SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549
FORM 10-KSB
ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 1998. Commission
file number 0-14465.
SONEX RESEARCH, INC.
Incorporated in State of Maryland
23 Hudson Street, Annapolis, Maryland 21401
Telephone Number:(410)266-5556 I.R.S. Employer Identification No. 52-1188993
Securities registered pursuant to Section 12(b) of the Act:
Title of Name of each exchange on
each class which registered
---------- ----------------
None None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $.01 par value
Check whether the Issuer (1) filed all reports required to be filed by Section
13 or 15(d) of the Exchange Act during the preceding 12 months, and (2) has been
subject to such filing requirements for the past 90 days. YES [X] NO [ ]
Check if there is no disclosure of delinquent filers in response to Item 405 of
Regulation S-B in this form, and no disclosure will be contained, to the best of
registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-KSB or any amendment to
this Form 10-KSB. [ X ]
The number of shares outstanding of the Issuer's $.01 par value Common Stock as
of March 31, 1999 was 17,662,518. The aggregate market value of voting stock
held by non-affiliates of the Registrant was $7,368,218 as of March 31, 1999.
Revenues for the year ended December 31, 1998 were $395,213.
Documents Incorporated by Reference: None.
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SONEX RESEARCH, INC. 1998 FORM 10-KSB
ITEM 1. DESCRIPTION OF BUSINESS
The Company
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Sonex Research, Inc. ("Sonex" or the "Company"), incorporated in Maryland in
1980, has developed a patented proprietary technology (the "Sonex Combustion
System", "SCS" or "Ultra Clean Burn(TM) technology") which improves the
combustion of fuel in engines through design modification of the pistons in
large engines or the cylinder heads in small engines. Variations of the
Company's technology have been applied to all types of internal combustion
engines, including those used in personal and commercial vehicles (automobiles,
trucks, buses, boats, motorcycles) as well as engines used in fixed or portable
utility applications (motor generator sets, pumps, chain saws), whether spark
ignited (SI) or compression ignited (CI), carburetted or fuel injected, using
gasoline, diesel, alcohol and/or other fuels.
Management believes that the Company's piston-based emissions reduction enabling
technology for direct injected (DI) diesel engines, which changes only a single
engine component while introducing no additional parts and is self-driven by the
combustion process, can be an alternative to exhaust aftertreatment. Ongoing
demonstration and development programs at various stages of completion with some
of the largest multi-national diesel engine original equipment manufacturers
(OEM's) in the world target engines used in medium and heavy duty trucks. The
Company's goal in such programs is to execute broad agreements with the diesel
engine manufacturers and their piston suppliers for industrial production of SCS
pistons under license from Sonex.
The demonstration process involves many stages, from proof of concept using
screw-assembled prototype pistons fabricated in-house by Sonex and tested by the
engine manufacturer in its laboratories, to working with piston suppliers for
the fabrication of finished pre-production pistons that will be used in field
trials, and durability, manufacturing optimization, and other tests required
before the start of full series production. Tests in OEM engines and in computer
models have shown that the SCS technology for DI turbocharged diesel engines has
the ability to improve combustion and that engines using the Company's
technology emit fewer harmful exhaust emissions, particularly soot, at all
engine speeds.
To date, the Company has completed separate demonstration programs with three of
these manufacturers, and each has verified and accepted that the SCS can
substantially reduce particulate emissions at future NOx (oxides of nitrogen)
levels in a DI turbocharged diesel engine for medium duty trucks while
maintaining fuel consumption and power. The most recent tests conducted by one
of these manufacturers showed that an engine using Sonex-modified pistons along
with EGR would attain future U.S. and European emissions targets when OEM type
production pistons become available. The Company has now reached the next stage
with these programs, that is, optimization of the piston design for the
fabrication of piston prototypes that will be used in field trials and
durability, manufacturing optimization, and other tests required before the
start of full series production. The engine manufacturers have stated that the
SCS benefits could be in lower cost, less complexity and greater reliability.
These three factors are now being addressed by the Company and its customers.
Continued revision of emissions limits, however, has challenged Sonex to produce
piston designs that reduce both NOx and soot, leading to a delay in licensing
negotiations.
The Company also has successfully applied a patented starting system and
modified combustion chamber design to the conversion of reliable, lightweight,
SI, two-stroke, gasoline fueled engines of various sizes used in small, remotely
controlled unmanned aerial vehicles (UAV's) by the military, to start and
operate on JP5/JP8 standard military fuels (also referred to as "heavy fuels").
As heavy fuels are less volatile than gasoline, in addition to the UAV market,
the Company is exploring a wide range of sustained commercial utility engine
applications for its heavy fuel conversion technology to reduce the hazards
associated with the storage of gasoline in buildings and on boats.
Employees
- ---------
As of March 31, 1999, the Company had five full-time employees and engaged the
part-time services of three consultants on a regular basis. The Company has
never experienced a strike or work stoppage, and believes its relations with its
employees are good.
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SONEX RESEARCH, INC. 1998 FORM 10-KSB
Cautionary Statement Regarding Forward-Looking Statements
- ---------------------------------------------------------
Sections of this Annual Report on Form 10-KSB, including but not limited to Item
1 - "Description of Business" and Item 6 - "Management's Discussion and Analysis
of Financial Position and Results of Operations", contain information in the
form of "forward-looking" statements within the meaning of the Private
Securities Litigation Act of 1995 (the "Act"). Such statements are based on
management's expectations, estimates, projections and assumptions. In order to
obtain the benefits of the "safe harbor" provisions of the Act for any such
forward-looking statements, the Company cautions shareholders, investors and
prospective investors about significant factors which, among other things, have
in some cases affected the Company's actual results and are in the future likely
to affect the Company's actual results and cause them to differ materially from
those expressed in any such forward-looking statements.
Overview of SCS Engine Design Modifications
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The SCS for DI diesel engines improves the process of combustion through a
combination of chemical and fluid dynamic effects that occur by modifying the
engine's combustion chamber and the processes occurring within that chamber. SCS
DI diesel designs integrate one or more cavities as microchambers which form a
ring around the piston bowl, with each microchamber positioned in line with a
spray from the fuel injector. The microchambers are connected to the piston bowl
by tunnel-like vents arranged in a unique geometric design. These vents control
the amount of fuel and air that enter the microchamber and also control the
amount of turbulence that is created when gases jet out of the microchambers
through these vents into the piston bowl. The position of the microchambers is a
critical factor in controlling the temperature of the microchamber and the rate
of reaction of gases that may be resident in the microchamber at any one time.
The microchambers perform as reservoirs that produce active chemical species
(partially reacted charges) which are expelled at high velocity to enhance
combustion and burn the soot cloud. This activity is the central point in the
Company's most advanced design innovation, the latest invention in the series
for the SCS for DI diesel engines; the U.S. patent for this invention issued in
January 1999. This advanced design, which follows the basic principles that
Sonex has used for its DI diesel systems for some time, involves re-arrangement
of SCS features to exploit new fundamental understandings of fluid dynamics.
The additional chemical activity is very effective with the use of EGR (exhaust
gas recirculation), allowing enhanced ignition with low soot production in the
presence of large amounts of EGR. Similar SCS piston designs allow the use of
alternative fuels in diesel engines with a minimum of change to the engine.
The SCS engine design modifications for heavy fuel operation in SI two-stroke
engines consist of modified cylinder heads and special combustion chamber
inserts housing the proprietary SCS technology. The SCS conversion aims to
maintain the gasoline engine's stock carburetion, intake and exhaust port
timing, intake and exhaust systems, ignition system, ignition timing,
compression ratio and weight. The SCS starting system employs heaters similar to
those used in a diesel engine.
Potential benefits of the SCS in the reduction of emissions
- -----------------------------------------------------------
Government agencies around the world continue to mandate increasingly more
strict requirements for the reduction of allowable diesel truck emissions,
specifically with respect to smoke/particulates and NOx. The use of costly
electronic controls and ultra-high pressure injection systems, including the new
"common rail" injection systems that are integral to the engine itself, may
permit truck manufacturers to attain some of these reductions; however, it is
unlikely any one emissions reduction technique will enable manufacturers to meet
the emission standards to be implemented in the next few years.
High pressure injectors may reduce smoke/particulates, but they also increase
NOx emissions while doing so. Manufacturers, therefore, may be able to eliminate
present equipment such as particulate traps, but they likely will need larger
catalytic converters, leading to an increase in fuel consumption and a decrease
in power, all at a significantly higher cost. Management believes that the
Company's diesel technology, which consists of a relatively simple change of
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SONEX RESEARCH, INC. 1998 FORM 10-KSB
piston design, under various conditions causes a reduction in
smoke/particulates, carbon monoxide (CO), hydrocarbons (HC), and NOx by
significant amounts while maintaining or improving upon brake specific fuel
consumption (BSFC) and power. In tests conducted in modern turbocharged engines
of several manufacturers, fitted with a variety of Sonex pistons, including
aluminum screw assembled pistons and electron beam welded (EBW) pistons, using
an earlier SCS piston design, the Company has demonstrated that the SCS may
reduce smoke/particulate emissions in excess of 40% and HC emissions by 5%,
while maintaining equal NOx emissions at future targets and BSFC within 2% above
or below that of the stock engine.
The ability of the SCS to reduce soot emissions has an added benefit towards the
reduction of NOx in diesel engines. Many manufacturers are turning to using EGR
to reduce NOx. (EGR is inert exhaust gas recycled and pumped back into the
engine cylinders for the next combustion cycle.) EGR can significantly reduce
NOx, but the soot recirculated with EGR can increase particulate emissions and
increase engine wear. The SCS acts to reduce both the engine wear and the
quantity of particulates in the emissions by significantly reducing the soot
content of the emissions.
Management believes that Sonex Ultra Clean BurnTM technology is perhaps the
least expensive method of emissions reduction, but it is likely to be used in
conjunction with other technologies to enable manufacturers to meet the strict
diesel truck emission standards that will be introduced in the near future. All
testing to date by Sonex and the engine OEM's has shown that SCS diesel
technology is complementary to new developments such as high pressure and common
rail injection and EGR.
Competition
- -----------
The Company's competition comes from the extensive research departments of the
world's major vehicle and engine manufacturers as well as independent research
organizations. Although the experience and financial resources of its
competitors far exceed those of the Company, management believes that the SCS
can provide significant advantages over the competition in terms of low cost,
improved performance, and simplicity, since no additional moving parts are added
to the engine.
Secrecy and non-disclosure
- --------------------------
Due to the highly competitive nature of the world's automotive and truck
industries, in connection with its contracts and/or demonstration programs with
such manufacturers the Company is required to execute joint secrecy and
disclosure agreements that expressly prohibit the public disclosure of the
customers' names and other significant information. Failure by Sonex to maintain
this strict level of confidentiality would jeopardize the relationship of the
Company with its customers.
Current DI diesel engine programs
- ---------------------------------
On a continuing basis for the past few years, the Company has performed
extensive design and development work on medium- and heavy-duty truck engines
for three large foreign multi-national diesel truck engine OEM's, in separate
programs. Funded development of Sonex pistons for industrial production for one
of these OEM's proceeded successfully through verification tests by the engine
manufacturer of pre-production, finished, aluminum pistons, using an earlier SCS
design, in an engine in its own facility. Since 1998 the Company, under contract
with this OEM, has been participating with suppliers of the OEM's injection
system and turbo-charger, and one of the world's leading independent engine R&D
and testing firms, on a joint engine application program involving Sonex
technology for DI diesel engines. In this program, the latest, most advanced SCS
piston design innovation is being introduced. SCS pistons and all engine
parameters are being optimized for eventual production in a DI turbo-charged,
intercooled, mid-range diesel engine using high pressure electronically
controlled injection, common rail high pressure, variable geometry turbocharger,
cooled EGR, etc.
