company from escrow.
F-42
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
FORWARD-LOOKING STATEMENTS
Statements that are not historical facts, including statements about our
prospects and strategies and our expectations about growth contained in
this report, are "forward-looking statements" within the meaning of Section
27A of the Securities Act of 1933, as amended, and Section 21E of the
Securities Exchange Act of 1934, as amended. These forward-looking
statements represent the present expectations or beliefs concerning future
events. We caution that such forward-looking statements involve known and
unknown risks, uncertainties and other factors which may cause our actual
results, performance or achievements to be materially different from any
future results, performance or achievements expressed or implied by such
forward-looking statements. Such factors include, among other things, the
uncertainty as to our future profitability; the uncertainty as to whether
our new business model can be implemented successfully; the accuracy of our
performance projections; and our ability to obtain financing on acceptable
terms to finance our operations until profitability.
OVERVIEW
Our business model includes the development and marketing of our Company
owned Slammers(r) and Bravo!(tm) trademarked brands, the obtaining of
license rights from third party holders of intellectual property rights to
other trademarked brands, logos and characters and the production of our
branded flavored milk drinks through third party processors. In the United
States and the United Kingdom, we generate revenue from the unit sales of
finished branded flavored milk drinks to retail consumer outlets. We
generate revenue in our Middle East business through the sale of "kits" to
these dairies. The price of the "kits" consists of an invoiced price for a
fixed amount of flavor ingredients per kit used to produce the flavored
milk and a fee charged to the dairy processors for the production,
promotion and sales rights for the branded flavored milk.
Our business in the United Kingdom started at the end of the second quarter
of 2005. Our UK business has not been profitable owing to the difficulties
encountered in initial market penetration with new products introduced in
the last half of 2005 through the nine months ended September 2006. In the
current period we had a negative gross margin for our UK operations. We are
examining other distribution alternatives in the UK and, while we are
making this determination, we have curtailed our production of inventory
necessary to maintain a normal supply pipeline.
CORPORATE GOVERNANCE
The Board of Directors
Our board has positions for seven directors that are elected as Class A or
Class B directors at alternate annual meetings of our shareholders. Six of
the seven current directors of our board are independent. Our chairman and
chief executive officer are separate. The board meets regularly either in
person or by telephonic conference at least four times a year, and all
directors have access to the information necessary to enable them to
discharge their duties. The board, as a whole, and the audit committee in
particular, review our financial condition and performance on an estimated
vs. actual basis and financial projections as a regular agenda item at
scheduled periodic board meetings, based upon separate reports submitted by
our Chief Executive Officer and Chief Accounting Officer. Our shareholders
elect directors after nomination by the board, or the board appoints
directors when a vacancy arises prior to an election. This year we have
adopted a nomination procedure based upon a rotating nomination committee
made up of
43
those members of the director Class not up for election. The board
presently is examining whether this procedure, as well as the make up of
the audit and compensation committees, should be the subject of an
amendment to the by-laws.
Audit Committee
Our audit committee is composed of three independent directors and
functions to assist the board in overseeing our accounting and reporting
practices. Our financial information is recorded in house by our Chief
Accounting Officer's office, from which we prepare financial reports. Lazar
Levine & Felix LLP, independent registered public accountants and auditors,
audit or review these financial reports. Our Chief Accounting Officer
reviews the preliminary financial and non-financial information prepared in
house with our securities counsel and the reports of the auditors. The
committee reviews the preparation of our audited and unaudited periodic
financial reporting and internal control reports prepared by our Chief
Accounting Officer. The committee reviews significant changes in accounting
policies and addresses issues and recommendations presented by our internal
accountants as well as our auditors.
Compensation Committee
Our compensation committee is composed of three independent directors and
reviews the compensation structure and policies concerning executive
compensation. The committee develops proposals and recommendations for
executive compensation and presents those recommendations to the full board
for consideration. The committee periodically reviews the performance of
our other members of management and the recommendations of the chief
executive officer with respect to the compensation of those individuals.
