UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C.   20549

FORM 10 - Q

x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2010

¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from __________ to ____________

Commission File Number 0-21743

NeoMedia Technologies, Inc.
(Exact Name of Issuer as Specified In Its Charter)

Delaware
36-3680347
(State or other jurisdiction of
(I.R.S. Employer
incorporation or organization)
Identification No.)

Two Concourse Parkway, Suite 500, Atlanta, GA 30328
(Address, including zip code, of principal executive offices)

678-638-0460
(Registrants’ telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act of 1934 during the preceding 12 months, and (2) has been subject to such filing requirements for the past 90 days. Yes x   No¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files. Yes ¨   No¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer ¨  Accelerated filer ¨   Non-accelerated filer ¨ Smaller Reporting Company x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ¨    No x

The number of outstanding shares of the registrant’s Common Stock on August 9, 2010 was 22,675,678.
 
 
 
 
 
NeoMedia Technologies, Inc.
Form 10-Q
For the Quarterly Period Ended June 30, 2010
Index
 
   
Page
     
PART I
Financial Information
2
     
ITEM 1.
Financial Statements
2
ITEM 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
26
ITEM 3.
Quantitative and Qualitative Disclosures About Market Risk
31
ITEM 4.
Controls and Procedures
31
     
PART II
Other Information
32
     
ITEM 1.
Legal Proceedings
32
ITEM 1A.
    Risk Factors
33
ITEM 2.
    Unregistered Sales of Equity Securities and Use of Proceeds
33
ITEM 3.
    Defaults Upon Senior Securities
33
ITEM 4.
    (Removed and Reserved)
33
ITEM 5.
    Other Information
33
ITEM 6.
Exhibits
34
     
Signatures
41
 
 
1
 
 
PART I — FINANCIAL INFORMATION
ITEM 1.  Financial Statements

 
NeoMedia Technologies, Inc. and Subsidiaries
Condensed Consolidated Balance Sheets
(in thousands, except share and per share data)
 
   
June 30,
    
December 31,
  
   
2010
    
2009
  
 
  
(Unaudited)
        
ASSETS            
Current assets:
            
Cash and cash equivalents
   $ 673     $ 198  
Trade accounts receivable
     236       374  
Inventories, net of allowance of $113 and $136
     100       124  
Prepaid expenses and other current assets
     122       294  
Total current assets
     1,131       990  
                 
Property and equipment, net
     96       129  
Goodwill
     3,418       3,418  
Proprietary software, net
     1,745       2,076  
Patents and other intangible assets, net
     1,870       1,996  
Cash surrender value of life insurance policies
     612       659  
Other long-term assets
     186       156  
Total assets
   $ 9,058     $ 9,424  
                 
LIABILITIES AND SHAREHOLDERS’ DEFICIT
                
Current liabilities:
                
Accounts payable
   $ 357     $ 558  
Taxes payable
     5       4  
Accrued expenses
     8,132       7,292  
Deferred revenues and customer prepayments
     459       791  
Note payable
     15       69  
Note payable - YA Global
     -       500  
Accrued purchase price guarantee
     4,535       4,535  
Deferred tax liability
     706       706  
Derivative financial instruments - warrants
     2,399       9,912  
Derivative financial instruments - Series C and D preferred stock and debentures payable
     7,422       50,985  
Debentures payable - carried at amortized cost
     14,411       12,523  
Debentures payable - carried at fair value
     19,864       37,678  
Total current liabilities
     58,305       125,553  
                 
Commitments and contingencies (Note 7)
                
                 
Series C convertible preferred stock, $0.01 par value, 27,000
                
shares authorized, 8,642 and 8,642 shares issued and outstanding,
                
liquidation value of $8,642 and $8,642
     8,642       8,642  
Series D convertible preferred stock, $0.01 par value, 25,000
                
shares authorized, 25,000 and 0 shares issued and outstanding,
                
liquidation value of $2,500 and $0
     2,500       -  
                 
Shareholders’ deficit:
                
Common stock, $0.001 par value, 5,000,000,000 shares authorized, 22,707,093 and
                
22,707,093 shares issued and 22,675,678 and 22,675,678 shares
                
outstanding, respectively
     23       23  
Additional paid-in capital
     153,157       153,059  
Accumulated deficit
     (212,651 )     (276,985 )
Accumulated other comprehensive loss
     (139 )     (89 )
Treasury stock, at cost, 2,012 shares of common stock
     (779 )     (779 )
Total shareholders’ deficit
     (60,389 )     (124,771 )
Total liabilities and shareholders’ deficit
   $ 9,058     $ 9,424  
 
The accompanying notes are an integral part of these consolidated financial statements.

 
2
 

NeoMedia Technologies, Inc. and Subsidiaries
Condensed Consolidated Statements of Operations (Unaudited)
 (in thousands, except share and per share data)

   
Three Months Ended
  
   
June 30,
    
June 30,
  
   
2010
    
2009
  
             
Revenues
   $ 221     $ 136  
Cost of revenues
     255       281  
Gross profit (deficit)
     (34 )     (145 )
                 
Sales and marketing expenses
     262       178  
General and administrative expenses
     1,041       863  
Research and development costs
     418       350  
                 
Operating loss
     (1,755 )     (1,536 )
                 
Gain (loss) on extinguishment of debt
     (363 )     -  
Gain (loss) from change in fair value of hybrid financial instruments
     1,180       23,343  
Gain (loss) from change in fair value of derivative liability - warrants
     4,305       20,879  
Gain (loss) from change in fair value of derivative liability -
                