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SONEX RESEARCH, INC. 1998 FORM 10-KSB
The manufacturer's objective is to meet future stringent emissions limits in the
production version of this engine by use of the SCS technology, in combination
with these other fuel system improvements, with no exhaust aftertreatment
devices, such as catalytic converters or particulate traps. Based on all OEM and
Sonex tests to date, with further optimization of traditional diesel parameters
and EGR, the OEM expects to achieve these particulate and NOx emissions goals.
This joint engine application program is expected to continue throughout 1999,
following which the SCS will be applied to additional engines, according to the
engine manufacturer.
A second large multi-national OEM also has verified Sonex test results on a set
of pre-production aluminum Sonex pistons using the earlier SCS design. In March
1999 the Company modified pistons received from this manufacturer to the
advanced SCS design, and is currently conducting tests at Sonex on this
manufacturer's six-cylinder engine. Later this year, the engine and the
Sonex-modified pistons, along with recorded test results, will be returned to
the manufacturer for evaluation. If emissions test results are confirmed by the
manufacturer, the design can be turned over to their piston supplier for
fabrication of pre-production pistons for application to a new engine.
In a similar, single-cylinder test engine demonstration program that is now at
the stage of testing pre-production prototype EBW pistons based on the earlier
SCS design, a third major international engine manufacturer has demonstrated
that by the use of EGR with SCS, it will be possible to attain future U.S. and
European emissions targets when OEM type production pistons become available.
Recently, Sonex learned that this OEM had experienced some mechanical
difficulties while testing the EBW pistons. The Company is now awaiting further
details from the engine manufacturer. It is expected that this OEM would test
the latest, most advanced SCS design in the single-cylinder engine prior to
proceeding to testing on the full, 8-cylinder engine.
In cooperation with the engine OEM's, the Company has worked with the major
piston suppliers to these manufacturers, providing engineering specifications
and drawings for their use in evaluating alternative production methods in
anticipation of eventual piston orders from the engine manufacturers. One of
these companies, formerly T&N Piston Products Group of the U.K., is widely
recognized as one of the world's leading suppliers of pistons and other
components to the engine industry. In 1998 T&N was acquired by Federal-Mogul
Corp., a major supplier of engine components based in Southfield, Michgan.
T&N invested significant funds internally in developing innovative and
economical techniques of manufacturing Sonex pistons for series production, as
well as performing finite element, thermal and stress analyses to examine the
effects of stress on the Sonex piston under a variety of extreme conditions.
Late in 1997 Sonex and T&N completed negotiations for a license agreement for
the marketing, manufacture and sale of SCS diesel truck engine pistons. Early in
1998, however, T&N informed the Company that signing of the agreement would be
delayed and, in subsequent discussions with Sonex following its acquisition of
T&N, Federal-Mogul indicated that it was not prepared to commit further funding
to complete the work initiated by T&N and declined to execute the license.
Federal-Mogul has since confirmed that it would cooperate with any engine OEM
willing to fund production development.
Because many of the on-road diesel engines produced in the U.S. use steel
articulated pistons for increased power, Sonex has recently started
investigating the feasibility of applying the SCS to steel articulated pistons.
It is known that such pistons are highly loaded thermally and engine OEM's are
projecting even higher thermal loadings. Sonex has conducted an investigation of
thermal effects of Sonex microchambers on aluminum pistons, which should aid
piston manufacturers in formulating new temperature-stress models in order to
examine the feasibility of using the SCS in steel pistons.
Response to government settlement with diesel engine manufacturers
- ------------------------------------------------------------------
In November 1998 seven diesel engine manufacturers completed negotiation of a $1
billion settlement with the Environmental Protection Agency (EPA) and the
Department of Justice to settle allegations that the companies used "defeat
devices" for the past several years that allowed their engines to emit more
pollution on the road than in certification tests in order to achieve
performance benefits. The settlement, in the form of Consent Decrees under the
Clean Air Act, levied stiff civil penalties, required industry to accelerate the
introduction of advanced anti-pollution controls on new engines, and included an
industry obligation to fund millions of dollars of research and development in
projects to lower emissions, including projects proposed by the public.
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SONEX RESEARCH, INC. 1998 FORM 10-KSB
Sonex responded to the announcement by submitting a Proposed Public Comment
Project (the "Project") to the EPA, the Justice Department, and the diesel
engine manufacturers in January 1999. The proposed Project contemplates a
cooperative effort between the diesel engine manufacturing industry and a world
class team, to be assembled and led by Sonex, consisting of a major university
or government-funded engine research facility, a major automotive piston
manufacturer and an advanced metal-forming parts manufacturer. It is the
objective of Sonex to demonstrate that a new engine design variable exists in
its piston-based SCS allowing in-cylinder reduction of emissions as an
alternative to exhaust aftertreatment.
In the proposed Project, Sonex describes a cooperative applications engineering
program segregated into work elements structured to develop, optimize and
integrate pre-production SCS pistons into direct-injected diesel engines, first
using aluminum pistons and, after completion of feasibility studies, steel
pistons. Sonex proposes to bring the domestic diesel engine industry on a par
with foreign diesel engine manufacturers with respect to progress made towards
the commercialization of the American-grown SCS technology.
The Company is currently engaged in discussions with prospective Project team
members that include descriptions of assigned tasks, resources, facilities,
timelines and estimated costs. Although there can be no assurances that the
Company's submission will be favorably received, should the response result in a
contract award, Sonex has received a commitment from an exprienced military and
commercial program manager to run the Project. Official reaction by the engine
companies and the Government to comments and proposed projects submitted by the
public is expected within the next few months.
Before the settlement becomes final, however, it must pass a judicial review. If
adverse public comments warrant, the agreement could be changed EPA officials
said, but only with the engine makers' consent. According to published reports,
even when it does become official, the agreement may face legal challenges from
environmental groups who believe that the settlement did not go far enough.
Lightweight, spark-ignited (SI) engines
- ---------------------------------------
The Company has successfully applied a proprietary patented starting system and
modified combustion chamber design to the conversion of reliable, lightweight,
SI, carburetted, two-stroke, gasoline fueled engines of various sizes used in
small, remotely controlled military unmanned aerial vehicles (UAV's) to start
and operate on JP5/JP8 standard military fuels (also referred to as "heavy
fuels"). UAV's conduct short-range tactical reconnaissance while operating
virtually unseen and unheard, taking pictures of battlefields and enemy
installations and relaying them back to ground forces. Existing UAV engines in
the military's inventory operate on gasoline. Because of safety and logistics
concerns, the use of gasoline aboard ship and in the motor pool is being phased
out by the military. All small engines, such as those found in UAV's, will be
required to operate on less volatile, widely available heavy fuels used by jet
aircraft and most military vehicles. Conversion of such engines to operate on
heavy fuels rather than gasoline would permit the military to continue to deploy
such weapons well into the next century.
In August 1997 the Company was awarded a demonstration contract by the United
States Marine Corps (USMC) Systems Command in Quantico, Virginia, to upgrade the
capabilities of an operational UAV known as the Exdrone by converting the
existing SI, carburetted, 100cc single cylinder, two-stroke, gasoline fueled
engine to start and run on heavy fuel and by installing improved electronics.
The electronics upgrade in the UAV to a configuration known as the Dragondrone
was performed under subcontract by AeroComm, Inc., a privately held Germantown,
Maryland company. Early in 1998 Sonex completed this program and demonstrated
the successful prototype conversion of five UAV engines from gasoline to heavy
fuel operation.
In March 1998 the USMC Systems Command contracted Sonex to convert an additional
forty of these gasoline engines, used in the Dragondrone UAV, to heavy fuel
operation. The USMC is now deploying tactical UAV's aboard ship for the first
time, as the Dragondrone UAV's with Sonex heavy fuel engine (HFE's) are in
service in several locations around the world.
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SONEX RESEARCH, INC. 1998 FORM 10-KSB
In August 1998 Sonex completed a UAV HFE conversion feasibility demonstration
under a contract awarded in October 1997 by the U.S. Naval Air Warfare Center,
Aircraft Division (the "Navy"), in Patuxent River, Maryland. The existing engine
in this UAV, known as the Pioneer, is a 350cc, two-stroke, carburetted, SI two
cylinder gasoline engine. Sonex was able to demonstrate this HFE starting,
idling, running steady-state at part load and wide-open-throttle (WOT), and
accelerating from idle to WOT with little visible smoke and without knock or
detonation. Two feasibility demonstration Sonex HFE's were delivered to the
Navy; however, the Company has since been informed that the Navy is planning to
replace the engine used in the Pioneer. The Navy has indicated that Sonex will
participate in the development of an HFE for the replacement engine.
Under a July 1998 contract from Northrop Grumman Corporation (NGC), in December
1998 Sonex successfully demonstrated the feasibility of converting a 342cc,
two-stroke, SI, carbureted, two cylinder, gasoline UAV engine to heavy fuel
operation using a preliminary SCS design. Bench tests of the Sonex HFE showed
WOT power to be comparable to that of the gasoline engine; however, due to the
limited scope of this feasibility effort, the HFE design was not optimized. Late
in March 1999, however, NGC notifed the Company that it would not pursue this
UAV opportunity and declined to fund further development work on this engine to
optimize the SCS engine design modifications for heavy fuel performance. Sonex
has received inquiries in regard to the SCS HFE technology demonstrated in the
various UAV engines from several other defense contractors who plan to respond
to the U.S. Army's current Tactical Unmanned Aerial Vehicle solicitation.
At the end of January 1999, the Company was awarded a prototype development
contract by NRL to modify a two-stroke, two cylinder, 290cc gasoline engine to
start and run on JP-5 fuel in a manner that will allow the engine to be
integrated into an NRL UAV. The objective is to demonstrate the projected
propeller load curve or equivalent of the Sonex HFE over a reasonable part of
the engine operatingrange, with power, weight and fuel consumption substantially
equal to that for the gasoline version of the engine. Work is expected to be
completed this summer.
By January 1999 the Company completed work on a Phase I Small Business
Innovation Research (SBIR) Program contract awarded in July 1998 by the U.S.
Naval Sea Systems Command (NAVSEA). Sonex demonstrated the feasibility of
utilizing SCS technology to design a low-cost, small, rugged engine to fit in a
5-inch diameter cylinder, capable of starting and operating on shipboard-safe
heavy fuels, for use in a small aircraft that would be suitable for launch from
guns and missiles and for delivery by airdrop. The aspects of the design
ruggedness and other interface requirements for potential transition
opportunities were performed under subcontract by Science Applications
International Corporation (SAIC), an advanced technology firm with particular
expertise in national defense concepts such as UAV's.
Phase I results indicated that the proposed prototype SCS HFE can be developed
in Phase II and subsequently transitioned in a Phase III effort. The first
transition opportunity is in the Forward Air Support Munition (FASM), a
gun-launched surveillance, targeting, and precision delivery air vehicle being
developed by the Naval Surface Fire Support program office. SAIC is the
designated prime contractor for the FASM Fleet Advanced Demonstration. In April
1999 Sonex submitted a Phase II SBIR proposal to NAVSEA for the development and
delivery of a well-defined operational prototype engine. The proposal
anticipates that SAIC will again serve as a subcontractor to the Company.
Sonex is exploring additional potential uses by the military for the SCS HFE
technology, such as in other UAV models and light-weight, man-portable generator
sets used in the field, as well as private sector opportunities. Operation of a
light-weight engine on a high flash point fuel such as diesel, rather than
gasoline, will reduce the hazard associated with gasoline, making such an engine
much more suitable for applications where gasoline storage is undesirable, such
as in diesel fueled utility engines used in pumps, generator sets, etc., in
homes, commercial buildings and boats. The Company recently initiated a research
testing program for its HFE technology to determine methods for streamlining the
design process. Currently, development work is very specific to each different
type of gasoline engine presented to Sonex for heavy fuel conversion. A more
general design process would allow the Company to accept projects for a greater
variety of heavy fuel engine applications while simultaneously reducing time and
cost of development.
