<PAGE>
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-QSB
[X] Quarterly Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For Period Ended September 30, 2000
[ ] Transition Report Pursuant to Section 13 or 15 (d) of the Securities
Exchange Act of 1934
For the transition period from ___________ to ___________
Commission File Number 00-23527
eSoft, Inc.
------------
(Exact name of small business issuer as specified in its charter)
DELAWARE 84-0938960
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(State or other jurisdiction (IRS Employer ID Number)
of incorporation or organization)
295 Interlocken Boulevard, #500
Broomfield, CO 80021
(Address of Principal Executive Offices)
(303) 444-1600
(Issuer's Telephone Number, Including Area Code)
----------------------------------------------------------------
(Former name, former address and former fiscal year,
if changed since last report)
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 / /
Transitional Small Business Disclosure format (check one):
YES / / NO /X/
The number of shares outstanding of the Registrant's $0.01 par value common
stock on November 6, 2000 was 15,458,407.
<PAGE>
eSOFT, INC. AND SUBSIDIARIES
TABLE OF CONTENTS
<TABLE>
<CAPTION>
PART I FINANCIAL INFORMATION Page
----
<S> <C>
Item 1. Consolidated Financial Statements 3 - 11
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 12 - 18
PART II OTHER INFORMATION 19 - 22
</TABLE>
2
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PART I - FINANCIAL INFORMATION
ITEM 1 - FINANCIAL STATEMENTS
eSOFT, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
<TABLE>
<CAPTION>
DECEMBER 31, SEPTEMBER 30,
1999 2000
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<S> <C> <C>
ASSETS
CURRENT ASSETS
Cash and cash equivalents $ 8,576,055 $ 22,054,963
Available-for-sale securities -- 1,402,500
Accounts receivable:
Trade, less allowances for doubtful accounts
of $310,453 and $585,062, respectively 1,454,471 1,182,701
Other 912,500 1,559,910
Inventories 672,691 413,513
Prepaid expenses and other 158,261 311,358
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Total current assets 11,773,978 26,924,945
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PROPERTY AND EQUIPMENT
Computer equipment 718,122 1,549,469
Furniture and equipment 326,092 512,837
Automobile -- 70,185
Leasehold improvements 176,314 211,023
Accumulated depreciation (660,904) (1,013,320)
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Net property and equipment 559,624 1,330,194
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OTHER ASSETS
Capitalized software costs, net of accumulated amortization
of $481,758 and $954,978, respectively 702,417 229,197
Deferred financing costs 283,215 195,992
Other assets 39,557 78,912
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Total other assets 1,025,189 504,101
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TOTAL ASSETS $ 13,358,791 $ 28,759,240
============ ============
</TABLE>
The accompanying notes are an integral part of the
consolidated financial statements.
3
<PAGE>
eSOFT, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
<TABLE>
<CAPTION>
DECEMBER 31, SEPTEMBER 30,
1999 2000
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<S> <C> <C>
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES
Accounts payable $ 831,496 $ 759,980
Deferred revenue 289,590 796,008
Accrued expenses:
Payroll and payroll taxes 185,983 420,747
Marketing -- 250,530
Facility closure cost -- 400,000
Other 454,815 612,470
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Total current liabilities 1,761,884 3,239,735
LONG TERM LIABILITIES
Convertible debentures 1,198,254 12,736,220
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Total liabilities 2,960,138 15,975,955
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STOCKHOLDERS' EQUITY
Common stock, par value $.01 per share;
Authorized 100,000,000 shares; 14,289,075 and
15,456,008 issued and outstanding, respectively 142,890 154,560
Additional paid-in capital 24,999,820 38,234,152
Subscriptions receivable (39,704) (373)
Accumulated other comprehensive income -- (378,000)
Accumulated deficit (14,704,353) (25,227,054)
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Total stockholders' equity 10,398,653 12,783,285
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TOTAL LIABILITIES AND
STOCKHOLDERS' EQUITY $ 13,358,791 $ 28,759,240
============ ============
</TABLE>
The accompanying notes are an integral part of the
consolidated financial statements.
