DOCUMENT SECURITY SYSTEMS INC
10-Ks and 10-Qs
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UNITED STATES SECURITIES AND EXCHANGE
COMMISSION
Washington, D.C. 20549
FORM 10-Q
THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended
September 30, 2011
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
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1-32146
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Commission file number
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DOCUMENT SECURITY SYSTEMS, INC.
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(Exact name of registrant as specified in its charter)
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New York
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16-1229730
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(State or other Jurisdiction of incorporation- or Organization)
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(IRS Employer Identification No.)
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28 Main Street East, Suite 1525
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Rochester,
NY
14614
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(Address of principal executive offices)
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(585) 325-3610
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(Registrant's telephone number, including area code)
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Indicate by check mark whether the registrant:
(1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 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
o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Date 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
x
No
o
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 definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer
o
Accelerated filer
o
Non-accelerated filer (Do not check if a smaller reporting company)
o
Smaller reporting company
x
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act)
Yes
o
No
x
As of November 12, 2011, there were 19,548,132 shares of the registrant’s common stock, $0.02 par value, outstanding.
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FORM 10-Q
TABLE OF CONTENTS
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PART I
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FINANCIAL INFORMATION
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Item 1
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Financial Statements
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Consolidated Balance Sheets
as of September 30, 2011 (Unaudited) and December 31, 2010 (Audited)
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3 | ||||
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Consolidated Statements of Operations
for the three and nine months ended September 30, 2011 and 2010 (Unaudited)
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4 | ||||
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Consolidated Statements of Cash Flows
for the nine months ended September 30, 2011 and 2010 (Unaudited)
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5 | ||||
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Notes to Interim Consolidated Financial Statements
(Unaudited)
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6 | ||||
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Item 2
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Management's Discussion and Analysis of Financial Condition and Results of Operations
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20 | |||
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Item 4
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Controls and Procedures
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28 | |||
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PART II
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OTHER INFORMATION
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Item 1
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Legal Proceedings
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29 | |||
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Item 2
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Unregistered
Sales of Equity Securities and Use of Proceeds
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29 | |||
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Item 3
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Defaults upon Senior Securities
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30 | |||
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Item 4
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Other Information
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30 | |||
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Item 5
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Exhibits
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30 | |||
2
DOCUMENT SECURITY SYSTEMS, INC. AND SUBSIDIARIES
Consolidated Balance Sheets
As of
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September 30, 2011
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December 31, 2010
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ASSETS
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(Unaudited)
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(Restated)
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Current assets:
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Cash
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$ | 1,070,510 | $ | 4,086,574 | ||||
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Accounts receivable, net of allowance
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||||||||
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Inventory
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1,043,780 | 601,359 | ||||||
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Prepaid expenses and other current assets
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98,102 | 231,190 | ||||||
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Total current assets
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4,018,127 | 7,147,000 | ||||||
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Property, plant and equipment, net
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4,147,327 | 2,543,494 | ||||||
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Other assets
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244,356 | 325,953 | ||||||
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Goodwill
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3,322,799 | 3,084,121 | ||||||
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Other intangible assets, net
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2,076,508 | 1,847,859 | ||||||
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Total assets
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$ | 13,809,117 | $ | 14,948,427 | ||||
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LIABILITIES AND STOCKHOLDERS' EQUITY
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Current liabilities:
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Accounts payable
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$ | 1,595,952 | $ | 1,828,138 | ||||
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Accrued expenses and other current liabilities
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1,181,767 | 1,312,363 | ||||||
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Revolving lines of credit
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842,109 | 614,833 | ||||||
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Short-term loan from related party
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150,000 | - | ||||||
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Current portion of long-term debt
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447,645 | 300,000 | ||||||
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Current portion of capital lease obligations
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97,683 | 88,776 | ||||||
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Total current liabilities
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4,315,156 | 4,144,110 | ||||||
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Revolving note from related party
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- | 583,000 | ||||||
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Long-term debt
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3,035,414 | 1,578,242 | ||||||
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Capital lease obligations
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16,698 | 98,532 | ||||||
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Deferred tax liability
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103,990 | 89,779 | ||||||
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Derivative liabilities
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- | 3,866,836 | ||||||
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Commitments and contingencies (see Note 7)
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Stockholders' equity
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Common stock, $.02 par value; 200,000,000 shares authorized, 19,503,132 shares issued and outstanding
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(19,391,319 in 2010)
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390,062 | 387,825 | ||||||
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Additional paid-in capital
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48,189,936 | 44,178,569 | ||||||
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Accumulated other comprehensive loss
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(22,156 | ) | (25,834 | ) | ||||
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Accumulated deficit
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(42,219,983 | ) | (39,952,632 | ) | ||||
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Total stockholders' equity
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6,337,859 | 4,587,928 | ||||||
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Total liabilities and stockholders' equity
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$ | 13,809,117 | $ | 14,948,427 | ||||
See accompanying notes
3
DOCUMENT SECURITY SYSTEMS, INC. AND SUBSIDIARIES
(Unaudited)
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For the Three Months Ended September 30,
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For the Nine Months Ended September 30,
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|||||||||||||||
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2011
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2010
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2011
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2010
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Revenue
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(Restated)
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Printing
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$ | 831,468 | $ | 1,056,167 | $ | 2,342,463 | $ | 3,488,351 | ||||||||
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Packaging
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1,575,948 | 1,381,526 | 3,795,599 | 3,452,106 | ||||||||||||
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Plastic IDs and cards
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757,489 | 564,037 | 2,087,196 | 1,821,630 | ||||||||||||
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Licensing and digital solutions
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451,254 | 149,206 | 951,669 | 489,051 | ||||||||||||
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Total revenue
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3,616,159 | 3,150,936 | 9,176,927 | 9,251,138 | ||||||||||||
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Costs of revenue
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Printing
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698,715 | 864,517 | 2,082,810 | 2,820,452 | ||||||||||||
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Packaging
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1,124,973 | 1,056,274 | 2,762,941 | 2,673,455 | ||||||||||||
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Plastic IDs and cards
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453,932 | 345,492 | 1,231,079 | 1,143,143 | ||||||||||||
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Licensing and digital solutions
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67,778 | - | 86,877 | 5,476 | ||||||||||||
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Total costs of revenue
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2,345,398 | 2,266,283 | 6,163,707 | 6,642,526 | ||||||||||||
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Gross profit
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1,270,761 | 884,653 | 3,013,220 | 2,608,612 | ||||||||||||
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Operating expenses:
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Selling, general and administrative
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1,976,913 | 1,332,229 | 5,212,788 | 4,441,793 | ||||||||||||
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Research and development
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83,387 | 71,731 | 208,498 | 204,086 | ||||||||||||
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Amortization of intangibles
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71,376 | 189,467 | 205,416 | 619,667 | ||||||||||||
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Operating expenses
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2,131,676 | 1,593,427 | 5,626,702 | 5,265,546 | ||||||||||||
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Operating loss
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(860,915 | ) | (708,774 | ) | (2,613,482 | ) | (2,656,934 | ) | ||||||||
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Other income (expense):
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Change in fair value of derivative liability
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- | - | 360,922 | - | ||||||||||||
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Interest expense
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(60,531 | ) | (78,572 | ) | (169,711 | ) | (228,082 | ) | ||||||||
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Loss on equity investment
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- | (49,714 | ) | - | (121,393 | ) | ||||||||||
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Amortizaton of note discount
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- | (40,732 | ) | - | (122,196 | ) | ||||||||||
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Other income
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- | - | - | 143,063 | ||||||||||||
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Loss before income taxes
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(921,446 | ) | (877,792 | ) | (2,422,271 | ) | (2,985,542 | ) | ||||||||
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Income tax (benefit) expense
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(164,394 | ) | 4,737 | (154,920 | ) | (1,126,828 | ) | |||||||||
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Net loss
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$ | (757,052 | ) | $ | (882,529 | ) | $ | (2,267,351 | ) | $ | (1,858,714 | ) | ||||
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Other comprehensive income (loss):
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Interest rate swap income (loss)
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- | (6,000 | ) | 3,678 | (31,834 | ) | ||||||||||
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Comprehensive Loss
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$ | (757,052 | ) | $ | (888,529 | ) | $ | (2,263,673 | ) | $ | (1,890,548 | ) | ||||
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Net loss per share -basic and diluted:
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$ | (0.04 | ) | $ | (0.05 | ) | $ | (0.12 | ) | $ | (0.11 | ) | ||||
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Dividend per share
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$ | - | $ | 0.01 | $ | - | $ | 0.01 | ||||||||
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Weighted average common shares outstanding, basic and diluted
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19,474,173 | 18,008,012 | 19,435,930 | 17,599,410 | ||||||||||||
See accompanying notes
4
DOCUMENT SECURITY SYSTEMS, INC. AND SUBSIDIARIES
For the Nine Months Ended September 30,
(
Unaudited
)
| 2011 |
2010
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Cash flows from operating activities:
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(Restated)
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Net loss
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$ | (2,267,351 | ) | $ | (1,858,714 | ) | ||
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Adjustments to reconcile net loss to net cash used by operating activities:
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Depreciation and amortization
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534,292 | 949,683 | ||||||
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Stock based compensation
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319,106 | 336,111 | ||||||
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Amortization of note discount
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- | 122,196 | ||||||
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Loss on equity investment
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- | 121,393 | ||||||
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Change in fair value of derivative liability
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(360,922 | ) | - | |||||
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Deferred tax benefit
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(169,131 | ) | (1,141,040 | ) | ||||
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(Increase) decrease in assets:
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Accounts receivable
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491,497 | 593,122 | ||||||
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Inventory
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(442,421 | ) | (125,381 | ) | ||||
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Prepaid expenses and other assets
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110,208 | (59,881 | ) | |||||
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Increase (decrease) in liabilities:
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Accounts payable
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(300,291 | ) | (406,598 | ) | ||||
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Accrued expenses and other current liabilities
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67,820 | 207,614 | ||||||
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Net cash used by operating activities
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(2,017,193 | ) | (1,261,495 | ) | ||||
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Cash flows from investing activities:
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Purchase of Property, plant and equipment
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(497,709 | ) | (138,640 | ) | ||||
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Purchase of other intangible assets
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(26,313 | ) | (118,999 | ) | ||||
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Acquisition of business
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61,995 | (2,272,405 | ) | |||||
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Net cash used by investing activities
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(462,027 | ) | (2,530,044 | ) | ||||
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Cash flows from financing activities:
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Net (payments) borrowings on revolving lines of credit
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(11,883 | ) | 285,705 | |||||
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Borrowings on long-term debt
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- | 1,500,000 | ||||||
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Payments of long-term debt
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(245,183 | ) | (175,000 | ) | ||||
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Payments of capital lease obligations
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(72,927 | ) | (69,424 | ) | ||||
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Issuance of common stock, net of issuance costs
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(206,851 | ) | 2,209,445 | |||||
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Net cash (used) provided by financing activities
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(536,844 | ) | 3,750,726 | |||||
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Net decrease in cash
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(3,016,064 | ) | (40,813 | ) | ||||
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Cash beginning of period
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4,086,574 | 448,895 | ||||||
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Cash end of period
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$ | 1,070,510 | $ | 408,082 | ||||
See accompanying notes.
5
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2011
(Unaudited)
1. Basis of Presentation and Significant Accounting Policies
The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Rule 8.03 of Regulation S-X for smaller reporting companies. Accordingly, these statements do not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements. In the opinion of management, the accompanying balance sheets and related interim statements of operations and cash flows include all adjustments, consisting only of normal recurring items, necessary for their fair presentation in accordance with U.S. generally accepted accounting principles. All significant intercompany transactions have been eliminated in consolidation.
Interim results are not necessarily indicative of results expected for a full year. For further information regarding Document Security Systems, Inc.’s (the “Company”) accounting policies, refer to the audited consolidated financial statements and footnotes thereto included in the Company's Form 10-K and Form 10-K/A for the fiscal year ended December 31, 2010.
The preparation of financial statements in conformity with accounting principles generally accepted in the United States (U.S. 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 materially from those estimates and assumptions. In preparing these financial statements, the Company has evaluated events and transactions for potential recognition or disclosure.
Reclassifications -
Certain prior period amounts in the accompanying consolidated financial statements and notes thereto have been reclassified to current period presentation. These classifications had no effect on the results of operations for the period presented.
Fair Value of Financial Instruments
-
The Company accounts for financial instruments measured at fair value on a recurring basis and on a non-recurring basis. The accounting guidance defines fair value, establishes a framework for measuring fair value in accordance with U.S. GAAP and expands disclosures about fair value measurements.
Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The Fair Value Measurement Topic of the FASB Accounting Standards Coded (“ASC “) establishes a three-tier fair value hierarchy which prioritizes the inputs used in measuring fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). These tiers include:
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Level 1, defined as observable inputs such as quoted prices for identical instruments in active markets;
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Level 2, defined as inputs other than quoted prices in active markets that are either directly or indirectly observable such as quoted prices for similar instruments in active markets or quoted prices for identical or similar instruments in markets that are not active; and
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Level 3, defined as unobservable inputs in which little or no market data exists, therefore requiring an entity to develop its own assumptions, such as valuations derived from valuation techniques in which one or more significant inputs or significant value drivers are unobservable.
