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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K/A
(Mark one)
[X] Annual Report pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934 for the fiscal year ended December 31, 1998, or
[ ] Transition Report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934 for the transition period from ______________ to
_____________.
Commission File No. 0-23862
Fonix Corporation
(Exact name of registrant as specified in its charter)
Delaware 87-0380088
(State or other jurisdiction (I.R.S. Employer Identification No.)
of incorporation or organization)
60 East South Temple, Suite 1225
Salt Lake City, Utah 84111
(Address of principal executive offices with zip code)
(801) 328-8700
(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock ($0.0001 par value per share)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days: Yes [X] No [ ].
The aggregate market value of the voting stock held by non-affiliates of the
registrant is approximately $35,828,186.25 calculated using a closing price of
$0.75 per share on April 9, 1999. For purposes of this calculation, the
registrant has included only the number of shares held by its officers and
directors directly of record as of April 9, 1999, (and not counting shares
beneficially owned on that date) in determining the shares held by
non-affiliates. As of April 9, 1999, there were issued and outstanding
70,064,495 shares of the Company's common stock.
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [ ]
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This Amendment No. 1 to the Annual Report on Form 10-K of Fonix
Corporation is submitted to amend the following Items, which originally were
submitted as part of the Annual Report filed with the Securities and Exchange
Commission as of April 15, 1999:
Part II
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations........................................28
Item 8. Financial Statements and Supplementary Data..................39
Pursuant to SEC Rule 12b-15, each of the foregoing Items, as amended hereby, is
set forth below in its entirety.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
THIS REPORT ON FORM 10-K CONTAINS, IN ADDITION TO HISTORICAL INFORMATION,
FORWARD-LOOKING STATEMENTS THAT INVOLVE SUBSTANTIAL RISKS AND UNCERTAINTIES. THE
COMPANY'S ACTUAL RESULTS COULD DIFFER MATERIALLY FROM THE RESULTS ANTICIPATED BY
THE COMPANY AND DISCUSSED IN THE FORWARD-LOOKING STATEMENTS. FACTORS THAT COULD
CAUSE OR CONTRIBUTE TO SUCH DIFFERENCES ARE DISCUSSED BELOW IN THE SECTION
ENTITLED "FACTORS AFFECTING FUTURE OPERATING RESULTS" AND UNDER THE HEADING
"CERTAIN SIGNIFICANT RISK FACTORS" IN ITEM 1 PART i OF THIS REPORT, ABOVE.
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Overview
Fonix is a development-stage company engaged in scientific research and
development of proprietary automated speech recognition and related technologies
("ASRT") comprised of components which may be licensed in whole or in part to
third parties. The Company has completed the Core Technologies related to the
ASRT such that they are available for third-party licensing and co-development.
In November 1997, the Company entered into an agreement with the semiconductor
unit of Siemens AG pursuant to which the Company and Siemens agreed to pursue
research and development of certain technologies related to the ASRT and the
commercialization of such technologies for the telecommunications industry
through a strategic alliance. Pursuant to the terms of the Siemens agreement,
the Company and Siemens entered into the First Statement of Work and License
Agreement pursuant to which Siemens paid the Company a license fee for the
development and production of Fonix ASRT in integrated circuits suitable for
certain telecommunications applications. Under the Siemens agreement, Fonix
received its first revenue associated with the ASRT in 1998. On October 14,
1997, the Company entered into a Master Technology Collaboration Agreement (the
"OGI Agreement") with the Oregon Graduate Institute of Science and Technology
("OGI") pursuant to which the Company and OGI have agreed to pursue research and
development of certain ASRT. Under the terms of the first Statement of Work
entered into pursuant to the OGI Agreement, the parties are collaborating on
advanced automated speech recognition applications for entry in the 1999 DARPA
competition. The OGI Agreement contemplates that the Company and OGI will enter
into other agreements to pursue research and development of certain technologies
related to the ASRT, although there can be no assurance that such additional
agreements will be entered into by the Company and OGI. In 1998, the Company
entered into a similar arrangement with Brigham Young University.
Other than the arrangements with Siemens, OGI, and Brigham Young University, the
Company has no licensing or co- development agreements with any third party for
its ASRT. Other than the non-refundable license fee paid by Siemens, the Company
has received no revenue to date with respect to the ASRT. Fonix presently
anticipates that any products incorporating the Company's Core Technologies
would be manufactured and marketed by such third party licensees and
co-development and strategic alliance partners such as Siemens and therefore has
no plans to manufacture products incorporating the ASRT for the foreseeable
future. There can be no assurance that the Company will be able to license its
Core Technologies or enter into additional co-development or strategic alliance
agreements.
In March 1998, the Company expanded its suite of human-computer interaction
technologies by acquiring the award-winning voice synthesis technologies of
AcuVoice. The business operations previously conducted by AcuVoice are now part
of the Company's Interactive Technologies Solutions Group, which also includes
the Company's previously developed Core Technologies. During the year ended
December 31, 1998, the Company received in the aggregate, $236,586 in revenue
from licensing or sale of the AcuVoice technologies.
In September 1998, the Company acquired Articulate, a developer of leading voice
recognition and systems software for specialized applications in the health care
industry. The business operations previously conducted by Articulate are now
conducted by the Company's HealthCare Solutions Group based in Woburn,
Massachusetts. During the year ended December 31, 1998, the Company received, in
the aggregate, $284,960 from sales of the PowerScribe products acquired from
Articulate.
In October 1998, the Company acquired Papyrus. Papyrus develops and markets
printing and cursive handwriting recognition software for PDAs, pen tablets and
mobile phones. The Company operates the business formerly operated by Papyrus as
part of its Interactive Technologies Solutions Group in Woburn, Massachusetts.
During the year ended December 31, 1998, the Company received, in the aggregate,
$0 from licensing of technologies acquired from Papyrus.
The Company markets its previously developed technologies, together with
text-to-speech technologies and products acquired from AcuVoice, handwriting
recognition technologies and products acquired from Papyrus, and intelligent
agent technologies, through its Interactive Technologies Solutions Group. The
present marketing direction for the Interactive Technologies Solutions Group is
to form relationships with third parties who can incorporate the Company's
technologies and the other technologies available to the Interactive
Technologies Solutions Group into their own products or product development
efforts. Such relationships may be structured in any of a variety of ways
including traditional technology licenses, co-development relationships through
joint ventures or otherwise, and strategic alliances. The third parties with
whom the Company presently has such relationships and with which it may have
similar
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relationships in the future include participants in the application software,
operating systems, computer, microprocessor chips, consumer electronics,
automobile, telephony and health care technology industries.
The Company markets its voice recognition and systems software for specialized
applications in the health care industry through its HealthCare Solutions Group.
The HealthCare Solutions Group presently markets large vocabulary voice
recognition software for the rapid capture, transcription and management of
clinical information dictated by radiologists and emergency medical physicians.
The products now being sold by the HealthCare Solutions Group, including
PowerScribeRAD and PowerScribeEM, are marketed to major hospitals and medical
centers.
In addition to the transactions involving AcuVoice, Articulate and Papyrus in
1998, the Company also was in negotiations to acquire several other speech
technology companies. The Company has now terminated all such acquisition
discussions. The Company advanced money to some of those acquisition candidates
in anticipation of the completion of an acquisition transaction. The Company
presently is pursuing the return of such funds in the aggregate amount of
$245,000.
Details of Acquisitions and Valuation Methodologies
During fiscal year 1998, the Company acquired AcuVoice and Articulate. A portion
of the consideration paid in each acquisition was for in-process research and
development ("IPR&D").
AcuVoice (Acquired March 13, 1998)
At the date of acquisition, AcuVoice was a developer of a speech-synthesizing
software system that is capable of translating text into natural sounding
speech. Its currently available products include the AcuVoice Speech Synthesizer
AV1700 Text Reader and the AcuVoice Speech Synthesizer AV2001
Telephony/Multimedia Interface. These applications are able to read a variety of
input text in an American English male voice.
At the date of acquisition, AcuVoice's IPR&D efforts were focused on the
continued development and evolution of the next generation of these products.
The Company now is working to expand voice capacity to include both a male and
female voice, and to expand language capacity to include Japanese, Mandarin
Chinese, French, German, and Spanish. In addition to the technological issues
resulting from these efforts, the Company also intends to enhance the next
generation applications with a stronger text-to-speech engine, sound bank, SAPI
4.0, SDK, and user dictionary; and increased VOX file output, documentation, C++
API and JSAPI. The Company is also developing an ESL product for the Windows
95/Windows NT environments that would have a customized dictionary and sample
English sentences, and a highly scalable multi-channel version for applications
that would operate in Windows NT/Solaris environments.
The developmental projects at the time of the acquisition were not
technologically feasible and had no alternative future use. This conclusion was
attributable to the fact that AcuVoice had not completed a working model that
had been tested and proven to work at performance levels which were expected to
be commercially viable, and that the technologies constituting the projects had
no alternative use other than their intended use. The value is attributable
solely to the development efforts completed as of the acquisition date. The
acquired IPR&D was valued at $9.3 million based on an analysis of forecasted
income.
As of the date of acquisition, AcuVoice had invested $3.5 million in the IPR&D
identified above. Development of the acquired in-process technology into
commercially viable products and services required efforts principally related
to the completion of all planning, designing, coding, prototyping, scalability
verification, and testing activities necessary to establish that the proposed
technologies would meet their design specifications, including functional,
technical, and economic performance requirements. Management estimates that
approximately $1.0 million will be required over the next 12 months to develop
the aforementioned products to commercial viability.
Through December 31, 1998, the Company has spent approximately $130,000 on
development of the projects. Management estimates that
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the projects are 78% complete and that a total of approximately $870,000 will be
required to complete the AcuVoice projects. The purchased IPR&D projects are
continuing to be developed as anticipated, and there are no changes to the
initial estimates regarding completion and cost of development.
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Articulate (Acquired September 2, 1998)
Articulate focused on developing and marketing speech recognition and integrated
speech-oriented software applications for desk-top and client server-based
computer environments. In 1993, Articulate focused on developing
large-vocabulary speech applications for the heath care market, with a primary
focus on medical records management. In 1995, Articulate began development of
PowerScribe, which converts speech into text to create an electronic medical
report. The first PowerScribe application focused on the radiology market.
At the date of acquisition, Articulate's IPR&D focused on (1) enhancing its
current PowerScribeRAD application to meet the needs of the health care market,
and (2) developing products addressing the needs of other health care segments.
The next generation of PowerScribeRAD, identified as Version 2.5, will differ
from Version 1.0 in that it will have an enhanced tool kit, providing a common
set of services including storage and retrieval, and improved voice recognition
technology using a different set of language models. In addition, Version 2.5
will also be developed with a new version of SQL. SQL Version 7.0 is
significantly improved over Version 6.5 in that it self-administers more
effectively and incorporates technology supporting remote access via a virtual
connection. Articulate is also developing PowerScribe products for emergency,
cardiology, and pathology health care segments.
The developmental projects at the time of the acquisition were not
technologically feasible and had no alternative future use. This conclusion was
attributable to the fact that Articulate had not completed a working model that
had been tested and proven to work at performance levels which were expected to
be commercially viable, and that the technologies constituting the projects had
no alternative use other than their intended use. The value is attributable
solely to the development efforts completed as of the acquisition date. The
acquired IPR&D was valued at $3.8 million based on an analysis of forecasted
income.
As of the date of acquisition, Articulate had invested $3.4 million in the IPR&D
identified above. Development of the acquired in-process technology into
commercially viable products and services required efforts principally related
to the completion of all planning, designing, coding, prototyping, scalability
verification, and testing activities necessary to establish that the proposed
technologies would meet their design specifications, including functional,
technical, and economic performance requirements. Management estimates that an
additional $1.0 million will be required over the next 12 months to develop the
aforementioned products to commercial viability.
Of the projects deemed IPR&D, both Radiology 2.5 and Emergency 1.0 achieved
technological feasibility and commercial viability subsequent to the acquisition
date, as anticipated in terms of time of release and cost to complete. Through
December 31, 1998, the Company has spent approximately $280,000 on development
of all of the projects. Management estimates that the combined projects are 82%
complete, and that a total of approximately $720,000 will be required to
complete all of the Articulate projects. The remaining IPR&D projects are
continuing to be developed as anticipated, and there are no changes to the
initial estimates regarding completion and cost of development.
Valuation Methodology
The valuations of the respective acquired IPR&D included, but were not limited
to, an analysis of (1) the market for AcuVoice and Articulate products and
technologies; (2) the completion costs for the projects; (3) the expected cash
flows attributable to the IPR&D projects; and (4) the risks associated with
achieving such cash flows. The assumptions underlying the cash flow projections
were derived from investment banking reports, independent analyst reports,
Fonix, AcuVoice, and Articulate company records, and discussions with the
management of all companies. Primary assumptions such as revenue growth and
profitability were compared to indications of similar companies as well as to
indications from industry analyst reports, to determine the extent to which
these assumptions were supportable. The Company did not assume in its valuation
any material change in its profit margins as a result of the acquisitions and
did not assume any material increases in selling, general and administrative
expenses as a result of the acquisitions. The Company did not anticipate any
expense reductions or other synergies as a result of the acquisitions. The basis
of the acquisitions was an attempt to enhance the Company's competitive position
by offering a broader product line, including applications and functionality
based upon the acquired speech recognition and text-to-speech technologies.
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The Company does not break down revenues attributable specifically to AcuVoice-
and Articulate-derived products. As products are offered both as a suite and as
individual applications, Fonix license fees are not necessarily application
specific. However, the Company believes that revenues generated to date concur
with the assumptions used in the valuation analysis.
Because the Company does not account for expenses by product, it is not possible
to determine the actual expenses associated with the technologies acquired from
AcuVoice and Articulate. The Company currently believes that expenses associated
with completing the purchased IPR&D and integrating the technologies with the
Company's existing products are approximately consistent with the Company's
estimates used in the analysis and that completion dates for the development
projects discussed above concur with projections used at the time of the
acquisition. Research and development spending with respect to these offerings
is expected to continue at a rate that is consistent with the Company's overall
research and development spending. The Company does not believe that the
acquisitions resulted in any material changes in its profit margins or in
selling, general and administrative expenses. The Company does not believe that
it achieved any material expense reductions or synergies as a result of the
acquisitions.