Given the size of our company, the board periodically reviews all such
employment contracts. The board must approve all compensation packages that
involve the issuance of our stock or stock options. Currently, there is one
vacancy on the compensation committee.
Nominating Committee
The nominating committee was established in the second quarter 2002 and
consists of those members of the director Class not up for election. The
committee is charged with determining those individuals who will be
presented to the shareholders for election at the next scheduled annual
meeting. The full board fills any mid term vacancies by appointment.
CRITICAL ACCOUNTING POLICIES
Estimates
---------
This discussion and analysis of our consolidated financial condition and
results of operations are based on our consolidated financial statements,
which have been prepared in accordance with accounting principles for
interim reports that are generally accepted in the United States of
America. The preparation of financial statements in conformity with
accounting principles generally accepted in the United States of America
requires management to make estimates and assumptions that affect the
reported amounts of assets and liabilities and disclosure of contingent
assets and liabilities at the date of the financial statements and the
reported amounts of revenues and expenses during the reporting period.
Among the more significant estimates included in our financial statements
are the following:
- Estimating future bad debts on accounts receivable that are carried
at net realizable values.
- Estimating our reserve for unsalable and obsolete inventories that
are carried at lower of cost or market.
- Estimating the fair value of our financial instruments that are
required to be carried at fair value.
- Estimating the recoverability of our long-lived assets.
44
We use all available information and appropriate techniques to develop our
estimates. However, actual results could differ from our estimates.
Revenue Recognition and Accounts Receivable
-------------------------------------------
Our revenues are derived from the sale of branded milk products to
customers in the United States of America, Great Britain and the Middle
East. Geographically, our revenues are dispersed 99% and 1% between the
United States of America and internationally, respectively. We currently
have one customer in the United States that provided 79% and 0% of our
revenue during the nine months ended September 30, 2006 and 2005,
respectively.
Revenues are recognized pursuant to formal revenue arrangements with our
customers, at contracted prices, when our product is delivered to their
premises and collectibility is reasonably assured. We extend
merchantability warranties to our customers on our products but otherwise
do not afford our customers with rights of return. Warranty costs have
historically been insignificant.
Our revenue arrangements often provide for industry-standard slotting fees
where we make cash payments to the respective customer to obtain rights to
place our products on their retail shelves for stipulated period of time.
We also engage in other promotional discount programs in order to enhance
our sales activities. We believe our participation in these arrangements is
essential to ensuring continued volume and revenue growth in the
competitive marketplace. These payments, discounts and allowances are
recorded as reductions to our reported revenue. Unamortized slotting fees
are recorded in prepaid expenses.
Our accounts receivable are exposed to credit risk. During the normal
course of business, we extend unsecured credit to our customers with normal
and traditional trade terms. Typically credit terms require payments to be
made by the thirtieth day following the sale. We regularly evaluate and
monitor the creditworthiness of each customer. We provide an allowance for
doubtful accounts based on our continuing evaluation of our customers'
credit risk and our overall collection history. As of September 30, 2006
and December 31, 2005, the allowance of doubtful accounts aggregated
$447,634 and $350,000, respectively.
Inventories
-----------
Our inventories, which consists primarily of finished goods, are stated at
the lower of cost on the first in, first-out method or market. Further, our
inventories are perishable. Accordingly, we estimate and record lower-of-
cost or market and unsalable-inventory reserves based upon a combination of
our historical experience and on a specific identification basis.
Impairment of Long-Lived Assets
-------------------------------
Our long-lived assets consist of furniture and equipment and intangible
assets. We evaluate the carrying value and recoverability of our long-lived
assets when circumstances warrant such evaluation by applying the
provisions of Financial Accounting Standard No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets ("FAS 144"). FAS 144 requires
that long-lived assets be reviewed for impairment whenever events or
changes in circumstances indicate that the carrying amount of an asset may
not be recoverable through the estimated undiscounted cash flows expected
to result from the use and eventual disposition of the assets. Whenever any
such impairment exists, an impairment loss will be recognized for the
amount by which the carrying value exceeds the fair value.