Sonex HFE technology is protected by a U.S. patent issued in January 1999, while
foreign counterparts to this patent have been applied for worldwide. As new
inventions are made to enhance this technology, the Company will apply for
improvement patents.
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SONEX RESEARCH, INC. 1998 FORM 10-KSB
Patents and proprietary information
- -----------------------------------
The Company has endeavored to protect its technology by filing for patents in
the U.S. and in those foreign countries in which it may be able to commercialize
the SCS. The Company has also developed a significant body of trade secrets,
proprietary information and know-how relating to its technology. Although the
principles underlying the SCS concept are capable of being understood by experts
in the field, management believes that it would be difficult to apply the SCS
successfully to any given engine configuration without the benefit of the trade
secrets, know-how and proprietary information owned by the Company. The name
"SONEX" was registered at the U.S. Patent and Trademark Office in 1987.
Management believes that the Company's business depends substantially upon the
protection afforded by its granted and pending patents, as well as its trade
secrets, proprietary information and know-how. All contracts outside the Company
involving any exchange of confidential technical information are made under
secrecy agreements approved by the Company's patent counsel. In addition, all of
the management and technical employees of the Company are required to sign
non-disclosure agreements respecting the Company's technology.
ITEM 2. DESCRIPTION OF PROPERTY
The Company's principal executive offices and testing facility are located at 23
Hudson Street, Annapolis, Maryland, 21401. The facility is equipped with
emissions test equipment and machine shop and storage facilities necessary to
support the laboratory. Management believes that all of the Company's property
is adequately covered by insurance. The building contains approximately 6,000
square feet and is being occupied by the Company on a month-to-month basis under
the terms of an operating lease agreement, pursuant to which the property owner
is required to provide thirty days notice if he wants the Company to vacate the
premises. Management will seek to negotiate a new long-term lease for its
facility or search for an alternative location in the event that an agreement
cannot be reached for the existing premises. Management believes that the
resolution of the uncertainty with respect to the facility will not result in a
significant interruption in the operations of the Company.
ITEM 3. LEGAL PROCEEDINGS
As of the date of this report, management is aware of no legal proceedings
pending against the Company.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders during the fourth
quarter of 1998.
ITEM 5. MARKET FOR COMMON STOCK AND RELATED STOCKHOLDER MATTERS
The Company's Common Stock currently is traded in the over-the-counter market on
the OTC Bulletin Board service under the symbol "SONX". The OTC Bulletin Board
is an electronic and screen-based quotation medium operated by Nasdaq. Quotation
information on OTC Bulletin Board stocks is available on stockbrokers' desktop
terminals.
The Company has never paid cash dividends on its Common Stock and does not
expect to pay any cash dividends in the foreseeable future. The high and low
closing prices of the Common Stock for each quarterly period since January 1,
1997 were as follows (These prices, which are drawn from reports provided to the
Company by Nasdaq, reflect inter-dealer prices without mark-ups, mark-downs, or
commissions, and may not necessarily represent actual transactions.):
Quarter ended: High Low
--------- ------
March 31, 1997 1.56 .63
June 30, 1997 1.38 .81
September 30, 1997 1.28 .69
December 31, 1997 1.25 .72
March 31, 1998 1.09 .56
June 30, 1998 .84 .47
September 30, 1998 .75 .41
December 31, 1998 .65 .38
March 31, 1999 .59 .38
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SONEX RESEARCH, INC. 1998 FORM 10-KSB
As of March 31, 1999, there were 17,662,518 shares issued and outstanding, with
approximately 980 holders of record. The shares for approximately 2,800
additional beneficial owners of the Common Stock are held of record (in "street
name") by brokers, dealers, banks, and other entities holding such securities of
record in nominee name or otherwise or as a participant in a clearing agency
registered pursuant to Section 17A of the Securities Exchange Act of 1934. A
total of 17,368,772 shares of the Company's Common Stock as of March 31, 1999
were reserved for issuance in connection with the conversion of preferred stock
and the exercise of warrants and options.
ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL POSITION
AND RESULTS OF OPERATIONS
Accumulated losses
- ------------------
Since its inception in 1980, the Company has generated cumulative net losses in
excess of $20 million. Operating funds have been raised primarily through the
sale of equity securities in both public and private offerings. During 1997 and
1998, however, revenues increased substantially while net losses from operations
were reduced. The Company is considered to have emerged from the development
stage in 1998.
Financial position and liquidity
- --------------------------------
As of March 31, 1999, the Company had available cash and equivalents of
approximately $180,000, marketable securities valued at approximately $30,000,
and accounts receivable of approximately $87,000, including receivables from the
U.S. Government of approximately $37,000. Based upon current and projected
spending levels, management believes that available resources and expected
revenue from current and potential contracts and other expected cash receipts
will be sufficient to fund operations at least through December 31, 1999. In the
absence of the realization of significant revenues, additional capital may be
necessary to fund operations beyond 1999.
Salary deferrals by employees
- -----------------------------
In order to help conserve the Company's limited cash resources, certain of the
Company's employees for several years have voluntarily deferred receipt of
payment of significant portions of their authorized annual salaries upon request
by the Board of Directors. By agreement with the Company, these individuals have
consented to the deferral of payment of amounts so accumulated until the Company
has received licensing revenue of at least $2 million or at such earlier date as
the Board of Directors determines that the Company's cash flow is sufficient to
allow such payment. Since January 1, 1997, however, there has been no further
deferral of salary requested of the Company's non-executive employees.
Results of operations
- ---------------------
Revenue and cost of subcontracts:
---------------------------------
1998 1997 1996
--------- --------- ---------
Government/defense prime contracts $ 261,362 $ 90,668
Commercial contracts 60,550 207,500 $ 70,000
--------- --------- ---------
321,912 298,168 70,000
Revenue from government/defense
sub-contracts 73,301 119,420
--------- --------- ---------
Total revenue $ 395,213 $ 417,588 $ 70,000
========= ========= =========
Cost of government/defense
sub-contracts $ 69,326 $ 111,750
========= =========
9
<PAGE>
SONEX RESEARCH, INC. 1998 FORM 10-KSB
Total revenue decreased 5% from 1997 to 1998, after having increased from
$70,000 in 1996 to $417,588 in 1997. Revenue from commercial contracts, earned
primarily in connection with the Company's DI diesel engine piston technology,
is subject to the negotiated amount, if any, that an engine manufacturer is
willing to provide in funding to partially offset the development costs incurred
by the Company in applying its technology to one of the manufacturer's engines.
Revenue for 1998 includes $50,000 for the first phase of a joint engine
application program for the development and testing of prototype SCS pistons for
an engine OEM. Revenue for 1997 includes $90,000 related to the delivery of
prototype Sonex pistons to another major international OEM. Revenue under a
demonstration program begun in 1996 to apply the SCS to a truck diesel engine
for a third international OEM was $90,000 in 1997 and $70,000 in 1996.
Since August 1997 the Company has obtained several military contracts for its
small engine, heavy fuel technology, an application that has been developed only
in the last few years. All contracts to date in this area have involved the
conversion of commercial gasoline fueled engines used in UAV's and the like. The
August 1997 contract with the U.S. Marine Corps (the USMC) to convert the
Exdrone UAV to use heavy fuel also included a substantial subcontract for the
installation of improved electronics.
The amount recorded in 1997 as "Cost of subcontracts" represents the accrual,
based on the percentage of completion of the contract as of year-end, of the
sub-contracted portion of the in-process USMC contract. There were no similar
sub-contract costs related to contracts in-process at December 31, 1998.
Management is unable to predict future changes to development and demonstration
contract revenue because the amounts earned to date under previous contracts
have been determined through negotiations with individual manufacturers based
upon the level of effort required and the level of funding, if any, that each
manufacturer has been willing to commit. Management anticipates, however, that
future revenue may also include consulting fees earned while working together
with manufacturers to optimize the results achieved on a particular
manufacturer's engine, and, ultimately, license fees and royalty revenue once
the Company's technology is placed into production engines by manufacturers. The
future amounts of such other types of revenue, however, cannot be reasonably
estimated.
Research and development (R&D) expenses:
---------------------------------------
1998 1997 1996
---- ---- ----
Personnel (includes stock and options):
Employee compensation $ 281,886 $ 287,663 $ 255,919
Taxes & benefits 39,676 41,071 37,025
Consultants, including expenses 99,382 63,864 27,125
--------- --------- ---------
Total personnel 420,944 392,598 320,069
Project parts and supplies 59,169 30,869 39,475
Occupancy 46,939 43,263 55,459
Patent maintenance fees
and amortization 24,659 44,298 71,180
Depreciation 8,955 13,750 21,783
Software engineering 5,000 20,000
Other expenses 17,530 13,748 15,558
--------- --------- ---------
Total R&D $ 583,196 $ 558,526 $ 523,524
========= ========= =========
Total R&D expenses increased by $24,670, or 4%, from 1997 to 1998, as increases
in personnel costs and project parts and supplies were partially offset by
decreases in software engineering fees and patent maintenance fees and
amortization. From 1996 to 1997, total R&D expenses increased $35,002, or 7%, as
increases in personnel costs and software engineering fees were partially offset
by a large decrease in patent maintenance fees and amortization along with
decreases all other expense categories.
The increase in personnel costs from 1997 to 1998 was largely due to a 55%
increase in consulting charges. Most of the increase relates to higher charges
for the compensation and expenses of the individual who serves as the Company's
R&D supervisor and corporate liaison in Europe. This individual, a former
officer of the Company, is compensated primarily in the form of restricted stock
or stock options for services performed in Europe based on part-time service,
10
<PAGE>
SONEX RESEARCH, INC. 1998 FORM 10-KSB
while for time spent in Annapolis he receives cash compensation, a portion of
which is deferred, for full-time service. He was asked to spend considerably
more time in Annapolis in 1998 as opposed to 1997, with no time spent in
Annapolis in 1996. A further increase related to the hiring in November 1998 of
a consultant to assist in the preparation of the Company's proposal response to
the Justice Department's Consent Decree against the diesel engine manufacturers.
This consultant continues to assist the Company in regard to business
opportunities for the SCS HFE technology.
Employee compensation declined slightly from 1997 to 1998, as a net increase
resulting from the resignation of an engineer in the second quarter of 1997 and
the hiring of a new engineer in the fourth quarter of 1997 was offset by a
reduction in charges for compensation paid in the form of stock or options from
1997 to 1998. Employee compensation increased from 1996 to 1997 as a result of
increases in the wage rates for all employees in 1997, an increase resulting
from the hiring of an engineer late in 1997, and an increase in charges for
stock option compensation, offset in part by decreases resulting from the
resignation of an engineer early in 1997 and the award of bonuses in 1996 while
none were awarded in 1997. The total number of options granted to employees each
year has remained approximately the same. Compensation cost for options is
measured as the excess, if any, of the market price of the Company's stock at
the date of grant over the exercise price of the option granted. Compensation
charges for stock issued for services is measured at the market price on the
date of award or at the agreed-upon value of the services.
The increase in project parts and supplies resulted from greater expenditures in
1998 versus 1997 for funded contracts and other research not performed under
contract, particularly with respect to the Company's HFE work. Project parts and
supplies include motor fuel, engine parts and other items used or consumed in
engine testing and in the machine shop. Related costs fluctuate from year to
year depending on the number and type of engines being tested, and the timing of
purchases of certain items, resulting in a decrease in such costs from 1996 to
1997.
Occupancy expenses declined significantly from 1996 to 1997 as a result of a
reduction in the monthly rent late in 1996. Rent expense is allocated 80% to R&D
and 20% to G&A based on the proportionate share of floor space devoted to each
category.
The Company experienced a reduction from 1997 to 1998 in total charges for
patent maintenance fees and amortization of the capitalized costs of patents and
technology due to the fact that in 1997 the Company wrote-off approximately
$24,500 in unamortized costs of patents abandoned, while there was no such
charge in 1998. The decrease in such charges from 1996 to 1997 resulted from a
significant reduction in amortization expense that was almost entirely due to
higher amortization in 1996 for the capitalized costs of computer simulations
that became fully amortized early in 1997, offset in part by the write-off in
1997 of unamortized costs of patents abandoned.