The rates utilized to discount the net cash flows to their present value were
consistent with the nature of the forecast and the risks associated with the
projected growth, profitability and developmental projects. Discount rates of
50% and 60% for AcuVoice and 35% and 40% for Articulate were deemed appropriate
for the business enterprises and for the acquired IPR&D, respectively. These
discount rates were consistent with the acquired companies' various stages of
development; the uncertainties in the economic estimates described above; the
inherent uncertainty at the time of the acquisition surrounding the successful
development of the purchased in-process technology; the useful life of such
technology; the profitability levels of such technology; and the inherent
uncertainties of the technological advances that were indeterminable at the time
of the acquisition.
The forecasts used in valuing the IPR&D were based upon assumptions the Company
believed to be reasonable but which were inherently uncertain and unpredictable.
For these reasons, actual results may vary from projected results. The Company
currently markets the AcuVoice and Articulate acquired and
subsequently-developed products.
For each acquisition, the excess purchase price over the net tangible assets was
allocated to in-process research and development, completed technology and
goodwill.
Results of Operations
1998 Compared to 1997
During fiscal year 1998, the Company recorded revenues of $2,889,684, of which
$2,368,138 was a non-refundable license fee from Siemens for which the Company
has no further obligation. The remainder of such revenues were from sales and
licensing fees related to the PowerScribe dictation and text-to-speech voice
synthesis technologies.
During fiscal year 1998, the Company incurred product development and research
expenses of $13,620,748, an increase of $6,554,454 over the $7,066,294 incurred
in 1997. This increase was due primarily to the addition of product development
and research personnel, increased use of independent contractors, equipment,
facilities and the operations of AcuVoice and Articulate. The Company
anticipates similar or increased product development and research costs as it
expands and continues to develop and market the applications and products
offered by its HealthCare Solutions and Interactive Technologies Solutions
Groups. Additionally, the Company purchased IPR&D totaling approximately
$13,136,000 during fiscal year 1998, in connection with the acquisitions of
AcuVoice and Articulate.
Selling, general and administrative expenses remained relatively flat at
$12,612,015 and $12,947,112 respectively, for fiscal years 1998 and 1997.
Salaries, wages and related costs were $4,163,943 and $2,216,400 for fiscal
years 1998 and 1997, respectively, an increase of $1,947,543. This increase is
attributable to incentive compensation for continued employment paid to
employees of Articulate of $857,000, and to increases in personnel from recent
acquisitions. Legal and accounting expenses increased $1,234,178 and
depreciation and amortization increased $2,629,956. The $2,629,956 increase in
depreciation and amortization is primarily attributable to the amortization of
intangible assets acquired in connection with the acquisitions of AcuVoice and
Articulate. Additionally, consulting and outside services
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decreased by $6,740,619.
The Company incurred losses from operations of $36,555,423 and $20,013,406
during fiscal years 1998 and 1997, respectively. The significant increase in
losses from operations is primarily due to purchased IPR&D charges of
$13,136,000 associated with the acquisitions of AcuVoice and Articulate. The
Company anticipates that its investment in ongoing scientific product
development and research will continue at present or increased levels for at
least the remainder of fiscal year 1999 assuming availability of working
capital.
Net other expense was $6,563,359 for the year ended December 31, 1998, an
increase of $5,004,681 over the previous year. This increase was primarily due
to a $6,111,577 expense recorded in connection with the settlement of a reset
provision associated with a private placement of the Company's common stock (see
Liquidity and Capital Resources). This increase was offset in part by a
reduction in interest expense of $1,231,182 from the previous year, primarily
due to extinguishment of certain debt instruments during the year ended December
31, 1998.
1997 Compared to 1996
Prior to March 1997, the Company conducted its scientific research and
development activities through Synergetics, Inc. ("Synergetics"), pursuant to
product development and assignment contracts (collectively the "Synergetics
Agreement"). Synergetics provided personnel and facilities and the Company
financed scientific research and development of the ASRT on an as-required
basis. There was no minimum requirement or maximum limit with respect to the
amount of funding the Company was obligated to provide to Synergetics under the
Synergetics Agreement, and the Company was obligated to use its best efforts in
raising all of the necessary funding for the development of the ASRT.
Synergetics submitted pre-authorized work orders and budgets, which were then
reviewed and approved by the Company. All funds paid to Synergetics have been
accounted for by the Company as research and development expense. Under the
Synergetics Agreement, the Company had also agreed to pay a royalty to
Synergetics equal to 10% of revenues from sales of the ASRT or products
incorporating the ASRT (the "Royalty"). On March 13, 1997, the Company and
Synergetics reached an agreement in principle to modify the Synergetics
Agreement with regard to the development and assignment of the Company's ASRT.
On April 6, 1998, the Company and Synergetics entered into a Royalty
Modification Agreement, under which the Company agreed, subject to its
compliance with applicable securities laws, to make an offer to exchange common
stock purchase warrants having an exercise price of $10 per share for the
Project Shares at the rate of one warrant to purchase 800 shares of the
Company's common shares for each Project Share. The warrants, if and when
issued, will not be exercisable until the earlier of (1) the date the Company's
common stock has traded for a period of 15 consecutive trading days at a minimum
of $37.50 per share or (2) September 30, 2000. The offer of warrants to holders
of Project Shares cannot be made by the Company until a registration statement
covering the total number of warrants issuable upon the exercise of the warrants
has been declared effective by the Securities and Exchange Commission. Upon the
tender to the Company of any Project Shares a corresponding percentage of the
Royalty will be canceled.
Because the Company did not license its ASRT until February 1998, the Company
did not generate any revenues during 1997 or 1996. From inception on October 1,
1993 through December 31, 1997, the Company has invested $17,937,293 in research
and development relating to its Core Technologies. During the year ended
December 31, 1997, the Company incurred research and development expenses of
$7,066,294, an increase of $2,308,282 over the previous year. This increase was
due primarily to the addition of research and development personnel, equipment
and facilities. The Company anticipates similar or increased research and
development costs as it expands and continues to develop and market its Core
Technologies.
General and administrative expenses were $12,947,112 and $3,530,400,
respectively, for the years ended December 31, 1997 and 1996. This increase over
the previous year was due primarily to non-cash expenses associated with the
issuance of debt and equity securities and an increase in consulting and outside
services. Consulting and outside services were $7,134,115 and $1,456,297 for the
years ended December 31, 1997 and 1996, respectively, an increase of $5,677,818
in 1997. In 1997, $4,112,970 of the consulting and outside services was a
non-cash expense for the issuance of common stock for services associated with
potential strategic alliances. Additionally, the Company incurred increased
expenses in salaries, rents, legal and accounting fees, and fees paid for
outside consulting services.
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Due to the lack of revenues and significant research and development and general
and administrative expenses, the Company has incurred losses from operations
since inception totaling $40,183,963, of which $20,013,406 and $8,288,412 were
incurred in the years ended December 31, 1997 and 1996, respectively. The
Company anticipates that its investment in ongoing scientific research and
development of the ASRT and related artificial intelligence and
compression/decompression technologies will continue at present or increased
levels.
Net other expense was $1,558,678 for the year ended December 31, 1997, an
increase of $2,017,582 over the previous year. This increase was due primarily
to expenses associated with the issuance of convertible debentures and warrants.
In addition, the Company drew down its line of credit to fund its operations,
thereby investing smaller amounts of cash reserves which decreased interest
income and increased interest expense.
The Company converted debentures in the amount of $2,150,000 and related accrued
interest of $28,213 by issuing 108,911 shares of Series B Preferred Stock. In
connection with the extinguishment of the debentures and the issuance of Series
B Preferred Stock, the Company expensed unamortized prepaid financing costs in
the amount of $220,014 as a loss on extinguishment of debt. In connection with
this extinguishment, the Company issued a warrant to purchase up to 175,000
shares of common stock. The Company recorded the fair value of the warrant of
$661,850 as an additional loss on extinguishment of debt.
Liquidity and Capital Resources
The Company must raise additional funds to be able to satisfy its cash
requirements during the next twelve months. The scientific research and
development, corporate operations and marketing expenses will continue to
require additional capital. In addition, the Company's recent acquisitions of
AcuVoice, Articulate, and Papyrus place further requirements on the Company's
limited cash resources. Because the Company presently has only limited revenue
from operations, the Company intends to continue to rely primarily on financing
through the sale of its equity and debt securities to satisfy future capital
requirements until such time as the Company is able to enter into additional
acceptable third party licensing or co-development arrangements such that it
will be able to finance ongoing operations out of license, royalty and sales
revenue. There can be no assurance that the Company will be able to enter into
such agreements. Furthermore, the issuance of equity securities or other
securities which are or may become convertible to the equity securities of the
Company in connection with such financing (or in connection with acquisitions)
would result in dilution to the stockholders of the Company which could be
substantial.
The Company had negative working capital of $14,678,975 at December 31, 1998,
compared to positive working capital of $678,823 at December 31, 1997. The
current ratio was 0.59 at December 31, 1998, compared to 1.03 at December 31,
1997. Current assets increased by $433,483 to $20,715,206 from December 31, 1997
to December 31, 1998. Current liabilities increased by $14,924,315 to
$35,394,181 during the same period. The decrease in working capital from
December 31, 1997, to December 31, 1998, was primarily attributable to an
increase in notes payable associated with the acquisition of Articulate and
increases in accounts payable, notes payable of $857,000 as incentive
compensation to Articulate employees to ensure continued employment, and accrued
liabilities due to minimal available cash. Total assets were $61,989,927 at
December 31, 1998, compared to $22,894,566 at December 31, 1997.
From its inception, the Company's principal source of capital has been private
and other exempt sales of the Company's debt and equity securities. During the
year ended December 31, 1998, the Company issued 22,542,407 shares of common
stock. Of such shares, 7,192,078 shares were issued in connection with three
private placements (see below), 10,944,081 shares were issued in connection with
the acquisitions of AcuVoice, Articulate and Papyrus, 4,081,234 shares were
issued upon the conversion of preferred stock and related dividends, 265,000
shares were issued upon the exercise of previously granted warrants and options,
35,000 shares were issued for loan structuring advice and 24,814 shares were
issued for the purchase of a patent. For the years ended December 31, 1998 and
1997, respectively, private and other exempt sales of the Company's debt and
equity securities resulted in net cash proceeds of $33,693,981 and $11,844,424.
In January 1998, 27,500 shares of Series B Convertible Preferred Stock and
related dividends were converted into 193,582 shares of common stock. At
December 31, 1998, no shares of Series B Convertible Preferred Stock were
outstanding.
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During the first quarter of 1998, 185,000 shares of Series C Convertible
Preferred Stock and related dividends were converted into 1,295,919 shares of
the Company's common stock. At December 31, 1998, no shares of Series C
Convertible Preferred Stock were outstanding.
On March 12, 1998, the Company the March 1998 Offering of its restricted common
stock to seven accredited investors. $15,000,000 was received by the Company on
March 12, 1998, in return for which the Company issued a total of 3,333,333
shares of restricted common stock and paid finders' fees of $870,000. The
investors agreed to purchase an additional $15,000,000 on July 27, 1998 (60 days
after the effectiveness of a registration statement that the Company filed with
the SEC covering the common stock issued and issuable to the investors) (the
"Second Funding Date"), provided that, as of such date, certain conditions were
satisfied. Certain conditions precedent to receiving the additional funding were
not met as of the Second Funding Date. In separate transactions in June and
August 1998, certain investors paid to the Company $3,000,000 in return for
which the Company issued 666,667 additional shares under the terms and
conditions set forth in the March 1998 Offering documents. Placement fees of
$163,846 were recorded in connection with the $3,000,000 received. No other
payment was received by the Company pursuant to the March 1998 Offering.
The investors in the March 1998 Offering acquired certain "reset rights"
pursuant to which they would receive additional shares of restricted common
stock ("Reset Shares") if the average market price of the Company's common stock
for the 60-day period following the effectiveness date and Second Funding Date
did not equal or exceed $5.40 per share. On August 31, 1998, the Company and the
investors restructured the reset provision whereby the Company issued 608,334
Series D shares and 1,390,476 shares of common stock for (i) the relinquishment
of the investors' contractual right to receive Reset Shares in connection with
the $15,000,000 received in March 1998 and the $3,000,000 received in June and
August 1998. In connection with the restructuring, the Company recorded an
expense of $6,111,577 for the difference between the Company's original
obligation to issue Reset Shares and the fair value of the shares of preferred
and common stock that were actually issued in settlement for the relinquishment
of the reset provision. The Company also issued 500,000 shares of Series D for
$10,000,000. The Company recorded a preferred stock dividend of $1,000,000
related to financing costs in connection with the issuance of these Series D
shares. Dividends accrue on the stated value ($20 per share) of Series D at the
rate of 4% per year, are payable annually or upon conversion, in cash or common
stock, at the option of the Company, and are presently convertible into shares
of the Company's common stock at the holder's option Each month the holders of
the Series D may not convert more than 25% of the total number of shares of
Series D originally issued to such holders on a cumulative basis. For example,
during the first month a holder may convert up to 25% of the total preferred
stock issued to the holder, and during the following month that same holder may
convert, on an aggregate to date basis, up to 50% of the total number of shares
of Series D held by the holder. Additionally, each month, the holders may
convert up to 50% of the total number of shares of Series D originally issued to
such holders on a cumulative basis, if both of the following conditions are
satisfied: (1) the average daily trading volume of the Company's common stock is
more than 500,000 shares for the 10-trading-day period before the conversion;
and (2) the average per share closing bid price for such 10-trading-day period
has not decreased by more than 5% during that 10-trading-day period. Any
outstanding shares of Series D as of August 31, 2001 automatically will be
converted at the conversion price most beneficial to the holders on such date.
In the event of liquidation, the holders of the Series D are entitled to an
amount equal to the stated value ($20 per share) plus accrued but unpaid
dividends whether declared or not. The holders of Series D have no voting
rights. The Series D shares, together with dividends accrued thereon, may be
converted into shares of the Company's common stock at the lesser of: $3.50 per
share; or the lesser of 110% of the average per share closing bid price for the
15 trading days immediately preceding the date of issuance of the Series D
shares; or 90% of the average of the three lowest per share closing bid prices
during the 22 trading days immediately preceding the conversion date. In the
event that the holders convert at the $3.50 per share price, the Company is
obligated to issue warrants to purchase 0.8 shares of common stock for each
share of Series D converted to common stock. Using the conversion terms most
beneficial to the holder, the Company is amortizing a beneficial conversion
feature of $2,462,964 as a dividend over a 180 day-period. As of December 31,
1998, no shares of Series D had been converted into common stock.