4
<PAGE>
eSOFT, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
<TABLE>
<CAPTION>
FOR THE NINE MONTHS ENDED FOR THE THREE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
1999 2000 1999 2000
------------ ------------ ------------ ------------
<S> <C> <C> <C> <C>
REVENUES:
Product $ 5,504,423 $ 5,602,180 $ 1,927,872 $ 1,107,277
Services 536,287 1,363,545 306,000 127,545
------------ ------------ ------------ ------------
Total revenues 6,040,710 6,965,725 2,233,872 1,234,822
------------ ------------ ------------ ------------
COST OF GOODS SOLD:
Product 2,688,700 2,861,334 786,007 469,477
Services 73,228 263,644 73,228 98,142
------------ ------------ ------------ ------------
Total cost of goods sold 2,761,928 3,124,978 859,235 567,619
GROSS PROFIT 3,278,782 3,840,747 1,374,637 667,203
------------ ------------ ------------ ------------
EXPENSES:
Sales and marketing expense 4,836,333 7,531,809 1,033,505 3,846,709
General & administrative expense 5,002,825 3,936,927 1,515,914 1,688,340
Engineering expense 1,047,163 1,871,323 332,074 848,306
Software amortization costs 125,479 473,220 41,826 41,229
Research and development expense 493,594 775,574 137,885 294,109
------------ ------------ ------------ ------------
Total Expenses 11,505,394 14,588,853 3,061,204 6,718,693
------------ ------------ ------------ ------------
Loss from operations (8,226,612) (10,748,106) (1,686,567) (6,051,490)
------------ ------------ ------------ ------------
OTHER INCOME (EXPENSE):
Realized gain 109,895 -- -- --
Interest income 40,648 683,310 6,518 377,666
Interest expense (283,296) (457,905) (223,306) (185,141)
Other 10,180 -- 95,063 --
------------ ------------ ------------ ------------
Total Other Income (Expense) (122,573) 225,405 (121,725) 192 ,525
------------ ------------ ------------ ------------
NET LOSS $ (8,349,185) $(10,522,701) $ (1,808,292) $ (5,858,965)
============ ============ ============ ============
BASIC AND DILUTED NET LOSS PER COMMON
SHARE $ (.81) $ (.70) $ (.17) $ (.38)
============ ============ ============ ============
BASIC AND DILUTED WEIGHTED AVERAGE SHARES
OUTSTANDING 10,302,233 15,005,869 10,751,198 15,428,747
============ ============ ============ ============
</TABLE>
The accompanying notes are an integral part of the
consolidated financial statements.
5
<PAGE>
eSOFT, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(UNAUDITED)
<TABLE>
<CAPTION>
Accumulated Total
Common Stock Additional Other Stockholders'
---------------------- Paid-in Subscriptions Comprehensive Accumulated Equity
Shares Amount Capital Receivable Income Deficit (Deficit)
---------- --------- ----------- ------------- ------------- ------------- -------------
<S> <C> <C> <C> <C> <C> <C> <C>
BALANCE, January 1, 2000 14,289,075 $142,890 $24,999,820 $ (39,704) -- $(14,704,353) $ 10,398,653
Exercise of warrants
and options 523,325 5,234 702,280 -- -- -- 707,514
Issuance of common
stock for bonus 2,812 28 38,460 -- -- -- 38,488
Collection of notes
receivable for exercise
of options and warrants -- -- -- 39,331 -- -- 39,331
Issuance of common
stock pursuant to
private placement 640,796 6,408 12,493,592 -- -- -- 12,500,000
Unrealized loss on
available-for-sale
securities -- -- -- -- (378,000) -- (378,000)
Net loss for the nine months
ended September 30, 2000 -- -- -- -- -- (10,522,701) (10,522,701)
---------- -------- ----------- ---------- ------------- ------------ ------------
BALANCE, September 30, 2000 15,456,008 $154,560 $38,234,152 $ (373) $ (378,000) $(25,227,054) $ 12,783,285
========== ======== =========== ========== ============= ============ ============
</TABLE>
The accompanying notes are an integral part of the
consolidated financial statements.
6
<PAGE>
eSOFT, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
<TABLE>
<CAPTION>
FOR THE NINE MONTHS
ENDED SEPTEMBER 30,
1999 2000
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<S> <C> <C>
CASH FLOW FROM OPERATING ACTIVITIES
Net loss from operations $ (8,349,185) $(10,522,701)
Adjustments to reconcile net loss to net cash
used in operating activities
Depreciation & software amortization 217,394 825,636
Provision for losses on accounts receivable 151,639 555,000
Amortization of discount on investments (8,459) --
Amortization of debt discounts and financing costs 204,150 344,690
Amortization of warrant valuation granted for
prepaid consulting 101,767 --
Issuance of compensatory options 40,420 --
Issuance of consultant options 45,383 --
Issuance of common stock to brokers 290,625 --
Issuance of common stock for bonuses -- 38,488
Proceeds from sale of trading securities 292,634 --
Gain on sale of fixed assets (450) --
Interest income on subscription receivable (1,009) --
Realized gain from sale of trading securities (109,445) --
Changes in operating assets and liabilities:
Accounts receivable - trade (321,678) (283,230)
Other accounts receivable (306,000) (647,410)
Inventories 783,679 259,178
Prepaid expenses and other (2,231) (153,096)
Other assets (25,945) (39,355)