Depreciation expense has been declining for the last few years, as most of the
Company's equipment that was purchased in prior years has become fully
depreciated, while purchases of equipment in 1996 and 1997 were not significant.
Software engineering charges represent amounts paid to the Company's former
president for programming assistance with a technology design manual that is to
be used to teach engineers from prospective customers how to incorporate the
elements of the SCS into pistons.
General and administrative (G&A) expenses:
-----------------------------------------
1998 1997 1996
---- ---- ----
Personnel (includes stock and options):
Employee compensation $ 110,079 $ 131,160 $ 114,753
Other option compensation 44,644 44,643
Taxes & benefits 12,066 15,601 9,523
--------- --------- ---------
Total personnel 166,789 191,404 124,276
Proxy solicitation & annual meeting 22,701 18,554 17,144
Legal fees 8,120 21,641 18,524
Audit fees 8,000 12,454 9,815
Stock transfer agent fees 9,565 8,106 10,245
Occupancy 11,398 12,106 13,159
Travel 10,328 27,761 21,153
Other expenses 39,773 42,363 46,797
--------- --------- ---------
Total G&A $ 276,674 $ 334,389 $ 261,113
========= ========= =========
11
<PAGE>
SONEX RESEARCH, INC. 1998 FORM 10-KSB
Total G&A expenses decreased by $57,715, or 17%, from 1997 to 1998 due to
decreases in personnel costs, professional fees, and travel charges. From 1996
to 1997, total G&A expenses increased by $73,276, or 28%, primarily as a result
of higher personnel charges.
The decrease in personnel costs from 1997 to 1998 results from a decrease in
employee compensation caused by the termination of the employment as of the end
of the third quarter of 1997 of the Company's former president, who had been
employed on a part-time basis, and higher charges in 1997 for options granted to
employees, offset in part by the hiring of an administrative assistant in the
fourth quarter of 1998.
The increase in personnel costs from 1996 to 1997 was due to an increase in the
wage rates for all of the Company's employees for 1997 and charges incurred in
1997 for temporary office employees, offset in part by a reduction caused by the
termination of the employment of the Company's former president.
The large percentage increase in payroll taxes and employee benefits from 1996
to 1997 was due primarily from payroll taxes incurred on the exercise of stock
options in 1997. There is no corresponding amount recorded as wages when
below-market options are exercised, but the optionee is taxed on the excess of
the aggregate market price over the aggregate exercise price, and the Company
incurs the related payroll taxes.
Expenses for proxy solicitation and the annual shareholders' meeting primarily
represent the costs for printing and distributing proxy materials, and also
include charges for travel and lodging for directors attending the meeting.
Travel charges accounted for most of the increase from 1997 to 1998.
Legal fees decreased 62% from 1997 to 1998 as charges from the Company's
securities counsel were significantly higher in 1997 due to work in 1996, some
of which was not billed until 1997, associated with an SEC registration
statement that eventually was not filed, as well as for advice on restructuring
certain stock warrants and undertaking two private financings. A decline in
charges from the Company's patent attorney resulted from the fact that
significant services were used in 1997 for the preparation of the proposed
piston licensing agreement with T&N that failed to be consummated. Audit fees
declined as a result of a change in independent accountants for 1997. The
significant decline in travel expenses from 1997 to 1998 is primarily attributed
to the extensive travel required by members of the Board in 1997 while
negotiating the proposed piston licensing agreement with T&N.
Gains on sales of marketable securities:
- ---------------------------------------
Gains on the sale of marketable securities of $247,144 in 1998, $38,299 in 1997,
and $30,113 in 1996, represent the proceeds from the sale of the Company's
holdings in the common stock of Digital Dictation, Inc. (acquired in 1998 by
Medquist, Inc.), the corporation which in 1995 was merged with and into the
Company's inactive former subsidiary, SonoChem, Inc. The Company liquidated most
of this investment during 1998 when its value increased substantially. Because
the recorded basis for this investment is zero, all sales proceeds are
recognized as gains.
Effects of Year 2000 (Y2K) millenium date-change issues:
- -------------------------------------------------------
During the past year, the Company has upgraded some of the hardware and software
currently being used in its operations, and expects to continue to make further
upgrades in the ordinary course of business during the remainder of 1999 to
ensure that all of its systems are Y2K compliant. Expenditures in this regard
outside the ordinary course of business are not expected to be significant.
Adoption of new accounting pronouncements
- -----------------------------------------
The adoption by the Company in fiscal 1998 of new accounting pronouncements
which have a delayed effective date is not expected to have a material impact on
the financial statements of the Company.
12
<PAGE>
SONEX RESEARCH, INC. 1998 FORM 10-KSB
ITEM 7. FINANCIAL STATEMENTS
Index to financial statements:
Reports of independent accountants
Financial statements:
Balance sheets as of December 31, 1998 and 1997
Statements of operations, accumulated deficit and comprehensive
income/loss for the three years ended December 31, 1998
Statements of paid-in capital for the three years ended December 31, 1998
Statements of cash flows for the three years ended December 31, 1998
Notes to financial statements
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and
Stockholders of Sonex Research, Inc.
In our opinion, the financial statements listed in the accompanying index
present fairly, in all material respects, the financial position of Sonex
Research, Inc. at December 31, 1998 and 1997, and the results of its operations
and its cash flows for the years then ended, in conformity with generally
accepted accounting principles. These financial statements are the
responsibility of the Company's management; our responsibility is to express an
opinion on these financial statements based on our audits. We conducted our
audits of these statements in accordance with generally accepted auditing
standards which require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements, assessing the
accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for the opinion expressed above.
The accompanying financial statements have been prepared assuming that the
Company will continue as a going concern. As described in Note 3 to the
financial statements, the Company's ability to commence generation of
significant revenue and ultimately achieve profitable operations remains
uncertain. The Company has incurred significant net losses since its inception.
The Company's future prospects depend upon its ability to demonstrate commercial
viability of its products and ultimately achieve profitable operations, which
raise substantial doubt about the Company's ability to continue as a going
concern. Management's plans in regard to these matters are also described in
Note 3. The financial statements do not include any adjustments that might
result from the outcome of this uncertainty.
C. L. STEWART & COMPANY
Annapolis, Maryland
March 10, 1999
REPORT OF PREVIOUS INDEPENDENT ACCOUNTANTS
To the Board of Directors and
Stockholders of Sonex Research, Inc.
In our opinion, the financial statements listed in the accompanying index
present fairly, in all material respects, the results of operations and the cash
flows of Sonex Research, Inc. (a development stage company) for the year ended
December 31, 1996, in conformity with generally accepted accounting principles.
These financial statements are the responsibility of the Company's management;
our responsibility is to express an opinion on these financial statements based
on our audit. We conducted our audit of these statements in accordance with
generally accepted auditing standards which require that we plan and perform the
audit to obtain reasonable assurance about whether the financial statements are
free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements,
assessing the accounting principles used and significant estimates made by
management, and evaluating the overall financial statement presentation. We
believe that our audit provides a reasonable basis for the opinion expressed
above.
13
<PAGE>
SONEX RESEARCH, INC. 1998 FORM 10-KSB
The accompanying financial statements have been prepared assuming that the
Company will continue as a going concern. As described in Note 3 to the
financial statements, the Company's ability to emerge from the development
stage, commence generation of significant revenue and ultimately achieve
profitable operations remains uncertain. The Company has incurred significant
net losses since its inception. The Company's future prospects depend upon its
ability to demonstrate commercial viability of its products and/or to obtain
capital sufficient to assure the completion of its development stage activities,
all of which raise substantial doubt about the Company's ability to continue as
a going concern. Management's plans in regard to these matters are also
described in Note 3. The financial statements do not include any adjustments
that might result from the outcome of this uncertainty.
PRICEWATERHOUSECOOPERS LLP
Baltimore, Maryland
April 8, 1997
SONEX RESEARCH, INC.
BALANCE SHEETS
December 31,
------------
Assets 1998 1997
---- ----
Current assets
Cash and equivalents $ 336,458 $ 355,582
Marketable securities, available-
for-sale (Note 4) 29,460 117,200
Accounts receivable, including unbilled
costs and estimated earnings on uncompleted
contracts of $183,750 in 1997 102,485 210,088
Prepaid expenses 28,837 36,284
Loans to officers and employees (Note 5) 27,500 22,500
---------- ----------
Total current assets 524,740 741,654
Patents and technology (Note 6) 243,600 231,742
Property and equipment (Note 7) 34,532 17,206
---------- ----------
Total assets $ 802,872 $ 990,602
========== ==========
Liabilities and Stockholders' Equity
Current liabilities
Accounts payable and other accrued liabilities $ 46,979 $ 35,470
Accrued subcontract costs on
uncompleted contracts 16,456 111,750
Deferred compensation (Note 8) 765,516 688,292
---------- ----------
Total current liabilities 828,951 835,512
---------- ----------
Stockholders' equity (Note 10)
Preferred stock, $.01 par value - 2,000,000
shares issued; 1,540,001 shares outstanding 15,400 15,400
Common stock, $.01 par value - shares issued
and outstanding: 17,642,860 in 1998 and
17,393,906 in 1997 176,429 173,939
Additional paid-in capital 20,209,503 20,035,060
Accumulated other comprehensive income,
representing unrealized increase in value
of marketable securities 29,460 117,200
Accumulated deficit (20,456,871) (20,186,509)
---------- ----------
Total stockholders' equity (26,079) 155,090
Commitments (Note 11)
---------- ----------
Total liabilities and stockholders' equity $ 802,872 $ 990,602
========== ==========
The accompanying notes are an integral part of the financial statements.
14
<PAGE>
SONEX RESEARCH, INC. 1998 FORM 10-KSB
SONEX RESEARCH, INC.
STATEMENTS OF OPERATIONS, ACCUMULATED DEFICIT
AND COMPREHENSIVE INCOME/(LOSS)
Year ended December 31,
-----------------------
1998 1997 1996
---- ---- ----
Revenue
Development contracts $ 321,912 $ 298,168 $ 70,000
Subcontracts 73,301 119,420
--------- -------- --------
395,213 417,588 70,000
--------- -------- --------
Costs and expenses
Research and development 583,196 558,526 523,524
Cost of subcontracts 69,326 111,750
General and administrative 276,674 333,389 261,113
--------- --------- ---------
929,196 1,004,665 784,637
--------- --------- ---------
Net loss from operations (533,983) (587,077 (714,637)
--------- -------- ----------
Other income and expense
Investment and other income 16,477 18,782 12,049
Gain on sales of
marketable securities 247,144 38,299 30,113
-------- -------- ----------
Net loss (270,362) (529,996) (672,475)
Deficit accumulated during
development stage
Beginning of period (20,186,509) (19,656,513) (18,984,038)
------------ ------------ ------------
End of period $(20,456,871) $(20,186,509) $(19,656,513)
============ ============ ============
Net loss per share $ (.02) $ (.03) $ (.04)
====== ====== ======
Weighted average number of
common shares outstanding 17,572,147 17,031,016 15,968,491
========== ========== ==========
Comprehensive income/(loss):
Net loss $ (270,362) $ (529,996) $ (672,475)
Other comprehensive income - unrealized
gains on marketable securities
Arising during the period 19,242 87,900 36,800
Reclassification of gains
reported in income (106,982) (7,500)
---------- ---------- ----------
Total comprehensive income/(loss) $ (358,102) $ (449,596) $ (635,675)
========== ========== ==========
The accompanying notes are an integral part of the financial statements.
15
<PAGE>
SONEX RESEARCH, INC. 1998 FORM 10-KSB
SONEX RESEARCH, INC.