Series C and D preferred stock and debentures
     6,645       37,978  
Interest expense related to convertible debt
     (510 )     (2,600 )
                 
Net income (loss)
     9,502       78,064  
                 
Dividends on convertible preferred stock
     -       (368 )
                 
Net income (loss) attributable to common shareholders
     9,502       77,696  
                 
Comprehensive income (loss):
                
Net income (loss)
     9,502       78,064  
Other comprehensive income (loss):
                
Foreign currency translation adjustment
     (26 )     (22 )
                 
Comprehensive income (loss)
   $ 9,476     $ 78,042  
                 
Net income (loss) per share, basic and diluted:
                
Basic
   $ 0.42     $ 4.89  
Fully diluted
   $ (0.01 )   $ 0.25  
                 
Weighted average number of common shares:
                
Basic
     22,675,678       15,882,816  
Fully diluted
     302,104,430       67,928,736  
 
The accompanying notes are an integral part of these consolidated financial statements.
 
 
3
 

NeoMedia Technologies, Inc. and Subsidiaries
Condensed Consolidated Statements of Operations (Unaudited)
 (in thousands, except share and per share data)

   
Six Months Ended
  
   
June 30,
    
June 30,
  
   
2010
    
2009
  
             
Revenues
   $ 576     $ 626  
Cost of revenues
     594       808  
Gross profit (deficit)
     (18 )     (182 )
                 
Sales and marketing expenses
     581       464  
General and administrative expenses
     2,136       1,787  
Research and development costs
     701       673  
                 
Operating loss
     (3,436 )     (3,106 )
                 
Gain (loss) on extinguishment of debt
     (6,006 )     -  
Gain (loss) from change in fair value of hybrid financial instruments
     19,552       312  
Gain (loss) from change in fair value of derivative liability - warrants
     10,856       (12,402 )
Gain (loss) from change in fair value of derivative liability -
                
Series C and D preferred stock and debentures
     46,824       (9,676 )
Interest expense related to convertible debt
     (956 )     (3,663 )
                 
Net income (loss)
     66,834       (28,535 )
                 
Dividends on convertible preferred stock
     (2,500 )     (743 )
                 
Net income (loss) attributable to common shareholders
     64,334       (29,278 )
                 
Comprehensive income (loss):
                
Net income (loss)
     66,834       (28,535 )
Other comprehensive income (loss):
                
Foreign currency translation adjustment
     (50 )     (79 )
                 
Comprehensive income (loss)
   $ 66,784     $ (28,614 )
                 
Net income (loss) per share, basic and diluted:
                
Basic
   $ 2.84     $ (1.98 )
Fully diluted
   $ (0.02 )   $ (1.98 )
                 
Weighted average number of common shares:
                
Basic
     22,675,678       14,785,746  
Fully diluted
     299,092,068       14,785,746  
 
The accompanying notes are an integral part of these consolidated financial statements.
 
4
 
NeoMedia Technologies, Inc. and Subsidiaries
Consolidated Statement of Shareholders’ Deficit (Unaudited)
(in thousands, except share data)
 
   
Common Stock
    
Additional
Paid-in
     Accumulated Other
Comprehensive
     Accumulated    
Treasury Stock
    
Total
Shareholders' Equity
  
   
Shares
    
Amount
    
 Capital
    
 Income (Loss)
    
Deficit
    
Shares
    
Amount
    
 (Deficit)
  
Balance, December 31, 2009, as previously reported
     22,675,678     $ 22,676     $ 130,406     $ (89 )   $ (276,985 )     2,012     $ (779 )   $ (124,771 )
                                                                 
Effect of 1 for 100 share reverse stock split and change in par value
     -       (22,653 )     22,653       -       -       -       -       -  
                                                                 
Balance, December 31, 2009, after retroactive adjustment
     22,675,678       23       153,059       (89 )     (276,985 )     2,012       (779 )     (124,771 )
                                                                 
Deemed dividend on Series D Preferred Stock issued to YA Global
                                     (2,500 )                     (2,500 )
                                                                 
Stock-based compensation expense
     -       -       98       -       -       -       -       98  
                                                                 
Comprehensive income - foreign currency translation adjustment
     -       -       -       (50 )     -       -       -       (50 )
                                                                 
Net income
     -       -       -       -       66,834       -       -       66,834  
Balance, June 30, 2010
     22,675,678     $ 23     $ 153,157     $ (139 )   $ (212,651 )     2,012     $ (779 )   $ (60,389 )
 
The accompanying notes are an integral part of the consolidated financial statements.
 
5
 
NeoMedia Technologies, Inc. and Subsidiaries
Condensed Consolidated Statements of Cash Flows (Unaudited)
(in thousands)
 
   
Six Months Ended
  
   
June 30,
  
   
2010
    
2009
  
Cash Flows from Operating Activities:
            
Net income (loss)
   $ 66,834     $ (28,535 )
Adjustments to reconcile net income (loss) to net cash used in operating activities:
                
Depreciation and amortization
     497       512  
(Gain) loss on extinguishment of debt
     6,006       -  
(Gain) loss from change in fair value of hybrid financial instruments
     (19,552 )     (312 )
(Gain) loss from change in fair value of derivative liability - warrants
     (10,856 )     12,402  
(Gain) loss from change in fair value of derivative liability -
                
Series C and D preferred stock and debentures
     (46,824 )     9,676  
Interest expense related to convertible debt
     956       3,663  
Stock-based compensation expense
     98       177  
Decrease (increase) in value of life insurance policies
     47       (58 )
                 