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The carrying amounts reported in the balance sheet of cash, accounts receivable, accounts payable and accrued expenses approximate fair value because of the immediate or short-term maturity of these financial instruments. The fair value of revolving credit lines, notes payable and long-term debt approximates their carrying value as the stated or discounted rates of the debt reflect recent market conditions. Derivative instruments are recorded as assets and liabilities at estimated fair value based on available market information. One of the Company's derivative instruments is an interest rate swap that changes a variable rate into a fixed rate on the term loan and mortgage and qualifies as a cash flow hedge and is included in accrued expenses on the accompanying Consolidated Balance Sheet as of September 30, 2011 and December 31, 2010. Gains and losses on this instrument are recorded in other comprehensive income (loss) until the underlying transaction is recorded in earnings. When the hedged item is realized, gains or losses are reclassified from accumulated other comprehensive income (loss) (AOCI) to the Consolidated Statement of Operations on the same line item as the underlying transaction. The cumulative net loss attributable to this cash flow hedge recorded in AOCl at September 30, 2011, was approximately $22,000 ($26,000 at December 31, 2010).
6
The Company accounts for warrants and other rights to acquire capital stock with exercise price reset features, or “down-round” provisions, as derivative liabilities. Similarly, down-round provisions for issuances of common stock are also accounted for as derivative liabilities. These derivative liabilities are measured at fair value with the changes in fair value at the end of each period reflected in current period income or loss. The fair value of derivative liabilities is estimated using a binomial model or Monte Carlo simulation to model the financial characteristics, depending on the complexity of the derivative being measured. A Monte Carlo simulation provides a more accurate valuation than standard option valuation methodologies such as the Black-Scholes or binomial option models when derivatives include changing exercise prices or different alternatives depending on average future price targets. In computing the fair value of the derivatives, the Company uses significant judgments, which, if incorrect, could have a significant negative impact to the Company’s consolidated financial statements. The input values for determining the fair value of the derivatives include observable market indices such as interest rates, and equity indices as well as unobservable model-specific input values such as certain volatility parameters. Future changes in the fair value of the derivatives liabilities, if any, will be recorded in the statement of operations as gains or losses from derivative liabilities.
Investment
- On October 8, 2009, the Company entered into an Asset Purchase Agreement with Internet Media Services, Inc. (“IMS”) whereby the Company sold the assets and liabilities of Legalstore.com, a division of the Company, in exchange for 7,500,000 shares of common stock of IMS. The Company recorded its investment in IMS as an equity method investment at the fair market value of the business sold. Management determined that the transaction qualified as a derecoginition of a subsidiary under ASC 810-10-40. The Company recognized gains or losses on its investment under the equity method of accounting for investments. During the nine months ended September 30, 2010, the Company recorded a cumulative loss on its investment of approximately $121,000. On September 23, 2010, the Company’s Board of Directors declared a dividend whereas the Company distributed to its stockholders of record on October 8, 2010 on a pro-rata basis its 7,500,000 shares of stock of IMS. There was no loss on investment in IMS during the nine months ended September 30, 2011 as the Company no longer owned shares in IMS as of September 23, 2010.
Business Combinations
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Business combinations and non-controlling interests are recorded in accordance with the Business Combination Topic of the FASB ASC. Under the guidance, the assets and liabilities of the acquired business are recorded at their fair values at the date of acquisition. The excess of the purchase price over the estimated fair values is recorded as goodwill. If the fair value of the assets acquired exceeds the purchase price and the liabilities assumed then a gain on acquisition is recorded. Under the guidance, all acquisition costs are expensed as incurred and in-process research and development costs are recorded at fair value as an indefinite-lived intangible asset. The application of business combination and impairment accounting requires the use of significant estimates and assumptions.
Earnings Per Common Share
-
The Company presents basic and diluted earnings per share. Basic earnings per share reflect the actual weighted average of shares issued and outstanding during the period. Diluted earnings per share are computed including the number of additional shares that would have been outstanding if dilutive potential shares had been issued. In a loss year, the calculation for basic and diluted earnings per share is considered to be the same, as the impact of potential common shares is anti-dilutive.
As of September 30, 2011 and 2010, there were up to 3,271,853 and 2,580,699, respectively, of shares potentially issuable under convertible debt agreements, options, warrants, restricted stock agreements and employment agreements that could potentially dilute basic earnings per share in the future. These shares were excluded from the calculation of diluted earnings per share because their inclusion would have been anti-dilutive to the Company’s losses in the respective periods.
Concentration of Credit Risk -
The Company maintains its cash in bank deposit accounts, which at times may exceed federally insured limits. The Company believes it is not exposed to any significant credit risk as a result of any non-performance by the financial institutions. During the nine months ended September 30, 2011 and 2010, one customer accounted for 15% and 25%, respectively, of the Company’s consolidated revenue. As of September 30, 2011 and 2010, this customer accounted for 20% and 26%, respectively, of the Company’s trade accounts receivable balance. The risk with respect to trade receivables is mitigated by credit evaluations we perform on our customers, the short duration of our payment terms for the significant majority of our customer contracts and by the diversification of our customer base.
7
Recent Accounting Pronouncements
- In May 2011, the FASB issued Accounting Standards Update No. 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS. This update results in common principles and requirements for measuring fair value and for disclosing information about fair value measurements in accordance with U.S. GAAP and IFRS. ASU 2011-04 is required to be applied prospectively in interim and annual periods beginning after December 15, 2011. Early application is not permitted. The Company is currently evaluating the impact that the adoption of ASU 2011-04 will have and does not believe the adoption will have a material impact on the consolidated financial statements.
In June 2011 the Financial Accounting Standards Board issued Accounting Standards Update No. 2011-05, Presentation of Comprehensive Income. This standard eliminates the option to report other comprehensive income and its components in the statement of changes in equity. The Company may elect to present items of net income and other comprehensive income in one continuous statement or in two consecutive statements. Each component of net income and each component of other comprehensive income, together with totals for comprehensive income and its two parts – net income and other comprehensive income – would need to be displayed under either alternative, and the statements would need to be presented with equal prominence as the other primary financial statements. This standard does not change 1) the items that constitute net income and other comprehensive income, 2) when an item of other comprehensive income must be reclassified to net income, or 3) the computation for earnings per share - which will continue to be based on net income. This standard is effective for fiscal years beginning after December 15, 2011, and the Company has not yet determined which method it will elect upon adoption.
In September 2011 the Financial Accounting Standards Board issued Accounting Standards Update No. 2011-08, Intangibles – Goodwill and Other (Topic 350), Testing Goodwill for Impairment. The revised standard is intended to reduce the cost and complexity of the annual goodwill impairment test by providing the option of performing a “qualitative” assessment to determine whether further impairment testing is necessary. Under this standard, the Company has the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If, after assessing the totality of events or circumstances, the Company determines that it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, performing the two-step impairment test under Topic 350 is unnecessary. However, if the Company concludes otherwise, it is required to perform the first step of the two-step impairment test, as described in Topic 350. If the carrying amount of a reporting unit exceeds its fair value under the first step, the Company is required to perform the second step of the goodwill impairment test to measure the amount of the impairment loss, if any. The Company also has the option to bypass the qualitative assessment for any reporting unit in any period and to proceed directly to performing the first step of the two-step goodwill impairment test. The Company may resume performing the qualitative assessment in any subsequent period. This standard is effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011, and early adoption is permitted. The Company believes that the adoption of this standard will not have a material impact on the Company’s financial statements.
2. Inventory
Inventory consisted of the following:
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September 30,
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December 31,
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|||||||
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2011
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2010
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|||||||
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Finished Goods
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$
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696,162
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$
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193,346
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||||
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Work in process
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114,575
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86,776
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||||||
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Raw Materials
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233,043
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321,237
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||||||
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$
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1,043,780
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$
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601,359
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|||||
8
3. Other Intangible Assets
Other intangible assets are comprised of the following:
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September 30, 2011
|
December 31, 2010
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||||||||||||||||||||||||
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Useful Life
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Gross Carrying Amount
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Accumulated Amortizaton
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Net Carrying Amount
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Gross Carrying Amount
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Accumulated Amortizaton
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Net Carrying Amount
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Acquired intangibles
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5 -10 years
|
$ | 2,446,300 | $ | 983,042 | $ | 1,463,258 | $ | 2,038,300 | $ | 815,177 | $ | 1,223,123 | ||||||||||||
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Patent application costs
|
Varied (1)
|
867,334 | 254,084 | 613,250 | 843,693 | 218,957 | 624,736 | ||||||||||||||||||
| $ | 3,313,634 | $ | 1,237,126 | $ | 2,076,508 | $ | 2,881,993 | $ | 1,034,134 | $ | 1,847,859 | ||||||||||||||
(1)- patent rights are amortized over their expected useful life which is generally the legal life of the patent. As of September 30, 2011 the weighted average remaining useful life of these assets in service was approximately 13 years.
4. Debt
Revolving Note - Related Party
-
On January 4, 2008, the Company entered into a Credit Facility Agreement with Fagenson and Co., Inc., as agent, a related party to Robert B. Fagenson, the Chairman of the Company's Board of Directors (the “Fagenson Credit Agreement” or “Credit Facility”). Under the Fagenson Credit Agreement, as amended on December 11, 2009, the Company could borrow up to a maximum of $1,000,000 from time to time up until January 4, 2012. Any amount borrowed by the Company pursuant to the Fagenson Credit Agreement had annual interest rate of 2% above LIBOR and was secured by the Common Stock of P3, the Company's wholly owned subsidiary. Interest was payable quarterly in arrears and the principal was payable in full at the end of the term under the Fagenson Credit Agreement. On June 29, 2011, the Credit Facility, along with accrued interest, was paid in full from the proceeds of a Commercial Term Note as described below under Long-Term Debt, along with approximately $119,000 of payments by the Company to the lenders.
Revolving Credit Lines-
On February 12, 2010, the Company entered into a Credit Facility Agreement with RBS Citizens, N.A. (“Citizens Bank”) in connection with the Company’s acquisition of Premier Packaging (“Premier”) pursuant to which Citizens Bank provided Premier with a revolving credit line of up to $1,000,000. The revolving line of credit is accessible by the Premier Packaging division subject to certain terms, scheduled to mature on July 13, 2011 and is payable in monthly installments of interest only beginning on March 1, 2010. Interest accrued at 1 Month LIBOR plus 3.75% (3.97% at September 30, 2011). On July 26, 2011, the Company entered into a Second Amended and Restated Credit Facility Agreement with Citizens (the “Second Credit Facility Agreement”) for the purpose of amending the Amended and Restated Credit Facility Agreement dated as of October 8, 2010, as amended on February 24, 2011 (collectively the “Original Credit Facility Agreement”). The Second Credit Facility Agreement provides for a revolving line of credit up to $1,000,000 and a loan of $1,075,000 to Premier. The effect of the Second Credit Facility Agreement was the elimination of the “borrowing base” component of the Original Revolving Note and the extension of the maturity date to May 31, 2012. As of September 30, 2011, the revolving line had a balance of $690,474.
On May 12, 2011, in conjunction with the Company’s acquisition of ExtraDev, Inc. (“ExtraDev”) the Company assumed revolving credit lines and open credit card accounts totaling approximately $239,000, comprising of a $100,000 revolving line of credit with a bank at 4.5% with an outstanding balance of $63,000, a $100,000 revolving line of credit with a bank at 8.09% with an outstanding balance of $86,000, and various credits cards with an aggregate outstanding balance of approximately $90,000. All of the credit lines are secured by personal guarantees of the former ExtraDev owners. In accordance with the purchase agreement with ExtraDev, the Company committed to paying these balances within 90 days of acquisition. In August, the Company reached an informal agreement with the former owners of ExtraDev whereas the Company would make monthly payments against the balances of these accounts of at least $25,000 in order to pay-down these liabilities. As of September 30, 2011, the aggregate balance of the ExtraDev credit lines was approximately $152,000.
Short-Term Loan from Related Party -
The DSS Note issued to Bzdick Properties, totaling $150,000, matures on March 31, 2012, and accrues interest at an annualized rate of 9.5% per annum. Prepayment of principal may be made without penalty. The DSS Note calls for interest only payments during its term with a balloon payment due at maturity, and will be secured by a guaranty agreement between Premier and Bzdick Properties. The DSS Note is subordinated to the Citizens loan documents. One of the members of Bzdick Properties is Robert Bzdick, who also serves as a director and chief operating officer of DSS, and as such is a related party to both DSS and Premier. The outstanding balance of the DSS note at September 30, 2011 was $150,000.
9
On February 12, 2010, in conjunction with the Credit Facility Agreement, the Company entered into a term loan with Citizens Bank for $1,500,000. The proceeds of the term loan were used to partially satisfy the purchase price of Premier. The Credit Facility Agreement contains customary representations and warranties, affirmative and negative covenants, including financial covenants (minimum coverage ratio, debt to EBITDA ratio, and current ratio requirements) and events of default and is secured by all of the assets of Premier. The $1,500,000 term loan was scheduled to mature on March 1, 2013 and was payable in 35 monthly payments of $25,000 plus interest commencing March 1, 2010 and a payment of $625,000 on the 36 month. Interest was accruing at 1 Month LIBOR plus 3.75% (3.97% at September 30, 2011). The Company subsequently entered into an interest rate swap agreement to lock into a 5.6% effective interest over the life of the term loan. On July 26, 2011, the Company entered into the Second Credit Facility Agreement for the purpose of amending the Original Credit Facility Agreement. The Second Credit Facility Agreement provides for a revolving line of credit up to $1,000,000 and a loan of $1,075,000 to Premier. The effect of the Second Credit Facility Agreement was the extension of the payment term of the Original Note to February 1, 2015 and the elimination of the $625,000 balloon payment originally due on July 1, 2013 under the Original Note. The outstanding balance of the term loan at September 30, 2011 was $1,025,000.