STATEMENTS OF PAID-IN CAPITAL
Price Preferred stock Common stock Additional
per ($.01 par value) ($.01 par value) paid-in
share Shares Amount Shares Amount capital
----- ------ ------ -------- ------ -----------
Note: Retroactive effect has been given to all previously declared stock splits.
Balance, January 1, 1996 1,830,000$18,300 15,281,535$152,815 $19,078,191
January for services 1.00 1,000 10 990
January through August
option exercises .50 131,488 1,315 64,429
April and July -
conversion (.35 to 1) (279,999)(2,800) 799,997 8,000 (5,200)
Compensation - grant of
stock options 27,125
--------- ------ ---------- ------- ----------
Balance, December 31, 1996 1,550,001 15,500 16,214,020 162,140 19,165,535
January through December
option exercises .50 352,834 3,528 172,889
January through June
option exercises .75 17,000 170 12,580
March - private placements .75 775,519 7,755 573,884
October -
conversion (.35 to 1) (10,000) (100) 28,571 286 (186)
December for services 1.00 5,962 60 5,902
Compensation - grant of
stock options 104,456
--------- ------ ---------- ------- ----------
Balance, December 31, 1997 1,540,001 15,400 17,393,906 173,939 20,035,060
January through December -
option exercises .50 181,500 1,815 88,935
March - for services .625 20,000 200 12,300
June - for services .75 7,949 80 5,882
September - for services .44 26,813 268 11,463
December - for services 1.00 12,692 127 6,219
Compensation - stock options 5,000
Compensation - grant of
stock options 44,644
--------- ------ ---------- ------- ----------
Balance, December 31, 1998 1,540,001$15,400 17,642,860$176,429 $20,209,503
========= ====== ========== ======= ===========
The accompanying notes are an integral part of the financial statements.
16
<PAGE>
SONEX RESEARCH, INC. 1998 FORM 10-KSB
SONEX RESEARCH, INC.
(A Development Stage Company)
STATEMENTS OF CASH FLOWS
Year ended December 31,
-----------------------
1998 1997 1996
---- ---- ----
Cash flows from operating activities:
Net loss $(270,362) $(529,996) $(672,475)
Adjustments to reconcile net loss to net
cash used in operating activities
Depreciation 8,955 13,747 21,783
Amortization of patents 12,933 72,394 101,970
Compensation - stock options 44,644 104,456 27,125
Current charges paid in stock 41,539 5,962 1,000
Gain on sale of marketable securities (247,144) (38,299) (30,113)
(Increase) decrease in
accounts receivable 107,603 (160,088) 13,741
(Increase) decrease in
prepaid expenses 7,447 2,408 (8,831)
Increase (decrease) in
accrued liabilities (6,561) 44,521 91,729
--------- --------- ---------
Net cash used in operating activities: (300,946) (484,895) (454,071)
--------- --------- ---------
Cash flows from investing activities:
Proceeds from sales of
marketable securities 247,144 38,299 30,113
(Increase) decrease in
loans to employees (5,000) 9,406 26,470
Decrease in cash posted as
security for judgment 182,687
Acquisition of property
and equipment (26,281) (2,945) (4,887)
Additions to patents
and technology (24,791) (64,828) (12,456)
--------- --------- ---------
Net cash provided by (used in)
investing activities: 191,072 (20,068) 221,927
--------- --------- ---------
Cash flows from financing activities:
Issuance of stock - private placement 581,639
Issuance of stock - exeercise of options 90,750 189,167 65,744
--------- --------- ---------
Net cash provided by financing activities: 90,750 770,806 65,744
--------- --------- ---------
Increase (decrease) in cash: (19,124) 265,843 (166,400)
Cash at beginning of period: 355,582 89,739 256,139
--------- --------- ---------
Cash at end of period: $ 336,458 $ 355,582 $ 89,739
========= ========= =========
The accompanying notes are an integral part of the financial statements.
17
<PAGE>
SONEX RESEARCH, INC. 1998 FORM 10-KSB
SONEX RESEARCH, INC.
NOTES TO FINANCIAL STATEMENTS
NOTE 1 - THE COMPANY
Sonex Research, Inc. has developed a proprietary technology, known as the Sonex
Combustion System (SCS), which improves the combustion of fuel in internal
combustion engines through modification of the pistons in large engines or the
cylinder heads in small engines. The Company expects to license several
applications of its technology and is commercially exploiting other applications
itself.
NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Presentation of financial statements
- ------------------------------------
Certain reclassifications have been made to the financial statements of the
prior years to conform to the classifications used in 1998. In prior years,
Sonex Research, Inc. was classified as a development stage company.
Cash and equivalents
- --------------------
The Company's By-Laws restrict the types of permitted investments to securities
issued by the U.S. Treasury, savings accounts insured by the U.S. Government, or
investment companies that invest in obligations of the U.S. Government or its
agencies. The Company considers all short-term, highly liquid investments which
are convertible into cash within three months or less to be cash equivalents.
Marketable securities
- ---------------------
Securities held by the Company are classified as "available-for-sale" in
accordance with Statement of Financial Accounting Standards (SFAS) No. 115 -
"Accounting for Certain Investments in Debt and Equity Securities"; accordingly,
unrealized gains and losses with respect to such securities are reported as a
separate component of stockholders' equity. Realized gains and losses are
reported in the Company's statement of operations.
Patents and technology
- ----------------------
The costs associated with the filing of patent
applications are deferred. Amortization is recorded on a straight-line basis
over the remaining legal life of patents, commencing in the year in which the
patent is granted. Costs related to patent applications which ultimately fail to
result in the grant of a patent, either through rejection by patent authorities
or through abandonment by the Company, will be charged to operations at the time
such determination is made.
Property and equipment
- ----------------------
Property and equipment is stated at cost or, in the case of leased equipment
under capital leases, at the present value of future lease payments, less
accumulated depreciation. Major renewals and betterments are capitalized and
ordinary repair and maintenance expenditures are charged to operations in the
year incurred. Depreciation is computed using the straight line method over
useful lives of three to seven years.
Revenue recognition
- -------------------
Revenue derived from development contracts is recognized upon the Company's
completion of the milestones and/or submission of progress reports specified in
each contract. Commercial development contracts are executed in situations in
which an engine manufacturer is willing to provide funding to partially offset
the development costs incurred by the Company in applying its technology to one
of the manufacturer's engines. Generally, commercial development contracts
require the Company to demonstrate that the manufacturer's engine, when modified
18
<PAGE>
SONEX RESEARCH, INC. 1997 FORM 10-KSB
with the Company's technology, can meet certain emissions reduction and
performance goals specified in the contract. In addition, these contracts
sometimes provide that payment of part of the contract amount will be made only
if the Company meets the specified goals. The Company is not required to repay
any funds received in connection with its development contracts.
Development contracts are executed for funding supplied by a United States
Government (the "Government") agency or defense contractor for proof-of-concept
demonstration programs. Certain of these contracts require a performance period
of several months and/or require the Company to serve as prime contractor with a
substantial portion of the related project being assigned to a subcontractor.
Revenue and costs for these contracts that require the Company to provide
stipulated services for a fixed price have been recognized using the
percentage-of-completion method of accounting by relating contract costs
incurred to date to total estimated contract costs at completion. Subcontract
revenue and costs, along with the associated receivables and accrued
liabilities, are reflected in the Company's financial statements because the
Company is contractually responsible for the ultimate acceptability of the
project by the Government.
Stock-based compensation
- -------------------------
The Company accounts for stock-based compensation using the intrinsic value
method prescribed in Accounting Principles Board (APB) Opinion No. 25 -
"Accounting for Stock Issued to Employees". Under APB No. 25, compensation cost
is measured as the excess, if any, of the quoted market price of the Company's
stock at the date of grant over the exercise price of the option granted.
Compensation cost for stock options, if any, is recognized ratably over the
vesting period. The Company provides additional pro forma disclosures as
required under SFAS No. 123 - "Accounting for Stock-based Compensation".
Comprehensive income
- --------------------
SFAS Statement No. 130 - "Reporting Comprehensive Income", effective for fiscal
years beginning after December 15, 1997 and adopted by the Company in 1998 on a
retroactive basis, defines comprehensive income as net income plus other
revenues, expenses, gains and losses that are excluded from net income and
included separately in the stockholders' equity section of the balance sheet.
The only adjustments necessary to arrive at the Company's comprehensive income
relate to unrealized gains, and the subsequent effect of recognized gains, on
marketable securities.
Net loss per share
- -------------------
Net loss per share is computed based upon the weighted average number of common
shares outstanding during the year. Potentially dilutive securities, which
include convertible preferred stock, stock options and warrants, would serve to
reduce the loss per share.
Use of estimates
- ----------------
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the amounts reported in the financial statements and accompanying notes.
Actual results may differ from those estimates.
NOTE 3 - LIQUIDITY
Although the Company is considered to have emerged from the development stage in
1998, management recognizes that the Company's history of operating losses,
level of available funds, and revenue from current and future development
contracts, in relation to projected expenditures, raise substantial doubt as to
the Company's ability to commence generation of significant revenues from the
commercialization of the SCS and ultimately achieve profitable operations.
Accordingly, the Company will continue to minimize its operating expenditures
through a number of measures, including the continued deferral by its officers
of significant portions of their salaries. In the event that the realization of
significant revenue from the commercialization of the SCS is further delayed,
the Company may need to raise additional capital to fund its operations beyond
1999.
19
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SONEX RESEARCH, INC. 1998 FORM 10-KSB
NOTE 4 - MARKETABLE SECURITIES
In 1995 the Company's former inactive subsidiary, SonoChem, Inc., effected a
1:10 reverse split of all of its outstanding shares of common stock, and was
merged with and into a privately held medical transcription services company.
The name of the surviving corporation was changed to Digital Dictation, Inc.
("Digital") and the officers and directors of the privately held company, two of
whom are directors of the Company and general partners of its largest
shareholder, Proactive (see Note 10), became the directors and officers of
Digital. At the time of this merger, the Company's carrying basis in the
SonoChem stock of zero was considered to be its cost basis in the Digital stock,
and no gain or loss was recorded in the accounts of the Company with respect to
this transaction. The shares of Digital stock received by the Company pursuant
to this merger became available for public trading in April 1996, and the
Company began to liquidate its holdings. In 1998 Digital was acquired by
Medquist, Inc., its largest competitor, in a share exchange. Shares of Medquist
also trade in the public market.
This investment is accounted for in accordance with SFAS No. 115 and classified
as a current asset as a security that is "available-for-sale". Accordingly, the
Company's investment in the Digital or Medquist shares still held at each
financial statement date is recorded at its aggregate fair value at that date. A
corresponding amount, representing the aggregate unrealized gain in the fair
value of this investment in excess of its cost basis at each financial statement
date, is reported as a separate component of stockholders' equity. The aggregate
net proceeds from the sale of these securities are recognized as gains in the
year of sale.
NOTE 5 - LOANS TO OFFICERS AND EMPLOYEES
Loans to officers and employees represent the remaining balance of amounts
advanced in prior years for the payment of income tax liabilities incurred by
these individuals upon their receipt of compensation in the form of shares of
the Company's common stock, and recent short-term loans made to Company
personnel. The loans, which are non-interest bearing, are secured by deferred
salaries payable to each of the borrowers, and become due on December 31, 1999.
NOTE 6 - PATENTS AND TECHNOLOGY
The capitalized costs of patents and technology consists of the following:
December 31,
------------------
1998 1997
---- ----
Capitalized costs $307,318 $282,527
Accumulated amortization (63,718) (50,785)
-------- --------
$243,600 $231,742
======== ========
The Company continues to conduct its own research and development activities
which have resulted in additional proprietary technology and patents.
Development of commercial applications of certain elements of the SCS has
commenced and management believes the capitalized cost of patents and technology
will be recovered through revenue derived from the licensing of such technology.
Management closely monitors the patent application process and other factors
which may affect the economic value of the Company's technology, and will reduce
the capitalized cost of patents and technology should the recovery of such cost
no longer be sustainable.