Accounts payable 416,266 (71,517)
Accrued expenses 26,120 1,042,949
Deferred revenue 23,296 506,418
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Net cash used in operating activities (6,531,029) (8,144,950)
------------ ------------
CASH FLOW FROM INVESTING ACTIVITIES
Proceeds from sale of investments 2,000,000 --
Proceeds from sale of assets 37,296 --
Purchase of available-for-sale securities -- (1,780,500)
Purchase of property and equipment (141,873) (1,122,986)
Restricted cash 85,000 --
</TABLE>
7
<PAGE>
<TABLE>
<S> <C> <C>
Additions to capitalized software (2,650) --
------------ ------------
Net cash provided by (used in) investing activities 1,977,773 (2,903,486)
------------ ------------
CASH FLOW FROM FINANCING ACTIVITIES
Proceeds from exercise of options and warrants and sale of
common stock 1,363,054 13,207,513
Proceeds from stock subscription receivable 56,487 39,331
Proceeds from issuance of convertible debt 4,950,000 11,280,500
Debt offering costs paid (538,953) --
Proceeds from short term debt 114,719 --
Payments on short term debt (159,151) --
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Net cash provided by financing activities 5,786,156 24,527,344
INCREASE IN CASH 1,232,900 13,478,908
CASH: BEGINNING OF PERIOD 732,384 8,576,055
------------ ------------
CASH: END OF PERIOD $ 1,965,284 $ 22,054,963
============ ============
SUPPLEMENTAL DISCLOSURE OF NON-CASH FINANCING ACTIVITIES:
Cash paid for interest -- $ 75,754
Common stock issued for subscriptions receivable $ 209,034 --
Warrants issued in connection with debt offering $ 2,466,633 --
</TABLE>
The accompanying notes are an integral part of the
consolidated financial statements.
8
<PAGE>
eSOFT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. Basis of Presentation
The consolidated interim financial statements include the accounts of
eSoft, Inc. and its two wholly-owned subsidiaries, Apexx Technology, Inc.
("Apexx") and Technologic, Inc. ("Technologic"), (collectively "eSoft" or
the "Company") and have been prepared by the Company, without audit,
pursuant to the rules and regulations of the Securities and Exchange
Commission. Certain information and footnote disclosures normally included
in financial statements prepared in accordance with generally accepted
accounting principles have been condensed or omitted pursuant to such rules
and regulations, although the Company believes that the disclosures are
adequate to make the information presented not misleading.
These statements reflect all adjustments, consisting of normal
recurring adjustments, which in the opinion of management, are necessary
for fair presentation of the information contained therein. It is suggested
that these consolidated financial statements be read in conjunction with
the audited financial statements and notes thereto included in the
Company's Annual Report on Form 10-KSB for the year ended December 31,
1999. The Company follows the same accounting policies in preparation of
interim reports.
Results of operations for the interim periods are not necessarily
indicative of annual results.
2. Account Receivable - Trade
The following information summarizes accounts receivable:
<TABLE>
<CAPTION>
DECEMBER 31, SEPTEMBER 30,
1999 2000
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<S> <C> <C>
Accounts Receivable $ 1,764,924 1,767,763
Allowance for doubtful accounts (310,453) (585,062)
----------- -----------
$ 1,454,471 $ 1,182,701
=========== ===========
</TABLE>
The Company did not have any customers which accounted for 10% or more
of the sales through the nine months ending September 30, 2000, or which
individually had outstanding balances which accounted for more than 10% of
the total outstanding accounts receivable balance as of September 30, 2000.
International sales represented approximately 25% of revenue for the nine
months ending September 30, 2000, and approximately 42% of outstanding
accounts receivable at September 30, 2000.
The Company with regard to its foreign sales does not take the risk of
foreign currency fluctuation. All sales are designated as payment in US
denominated funds at the time of sale.
9
<PAGE>
eSOFT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
3. Accounts Receivable - Other
During 1999, the Company entered into an agreement with Intel
Corporation, a stockholder of the Company, to jointly architect and design
certain software applications. The agreement grants the stockholder of the
Company the right to use or sell the stockholder's products, which include
the Company's software, as well as the right to modify the software and
related products. The Company has recognized revenue of $2,500,000 to date
in accordance with the percentage of completion method of which $1,132,500
is due the Company at September 30, 2000. The Company has also entered into
other various licensing and engineering development agreements during the
year, of which the receivable balance at September 30, 2000 is $427,410.