On June 29, 2011, the Company and Plastic Printing Professionals, Inc. (“P3”), a wholly owned subsidiary of the Company entered into a Commercial Term Note (the “Note”) with Neil Neuman (”Neuman”) whereby the Company borrowed $650,000 from Neuman. The applicable interest rate under the Note is 6.5% per annum, and the term is forty-eight months (the “Term”). Commencing on August 1, 2011, the Company will pay monthly installments of $13,585 for the Term of the Note, and a final balloon payment of $100,000 on August 1, 2015. Any reasonable expense incurred by Neuman (including reasonable attorneys’ fees and disbursements) in connection with the administration or enforcement of the Note shall be paid by the Company and, if not timely paid, shall earn interest at the same rate as the principal. The Company may prepay all or a portion of the outstanding principal balance prior to maturity at any time, without penalty. The Note is collateralized by all of the machinery and equipment of P3. Neuman is neither an affiliate of, nor a related party to, the Company or P3. The proceeds from the Note were used to pay in full all sums owed by the Company under a Credit Agreement executed between the Company and Fagenson & Co., Inc., as agent for certain lenders, including Neuman, dated January 4, 2008. Upon such payment the Credit Agreement between the Company and Fagenson & Co., Inc. was terminated in its entirety. As of September 30, 2011, the Note had a balance of $629,817.
Promissory Note-
On August 30, 2011, the Company’s wholly owned subsidiary Premier entered into a Purchase and Sale Agreement (the “Purchase Agreement”) with Bzdick Properties, LLC, a New York limited liability company (“Bzdick Properties”), to purchase the packaging plant at 6 Framark Drive, Victor, NY, (the “Real Estate”). The Real Estate transaction closed simultaneously with the execution of the Purchase Agreement.
The purchase price for the Real Estate was $1,500,000. The purchase price consisted of a $150,000 cash down payment, a $150,000 subordinated promissory note (the “DSS Note”) from DSS to Bzdick Properties, and a $1,200,000 loan obtained by Premier from Citizens Bank. The Citizens loan documents for the Real Estate transaction consisted of a Promissory Note (the “Citizens Promissory Note”), an Amended and Restated Promissory Note (the “Citizens Amended and Restated Note”), a Mortgage and Security Agreement (the “Citizens Mortgage”), a Consolidation, Modification and Extension Agreement (the “Citizens Consolidation”), a Guaranty Agreement (the “Citizens Guaranty”) and an Indemnity Agreement (the “Citizens Indemnity”), each executed on August 30, 2011. Monthly payments of principal and interest in the amount of $7,658 and interest of 1 month LIBOR plus 3.15% (3.37% at September 30, 2011) are due under the Citizens Amended and Restated Note. Concurrently with the transaction, the Company entered into an interest rate swap agreement to lock into a 5.865% effective interest rate for the life of the loan. The Citizens Promissory Note matures in 10 years at which time a balloon payment of the remaining principal balance of $919,677 is due. As of September 30, 2011, the Citizens Promissory Note had a balance of $1,200,000.
The Real Estate is currently occupied solely by Premier and prior to this Real Estate transaction, Premier was leasing the Real Estate from Bzdick Properties under a lease which was set to expire in January 2020 at a rental rate of $13,333 per month. The Real Estate transaction resulted from the exercise of a purchase option under the existing lease, and the lease was terminated on August 30, 2011.
10
Stand-By Term Note -
On October 8, 2010, the Company amended the Credit Facility Agreement with Citizens Bank to add a Standby Term Loan Note pursuant to which Citizens Bank will provide Premier with up to $450,000 towards the funding of eligible equipment purchases. The Company has 12 months to draw upon this line of credit, after which the balance of funds advanced from the line is converted into a 5 year term loan. Interest accrues at 1 month LIBOR plus 3.00% (3.22% at September 30, 2011). As of September 30, 2011, the Company has drawn approximately $53,000 ($53,000 at December 31, 2010) from the Standby line for the purchase of equipment.
All of the Citizen
’
s Credit Facilities are secured by all the assets of Premier Packaging and are also cross guarentee by Document Security System, Inc. and the Company
’
s other wholly owned subsidiaries, P3 and Secuprint. In addition, the citizen credit facilities are subject to various financial ratio covenents. The Company was in compliance with the covenents at September 30, 2011.
5. Stockholders’ Equity
On February 18, 2011, the Company entered into an Amended and Restated Agreement (“Amended Agreement”) with Fletcher International, Ltd. (“Fletcher”) for the purpose of modifying the terms of an agreement (“Original Agreement”) previously entered into between the Company and Fletcher on December 31, 2010.
Under the Original Agreement, Fletcher purchased $4,000,000 of the Company’s common stock (756,287 shares) at a price of approximately $5.29 per share on December 31, 2010 (the “Initial Investment”). In conjunction with the Initial Investment, Fletcher received a warrant (the “Initial Warrant”) to purchase up to $4,000,000 of the Company’s common stock at a price of approximately $5.29 per share at any time until December 31, 2019, subject to adjustment as set forth in the Initial Warrant. Under the Original Agreement, Fletcher also received the right to make additional equity investments of up to $4,000,000 in total (the “Later Investments”) by May 2, 2011 at the average of the daily volume-weighted price of the Company’s common stock in the calendar month preceding each Later Investment notice date at prices no lower than approximately $4.76 per share and no greater than approximately $6.35 per share, subject to adjustment as set forth in the Original Agreement. The warrants issued to Fletcher had down-round and anti-dilution provisions as of December 31, 2010, and were considered derivative liabilities recorded at fair value. The down-round provisions result in the number of shares to be issued determined on a variable that is not an input to the fair value of a “fixed-for-fixed” option. Under the Original Agreement, Fletcher also received a second warrant (the “Second Warrant”) to purchase shares of the Company’s common stock with an aggregate purchase price of up to the total dollar amount of the Later Investments at a per-share exercise price of 120% of the per-share price paid in the final Later Investment to occur, subject to adjustment as set forth in the Second Warrant. The Initial Warrant and the Second Warrant each also had a cashless exercise provision.
Under the Amended Agreement, the purchase price for the Initial Investment made on December 31, 2010 was increased to $5.38 per share, increasing the aggregate purchase price paid by Fletcher for the Initial Investment from $4,000,000 to $4,068,825. The Initial Warrant received by Fletcher was amended and reissued (the “Amended Initial Warrant”) entitling Fletcher to purchase newly-issued shares of common stock at $5.38 per share (the “Warrant Price”) at any time until February 18, 2020 (the “Warrant Term”), up to an aggregate purchase price of $4,300,000 (the “Warrant Amount”). Under the Amended Agreement, Fletcher also received the right to make additional equity investments (“Later Investments”) of up to $4,068,000 (the “Aggregate Later Investment Amount”) provided notice was given to the Company prior to July 2, 2011 of Fletcher’s intention to make the Later Investment. The Second Warrant received by Fletcher was amended (the “Amended Second Warrant”, and together with the Amended Initial Warrant, the “Warrants”) to fix the Warrant Price at $5.38 per share. The Second Warrant entitled Fletcher to purchase newly-issued shares of common stock up to the aggregate purchase price of the Later Investments. The Amended Initial Warrant and the Amended Second Warrant each had a cashless exercise provision. Fletcher did not make the Later Investment.
In connection with the Amended Agreement, the Company filed a registration statement with the Securities and Exchange Commission (“SEC”) covering the Initial Investment of 756,287 shares and 799,256 shares underlying the Initial Warrant. The registration statement was declared effective on April 13, 2011.
On March 14, 2011, the Company and Fletcher executed further amendments to the Amended and Restated Agreement and Warrants addressing stockholder approval and pricing provisions relating to Change of Control (as defined therein). The March 14, 2011 amendments were executed by the Company and Fletcher in response to an NYSE Amex inquiry, and were required to solidify NYSE Amex approval of the Company’s additional listing applications, which approval was received from NYSE Amex on March 15, 2011.
Certain events, such as dividends, stock splits, and other events specified in the Amended Agreement and in the Warrants could have resulted in additional shares of Common Stock being issued to Fletcher, adjustments being made to the terms of the Later Investments, the Initial Warrant or the Second Warrant, or other results, in each case as set forth in the Amended Agreement, the Amended Initial Warrant and the Amended Second Warrant. The terms of the Amended Agreement granted Fletcher certain participation rights in certain later equity issuances by the Company (except for certain exclusions) and certain other rights upon a change of control, in each case as set forth in the Amended Agreement, the Amended Initial Warrant and the Amended Second Warrant.
11
Proceeds from the transaction were used primarily for sales and marketing, product development, and working capital. The Company paid WM Smith & Co., as placement agent, a cash placement fee of 6% of all cash investments received under the Amended Agreement, or in the case of the cashless exercise of the Warrants, common stock equal to 6% of the shares issued to Fletcher in conjunction with the cashless exercise. During the first quarter of 2011, the Company paid $240,000 in accrued placement agent fees.
Derivative Liability -
The financial instruments issued to Fletcher had down-round and anti-dilution provisions as of December 31, 2010, which are considered a derivative liability recorded at fair value. The down-round provisions result in the number of shares to be issued determined on a variable that is not an input to the fair value of a “fixed-for-fixed” option. The Company recognized the derivative liability at the fair value at inception. The derivative liability was considered a Level 3 liability on the fair value hierarchy as the determination of fair value includes various assumptions about the Company’s future activities and the Company’s stock prices and historical volatility as inputs. To determine the fair value of the various components of the Fletcher investments, the Company selected the binomial option model and the Monte Carlo Simulation to model the financial characteristics of the various components. The derivative liability was initially recorded in the consolidated balance sheet upon issuance as of December 31, 2010 at a fair value of $3,866,836. On February 18, 2011 the Company entered into certain amendments with Fletcher for the purpose of modifying the terms of the previous agreement entered into between the Company and Fletcher on December 31, 2010. As a result of the amendments, the down-round and anti-dilution provisions were eliminated; therefore, the Company determined that the derivative liability that existed under the terms of the original agreement no longer existed. As a result, the Company determined the fair value of the derivative liability instrument as of the modification date of February 18, 2011 and recorded the change in fair value of the derivative liability since December 31, 2010 amounting to $360,922 which is reflected in the statement of operations. With the elimination of the derivative liability provision, the Company re-classed the fair value of the financial instruments amounting to $3,505,914 from derivative liability to additional paid in capital.
The table below provides a reconciliation of the beginning and ending balances for the derivative liability measured at fair value using significant unobservable inputs (Level 3). There were no assets as of or during the period ended September 30, 2011 measured using significant unobservable inputs.
Fair Value Measurements Using Significant Unobservable Inputs (Level 3):
|
Derivative
Liability
|
||||
|
Balance, January 1, 2011
|
$
|
3,866,836
|
||
|
Fair
|
||||
|
Change in fair value
|
(360,922)
|
|||
|
Reclass to equity on date of amendment that eliminated derivative liabilities to net proceeds
|
(3,505,914)
|
|||
|
Balance, September 30, 2011
|
$
|
-
|
||
Restricted Stock
–
In May 2011, the Company issued an aggregate of 82,352 restricted shares of the Company’s common stock, pursuant to the Company’s 2004 Employee Stock Option Plan, as amended, valued at $3.33 per share to the owners of ExtraDev, which the Company acquired. Such restricted stock vests in equal installments annually over four years. The restricted stock granted to the owners of ExtraDev was classified as consideration for the acquisition of ExtraDev at a fair value of approximately $274,000, which upon termination any unvested restricted stock shall immediately vest. In addition, as of September 30, 2011, there are 45,000 restricted shares that will vest only upon the occurrence of certain events prior to May 3, 2012, which include, among other things a change of control of the Company or other merger or acquisition of the Company, the achievement of certain financial goals, including among other things a successful result of the Company’s patent infringement lawsuit against the European Central Bank. These 45,000 shares, if vested, would result in the recording of stock based compensation expense of approximately $563,000, the grant date fair value, over the period beginning when any of the contingent vesting events is deemed to be probable over the expected requisite service period. As of September 30, 2011, vesting is not considered probable and no compensation expense has been recognized related to the performance grants.
12
Stock Options
– The Company records stock-based payment expense related to these options based on the grant date fair value in accordance with FASB ASC 718. During the nine months ended September 30, 2011, the Company issued an aggregate of 262,648 options to purchase its common shares at an exercise price ranging from $3.33 to $5.52 per share to employees and non-employee directors. The fair value of these options amounted to approximately $402,000 determined by utilizing the Black Scholes option pricing model. Included in the options issued during the nine months ended September 30, 2011 are five-year options to purchase an aggregate of 77,648 shares of the Company’s common stock, pursuant to the Company’s 2004 Employee Stock Option Plan, as amended, at an exercise price of $3.33 per share, to the owners of ExtraDev. Such options vest in equal installments annually over four years. The fair value of these options amounted to approximately $121,000 determined by utilizing the Black Scholes option pricing model. Additionally, pursuant to the employment agreements with the previous owners of ExtraDev, the Company awarded earn-out options to purchase an aggregate of 450,000 shares of common stock at an exercise price of $4.50 per share that will be granted if the Company’s Digital division achieves certain annual revenue targets by the end of fiscal year 2016. If the annual revenue targets are met or are deemed probable to occur, then the Company will record stock based compensation expense at the then current fair value. As of September 30, 2011 vesting is considered remote. All options granted to the owners of ExtraDev were classified as compensation for post combination services since the vesting of each grant is based on length of employment, with all unvested options forfeiting upon termination of employment, therefore, the fair value of these equity instruments was not considered a component of the purchase price of the acquisition.
Stock-Based Compensation -
Stock-based compensation includes expense charges for all stock-based awards to employees, directors and consultants. Such awards include option grants, warrant grants, and restricted stock awards. During the nine months ended September 30, 2011, the Company had stock compensation expense of approximately $319,000 ($0.02 per share) ($336,000- 2010; $0.02 per share).