NOTE 7 - PROPERTY AND EQUIPMENT
Property and equipment consists of the following:
December 31,
------------------
1998 1997
---- ----
Shop equipment $407,687 $383,380
Office equipment 22,920 20,946
Vehicle 11,053 11,053
-------- --------
441,660 415,379
Accumulated depreciation (407,128) (398,173)
-------- --------
$ 34,532 $ 17,206
======== ========
20
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SONEX RESEARCH, INC. 1998 FORM 10-KSB
NOTE 8 - DEFERRED COMPENSATION
In order to help conserve the Company's limited cash resources, certain of the
Company's employees for several years have voluntarily deferred receipt of
payment of significant portions of their authorized annual salaries upon request
by the Board of Directors. By agreement with the Company, these individuals have
consented to the deferral of payment of amounts so accumulated until the Company
has received licensing revenue of at least $2 million or at such earlier date as
the Board of Directors determines that the Company's cash flow is sufficient to
allow such payment. Since January 1, 1997, however, there has been no further
deferral of salary requested of the Company's non-executive employees.
The conditions that would require repayment of deferred amounts have yet to
occur. From time to time, however, portions of such deferred amounts have been
paid through the issuance to the employees of shares, or discounted options to
purchase shares, of the Company's common stock. An aggregate of $714,039 and
$648,292 as of December 31, 1998 and 1997, respectively, of wages so deferred by
current and former employees remained unpaid and has been recorded as deferred
compensation on the Company's balance sheet.
The $182,687 described as "Cash posted as security for judgment" in the
Company's 1996 Statement of Cash Flows represents the return of funds upon the
reversal on appeal of a judgment stemming from a lawsuit against the Company
filed in 1993 by two former officers who sought repayment of deferred salaries
upon the termination of their employment.
NOTE 9 - INCOME TAXES
The Company has not incurred any federal or state income taxes since its
inception due to operating losses. At December 31, 1998, the Company had net
operating loss ("NOL") carryforwards of approximately $16.6 million available to
offset future taxable income. Net operating losses generated in 1998 and
subsequent years may be carried forward twenty years, while such losses
generated in 1997 and prior years may be carried forward fifteen years. If
certain substantial changes in the Company's ownership should occur, there would
be an annual limitation on the amount of the carryforwards which can be
utilized. Sales of marketable securities have also generated capital loss
carryforwards for income tax purposes. Capital loss carryforwards, which expire
after five years, may only be used to offset future capital gains. The Company's
tax loss carryforwards are summarized as follows:
Expiration NOL's Capital
------------ ------------ ---------
1999 $ 900,078
2000 1,105,399
2001 1,748,874 $ 201,681
2002 1,837,965 133,400
2003 1,344,816 365,147
2004 - 2012 9,180,907
2018 433,915
------------ ---------
$ 16,551,954 $ 700,228
============ =========
The difference between the net operating loss carryforwards described above and
the accumulated deficit reported in these financial statements results
principally from (1) temporary differences for income tax and financial
reporting purposes relating to the amounts and timing of deductibility of
deferred salaries and compensation related to the grant of stock options, and
the differences in the accounting for the Company's investment in its former
consolidated subsidiary for income tax and financial reporting purposes, and (2)
permanent differences principally due to the non-deductibility for income tax
purposes of a significant charge to operations for debt conversion expense in
1988 and the non-deductibility of compensation related to the exercise of stock
options recorded previously in the Company's accounts.
The potential income tax benefit of these loss carryforwards and temporary
differences of approximately $6.4 million has not been recorded in the financial
statements due to the uncertainty of realization based on the Company's
financial performance to date. Since 1995 net operating loss carryforwards
aggregating $1,027,283 have expired unused.
21
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SONEX RESEARCH, INC. 1998 FORM 10-KSB
NOTE 10 - CAPITAL STOCK
Authorized capital stock
- ------------------------
The Company is presently authorized to issue 48 million shares of $.01 par value
common stock and 2 million shares of $.01 par value convertible preferred stock.
All of the authorized shares of preferred stock, along with common stock
purchase warrants, were issued for $2 million in February 1992 (the "Preferred
Stock Investment") to a small number of individuals who qualified as "accredited
investors" pursuant to Rule 501 of Regulation D of the Securities Act of 1933
(the "Act") and to Proactive Partners, L.P. and certain of its affiliates
("Proactive"), who became the largest beneficial owner of the Company's common
stock by virtue of the acquisition of the convertible preferred stock and common
stock purchase warrants.
The preferred stock has priority in liquidation over the common stock, but it
carries no stated dividend. The holders of the preferred stock, voting as a
separate class, have the right to elect that number of directors of the Company
which represents a majority of the total number of directors. The preferred
stock is convertible at any time at the option of the holder into common stock
at the rate of $.35 per share of common stock. As of December 31, 1998, a total
of 459,999 shares of preferred stock had been converted into 1,314,278 shares of
common stock.
Private placements of common equity
- -----------------------------------
In February 1997 the Company notified the holders of all of its outstanding
warrants to purchase shares of its common stock, issued in private financings in
February 1992, June 1994, June 1995 and December 1995, of proposed amendments to
such warrants, offered because the Company was unable to complete a planned
registration during 1996 of the common stock issuable upon the exercise of the
warrants. The proposed amendments included, in various combinations, extensions
of the expiration dates, reductions in the exercise prices, reductions in the
number of warrants, provisions for cashless exercise, and provisions for
"piggy-back" registration rights.
The amendments proposed for the warrants issued in February 1992 (the "February
1992 Warrants") were also offered in connection with a $250,000 equity
investment proposal from Proactive accepted by the Board of Directors in
February 1997. In exchange for this cash investment, Proactive received 333,333
shares of common stock and five-year warrants to purchase 166,666 shares of
common stock at an exercise price of $.75 per share, along with a number of
amendments to the February 1992 Warrants. One other participant in the Preferred
Stock Investment, who also agreed to make an additional investment in February
1997, also received the amendments to the February 1992 Warrants in exchange for
his cash investment of $1,639, pursuant to which he also received 2,186 shares
of common stock and five-year warrants to purchase 1,093 shares of common stock
at an exercise price of $.75 per share.
In March 1997 the Company completed a private financing in which it raised
$330,000 from a small number of the Company's shareholders who participated in
previous private financings of the Company and who qualified as accredited
investors. A total of 440,000 shares of the Company's common stock and five-year
warrants to purchase an additional 220,000 shares of common stock at $.75 per
share were issued in this financing.
The offer and sale of a total of 775,519 shares of common stock and five-year
warrants to purchase a total of 387,759 shares of common stock in connection
with the February 1997 and March 1997 financings described above satisfied the
conditions of Rule 506 of Regulation D of the Act and, as such, were exempt from
the registration requirements of Section 5 of the Act as transactions not
involving any public offering within the meaning of Section 4(2) of the Act.
No separate value has been reflected in the financial statements for the
warrants issued in the above transactions based on management's belief that the
separate fair value of such warrants is not significant.
Stock options
- -------------
The Company maintains a non-qualified stock option plan (the "Plan") which has
made available for issuance a total of 7.5 million shares of common stock
following an increase of 2.5 million shares authorized by the Board of Directors
in December 1998. All directors, full-time employees and consultants to the
Company are eligible for participation. Option awards are determined at the
discretion of the Board of Directors. Upon a change in control of the Company,
all outstanding options granted to employees and directors become vested with
22
<PAGE>
SONEX RESEARCH, INC. 1998 FORM 10-KSB
respect to those options which have not already vested. Options outstanding
expire at various dates through December 2008.
In December 1998 the Board of Directors approved the grant to each of the
Company's four outside directors of ten-year options to purchase 100,000 shares
of common stock. These options vest at the rate of 25% per year beginning with
the date of grant and have an exercise price of $.50 per share, which price was
above the then current market price of the common stock.
Between January 1, 1996 and December 31, 1998, the Company had the following
activity in options to purchase shares of common stock under the Plan:
Weighted Weighted
average average
exercise # of shares exercise
# of shares price exercisable price
----------- ------- ----------- --------
Unexercised at January 1, 1996 4,026,972 $.51 2,807,372 $.52
========= ====
Granted 123,000 .80
Exercised (131,488) .50
Lapsed or canceled (45,000) .50
----------- -------
Unexercised at December 31, 1996 3,973,484 .51 3,195,734 $.53
========= ====
Granted 147,000 .56
Exercised (369,834) .51
Lapsed or canceled (152,934) .50
----------- -------
Unexercised at December 31, 1997 3,597,716 $.52 3,277,966 $.52
========= ====
Granted 548,500 .50
Exercised (181,500) .50
Lapsed or canceled (108,000) .50
----------- -------
Unexercised at December 31, 1998 3,856,716 $.52 3,391,966 $.52
=========== ==== ========= ====
During 1997 the number of members of the Company's Board of Directors was
reduced from nine to five, and one of the remaining directors was also named
president of the Company. As a result of the reduction in the number of
directors, unvested options for the purchase of 150,000 shares of common stock
lapsed. Also, in order to induce the new president to take that position,
Proactive, the Company's principal shareholder, granted him a ten-year option to
purchase 714,286 shares of common stock owned by Proactive at an exercise price
of $.35 per share. This option, which is not covered by the Plan, is exercisable
at the rate of 20% per year beginning with the date of grant.
For certain options under the Plan granted or repriced, the Company credited
$59,813 and $27,125 in 1997 and 1996, respectively, to additional paid-in
capital, representing the excess of the aggregate market value at the date of
grant or repricing of shares under option over the aggregate exercise price of
such options, and charged a like amount to compensation expense in each of those
years. In connection with the grant of the option in 1997 by Proactive to the
new president of the Company, $44,644 in 1998 and $44,643 in 1997 was credited
to additional paid-in capital and like amounts charged to compensation expense.
Additional compensation of $89,285 is being amortized to compensation expense
over the remaining vesting period of this option.
The Company applies APB Opinion No. 25 in accounting for stock option
compensation; however, SFAS No. 123 requires the Company to make certain
disclosures as if the fair value based method of accounting had been applied to
the Company's stock option grants. Accordingly, the Company has estimated the
grant date fair value of each option using the Black-Sholes option pricing model
with the following weighted average assumptions: volatility factor of 101% in
1998, 112% in 1997 and 124% in 1996, risk-free interest rate of 6%, zero
dividend yield, and expected term of ten years. For purposes of pro forma
disclosures, the estimated fair value of options is amortized to expense over
the vesting period of each option.
23
<PAGE>
SONEX RESEARCH, INC. 1998 FORM 10-KSB
Had compensation cost for the Company's stock option plan been determined
consistent with the method of SFAS No. 123 using the weighted average fair value
of options granted during the year as indicated below, the Company's net loss
and net loss per share for each year on a pro forma basis would have been as
follows:
1998 1997 1996
-------- -------- ----------
Weighted average fair value per share $.70 $.70 $.96
Net loss - as reported $270,362 $529,996 $672,475
Net loss - pro forma $531,122 $876,273 $910,840
Net loss per share - as reported $.02 $.03 $.04
Net loss per share - pro forma $.03 $.05 $.06
The Black-Sholes and other option pricing models were developed for use in
estimating the fair value of traded options as opposed to the type of
compensatory options granted by the Company. It also requires the input of
highly subjective assumptions, such as the expected stock price volatility,
changes in which can materially affect the fair value estimate. As a result, the
amounts calculated using the Black Sholes option pricing model may not
necessarily provide a reliable single measure of fair value of options granted
by the Company. In addition, these pro forma disclosures are not representative
of the effects on reported net loss and net loss per share for future years due
to the effects of vesting.