Effective as of September 30, 1998, the Company entered into an agreement with
two of the investors who participated in the March 1998 Offering whereby the
Company issued 100,000 shares of Series E for $2,000,000. Additionally, the
Company issued to the purchasers of the Series E a total of 150,000 additional
shares of Series E in exchange for which those purchasers surrendered a total of
150,000 shares of Series D. Dividends accrue on the stated value ($20 per share)
10
<PAGE>
of Series E at a rate of 4% per year, are payable annually or upon conversion,
in cash or common stock, at the option of the Company, and are convertible into
shares of the Company's common stock at anytime at the holder's option. Any
outstanding shares of Series E as of September 30, 2001 automatically will be
converted at the conversion price most beneficial to the holders on such date.
In the event of liquidation, the holders of the Series E are entitled to an
amount equal to the stated value ($20 per share) plus accrued but unpaid
dividends whether declared or not. The holders of Series E have no voting
rights. The Series E, together with dividends accrued thereon, may be converted
into shares of the Company's common stock at the lesser of: $3.50 per share; or
the lesser of 110% of the average per share closing bid price for the 15 trading
days immediately preceding the date of issuance of the Series E shares; or 90%
of the average of the three lowest per share closing bid prices during the 22
trading days immediately preceding the conversion date. If the investors convert
at the $3.50 per share price, the Company is obligated to issue warrants to
purchase 0.8 shares of common stock for each share of Series E converted to
common stock. Using the conversion terms most beneficial to the holder, the
Company recorded a preferred stock dividend of $968,047 for the beneficial
conversion feature of the Series E. As of December 31, 1998, 114,928 shares of
Series E and related dividends had been converted into 2,591,733 shares of
common stock.
On December 22, 1998, the Company completed a private placement of 1,801,802
shares of common stock. The investor that participated in that transaction also
acquired "Repricing Rights" that entitle the holder thereof to receive upon
exercise that number of additional shares of common stock for no additional
consideration as shall be determined by multiplying the number of Repricing
Rights exercised by the following fraction:
(Repricing Price - Market Price)
-----------------------------------
Market Price
The investor acquired one Repricing Right for each share of common stock
purchased. "Market Price" means the lowest closing bid price of common stock, as
quoted on the Nasdaq SmallCap Market, during the 15 consecutive trading days
immediately preceding the exercise date. "Repricing Price" means:
$1.3875 from March 22, 1999 to and including April 21, 1999,
$1.3986 from April 22, 1999 to and including May 21, 1999,
$1.4097 from May 22, 1999 to and including June 20, 1999,
$1.4208 from June 21, 1999 to and including July 20, 1999,and
$1.4319 at any time after July 20, 1999 until the
expiration of the Repricing Rights
On January 29, 1999, the Company entered into a Securities Purchase Agreement
with four investors pursuant to which the Company sold its Series C 5%
Convertible Debentures (the "Debentures") in the aggregate principal amount of
$4,000,000. The outstanding principal amount of the Debentures is convertible at
any time at the option of the holder into shares of the Company's common stock
at a conversion price equal to the lesser of $1.25 or 80% of the average of the
closing bid price of the Company common stock for the five trading days
immediately preceding the conversion date. The Company also issued 400,000
warrants in connection with this financing. Each warrant entitles the holder to
purchase up to 400,00 shares of the Company common stock at an exercise price of
$1.1625 per share. On March 3, 1999, the Company executed a Supplemental
Agreement pursuant to which the Company agreed to sell an additional $2,500,000
principal amount of the Debentures on the same terms and conditions as the
January 29, 1999 agreement, except no additional warrants were issued. Gross
proceeds to the Company from these two transactions were $6,500,000. The
obligations of the Company for repayment of the Debentures, as well as its
obligation to register the common stock underlying the potential conversion of
the Debentures and the exercise of the warrants issued in these transactions,
were personally guaranteed by Thomas A. Murdock, Roger D. Dudley (each of whom
are executive officers and directors of the Company) and Stephen M. Studdert
(Chairman of the Board of Directors of the Company). The personal guarantees of
these three directors were secured by a pledge of 6,000,000 shares of Fonix
common stock beneficially owned by them and held in the name of Thomas A.
Murdock, Trustee. In connection with the Supplemental Agreement, the Company
agreed to pledge as collateral for repayment of the Debentures, a lien on the
patent covering the ASRT. At the present time the Company has not executed a
security agreement in favor of the investors describing the patent. In
connection with the guaranty and the pledge for that guaranty given by these
directors, the Company agreed to indemnify and hold them harmless in the event
of a default by the Company that results in any payment or other liability or
damage incurred by any of them. In consideration for the guaranty and pledge by
these directors, the
11
<PAGE>
Company agreed to grant each of them common stock purchase warrants to purchase
666,666 shares of common stock at a price of $1.59 per share. On or about April
6, 1999, the holders of the Debentures notified the Company and the Guarantors
that the Guarantors were in default under the terms of the pledge, and that the
holders intended to exercise their rights to sell some or all of the pledged
shares. At the present time, the Company has no knowledge of sales of the
Guarantors' shares by the holders. However, if the holders proceed to sell some
or all of the Guarantors' shares, the Company may be obligated under its
indemnity agreement in favor of the Guarantors to issue shares to the Guarantors
in replacement of all shares sold by the holders and reimburse the Guarantors
for any income tax liability incurred as a result of the holders' sales of the
Guarantors' shares.
At December 31, 1998 and 1997, the Company had a revolving note payable to a
bank in the amount of $19,988,193 and $18,612,272, respectively. Borrowings
under the revolving note payable were limited to $20,000,000. The weighted
average outstanding balance during 1998 and 1997 was $18,590,642 and
$18,861,104, respectively. The weighted average interest rate was 6.40 percent
and 5.94 percent during 1998 and 1997, respectively. This note was due January
8, 1999, bore an interest rate of 6.00 percent at December 31,1998, and was
secured by a certificate of deposit in the amount of $20,000,000. This revolving
note has been renegotiated quarterly and interest was payable monthly. The
Company paid this revolving note in full, including accrued interest, on January
8, 1999 with proceeds from the related certificate of deposit and $22,667 in
cash.
At December 31, 1998, the Company has an unsecured revolving note payable to a
bank in the amount of $50,000. Loaned amounts under the revolving note payable
are limited to $50,000. The weighted average outstanding balance during the year
ended December 31, 1998 was $14,384. The weighted average interest rate was 9.4
percent during 1998. This note is payable on demand, matures April 1, 2007,
bears interest at an annual rate of the banks prime rate plus 2.0 percent (9.75
percent at December 31, 1998) and interest is payable monthly.
At December 31, 1998, the Company has an unsecured, non-interest bearing demand
note payable in the amount of $100,000 to Synergetics, Inc. ("Synergetics"), a
research and development entity. This note is payable on demand.
At December 31, 1998, the Company has a note payable to a lender in the amount
of $560,000 which bears interest at 18 percent, was due January 2, 1999 and is
secured by certain accounts receivable. The Company has subsequently extended
the due date from month to month by paying the lender accrued interest plus a
fee of $5,600. The loan balance is currently due May 1, 1999. The Company
anticipates that it will request additional extensions of the due date. Interest
is payable monthly on the first day of the following month. In connection with
the issuance of the note payable, the Company issued 35,000 shares of common
stock (having a fair value of $50,314 on the date of issuance) as a loan fee.
This amount is included in interest expense in the accompanying consolidated
statement of operations. The note is guaranteed by three officers and directors
of the Company. The Company has entered into an indemnity agreement with the
three officers and directors relating to this and other guarantees and pledges.
At December 31, 1998, the Company has unsecured 8.5 percent demand notes payable
outstanding to former Articulate stockholders in the aggregate amount of
$4,708,980, issued in connection with the Articulate acquisition (see Note 2).
These notes bear interest at an annual rate of 9.0 percent to 10.0 percent and
were payable on demand after November 1, 1998. The Company has made partial
payment of several of these notes and has agreed with all the holders of these
notes to extend the due dates of these notes to between March 15 and April 30,
1999.
At December 31, 1998, the Company has unsecured 8.5 percent demand notes payable
outstanding to various Articulate employees in the aggregate amount of $452,900.
Subsequent to the Articulate acquisition, the Company agreed to pay several
Articulate employees incentive compensation for continued employment in the
aggregate amount of $857,000, for which the Company issued demand notes for
$452,900 and recorded an accrued liability of $404,100 for the balance. The
demand notes bear interest currently at an annual rate of 9.0 percent and were
payable upon demand after November 1, 1998. None of the holders of these notes
have made demand for payment and they all have agreed to extend the due dates of
these notes to April 30 1999. The Company has not yet paid $404,100 of the
accrued liability due on or before January 31, 1999.
In connection with the acquisition of certain liabilities of Articulate pursuant
to the Articulate merger (see Note 2), the Company executed and delivered a
$1,500,000 unsecured demand note payable to a company which is a stockholder
12
<PAGE>
of the Company. This demand note bore interest at an annual rate of ten percent
and was payable upon demand after November 1, 1998. The Company obtained an
extension of the due date from the holder of the note and on February 2, 1999,
this note, including all accrued interest, was paid in full.
At December 31, 1998, the Company has an unsecured note payable to an officer of
the Company in the amount of $20,000, which bears interest at an annual rate of
ten percent and was due December 31, 1998. The holder of this note has agreed to
extend the due date to June 30, 1999.
Even taking into account expected revenues from the HealthCare Solutions and
Interactive Technologies Solutions Groups, the Company's ongoing operating
expenses will remain higher than revenues from operations at least through the
first half of 1999. Accordingly, the Company expects to incur significant losses
until such time as it is able to enter into substantial licensing and
co-development agreements and receive substantial revenues from such
arrangements or from the operations of its recently acquired subsidiaries, of
which there can be no assurance.
As of December 31, 1998, the Company had a revolving note payable to a bank in
the amount of $19,988,193. Loaned amounts under the revolving note payable are
limited, in the aggregate at any time, to $20,000,000. In order to reduce
interest expenses, on January 8, 1999, the Company applied its deposit account
in the amount of $20,024,109 against the unpaid loan balance of $20,046,776,
resulting in a balance of $22,667 due, which amount was subsequently paid by the
Company.
The Company's Core Technologies are designed to be Year 2000 compliant. The
Company intends to monitor the efforts of third-party providers whose services
are critical to the Company as they become Year 2000 compliant. Management is
presently not aware of any Year 2000 issues that have been encountered by any
such third-party which could materially affect the Company's operations.
Notwithstanding the foregoing, there can be no assurance that the Company will
not experience operational difficulties as a result of Year 2000 issues, either
arising out of internal operations, or caused by third-party service providers,
which individually or collectively could have an adverse impact on business
operations or require the Company to incur unanticipated expenses to remedy any
problems. The Company expects that its year 2000 compliance efforts will cost
approximately $70,000 during fiscal year 1999.
The Company presently has no plans to purchase any new research and development
or office facilities.
Outlook
Corporate Objectives and Technology Vision
The Company believes that its Core Technologies will be the platform for the
next generation of automated speech technology and products. Most speech
recognition products offered by other companies are based on technologies such
as HMM, that are largely in the public domain and represent nothing particularly
"new" or creative. The Fonix Core Technologies are based on proprietary,
patented technology. The Company will continue to seek patent protection of the
Core Technologies as well as technologies and inventions derived from the
knowhow, technologies and products obtained with the acquisition of AcuVoice,
Articulate and Papyrus. Management believes this strategy will set the Company's
advanced human computer interaction products apart from the competition.
The Company is determined to become a multi-market, multi-product enterprise
offering advanced speech and human- computer interface technologies for
business, consumer and service applications. Advanced human-computer interface
technologies and multi-modal systems include:
o speech recognition and synthesis
o speaker identification and verification
o handwriting recognition
o pen and touch screen input
o natural language understanding
Anticipated products incorporating such advanced multi-modal human computer
interface technology include the
13
<PAGE>
following:
o PCs and PDAs
o cellular phones
o automotive and home environment speech controls
o automated information and transaction kiosks
o telephone systems with natural dialogue and gesture
controls
o medical transcription and reporting systems, including
PowerScribeRAD
o PowerScribeEM
o smart consumer appliances and electronics
o speech and pen-based computers utilizing handwriting and
cursive recognition
o interactive education and entertainment systems
o redesigned appliances
o toys and games
This next generation technology presents important product and service
opportunities for companies like Fonix in a variety of industry segments,
including:
o semiconductors
o health care
o telecommunications
o computers
o software
o consumer electronics
o entertainment
o automotive
Fonix is a technology company. Since its inception, the Company has focused on
the development of its Core Technologies and related complementary
technologies., including those technologies obtained in connection with the
acquisitions of AcuVoice, Articulate and Papyrus. The Company will pursue the
development of advanced speech and computer-interface technologies that will
enhance or may be enhanced by its own Core Technologies. Fonix will pursue this
development through strategic alliances, such as the Siemens agreement in the
telecommunications industry, and through collaborative research arrangements
such as its agreements with OGI and Brigham Young University.
As the Company proceeds to implement its strategy and to reach its objectives,
it anticipates that it will continue to realize several benefits for itself and
for its shareholders. In addition, the Company expects further development of
complementary technologies, added product and applications development
expertise, access to market channels and additional opportunities for strategic
alliances in other industry segments.
The strategy described above is not without risk, and shareholders and others
interested in the Company and its common stock should carefully consider the
risks contained elsewhere in this report.
Special Note Regarding Forward-Looking Statements
Certain statements contained herein under "Business," "Management's Discussion
and Analysis of Financial Condition and Results of Operations" and "Outlook,"
including statements concerning (i) the Company's strategy, (ii) the Company's
expansion plans, (iii) the market for the Company's technology, products and
services, (iv) the effects of future government regulation of the Company's
products, (v) the development and launch of new products and the results of
research and development efforts, and (vi) the growth of the Company's business,
contain certain forward- looking statements concerning the Company's operations,
economic performance and financial condition. Because such statements involve
risks and uncertainties, actual results may differ materially from those
expressed or implied by such forward-looking statements. Factors that could
cause such differences include, but are not necessarily limited to, those
discussed under the heading "Certain Significant Risk Factors," in Item I, Part
I, above.