As of September 30, 2011, there was approximately $451,000 of total unrecognized compensation costs (excluding the $563,000 that vest upon the occurrence of certain events) related to non-vested options and restricted stock granted under the Company’s stock option plans which the Company expects to vest over a period of not to exceed five years.
6. Business Combination
On May 12, 2011, the Company entered into an agreement (“Agreement”) to purchase all the issued and outstanding common stock of ExtraDev pursuant to which the Company purchased 10,000 shares of ExtraDev common stock, par value $.01 per share, from each of ExtraDev’s two owners, representing all of ExtraDev’s issued and outstanding common stock.
The Agreement provided that as consideration for the purchase of the ExtraDev common stock, the Company would acquire all of the assets of ExtraDev in exchange for the assumption of all the liabilities of Extradev, employment agreements with the two owners of Extradev, and an aggregate of 94,336 restricted shares of the Company’s common stock valued at $3.33 per share and five-year options to purchase an aggregate of 65,664 shares of the Company’s common stock, at an exercise price of $3.33 per share, were granted to the owners of ExtraDev pursuant to the Company’s 2004 Employee Stock Option Plan, as amended. Such restricted stock and options vest in equal installments annually over four years and are subject to adjustment based upon ExtraDev’s working capital deficit as set forth in its final financial statements, which were provided within 30 days of closing. A subsequent contractual adjustment resulted in a reduction in the aggregate number of restricted shares issued to the two ExtraDev owners to 82,352 and an increase in the aggregate number of options issued to the ExtraDev owners to 77,648. The fair value of the restricted shares was approximately $274,000 and shall vest immediately upon termination. Therefore, restricted shares were recorded as consideration transferred. The options were valued using the Black-Scholes Option Pricing Model at approximately $121,000. The options granted are based on the length of employment with all unvested options forfeiting upon termination of employment. Therefore they are being recorded as post combination compensation expense and not a component of the purchase price of the acquisition. The fair value of these instruments will be expensed pro-ratably over the 4-year vesting period.
The acquisition was accounted for as a business combination, whereby the Company measured the identifiable assets acquired and liabilities assumed based on the acquisition date fair value. The Company is required to recognize and measure any related goodwill acquired in the business combination or a gain from a bargain purchase. Based on management’s assumptions, the fair value of the assets acquired, which included customer lists of $258,000 and non-compete agreements of $150,000, and the liabilities assumed was less than the purchase price resulting in the recording of goodwill. The goodwill recorded with this transaction has been recorded in the Company’s Digital division and is not deductible for income taxes.
13
The preliminary allocation of the purchase price and the fair values of the assets acquired and their associated useful lives and liabilities were estimated by management as follows:
|
Estimated Useful Lives
|
|||||
|
Fair value of consideration transferred
|
$ | 274,232 | |||
|
Fair value of assets acquired and liabilities assumed:
|
|||||
|
Cash
|
$ | 61,995 | |||
|
Accounts receivable
|
69,355 | ||||
|
Prepaid expenses
|
10,050 | ||||
|
Computer equipment
|
85,000 |
3 to 7 years
|
|||
|
Other intangible assets
|
408,000 |
5 to 10 years
|
|||
|
Goodwill
|
238,678 | ||||
|
Fair value of assets acquired
|
$ | 873,078 | |||
|
Liabilities assumed:
|
|||||
|
Accounts payable
|
$ | 68,353 | |||
|
Outstanding credit card balances
|
90,207 | ||||
|
Revolving credit lines
|
148,952 | ||||
|
Accrued liabilities and deferred revenue
|
122,203 | ||||
|
Deferred tax liability
|
169,131 | ||||
|
Fair value of liabilities
|
$ | 598,846 | |||
|
Total Purchase Price
|
$ | 274,232 | |||
Set forth below is the unaudited proforma revenue, operating loss, net loss and loss per share of the Company as if ExtraDev had been acquired by the Company as of January 1, 2010.
|
For the Three Months Ended September 30,
|
For the Nine Months Ended September 30,
|
|||||||||||||||
|
2011
|
2010
|
2011
|
2010
|
|||||||||||||
|
Revenue
|
3,616,159 | 3,355,642 | 9,527,685 | 9,925,329 | ||||||||||||
|
Net Loss
|
(757,052 | ) | (867,039 | ) | (2,249,448 | ) | (1,780,573 | ) | ||||||||
|
Basic and diluted loss per share
|
(0.04 | ) | (0.05 | ) | (0.12 | ) | (0.10 | ) | ||||||||
In conjunction with the acquisition of ExtraDev completed on May 12, 2011, ExtraDev’s two owners entered into five-year employment agreements (with an option to renew for three years on mutually agreed upon terms) with the Company (the “Employment Agreements”), pursuant to which Michael Roy (former ExtraDev owner) will serve as the President and Timothy Trueblood (former ExtraDev owner) will serve as the Chief Technology Officer of the Company’s newly-formed Digital Division (“Digital”), each at an annual base salary of $100,000. Under the Employment Agreements, each of the former ExtraDev shareholders will be eligible for an annual (i) earn-out bonus based upon Digital’s earnings, before interest, taxes depreciation and amortization for the prior year as described in the Employment Agreements payable within days of the end of the year and (ii) earn-out options to purchase common stock of the Company at an exercise price of $4.50 per share under the Company’s Option Plan that vest if Digital achieves certain annual revenue targets by the end of fiscal year 2016. Both the earn-out bonus and earn-out options will be recorded as post combination compensation expense, if earned, since both are based on length of employment and forfeit upon termination. In addition, the former ExtraDev shareholders are eligible for a one-time grant of options to purchase common stock of the Company, at an exercise price of $4.50 per share in the amounts and in accordance with the conditions set forth in the Employment Agreements. The Employment Agreements also provide for health care insurance for each former ExtraDev shareholder and his family. The Company may terminate the Employment Agreements at any time upon 30 days notice, in which event, any vested earn-out options will be exercisable for 90 days and the former ExtraDev shareholders will be entitled to receive an annualized salary of $50,000 and continued health insurance coverage for the remainder of the term of the Employment Agreement.
14
ExtraDev was a privately owned company founded in 1998 and headquartered in Rochester, NY. ExtraDev provides data center centric solutions to businesses and governments. The acquisition of ExtraDev is expected to enhance the Company’s digital security solutions capabilities, including the ability of the Company to offer its digital security products in a “cloud computing” format. ExtraDev had approximately $837,000 in revenue for the year ended December 31, 2010 and lost $10,000 on a tax basis. The acquisition did not create a significant subsidiary in accordance with the Securities and Exchange Commission Regulation S-X 210.1-2(w). Since the date of the acquisition, ExtraDev has generated approximately $392,000 of revenue and experienced net loss of approximately $4,000.
7. Commitments and Contingencies
Legal Matters
-
On August 1, 2005, the Company commenced a suit in the European Court of First Instance in Luxembourg against the ECB alleging patent infringement by the ECB and claimed unspecified damages (the “ECB Litigation”). We brought the suit in the European Court of First Instance in Luxembourg. We alleged that all Euro banknotes in circulation infringe the Company European Patent 0 455 750B1 which covers a method of incorporating an anti-counterfeiting feature into banknotes or similar security documents to protect against forgeries by digital scanning and copying devices. In 2006, the Company received notices that the ECB had filed separate claims in each of the United Kingdom, The Netherlands, Belgium, Italy, France, Spain, Germany, Austria and Luxembourg courts seeking the invalidation of the Patent. Proceedings were commenced before each of the national courts seeking revocation and declarations of invalidity of the Patent. On August 20, 2008, the Company entered into an agreement with Trebuchet Capital Partners, LLC (“Trebuchet”) under which Trebuchet agreed to pay substantially all of the litigation costs associated with validity proceedings in eight European countries relating to the Patent. The Company provided Trebuchet with the sole and exclusive right to manage infringement litigation relating to the Patent in Europe, including the right to initiate litigation in the name of the Company, Trebuchet or both and to choose whom and where to sue, subject to certain limitations set forth in the Trebuchet Agreement. In consideration for Trebuchet's funding obligations, the Company assigned and transferred a 49% interest in the Company's rights, title and interest in the Patent to Trebuchet which allows Trebuchet to have a separate and distinct interest in and share of the Patent, along with the right to sue and recover in litigation, settlement or otherwise and to collect royalties or other payments under or on account of the Patent. In addition, the Company and Trebuchet agreed to equally share all proceeds generated from litigation relating to the Patent, including judgments and licenses or other arrangements entered into in settlement of any such litigation. On July 7, 2011, Trebuchet and the Company entered into a series of agreements wherein Trebuchet effectively ended its ongoing participation in the ECB litigation, except for continuing involvement in the final settlement of fees that may become payable as a result of the infringement case in the Netherlands described below. The original agreement with Trebuchet will remain in effect until Trebuchet makes any and all final payments that may become due in the Netherland infringement case.
On March 26, 2007, the High Court of Justice, Chancery Division, Patents Court in London, England ruled that the Patent was deemed invalid in the United Kingdom, and on March 19, 2008 this decision was upheld on appeal. As a result of these decisions, the Company paid the ECB costs for both court cases in the amount of ₤356,490. On March 27, 2007 the Bundespatentgericht of the Federal Republic of Germany ruled that the German part of the Patent was valid, having considered the English Court’s decision. However, on July 6, 2010, the Company was notified that the German Court had reversed the ruling on appeal and the Patent was deemed invalid in Germany. The Court of First Instance in Luxembourg ruled on September 5, 2007 that it does not have jurisdiction to rule on the patent infringement claim. On January 9, 2008 the French Court held that the Patent was invalid in France and on March 10, 2010, this decision was upheld on appeal. On March 12, 2008 the Dutch Court ruled that the Patent was valid in the Netherlands. However, on December 21, 2010 the Dutch Court reversed the ruling on appeal and the Patent was deemed invalid in the Netherlands. On November 3, 2009, the Belgium Court held that the Patent was invalid in Belgium. On November 17, 2009, the Austrian Court held that the Patent was invalid in Austria. On March 24, 2010 the Spanish Court ruled that the Patent was valid. The decision is being appealed by the ECB. In July 2010, the Company was notified that the Italian Court deemed the patent invalid. The decision was not appealed.
In certain jurisdictions in the ECB Litigation, the losing party is responsible for the other party’s legal fees, subject to court approval. The Company paid a total of ₤356,490 to the ECB for the United Kingdom case. Trebuchet paid for the costs reimbursements due, if any, for all of the other jurisdictions involved, except for approximately €156,000 for the Germany case and approximately €175,000 for the Netherlands case, which were still due as of September
30, 2010. In July 2011, Trebuchet transferred funds to the Company for disbursement of these amounts, which the Company has recorded as accrued liabilities. In addition, the ECB formally requested the Company to pay attorneys and court fees for the Court of First Instance case in Luxembourg in the amount of €93,752 which, unless the amount is settled will be subject to an assessment procedure that has not been initiated. The Company will accrue the assessed amount, if any, as soon as it is reasonably estimable.
15
On February 18, 2010, Trebuchet, on behalf of the Company, filed an infringement suit in the Netherlands against the ECB and two security printing entities with manufacturing operations in the Netherlands, Joh. Enschede Banknotes B.V and Koninklijke Joh. Enschede B.V. Upon determination on December 21, 2010, that the patent was invalid in the Netherlands, the infringement case was terminated by Trebuchet. Trebuchet will be responsible for costs reimbursement associated with the case, if any, when determined by the Dutch Court.
On October 24, 2011 the Company initiated a law suit against Coupon.com Incorporated (“Coupons.com”). The suit was filed in the United States District Court, Western District of New York, located in Rochester, New York. Coupons.com is a Delaware corporation having its principal place of business located in Mountain View, California.
In the Coupons.com suit, the Company alleges breach of contract, misappropriation of trade secrets, unfair competition and unjust enrichment, and is seeking in excess of $10 million in money damages from Coupons.com for those claims.
A summary of the factual basis for the law suit is as follows. The parties executed a Mutual Non-Disclosure Agreement (the “Coupons NDA”) in February 2005. Thereafter, in July 2006, an employee of the Company traveled to California to meet with Coupons.com executives. Pursuant to the Coupons NDA, the employee provided Coupons.com with discs containing numerous proprietary technologies owned by the Company, including its “Blockout” technology, a trade secret. The Blockout technology disc contained a graphic file with anti-copy pattern and color features (the “Block-Out File”), and was delivered as a potential solution for preventing counterfeiting of coupons. The Block-Out File was constructed by the use of technology that is proprietary and confidential to the Company (the “Block-Out File Technology”) and, when placed onto an image, will render a print-out of an image unable to be copied or scanned by electronic devices. In August 2010, the Company learned that Coupons.com was using its Block File Technology on its coupons, and had commercialized the Block-Out File Technology in violation of the Coupons NDA. Upon information and belief, Coupons.com has utilized the Block-Out File Technology on hundreds of millions of coupons, and realized revenues and profits in the millions of dollars. Coupons.com has never paid the Company for the use of the Block-Out File, nor has the Company ever granted Coupons.com the right to commercial use of the Block-Out file. The Company alleges that the unauthorized use of the Block-Out File Technology by Coupons.com has been intentional, willful, malicious and in bad faith.
There are no other material pending legal proceedings to which the Company or any of its subsidiaries is a party or of which any of its property is subject, other than ordinary routine litigation incidental to the Company’s business.