45
Financial Instruments
---------------------
We generally do not use derivative financial instruments to hedge exposures
to cash-flow, market or foreign-currency risks. However, we frequently
enter into certain other financial instruments and contracts, such as debt
financing arrangements, redeemable preferred stock arrangements, and
freestanding warrants with features that are either (i) not afforded equity
classification, (ii) embody risks not clearly and closely related to host
contracts, or (iii) may be net-cash settled by the counterparty. As
required by FAS 133, these instruments are required to be carried as
derivative liabilities, at fair value, in our financial statements.
We estimate fair values of derivative financial instruments using various
techniques (and combinations thereof) that are considered to be consistent
with the objective measuring fair values. In selecting the appropriate
technique, we consider, among other factors, the nature of the instrument,
the market risks that it embodies and the expected means of settlement. For
less complex derivative instruments, such as freestanding warrants, we
generally use the Black Scholes option valuation technique because it
embodies all of the requisite assumptions (including trading volatility,
estimated terms and risk free rates) necessary to fair value these
instruments. For complex derivative instruments, such as embedded
conversion options, we generally use the Flexible Monte Carlo valuation
technique because it embodies all of the requisite assumptions (including
credit risk, interest-rate risk and exercise/conversion behaviors) that are
necessary to fair value these more complex instruments. For forward
contracts that contingently require net-cash settlement as the principal
means of settlement, we project and discount future cash flows applying
probability-weightage to multiple possible outcomes. Estimating fair values
of derivative financial instruments requires the development of significant
and subjective estimates that may, and are likely to, change over the
duration of the instrument with related changes in internal and external
market factors. In addition, option-based techniques are highly volatile
and sensitive to changes in our trading market price which has a high-
historical volatility. Since derivative financial instruments are initially
and subsequently carried at fair values, our income will reflect the
volatility in these estimate and assumption changes.
RESULTS OF OPERATIONS
Nine Months Ended September 30, 2006 Compared to Nine Months Ended
------------------------------------------------------------------
September 30, 2005
------------------
Consolidated Revenues
We had revenue for the nine months ended September 30, 2006 of $12,376,641,
with product costs of $10,440,374, and shipping costs of $1,154,089,
resulting in a gross margin of $782,178. Our reported revenues for the nine
months ended September 30, 2006 increased by $5,784,948, or 88%, compared
to revenues of $6,591,693 for the comparable period in 2005. This increase
is the result of an increase in market penetration and distribution, owing
to the continued implementation of our Master Distribution Agreement with
Coca-Cola Enterprises in 2006. Revenues and gross margin are net of
slotting fees and promotional discounts for the nine months ended September
30, 2006 in the amount of $491,718 compared to $330,699 for the comparable
period in the prior year.
Geographically, our revenues are dispersed 99% and 1% between the United
States of America and internationally, respectively. We plan to take
measures to increase our international revenues as a percentage of our
total revenues. In addition, we currently have one customer in the United
States that provided 79% and 0% of our revenue during the nine months ended
September 30, 2006 and 2005, respectively. The loss of this customer or
curtailment in business with this customer could have a material adverse
affect on our business.
46
Consolidated Product Costs
We incurred product costs and shipping costs of $10,440,374 and $1,154,089,
respectively, for the nine months ended September 30, 2006. Product costs
in this period increased by $5,721,363, a 121% increase compared to
$4,719,011 for the same period in 2005. Shipping costs in this period
increased $328,180, a 40% increase compared to $825,909 for the same period
in 2005. The increase in product costs reflects an increase in revenues and
the concomitant increase in reported product costs and shipping costs
associated with that increase.