Changes in operating assets and liabilities
                
Trade and other accounts receivable
     138       46  
Inventories
     24       (50 )
Prepaid expenses and other assets
     142       113  
Accounts payable and accrued liabilities
     (537 )     (198 )
Deferred revenue and other current liabilities
     (332 )     (124 )
Net cash used in operating activities
     (3,359 )     (2,688 )
                 
 Cash Flows from Investing Activities:
                
Acquisition of property and equipment
     (7 )     (24 )
Net cash provided by (used in) investing activities
     (7 )     (24 )
                 
 Cash Flows from Financing Activities:
                
Proceeds from issuance of Series D convertible preferred stock
     2,500       -  
Costs attributed to issuance of Series D convertible preferred stock
     (100 )     -  
Repayment of note payable - YA Global
     (500 )     -  
Borrowings under convertible debt instruments, net
     1,885       1,660  
Net proceeds from exercise of stock options
     -       116  
Net cash provided by financing activities
     3,785       1,776  
                 
Effect of exchange rate changes on cash
     56       (20 )
                 
Net increase (decrease) in cash and cash equivalents
     475       (956 )
                 
Cash and cash equivalents, beginning of period
     198       1,259  
Cash and cash equivalents, end of period
   $ 673     $ 303  
                 
Supplemental cash flow information:
                
Interest paid during the period
   $ 1     $ 3  
Accretion of dividends on Series C Convertible Preferred Stock
   $ -     $ 743  
Series C Convertible Preferred Stock converted to common stock
   $ -     $ 720  
Deemed dividend on Series D Convertible Preferred Stock issued
   $ 2,500     $ 1,337  
Fair value of common shares issued to satisfy purchase price guarantee obligations
   $ -     $ 445  
 
The accompanying notes are an integral part of the consolidated financial statements.

 
6
 

NeoMedia Technologies, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
Note 1 - General

Business - NeoMedia utilizes the mobile phone by leveraging barcodes (printed symbols) as a seamless mechanism to link brands, advertisers, carriers, retailers and consumers using the power of the mobile internet.

With our barcode ecosystem technology, NeoMedia transforms mobile phones with cameras into barcode scanners that provide instant access to mobile web content whenever a barcode is scanned. A barcode makes any medium immediately interactive, and the code links consumers to the multimedia capability of the mobile web. We believe that combining this technology with analytics and reporting capabilities improves the way advertisers market to mobile consumers.

NeoMedia provides the infrastructure to facilitate mobile barcode scanning and its associated commerce worldwide. Our mobile barcode ecosystem software reads and transmits data from 2D barcodes to its intended destination. Our code management and clearinghouse platforms create, connect, record, and transmit the transactions embedded in the barcodes, ubiquitously and reliably.

In order to provide complete mobile marketing solutions, NeoMedia also offers barcode scanning hardware that reads barcodes displayed on mobile phone screens or printed media. NeoMedia provides infrastructure solutions to enable mobile ticketing and couponing programs – including scanner hardware and system support software for seamless implementation.

This technology is supported by our patents. In addition, NeoMedia has an open standards philosophy designed to make integration and use of the technology easy for handset manufacturers, mobile operators and advertisers; and the consumer’s experience safe, reliable and interoperable.
 
Going Concern – We have historically incurred net losses from operations and we expect that we will continue to have negative cash flows as we implement our business plan.  There can be no assurance that our continuing efforts to execute our business plan will be successful and that we will be able to continue as a going concern. The accompanying consolidated financial statements have been prepared in conformity with United States Generally Accepted Accounting Principals (“US GAAP”), which contemplate our continuation as a going concern.  Net income (loss) for the six months ended June 30, 2010 and 2009 was $66.8 million and ($28.5) million, respectively and net cash used by operations during the same periods was $3.4 million and $2.7 million, respectively.  During 2010 and 2009, $77.2 million of net income and $21.3 million of net loss was attributed to the change in fair values of hybrid financial instruments and derivative liabilities. At June 30, 2010, we have an accumulated deficit of $212.7 million. We also have a working capital deficit of $57.2 million, of which $44.1 million is related to our financing instruments, including $22.3 million related to the fair value of warrants and those debentures that are recorded as hybrid financial instruments, and $21.8 million related to the amortized cost carrying value of certain of our debentures and the fair value of the associated derivative liabilities.
 
The items discussed above raise substantial doubts about our ability to continue as a going concern.
 
We currently do not have sufficient cash to sustain us for the next twelve months. We will require additional financing in order to execute our operating plan and continue as a going concern. Our management’s plan is to attempt to secure adequate funding to bridge the commercialization of our barcode ecosystem business. We cannot predict whether this additional financing will be in the form of equity, debt, or another form and we may not be able to obtain the necessary additional capital on a timely basis, on acceptable terms, or at all.  In the event that these financing sources do not materialize, or that we are unsuccessful in increasing our revenues and profits, we may be unable to implement our current plans for expansion, repay our debt obligations as they become due or continue as a going concern, any of which circumstances would have a material adverse effect on our business, prospects, financial condition and results of operations. Should our lender, YA Global Investments, L.P. (“YA Global”) choose not to provide us with capital financing, or if we do not find alternative sources of financing to fund our operations, or if we are unable to generate significant product revenues, we only have sufficient funds to sustain our current operations through approximately September 15, 2010. We currently do not have any commitments for additional financing.
 