Contingent Litigation Payment –
In May 2005, the Company made an agreement with its legal counsel in charge of the Company’s litigation with the European Central Bank which capped the fees for all matters associated with that litigation at $500,000 plus expenses, and a $150,000 contingent payment upon a successful ruling or settlement on the Company’s behalf in that litigation. The Company will record the $150,000 in the period in which the Company has determined that a successful ruling or settlement is probable.
In addition, pursuant to an agreement made in December 2004, the Company is required to share the economic benefit derived from settlements, licenses or subsequent business arrangements that the Company obtains from any infringer of patents formerly owned by the Wicker Family. For infringement matters involving certain U.S. patents, the Company will be required to disburse 30% of the settlement proceeds. For infringement matters involving certain foreign patents, the Company will be required to disburse 14% of the settlement proceeds. These payments do not apply to licenses or royalties to patents that the Company has developed or obtained from persons other than the Wicker Family. As of September 30, 2011, there has been no settlement amounts related to these agreements.
On October 21, 2011, the Company entered into a contingency legal fee agreement with Nixon Peabody LLP (the “Contingency Agreement”), in connection with its law suit against Coupons.com Incorporated. Under the Contingency Agreement, the Company would pay Nixon Peabody LLP 33 1/3% of any settlements or damages awards collected from Coupons.com Incorporated in connection with the suit. Under the Contingency Agreement, the Company is responsible for payment of out-of-pocket charges and disbursements of Nixon Peabody LLP necessarily accrued during the prosecution of the suit.
Contingent Purchase Price
-In December, 2008, the Company acquired substantially all of the assets of DPI of Rochester, LLC in which the Company guaranteed up to $50,000 to certain parties depending on whether certain conditions occurred within five years of the acquisition. As of September 30, 2011, the Company considers the likelihood that the payment will be required as remote.
8. Supplemental Cash Flow Information
|
For the Nine Months Ended September 30, 2011
|
For the Nine Months Ended September 30, 2010
|
|||||||
|
Cash paid for interest
|
$ | 333,000 | $ | 185,000 | ||||
|
Non-cash investing and financing activities:
|
||||||||
|
Equity issued for severance agreements
|
- | 74,000 | ||||||
|
Equity issued for acqusition
|
274,000 | 2,567,000 | ||||||
|
Non-monetary dividend
|
- | 229,000 | ||||||
|
Retirement of derivative liability instruments
|
3,506,000 | - | ||||||
|
Refinance of related party revolving line of credit and accrued interest
|
650,000 | - | ||||||
|
Property and Plant acquired with debt
|
1,350,000 | - | ||||||
16
9. Segment Information
The Company's businesses are organized, managed and internally reported as four operating segments. In the second quarter of 2011, the Company acquired ExtraDev for its DSS Digital Group and the Company launched a new corporate identity and logo, along with a new website that grouped the Company under four distinct divisions. In conjunction with this, the Company determined that an expansion of its segment reporting to align with the new internal structure was appropriate. A summary of the four reportable segments follows:
|
Licenses security printing technologies and manufactures and sells secure documents such as vital records, transcripts, safety paper, secure coupons, voter ballots, event tickets, among others. In addition, sells general commercial printing services utilizing digital and offset printing capabilities.
|
|
|
DSS Plastics
|
Manufactures and sells secure and non-secure plastic printed products such as ID cards, event badges and passes, and loyalty and gift cards, among others. Plastic cards include RFID chips, magnetic strips with variable data, high quality graphics with overt and covert security features.
|
|
DSS Packaging
|
Manufactures and sells secure and non-secure custom paperboard packaging serving clients in the pharmaceutical, beverage, photo packaging, toy, specialty foods and direct marketing industries, among others.
|
|
DSS Digital
|
Develops, installs, hosts and services IT services including remote server and application hosting, cloud computing, secure document systems, back-up and disaster recovery services and customer program development services.
|
Approximate information concerning the Company’s operations by reportable segment for the three and nine months ended September 30, 2011 and 2010 is as follows. The Company relies on intersegment cooperation and management does not represent that these segments, if operated independently, would report the results contained herein:
|
Three months ended September 30, 2011
|
DSS Printing
|
DSS Plastics
|
DSS Packaging
|
DSS Digital
|
Corporate
|
Total | ||||||||||||||||||
|
Revenues from external customers
|
$ | 986,000 | $ | 757,000 | 1,576,000 | 297,000 | $ | - | $ | 3,616,000 | ||||||||||||||
|
Depreciation and amortization
|
39,000 | 44,000 | 90,000 | 9,000 | 1,000 | 183,000 | ||||||||||||||||||
|
Net (loss) income
|
(448,000 | ) | (33,000 | ) | 120,000 | 19,000 | (415,000 | ) | (757,000 | ) | ||||||||||||||
|
Three months ended September 30, 2010
|
||||||||||||||||||||||||
|
Revenues from external customers
|
$ | 1,205,000 | $ | 564,000 | 1,382,000 | - | $ | - | $ | 3,151,000 | ||||||||||||||
|
Depreciation and amortization
|
146,000 | 75,000 | 86,000 | - | 1,000 | 308,000 | ||||||||||||||||||
|
Net loss
|
(553,000 | ) | (104,000 | ) | (27,000 | ) | - | (199,000 | ) | (883,000 | ) | |||||||||||||
|
Nine months ended September 30, 2011
|
||||||||||||||||||||||||
|
Revenues from external customers
|
$ | 2,901,000 | $ | 2,087,000 | 3,796,000 | 393,000 | $ | - | $ | 9,177,000 | ||||||||||||||
|
Depreciation and amortization
|
113,000 | 142,000 | 263,000 | 14,000 | 2,000 | 534,000 | ||||||||||||||||||
|
Net (loss) income
|
(1,312,000 | ) | (12,000 | ) | (51,000 | ) | (4,000 | ) | (888,000 | ) | (2,267,000 | ) | ||||||||||||
|
Identifiable assets
|
2,237,000 | 2,233,000 | 7,609,000 | 713,000 | 1,017,000 | 13,809,000 | ||||||||||||||||||
| Nine months ended September 30, 2010 (As Restated) | ||||||||||||||||||||||||
|
Revenues from external customers
|
$ | 3,977,000 | $ | 1,822,000 | 3,452,000 | - | $ | - | $ | 9,251,000 | ||||||||||||||
|
Depreciation and amortization
|
512,000 | 224,000 | 212,000 | - | 2,000 | 950,000 | ||||||||||||||||||
|
Net (loss) income
|
(1,679,000 | ) | (262,000 | ) | (102,000 | ) | - | 184,000 | (1,859,000 | ) | ||||||||||||||
|
Identifiable assets at December 31, 2010
|
2,294,000 | 2,063,000 | 6,465,000 | - | 4,126,000 | 14,948,000 | ||||||||||||||||||
17
10. Restatement
The Company identified an error in the Company’s accounting treatment relating to the deferred tax liability created as a result of an acquisition in the first quarter of 2010, On February 12, 2010, the Company purchased all of the outstanding stock of Premier Packaging Corporation for $2,000,000 in cash and 735,437 shares of the Company’s common stock with a value of $2,566,675 plus the assumption of liabilities at February 12, 2010. Among the various assets and liabilities acquired, the Company allocated $1,557,500 to machinery and equipment and $1,372,000 to other intangible assets. The tax basis for the machinery and equipment and other intangible assets as of the date of acquisition was zero, resulting in a deferred tax liability of $1,141,040 as a result of the acquisition. As part of the business combination accounting, the Company properly recorded the deferred tax liability that was caused by the acquisition, but erroneously reduced a deferred tax asset valuation allowance. The Company has determined that the deferred tax liability should have been included in the business combination accounting, resulting in an additional $1,141,040 of goodwill. Also, the Company in a separate entry should have recorded a deferred tax benefit along with a reversal of the deferred tax asset valuation allowance. As a result of this determination, the Company recorded an additional deferred tax benefit and additional goodwill in the amount of $1,141,040 as of the March 31, 2010 and subsequent periods. The correction of this error had no impact on previously disclosed revenue, cost of sales, gross profit, operating expenses and other income and expense. Additionally, this error had no impact on net loss for the interim periods ended June 30, 2011 and March 31, 2011.
18
The following table represents the impact of the restatement adjustments on the Company's Condensed Consolidated
Balance Sheet as of December 31, 2010
|
As Originally Reported
|
As Adjusted
|
Effect of Change
|
||||||||||
|
Current assets
|
7,147,000 | 7,147,000 | - | |||||||||
|
Goodwill
|
1,943,081 | 3,084,121 | 1,141,040 | |||||||||
|
Total assets
|
13,807,387 | 14,948,427 | 1,141,040 | |||||||||
|
Total current liabilities
|
4,144,110 | 4,144,110 | - | |||||||||
|
Total liabilities
|
10,360,499 | 10,360,499 | - | |||||||||
|
Accumulated deficit
|
(41,093,672 | ) | (39,952,632 | ) | 1,141,040 | |||||||
|
Total stockholders' equity
|
3,446,888 | 4,587,928 | 1,141,040 | |||||||||
|
Total liabilities and stockholders' equity
|
13,807,387 | 14,948,427 | 1,141,040 | |||||||||
The following table represents the impact of the restatement adjustments on the Company's Condensed Consolidated
Statement of Operations for the nine months ended September 30, 2010. There was no effect on the three months ended September 30, 2010 Consolidated Statement of Operations.
|
Originally Reported
|
As Adjusted
|
Effect of Change
|
||||||||||
|
Revenue
|
9,251,138 | 9,251,138 | - | |||||||||
|
Cost of revenue
|
6,642,526 | 6,642,526 | - | |||||||||
|
Gross profit
|
2,608,612 | 2,608,612 | - | |||||||||
|
Operating expense
|
5,265,546 | 5,265,546 | - | |||||||||
|
Operating loss
|
(2,656,934 | ) | (2,656,934 | ) | - | |||||||
|
Other expense
|
(328,608 | ) | (328,608 | ) | - | |||||||
|
Loss before income taxes
|
(2,985,542 | ) | (2,985,542 | ) | - | |||||||
|
Income tax expense (benefit)
|
14,212 | (1,126,828 | ) | (1,141,040 | ) | |||||||
|
Net Loss
|
(2,999,754 | ) | (1,858,714 | ) | 1,141,040 | |||||||
|
Comprehensive loss
|
(3,031,588 | ) | (1,890,548 | ) | 1,141,040 | |||||||
|
Net Loss per share -basic and diluted
|
(0.17 | ) | (0.11 | ) | 0.06 | |||||||
The following table represents the impact of the restatement adjustments on the Company's Condensed Consolidated
Statement of Cash Flows for the nine months ended September 30, 2010
|
Originally Reported
|
As Adjusted
|
Effect of Change
|
||||||||||
|
Net Loss
|
(2,999,754 | ) | (1,858,714 | ) | 1,141,040 | |||||||
|
Adjustments to reconcile net loss to net cash used by operating activities:
|
||||||||||||
|
Deferred tax benefit
|
- | 1,141,040 | 1,141,040 | |||||||||
|
Net cash used by operating activities
|
(1,261,495 | ) | (1,261,495 | ) | - | |||||||
|
Net cash used by investing activities
|
(2,530,044 | ) | (2,530,044 | ) | - | |||||||
|
Net cash provided by financing activities
|
3,750,726 | 3,750,726 | - | |||||||||
|
Net decrease in cash
|
(40,813 | ) | (40,813 | ) | - | |||||||
19
FORWARD-LOOKING STATEMENTS
Certain statements contained herein constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995 (the “1995 Reform Act”). Document Security Systems, Inc. desires to avail itself of certain “safe harbor” provisions of the 1995 Reform Act and is therefore including this special note to enable us to do so. Except for the historical information contained herein, this report contains forward-looking statements (identified by the words "estimate," "project," "anticipate," "plan," "expect," "intend," "believe," "hope," "strategy" and similar expressions), which are based on our current expectations and speak only as of the date made. These forward-looking statements are subject to various risks, uncertainties and factors that could cause actual results to differ materially from the results anticipated in the forward-looking statements, including, without limitation, those contained in our Annual Report on Form 10-K and Form 10-K/A for the year ended December 31, 2010, and as follows:
|
·
|
Our limited operating history with our business model.
|
|
·
|
Our ability to effect a financing transaction to fund our operations could adversely affect the value of your stock.
|
|
·
|
A potential loss in current litigation in which we may lose certain of our technology rights, which may affect our business plan.
|
|
·
|
The inability to adequately protect our intellectual property.
|
|
·
|
Intellectual property infringement or other claims against us, our customers or our intellectual property that could be costly to defend and result in our loss of significant rights.
|
|
·
|
The failure of our products and services to achieve market acceptance.
|
|
·
|
Changes in document security technology and standards could render our applications and services obsolete.
|
|
·
|
The inability to compete in our market, especially against established industry competitors with greater market presence and financial resources.
|
|
·
|
The inability to meet our growth strategy of acquiring complementary businesses and assets and expanding our existing operations to include manufacturing capabilities.
|
Overview
Document Security Systems, Inc. (referred to herein as “DSS” “Document Security Systems”, “Document Security,” “we,” “us,” “our” or “Company”) develops, markets, manufactures and sells paper, plastic and packaging products, along with digital systems, designed to protect valuable information from unauthorized scanning, copying, and digital imaging. We have developed security technologies that are applied during the normal printing process and by all printing methods including traditional offset, gravure, flexo, digital or via the internet on paper, plastic, or packaging. Our technologies and products are used by federal, state and local governments, law enforcement agencies and are also applied to a broad variety of industries as well, including financial institutions, high technology and consumer goods, entertainment and gaming, healthcare/pharmaceutical, defense and genuine parts industries. Our customers use our technologies where there is a need for enhanced security for protection and verification of critical financial instruments and vital records, or where there are concerns of counterfeiting, fraud, identity theft, brand protection and liability.