Common stock reserved for future issuance:
- -----------------------------------------
As of December 31, 1998, a total of 17,355,273 shares of common stock were
reserved by the Company for issuance for the following purposes:
Purpose # of shares
----------------------------- -----------
Currently exercisable warrants:
Exercisable at $.35 per share, expiring in February 2000 571,428
Exercisable at $.375 per share, expiring in June 2000 595,000
Exercisable at $.50 per share, expiring in June 2000 595,000
Exercisable at $.75 per share, expiring in
June 1999 1,048,536
February 2000 3,098,214
December 2000 340,000
February 2002 167,159
March 2002 220,000
----------
6,635,937
----------
Currently exercisable options:
Exercisable at $.50 per share 3,168,466
Exercisable at $.75 per share 173,500
Exercisable at $1.00 per share 50,000
----------
3,391,966
----------
Granted options becoming exercisable in the future:
Exercisable at $.50 per share 442,250
Exercisable at $.75 per share 22,500
----------
464,750
Options available for future grants 383,617
Conversion of preferred stock 4,400,003
----------
Total shares reserved 17,355,273
==========
24
<PAGE>
SONEX RESEARCH, INC. 1998 FORM 10-KSB
NOTE 11 - COMMITMENTS
The Company occupies its office and laboratory facility on a month-to-month
basis under the terms of an operating lease agreement pursuant to which the
property owner is required to provide thirty days notice if he wants the Company
to vacate the premises. The lease requires the Company to pay all property
related expenses. Gross rent charges aggregated $42,000, $42,000 and $52,000 in
1998, 1997 and 1996, respectively, while the Company also earned sublease income
of $2,000, $750 and $2,400 in 1998, 1997 and 1996, respectively. The Company
will seek to negotiate a new long-term lease for its facility or search for an
alternative location in the event that an agreement cannot be reached for the
existing premises. Management believes that the resolution of the uncertainty
with respect to the facility will not result in a significant interruption in
the operations of the Company.
ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS
ON ACCOUNTING AND FINANCIAL DISCLOSURE
On October 31, 1997, the Company informed PricewaterhouseCoopers LLP,
independent accountants for Sonex since 1985, that it had been dismissed as
independent accountants for the year ended December 31, 1997. The Company's
Board of Directors made the decision to change independent accountants.
In connection with its audit for the year ended December 31, 1996, and through
October 31, 1997, there were no disagreements with PricewaterhouseCoopers LLP on
any matter of accounting principles or practices, financial statement
disclosure, or auditing scope or procedure, which disagreements, if not resolved
to the satisfaction of PricewaterhouseCoopers LLP, would have caused them to
make reference thereto in their report on the financial statements for 1996.
The report of PricewaterhouseCoopers LLP on the financial statements of the
Company for the year ended December 31, 1996, presented on page 17 of this Form
10-KSB, contains no adverse opinion or disclaimer of opinion and is not
qualified or modified as to audit scope or accounting principle; however, such
report is modified by the inclusion of an explanatory paragraph indicating that
there is substantial doubt about the Company's ability to emerge from the
development stage and/or continue as a going concern.
The Company's Board of Directors made the decision to engage C. L. Stewart &
Company as new independent accountants as of October 31, 1997. During the two
previous fiscal years and through October 31, 1997, the Company had not
consulted with C. L. Stewart & Company regarding either (i) the application of
accounting principles to a specified transaction, either completed or proposed;
or the type of audit opinion that might be rendered on the Company's financial
statements, and either a written report was provided to the Company or oral
advice was provided that C.L. Stewart & Co. concluded was an important factor
considered by the Company in reaching a decision as to the accounting, auditing
or financial reporting issue; or (ii) any matter that was either the subject of
a disagreement, as that term is defined in Item 304(a)(1)(iv) of Regulation S-K
and the related instructions to Item 304 of Regulation S-K, or a reportable
event, as that term is defined in Item 304(a)(1)(v) of Regulation S-K.
The Company has had no disagreements with its current independent accountants,
C. L. Stewart & Company, on any matter of accounting principles or practices or
financial statement disclosure. C. L. Stewart & Company has been the Company's
independent accountants since October 31, 1997.
ITEM 9. DIRECTORS, EXECUTIVE OFFICERS AND CONTROL PERSONS
The Company's Board of Directors is divided into two categories: "Common Stock"
directors elected by the holders of Common Stock; and "Preferred Stock"
directors elected by the holders of Preferred Stock. These two categories of
directors are further divided into three classes as nearly equal in number as
possible, with the term of one of the three classes of directors expiring at
each annual meeting of shareholders. The members of each class of directors are
to hold office for terms of three years until their successors have been elected
and qualified. The holders of the Preferred Stock, voting as a separate class,
have the right to elect that number of directors of the Company which represents
a majority of the total number of directors.
The Company's By-laws state that the Board of Directors shall consist of not
fewer than three directors, with the total number of directors to be set by the
Board by resolution. Following the resignation of three Preferred Stock
directors and one Common Stock director in 1997, the total number of directors
is now five, two of whom are Preferred Stock directors and three of whom are
Common Stock directors.
25
<PAGE>
SONEX RESEARCH, INC. 1998 FORM 10-KSB
Directors of the Company do not receive fees for their services, but are
eligible to receive stock option grants and are reimbursed for expenses related
to their activities as directors. Executive officers are appointed and serve at
the discretion of the Board of Directors.
The names, ages, dates first elected as directors, and principal occupations and
employment of the directors and executive officers of the Company are set forth
below.
Term as
director
Name Age expires Position
---------------- --- ------- -------------------
Preferred Stock Directors:
Mr. Charles C. McGettigan 54 1999 Director
Mr. Myron A. Wick, III 55 1999 Chairman of the Board
Common Stock Directors:
Mr. Nuno Brandolini 45 2000 Vice Chairman of the Board
Mr. Lawrence H. Hyde 74 1999 President and Director
Dr. Andrew A. Pouring 67 2001 Chief Executive Officer, Chief Scientist
and Vice Chairman of the Board
Other Executive Officers:
Mr. George E. Ponticas 39 Vice President - Finance, Secretary,
Treasurer and Chief Financial Officer
Background of directors and executive officers
- ----------------------------------------------
Mr. Charles C. McGettigan has been a director of the Company since February
1992. He was a founding partner in 1991 and is a general partner of Proactive
Investment Managers, L.P., which is the general partner of Proactive Partners,
L.P. In 1988 Mr. McGettigan co-founded McGettigan, Wick & Co., Inc., an
investment banking firm. From 1984 to 1988 he was a Principal, Corporate
Finance, of Hambrecht & Quist, Inc. Prior to that Mr. McGettigan was a Senior
Vice President of Dillon, Read & Co. Inc. He currently serves on the Boards of
Directors of Cuisine Solutions, Inc., Modtech, Inc., PMR Corporation, Tanknology
- - NDE Corporation, WrayTech Instruments, Inc., and Onsite Energy, Inc., of which
he is the Chairman. Mr. McGettigan is a graduate of Georgetown University, and
received his MBA in Finance from The Wharton School of the University of
Pennsylvania.
Mr. Myron A. ("Mike") Wick, III, has been a director of the Company since
November 1991 and was elected Chairman of the Board of Directors in June 1993.
He was a founding partner in 1991 and is a general partner of Proactive
Investment Managers, L.P., which is the general partner of Proactive Partners,
L.P. In 1988 Mr. Wick co-founded McGettigan, Wick & Co., Inc., an investment
banking firm. From 1985 to 1988 Mr. Wick was Chief Operating Officer of
California Biotechnology, Inc. in Mountain View, California. He currently serves
on the Boards of Directors of Modtech, Inc. and Tanknology - NDE Corporation,
and is the Chairman of the Board of StoryFirst Communications, Inc.,and WrayTech
Instruments, Inc. Mr. Wick received a B.A. degree from Yale University and an
MBA from the Harvard Business School.
Mr. Nuno Brandolini has been a director of the Company since January 1982 and
was elected a Vice Chairman of the Board in May 1988. Since November 1995 Mr.
Brandolini has been the Chairman of the Board and Chief Executive Officer of
Scorpion Holdings, Inc., a merchant banking company. From December 1993 through
October 1995 he was a managing director of Rosecliff, Inc., also a merchant
banking company. From June 1991 to November 1993 he was a Vice President with
Salomon Brothers, Inc. From 1988 to 1991 Mr. Brandolini was a part owner of The
Baltheus Group, Inc., a management consulting and financial advisory firm. He
has a law degree from the University of Paris and he received an MBA from The
Wharton School of the University of Pennsylvania.
Mr. Lawrence H. Hyde has been a director of the Company since September 1986,
serving as Chairman of the Board from June 1987 to June 1993, and was appointed
President of the Company in October 1997. Mr. Hyde was a director of Harris
Graphics Corp. from 1983 to 1986, where during 1985 and 1986 he also served as
its Chairman of the Board and Chief Executive Officer. He was President and
Chief Executive Officer of AM General Company from 1979 to 1985. He joined
American Motors in 1974 and remained until 1983. At various times he had
corporate wide responsibility for engineering, international and marketing; his
last position was Executive Vice President responsible for International and
Engineering. He is a director of Whatman plc and a trustee of the American
26
<PAGE>
SONEX RESEARCH, INC. 1998 FORM 10-KSB
University in Cairo, where he is also chairman of the Karnac Equity Fund. Mr.
Hyde is a graduate of Harvard College and Harvard Business School.
Dr. Andrew A. Pouring has been a full-time employee, director, and Chief
Scientist of the Company since 1980, serving as President from April 1980
through November 1991, and as Chief Executive Officer since May 1985. In
November 1991 he was elected a Vice Chairman of the Board of Directors. He has
co-authored all of the Company's patented inventions. He served as a Professor
of Aerospace Engineering at the U.S. Naval Academy from 1964 to 1983, and was
Chairman of the Academy's Department of Aerospace Engineering from 1975 to 1978.
Dr. Pouring is a member of various professional and scientific societies,
including the American Society of Mechanical Engineers and the Society of
Automotive Engineers, as has been organizer and chairman of many symposia for
these societies. Dr. Pouring received his Bachelors and Masters degrees in
mechanical engineering from Rensselaer Polytechnic Institute. He received his
Doctor of Engineering degree from Yale University, where he also was a post
doctoral research fellow and lecturer.
Mr. George E. Ponticas has been Vice President of Finance, Chief Financial
Officer, Secretary and Treasurer of the Company since September 1991. From May
1987 through August 1991, he served as the Company's Controller and Assistant
Secretary. From August 1981 through April 1987, Mr. Ponticas was a member of the
auditing staff of Price Waterhouse in Baltimore, Maryland, attaining the
position of audit manager in 1986. At Price Waterhouse, he worked on the audits
of a number of public and private companies, with an emphasis on small
businesses. Mr. Ponticas is a Certified Public Accountant, and is a member of
the American Institute of Certified Public Accountants and the Maryland
Association of Certified Public Accountants. He received his B.S. in Accounting
from Loyola College in Maryland.
ITEM 10. EXECUTIVE COMPENSATION
The following table sets forth the compensation paid by the Company to its chief
executive officer; no other executive officer earned annual compensation during
the most recently completed year in excess of $100,000 (together referred to as
the "Named Executives").
SUMMARY COMPENSATION TABLE
Annual compensation
--------------------------------
Salary Long-term
-------------------- compensation
Name and Position Year In cash Deferred Bonus # of options
----------------- ---- --------- -------- -------- ------------
Dr. Andrew A. Pouring 1998 $ 72,000 $ 48,000 35,000
CEO & Chief Scientist 1997 72,000 48,000 35,000
1996 60,798 40,531 $ 10,000 25,000
In order to help conserve the Company's limited cash resources, certain of the
Company's employees for several years have voluntarily deferred receipt of
payment of significant portions of their authorized annual salaries upon request
by the Board of Directors. By agreement with the Company, these individuals have
consented to the deferral of payment of amounts so accumulated until the Company
has received licensing revenue of at least $2 million or at such earlier date as
the Board of Directors determines that the Company's cash flow is sufficient to
allow such payment. Since January 1, 1997, however, there has been no further
deferral of salary requested of the Company's non-executive employees.