7
 
The financial statements do not include any adjustments relating to the recoverability and reclassification of recorded asset amounts or the amounts and classification of liabilities that might be necessary, should we be unable to continue as a going concern.
 
Note 2 - Summary of Significant Accounting Policies

The accompanying unaudited financial statements have been prepared in accordance with US GAAP for interim financial information and Rule 8.03 of Regulation SX. They do not include all of the information and footnotes required by US GAAP for complete financial statements. In the opinion of management, all adjustments, consisting only of normal recurring adjustments, considered necessary for a fair presentation have been included. The results of operations for the periods presented are not necessarily indicative of the results to be expected for the full year. For further information, refer to the financial statements of the Company as of December 31, 2009 and 2008, and for the years then ended, including notes thereto included in the Company’s Form 10-K.

Basis of Presentation – The consolidated financial statements include the accounts of NeoMedia Technologies, Inc. and our wholly-owned subsidiaries.  We operate as one reportable segment.  All significant intercompany accounts and transactions have been eliminated.

Use of Estimates – The preparation of consolidated financial statements in conformity with US GAAP 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. Actual results could differ from those estimates.  Changes in facts and circumstances may result in revised estimates, which are recorded in the period in which they become known.

Basic and Diluted Income (Loss) Per Share – Basic net income (loss) per share is computed by dividing net income (loss) attributable to common shareholders by the weighted average number of shares of common stock outstanding during the period. During the six months ended June 30, 2010, and the three months ended June 30, 2010 and 2009, we reported net income per share and included dilutive instruments in the fully diluted net income per share calculation. During the six months ended June 30, 2009, we reported a net loss per share, and as such, basic and diluted loss per share were equivalent. We excluded all outstanding stock options, warrants, convertible debt and convertible preferred stock from the calculation of diluted net loss per share because these securities were anti-dilutive. The following is a reconciliation of the numerator and denominator of the basic and diluted earnings per share calculations for each period:
 
8
 
   
Three Months Ended June 30,
    
Six Months Ended June 30,
  
    
2010
    
2009
    
2010
    
2009
  
    
(in thousands except share and per share data)
  
Numerator:
                        
Net income (loss)
   $ 9,502     $ 78,064     $ 66,834       (28,535 )
Adjustments to reconcile net income to income (loss)
                                
applicable to common stockholders:
                                
Accretion of preferred stock dividends
     -       (368 )     (2,500 )     (743 )
Numerator for basic earnings per share - income available to common stockholders
   $ 9,502     $ 77,696     $ 64,334     $ (29,278 )
                                 
Effect of dilutive securities:
                                
Adjustment for change in fair value of derivative liability-Series C and D preferred stock and debentures
     (6,645 )     (37,978 )     (46,824 )     -  
Adjustment for change in fair value of derivative liability- warrants
     (4,305 )     -       (10,856 )     -  
Adjustment for loss on extinguishment of debt
     -               5,643       -  
Adjustment for change in fair value of hybrid financial instruments
     (1,180 )     (23,343 )     (19,552 )     -  
Adjustment for dividends on convertible preferred stock
     -       368       -       -  
Adjustment for interest expense related to convertible debt
     478       -       927       -  
      (11,652 )     (60,953 )     (70,662 )     -  
Numerator for diluted earnings per share-
                                
income available for  common stockholders
                                
after assumed conversions of debentures and
                                
exercise of warrants
   $ (2,150 )   $ 16,743     $ (6,328 )   $ (29,278 )
                                 
Denominator:
                                
Weighted average shares used to compute basic EPS
     22,675,678       15,882,816       22,675,678       14,785,746  
Effect of dilutive securities:
                                
Employee stock options
     76,319       370,410       118,522       -  
Derivative warrants
     -       7,025,750       -       -  
Convertible debentures
     202,777,415       24,829,170       200,102,566       -  
Convertible preferred stock
     76,575,018       19,820,590       76,195,302       -  
Dilutive potential common shares
     279,428,752       52,045,920       276,416,390       -  
                                 
Denominator for diluted earnings per share-
                                
adjusted weighted average shares and assumed
                                
conversions
     302,104,430       67,928,736       299,092,068       14,785,746  
                                 
Basic earning per share
   $ 0.42     $ 4.89     $ 2.84     $ (1.98 )
Diluted earnings per share
   $ (0.01 )   $ 0.25     $ (0.02 )   $ (1.98 )
 
The above table includes only dilutive instruments and their effects on earnings per common share.
 
The following outstanding stock options, warrants, convertible debt and convertible preferred securities for the three and six months ended June 30, 2010 and 2009, are anti-dilutive and therefore have been excluded from diluted earnings per share:

   
Three Months Ended June 30,
    
Six Months Ended June 30,
  
   
2010
    
2009
    
2010
    
2009
  
Stock options
     839,830       737,071       872,662       904,554  
Warrants
     13,465,035       67,583       12,459,085       10,063,708  
Convertible debt
     -       -       -       24,829,170  
Convertible preferred stock
     -       -       -       19,820,590  
      14,304,865       804,654       13,331,747       55,618,022  
 
Inventories – Inventories are stated at the lower of cost or market and are comprised of barcode-reading equipment at our NeoMedia Europe location.  Cost is determined using the first-in, first-out method.