Consolidated Operating Expenses
We incurred selling expenses of $12,874,022 for the nine months ended
September 30, 2006. Our selling expenses for this period increased by
$9,827,498, a 323% increase compared to our selling expenses of $3,046,524
for the same period in 2005. The increase in selling expenses in the
current period was due to the hiring of additional sales staff and
promotional charges associated with increased revenues and our development
of four new product lines. Selling expenses also increased due to a major
nationwide sales and marketing campaign which ran during the quarter ended
September 30, 2006. "Operation Milk Attack" was aimed at educating,
motivating, and building brand awareness of the Slammers products to the
CCE salesforce and to our end customers.
We incurred general and administrative expense for the nine months ended
September 30, 2006 of $7,454,344. Our general and administrative expense
for this period increased by $4,484,185, a 151% increase compared to
$2,970,159 for the same period in 2005. The increase is attributed to the
building of a larger company infrastructure, including the hiring of
several new employees, which is needed to support our current and future
growth initiatives. As a percentage of total revenue, our general and
administrative expense increased from 45% in the period ended September 30,
2005, to 60% for the current period in 2006. We plan to reduce this expense
as a percentage of revenues through revenue growth, cost cutting efforts
and the refinement of business operations.
We incurred product development expense for the nine months ended September
30, 2006 of $509,912 representing a 27% increase over product development
expense for the comparable period of the prior year. This increase resulted
from the reformulation of existing products and the development of new
products under our license agreement with General Mills.
Interest Expense
We incurred interest expense for the nine months ended September 30, 2006
of $1,594,860. Our interest expense decreased by $49,031, a 3% decrease
compared to $1,643,891 for the same period in 2005. The decrease was due to
conversions of debt to common stock in late 2005 that eliminated the
accrual of interest associated with that debt.
Gain (loss) on Debt Extinguishment
We reported a loss on debt extinguishment of $425,869 for the nine months
ended September 30, 2006, compared with a gain on debt extinguishments for
the nine months ended September 30, 2005 of $7,164. These amounts result
from modification of the terms of certain notes.
47
Derivative Expense
Derivative expense arises from changes in the fair value of our derivative
financial instruments and, in rare instances, day-one losses when the fair
value of embedded and freestanding derivative financial instruments issued
or included in financing transactions exceed the proceeds or other basis.
Derivative financial instruments include freestanding warrants, compound
embedded derivative features that have been bifurcated from debt and
preferred stock financings. In addition, our derivative financial
instruments arise from the reclassification of other non-financing
derivative and other contracts from stockholders' equity because share
settlement is not within our control while certain variable share price
indexed financing instruments are outstanding.
Our derivative income amounted to $10,958,409 for the nine months ended
September 30, 2006, compared to derivative expense of $52,518,630 for the
corresponding period of the prior year.
Changes in the fair value of compound derivatives indexed to our common
stock are significantly affected by changes in our trading stock price and
the credit risk associated with our financial instruments. The fair value
of warrant derivatives is significantly affected by changes in our trading
stock prices. The fair value of derivative financial instruments that are
settled solely with cash fluctuate with changes in management's weighted
probability estimates following the financing inception and are generally
attributable to the increasing probability of default events on debt and
preferred stock financings. The fair value of the warrants declined
principally due to the decline in our common stock trading price. Since
these instruments are measured at fair value, future changes in
assumptions, arising from both internal factors and general market
conditions, may cause further variation in the fair value of these
instruments. Future changes in these underlying internal and external
market conditions will have a continuing effect on derivative expense
associated with our derivative financial instruments.
Liquidated Damages
During the three and nine months ended September 30, 2006, we recorded
liquidated damages expense of $225,938 and $4,784,213; none in the
comparable periods of 2005. We have entered into registration rights
agreements with certain investors that require us to file a registration
statement covering underlying indexed shares, become effective on the
registration statement, maintain effectiveness, and, in some instances,
maintain the listing of the underlying shares. Certain of these
registration rights agreements require our payment of cash penalties to the
investors in the event we do not achieve the requirements. We record
estimated liquidated damages penalties as liabilities and charges to our
income when the cash penalties are probable and estimable. We will evaluate
our estimate of liquidated damages in future periods and adjust our
estimates for changes, if any, in the facts and circumstances underlying
their classification.