The conditions that would require repayment of deferred amounts have yet to
occur. As of December 31, 1998, an aggregate of $714,039 in deferred salaries is
owed to current and former employees, including $298,981 owed to Dr. Pouring.
For many years through December 31, 1998, Dr. Pouring has been deferring 40% of
his annual salary. On January 1, 1999, the percentage deferral was reduced to
30%.
In order to avoid long-term financial commitments, the Company does not have
employment agreements with any of its personnel. The salaries of executive
officers are set by the Board of Directors on an annual basis. Dr. Pouring's
authorized annual salary was increased in 1997 for the first time since 1989.
With the exception of the granting of stock options, the Company does not pay
its Named Executives any bonuses or any type of long-term compensation in the
form of restricted stock awards, stock appreciation rights (SARs) or other form
of long-term incentive plan payments.
27
<PAGE>
SONEX RESEARCH, INC. 1998 FORM 10-KSB
OPTION GRANTS IN LAST FISCAL YEAR
Individual Grants
-------------------------------------------------------------------
Number of % of total
securities options
underlying granted to
options employees in Exercise Market Expiration
Name granted fiscal year price price date
---- ------- ----------- ----- ----- -------------
Pouring 35,000 30% $.50 $.375 Dec. 7, 2008
AGGREGATED OPTION/SAR EXERCISES IN LAST FISCAL YEAR
AND FISCAL YEAR-END OPTION/SAR VALUES
Number of securities Value of unexercised
underlying unexercised in-the-money
options/SARs at options/SARs at
December 31, 1998 December 31, 1998
# of shares
acquired on Value Exercisable/ Exercisable/
Name exercise realized unexercised unexercised
- -------- ----------- -------- ---------------------- -------------------
Pouring - - 163,816/220,066 $0/$0
With the exception of options to purchase 25,000 shares held by Dr. Pouring that
are exercisable at $.75 per share, all options held by the Named Executives are
exercisable at $.50 per share, which price was equal to the December 31, 1998
market price of the Company's publicly traded common stock.
ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS
AND MANAGEMENT
The following table sets forth as of March 31, 1999 information relating to
beneficial ownership by directors of the Company, directors and executive
officers of the Company as a group, and any other persons known by the Company
to be the beneficial owner of more than five percent of the currently issued and
outstanding common stock of the Company. A reporting person is deemed to be the
"beneficial owner" of a security if that person has or shares the power to vote
or to direct the voting of such security, or the power to dispose or to direct
the disposition of such security. Under this definition, more than one person
may be deemed to be a beneficial owner of securities as to which he has no
record ownerhip interest. Beneficial ownership includes securities which the
reporting person currently owns or has the right to acquire within sixty days
through the exercise of currently exercisable options and warrants or through
the conversion of preferred stock. Shares which the reporting person has the
right to acquire are not deemed to be outstanding for computing the percentage
of beneficial ownership of any other person. Unless otherwise noted, all shares
are beneficially owned and sole voting and investment power is held by the
persons named.
28
<PAGE>
SONEX RESEARCH, INC. 1998 FORM 10-KSB
Total Beneficial Ownership
--------------------------
Common Rights to Total shares
shares acquire beneficially Percent
Name and address (1) owned shares owned of class
-------------------- --------- --------- --------- --------
Nuno Brandolini 111,726 405,150 516,876 2.9
Lawrence H. Hyde 394,986 824,714 1,219,700 6.7
Charles C. McGettigan 1,570,211 5,846,366 7,416,577 (3) 31.4
Andrew A. Pouring 688,239 163,816 852,055 4.8
Myron A. Wick, III 1,570,211 5,846,366 7,416,577 (3) 31.4
All directors & officers
as a group (6 persons) 2,906,424 7,461,296 10,367,720 41.3
Herbert J. Mitschele, Jr.
Far Hills, NJ 946,755 105,715 1,052,470 5.9
Proactive , et.al. (2)
San Francisco, CA 2,748,457 9,593,146 12,341,603 44.8
- -----------------------------
(1) The business address for each director and named executive officer is 23
Hudson Street, Annapolis, Maryland, 21401.
(2) Includes shares beneficially owned directly and indirectly by Proactive
Partners, L.P. and several affiliated entities and individuals
("Proactive et.al."), as reported in a Form 13D filing with the Securities
and Exchange Commission.
(3) Includes 7,127,577 shares beneficially owned by Proactive et.al.,
which shares could be deemed to be beneficially owned by both Mr.
McGettigan and Mr. Wick by virtue of their executive and ownership
positions in Proactive et.al. Both individuals exercise shared voting
and investment power with respect to such shares.
Rights to Acquire Shares
------------------------
Total
Exercisable Preferred rights to
Exercisable (put)/ Exercisable stock acquire
Name options call (2) warrants converted shares
- -------------------- ---------- --------- --------- --------- ---------
Nuno Brandolini 405,150 405,150
Lawrence H. Hyde 539,000 285,714 824,714
Charles C. McGettigan (1) 289,000 (142,857) 3,414,510 2,285,713 5,846,366
Andrew A. Pouring 163,816 146,316
Myron A. Wick, III (1) 289,000 (142,857) 3,414,510 2,285,713 5,846,366
All directors & officers
as a group (6 persons) 1,807,216 142,857 3,514,510 2,285,713 7,461,296
Herbert J. Mitschele, Jr. 62,858 42,857 105,715
Proactive , et.al. (2)
San Francisco, CA (285,714) 5,521,719 4,357,141 9,593,146
- ---------------------------
(1) Includes 5,628,794 shares beneficially owned by Proactive, et.al.,
which shares could be deemed to be beneficially owned by both Mr.
McGettigan and Mr. Wick by virtue of their executive and ownership
positions in Proactive, et.al. Both individuals exercise shared voting
and investment power with respect to such shares.
(2) Represents the currently exercisable portion of a ten-year option
granted by Proactive, et.al. to Mr. Hyde to purchase 714,286 shares of
common stock presently owned by Proactive, et.al. at an exercise price
of $.35 per share. This option becomes exercisable at the rate of 20%
per year beginning with the December 15, 1997 date of grant. Because
this agreement relates to shares which are already outstanding, the
exercise of such rights will not result in an increase in the total
number of the Company's outstanding shares for purposes of computing
the percentage of beneficial ownership of each reporting person. Mr.
McGettigan and Mr. Wick each has indirect beneficial ownership in 50%
of the shares subject to this agreement.
29
<PAGE>
SONEX RESEARCH, INC. 1998 FORM 10-KSB
ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
None.
ITEM 13. EXHIBITS LIST AND REPORTS ON FORM 8-K
(a) Exhibits.
3 Articles of Incorporation and Bylaws (as amended) - Incorporated
by reference to the Company's Annual Report on Form 10-KSB for
the year ended December 31, 1992.
4 Instruments defining the rights of security holders (contained in
Exhibit 3 hereof).
10.1 1987 Non-Qualified Stock Option Plan, as amended - Incorporated by
reference to the Company's Registration Statement No. 33-34520 on
Form S-8.
21 Subsidiaries of the Registrant: Sonex International, B.V. - The
Netherlands; Sonex Engines, Inc. - Delaware (both are inactive
subsidiaries).
23.a Consent of C.L. Stewart & Company
23.b Consent of PricewaterhouseCoopers LLP
24 Power of Attorney
27 Financial Data Schedule
(b) Reports on Form 8-K.
None.
30
<PAGE>
SONEX RESEARCH, INC. 1998 FORM 10-KSB
SIGNATURES
In accordance with Section 13 or 15(d) of the Exchange Act , the Registrant
caused this report to be signed on its behalf by the undersigned, thereunto duly
authorized.
SONEX RESEARCH, INC.
April 12, 1999 By: /s/ Andrew A. Pouring
----------------------------------
Andrew A. Pouring
Principal Executive Officer
April 12, 1999 By: /s/ George E. Ponticas
----------------------------------
George E. Ponticas
Principal Financial and Accounting Officer
In accordance with the Exchange Act, this report has been signed below by the
following persons on behalf of the Registrant and in the capacities and on the
dates indicated.
April 12, 1999 *
----------------------------------
Myron A. Wick, III
Chairman of the Board of Directors
April 12, 1999 *
----------------------------------
Nuno Brandolini
Vice Chairman of the Board of Directors
April 12, 1999 /s/ Andrew A. Pouring
----------------------------------
Andrew A. Pouring
Vice Chairman of the Board of Directors
April 12, 1999 *
----------------------------------
Lawrence H. Hyde
President and Director
April 12, 1999 *
----------------------------------
Charles C. McGettigan
Director
- --------------------
* Executed on behalf of these persons by George E. Ponticas, a duly appointed
attorney-in-fact of each such person.
/s/ George E. Ponticas
- ----------------------------------
George E. Ponticas, Attorney-In-Fact
The Registrant will furnish its shareholders with copies of its annual report
and proxy statement after the date of this report.
31
<PAGE>
SONEX RESEARCH, INC. 1998 FORM 10-KSB
EXHIBIT 23.a
CONSENT OF INDEPENDENT ACCOUNTANTS
We hereby consent to the incorporation by reference in the Prospectus
constituting part of the Registration Statement on Form S-8 (No. 33-34520) of
Sonex Research, Inc. of our report dated March 10, 1999 appearing on page 13 of
this Form 10-KSB.
/s/C.L. STEWART & COMPANY
Annapolis, Maryland
April 12, 1999
EXHIBIT 23.b
CONSENT OF INDEPENDENT ACCOUNTANTS
We hereby consent to the incorporation by reference in the Prospectus
constituting part of the Registration Statement on Form S-8 (No. 33-34520) of
Sonex Research, Inc. of our report dated April 8, 1997 appearing on page 13 of
this Form 10-KSB.
/s/PRICEWATERHOUSECOOPERS LLP
Baltimore, Maryland
April 12, 1999
EXHIBIT 24
APPOINTMENT OF ATTORNEY-IN FACT
KNOW ALL MEN BY THESE PRESENTS, that each of the undersigned Directors and
Executive Officers of Sonex Research, Inc., a Maryland corporation that is
subject to certain filing requirements with the Securities and Exchange
Commission (SEC) and other regulatory agencies and governmental bodies,
including but not limited to the Annual Report on Form 10-KSB and Registration
Statements on Forms S-3 and S-8, hereby constitutes and appoints George E.
Ponticas his true and lawful attorney-in-fact and agent with full power of
substitution and resubstitution, for him and in his name, place and stead, in
any and all capacities, to sign any and all reports and registration statements
filed with the SEC and other regulatory agencies and governmental bodies,
including amendments thereto and all other documents in connection therewith,
granting unto said attorney-in-fact and agent full power and authority to do so
and perform each and every act and thing requisite and necessary to be done in
and about the premises, as fully to all intents and purposes as he might or
could do in person, hereby ratifying and confirming all that said
attorney-in-fact and agent or his substitute or substitutes may lawfully do or
cause to be done by virtue hereof.
NAME POSITION DATE
/s/Myron A. Wick, III
- -------------------------- Chairman of the Board
Myron A. Wick, III of Directors September 16, 1998
/s/Andrew A. Pouring
- -------------------------- Vice Chairman of the
Andrew A. Pouring Board of Directors &
Chief Executive Officer September 16, 1998
/s/Nuno Brandolini
- -------------------------- Vice Chairman of the
Nuno Brandolini Board of Directors September 16, 1998
/s/Lawrence H. Hyde President and Director September 16, 1998
- -------------------------
Lawrence H. Hyde
/s/Charles C. McGettigan Director September 16, 1998
- --------------------------
Charles C. McGettigan
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<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> DEC-31-1998
<CASH> 336,458
<SECURITIES> 29,460
<RECEIVABLES> 102,485
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<PP&E> 441,660
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<CURRENT-LIABILITIES> 828,951
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0
15,400
<COMMON> 176,429
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<TOTAL-LIABILITY-AND-EQUITY> 802,872
<SALES> 0
<TOTAL-REVENUES> 395,213
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