 
9
 
Recent Accounting Pronouncements - The following Accounting Standards Codification Updates have been issued, or will become effective, after the end of the period covered by this discussion:

Pronouncement
  
Issued
  
Title
         
ASU No. 2010-12
  
April  2010
  
Income Taxes (Topic 740): Accounting for Certain Tax Effects of the 2010 Health Care Reform Acts
         
ASU No. 2010-13
  
April  2010
  
Compensation—Stock Compensation (Topic 718): Effect of Denominating the Exercise Price of a Share-Based Payment Award in the Currency of the Market in Which the Underlying Equity Security Trades (A consensus of the FASB Emerging Issues Task Force)
         
ASU No. 2010-14
  
April  2010
  
Accounting for Extractive Activities—Oil & Gas—Amendments to Paragraph 932-10-S99-1 (SEC Update)
         
ASU No. 2010-15
  
April  2010
  
Financial Services—Insurance (Topic 944): How Investments Held through Separate Accounts Affect an Insurer’s Consolidation Analysis of Those Investments—a consensus of the FASB Emerging Issues Task Force
         
ASU No. 2010-16
  
April  2010
  
Entertainment—Casinos (Topic 924): Accruals for Casino Jackpot Liabilities—a consensus of the FASB Emerging Issues Task Force
         
ASU No. 2010-17
  
April  2010
  
Revenue Recognition—Milestone Method (Topic 605): Milestone Method of Revenue Recognition—a consensus of the FASB Emerging Issues Task Force
         
ASU No. 2010-18
  
April  2010
  
Receivables (Topic 310): Effect of a Loan Modification When the Loan is Part of a Pool That is Accounted for as a Single Asset—a consensus of the FASB Emerging Issues Task Force
         
ASU No. 2010-19
  
May  2010
  
Foreign Currency (Topic 830): Foreign Currency Issues: Multiple Foreign Currency Exchange Rates
         
ASU No. 2010-20
  
July  2010
  
Receivables (Topic 310): Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses
         
ASU No. 2010-21
  
August  2010
  
Accounting for Technical Amendments to Various SEC Rules and Schedules Amendments to SEC Paragraphs Pursuant to Release No. 33-9026: Technical Amendments to Rules, Forms, Schedules and Codification of Financial Reporting Policies (SEC Update)
 
To the extent appropriate, the guidance in the above Accounting Standards Codification Updates is already reflected in our consolidated financial statements and management does not anticipate that these accounting pronouncements will have any future effect on our consolidated financial statements.

Note 3 – Capital Stock

Common Stock – On March 30, 2010, we held a special meeting of our stockholders, at which our stockholders approved amendments to our certificate of incorporation as follows:

·         To effect a 1 share for 100 shares reverse stock split of our outstanding common stock; and

·         To fix the amount of authorized shares of common stock at 5,000,000,000 shares; and

·         To effect a change in our common stock par value from $0.01 to $0.001.
 
10
 
In accordance with FASB ASC 260, Earnings per Share, and SAB Topic 4.C, Changes in Capital Structure, all of the share and per share information related to our common stock included in these financial statements has been retroactively re-stated to reflect the above changes.

We filed an amendment to our certificate of incorporation on April 1, 2010 to reflect the above amendments. On April 19, 2010, we filed for, and were assigned a new CUSIP number 640505-301 in connection with the issuance of new common stock securities pursuant to the reverse stock split. On April 21, 2010 we filed a request for regulatory approval from the Financial Industry Regulatory Authority (“FINRA”). On May 7, 2010, final regulatory approval was granted and became effective on May 10, 2010.

Holders of common stock are entitled to one vote for each share held of record on each matter submitted to a vote of shareholders. Holders of our common stock do not have a cumulative voting right, which means that the holders of more than one half of our outstanding shares of common stock, subject to the rights of the holders of preferred stock, can elect all of our directors, if they choose to do so. In this event, the holders of the remaining shares of common stock would not be able to elect any directors. Subject to the prior rights of any class or series of preferred stock which may from time to time be outstanding, if any, holders of common stock are entitled to receive ratably, dividends when, as, and if declared by our Board of Directors out of funds legally available for that purpose. Upon our liquidation, dissolution, or winding up, the holders are entitled to share ratably in all assets remaining after payment of liabilities and payment of accrued dividends and liquidation preferences on the preferred stock, if any. Holders of common stock have no preemptive rights, nor rights to convert their common stock into any other securities. Except as otherwise required by Delaware law, and subject to the rights of the holders of preferred stock, all stockholder action is taken by the vote of a majority of the outstanding shares of common stock present at a meeting of stockholders at which a quorum consisting of a majority of the outstanding shares of common stock is present in person or by proxy.  Shares repurchased are held as treasury shares and used for general corporate purposes including, but not limited to, satisfying obligations under our employee benefit plans. Treasury stock is recorded at cost.

Note 4 – Financing

At June 30, 2010, our financing transactions with YA Global, an accredited investor, included shares of our Series C Convertible Preferred Stock issued in February 2006, Series D Convertible Redeemable Preferred Stock issued in January 2010, a series of sixteen secured convertible debentures issued between August 2006 and May 2010 and various warrants to purchase shares of our common stock.

On January 5, 2010, we entered into an investment agreement with YA Global which included i) the issuance to YA Global of 25,000 shares of our $100 Series D Convertible Redeemable Preferred Stock ii) the modification of the conversion terms of all of our outstanding secured convertible debentures and extension of their maturity dates to July 29, 2012 iii) issuance of additional warrants to acquire 225,000 shares of our common stock and, iv) modification of the terms of three outstanding warrants to acquire a total of 350,000 shares of our common stock. The gross amount of this transaction was $2.5 million and we received net proceeds of $1.9 million after fees of $100,000 and the redemption of a $500,000 promissory note issued to YA Global on December 23, 2009.