Net Loss
We had a net loss for the nine months ended September 30, 2006 of
$16,455,233 compared with a net loss of $63,419,214 for the same period in
2005. The magnitude of both the 2006 and 2005 net loss is the result of our
recording changes in derivative expense on the consolidated statement of
operations.
Loss Applicable to Common Shareholders
Loss applicable to common shareholders represents net loss less preferred
stock dividends and accretion of our redeemable preferred stock to
redemption value using the effective method. Diluted loss per common share
reflects the assumed conversion of all dilutive securities, such as
convertible preferred stock, convertible debt, warrants, and employee stock
options.
48
Loss per Common Share
The Company's basic loss per common share for the nine months ended
September 30, 2006 was $0.09, compared with a basic loss per common share
for the same period in 2005 of $0.79. Because the Company experienced net
losses for all periods presented, all potential common share conversions
existing in our financial instruments would have an antidilutive impact on
earnings per share; therefore, diluted loss per common share equals basic
loss per common share for all periods presented.
The weighted average common shares outstanding increased from 82,091,556
for the nine months ended September 30, 2005 to 189,474,500 for the same
period in 2006. The increase is attributed primarily to conversions of our
convertible debt and preferred instruments into common shares. Potential
common stock conversions excluded from the computation of diluted earnings
per share amounted to 122,567,616 and 142,611,032 for the nine month
periods ending September 30, 2006 and September 30, 2005, respectively.
Comprehensive Income (Loss)
Comprehensive income (loss) differs from net income (loss) for the nine
months ended September 30, 2006 and 2005 by $30,494 and ($23,649),
respectively, which represents the effects of foreign currency translation
on the financial statements of our subsidiaries denominated in foreign
currencies. Our foreign operations are currently not significant. Increases
in our foreign operations will likely increase the effects of foreign
currency translation adjustments on our financial statements.
Three Months Ended September 30, 2006 Compared to the Three Months Ended
------------------------------------------------------------------------
September 30, 2005
------------------
Consolidated Revenues
The Company had revenues for the three months ended September 30, 2006 of
$5,110,200, with product costs of $4,240,277 and shipping costs of
$409,453, resulting in a gross margin of $460,470, or 9% of sales. Our
revenues for the three months ended September 30, 2006 increased by
$1,864,895, a 57% increase compared to revenues of $3,245,305 for the three
months ended September 30, 2005. The increase in revenue in the United
States for the three months ended September 30, 2006 is the result of the
increased distribution of our products through Coca-Cola Enterprises.
Consolidated Product Costs
The Company incurred product costs of $4,240,277 and shipping costs of
$409,453 for the three months ended September 30, 2006. Product costs for
this period increased by $1,879,393, an 80% increase compared to $2,360,884
for the three months ended September 30, 2005. The increase in product
costs and shipping costs in the United States for the three months ended
September 30, 2006 is the result of increased revenues.
Consolidated Operating Expenses
The Company incurred selling expenses for the three months ended September
30, 2006 of $6,663,113. Selling expenses increased for the three months
ended September 30, 2006 by $5,137,169, a 337% increase compared to the
selling expenses of $1,525,944 for the three months ended September 30,
2005. The increase in selling expenses is the result of increased sales and
the "Operation Milk Attack" campaign.
49
The Company incurred general and administrative expenses for the three
months ended September 30, 2006 of $4,057,823. General and administrative
expenses for the three months ended September 30, 2006 increased by
$3,682,742, a 982% increase compared to $375,081 for the same period in
2005.
Interest Expense
The Company incurred interest expense for the three months ended September
30, 2006 of $1,163,599. Interest expense for the three months ended
September 30, 2006 increased by $1,011,598, a 666% increase compared to
$152,001, for the same period in 2005. This increase was the result of
interest that was accrued for the new July 2006 convertible debt.