4. Convertible debentures
In September 1999, the Company issued $2,000,000 of unsecured 5%
Convertible Debentures at a 2.5% discount, due June 10, 2002,
("Debentures"), along with stock purchase warrants ("Warrants") with a
right to purchase an aggregate of 511,182 shares of common stock at an
exercise price of $4.4994 per share. The principal amount of the Debenture
is convertible at any time at the investor's option into a fixed number of
shares of eSoft common stock at $3.9125 per share, subject to certain
anti-dilution provisions and adjustments. The Company has the ability,
under certain circumstances, to obligate the investor to convert the
Debentures into common stock and to exercise the Warrants. The investor has
the option to purchase an additional $3 million of debentures, together
with warrants to purchase shares of common stock of the Company equal to
the quotient obtained by dividing $3 million by the conversion price for
the debentures with an exercise price of 115% of the debenture conversion
price. The additional $3 million of debentures would be convertible at the
lower of (i) the Company's then current market price or (ii) $5.50, but in
no event less than $3.9125 per share. The Debentures are manditorily
convertible if the average per share market value over thirty consecutive
trading days exceed 200% of the exercise price of the Warrants. The Black
Scholes value of the Warrants issued of $846,607 plus an initial discount
of $50,000 related to the aforementioned 2.5% discount, for a total of
$896,607, was recorded as an original issue discount and is being amortized
over the term of the Debentures and recorded as non-cash interest expense.
At September 30, 2000, the balance of the unamortized original issue
discount was $556,983. The balance of the Debentures at September 30, 2000,
of $1,443,017 represents the original face value of the remaining
outstanding Debentures of $2,000,000 less the balance of the unamortized
discount of $556,983.
In September 2000, the Company entered into an Amendment of the Stock
and Warrant Purchase and Investor Rights Agreement dated April 26, 2000
whereby the Company issued $12,500,000 of unsecured 7% Convertible
Debentures due September 15, 2004 ("September 2000 Debentures") and stock
purchase warrants ("September 2000 Warrants") with a right to purchase an
aggregate of 600,000 shares of common stock, par value $.01 per share, at
an exercise price of $11.00. The principal amount of the September 2000
Debentures is convertible at any time at the investor's
10
<PAGE>
eSOFT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
option into a fixed number of shares of eSoft common stock at fair market
value, but not less than $11.00 or more than $19.507 per share. The
September 2000 Warrants shall vest and become exercisable based upon
certain performance milestones as indicated in the agreement. At this time,
management has estimated the fair value of the September 2000 Warrants to
be nominal. However, the Company will be required to remeasure the
September 2000 Warrants at each reporting date. The fair value of the
September 2000 Warrants will be reflected in stockholders' equity, and
changes in the fair value of these warrants will be reflected in the
current period as a charge to earnings. In addition, the Company agreed
to purchase 30,000 shares of Gateway common stock for $3,000,000, a
$1,219,500 premium over the fair market value of the securities on the date
of purchase. The premium paid is recorded as a reduction to the balance of
the September 2000 Debentures and is being amortized over the term of the
debentures and recorded as non-cash interest expense. At September 30,
2000, the balance of the premium was $1,206,797. The balance of the
September 2000 Debentures at September 30, 2000 of $11,293,203 represents
the original face value of the outstanding September 2000 Debentures, of
$12,500,000 less the balance of the unamortized premium of $1,206,797. The
investment in the Gateway common stock is being accounted for as
available-for-sale securities, whereby unrealized gains and losses are
recognized as Other Comprehensive Income, a component of Stockholders'
Equity.
5. Net Loss per Share
Basic loss per share is calculated by dividing the net loss by the
weighted average common shares outstanding during the period. For purposes
of computing diluted earnings per share, dilutive securities are not
included when the effect is anti-dilutive.
Options and warrants to purchase 4,933,140 and 3,789,296 shares of
common stock and notes convertible into zero shares and 511,182 shares were
not included in the computation of diluted earnings per share because their
effect was anti-dilutive for the period ending September 30, 1999, and
2000.
11
<PAGE>
FORWARD-LOOKING STATEMENTS
Statements made in this Form 10-QSB that are not historical or current
facts are "forward-looking statements" made pursuant to the safe harbor
provisions of Section 27A of the Securities Act of 1933, as amended and Section
21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act").
These statements often can be identified by the use of terms such as "may,"
"will," "expect," "believes," "anticipate," "estimate," "approximate" or
"continue," or the negative thereof. The Company intends that such
forward-looking statements be subject to the safe harbors for such statements.
The Company wishes to caution readers not to place undue reliance on any such
forward-looking statements, which speak only as of the date made. Any
forward-looking statements represent management's best judgment as to what may
occur in the future. However, forward-looking statements are subject to risks,
uncertainties and important factors beyond the control of the Company that could
cause actual results and events to differ materially from historical results of
operations and events and those presently anticipated or projected. These
factors include adverse economic conditions, entry of new and stronger
competitors, inadequate capital, unexpected costs, failure to gain product
approval in foreign countries and failure to capitalize upon access to new
markets. Additional risks and uncertainties which may affect forward-looking
statements about the Company's business and prospects include the possibility
that a competitor will develop a more comprehensive or less expensive solution,
delays in market awareness of eSoft and its products, possible delays in eSoft's
marketing strategy, which could have an immediate and material adverse effect by
placing eSoft behind its competitors. Additional risks and uncertainties are
described in the Company's most recently filed Annual Report on Form 10-KSB for
the fiscal year ended December 31, 1999. The Company disclaims any obligation
subsequently to revise any forward-looking statements to reflect events or
circumstances after the date of such statement or to reflect the occurrence of
anticipated or unanticipated events.
ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Through the end of the quarter, the company's primary legacy products were
targeted at providing all of the components an organization needs to develop,
manage, and monitor its Intranet, external web presence and Internet-based
applications. These legacy products included the TEAM Internet all-in-one
Internet server, the Interceptor firewall and the InstaGate Internet server. In
October of 2000, we introduced the InstaGate EX, which has been under
development for several quarters. InstaGate EX combines the best of breed
features from the legacy offerings as well as new, market-driven features and
functions. The InstaGate EX is a firewall with full virtual private network or
VPN features.
The new product is a highly modular, flexible and scalable Linux-based
architecture specifically designed to address the evolving requirements of
small-to-medium enterprises who establish a broadband connection to the
Internet. New applications and upgrades, called SoftPaks-TM-, are available
through software downloads as businesses grow and new applications are
developed. SoftPaks include remote access service, anti-virus, Web site
filtering and reporting with new SoftPaks being added continually. SoftPaks are
applications that have been developed by eSoft or in combination with third
parties. SoftPaks are licensed to the end user on a monthly or annual
subscription basis and form a recurring revenue stream for eSoft and our channel
partners. The
12
<PAGE>
SoftPaks, as well as software updates, firewall enhancements and more are
distributed via a unique process called the SoftPak Director. SoftPak Director
allows an end user to utilize a browser-based interface to evaluate and select
SoftPaks. The value to channel partners is the elimination of truck rolls to
implement new features and functions. Additionally, SoftPaks can be added
without requiring new boxes, thereby eliminating the need for hardware swaps and
downtime typically associated with new applications and services.
In addition, the InstaGate EX creates an incremental, recurring revenue
stream for eSoft and its partners. We will continue to sell this product through
the reseller and ISP channels, with the ability to bill the end users directly
upon the downloading of the SoftPaks-TM-. Research from Frost & Sullivan shows
the firewall market growing at a compound annual rate of 38.7 percent in number
of units and 25.7 percent in revenue between 1999 and 2006, reaching a total
market size of $2.7 billion by 2006. The research attributes this steady growth
to the convergence of VPN and firewall technologies, the growing number of
companies linking their networks to the Internet, remote access connectivity for
branch offices and mobile users, and growing concern over network hacking.
Our products target small-to-medium sized businesses that typically have
between ten and two hundred and fifty desktop computers connected to a local
area network, or LAN. The availability of low cost, high speed bandwidth,
through technologies such as cable modems and digital subscriber line or DSL is
driving small-to-medium sized business demand for full time Internet access
across their LANs, which in turn creates the need to effectively protect the
corporate assets and data through the implementation of a firewall. The SMB
segment comprises the largest portion of the installed local area networks and
increasingly recognizes the importance of the Internet to grow their business
and improve productivity. Internet penetration has been estimated to increase
from 54.9% of small business PC owners in 1998 to 68.5% in 2002. The number of
small businesses online is expected to increase from 3.2 million in 1998 to 4.6
million in 2002.
During 1999, we launched our redphish-TM- program, which is targeting the
licensing of our InstaGate EX technology, both hardware and software, along with
certain customization or modifications from our professional engineering
services, in order to create highly specialized or customized offerings for
hardware manufacturers, networking companies and broadband service providers to
integrate into their own offerings. This program allows us to leverage our
research, development and product offerings, along with our partners' expertise
in hardware design, manufacturing and distribution. We believe that the redphish
program greatly improves our distribution capabilities and helps to drive
product requirements, and that it enables us to gain time to market advantages
in developing new software features, as well as building out our distribution
network.
Our redphish program provides a vehicle through which major hardware
manufacturers can deliver customized Internet security appliance and
connectivity solutions to their small and medium-sized customers. Delivered
initially as an Internet security appliance, this platform can later serve as a
foundation for additional products and services, such as enhanced e-mail,
virtual private networking, and business-to-business applications, as well as
any SoftPaks provided by eSoft. Our program is based on revenue sharing, which
provides incentive at every point of the distribution chain. Currently, Gateway
Companies, Inc., 3Com Corporation and Hewlett Packard are actively involved in
pursuing marketing efforts that utilize or bundle eSoft's software or appliance.
Our strategy is to continue to aggressively develop additional redphish
partnerships with key hardware and service providers.