14
<PAGE>
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Index to Financial Statements:
Report of Independent Public Accountants (Arthur Andersen LLP) F-2
Report of Independent Public Accountants Deloitte & Touche LLP) F-3
Report of Independent Public Accountants (Pritchett, Siler & Hardy, P.C.) F-4
Consolidated Balance Sheets as of December 31, 1998 and 1997 F-5
Consolidated Statements of Operations for the Years Ended December 31, 1998,
1997 and 1996 and for the Period from October 1, 1993 (Date of Inception) to
December 31, 1998 F-6
Consolidated Statements of Stockholders' Equity for the Years Ended December 31,
1998, 1997 and 1996 and for the Period from October 1, 1993 (Date of Inception)
to December 31, 1998 F-7
Consolidated Statements of Cash Flows for the Years Ended December 31, 1998,
1997 and 1996 and for the Period from October 1, 1993 (Date of Inception) to
December 31, 1998 F-10
Notes to Consolidated Financial Statements F-12
15
<PAGE>
TABLE OF CONTENTS
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS (ARTHUR ANDERSEN LLP)...............F-2
INDEPENDENT AUDITORS' REPORT (DELOITTE & TOUCHE LLP).........................F-3
INDEPENDENT AUDITORS' REPORT (PRITCHETT, SILER & HARDY, P.C.)................F-4
FINANCIAL STATEMENTS:
Consolidated Balance Sheets as of December 31, 1998 and 1997.................F-5
Consolidated Statements of Operations for the Years Ended December 31, 1998,
1997 and 1996 and for the Period from October 1, 1993 (Date of Inception) to
December 31, 1998............................................................F-6
Consolidated Statements of Stockholders' Equity for the Years ended December 31,
1998, 1997 and 1996 and for the Period from October 1, 1993 (Date of Inception)
to December 31, 1998.........................................................F-7
Consolidated Statements of Cash Flows for the Years Ended December 31, 1998,
1997 and 1996 and for the Period from October 1, 1993 (Date of Inception) to
December 31, 1998...........................................................F-10
Notes to Consolidated Financial Statements .................................F-12
F-1
<PAGE>
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To Fonix Corporation:
We have audited the accompanying consolidated balance sheets of Fonix
Corporation (a Delaware corporation in the development stage) and subsidiaries
as of December 31, 1998 and 1997 and the related consolidated statements of
operations, stockholders' equity and cash flows for the years then ended and for
the period from inception (October 1, 1993) to December 31, 1998. 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. The consolidated financial statements of the Company for the year
ended December 31, 1996 and for the period from inception (October 1, 1993) to
December 31, 1996, were audited by other auditors whose report dated March 28,
1997, expressed an unqualified opinion on those statements and included an
explanatory paragraph regarding the Company's ability to continue as a going
concern. The consolidated financial statements for the period from inception
(October 1, 1993) to December 31, 1996 reflect a net loss of $19,841,807 of the
total inception to date net loss of $85,414,537. The other auditors' report has
been furnished to us, and our opinion, insofar as it relates to the amounts
included for such prior periods, is based solely on the report of such other
auditors.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards 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. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits and the report of other auditors provide a reasonable
basis for our opinion.
In our opinion, based on our audits and the report of other auditors for the
cumulative information for the period from inception (October 1, 1993) to
December 31, 1996, the consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position of
Fonix Corporation and subsidiaries as of December 31, 1998 and 1997 and the
results of their operations and their cash flows for the years then ended and
for the period from inception (October 1, 1993) to December 31, 1998 in
conformity with generally accepted accounting principles.
The accompanying consolidated financial statements have been prepared assuming
that the Company will continue as a going concern. As discussed in Note 1 to the
consolidated financial statements, the Company has generated no significant
recurring revenues through December 31,1998 and has incurred significant
recurring losses since its inception. The Company expects these losses to
continue at least through December 31, 1999. As of December 31, 1998, the
Company has an accumulated deficit of $92,933,777, negative working capital of
$14,678,975, demand and other notes currently due of $29,438,218 (some of which
are in default) and $1,965,490 of accounts payable over 60 days past due. These
matters raise substantial doubt about the Company's ability to continue as a
going concern. Management's plans with respect to these matters are also
described in Note 1. The accompanying consolidated financial statements do not
include any adjustments that might result from the outcome of this uncertainty.
/s/ Arthur Andersen LLP
ARTHUR ANDERSEN LLP
Salt Lake City, Utah
April 14, 1999
F-2
<PAGE>
INDEPENDENT AUDITORS' REPORT
To the Board of Directors
and Shareholders of
Fonix Corporation
Salt Lake City, Utah
We have audited the accompanying consolidated statements of operations,
stockholders' equity and cash flows of Fonix Corporation and subsidiary (a
development stage company) (the Company) for the year ended December 31, 1996,
and for the period from October 1, 1993 (date of inception) to December 31,
1996. 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. The Company's consolidated financial statements
for the period from October 1, 1993 (date of inception) to December 31, 1995
were audited by other auditors whose report, dated March 4, 1996, expressed an
unqualified opinion on those statements and included an explanatory paragraph
regarding the Company's ability to continue as a going concern. The financial
statements for the period October 1, 1993 (date of inception) through December
31, 1995 reflect a net loss of $12,012,299 of the total inception to date net
loss. The other auditors' report has been furnished to us, and our opinion,
insofar as it relates to the amounts included for such prior periods, is based
solely on the report of such other auditors.
We conducted our audit in accordance with generally accepted auditing standards.
Those standards 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. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audit and the report of other auditors provide a reasonable
basis for our opinion.
In our opinion, based on our audit and the report of other auditors, such
financial statements present fairly, in all material respects, the results of
the Company's operations and its cash flows for the year ended December 31,
1996, and for the period from October 1, 1993 (date of inception) to December
31, 1996, in conformity with generally accepted accounting principles.
The accompanying consolidated financial statements have been prepared assuming
that the Company will continue as a going concern. The Company is a development
stage enterprise engaged in developing automated speech recognition
technologies. As discussed in Note 1 to the consolidated financial statements,
the Company's operating losses since inception 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 1. The consolidated financial
statements do not include any adjustments that might result from the outcome of
this uncertainty.
/s/ Deloitte & Touche LLP
DELOITTE & TOUCHE LLP
Salt Lake City, Utah
March 28, 1997
F-3
<PAGE>
INDEPENDENT AUDITORS' REPORT
To the Board of Directors
Fonix Corporation
Salt Lake City, Utah
We have audited the consolidated statements of operations, stockholders' equity
and cash flows of Fonix Corporation and subsidiary [a development stage company]
for the year ended December 31, 1995, and for the period from October 1, 1993
(date of inception) to December 31, 1995 (these financial statements are not
presented separately herein). These consolidated 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 in accordance with generally accepted auditing standards.
Those standards 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. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated results of operations and cash flows of
Fonix Corporation and subsidiary (a development stage company) for the period
from October 1, 1993 (date of inception) to December 31, 1995 in conformity with
generally accepted accounting principles.
The consolidated financial statements referred to above have been prepared
assuming that the Company will continue as a going concern. As discussed in Note
1 to the consolidated financial statements, the Company is still in the
development stage and has suffered recurring losses which raise substantial
doubt about its ability to continue as a going concern. Management's plans in
regard to these matters are also described in Note 1. The consolidated financial
statements do not include any adjustments that might result from the outcome of
this uncertainty.
/s/ PRITCHETT, SILER & HARDY, P.C.
PRITCHETT, SILER & HARDY, P.C.
Salt Lake City, Utah
March 4, 1996
F-4
<PAGE>
Fonix Corporation
[A Development Stage Company]
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
December 31, December 31,
1998 1997
--------------- --------------
<S> <C> <C>
ASSETS
- ------
Current assets:
Cash and cash equivalents $ 20,045,539 $ 20,501,676
Notes receivable 245,000 600,000
Accounts receivable, net of allowance for doubtful accounts of $8,115 219,908 -
Employee advances 67,231 -
Interest and other receivables 8,276 14,919
Inventory 77,386 -
Prepaid expenses 51,866 32,094
--------------- --------------
Total current assets 20,715,206 21,148,689
Property and equipment, net of accumulated depreciation of
$1,195,390 and $464,100, respectively 2,328,012 1,567,279
Intangible assets, net of accumulated amortization of $2,599,554
and $25,509, respectively 38,816,421 138,951
Other assets 130,288 39,647
--------------- --------------
Total assets $ 61,989,927 $ 22,894,566
=============== ==============
LIABILITIES AND STOCKHOLDERS' EQUITY
- ------------------------------------
Current liabilities:
Bank overdraft $ 138,034 $ -
Revolving notes payable 20,038,193 18,612,272
Notes payable - related parties 8,491,880 551,510
Notes payable - other 560,000 -
Accounts payable 3,536,074 291,638
Accrued liabilities 981,774 505,619
Accrued liabilities - related parties 900,004 459,502
Deferred revenues 695,997 -
Capital lease obligation - current portion 52,225 49,325
--------------- --------------
Total current liabilities 35,394,181 20,469,866
Capital lease obligation, net of current portion - 52,225
--------------- --------------
Total liabilities 35,394,181 20,522,091
--------------- --------------
Common stock and related repricing rights subject to redemption; 1,801,802
shares and repricing rights outstanding in 1998 (aggregate redemption
value of $2,500,000 1,830,000 -
--------------- --------------
Commitments and contingencies (Notes 1, 7, 12, 14, 16, 17 and 20)
Stockholders' equity:
Preferred stock, $.0001 par value; 100,000,000 shares authorized;
Series A, convertible; 166,667 shares outstanding
(aggregate liquidation preference of $6,055,012) 500,000 500,000
Series B, 5% cumulative convertible; 27,500 shares outstanding in 1997
(aggregate liquidation preference of $555,197) - 667,659
Series C, 5% cumulative convertible; 185,000 shares outstanding in 1997
(aggregate liquidation preference of $3,734,550) - 4,644,785
Series D, 4% cumulative convertible; 1,008,334 shares outstanding
in 1998 (aggregate liquidation preference of $20,441,828) 22,200,936 -
Series E, 4% cumulative convertible; 135,072 shares outstanding in 1998
(aggregate liquidation preference of $2,739,403) 3,257,886 -
Common stock, $.0001 par value; 100,000,000 shares authorized;
64,324,480 and 43,583,875 shares outstanding, respectively 6,432 4,358
Additional paid-in capital 88,517,711 38,637,059
Outstanding warrants 3,323,258 2,936,360
Deferred consulting expense (106,700) -
Deficit accumulated during the development stage (92,933,777) (45,017,746)
--------------- --------------
Total stockholders' equity 24,765,746 2,372,475
--------------- --------------
Total liabilities and stockholders' equity $ 61,989,927 $ 22,894,566
=============== ==============
</TABLE>
See accompanying notes to consolidated financial statements.
F-5
<PAGE>
Fonix Corporation
[A Development Stage Company]
CONSOLIDATED STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
October 1,
1993
Years Ended December 31, (Inception) to
------------------------------------------- December 31,
1998 1997 1996 1998
------------ ------------ ----------- ------------
<S> <C> <C> <C> <C>
Revenues $ 2,889,684 $ -- $ -- $ 2,889,684
Cost of revenues 76,344 -- -- 76,344
------------ ------------ ----------- ------------
Gross margin 2,813,340 -- -- 2,813,340
------------ ------------ ----------- ------------
Expenses:
Product development and research 13,620,748 7,066,294 4,758,012 31,558,041
Purchased in-process research and development 13,136,000 -- -- 13,136,000
Selling, general and administrative 12,612,015 12,947,112 3,530,400 34,858,685
------------ ------------ ----------- ------------
Total expenses 39,368,763 20,013,406 8,288,412 79,552,726
------------ ------------ ----------- ------------
Loss from operations (36,555,423) (20,013,406) (8,288,412) (76,739,386)
------------ ------------ ----------- ------------
Other income (expense):
Interest income 1,075,324 1,199,610 1,180,259 3,667,391
Interest expense (1,527,106) (2,758,288) (721,355) (5,379,649)
Cancellation of common stock reset provision (6,111,577) -- -- (6,111,577)
------------ ------------ ----------- ------------
Total other income (expense), net (6,563,359) (1,558,678) 458,904 (7,823,835)
------------ ------------ ----------- ------------
Loss before extraordinary items (43,118,782) (21,572,084) (7,829,508) (84,563,221)
Extraordinary items:
Loss on extinguishment of debt -- (881,864) -- (881,864)
Gain on forgiveness of debt -- -- -- 30,548
------------ ------------ ----------- ------------
Net loss $(43,118,782) $(22,453,948) $(7,829,508) $(85,414,537)
============ ============ =========== ============
Basic and diluted net loss per common share $ (0.91) $ (0.59) $ (0.21)
============ =========== ============
</TABLE>
See accompanying notes to consolidated financial statements.