In addition, the January 5, 2010 investment agreement required us to seek shareholder approval to enact the following changes relating to our common stock, a 1 share for 100 shares reverse stock split, the fixing of our authorized shares at 5,000,000,000, and the reduction in the par value from $0.01 to $0.001. On March 30, 2010, we held a Special Meeting of our shareholders at which the shareholders approved amending the Company’s certificate of incorporation to reflect these changes. (See Note 3).

On May 27, 2010, we entered into a Securities Purchase Agreement to issue and sell a secured convertible debenture to YA Global in the principal amount of $2,006,137 and we also entered into an agreement which amended certain terms of all previously issued and outstanding warrants between us and YA Global which changed the ownership limitation provision from 4.99% to 9.99%.

11
 
Series D Convertible Redeemable Preferred Stock - The Series D Convertible Redeemable Preferred Stock issued on January 5, 2010 has a stated value of $100 per share and provides for an 8% cumulative dividend, subject to Board declaration. Each share of Series D Preferred is convertible, at the option of the holder, at a conversion price equal to the lesser of (i) $2.00 or (ii) 97% of the lowest closing bid price of our common stock for the 125 trading days preceding the date of conversion, provided that no conversion will be at a price less than the par value of the common stock. The conversion price is subject to adjustment for down-round, anti-dilution protection. Accordingly, if we sell common stock or common share indexed financial instruments below the conversion price, the Series D Preferred conversion price adjusts to that lower amount. The Series D Preferred conversion price is also subject to adjustment for traditional equity restructuring and reorganizations. The Series D Preferred has a liquidation amount equal to $100 per share plus all declared and unpaid dividends and is redeemable by us, at our option, at an amount of $100 per share plus a redemption premium of 10%. The instrument is also redeemable at the holder’s option upon certain events of default, which include events and factors that are not related to interest or credit risk.

The Series D Preferred is a hybrid financial instrument that embodies the risks and rewards typically associated with both equity and debt instruments. Accordingly, we are required to evaluate the features of this contract to determine its nature as either an equity-type contract or a debt-type contract. We determined that the Preferred Stock is generally more akin to a debt-type contract, principally due to its variable conversion price and redemption features. This determination is subjective. However, in complying with the guidance provided in FASB ASC 815, we concluded, based upon the preponderance and weight of all terms, conditions and features of the host contracts, that the Series D Preferred was more akin to a debt instrument for purposes of considering the clear and close relationship of the embedded derivative features to the host contract. The principal accounting concept requires bifurcation in these instances when the embedded feature and the host contract have risks that are not clearly and closely related. Certain exemptions to this rule, such as the traditional conventional convertible exemption and the common-indexed exemption were not available to us because the Preferred Stock is not indexed, as that term is defined, only to our common stock. Accordingly, the conversion feature, along with certain other features that have risks of equity, required bifurcation and classification in liabilities as a compound embedded derivative financial instrument. Derivative financial instruments are required to be measured at fair value both at inception and an ongoing basis.

As discussed in further detail below, the initial allocation of the basis in the Series D Preferred financing transaction resulted in no basis being ascribed to the redeemable preferred stock. According to FASB ASC 480-10, Distinguishing Liabilities from Equity, if the security is not currently redeemable and it is not probable that the security will be become redeemable, accretion to face value is not necessary.  The Series D Preferred is convertible upon inception and there was no persuasive evidence that the Preferred Stock would not be redeemed.  Based on this information, redemption could not be considered “not probable” of occurring and accretion was necessary. Redeemable preferred stock may be accreted to its redemption value through periodic charges to retained earnings or over the period from the date of issuance to the earliest redemption date. Because there was no term of redemption embodied in the contract, the issuance date was considered the earliest possible redemption date. As a result, a day-one deemed dividend of $2,500,000 was recorded to accrete the Series D Preferred to its redemption value.

In conjunction with the Series D Preferred financing, we also issued warrants to acquire 225,000 shares of our common stock.   We evaluated the warrants for purposes of classification under FASB ASC 480 and determined the warrants require liability classification because they embody down-round anti-dilution that precludes the instrument from being considered indexed to the Company’s own stock.

Our accounting required the allocation of the proceeds to the individual financial instruments comprising the Series D Preferred financing.  Current accounting concepts generally provide that the allocation is made, first to the instruments that are required to be recorded at fair value; that is, the compound embedded derivative and the warrants, and the remainder to the host instrument. The fair value of the embedded conversion feature and the warrants exceeded the proceeds which resulted in a day-one derivative loss.

12
 
The allocation of the basis arising from the issuance of Series D Preferred and warrants is summarized in the table below:

   
Proceeds
    
Deemed
    
Total
  
   
Allocation
    
Dividend
    
Allocation
  
   
(in thousands)
  
                   
Gross proceeds
   $ 2,500           $ 2,500  
Financing costs paid to investor
     (100 )           (100 )
     $ 2,400           $ 2,400  
                       
Derivative liabilities:
                      
   Investor warrants
   $ (2,431 )         $ (2,431 )
   Compound derivative
     (4,551 )           (4,551 )
      Total derivative liabilities
     (6,982 )           (6,982 )
                       
Redeemable preferred stock:
                      
   Series D Preferred Stock
     -       -       -  
   Deemed dividend
     -     $ (2,500 )     (2,500 )
      Total redeemable preferred stock
     -       (2,500 )     (2,500 )
                         
Accumulated deficit (deemed dividend)
     -       2,500       2,500  
                         
Day-one derivative loss
     4,582               4,582  
    $ (2,400 )   $ -     $ (2,400 )
 
Series C Convertible Preferred Stock - On February 17, 2006, we issued 22,000 shares of $1,000 Series C 8% Convertible Preferred Stock, with a face value of $22 million, to YA Global. The Series C Preferred Stock was originally convertible into shares of common stock at the lower of $2.00 per share and 97% of the lowest closing bid price of the common stock for the 30 trading days immediately preceding the conversion date. On January 5, 2010, we entered into an amendment to the Series C Convertible Preferred Stock, which modified the conversion provisions to increase the look-back period in the variable conversion rate calculation to 125 days.