Liquidated Damages
During the three months ended September 30, 2006, we recorded liquidated
damages expense of $225,938; none in the comparable period of 2005. We have
entered into registration rights agreements with certain investors that
require us to file a registration statement covering underlying indexed
shares, become effective on the registration statement, maintain
effectiveness, and, in some instances, maintain the listing of the
underlying shares. Certain of these registration rights agreements require
our payment of cash penalties to the investors in the event we do not
achieve the requirements. We record estimated liquidated damages penalties
as liabilities and charges to our income when the cash penalties are
probable and estimable. We will evaluate our estimate of liquidated damages
in future periods and adjust our estimates for changes, if any, in the
facts and circumstances underlying their classification.
Net Loss
We had had a net loss for the three months ended September 30, 2005 of
$1,252,045, compared with a net gain of $17,679,152 for the same period in
2005. The magnitude of the 2006 and 2005 loss is the result of our
recording changes in the fair value in our derivatives.
LIQUIDITY AND CAPITAL RESOURCES
Management's Plans:
As reflected in the accompanying consolidated financial statements, we have
incurred operating losses and negative cash flow from operations and have
negative working capital of $54,652,550 as of September 30, 2006. This
negative figure is largely the effect of our recording of $37,075,023 for
derivative liabilities. In addition, we have experienced delays in filing
our financial statements and registration statements due to errors in our
historical accounting that now have been corrected. Our inability to make
these filings resulted in our recognition of penalties payable to the
investors. These penalties have ceased with our completed filings and the
registration of the common shares into which the investors' financial
instruments are convertible. Finally, our revenues are significantly
concentrated with one major customer. The loss of this customer or
curtailment in business with this customer could have a material adverse
affect on our business. These conditions raise substantial doubt about our
ability to continue as a going concern.
We have been dependent upon third party financings as we execute on our
business model and plans. While our liquid reserves have been substantially
depleted as of June 30, 2006, we completed a $30.0 million convertible note
financing in July 2006 that is expected to fulfill our liquidity
requirements through the end of 2006. However, $15.0 million of this
financing was held in escrow, pending the increase in our authorized shares
and the effectiveness of a registration statement filed by us in connection
with a November 2005 financing. We have satisfied the escrow release
conditions
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and, on November 14, 2006, the balance of the proceeds from our July 2006
sale of the $30 million of Senior Convertible Notes was released from
escrow.
We plan to increase our revenues, improve our gross margins, augment our
international business and, if necessary, obtain additional financing.
Ultimately, our ability to continue is dependent upon the achievement of
profitable operations. There is no assurance that further funding will be
available at acceptable terms, if at all, or that we will be able to
achieve profitability.
The accompanying financial statements do not reflect any adjustments that
may result from the outcome of this uncertainty.
Information about our cash flows
As of September 30, 2006, we reported that net cash used in operating
activities was $16,594,704, net cash provided by financing activities was
$13,462,392 and net cash used in investing activities was $708,044 during
the nine months ended September 30, 2006.
Compared to $3,610,995 of net cash used in operating activities in the nine
months ended September 30, 2005, our current period net cash used in
operating activities increased by $12,983,709 to $16,594,704.
Changes in accounts receivable during the nine months ended September 30,
2006 resulted in a cash increase of $2,795,948, compared to a cash decrease
in receivables of $149,281 for the same period in 2005, having a net result
of an increase of $2,945,229. The changes in inventories during the nine
months ended September 30, 2006 reflected a cash usage of $456,283,
compared to a usage of $241,173 for the same period in 2005. This was the
result of our building inventory in connection with the continued
implementation of our Master Distribution Agreement with Coca-Cola
Enterprises. The changes in accounts payable and accrued liabilities in the
nine months ended September 30, 2006 contributed to a cash increase of
$3,748,743, whereas the changes in accounts payable and accrued liabilities
for the period ended September 30, 2005 amounted to an increase of
$5,117,240. Cash flows generated through our operating activities was
inadequate to cover all of our cash disbursement needs in the period ended
September 30, 2006, and we had to rely on prior equity and new convertible
debt financing to cover operating expenses.