F-6
<PAGE>
Fonix Corporation
[A Development Stage Company]
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
<TABLE>
<CAPTION>
Series A Series B Series C
Preferred Stock Preferred Stock Preferred Stock
--------------- --------------- ---------------
Shares Amount Shares Amount Shares Amount
------ ------ ------ ------ ------ ------
<S> <C> <C> <C> <C> <C> <C>
Balance, December 31, 1992 - $ - - $ - - $ -
Reverse stock split one share for ninety shares - - - - - -
Restatement for reverse acquisition of fonix
corporation by Phonic Technologies, Inc. - - - - - -
------ ------ ------ ------ ------ ------
Balance, October 1, 1993 (date of inception) - - - - - -
Net loss for the period October 1, 1993
(date of inception) to December 31, 1993 - - - - - -
------ ------ ------ ------ ------ ------
Balance, December 31, 1993 - - - - - -
Acquisition of Taris, Inc. - - - - - -
Shares issued for services at $.14 to $.18 per share - - - - - -
Shares issued for services at $.25 per share - - - - - -
Shares issued for conversion of notes payable
and interest payable at $.04 per share - - - - - -
Shares issued for cash at $1.19 to $3.13 per
share, less offering costs of $368,450 - - - - - -
Net loss for the year ended December 31, 1994 - - - - - -
------ ------ ------ ------ ------ ------
Balance, December 31, 1994 - - - - - -
Shares issued during the year for cash at $.45 to
$2.50 per share, less offering costs of $ 267,714 - - - - - -
Shares issued during the year for services
rendered and cancellation of accounts payable
at $.55 to $1.55 per share - - - - - -
Warrants issued during the year for cancellation
of accounts payable at $.033
per warrant (additional compensation expense
of $2,282,900 or $.62 per share was recorded) - - - - - -
Shares issued during the year upon conversion of
warrants for cancellation of accounts
payable at $.35 per share - - - - - -
Warrants issued during the year for cash at $.0033 to
$.10 per warrant, less offering costs of$5,040 - - - - - -
Shares issued during the year upon conversion of
warrants for cash at $.50 to $1.00 per share - - - - - -
Forgiveness of debt with related parties - - - - - -
Net loss for the year ended December 31, 1995 - - - - - -
------ ------ ------ ------ ------ ------
Balance, December 31, 1995 - - - - - -
</TABLE>
<TABLE>
<CAPTION>
Series D Series E
Preferred Stock Preferred Stock Common Stock
--------------- --------------- ------------------------------
Shares Amount Shares Amount Shares Amount
------ ------ ------ ------ ------------- -------------
<S> <C> <C> <C> <C> <C> <C>
Balance, December 31, 1992 - $ - - $ - 37,045,000 $ 3,704
Reverse stock split one share for ninety shares - - - - (36,633,389) (3,663)
Restatement for reverse acquisition of fonix
corporation by Phonic Technologies, Inc. - - - - 9,983,638 999
------ ------ ------ ------ ------------- -------------
Balance, October 1, 1993 (date of inception) - - - - 10,395,249 1,040
Net loss for the period October 1, 1993
(date of inception) to December 31, 1993 - - - - - -
------ ------ ------ ------ ------------- -------------
Balance, December 31, 1993 - - - - 10,395,249 1,040
Acquisition of Taris, Inc. - - - - 411,611 41
Shares issued for services at $.14 to $.18 per share - - - - 1,650,000 165
Shares issued for services at $.25 per share - - - - 20,000 2
Shares issued for conversion of notes payable
and interest payable at $.04 per share - - - - 3,900,000 390
Shares issued for cash at $1.19 to $3.13 per
share, less offering costs of $368,450 - - - - 1,819,293 181
Net loss for the year ended December 31, 1994 - - - - - -
------ ------ ------ ------ ------------- -------------
Balance, December 31, 1994 - - - - 18,196,153 1,819
Shares issued during the year for cash at $.45 to $2.50
per share, less offering costs of $ 267,714 - - - - 6,442,538 645
Shares issued during the year for services
rendered and cancellation of accounts payable
at $.55 to $1.55 per share - - - - 516,630 52
Warrants issued during the year for
cancellation of accounts payable at $.033
per warrant (additional compensation expense
of $2,282,900 or $.62 per share was recorded) - - - - - -
Shares issued during the year upon conversion of
warrants for cancellation of
accounts payable at $.35 per share - - - - 3,700,000 370
Warrants issued during the year for cash at $.0033 to
$.10 per warrant, less offering costs of$5,040 - - - - - -
Shares issued during the year upon conversion of
warrants for cash at $.50 to $1.00 per share - - - - 550,000 55
Forgiveness of debt with related parties - - - - - -
Net loss for the year ended December 31, 1995 - - - - - -
------ ------ ------ ------ ------------- -------------
Balance, December 31, 1995 - - - - 29,405,321 2,941
</TABLE>
<TABLE>
<CAPTION>
Deficit
Deferred Accumulated
Additional Consult- During the
Paid-in Outstanding ing Development
Capital Warrants Expense Stage Total
------------- ----------- -------- ------------- -----------
<S> <C> <C> <C> <C> <C>
Balance, December 31, 1992 $ 136,659 $ - $ - $ (29,495) $ 110,868
Reverse stock split one share for ninety shares 3,663 - - - -
Restatement for reverse acquisition of fonix
corporation by Phonic Technologies, Inc. (141,362) - - 29,495 (110,868)
------------- ----------- -------- ------------- -----------
Balance, October 1, 1993 (date of inception) (1,040) - - - -
Net loss for the period October 1, 1993
(date of inception) to December 31, 1993 - - - (1,782,611) (1,782,611)
------------- ----------- -------- ------------- -----------
Balance, December 31, 1993 (1,040) - - (1,782,611) (1,782,611)
Acquisition of Taris, Inc. 1,240 - - - 1,281
Shares issued for services at $.14 to $.18 per share 249,835 - - - 250,000
Shares issued for services at $.25 per share 4,998 - - - 5,000
Shares issued for conversion of notes payable
and interest payable at $.04 per share 156,515 - - - 156,905
Shares issued for cash at $1.19 to $3.13 per
share, less offering costs of $368,450 3,315,874 - - - 3,316,055
Net loss for the year ended December 31, 1994 - - - (3,914,339) (3,914,339)
------------- ----------- -------- ------------- -----------
Balance, December 31, 1994 3,727,422 - - (5,696,950) (1,967,709)
Shares issued during the year for cash at $.45 to
$2.50 per share, less offering costs of $267,714 4,509,542 - - - 4,510,187
Shares issued during the year for services
rendered and cancellation of accounts payable
at $.55 to $1.55 per share 355,319 - - - 355,371
Warrants issued during the year for
cancellation of accounts payable at $.033
per warrant (additional compensation expense
of $2,282,900 or $.62 per share was recorded) - 2,405,000 - - 2,405,000
Shares issued during the year upon conversion of
warrants for cancellation of accounts
payable at $.35 per share 3,699,630 (2,405,000) - - 1,295,000
Warrants issued during the year for cash at $.0033 to
$.10 per warrant, less offering costs of$5,040 - 45,360 - - 45,360
Shares issued during the year upon conversion of
warrants for cash at $.50 to $1.00 per share 519,945 (45,000) - - 475,000
Forgiveness of debt with related parties 506,874 - - - 506,874
Net loss for the year ended December 31, 1995 - - - (6,315,349) (6,315,349)
------------- ----------- -------- ------------- -----------
Balance, December 31, 1995 13,318,732 360 - (12,012,291) 1,309,734
</TABLE>
See accompanying notes to consolidated financial statements
F-7
<PAGE>
Fonix Corporation
[A Development Stage Company]
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
<TABLE>
<CAPTION>
Series A Series B Series C
Preferred Stock Preferred Stock Preferred Stock
--------------- --------------- ---------------
Shares Amount Shares Amount Shares Amount
------------ ------------ ------------ ------------ ------------ -----------
<S> <C> <C> <C> <C> <C> <C>
Shares issued during the year for finders' fees
at $1.52 to $2.72 per share - $ - - $ - - $ -
Shares issued during the year upon conversion
of warrants for cash at $.50 per share - - - - - -
Shares issued during the year for cash at $.48
to $3.38 per share, less offering costs of
$2,033,286 - - - - - -
Net loss for the year ended December 31, 1996 - - - - - -
------------ ------------ ------------ ------------ ------------ -----------
Balance, December 31, 1996 - - - - - -
Shares issued for services at $3.75 to $5.31
per share - - - - - -
Shares issued for services at $6.50 to
$8.38 per share - - - - - -
Warrants issued during the year for services - - - - - -
Shares issued upon the exercise of warrants
for services at $2.00 per share - - - - - -
Shares issued during the year for cash at
$2.50 per share - - - - - -
Warrants issued during the year in connection
with the issuance of a convertible debenture
and convertible preferred stock - - - - - -
Shares issued upon conversion of convertible
debenture to common shares - - - - - -
Series B preferred shares issued for
extinguishment of convertible debenture at
$20 stated value per share - - 108,911 2,178,213 - -
Sale of Series C preferred shares and
warrants, less cash fees of $201,500 - - - - 187,500 2,948,500
Sale of Series B preferred shares for cash,
less cash fees of $145,000 - - 125,000 2,355,000 - -
Capital contribution in connection with
put options - - - - - -
Beneficial conversion features of Series B
convertible debenture - - - - - -
Series A preferred shares issued upon
conversion of convertible debenture at
$3 per share 166,667 500,000 - - - -
Conversion of Series B and Series C
preferred shares to common shares - - (206,411) (4,828,488) (2,500) (62,772)
Shares issued during the year in connection
with exercise of options at $2.97 per share - - - - - -
Shares issued during the year in connection
with the exercise of warrants at $.50
per share - - - - - -
Accretion of Series C preferred stock - - - - - 600,000
Dividends on preferred stock - $ - - $ 962,934 - $ 1,159,057
Net loss for the year ended December 31, 1997 - - - - - -
------------ ------------ ------------ ------------ ------------ ------------
</TABLE>
<TABLE>
<CAPTION>
Series D Series E
Preferred Stock Preferred Stock Common Stock
--------------- --------------- -----------------------
Shares Amount Shares Amount Shares Amount
------------ ------------ ------------ ------------ ------------ ------------
<S> <C> <C> <C> <C> <C> <C>
Shares issued during the year for finders' fees
at $1.52 to $2.72 per share - $ - - $ - 420,000 $ 42
Shares issued during the year upon conversion
of warrants for cash at $.50 per share - - - - 60,000 6
Shares issued during the year for cash at $.48
to $3.38 per share, less offering costs of
$2,033,286 - - - - 11,741,242 1,174
Net loss for the year ended December 31, 1996 - - - - - -
------------ ------------ ------------ ------------ ------------ ------------
Balance, December 31, 1996 - - - - 41,626,563 4,163
Shares issued for services at $3.75 to $5.31
per share - - - - 87,500 9
Shares issued for services at $6.50 to
$8.38 per share - - - - 505,000 50
Warrants issued during the year for services - - - - - -
Shares issued upon the exercise of warrants
for services at $2.00 per share - - - - 150,000 15
Shares issued during the year for cash at
$2.50 per share - - - - 150,000 15
Warrants issued during the year in connection
with the issuance of a convertible debenture
and convertible preferred stock - - - - - -
Shares issued upon conversion of convertible
debenture to common shares - - - - 145,747 15
Series B preferred shares issued for
extinguishment of convertible debenture at
$20 stated value per share - - - - - -
Sale of Series C preferred shares and
warrants, less cash fees of $201,500 - - - - - -
Sale of Series B preferred shares for cash,
less cash fees of $145,000 - - - - - -
Capital contribution in connection with
put options - - - - - -
Beneficial conversion features of Series B
convertible debenture - - - - - -
Series A preferred shares issued upon
conversion of convertible debenture at
$3 per share - - - - - -
Conversion of Series B and Series C
preferred shares to common shares - - - - 804,065 80
Shares issued during the year in connection
with exercise of options at $2.97 per share - - - - 15,000 1
Shares issued during the year in connection
with the exercise of warrants at $.50 - - - - 100,000 10
per share
Accretion of Series C preferred stock - - - - - -
Dividends on preferred stock - $ - - $ - - $ -
Net loss for the year ended December 31, 1997 - - - - - -
------------ ------------ ------------ ------------ ------------ ------------
</TABLE>
<TABLE>
<CAPTION>
Deficit
Deferred Accumulated
Additional Consult- During the
Paid-in Outstanding ing Development
Capital Warrants Expense Stage Total
------------ ------------ ------------ ------------ ------------
<S> <C> <C> <C> <C> <C>
Shares issued during the year for finders' fees
at $1.52 to $2.72 per share 901,478 $ - $ - $ - $ 901,520
Shares issued during the year upon conversion
of warrants for cash at $.50 per share 29,994 - - - 30,000
Shares issued during the year for cash at $.48
to $3.38 per share, less offering costs of
$2,033,286 11,857,269 - - - 11,858,443
Net loss for the year ended December 31, 1996 - - - (7,829,508) (7,829,508)
------------ ------------ ------------ ------------ ------------
Balance, December 31, 1996 26,107,473 360 - (19,841,807) 6,270,189
Shares issued for services at $3.75 to $5.31
per share 366,710 - - - 366,719
Shares issued for services at $6.50 to
$8.38 per share 3,426,202 - - - 3,426,252
Warrants issued during the year for services - 1,165,500 - - 1,165,500
Shares issued upon the exercise of warrants
for services at $2.00 per share 689,085 (389,100) - - 300,000
Shares issued during the year for cash at
$2.50 per share 1,256,235 - - - 1,256,250
Warrants issued during the year in connection
with the issuance of a convertible debenture
and convertible preferred stock - 1,559,600 - - 1,559,600
Shares issued upon conversion of convertible
debenture to common shares 857,835 - - - 857,850
Series B preferred shares issued for
extinguishment of convertible debenture at
$20 stated value per share - - - - 2,178,213
Sale of Series C preferred shares and
warrants, less cash fees of $201,500 - 600,000 - - 3,548,500
Sale of Series B preferred shares for cash,
less cash fees of $145,000 - - - - 2,355,000
Capital contribution in connection with
put options 500,000 - - - 500,000
Beneficial conversion features of Series B
convertible debenture 427,850 - - - 427,850
Series A preferred shares issued upon
conversion of convertible debenture at
$3 per share - - - - 500,000
Conversion of Series B and Series C
preferred shares to common shares 4,891,180 - - - -
Shares issued during the year in connection
with exercise of options at $2.97 per share 44,499 - - - 44,500
Shares issued during the year in connection
with the exercise of warrants at $.50 49,900 - - - 50,000
per share
Accretion of Series C preferred stock - - - (600,000) -
Dividends on preferred stock $ - $ - $ - $(2,121,991) $ -
Net loss for the year ended December 31, 1997 - - - (22,453,948) (22,453,948)
------------ ------------ ------------ ------------ ------------
</TABLE>
See accompanying notes to consolidated financial statements.