As of June 30, 2010, 13,358 shares of the original 22,000 shares of Series C Preferred have been converted into 1,240,037 of our common shares, leaving 8,642 shares of Series C Preferred with a face value of $8.6 million outstanding.

Secured Convertible Debentures - The underlying agreements for each of the fifteen debentures issued to YA Global are essentially the same, except in regard to the interest rate, varying conversion prices per share, and the number of warrants that were issued in conjunction with each of the debentures. The debentures are convertible into our common stock, at any time, at the option of the holder, at the lower of a fixed conversion price per share or a percentage of the lowest volume-weighted average price (“VWAP”) for a specified number of days prior to the conversion (the “look-back period”). The conversion is limited such that the holder cannot exceed 9.99% ownership, unless the holder waives their right to such limitation. All of the convertible debentures are secured according to the terms of a Security Pledge Agreement dated August 23, 2006, which was entered into in connection with the first convertible debenture issued to YA Global and which provides YA Global with a security interest in substantially all of our assets.  The debentures are also secured by a Patent Security Agreement dated July 29, 2008.

As discussed above, on January 5, 2010, the terms of all of the debentures were modified to extend the stated maturity date to July 29, 2012.  The January 5, 2010 amendments also increased the look-back period used to calculate the variable conversion price per share for all debentures to a period of 125 days and increased the fixed portion of the conversion price for certain of the debentures from $1.00 to $2.00.

13
 
On May 27, 2010, we entered into a Securities Purchase Agreement to issue and sell a secured convertible debenture to YA Global in the principal amount $2,006,137. The debenture bears interest at 14% and matures on July 29, 2012. The debenture provided net proceeds of $1,410,000 after payment of $90,000 in fees and the use of $506,137 to repay the outstanding principal and interest on a promissory note dated April 1, 2010 owed to YA Global. In addition to the debenture, we also issued a warrant to YA Global to purchase 5,000,000 shares of common stock for an exercise price of $0.30 per share for a period of five years.  We have the right to redeem a portion or all amounts outstanding under the debenture at a redemption premium of 10%, plus accrued interest. YA Global may require cash redemption of all or a portion of the debenture at any time after August 26, 2010.

At inception, a summary of the allocation of the components of the new debenture and the extinguishment of the April 2010 note was as follows:

   
Proceeds
    
Settlement of
        
   
Received
    
April 2010 Note
    
Total
  
   
(in thousands)
  
                   
Gross proceeds
   $ (1,500 )   $ (506 )   $ (2,006 )
Structuring and due diligence fee
     90       -       90  
    $ (1,410 )   $ (506 )   $ (1,916 )
                         
Derivative liabilities:
                        
   Investor warrants
   $ (684 )   $ (228 )   $ (912 )
   Compound derivative
     (1,473 )     (491 )     (1,964 )
      Total derivative liabilities
     (2,157 )     (719 )     (2,876 )
                         
Day one derivative loss
     747       -       747  
Convertible debenture-initial carrying value
     -       (150 )     (150 )
Loss on extinguishment
     -       363       363  
    $ (1,410 )   $ (506 )   $ (1,916 )
 
The compound derivative was valued using the Monte Carlo Simulation valuation method. Significant assumptions used to value the compound derivative as of inception of the financing included a conversion price of $0.1425, equivalent volatility of 182.57%, equivalent interest risk adjusted rate of 13.15% and an equivalent credit risk adjusted rate of 8.59% and estimated exercise behaviors. The warrants are valued using the Black-Scholes-Merton valuation methodology. Significant assumptions used in this model as of May 27, 2010 included an expected life equal to the five year term of the warrants, an expected dividend yield of zero, estimated volatility of 155.57%, and a risk-free rate of return of 2.18%. For the risk-free rates of return, we use the published yields on zero-coupon Treasury Securities with maturities consistent with the term of the warrants and volatility is based upon our expected stock price volatility over the term of the warrants.

14
 
The table below summarizes the significant terms of each of the debentures as of June 30, 2010:

               
Default
  
Conversion Price – Lower of Fixed Price or Percentage of
VWAP for Preceding Period
   