Cash used in the period ended September 30, 2006 in our investing
activities was $708,044 for license and trademark costs, and equipment
purchases, compared to $879,754 for the same period in 2005.
Net cash provided by our financing activities for the nine months ended
September 30, 2006 was $13,462,392, mainly as a result of proceeds received
from a convertible note financing amounting to $30,000,000. Net cash
provided by financing activities for the same period in 2005 was
$4,954,367, for a net increase of $8,508,025.
Going forward, our primary requirements for cash consist of the
following:
* the continued development of our business model in the United
States and on an international basis;
* promotional and logistic production support for the capacity
demands presented by our Master Distribution Agreement with
Coca-Cola Enterprises;
* general overhead expenses for personnel to support the new
business activities;
51
* development, launch and marketing costs for our line of new
branded flavored milk products; and
* the payment of guaranteed license royalties.
We estimate that our need for financing to meet cash requirements for
operations will continue through the first quarter of 2007, when we expect
that cash supplied by operating activities will approach the anticipated
cash requirements for operating expenses. We anticipated the need for
additional financing in 2006 to reduce our liabilities, assist in marketing
and to improve stockholders' equity status, and we secured $30 million in
senior convertible note financing in July 2006.
We currently have monthly working capital needs of approximately $650,000.
We will continue to incur significant selling and other expenses in order
to derive more revenue in retail markets, through the introduction and
ongoing support of our new products and the implementation of the Master
Distribution Agreement with Coca-Cola Enterprises. Certain of these
expenses, such as slotting fees and freight charges, will be reduced as a
function of unit sales costs as we expand our sales markets and increase
our revenues within established markets. Freight charges will be reduced as
we are able to ship more full truckloads of product given the reduced per
unit cost associated with full truckloads versus less than full truckloads.
Similarly, slotting fees, which are paid to warehouses or chain stores as
initial set up or shelf space fees, are essentially one-time charges per
new customer. We believe that along with the increase in our unit sales
volume, the average unit selling expenses and associated costs will
decrease, resulting in gross margins sufficient to mitigate cash needs. In
addition, we are actively seeking additional financing to support our
operational needs and to develop an expanded promotional program for our
products.
External Sources of Liquidity
-----------------------------
On July 27, 2006, we entered into definitive agreements to sell $30 million
senior convertible notes (the "Notes") that are due in 2010 to several
institutional and accredited investors in a private placement exempt from
registration under the Securities Act of 1933. The notes initially carry a
9% coupon, payable quarterly, and are convertible into shares of common
stock at $0.70 per share. In 2007, the coupon may decline to LIBOR upon the
Company achieving certain financial milestones. The Notes will begin to
amortize in equal, bi-monthly payments beginning in mid-2007. We issued
warrants to purchase 12,857,143 shares of common stock at $0.73 per share
that expire in July 2011 to the investors in the private placement. We will
utilize this financing for, among other things, our working capital needs.
On August 31, 2006, the Company entered into Amendment Agreements in which
the investors agreed to release the Company from events of default that
occurred under the terms of the original July 27, 2006 financing. In
exchange, Amended and Restated Notes were issued in which the conversion
price on the $15,000,000 financing, which was held in escrow, was reduced
from $0.70 to $0.51. In addition, the holder could require the Company to
redeem any portion of the Amended and Restated Note in cash or common stock
at 125% from October 10, 2006 through December 31, 2006.
EFFECTS OF INFLATION
We believe that inflation has not had any material effect on our net sales
and results of operations.
ITEM 3. CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
We maintain "disclosure controls and procedures," as such term is defined
in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934
(the "Exchange Act") designed to ensure information
52
required to be disclosed by us in reports that we file or submit under the
Exchange Act is recorded, processed, summarized, and reported within the
time periods specified in Securities and Exchange Commission rules and
forms, and that such information is accumulated and communicated to our
management, including our chief executive officer and chief accounting
officer, as appropriate, to allow timely decisions regarding required
disclosure.