F-8
<PAGE>
Fonix Corporation
[A Development Stage Company]
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
<TABLE>
<CAPTION>
Series A Series B Series C
Preferred Stock Preferred Stock Preferred Stock
--------------- --------------- ---------------
Shares Amount Shares Amount Shares Amount
------------ ------------ ------------ ------------ ------------ ------------
<S> <C> <C> <C> <C> <C> <C>
Balance, December 31, 1997 166,667 500,000 27,500 667,659 185,000 4,644,785
Shares issued for debt costs at $1.44 per share - - - - - -
Options issued during the year for services - - - - - -
Shares issued during the year for patent - - - - - -
Warrants issued during the year for cash - - - - - -
Shares issued upon the exercise of options
and warrants - - - - - -
Shares issued during the year for cash at $4.50
per share, less issuance costs of $1,033,846 - - - - - -
Shares issued during the year in connection
with the acquisitions of AcuVoice, Articulate
and Papyrus - - - - - -
Sale of Series D preferred shares, less
issuance costs of $546,154 - - - - - -
Sale of Series E preferred shares, less
issuance costs of $50,000 - - - - - -
Exchange of Series D for Series E preferred
stock - - - - - -
Conversions of preferred stock to common
stock - - (27,500) (676,190) (185,000) (4,767,913)
Shares issued in connection with the
relinquishment of a reset provision - - - - - -
Expiration of warrants - - - - - -
Amortization of deferred consulting
expense - - - - - -
Dividends on preferred stock - - - 8,531 - 123,128
Net loss for the year ended December
31, 1998 - - - - - -
------------ ------------ ------------ ------------ ------------ ------------
Balance, December 31, 1998 166,667 $ 500,000 - $ - - $ -
============ ============ ============ ============ ============ ============
</TABLE>
<TABLE>
<CAPTION>
Series D Series E
Preferred Stock Preferred Stock Common Stock
--------------- --------------- -----------------------
Shares Amount Shares Amount Shares Amount
------------ ------------ ------------ ------------ ------------ ------------
<S> <C> <C> <C> <C> <C> <C>
Balance, December 31, 1997 - - - - 43,583,875 4,358
Shares issued for debt costs at $1.44 per share - - - - 35,000 4
Options issued during the year for services - - - - - -
Shares issued during the year for patent - - - - 24,814 3
Warrants issued during the year for cash - - - - - -
Shares issued upon the exercise of options
and warrants - - - - 265,000 27
Shares issued during the year for cash at $4.50
per share, less issuance costs of $1,033,846 - - - - 4,000,000 400
Shares issued during the year in connection
with the acquisitions of AcuVoice, Articulate
and Papyrus - - - - 10,944,081 1,094
Sale of Series D preferred shares, less
issuance costs of $546,154 500,000 10,453,846 - - - -
Sale of Series E preferred shares, less
issuance costs of $50,000 - - 100,000 1,950,000 - -
Exchange of Series D for Series E preferred
stock (150,000) (3,079,167) 150,000 3,079,167 - -
Conversions of preferred stock to common
stock - - (114,928) (2,777,292) 4,081,234 407)
Shares issued in connection with the
relinquishment of a reset provision 608,334 11,166,668 - - 1,390,476 139
Expiration of warrants - - - - - -
Amortization of deferred consulting
expense - - - - - -
Dividends on preferred stock - 3,659,579 - 1,006,011 - -
Net loss for the year ended December
31, 1998 - - - - - -
------------ ------------ ------------ ------------ ------------ ------------
Balance, December 31, 1998 1,008,334 $22,200,936 135,072 $3,257,886 $64,324,480 $ 6,432
============ ============ ============ ============ ============ ============
</TABLE>
<TABLE>
<CAPTION>
Deficit
Deferred Accumulated
Additional Consult- During the
Paid-in Outstanding ing Development
Capital Warrants Expense Stage Total
------------ ------------ ------------ ------------ ------------
<S> <C> <C> <C> <C> <C>
Balance, December 31, 1997 38,637,059 2,936,360 - (45,017,746) 2,372,475
Shares issued for debt costs at $1.44 per share 50,310 - - - 50,314
Options issued during the year for services 320,100 - (320,100) - -
Shares issued during the year for patent 100,804 - - - 100,807
Warrants issued during the year for cash - 472,928 - - 472,928
Shares issued upon the exercise of options
and warrabnts 505,333 360) - - 505,000
Shares issued during the year for cash at $4.50
per share, less issuance costs of $1,033,846 16,965,754 - - - 16,966,154
Shares issued during the year in connection with
the acquisitions of AcuVoice, Articulate
and Papyrus 28,686,933 - - - 28,688,027
Sale of Series D preferred shares, less
issuance costs of $546,154 - - - - 10,453,846
Sale of Series E preferred shares, less
issuance costs of $50,000 - - - - 1,950,000
Exchange of Series D for Series E
preferred stock - - - - -
Conversions of preferred stock to common stock 8,220,988 - - - -
Shares issued in connection with the
relinquishment of a reset provision (5,055,240) - - - 6,111,577
Expiration of warrants 85,670 (85,670) - - -
Amortization of deferred consulting expense - - 213,400 - 213,400
Dividends on preferred stock - - - (4,797,249) -
Net loss for the year ended December 31, 1998 - - - (43,118,782) (43,118,782)
------------ ------------ ------------ ------------ ------------
Balance, December 31, 1998 $88,517,711 $3,323,258 $(106,700) $(92,933,777) $ 24,765,746
============ ============ ============ ============ =============
</TABLE>
See accompanying notes to consolidated financial statements.
F-9
<PAGE>
Fonix Corporation
[A Development Stage Company]
CONSOLIDATED STATEMENTS OF CASH FLOWS
Increase (Decrease) in Cash and Cash Equivalents
<TABLE>
<CAPTION>
October 1,
1993
Years Ended December 31, (Inception) to
---------------------------------------------- December 31,
1998 1997 1996 1998
--------------- ------------- ------------- --------------
<S> <C> <C> <C> <C>
Cash flows from operating activities:
Net loss $ (43,118,782) $(22,453,948) $ (7,829,508) $ (85,414,537)
Adjustments to reconcile net loss to net cash
used in operating activities:
Issuance of common stock for services 50,314 4,112,970 901,520 5,487,554
Issuance of common stock for patent 100,807 -- -- 100,807
Non-cash expense related to issuance of debentures,
warrants, preferred and common stock 6,111,577 3,967,337 -- 10,078,914
Non-cash compensation expense related to issuance
of stock options 213,400 -- -- 2,496,300
Non-cash expense related to issuance of notes payable
and accrued expense for services 857,000 -- -- 857,000
Non-cash exchange of notes receivable for services 150,000 -- -- 150,000
Non-cash portion of purchased in-process research and
development 13,136,000 -- -- 13,136,000
Write-off of assets received in acquisition -- -- -- 1,281
Depreciation and amortization 3,285,845 405,209 83,183 3,775,454
Extraordinary loss on extinguishment of debt -- 881,864 -- 881,864
Extraordinary gain on forgiveness of debt -- -- -- (30,548)
Changes in assets and liabilities, net of effects
of acquisitions:
Accounts receivable (148,498) -- -- (148,498)
Employee advances (67,231) -- -- (67,231)
Interest and other receivables 9,436 142,724 (131,419) (5,483)
Inventory (20,221) -- -- (20,221)
Prepaid assets (15,372) (27,922) (4,172) (47,466)
Other assets (80,198) (8,735) (30,912) (119,845)
Accounts payable 2,941,898 128,638 42,702 5,013,736
Accrued liabilities 8,189 (922,367) 83,053 641,789
Accrued liabilities - related party (311,743) 47,759 1,500,918 147,759
Deferred revenues 81,266 -- -- 81,266
--------------- ------------- ------------- --------------
Net cash used in operating activities (16,816,313) (13,726,471) (5,384,635) (43,004,105)
--------------- ------------- ------------- --------------
Cash flows from investing activities, net of effects of
acquisitions:
Acquisition of subsidiaries, net of cash acquired (15,323,173) -- -- (15,323,173)
Purchase of property and equipment (1,305,091) (671,401) (1,311,236) (3,336,470)
Investment in intangible assets -- (107,281) (33,126) (164,460)
Issuance of notes receivable (745,000) (1,483,600) (963,106) (3,228,600)
Payments received on notes receivable -- 1,883,600 -- 1,883,600
--------------- ------------- ------------- --------------
Net cash used in investing activities (17,373,264) (378,682) (2,307,468) (20,169,103)
--------------- ------------- ------------- --------------
Cash flows from financing activities:
Bank overdraft 138,034 -- -- 138,034
Net proceeds from revolving note payable 1,376,671 2,234,914 10,759,836 19,988,943
Net proceeds (payments) from revolving note
payable - related parties (469,869) 551,510 -- 81,641
Proceeds from other notes payable 560,000 -- -- 2,911,667
Payments on other notes payable -- -- -- (1,779,806)
Principal payments on capital lease obligation (49,325) (43,381) -- (92,706)
Proceeds from issuance of convertible debentures, net -- 2,685,000 -- 3,185,000
Proceeds from sale of warrants 472,928 600,000 -- 1,072,928
Proceeds from sale of common stock, net 17,471,155 469,500 11,888,443 38,175,700
Proceeds from sale of preferred stock, net 12,403,846 5,303,500 -- 17,707,346
Proceeds from sale of common stock and related
repricing rights subject to redemption, net 1,830,000 -- -- 1,830,000
--------------- ------------- ------------- --------------
Net cash provided by financing activities 33,733,440 11,801,043 22,648,279 83,218,747
--------------- ------------- ------------- --------------
Net (decrease) increase in cash and cash equivalents (456,137) (2,304,110) 14,956,176 20,045,539
Cash and cash equivalents at beginning of period 20,501,676 22,805,786 7,849,610 --
--------------- ------------- ------------- --------------
Cash and cash equivalents at end of period $ 20,045,539 $ 20,501,676 $ 22,805,786 $ 20,045,539
============== ============= ============= ==============
</TABLE>
See accompanying notes to consolidated financial statements.
F-10
<PAGE>
Fonix Corporation
[A Development Stage Company]
CONSOLIDATED STATEMENTS OF CASH FLOWS (continued)
Supplemental disclosure of cash flow information:
<TABLE>
<CAPTION>
October 1,
1993
Years Ended December 31, (Inception) to
----------------------------------------------- December 31,
1998 1997 1996 1998
------------- ------------- ------------- --------------
<S> <C> <C> <C> <C>
Cash paid during the period for interest $ 1,392,987 $ 1,148,553 $ 638,302 $ 3,430,006
</TABLE>
Supplemental Schedule of Non-cash Investing and Financing Activities:
For the Year Ended December 31, 1998:
Preferred stock dividends of $3,461,543 were recorded related to the
beneficial conversion features of convertible preferred stock.
Preferred stock dividends of $335,706 were accrued on convertible preferred
stock.
A total of 27,500 shares of Series B convertible preferred stock and
related dividends of $8,531 were converted into 193,582 shares of common
stock.
A total of 185,000 shares of Series C convertible preferred stock and
related dividends of $123,129 were converted into 1,295,919 shares of
common stock.
TheCompany issued 1,390,476 shares of common stock and 608,334 shares of
Series D 4% convertible preferred stock in connection with the cancellation
of an existing reset provision and costs associated with the issuance of
Series D 4% convertible preferred stock.
Preferred stock dividends of $1,000,000 were recorded related to the
issuance of 1,390,476 common shares and 608,334 shares of Series D 4%
convertible preferred stock in connection with the cancellation of an
existing reset provision.
The Company exchanged 150,000 shares of Series D 4% convertible preferred
stock for 150,000 shares of Series E 4% convertible preferred stock.
A total of 114,928 shares of Series E convertible preferred stock and
related dividends of $15,969 were converted into 2,591,733 shares of common
stock.
The Company issued 2,692,216 shares of common stock (having a market value
of $16,995,972) in connection with the acquisition of AcuVoice, Inc.
The Company issued 5,140,751 shares of common stock (having a market value
of $8,353,720) and notes payable of $4,747,339 in connection with the
acquisition of Articulate Systems, Inc.
The Company issued 3,111,114 shares of common stock (having a market value
of $3,208,336) and notes payable of $1,710,000 in connection with the
acquisition of Papyrus.
The Company issued notes payable of $348,145 in connection with the
acquisition of certain assets of The MRC Group, Inc.
For the Year Ended December 31, 1997:
A $500,000 Series A convertible debenture was converted into 166,667 shares
of Series A preferred stock.
Series B convertible debentures in the amount of $850,000 and related
accrued interest of $7,850 were converted into 145,747 shares of common
stock.
Series B convertible debentures in the amount of $2,150,000 and related
accrued interest of $28,213 were converted into 108,911 shares of Series B
convertible preferred stock.
Dividends of $2,721,991 were recorded related to the beneficial conversion
features and accretion of Series B and Series C convertible preferred
stock.
206,411 shares of Series B convertible preferred stock and related
dividends of $13,422 were converted into 786,867 shares of common stock.
2,500 shares of Series C convertible preferred stock and related dividends
of $472 were converted into 17,198 shares of common stock.
Accounts payable of $144,931 was converted into a capital lease obligation
of the same amount.
For the Year Ended December 31, 1996:
The Company issued 420,000 shares of common stock to unrelated parties for
finders' fees of $901,520.
See accompanying notes to consolidated financial statements.
F-11
<PAGE>
Fonix Corporation
[A Development Stage Company]
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. NATURE OF OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES
Nature of Operations -The Company's primary focus to date has been the
development of its human computer interface technologies including: sound
recognition engine, neural network, audio signal processor, and command
processing engine for use in its core automated speech recognition ("ASR")
technologies and the development of its text-to-speech ("TTS") technologies,
handwriting recognition technologies, and speech embedded and speech
verification technologies.
The Company is also developing pen-voice technologies, a combination of
handwriting and ASR. The Company has received a patent and continues to seek
additional United States and foreign patent protection for various aspects of
its technologies through the filing of domestic and international applications.
The U.S. Patent and Trademark Office issued the initial patent to the Company
describing 36 claims on June 17, 1997. Additionally, Fonix has acquired other
patents and has filed additional patent applications. The Company licenses its
technologies to and has entered into co-development relationships and strategic
alliances with third parties that are participants in the computer and
electronic devices industry (including producers of application software,
operating systems, computers and microprocessor chips) or are research and
development entities, including academia and industrial and commercial speech
product developers. The Company intends for the foreseeable future to continue
this practice and will seek to generate revenues from its proprietary
technologies from product sales, licensing royalties and strategic partnerships
and alliances. To date, the Company has entered into a strategic partnership and
one license agreement relating to its ASR technologies. The Company generated
its first revenue from its ASR technologies in February 1998 under a license
agreement (see Note 13). Additionally, in 1998, the Company recorded minimal
revenues from sales of its TTS technologies and PowerScribe medical speech
recognition and dictation products. Although the Company has completed
development of the key components of its core technologies, there can be no
assurance that Fonix will be able to sell, license or otherwise market its
technologies to third parties in order to generate sufficient recurring revenues
to pay its operating costs and complete the development of its technologies.
Fonix Corporation (known as Taris, Inc. prior to its acquisition of Phonic
Technologies, Inc., as described below) (the "Company") was organized under the
laws of the state of Delaware on September 12, 1985. Taris, Inc. was a public
company with no operations. Prior to June 17, 1994, Taris, Inc. effected a
reverse stock split of one share for ninety shares. The financial statements
have been adjusted to reflect the stock split as though it had happened January
1, 1993. Phonic Technologies, Inc. ("PTI"), a Utah corporation and the Company's
predecessor in interest with respect to some of the Company's technology, was
organized on October 1, 1993 (the Company's date of inception) for the purpose
of developing proprietary ASR technologies. On June 17, 1994, Fonix Corporation
("Fonix") entered into a merger agreement with PTI whereby Fonix issued
10,395,249 shares of its common stock for all of the issued and outstanding
common shares of PTI. Upon completion of the merger, PTI stockholders owned in
excess of 90 percent of the outstanding common stock of Fonix. The transaction
was accounted for as a reverse acquisition as though PTI acquired Fonix. The
financial statements, therefore, reflect the operations of Fonix since the
acquisition on June 17, 1994 and PTI since October 1, 1993.