Face
      
Interest
  
Interest
  
Fixed
        
Default
  
Preceding
Debenture Issue Date
  
Amount
  
Maturity
  
Rate
  
Rate
  
Price
    
%
  
%
  
Period
                                   
August 24, 2006
   $ 5,000,000  
7/29/2012
  
10%
  
n/a
   $ 2.00    
90%
  
n/a
  
125 Days
December 29, 2006
   $ 2,500,000  
7/29/2012
  
10%
  
n/a
   $ 2.00    
90%
  
n/a
  
125 Days
March 27, 2007
   $ 7,458,651  
7/29/2012
  
13%
  
n/a
   $ 2.00    
90%
  
n/a
  
125 Days
August 24, 2007
   $ 1,775,000  
7/29/2012
  
14%
 
n/a
   $ 2.00    
80%
  
n/a
  
125 Days
April 11, 2008
   $ 390,000  
7/29/2012
  
15%
  
24%
   $ 1.50    
80%
  
75%
  
125 Days
May 16, 2008
   $ 500,000  
7/29/2012
  
15%
  
24%
   $ 1.50    
80%
  
50%
  
125 Days
May 29, 2008
   $ 790,000  
7/29/2012
  
15%
 
24%
   $ 1.00    
80%
  
50%
  
125 Days
July 10, 2008
   $ 137,750  
7/29/2012
  
15%
  
24%
   $ 1.00    
80%
  
50%
  
125 Days
July 29, 2008
   $ 2,325,000  
7/29/2012
  
14%
 
24%
   $ 2.00    
95%
  
50%
  
125 Days
October 28, 2008
   $ 2,325,000  
7/29/2012
  
14%
  
20%
   $ 2.00    
95%
  
50%
  
125 Days
May 1, 2009
   $ 294,000  
7/29/2012
  
14%
  
20%
   $ 2.00    
95%
  
50%
  
125 Days
June 5, 2009
   $ 715,000  
7/29/2012
  
14%
  
20%
   $ 2.00    
95%
  
50%
  
125 Days
July 15, 2009
   $ 535,000  
7/29/2012
  
14%
  
20%
   $ 2.00    
95%
  
50%
  
125 Days
August 14, 2009
   $ 475,000  
7/29/2012
  
14%
  
20%
   $ 2.00    
95%
  
50%
  
125 Days
May 27, 2010
   $ 2,006,137  
7/29/2012
  
14%
  
20%
   $ 0.30    
95%
  
50%
  
60 Days
 
All debentures with YA Global contain provisions for acceleration of principal and interest upon default. Certain debentures also contain default interest rates and conversion prices, as reflected in the table above.
 
In our evaluation of these financing transactions, we concluded that the conversion features were not afforded the exemption as conventional convertible instruments due to the variable conversion rate; and they did not otherwise meet the conditions set forth in current accounting standards for equity classification. Because equity classification was not available for the conversion features, we elected to bifurcate the compound derivatives, and carry them as derivative liabilities, at fair value. Each compound derivative consists of (i) the embedded conversion feature, (ii) down-round anti-dilution protection features, and (iii) default, non-delivery and buy-in puts which were combined into one compound instrument that is carried as a component of derivative liabilities.

Fair Value Considerations - In accordance with FASB ASC 815, Derivatives and Hedging, we determined that the conversion features of the Series C and Series D Convertible Preferred Stock, and the August 2006, December 2006, July 2008, October 2008, April 2009, May 2009, June 2009, July 2009, August 2009 and May 2010 Debentures met the criteria of embedded derivatives and that the conversion features of these instruments required bifurcation and accounting as derivative instrument liabilities. Changes in the fair value of the derivative liability for the embedded conversion option are charged or credited to income each period. As permitted by FASB ASC 815-15-25, Recognition of Embedded Derivatives, we elected not to bifurcate the embedded derivatives in the March 2007, August 2007, April 2008 or May 2008 Debentures and accordingly, these convertible instruments are being carried in their entirety at their fair values, with the changes in the fair value of the Debentures charged or credited to income each period.

Derivative financial instruments arising from the issuance of convertible financial instruments are initially recorded, and continuously carried, at fair value. Upon conversion of any of the convertible financial instruments, the carrying amount of the debt, including any unamortized premium or discount, and the related derivative instrument liability are credited to the capital accounts upon conversion to reflect the stock issued and no gain or loss is recognized.

Embedded Derivative Instruments – Series C and Series D Preferred Stock and August 2006, December 2006, July 2008, October 2008, April 2009, May 2009, June 2009, July 2009, August 2009 and May 2010 Convertible Debentures - Embedded derivative financial instruments arising from the convertible instruments consist of multiple individual features that were embedded in each instrument. For each convertible instrument, we evaluated all significant features and, as required under current accounting standards, aggregated the components into one compound derivative financial instrument for financial reporting purposes. For financings recorded in accordance with FASB ASC 815, the compound embedded derivative instruments are valued using the Monte Carlo Simulation methodology because that model embodies certain relevant assumptions (including, but not limited to, interest rate risk, credit risk, and conversion/redemption privileges) that are necessary to value these complex derivatives.

15
 
The conversion price in each of the convertible debentures is subject to adjustment for down-round, anti-dilution protection.  Accordingly, if we sell common stock or common share indexed financial instruments below the stated or variable conversion price in the agreement, the conversion price adjusts to that lower amount.

As discussed above, on January 5, 2010, we entered into amendments to the convertible debentures, which extended the maturity dates to July 29, 2012, and modified the terms of the conversion prices.  The modification changed the remaining term for the debentures from 0.52 - 0.58 years to 2.56 years.

The assumptions included in the calculations are highly subjective and subject to interpretation.  Assumptions used as of June 30, 2010 included exercise estimates/behaviors and the following other significant estimates:

       
Remaining
      
Equivalent
  
Equivalent
  
   
Conversion
  
Term
  
Equivalent
  
Interest-Risk
  
Credit-Risk
  
   
Prices
  
(years)
  
Volatility
  
Adjusted Rate
  
Adjusted Rate
  
                       
Series C Convertible Preferred Stock
   $ 0.15   2.08   187%   7.51%   8.59%  
Series D Convertible Preferred Stock
  
$
0.15
   2.08   187%   7.51%   8.59%  
 
                       
August 24, 2006
  
$
0.14