We have carried out an evaluation, under the supervision and with the
participation of our audit committee and management, including our chief
executive officer and chief accounting officer, of the effectiveness of the
design and operation of our disclosure controls and procedures pursuant to
Exchange Act Rules 13a-15(b) and 15d-15(b). During this evaluation,
management considered the impact any material weaknesses and other
deficiencies in our internal control over financial reporting might have on
our disclosure controls and procedures.
Based upon this evaluation, we determined that the following material
weakness existed:
Inadequate controls over the process for the identification and
implementation of the proper accounting for complex and non-routine
transactions, particularly as they relate to accounting for derivatives,
which has caused the Company to restate its consolidated financial
statements for each of the two years ended December 31, 2004 and 2005, and
for the quarterly periods ended March 31, 2006 and June 30, 2006
(collectively, the "financial statements") in order to properly present
those financial statements.
Because the material weakness identified in connection with the assessment
of our internal control over financial reporting as of September 30, 2006
has not been fully remedied, our Chief Executive Officer and our Chief
Accounting Officer concluded our disclosure controls and procedures were
not effective as of September 30, 2006. To address these control
weaknesses, the Company engaged advisory accountants, who performed
additional analysis and performed other procedures in order to prepare the
unaudited quarterly condensed consolidated financial statements appearing
in this Form 10-QSB in accordance with generally accepted accounting
principles in the United States of America.
In addition, we have added or are initiating the following additional
controls to the Company's internal control over financial reporting which
will improve such internal control subsequent to the date of the
evaluation. These changes are:
* We have restructured certain departmental responsibilities as
they relate to the financial reporting function.
* We have added one more experienced full-time accountant to our
accounting staff, whose responsibilities will include the
identification and implementation of proper accounting
procedures relating to current and new guidance on financial
reporting issues which apply to the Company.
* We have retained a consultant who is heavily experienced in
accounting and reporting on complex non-routine transactions
including derivative financial instruments.
PART II - OTHER INFORMATION
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
See Note 8 of Notes to Consolidated Financial Statements.
53
Subsequent Events
See Note 11 of Notes to Consolidated Financial Statements.
Item 6. Exhibits
Exhibits - Required by Item 601 of Regulation S-B:
No. 20.1: Form 8-K filed August 2, 2006 Item 8.01 Transaction
Documents for $30 million financing (incorporated by
reference)
No. 20.2: Form 8-K Filed August 14, 2006 Item 7.01 Triggering
Events of Default (incorporated by reference)
No. 20.3: Form 8-K Filed August 22, 2006 Item 4.02 Non-Reliance
on Previously Issued Financial Statements (incorporated
by reference)
No. 20.4: Form 8-K Filed September 5, 2006 Item 1.01 Amendment
Agreement -Release of Default (incorporated by
reference)
No. 20.5: Form 8-K Filed September 25, 2006 Item 1.01 - Entry
into a Material Definitive Agreement (incorporated by
reference)
No. 20.6: Form 8-K Filed October 11, 2006 Item 8.01 - Other
Events (incorporated by reference)
No. 31: Rule 13a-14(a) / 15d-14(a) Certifications
No. 32: Section 1350 Certifications
SIGNATURES
In accordance with the requirements of the Exchange Act of 1934, the
registrant caused this report to be signed on its behalf of the
undersigned, duly authorized.
BRAVO! FOODS INTERNATIONAL CORP.
(Registrant)
Date: November 14, 2006
/s/ Roy G. Warren
Roy G. Warren, Chief Executive Officer
In accordance with the Securities Exchange Act of 1934, Bravo! Foods
International Corp. has caused this report to be signed on its behalf by
the undersigned in the capacities and on the dates stated.
Signature Title Date
--------- ----- ------
/S/ Roy G. Warren Chief Executive Officer November 14, 2006
and Director
/S/ Tommy E. Kee Chief Accounting Officer November 14, 2006
54