We were organized as a New York corporation in 1984, and in 2002, chose to strategically focus on becoming a developer and marketer of secure technologies for all forms of print media. To accomplish this, we acquired Lester Levin, Inc, an operator of a small printing company called Patrick Printing and an Internet-based business called Legalstore.com, and Thomas M. Wicker Enterprises, Inc. and Document Security Consultants, Inc., two privately owned companies engaged in the document security technology business with rights to certain patents developed by certain members of the Wicker Family. As a result of these acquisitions, we compiled the basis of our document security business by combining basic print capabilities necessary for research and development with the knowledge and expertise of our team of printing professionals and a foundation of patented technologies and trade secrets from which to launch our product offerings. Since this early stage, we have focused our efforts on developing and in some cases patenting new technologies and products, building our corporate, operational, marketing and sales staff to accommodate our expected growth, and developing and implementing our patent and intellectual property protection strategy. In September 2007, we sold certain assets and the operations of Patrick Printing to a private company, as this operation no longer supported our core industry focus. In October 2009, we sold the assets and liabilities associated with our Legalstore.com business.
20
In December 2004, the Company entered into an agreement with the Wicker Family in which Document Security Systems obtained the legal ownership of technology (including patent ownership rights) previously held by the Wicker Family. At that time, the agreement with the Wicker Family provided that the Company would retain 70% of the future economic benefit derived from settlements, licenses or subsequent business arrangements from any infringer of the Wicker patents that Document Security Systems chooses to pursue. The Wicker Family was to receive the remaining 30% of such economic benefit. In February 2005, the Company further consolidated its ownership of the Wicker Family based patents and its rights to the economic benefit of infringement settlements when the Company purchased economic interests and legal ownership from approximately 45 persons and entities that had purchased various rights in Wicker Family technologies over several decades.
In August 2005, the Company commenced a suit against the European Central Bank (“ECB”) alleging patent infringement by the ECB and claimed unspecified damages. We brought the suit in the European Court of First Instance in Luxembourg. We alleged that all Euro banknotes in circulation infringe the Company European Patent 0 455 750B1 (the “Patent”), which covers a method of incorporating an anti-counterfeiting feature into banknotes or similar security documents to protect against forgeries by digital scanning and copying devices. Commencing in March 2006, the ECB countersued in eight national courts that the Patent was invalid. To date, the most significant events in the case since it was filed have been the challenges of patent validity by the ECB. To date, there have been six adverse rulings and one positive ruling in regard to the patent’s validity. Through August 2008, the Company spent approximately $4.2 million dollars on legal, expert and consulting fees for its case. In August 2008, the Company decided to reduce its cost burden from the case and entered into an agreement with Trebuchet Capital Partners, LLC (“Trebuchet”) under which Trebuchet agreed to pay substantially all of the litigation costs associated with pending validity proceedings and future validity and future patent infringement suits filed against the ECB and certain other alleged infringers of the Patent in exchange for 50% of any future proceeds or settlements associated with the litigation.
In addition to its patent defense efforts, since 2002, the Company has also worked to develop and expand its patent and product portfolio. The Company has multiple patents, patents pending and patent applications in the U.S.A and various countries throughout the world. These cover the Company’s technologies, including our AuthentiGuard® On-Demand, AuthentiGuard® Prism™, AuthentiGuard® Phantom™, AuthentiGuard® ObscuraScan™, AuthentiGuard® Survivor 21™, AuthentiGuard® VeriGlow™ technologies, and several other anti-counterfeiting and authentication technologies in development. The Company believes that its commitment to research and development is critical to its position as a leading provider of anti-counterfeiting solutions to our customers.
Prior to 2006, the Company’s primary revenue source in its document security division was derived from the licensing of its technology. The Company had limited production capabilities. In 2006, the Company began to expand its ability to be a provider of anti-counterfeiting products that utilize the Company’s anti-counterfeiting technologies. In 2006, we acquired San Francisco-based Plastic Printing Professionals, Inc. (“P3”), a privately held plastic cards manufacturer located in the San Francisco, CA area. P3’s primary focus is manufacturing long-life composite, laminated and surface printed cards which can include magnetic stripes, bar codes, holograms, signature panels, invisible ink, micro fine printing, guilloche patterns, Biometric, RFID and a patent-pending watermark technology. P3’s products are marketed through an extensive broker network that covers much of North America, Europe and South America and by manufacturing for various industry integrators. In June 2011, P3 began doing business as DSS Plastics Group as part of the Company’s rebranding of its corporate marketing identity under the DSS name and logo.
In December 2008, we acquired substantially all of the assets of DPI of Rochester, LLC, a privately held commercial printer located in Rochester, NY. We formed a new subsidiary called Secuprint Inc. (a/k/a DPI Secuprint) (“DPI”) to incorporate this new company which significantly improved our ability to produce our security paper products as well as improving our competitiveness in the market for custom security printing, especially in the areas of vital records, secure coupons, transcripts, and prescription paper along with the ability to offer our customers a wider range of commercial printing offerings. In June 2011, Secuprint began doing business as DSS Printing Group as part of the Company’s rebranding of its corporate marketing identity under the DSS name and logo.
In February 2010, we acquired Premier, a privately held packaging company located in the Rochester NY area. Premier is an ISO 9001:2008 registered manufacturer of custom paperboard packaging serving clients in the pharmaceutical, beverage, photo packaging, toy, specialty foods and direct marketing industries, among others. The Company has introduced anti-counterfeiting products to the packaging market that further expands the usage of its technologies. The Company believes that the ability to deter and prevent counterfeiting of brand packaging will provide major benefits to companies around the globe who are affected by product counterfeiting. In June 2011, Premier began doing business as DSS Packaging Group as part of the Company’s rebranding of its corporate marketing identity under the DSS name and logo.
21
In May 2011, we acquired ExtraDev, Inc. (“ExtraDev”), a privately held information technology and cloud computing company located in the Rochester NY area. ExtraDev provides data center centric solutions to businesses and governments. The Company believes that the acquisition of ExtraDev will enhance the Company’s digital security solutions capabilities, including the ability of the Company to offer its digital security products in a “cloud computing” format. ExtraDev will be a part of the Company’s Digital Group. ExtraDev had approximately $837,000 in revenue for the calendar year ended December 31, 2010.
Reference is made to the Company’s Annual Report on Form 10-K/A filed on November 14, 2011 and Quarterly Reports on Form 10-Q/A for the quarterly periods ended March 31, 2011 and June 30, 2011 filed on November 14, 2011 in which the Company’s audited and unaudited financial statements were restated.
Technologies
We have developed or acquired numerous technologies that provide to our customers a wide spectrum of solutions. The Company’s primary anti-counterfeiting products and technologies are marketed under the following trade names:
|
·
|
AuthentiGuard™ DX™
|
|
·
|
AuthentiGuard
®
Laser Moiré™
|
|
·
|
AuthentiGuard
®
Prism™
|
|
·
|
AuthentiGuard
®
Pantograph 4000™
|
|
·
|
AuthentiGuard
®
Phantom™
|
|
·
|
AuthentiGuard
®
VeriGlow™
|
|
·
|
AuthentiGuard
®
Survivor 21®
|
|
·
|
AuthentiGuard
®
Block-Out™
|
|
·
|
AuthentiGuard
®
MicroPerf™
|
Products and Services
Security and commercial printing
:
We market and sell to end-users that require anti-counterfeiting and authentication features in a wide range of printed materials such as documents, vital records, prescription paper, driver’s licenses, birth certificates, receipts, manuals, identification materials, entertainment tickets, secure coupons, parts tracking forms, as well as product packaging including pharmaceutical and a wide range of consumer goods. In addition, we provide a full range of digital and large offset commercial printing capabilities to our customers.
Plastic Cards and ID’s:
We produce plastic printed documents at our manufacturing facility in Brisbane, California. The Company produces secure and non-secure RFID cards, identification cards, integrated cards, event badges, loyalty cards and gift cards.
Packaging:
We produce our secure and non-secure packaging products such as boxes, mailers, and point of sale displays, utilizing a CAD/CAM design system that allows for early stage prototyping at our manufacturing facility in Victor, New York. Our packaging division offers automated die cutting, high speed folding, gluing, window and paper patching, automated in-line inserting, pick and place and tip-on systems. We can incorporate our security technologies into printed packaging to help companies prevent or deter brand and product counterfeiting. In addition, our technologies and services can be integrated into various supply chain anti-diversion programs such as track and trace that deter product diversion throughout the supply chain.
Digital Security Solutions:
Using software that we have developed, we can electronically render several of our technologies digitally to extend the use of optical security to the end-user of sensitive information. With our AuthentiGuard® DX™ technology we market a networked appliance that allows the author of any Microsoft Office document (Outlook, Word, Excel, or PowerPoint) to secure nearly any of its alphanumeric content when it is printed or digitally stored. AuthentiGuard® DX prints selected content using our patented technology so that it cannot be read by the naked eye. Reading the hidden content, or authenticating the document is performed with a proprietary viewing device or software.
22
The Company also sells an internet delivered technology called AuthentiGuard® – On Demand™ where information is hidden and then verified utilizing an inexpensive viewing glass. This technology is currently being utilized by a Central American country for travel visas.
The Company has also developed digital versions of its AuthentiGuard® – Prism™ and AuthentiGuard® – Pantograph 4000™ technologies which are produced on HP Indigo Presses, Canon Color Copiers, Ricoh Color Copiers and Konica Desktop Printers. The Company sells the digital products directly through its internal sales force and it has also entered into a contract to sell its digital solutions through a third party who specializes in hardware software engineering solutions.
In addition, with the acquisition of ExtraDev in May 2011, the Company sells a wide array of IT services including remote hosted server and application services known as “cloud computing” along with disaster recovery, secure storage and custom programming services.
Technology Licensing:
We license our AuthentiGuard ™ anti-counterfeiting technology and trade secrets to security printers through licensing arrangements. We seek licensees that have a broad customer base that can benefit from our technologies or have unique and strategic capabilities that expand the capabilities that we can offer our potential customers. Licenses can be for a single technology or for a package of technologies and are typically priced as a percentage of sales or on a per item basis, subject to annual minimums.
Approximate Results of Operations for the Three and Nine Months Ended
September 30, 2011 Compared to the Three and Nine Months Ended September 30, 2010
The discussion should be read in conjunction with the financial statements and footnotes in this quarterly report and in our Annual Report on Form 10-K and Form K/A for the year ended December 31, 2010.
Revenue
|
Three Months Ended September 30, 2011
|
Three Months Ended September 30, 2010
|
% change
|
Nine Months Ended September 30, 2011
|
Nine Months Ended September 30, 2010
|
% change
|
|||||||||||||||||||
|
Revenue
|
||||||||||||||||||||||||
|
Printing
|
$ | 832,000 | $ | 1,056,000 | -21 | % | $ | 2,342,000 | $ | 3,488,000 | -33 | % | ||||||||||||
|
Packaging
|
1,576,000 | 1,382,000 | 14 | % | 3,796,000 | 3,452,000 | 10 | % | ||||||||||||||||
|
Plastic IDs and cards
|
757,000 | 564,000 | 34 | % | 2,087,000 | 1,822,000 | 15 | % | ||||||||||||||||
|
Licensing and digital solutions
|
451,000 | 149,000 | 203 | % | 952,000 | 489,000 | 95 | % | ||||||||||||||||
|
Total Revenue
|
$ | 3,616,000 | $ | 3,151,000 | 15 | % | $ | 9,177,000 | $ | 9,251,000 | -1 | % | ||||||||||||
For the three months ended September 30, 2011, revenue was $3.6 million which was 15% greater than revenue for the three months ended September 30, 2010. Printing revenue declined 21% which was primarily the result of a decline in sales at the Company’s commercial printing division driven by the loss of a large commercial print customer in the second half of 2010 along with a strategic reduction in the level of low profit margin commercial print work that the Company has determined does not fit its long-term business model. The Company’s packaging revenue increased 14% in the third quarter of 2011 as compared to the third quarter of 2010 due to the timing of orders from certain of the packaging division’s largest customers as well as a general increase in sales activity. The Company’s plastics revenue increased 34% in the third quarter of 2011 as compared to the third quarter of 2010. The Company’s technology license and digital solutions sales increased 203% which reflect approximately $297,000 in sales from the Company’s acquisition of ExtraDev in May 2011.
For the nine months ended September 30, 2011, revenue was $9.2 million which was 1% lower than revenue for the nine months ended September 30, 2010. Security and commercial printing declined 33% which was primarily the result of a 35% decline in external sales at the Company’s commercial printing division, driven by the general decline in the Company’s commercial printing business that began in the second half of 2010 caused by the loss of a large direct mail customer along with a strategic reduction in the level of low profit margin commercial print that the Company has determined does not fit its long-term business model. The Company’s packaging revenue increased 10% in the first nine months of 2011 as compared to the first nine months of 2010 due to the fact that the Company acquired its packaging division in February 2010. The Company’s plastics revenue increased 15% during the first nine months of 2011 as compared to the first nine months of 2010 due to general strength in sales of higher priced cards such as RFID cards and secure driver’s licenses. The Company’s technology licensing and digital solutions sales reflect approximately $392,000 in sales from the Company’s acquisition of ExtraDev in May 2011 and a 14% increase in revenue from technology licenses during the first nine months of 2011 as compared to 2010.