Development Stage Presentation - Fonix is a development stage company. The
Company generated revenues of $2,889,684 and incurred net losses totaling
$43,118,782 for the year ended December 31, 1998. The Company has incurred
cumulative losses of $85,414,537 for the period from inception to December 31,
1998. The Company has an accumulated deficit of $92,933,777, negative working
capital of $14,678,975, demand and other notes currently due of $29,438,218 (of
which $1,335,030 is due upon demand or is in default) and $1,965,490 of accounts
payable over 60 days past due as of December 31, 1998. The net loss for 1998 and
the accumulated deficit as of December 31, 1998 include charges of $9,315,000
and $3,821,000 related to the Company's acquisition of in-process product
research and development in connection with its acquisitions of AcuVoice, Inc.
and Articulate Systems, Inc., respectively. Although the Company generated its
first revenue in February 1998, the Company expects to continue to incur
significant losses through at least December 31, 1999, primarily due to
significant expenditure requirements associated with the marketing and
development of its proprietary ASR and related technologies. These factors, as
well as the risk factors set out elsewhere in the Company's Annual Report on
Form 10-K, raise substantial doubt about the Company's ability
F-12
<PAGE>
Fonix Corporation
[A Development Stage Company]
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
to continue as a going concern. The accompanying financial statements do not
include any adjustments that might result from the outcome of this uncertainty.
Management plans to fund the operations of the Company through proceeds from
sales of debt and equity securities and, if necessary, the sale of certain of
its technologies (see Note 20). There can be no assurance that management's
plans will be successful.
Consolidation - The accompanying consolidated financial statements include the
accounts of the Company and its wholly owned subsidiaries, Fonix Systems
Corporation, Fonix/AcuVoice, Inc., Fonix/Articulate, Inc. and Fonix/Papyrus,
Inc. All significant intercompany balances and transactions have been eliminated
in consolidation.
Cash and Cash Equivalents - The Company considers all highly liquid short-term
investments with a maturity of three months or less to be cash equivalents.
Inventory - Inventory, consisting primarily of microphones and related
accessories, is stated at the lower of cost (first-in, first -out method) or
market value.
Property and Equipment - Property and equipment are stated at cost. Depreciation
is computed for financial statement purposes on a straight-line basis over the
estimated useful lives of the assets as follows:
Furniture and fixtures 5 years
Computer equipment 3 to 5 years
Leasehold improvements 18 months to 8 years
Leasehold improvements are amortized over the shorter of the useful life of the
applicable asset or the remaining lease term. Maintenance and repairs are
charged to expense as incurred and major improvements are capitalized. Gains or
losses on sales or retirements are included in the consolidated statements of
operations in the year of disposition.
Intangible Assets - Intangible assets consist of the purchase cost of completed
technology and goodwill in connection with the acquisitions of AcuVoice, Inc.,
Articulate Systems, Inc., Papyrus Development Corporation, Papyrus Associates,
Inc. and certain assets of The MRC Group, Inc. (see Note 2) and direct costs
incurred by the Company in applying for patents covering its technologies.
Amortization is computed on a straight-line basis over the estimated useful
lives of the completed technology, goodwill and patents ranging from five to
eight years. The patent covering the Company's core technologies is pledged as
collateral for repayment of the Company's Series C 5 % Convertible Debentures
that were issued subsequent to December 31, 1998 (see Note 20).
Revenue Recognition - The Company recognizes revenues in accordance with the
provisions of Statement of Position No. 97-2, "Software Revenue Recognition".
The Company generates revenues from licensing the rights to its software
products to end users and from royalties. The Company also generates service
revenues from the sale of consulting and development services.
Revenues from software license agreements are recognized upon shipment of the
software if there are no significant post delivery obligations. If post delivery
obligations exist, revenues are recognized upon customer acceptance. Revenues
from development and consulting services are recognized upon customer
acceptance.
Cost of revenues consists of costs to distribute the product (including the cost
of the media on which it is delivered), installation and support personnel
salaries and licensed technology and related costs.
Research and Development - All expenditures for research and development are
charged to expense as incurred. The Company incurred total research and
development expenses of $13,620,748, $7,066,294 and $4,758,012 for the years
F-13
<PAGE>
Fonix Corporation
[A Development Stage Company]
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
ended December 31, 1998, 1997 and 1996, respectively. The Company expensed
$13,136,000 of research and development costs purchased in connection with the
acquisitions of AcuVoice, Inc. and Articulate Systems, Inc. (see Note 2).
Income Taxes - The Company recognizes deferred income tax assets or liabilities
for the expected future tax consequences of events that have been recognized in
the financial statements or tax returns. Under this method, deferred income tax
assets or liabilities are determined based upon the difference between the
financial and income tax bases of assets and liabilities using enacted tax rates
expected to apply when differences are expected to be settled or realized.
Concentration of Credit Risks - The Company's cash and cash equivalents are
maintained in bank deposit accounts which exceed federally insured limits. The
Company has not experienced any losses with respect to these deposits and
believes it is not exposed to any significant credit risk on cash and cash
equivalents. In the normal course of business, the Company provides credit terms
to its customers. Accordingly, the Company performs on-going credit evaluations
of its customers and maintains allowances for possible losses, which when
realized, have been within the range of management's expectations.
Accounting Estimates - The preparation of financial statements in conformity
with generally accepted accounting principles requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and the disclosures of contingent assets and liabilities at the date
of the financial statements, and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those estimates.
Fair Value of Financial Instruments - The book value of the Company's financial
instruments approximates fair value. The estimated fair values have been
determined using appropriate market information and valuation methodologies.
Net Loss Per Common Share - Basic and diluted net loss per common share are
calculated by dividing net loss attributable to common stockholders by the
weighted average number of shares of common stock outstanding during the year.
At December 31, 1998, 1997 and 1996, there were outstanding common stock
equivalents to purchase 38,319,638, 13,395,948 and 2,450,000 shares of common
stock, respectively, that were not included in the computation of diluted net
loss per common share as their effect would have been anti-dilutive, thereby
decreasing the net loss per common share.
The following table is a reconciliation of the net loss numerator of basic and
diluted net loss per common share for the years ended December 31, 1998, 1997
and 1996.
F-14
<PAGE>
Fonix Corporation
[A Development Stage Company]
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
1998 1997 1996
---------------------------- ---------------------------- ------------------------
Loss Loss Loss
Loss Per Share Loss Per Share Loss Per Share
-------------- --------- -------------- --------- ------------ ---------
<S> <C> <C> <C> <C> <C> <C>
Loss before extraordinary item $ (43,118,782) $(21,572,084) $(7,829,508)
Preferred stock dividends (4,797,249) (2,721,991) -
-------------- -------------- ------------
Loss attributable to common
stockholders before extraordinary
items (47,916,031) $(0.91) (24,294,075) $(0.57) (7,829,508) $(0.21)
Extraordinary items:
Loss on extinguishment of debt - - (881,864) (0.02) - -
-------------- ---------- -------------- ---------- ------------ ---------
Net loss attributable to common
stockholders $(47,916,031) $(0.91) $(25,175,939) $(0.59) $(7,829,508) $(0.21)
============== ========== ============== ========== ============ =========
Weighted average common shares
outstanding 52,511,185 42,320,188 36,982,610
============== ============== ============
</TABLE>
Recently Enacted Accounting Standards - Effective January 1, 1998, the Company
adopted Statement of Financial Accounting Standards ("SFAS") No. 130, "Reporting
Comprehensive Income." This statement established standards for reporting and
display of comprehensive income and its components in financial statements. The
adoption of this statement had no effect on the Company's consolidated financial
statement presentation.
In June 1997, the Financial Accounting Standards Board issued SFAS No. 131,
"Disclosures about Segments of an Enterprise and Related Information." SFAS No.
131 established new standards for public companies to report information about
their operating segments, products and services, geographic areas and major
customers. The Company has adopted SFAS No. 131 beginning with the year ended
December 31, 1998 (see Note 19).
In June 1998, the Financial Accounting Standards Board issued SFAS No. 133,
"Accounting for Derivative Instruments and Hedging Activities." This statement
establishes accounting and reporting standards requiring that derivative
instruments be recorded in the balance sheet as either an asset or liability
measured at its fair value and that changes in the derivative's fair value be
recognized currently in earnings unless specific hedge accounting criteria are
met. SFAS No. 133 is effective for fiscal years beginning after June 15, 1999.
The adoption of this statement in not expected to have a material effect on the
Company's consolidated financial statements as the Company does not currently
hold any derivative or hedging instruments.
2. ACQUISITIONS
AcuVoice, Inc. - In March 1998, the Company created a wholly owned subsidiary
(Fonix/AcuVoice, Inc.) that acquired AcuVoice, Inc. ("AcuVoice"). AcuVoice
developed and marketed TTS technologies and products directly to end-users,
systems integrators and original equipment manufacturers for use in the
telecommunications, multi-media, education and assistive technology markets.
These same products and services are now provided by the Company's Interactive
Technologies Solutions Group. The Company issued 2,692,216 shares of restricted
common stock (having a market value of $16,995,972 on that date) and paid cash
of approximately $8,000,000 for all of the then outstanding common shares of
AcuVoice. The acquisition was accounted for as a purchase.
Of the 2,692,216 shares of stock issued, 80,000 shares were placed in escrow
against which any claims for breach of warranty against the former shareholders
of AcuVoice could be asserted by the Company. On March 12, 1999, the Company
submitted a claim for the shares deposited into the escrow account based on the
Company's assertion of
F-15
<PAGE>
Fonix Corporation
[A Development Stage Company]
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
misrepresentations made to the Company (see Note 16). The shares held in escrow
have been excluded from the calculation of basic net loss per common share for
the year ended December 31, 1998.
The purchase price allocations to tangible assets included $253,881 of cash,
$13,728 of accounts receivable, $9,902 of fixed assets and $800 of prepaid
expenses. The purchase price allocations to liabilities assumed included $22,929
of accounts payable and accrued expenses and $599,250 of notes payable.
The excess of the purchase price over the estimated fair market value of the
acquired tangible net assets of AcuVoice was $25,339,840, of which $11,192,000
was capitalized as the purchase cost of the completed technology, $4,832,840 was
capitalized as goodwill and $9,315,000 was expensed as purchased in-process
research and development.
The amount attributed to purchased in-process research and development was
expensed in connection with the acquisition because the purchased in-process
technology had not yet reached technological feasibility and had no alternative
future use.
Articulate Systems, Inc. - In 1998, the Company created a wholly owned
subsidiary ("Fonix/Articulate") that acquired Articulate Systems, Inc.
("Articulate") in September 1998. Articulate was a provider of sophisticated
voice recognition products to specialized segments of the health care industry.
These same products and services are now provided by the Company's HealthCare
Solutions Group. The Company delivered 5,140,751 shares of restricted common
stock (having a market value of $8,353,720 on that date), a cash payment of
$7,787,249 and 8.5 percent demand notes in the aggregate amount of $4,747,339
for all the then outstanding common shares of Articulate. Additionally, the
Company issued 98,132 stock options in exchange for all Articulate stock options
outstanding on the date of acquisition at an exchange rate based on the relative
fair value of the companies' stocks. The estimated fair value of the options
issued was $130,000 using the Black-Scholes option pricing model with weighted
average assumptions of a risk-free rate of 5.1 percent, expected life of 2.5
years, expected volatility of 85 percent and an expected dividend yield of 0
percent. Subsequent to the acquisition, the Company agreed to pay several
Articulate employees incentive compensation for continued employment in the
aggregate amount of $857,000. The Company issued 8.5 percent demand notes for
$452,900 and recorded an accrued liability of $404,100 for the balance of this
obligation. The demand notes issued to both the Articulate stockholders and the
Articulate employees were payable after November 1, 1998 (see Note 7). The
$404,100 accrued liability is payable on or before January 31, 1999. The
Articulate acquisition was accounted for as a purchase.
Of the 5,140,751 shares of common stock issued, 315,575 shares were placed in
escrow against which any claims for breach of warranty against the former
shareholders of Articulate could be asserted by the Company and 1,985,000 shares
were placed in escrow to be converted to a new class of non-voting common stock
upon approval of the establishment of such a class of stock by the shareholders
of the Company. The shares held in escrow have been excluded from the
calculation of basic net loss per common share for the year ended December
31,1998.
The purchase price allocations to tangible assets included $286,954 of cash,
$62,835 of accounts receivable, $57,165 of inventory, $14,043 of prepaid
expenses and $117,540 of fixed assets. The purchase price allocations to
liabilities assumed included $310,008 of accounts payable and accrued expenses,
$1,900,000 of notes payable and $929,690 of deferred revenue.
The excess of the purchase price over the estimated fair market value of the
acquired tangible net assets of Articulate was $23,584,256, of which $13,945,000
was capitalized as the purchase cost of completed technology, $5,818,256 was
F-16
<PAGE>
Fonix Corporation
[A Development Stage Company]
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
capitalized as goodwill and other intangibles and $3,821,000 was expensed as
purchased in-process research and development. The amount attributed to
purchased in-process research and development was expensed in connection with
the acquisition because the purchased in-process technology had not yet reached
technological feasibility and had no alternative future use.
In Process Research & Development Valuation Methodologies - The valuation of the
acquired in-process research and development included, but was not limited to,
an analysis of (1) the market for Articulate and AcuVoice products and
technologies; (2) the completion costs for the projects; (3) the expected cash
flows attributed to the projects; and (4) the risks associated with achieving
such cash flows. The assumptions used in valuing the in-process research and
development were based upon assumptions the Company believed to be reasonable
but which are inherently uncertain and unpredictable. For these reasons, actual
results may vary from projected results.
At the time of its acquisition by Fonix, Articulate's research and development
focused on developing a new PowerScribe platform design that will support as-yet
unproven features including an enhanced tool kit that supports advanced voice
recognition technology built on all-new language models, as well as new storage
and retrieval applications. At the time of its acquisition by Fonix, AcuVoice's
research and development efforts were focused on the continued development of a
completely new generation of proprietary text-to-speech technology.
Specifically, AcuVoice was working to expand voice capacity to include other
voices (including female and foreign language voices). As of the date of
acquisition, Articulate and AcuVoice invested approximately $3,400,000 and
$3,500,000, respectively, in the projects identified above. Development of the
acquired in-process technology into commercially viable products and services
required efforts principally related to the completion of all planning,
designing, coding, prototyping, scalability verification, and testing activities
necessary to establish that the proposed technologies would meet their design
specifications, including functional, technical, and economic performance
requirements. As of the date of acquisition, management estimated that each of
the Articulate and AcuVoice projects was approximately 75 percent complete based
on costs. Remaining development efforts for these projects include various
phases of design, development and testing. Funding for the projects was expected
to be obtained from private offerings of the Company's equity securities.