13
<PAGE>
In the second quarter of 2000, we launched our Smart DSL program in three
cities, which targets small to medium sized businesses. This program focuses on
a subscription-based model that minimizes the cash outlay requirements for our
customers and generates a more predictable recurring revenue stream associated
with each sale. Previously, most of our product revenue was generated from
one-time product sales. This approach maximized short-term revenue, but made
ongoing revenue predictions difficult. eSoft believes that a subscription-based
pricing model will result in better predictability of future revenue, and will
also better suit the cash flow requirements of our small and medium size
business customers.
Smart DSL bundles broadband local access with the InstaGate EX and
installation, providing a one-stop shopping experience for end user customers
seeking to gain a secure, dedicated connection to the Internet. This eliminates
the historical complications small businesses faced when trying to integrate
many different features, numerous pieces of hardware, several versions of
software and more than one access provider into a DSL solution. It is our
intention to continue bringing to market new product offerings and services that
can contribute to a recurring revenue stream. We will continuously evaluate the
return on investment for SmartDSL and other offerings to determine the optimal
deployment of our resources.
The Company expects to use outside financing for its continued company wide
expansion. We will continue to pursue recurring revenue opportunities, grow our
revenue and customer base and closely manage the operating expenses in order to
extend the availability of our working capital. The Company is targeting
break-even operations in late 2001 through the increase in sales and related
margins, while keeping general and administrative expenses fairly constant.
LIQUIDITY AND CAPITAL RESOURCES
The Company's cash position on September 30, 2000 was $22,055,000, an
increase of $13,479,000 from year end primarily due to the equity and debt
investments by Gateway. The Company's working capital at September 30, 2000 was
$23,685,000, an increase of $13,673,000 from December 31, 1999. Management
anticipates continuing losses in support of its growth initiatives and, thus
expects continued negative cash flow. The Company is increasing efforts to
reduce its accounts receivable balance through more stringent collection efforts
of the current customer base in an attempt to reduce the days sales outstanding.
The Company has analyzed its accounts receivable and adjusted its allowance for
doubtful accounts to $585,000 at September 30, 2000. Other accounts receivable
relate to software development fees and licensing fees from long-term
development contracts, which are due upon completion of certain performance
criteria. The Company has expended $1,123,000 in capital expenditures in 2000,
mainly attributable to additional computers purchased for new employees, a
customer relations management, and leasehold improvements related to additional
space leased. Management believes that its current cash position, the
anticipated cash receipts from receivables, and available sources of additional
capital will be sufficient to meet its working capital needs for the foreseeable
future.
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CASH FLOW
Net cash used in operating activities for the nine months ended
September 30, 2000 was $8,145,000 compared with $6,531,000 for the nine
months ended September 30, 1999, an increase of $1,614,000 for the 2000
period compared to the 1999 period. The Company's net loss at September 30,
2000 was $10,523,000, an increase of $2,174,000 from September 30, 1999. This
increase in net loss was primarily the result of the intensive Smart DSL
business launch during the third quarter of 2000. Other significant expenses
were incurred in relation to the closing of the Atlanta facility in order to
maximize efficiencies. Adding to these increases were the increase in
accounts receivable of $930,000 related to software development and
licensing. Other items impacting the cash used in operating activities during
the nine months ended September 30, 2000 were adjustments of $826,000 for
depreciation and amortization, $555,000 for the provision for losses on
accounts receivable, and $345,000 for amortization of debt discounts and
financing costs. In addition, prepaid expenses increased $153,000,
inventories decreased $259,000, accrued expenses increased $1,043,000 and
deferred revenue increased $506,000.
Net cash used in investing activities for the nine months ended September
30, 2000 was $2,903,000 compared with $1,978,000 provided by investing
activities for the nine months ended September 30, 1999. The decrease in cash of
$4,881,000 for the 2000 period compared to the 1999 period was primarily due to
$1,780,000 invested in Gateway common stock during the third quarter of 2000 and
about $2,000,000 of investments maturing in 1999. In addition, purchases of
property and equipment amounted to about $1,123,000 during 2000.
Net cash provided by financing activities for the nine months ended
September 30, 2000 was $24,527,000 compared with $5,786,000 for the nine months
ended September 30, 1999. The increase of $18,741,000 for the 2000 period
compared to the 1999 period was primarily due to $12,500,000 for the proceeds
from the equity investment by Gateway and $11,281,000 for the net proceeds from
the issuance of convertible debentures to Gateway. In 1999, proceeds of
$4,950,000 were received as a result of the issuance of convertible subordinated
debentures.
RESULTS OF OPERATIONS FOR THREE MONTHS ENDED SEPTEMBER 30, 2000
COMPARED TO THE THREE MONTHS ENDED SEPTEMBER 30, 1999
Quarterly revenues totaled $1,235,000, of which $1,107,000 was related
to product and $128,000 was related to services, versus revenue of $2,234,000
for the comparable quarter in 1999, of which $1,928,000 was related to
product and $306,000 was related to services. In total, revenue decreased
$999,000 or 45% over the comparable quarter in 1999. Product sales decreased
43% for the three months ending September 30, 2000 compared to the three
months ending September 30, 1999. The decrease is due to the transitioning of
sales to a subscription model where revenue is recognized over the life of a
contract as opposed to recognizing all of the revenue up front upon shipment.