23
Cost of Revenue and Gross Profit
|
Three Months Ended September 30, 2011
|
Three Months Ended September 30, 2010
|
% change
|
Nine Months Ended September 30, 2011
|
Nine Months Ended September 30, 2010
|
% change
|
|||||||||||||||||||
|
Costs of revenue
|
||||||||||||||||||||||||
|
Printing
|
$ | 699,000 | $ | 865,000 | -19 | % | $ | 2,083,000 | $ | 2,821,000 | -26 | % | ||||||||||||
|
Packaging
|
1,125,000 | 1,056,000 | 7 | % | 2,763,000 | 2,673,000 | 3 | % | ||||||||||||||||
|
Plastic IDs and cards
|
453,000 | 345,000 | 31 | % | 1,231,000 | 1,143,000 | 8 | % | ||||||||||||||||
|
Licensing and digital solutions
|
68,000 | - | 100 | % | 87,000 | 5,000 | 1640 | % | ||||||||||||||||
|
Total cost of revenue
|
2,345,000 | 2,266,000 | 3 | % | 6,164,000 | 6,642,000 | -7 | % | ||||||||||||||||
|
Gross profit
|
||||||||||||||||||||||||
|
Printing
|
133,000 | 191,000 | -30 | % | 259,000 | 667,000 | -61 | % | ||||||||||||||||
|
Packaging
|
451,000 | 326,000 | 38 | % | 1,033,000 | 779,000 | 33 | % | ||||||||||||||||
|
Plastic IDs and cards
|
304,000 | 219,000 | 39 | % | 856,000 | 679,000 | 26 | % | ||||||||||||||||
|
Licensing and digital solutions
|
383,000 | 149,000 | 157 | % | 865,000 | 484,000 | 78 | % | ||||||||||||||||
|
Total gross profit
|
$ | 1,271,000 | $ | 885,000 | 44 | % | $ | 3,013,000 | $ | 2,609,000 | 15 | % | ||||||||||||
|
Three Months Ended September 30, 2011
|
Three Months Ended September 30, 2010
|
% change
|
Nine Months Ended September 30, 2011
|
Nine Months Ended September 30, 2010
|
% change
|
|||||||||||||||||||
| Gross profit percentage: | 35 | % | 28 | % | 25 | % | 33 | % | 28 | % | 18 | % | ||||||||||||
Costs of revenue increased 3% in the third quarter of 2011 as compared to the third quarter of 2010 as a result of the increase in revenue described above. Gross profit increased 44% to $1,271,000 in the third quarter of 2011 as compared to the third quarter of 2010. The increase in gross profit was primarily due to the significant increases in gross profits in the Company’s packaging and plastic divisions due to favorable product sales mixes for each, along with a decrease in equipment lease costs which further favorably impacted the plastic division. These increases were partially offset by a 30% decrease in gross profits from the Company’s printing division, which reflects the impact of the significant declines in commercial printing revenues causing fixed costs of sales to be a much larger percentage of cost of sales than comparable 2010 levels. Gross profits from licensing and digital sales increased 157% primarily due to the addition of gross profits from the Company’s new acquisition, ExtraDev, which occurred in May 2011.
During the first nine months of 2011, gross profit increased 15%, as increases in gross profits from packaging, plastics and licensing and digital sales were offset by a 61% decrease in printing gross profits due to the significant declines in commercial printing revenues which caused fixed costs of sales in the first nine months of 2011 to be a much larger percentage of cost of sales than the first nine months of 2010.
24
Operating Expenses
|
Three Months
|
Three Months
|
Nine Months
|
Nine Months
|
|||||||||||||||||||||
|
Ended September
|
Ended September
|
Ended September
|
Ended September
|
%
|
||||||||||||||||||||
| 30, 2011 | 30, 2010 |
% change
|
30, 2011 | 30, 2010 |
change
|
|||||||||||||||||||
|
Operating Expenses
|
||||||||||||||||||||||||
|
Sales, general and administrative compensation
|
$ | 1,080,000 | $ | 870,000 | 24 | % | $ | 2,684,000 | $ | 2,561,000 | 5 | % | ||||||||||||
|
Professional Fees
|
219,000 | 92,000 | 138 | % | 582,000 | 437,000 | 33 | % | ||||||||||||||||
|
Sales and marketing
|
127,000 | 46,000 | 176 | % | 413,000 | 172,000 | 140 | % | ||||||||||||||||
|
Research and
development
|
83,000 | 72,000 | 15 | % | 208,000 | 205,000 | 1 | % | ||||||||||||||||
|
Rent and utilities
|
195,000 | 170,000 | 15 | % | 547,000 | 478,000 | 14 | % | ||||||||||||||||
|
Other
|
212,000 | (10,000 | ) | 2220 | % | 575,000 | 361,000 | 59 | % | |||||||||||||||
| 1,916,000 | 1,240,000 | 55 | % | 5,009,000 | 4,214,000 | 19 | % | |||||||||||||||||
|
Other Operating Expenses
|
||||||||||||||||||||||||
|
Depreciation and software amortization
|
31,000 | 34,000 | -9 | % | 94,000 | 96,000 | -2 | % | ||||||||||||||||
|
Stock based compensation
|
114,000 | 130,000 | -12 | % | 319,000 | 336,000 | -5 | % | ||||||||||||||||
|
Amortization of
intangibles
|
71,000 | 189,000 | -62 | % | 205,000 | 620,000 | -67 | % | ||||||||||||||||
| 216,000 | 353,000 | -39 | % | 618,000 | 1,052,000 | -41 | % | |||||||||||||||||
|
Total Operating
|
||||||||||||||||||||||||
|
Expenses
|
$ | 2,132,000 | $ | 1,593,000 | 34 | % | $ | 5,627,000 | $ | 5,266,000 | 7 | % | ||||||||||||
Selling, General and Administrative
Sales, general and administrative compensation
costs were 24% higher for the three months ended September 30, 2011 as compared to the three months ended September 30, 2010 which reflect additions in sales and marketing personnel made during the third quarter of 2011. For the nine months ended September 30, 2011, sales, general and administrative compensation costs increased 5%.
Professional fees
in the three and nine months ended September 30, 2011 increased 138% and 33%, respectively, primarily due to increases in sales consulting and investor relations costs.
Sales and marketing
costs during the third quarter of 2011 increased 176% as compared to the third quarter of 2010, as the Company has incurred increased travel and entertainment costs associated with a larger direct sales force, increased costs associated with internet based advertising, and higher costs due to an increase in trade show presence.
Research and development
costs
consist primarily of compensation costs for research personnel and direct costs for the use of third-party printers’ facilities to test our technologies on equipment that we do not have access to internally. Research and development costs decreased due to a reduction in compensation cost.
Rent and utilities
expenses have increased primarily as a result of the acquisition of ExtraDev in May 2011.
Other
operating expenses are primarily equipment maintenance and repairs, office supplies, IT support, bad debt expense and insurance costs. Other expenses increased in the third quarter of 2011 and for the first nine months of 2011 as compared to of the same periods in 2010 due to a $215,000 reversal of expense which had occurred during the third quarter of 2010 which did not occur in the third quarter of 2011. Otherwise, other operating expenses were nearly the same for the 2011 and 2010 periods.
Stock based compensation
includes expense charges for all stock based awards to employees, directors and consultants. Such awards include option grants, warrant grants, and restricted stock awards. Stock based compensation in the third quarter of 2011 was approximately $114,000 as compared to a $130,000 recorded in the third quarter of 2010.
25
Amortization of intangibles
expense decreased 62% and 67% in the three and nine months ended September 30, 2011, respectively, as compared to the three and nine months ended September 30, 2010 due to the reduction in the Company’s net capitalized patent acquisition and defense costs asset.
Other Income and expenses
|
Three Months
|
Three Months
|
Nine Months
|
Nine Months
|
|||||||||||||||||||||
|
Ended September
|
Ended September
|
Ended September
|
Ended September
|
%
|
||||||||||||||||||||
| 30, 2011 | 30, 2010 |
% change
|
30, 2011 | 30, 2010 |
change
|
|||||||||||||||||||
|
Other income (expense):
|
||||||||||||||||||||||||
|
Change in fair value of derivative liability
|
$ | - | $ | - | 0 | % | $ | 361,000 | $ | - | 0 | % | ||||||||||||
|
Interest expense
|
(61,000 | ) | (79,000 | ) | -23 | % | (170,000 | ) | (228,000 | ) | -25 | % | ||||||||||||
|
Amortizaton of note discount
|
- | (41,000 | ) | -100 | % | - | (122,000 | ) | -100 | % | ||||||||||||||
|
Loss in equity investment
|
- | (50,000 | ) | -100 | % | - | (121,000 | ) | -100 | % | ||||||||||||||
| Other income | - | - | 0 | % | - | 143,000 | -100 | % | ||||||||||||||||
|
Other income (expense), net
|
$ | (61,000 | ) | $ | (170,000 | ) | -64 | % | $ | (191,000 | ) | $ | (328,000 | ) | -42 | % | ||||||||
Change in fair value of derivative liability:
In late 2010, the Company issued various financial instruments to an investor in connection with a stock purchase agreement which contained certain provisions that resulted in a derivative liability. On February 18, 2011 the Company entered into certain amendments with the investor for the purpose of modifying the terms of the financial instruments that among other things eliminated the provisions of the warrants that had created the derivative liabilities. As a result, the Company determined the fair value of the derivative liability as of the modification date of February 18, 2011 and recorded the change in fair value of the derivative liability since December 31, 2010 of $360,922 in the statement of operations.
Other Income:
In March 2010, the Company received notification that it was due approximately $143,000 for New York State Qualified Emerging Technology Company (“QETC”) refundable tax credits for the tax year ended 2008 which the Company received in April 2010.
Income Taxes
|
Three Months
|
Three Months
|
Nine Months
|
Nine Months
|
|||||||||||||||||||||
|
Ended
|
Ended
|
Ended |
Ended
|
|||||||||||||||||||||
| September 30, 2011 | September 30, 2010 |
% change
|
September
30, 2011
|
September
30, 2010 (Restated)
|
%
change
|
|||||||||||||||||||
|
Income taxes
|
(165,000 | ) | 5,000 | -3400 | % | (156,000 | ) | (1,127,000 | ) | -86 | % | |||||||||||||
The Company recognized a $169,000 deferred tax benefit during the third quarter of 2011. As a result of its acquisition of ExtraDev during 2011 a
temporary difference between the book fair value and the tax basis for equipment and other intangible assets acquired was created resulting in a deferred tax liability and additional goodwill. As a result of the additional deferred tax liability the Company reduced the deferred tax valuation account and recognized a deferred tax benefit.
The Company recognized a $1,141,000 deferred tax benefit during the first quarter of 2010. As a result of its acquisition of Premier Packaging a
temporary difference between the book fair value and the tax basis for equipment and other intangible assets acquired was created resulting in a deferred tax liability and additional goodwill. As a result of the additional deferred tax liability the Company reduced the deferred tax valuation account and recognized a deferred tax benefit.
26
Net Loss and Loss Per Share
|
Three Months
|
Three Months
|
Nine Months
|
Ended September
|
|||||||||||||||||||||
|
Ended September
|
Ended September
|
Ended September
|
30, 2010 |
%
|
||||||||||||||||||||
| 30, 2011 | 30, 2010 |
% change
|
30, 2011 |
(Restated)
|
change
|
|||||||||||||||||||
|
Net loss
|
$ | (757,000 | ) | $ | (883,000 | ) | -14 | % | $ | (2,267,000 | ) | $ | (1,859,000 | ) | 22 | % | ||||||||
|
|
||||||||||||||||||||||||
|
Net loss per share, basic and
diluted
|
$ | (0.04 | ) | $ | (0.05 | ) | -20 | % | $ | (0.12 | ) | $ | (0.11 | ) | 9 | % | ||||||||
|
Weighted average common
|
||||||||||||||||||||||||
|
shares outstanding, basic and
diluted
|
19,474,173 | 18,008,012 | 8 | % | 19,435,930 | 17,599,410 | 10 | % | ||||||||||||||||
During the third quarter of 2011, the Company had a net loss of $757,000, representing a 14% decrease from the net loss of the third quarter of 2010. The decrease in net loss was primarily the result of the decrease in other expense and a $169,000 deferred tax benefit amount recognized in the third quarter of 2011.
For the first nine months of 2011, net loss increase 22%, which primarily reflects the decrease in the deferred tax benefits recognized by the Company between the two periods.
LIQUIDITY AND CAPITAL RESOURCES
The Company’s cash flows and other key indicators of liquidity are summarized as follows:
|
As Of And For The Period Ended:
|
||||||||||||
|
September 30, 2011
|
September 30, 2010
|
% change vs. 2010 | ||||||||||
|
Cash flows from:
|
||||||||||||
|
Operating activities
|
$ | (2,017,000 | ) | $ | (1,261,000 | ) | -60 | % | ||||
|
Investing activities
|
(462,000 | ) | (2,530,000 | ) | 82 | % | ||||||
|
Financing activities
|
(537,000 | ) | 3,751,000 | -114 | % | |||||||
|
Working capital
|
(297,000 | ) | (329,000 | ) | 17 | % | ||||||
|
Current ratio
|
.93 | .91 | 3 | % | ||||||||
|
Cash
|
$ | 1,071,000 | $ | 408,000 | 163 | % | ||||||
|
Funds Available from Open Credit Facilities
|
$ | 310,000 | $ | 1,131,000 | -73 | % | ||||||
|
Debt (excluding unamortized debt discount and capitalized Leases)
|
$ | 4,475,000 | $ | 3,569,000 | 24 | % | ||||||
Operating Cash Flow
– During the first nine months of 2011, the Company used approximately $2,017,000 of cash for operations, a 60% increase from our use of cash for operations in 2010, which was primarily due to the Company’s operating losses along with a significant payment of the Company’s accounts payables and accrued expenses and an increase in inventory at the Company’s packaging division.
Investing Cash Flow
–
During the first nine months of 2011, the Company used $462,000 of cash for investing in equipment at its plastic division and as a down payment for the acquisition of the Company’s packaging division building.
27
Financing Cash Flows
– The Company used a net of $537,000 of cash for financing activities including
payments under debt and capilalized lease obligations. In addition, the Company paid $240,000 in accrued placement agent in January 2011 relating to the sale of equity which had occurred in December 2010.
Future Capital Needs
- As of September 30, 2011, the Company had approximately $1,071,000 in cash and up to $310,000 available under a revolving credit line and $397,000 under an equipment line at its packaging subsidiary. As of September 30, 2011, the Company had a working deficit of $297,000 which is primarily due to approximately $297,000 of newly added short-term debt associated with the Company’s purchase of its packaging subsidiary’ building during the third quarter. In addition, the Company’s working capital position reflects an increase in inventory at its packaging division for anticipated sales in the fourth quarter, that when completed, will result in an improvement in working capital. The Company believes that its current cash resources and credit line resources provide it sufficient resources in order to fund its operations and meet its obligations for at least the next twelve months, as the Company currently expects to experience significantly reduced operating cash requirements in the final quarter of 2011 due to the expected increase in sales at its packaging division that the Company has typically realized during the last quarter of the year. The Company believes that an increase in sales will allow the Company to turn its inventory into sales and resulting cash to free up cash availability under its line of credit as well as improve its working capital position. However, if expected revenues in the last quarter of 2011 or for the first quarter of 2012 do not materialize and if the Company cannot generate sufficient cash from its operations in the future, the Company may need to raise additional funds in order to fund its working capital needs and pursue its growth strategy. However, there is no guarantee we will be able to raise such funds if necessary.
We do not have any off-balance sheet arrangements that have, or are reasonably likely to have, an effect on our financial condition, financial statements, revenues or expenses.
Critical Accounting Policies and Estimates
As of September 30, 2011, our critical accounting policies and estimates have not changed materially from those set forth in our Annual Report on Form 10-K and Form 10-K/A for the year ended December 31, 2010.
Evaluation of Disclosure Controls and Procedures
Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of our disclosure controls and procedures, as such term is defined under Rule 13a-15(e) and Rule 15d-15(e) promulgated under the Securities Exchange Act of 1934, as amended, as of September 30, 2011. Based on this evaluation, our principal executive officer and principal financial officer have concluded that, based on the material weaknesses discussed below, our disclosure controls and procedures were not effective to ensure that information required to be disclosed by us in reports filed or submitted under the Securities Exchange Act were recorded, processed, summarized, and reported within the time periods specified in the Securities and Exchange Act Commission’s rules and forms and that our disclosure controls are not effectively designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act is accumulated and communicated to management, including our principal executive officer and principal financial officer, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In connection with management’s assessment of our internal control over financial reporting described above, management has identified the following material weaknesses in the Company’s internal control over financial reporting as of September 30, 2011:
We did not maintain a sufficient complement of qualified accounting personnel and controls associated with segregation of duties. We have two people on staff that perform nearly all aspects of our external financial reporting process, including but not limited to access to the underlying accounting records and systems, the ability to post and record journal entries and responsibility for the preparation of the external financial statements. This creates certain incompatible duties and a lack of review over the financial reporting process that would likely fail to detect errors in spreadsheets, calculations, or assumptions used to compile the financial statements and related disclosures as filed with the Securities and Exchange Commission (“SEC”). Specifically, we determined that our controls over the preparation, review and monitoring of the financial statements were ineffective to provide reasonable assurance that financial disclosures agree with appropriate supporting detail, calculations or other documentation. These control deficiencies could potentially result in a material misstatement to our interim consolidated financial statements that may not be prevented or readily detected.
Controls associated with identifying and accounting for complex and non-routine transactions in accordance with U.S. generally accepted accounting principles were ineffective. The Company identified an error in the Company’s accounting treatment relating to the deferred tax liability created as a result of an acquisition in the first quarter of 2010 which resulted in a restatement described in Note 10 to these interim consolidated financial statements. Management believes that this error constitutes a material weakness in the design of the Company’s internal control over financial reporting in the area of accounting for income taxes and has begun to take the following steps to remediate the deficiency:
|
|
•
|
develop and implement additional procedures to increase the level of review, evaluation and validation of the Company’s valuation of deferred tax assets; and
|
|
•
|
increase the level of knowledge among Company employees in the area of accounting for income taxes.
|
28
Plan for Remediation of Material Weaknesses
In response to the identified material weaknesses, management, with oversight from the Company’s audit committee, plans to review our control environment and to evaluate whether cost effective solutions are available to remedy the identified material weaknesses by expanding the resources available to the financial reporting process. In June 2011, we hired a staff accountant to assist in the financial reporting process and to reduce the lack of segregation of duties weakness discussed above and expect that such person will be able to increase their involvement and capability in the financial reporting process to the extent necessary to overcome the segregation of duties issues in the near future.
Changes in Internal Control over Financial Reporting
There were no changes in our internal controls over the financial reporting during our second fiscal quarter ending September 30, 2011 that have materially affected, or are reasonably likely to materially effect, our internal control over financial reporting.
OTHER INFORMATION
On August 1, 2005, the Company commenced a suit in the European Court of First Instance in Luxembourg against the ECB alleging patent infringement by the ECB and claimed unspecified damages (the “ECB Litigation”). We brought the suit in the European Court of First Instance in Luxembourg. We alleged that all Euro banknotes in circulation infringe the Company European Patent 0 455 750B1 which covers a method of incorporating an anti-counterfeiting feature into banknotes or similar security documents to protect against forgeries by digital scanning and copying devices. In 2006, the Company received notices that the ECB had filed separate claims in each of the United Kingdom, The Netherlands, Belgium, Italy, France, Spain, Germany, Austria and Luxembourg courts seeking the invalidation of the Patent. Proceedings were commenced before each of the national courts seeking revocation and declarations of invalidity of the Patent. On August 20, 2008, the Company entered into an agreement with Trebuchet Capital Partners, LLC (“Trebuchet”) under which Trebuchet agreed to pay substantially all of the litigation costs associated with validity proceedings in eight European countries relating to the Patent. The Company provided Trebuchet with the sole and exclusive right to manage infringement litigation relating to the Patent in Europe, including the right to initiate litigation in the name of the Company, Trebuchet or both and to choose whom and where to sue, subject to certain limitations set forth in the Trebuchet Agreement. In consideration for Trebuchet's funding obligations, the Company assigned and transferred a 49% interest in the Company's rights, title and interest in the Patent to Trebuchet which allows Trebuchet to have a separate and distinct interest in and share of the Patent, along with the right to sue and recover in litigation, settlement or otherwise and to collect royalties or other payments under or on account of the Patent. In addition, the Company and Trebuchet agreed to equally share all proceeds generated from litigation relating to the Patent, including judgments and licenses or other arrangements entered into in settlement of any such litigation. On July 7, 2011, Trebuchet and the Company entered into a series of agreements wherein, Trebuchet effectively ended its ongoing participation in the ECB litigation, except for continuing involvement in the final settlement of fees that may become payable as a result of the infringement case in the Netherlands described below. The original agreement with Trebuchet will remain in effect until Trebuchet makes any and all final payments that may become due in the Netherland infringement case.
On March 26, 2007, the High Court of Justice, Chancery Division, Patents Court in London, England ruled that the Patent was deemed invalid in the United Kingdom, and on March 19, 2008 this decision was upheld on appeal. As a result of these decisions, the Company paid the ECB costs for both court cases in the amount of ₤356,490. On March 27, 2007 the Bundespatentgericht of the Federal Republic of Germany ruled that the German part of the Patent was valid, having considered the English Court’s decision. However, on July 6, 2010, the Company was notified that the German Court had reversed the ruling on appeal and the Patent was deemed invalid in Germany. The Court of First Instance in Luxembourg ruled on September 5, 2007 that it does not have jurisdiction to rule on the patent infringement claim. On January 9, 2008 the French Court held that the Patent was invalid in France and on March 10, 2010, this decision was upheld on appeal. On March 12, 2008 the Dutch Court ruled that the Patent was valid in the Netherlands. However, on December 21, 2010 the Dutch Court reversed the ruling on appeal and the Patent was deemed invalid in the Netherlands. On November 3, 2009, the Belgium Court held that the Patent was invalid in Belgium. On November 17, 2009, the Austrian Court held that the Patent was invalid in Austria. On March 24, 2010 the Spanish Court ruled that the Patent was valid. The decision is being appealed by the ECB. In July 2010, the Company was notified that the Italian Court deemed the patent invalid. The decision was not appealed.
29
In certain jurisdictions in the ECB Litigation, the losing party is responsible for the other party’s legal fees, subject to court approval. The Company paid a total of ₤356,490 to the ECB for the United Kingdom case. Trebuchet paid for the costs reimbursements due, if any, for all of the other jurisdictions involved, except for approximately €156,000 for the Germany case and approximately €175,000 for the Netherlands case, which were still due as of September 30, 2010. In July 2011, Trebuchet transferred funds to the Company for disbursement of these amounts, which the Company has recorded as accrued liabilities. In addition, the ECB formally requested the Company to pay attorneys and court fees for the Court of First Instance case in Luxembourg in the amount of €93,752 which, unless the amount is settled will be subject to an assessment procedure that has not been initiated. The Company will accrue the assessed amount, if any, as soon as it is reasonably estimable.
On February 18, 2010, Trebuchet, on behalf of the Company, filed an infringement suit in the Netherlands against the ECB and two security printing entities with manufacturing operations in the Netherlands, Joh. Enschede Banknotes B.V and Koninklijke Joh. Enschede B.V. Upon determination on December 21, 2010, that the patent was invalid in the Netherlands, the infringement case was terminated by Trebuchet. Trebuchet will be responsible for costs reimbursement associated with the case, if any, when determined by the Dutch Court.
On October 24, 2011 the Company initiated a law suit against Coupon.com Incorporated (“Coupons.com”). The suit was filed in the United States District Court, Western District of New York, located in Rochester, New York. Coupons.com is a Delaware corporation having its principal place of business located in Mountain View, California.
In the Coupons.com suit, the Company alleges breach of contract, misappropriation of trade secrets, unfair competition and unjust enrichment, and is seeking in excess of $10 million in money damages from Coupons.com for those claims.
A summary of the factual basis for the law suit is as follows. The parties executed a Mutual Non-Disclosure Agreement (the “Coupons NDA”) in February 2005. Thereafter, in July 2006, an employee of the Company traveled to California to meet with Coupons.com executives. Pursuant to the Coupons NDA, the employee provided Coupons.com with discs containing numerous proprietary technologies owned by the Company, including its “Blockout” technology, a trade secret. The Blockout technology disc contained a graphic file with anti-copy pattern and color features (the “Block-Out File”), and was delivered as a potential solution for preventing counterfeiting of coupons. The Block-Out File was constructed by the use of technology that is proprietary and confidential to the Company (the “Block-Out File Technology”) and, when placed onto an image, will render a print-out of an image unable to be copied or scanned by electronic devices. In August 2010, the Company learned that Coupons.com was using its Block File Technology on its coupons, and had commercialized the Block-Out File Technology in violation of the Coupons NDA. Upon information and belief, Coupons.com has utilized the Block-Out File Technology on hundreds of millions of coupons, and realized revenues and profits in the millions of dollars. Coupons.com has never paid the Company for the use of the Block-Out File, nor has the Company ever granted Coupons.com the right to commercial use of the Block-Out file. The Company alleges that the unauthorized use of the Block-Out File Technology by Coupons.com has been intentional, willful, malicious and in bad faith.
There are no other material pending legal proceedings to which the Company or any of its subsidiaries is a party or of which any of its property is subject, other than ordinary routine litigation incidental to the Company’s business.
None
None
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Item 31.1
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Certification of Chief Executive Officer as required by Rule 13a-14 or 15d-14 of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes Oxley Act of 2002.*
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Item 31.2
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Certification of Chief Financial Officer as required by Rule 13a-14 or 15d-14 of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes Oxley Act of 2002 *
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Item 32.1
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Certification of Chief Executive Officer as required by 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes Oxley Act of 2002.
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Item 32.2
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Certification of Chief Financial Officer as required by 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes Oxley Act of 2002.
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| 101 ** | The following materials from our Quarterly Report on Form 10-Q for the quarter ended September 30, 2011 formatted in XBRL (eXtensible Business Reporting Language): (i) Consolidated Balance Sheets, (ii) Consolidated Statements of Operations, (iii) Consolidated Statements of Cash Flows, and (iv) related notes to these financial statements, tagged as blocks of text. |
* Filed herewith.
** Furnished herewith
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30
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
| DOCUMENT SECURITY SYSTEMS, INC. | |||||
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November 14, 2011
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By:
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/s/ Patrick White
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Patrick White
Chief Executive Officer
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November 14, 2011
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By:
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/s/ Philip Jones
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Philip Jones
Chief Financial Officer
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31
TABLE OF CONTENTS
Part I Financial InformationItem 1 - Financial StatementsItem 2 - Management's Discussion and Analysis Of Financial Condition and Results Of OperationsItem 4 - Controls and ProceduresPart IIItem 1 - Legal ProceedingsItem 2 - Unregistered Sales Of Equity Securities and Use Of ProceedsItem 3 - Defaults Upon Senior SecuritiesItem 4 - Other InformationItem 5 - Exhibits