International sales accounted for 25% of product revenue in 2000. The
services revenue was generated mainly from engineering fees for development
of software and related licensing fees mainly in connection to agreements
with Gateway Companies, Inc. and 3Com Corporation.
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Gross profit margin in the current quarter was $667,000, which is 54% of
revenues compared to $1,375,000, which is 62% of revenues for the three
months ended September 30, 1999. Gross margin on product was 58% and 59% for
the three months ending September 30, 2000 and 1999, respectively. During the
current quarter, there was a higher concentration of sales of the Instagate
and Interceptor products, which have more favorable margins. Offsetting these
better margins, certain items were sold on auction sites at little above cost
and certain unusable items were sold as scrap. Gross profit margin on product
and services relating to redphish sales has decreased from 76% for the three
months ending September 30, 1999 to 55% for the three months ending September
30, 2000. The decrease is due to the revenue in 1999 being made up of non
recurring engineering fees and licensing fees, which had little costs
associated with them. In 2000, the majority of the redphish revenue is made
up of non recurring engineering fees and product sales.
Operating expenses increased $3,658,000 or 119% from $3,061,000 for the
quarter ending September 30, 1999 to $6,719,000 for the quarter ending
September 30, 2000. Sales and marketing expenses increased $2,813,000 from
$1,034,000 in 1999 to $3,847,000 in 2000. The increase is associated with
lead generation expenses, more intense product marketing efforts, and
marketing efforts and additional salespeople hired in connection with the
start up of Smart DSL. General and administrative expenses increased $172,000
from $1,516,000 in 1999 compared to $1,688,000 for the current quarter. This
increase can be attributed to the third quarter 2000 nonrecurring charge for
the closing of the Atlanta facility. Engineering expenses increased $516,000
from $332,000 in 1999 to $848,000 in 2000. This can be attributed to
additional people hired for domestic technical support and technical support
services being contracted out for our European operations. Furthermore,
services were outsourced for translation of the product into German, Spanish,
French, Chinese, Korean, and Japanese, and there were additional employees
eligible for bonuses. Amortized software development costs total $42,000 for
the third quarter in 1999 and 2000.
Interest expense decreased $38,000 in the three months ended September
30, 2000 from $223,000 in 1999 to $185,000 in 2000. The interest is due to
the interest and discount amortization on the convertible debentures and
amortization of deferred offering costs. Interest income increased $371,000
in the quarter as a result of additional cash on hand related to convertible
debentures issued by Gateway in the beginning of the quarter and an equity
investment by Gateway earlier in the year.
Net loss from operations was $5,859,000 for the three months ended
September 30, 2000, compared to $1,808,000 for the same period in 1999, an
increase in the loss of $4,051,000 over the same period. The net losses are
associated with the increased selling, general and administrative expense
necessary to support its current business strategy. Losses are anticipated to
continue through the current fiscal year due to expenditures in support of
continued growth and market penetration.
RESULTS OF OPERATIONS FOR NINE MONTHS ENDED SEPTEMBER 30, 2000
COMPARED TO THE NINE MONTHS ENDED SEPTEMBER 30, 1999
Revenues for nine months of operations totaled $6,966,000 of which
$5,602,000 was related to product and $1,364,000 was related to services,
compared to revenues of $6,041,000 for the same period in 1999 of which
$5,504,000 was related to product and $536,000 was related to services. This
represents an increase of $925,000 or 15% over the comparable nine month period
in 1999. Product
16
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sales remained relatively flat for the nine months ending September 30, 2000
compared to the nine months ending September 30, 1999. The lack of revenue
growth is mainly due to the transitioning of sales to a subscription model where
revenue is recognized over the life of a contract as opposed to recognizing all
of the revenue up front upon shipment. In 2000, international sales accounted
for 25% of product revenue. Services revenue increased $828,000 or 154% for the
nine months ending September 30, 2000 compared to the nine months ending
September 30, 1999. During 2000, the services revenue was mainly generated from
engineering fees for development of software, and the related licensing fees in
connection with agreements with Intel, Inc., Gateway Companies, Inc., 3Com
Corporation, and Compaq.
Gross profit margin for the nine months ending September 30, 2000 was
$3,841,000, which is 55% of revenues for the nine months ended September 30,
2000 compared to $3,279,000, which is 54% of revenues for the nine months ended
September 30, 1999. The increase is partially due to a higher concentration of
services revenue in 2000, which had margins of about 81%.
Operating expenses increased $3,084,000 or 27% from $11,505,000 for the
first nine months in 1999 to $14,589,000 for the same nine months in the 2000
period. Sales and marketing expenses increased $2,696,000 from $4,836,000 in
1999 to $7,532,000 in 2000. In 2000, there was an extensive marketing
campaign in relation to the launch of Smart DSL. In addition, sales people
were hired in connection with the Smart DSL launch, and in relation to the
expansion of product sales efforts domestically and internationally. General
and administrative expense decreased $1,065,000 from $5,002,000 in the 1999
period compared to total expenses of $3,937,000 in 2000. This decrease can be
attributed to the costs relating to the Apexx and Technologic mergers in
1999, which include filing fees, audit fees, legal fees, banking fees,
consulting fees, and printing fees that did not recur in 2000. Engineering
expenses increased $824,000 from $1,047,000 for the nine months ending
September 1999 to $1,871,000 for the same period in 2000. This increase was
related to additional engineers hired in response to the demand for software
development under the redphish program and increased travel in relation to
these projects. Engineering expenses also increased due to additional people
hired for domestic technical support and technical support services being
contracted out for our European operations. Furthermore, services were
outsourced for translation of the product into German, Spanish, French,
Chinese, Korean, and Japanese, and there were additional employees eligible
for bonuses. Amortized software development costs total $473,000 for the
current year, compared to $125,000 in the 1999 period. This increase is
associated with the life of the software being reevaluated and amortization
being accelerated through June 2000 for certain older versions of software.
Interest expense increased $175,000 for the nine months ended September 30,
2000 from $283,000 in 1999 to $458,000 in 2000. The additional interest is due
to the interest and discount amortization on the convertible subordinated
debentures and amortization of deferred offering costs. Interest income
increased $643,000 for the nine month period due to additional cash on hand
related to convertible debentures issued by Gateway, the equity investment by
Gateway, and the exercise of warrants and options in the fourth quarter of 1999.
Net losses from operations totaled $10,523,000 for the nine months ended
September 30, 2000, compared to a $8,349,000 loss for the same period in 1999,
an increase of $2,174,000 over the same period. The net losses are associated
with the selling, general and administrative expenses necessary
17
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to support its current business strategy. Losses are anticipated to continue
into 2001 due to expenditures in support of continued growth and market
penetration.
Income Taxes
At September 30, 2000, a valuation allowance of 100% of the deferred tax
asset has been recorded, as management of the Company is not able to determine
that it is more likely than not that its deferred tax assets will be realized.
The Company's operating loss carryforwards may be limited under Section 382 of
the Internal Revenue Code.
Other Matters
The Company has reviewed all other recently issued, but not yet adopted,
accounting standards in order to determine their effects, if any, on the results
of operations or financial position of the Company. Based on that review, the
Company believes that none of these pronouncements will have a significant
effect on current or future earnings or operations.
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PART II - OTHER INFORMATION
Item 1. LEGAL PROCEEDINGS
The Company is not currently involved in any litigation other than
routine litigation arising in the ordinary course of business that, if
determined adversely, is not reasonably likely to have a material
adverse effect on the Company.
Item 2. CHANGES IN SECURITIES
Not applicable
Item 3. DEFAULTS UPON SENIOR SECURITIES
Not applicable
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not Applicable
Item 5. OTHER INFORMATION
Not applicable
Item 6. EXHIBITS AND REPORTS ON FORM 8-K
a) Exhibits
27 Financial Data Schedules.
b) Reports on Form 8-K.
On July 19, 2000, the Company filed a Current Report on Form 8-K that
reported a change in independent accountants.
On August 2, 2000, the Company filed a Current Report on Form 8-K that
reported information regarding certain negotiations between the
Company and Gateway Companies, Inc. related to an investment made by
Gateway Companies, Inc. in the Company.
On September 5, 2000, the Company filed a Current Report on Form 8-K
that reported a resolution between the Company and Gateway Companies,
Inc. related to an investment made by Gateway Companies, Inc. in the
Company.
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On September 25, 2000, the Company filed a Current Report on Form 8-K
that reported the completion of the investment of Gateway Companies,
Inc. in the Company and an investment by the Company in Gateway
Companies, Inc.
20
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SIGNATURES
In accordance with the requirements of the Exchange Act, the Registrant caused
this report to be signed on its behalf by the undersigned, thereunto duly
authorized.
Date: November 14, 2000 eSoft, Inc.
/s/ Jeffrey Finn
Jeffrey Finn
President, Chief Executive Officer
Date: November 14, 2000 /s/ Amy Beth Hansman
Amy Beth Hansman
Chief Accounting Officer
21
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Exhibit Index
<TABLE>
<CAPTION>
Exhibit No. Description
----------- -----------
<S> <C>
27.1 Financial Data Schedule
</TABLE>
22