Management believes that the AcuVoice projects may be finished as early as
October 1999 while the Articulate projects are expected to be finished no
earlier than fiscal 2000. Expenditures to complete the AcuVoice projects and the
Articulate projects are each expected to total approximately $1,000,000. These
estimates are subject to change, given the uncertainties of the development
process, and no assurance can be given that significant deviations from these
estimates will not occur.
The net cash flows resulting from the projects at Articulate and AcuVoice, which
were used to value the purchased in-process research and development, were based
on management's estimates of revenues, cost of revenues, research and
development costs, selling, general and administrative costs, and income taxes
from such projects. These estimates are based on the following assumptions: the
potential market size that the projects are addressing; the Company's ability to
gain market share in these segments; and the life cycle of in-process
technology. Earnings before interest and taxes are estimated to be approximately
35 percent to 60 percent for the sales generated from the Articulate and
AcuVoice in-process technology. Estimated total revenues from the purchased
in-process product areas peak in calendar years 2000-2001 and decline thereafter
as other new products are expected to enter the market. In addition, a portion
of the anticipated revenues has been attributed to enhancements of the base
technology under development, and has been excluded from the net cash flow
calculations. Existing technology was valued at $13,945,000 for Articulate and
$11,192,000 for AcuVoice. There can be no assurances that these assumptions will
prove accurate, or that the Company will realize the anticipated benefit of
these acquisitions.
The rates utilized to discount the net cash flows to their present value are
based on cost of capital calculations. Due to the high risk nature of the growth
and profitability inherent in the forecast and the risks associated with the
developmental projects, capital rates of return of 40 percent and 60 percent for
Articulate and AcuVoice,
F-17
<PAGE>
Fonix Corporation
[A Development Stage Company]
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
respectively, were considered appropriate for the acquired companies. The
discount rates used to derive the net present value of cash flows from each
purchased in-process technology were commensurate with each acquired company's
i) early stage of development; ii) history of limited revenues and losses; iii)
the uncertainties in the economic estimates described above; iv) the inherent
uncertainty surrounding the successful development of the purchased in-process
technology; v) the useful life of such technology; vi) the profitability levels
of the technology; and, vii) the uncertainty associated with technological
advances inherent in the research and development.
If these projects are not successfully developed, the Company's business,
operating results, and financial condition may be adversely affected in future
periods. In addition, the value of other intangible assets acquired may become
impaired. To date, results have not differed significantly from the forecast
assumptions at each respective date of acquisition in terms of anticipated date
of release and cost to complete. Management believes the value allocated to
acquired developed technology and in-process research and development is
consistent with these facts and circumstances.
Papyrus Associates, Inc. and Papyrus Development Corporation - In October 1998,
the Company created a wholly owned subsidiary (Fonix/Papyrus, Inc.) that
acquired Papyrus Associates, Inc. ("PAI"), and Papyrus Development Corporation
("PDC") (together with PAI, "Papyrus"). PAI developed, marketed and supported
printing and cursive handwriting recognition software for "personal digital
assistants", pen tablets and mobile phones under the trademark, Allegro(TM). PDC
was a systems integration provider with expertise and intellectual property in
imbedded systems and enhanced Internet applications. These same products and
services are now provided by the Company's Interactive Technologies Solutions
Group. The Company issued 3,111,114 shares of restricted common stock (having a
market value of $3,208,336 on that date) and promissory notes aggregating
$1,710,000 with due dates from February 28, 1999 to September 30, 1999 for all
of the then outstanding common shares of PAI and PDC.
Of the 3,111,114 shares of common stock issued, 311,106 shares were placed in
escrow against which any claims for breach of warranty against the former
shareholders of Papyrus could be asserted by the Company. The shares held in
escrow have been excluded from the calculation of basic net loss per common
share for the year ended December 31, 1998. The acquisition was accounted for as
a purchase.
The purchase price allocation to tangible assets included $10,342 of cash and
$7,629 of accounts receivable. The purchase price allocation to liabilities
assumed included $118,293 of accounts payable and accrued liabilities. The
excess of the purchase price over the estimated fair market value of the
acquired tangible net assets of Papyrus was $5,018,658 and was capitalized as
goodwill.
The Company incurred $821,197 in research and development expenses related to
services performed by Papyrus prior to the date of the acquisition.
The MRC Group, Inc. - On December 31, 1998, the Company acquired certain assets
of The MRC Group, Inc. ("MRC") relating to MRC's selling, marketing and
servicing of the PowerScribe(R) products. In consideration for the assets, the
Company agreed to pay MRC $219,833 less certain amounts then owed to the
Company, plus $133,333 per month for each of the three months immediately
following the closing, less certain credits. Subsequent to December 31, 1998,
the remaining amounts owing related to this acquisition are $216,666.
The purchase price allocations to tangible assets included $142,852 of accounts
receivable and $40,000 of fixed assets. The purchase price allocations to
liabilities assumed included $311,588 of accrued expenses and $849,742 of
deferred revenue. Additionally, $152,839 of accounts receivable and $987,531 of
deferred revenue from Articulate were eliminated in purchase accounting.
The excess of the purchase price over the estimated fair market value of the
acquired tangible net assets of MRC was $314,761 which was capitalized as
goodwill.
F-18
<PAGE>
Fonix Corporation
[A Development Stage Company]
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Proforma Financial Statement Data - The following unaudited pro forma financial
statement data for the years ended December 31, 1998 and 1997 present the
results of operations of the Company as if the acquisitions of AcuVoice,
Articulate and Papyrus had occurred at the beginning of each year. The pro forma
results have been prepared for comparative purposes only and do not purport to
be indicative of future results or what would have occurred had the acquisitions
been made at the beginning of the applicable year. Purchased in-process research
and development expenses related to the acquisitions of AcuVoice and Articulate
of $9,315,000 and $3,821,000, respectively, were recorded at the date of the
acquisitions and are not presented in the following unaudited pro forma
financial statement data since they are non-recurring charges directly
attributable to the acquisitions. The results of operations of MRC are not
included in the unaudited pro forma financial statement data as the acquisition
did not constitute the purchase of a business.
<TABLE>
<CAPTION>
For the Year Ended December 31,
----------------------------------
1998 1997
-------- --------
<S> <C> <C>
Revenues $ 3,493,460 $ 2,055,419
Loss before extraordinary items (36,131,670) (21,360,635)
Net loss (36,131,670) (22,242,499)
Basic and diluted net loss per common share (0.64) (0.49)
</TABLE>
3. CERTIFICATE OF DEPOSIT
At December 31, 1998 and 1997, the Company maintained a $20,000,000 short-term
certificate of deposit at a bank which is included in cash and cash equivalents.
The certificate bore interest at 4.0 percent and 5.5 percent at December 31,
1998 and 1997, respectively. Interest was payable monthly. This certificate was
pledged as collateral on a revolving note payable (see Note 6). On January 8,
1999, this certificate of deposit matured and was not renewed. Proceeds from the
certificate were applied to reduce the related revolving note payable balance.
4. NOTES RECEIVABLE
At December 31, 1998, the Company had a note receivable from a research and
development entity in the amount of $20,000 which was repaid subsequent to
December 31, 1998.
As of December 31, 1998, the Company had a six percent short-term, unsecured,
demand note receivable from an unrelated entity in the amount of $225,000, which
note was issued in connection with the Company's intended acquisition of the
entity. Because the acquisition was not pursued, subsequent to December 31,
1998, the Company demanded and received payment of the $225,000 note.
At December 31, 1997, the Company had a short-term, unsecured, non-interest
bearing note receivable from AcuVoice in the amount of $500,000. When AcuVoice
was acquired effective March 13, 1998, this note receivable was eliminated in
connection with the acquisition. Additionally, at December 31, 1997, the Company
had a short-term, unsecured, demand note receivable from an unrelated entity in
the amount of $100,000. During 1998, the Company determined this note was
uncollectible and expensed the related amount.
5. PROPERTY AND EQUIPMENT
Property and equipment consisted of the following at December 31, 1998 and 1997:
1998 1997
------------ ------------
Computer equipment $2,463,208 $1,321,016
Furniture and fixtures 854,050 640,992
Leasehold improvements 206,144 69,371
------------ ------------
Less accumulated depreciation 3,523,402 2,031,379
and amortization (1,195,390) (464,100)
------------ ------------
Net property and equipment $2,328,012 $1,567,279
============ ============
F-19
<PAGE>
Fonix Corporation
[A Development Stage Company]
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
6. REVOLVING AND OTHER NOTES PAYABLE
At December 31, 1998 and 1997, the Company had a revolving note payable to a
bank in the amount of $19,988,193 and $18,612,272, respectively. Borrowings
under the revolving note payable were limited to $20,000,000. The weighted
average outstanding balance during 1998 and 1997 was $18,590,642 and
$18,861,104, respectively. The weighted average interest rate was 6.40 percent
and 5.94 percent during 1998 and 1997, respectively. This note was due January
8, 1999, bore an interest rate of 6.00 percent at December 31,1998, and was
secured by a certificate of deposit in the amount of $20,000,000 (see Note 3).
This revolving note was renegotiated quarterly and interest was payable monthly.
The Company paid this revolving note in full, including accrued interest, on
January 8, 1999 with proceeds from the certificate of deposit that secured the
note and $22,667 in cash.
At December 31, 1998, the Company has an unsecured revolving note payable to a
bank in the amount of $50,000. Loaned amounts under the revolving note payable
are limited to $50,000. The weighted average outstanding balance during the year
ended December 31, 1998 was $14,384. The weighted average interest rate was 9.4
percent during 1998. This note is payable on demand, matures April 1, 2007,
bears interest at a bank's prime rate plus 2.0 percent (9.75 percent at December
31, 1998) and requires interest to be paid monthly.
At December 31, 1998, the Company has a note payable to a lender in the amount
of $560,000 which bears interest at 18 percent, which interest is payable
monthly. The note payable was due January 2, 1999 and is secured by certain
accounts receivable. The Company has subsequently extended the due date from
month to month by paying the lender accrued interest plus a fee of $5,600. The
loan balance is currently due May 28, 1999. The Company anticipates that it will
request additional extensions of the due date. In connection with the issuance
of the note payable, the Company issued 35,000 shares of common stock (having a
fair value of $50,314 on the date of issuance) in payment for a loan origination
fee. This amount is included in interest expense in the accompanying
consolidated statement of operations. The note is personally guaranteed by two
officers and directors and the chairman of the board of directors of the
Company. The Company has entered into an indemnity agreement with the three
directors relating to this and other guarantees and pledges (see Note 12).
7. RELATED-PARTY NOTES PAYABLE
At December 31, 1998, the Company has unsecured demand notes payable outstanding
to the former Articulate stockholders in the aggregate amount of $4,708,980.
These notes were issued in connection with the Articulate acquisition (see Note
2). These notes were payable on demand any time after November 1, 1998. In
December 1998, the holder of $ 407,971 of notes demanded payment. In connection
with this demand, the Company paid the holder $50,000 representing a partial
payment and the holder agreed to extend the date to March 15, 1999 and increase
the interest rate to 11 percent per annum. No additional demand has been given
for this note. Additionally in 1998, the Company negotiated extensions on
$3,521,726 of the notes which adjusted the interest rate to 10 percent and
extended the due dates to May 30, 1999. No demand has been given for the
remaining balance of notes.
Subsequent to the Articulate acquisition, the Company agreed to pay several
Articulate employees incentive compensation for continued employment in the
aggregate amount of $857,000. The Company issued demand notes for $452,900 and
recorded an accrued liability of $404,100 for the balance of this obligation
(see Note 2). The demand notes bear interest at an annual rate of 8.5 percent
and were payable upon demand after November 1, 1998. None of the holders of
these notes has demanded payment and they have verbally agreed to extend the due
dates of these notes to April 30, 1999, and the Company has also verbally agreed
to pay interest at nine percent per annum after the November 1, 1998 due date.
The Company has not paid the $404,100 of accrued liability which was due on or
before January 31, 1999.
In connection with the acquisition of certain liabilities of Articulate (see
Note 2), the Company executed and delivered a $1,500,000 unsecured demand note
payable to a company which is a stockholder of the Company. This demand note
F-20
<PAGE>
Fonix Corporation
[A Development Stage Company]
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
bore interest at an annual rate of 10 percent and was payable upon demand after
November 1, 1998. The Company obtained an extension of the due date from the
holder of the note and on February 2, 1999, this note and related interest were
paid in full.
At December 31, 1998, the Company has unsecured demand notes payable to former
Papyrus stockholders in the aggregate amount of $1,710,000, which notes were
issued in connection with the Papyrus acquisition. The notes are payable as
follows: $1,190,000 due by February 28, 1999, $180,000 due on April 30, 1999 and
$340,000 due on September 30, 1999, and bear interest at six percent per annum
after their due date. The Company has not made any payments on these notes and
is negotiating with the former shareholders of Papyrus to resolve issues raised
in a legal action filed by the Company against certain former shareholders of
Papyrus (see Note 17).
The Company has an unsecured revolving note payable to a company owned by three
individuals who are executive officers and directors of the Company and who each
beneficially own more than 10 percent of the Company's common stock. At December
31, 1998 and 1997, $0 and $551,510 in principal and $2,482 and $22,243 in
accrued interest were outstanding under this revolving note payable,
respectively. The weighted average balance outstanding during the borrowing
period was $73,811 in 1998 and $555,407 in 1997. This revolving note is payable
on demand and bears interest at an annual rate of 12 percent. The maximum amount
outstanding under this revolving note was $551,510 in 1998 and $1,550,000 in
1997. In connection with this revolving note, the Company paid a loan
origination fee of $93,000 in 1997. The Company believes the terms of the
related-party revolving note payable are at least as favorable as the terms that
could have been obtained from an unrelated third party in a similar transaction.
At December 31, 1998, the Company has an unsecured, non-interest bearing demand
note payable in the amount of $100,000 to Synergetics, Inc. ("Synergetics"), a
research and development entity (see Note 12). This note is payable on demand.
At December 31, 1998, the Company has an unsecured note payable to an officer of
the Company in the amount of $20,000, which bears interest at an annual rate of
10 percent and was due December 31, 1998. Subsequent to December 31, 1998, the
holder of this note agreed to extend the due date to June 30, 1999.
8. CONVERTIBLE DEBENTURES
Series A Convertible Debenture - On October 23, 1995, the Company entered into a
Securities Purchase Agreement (the "Securities Purchase Agreement") with
Beesmark Investments, L.C., a Utah limited liability company controlled by an
individual who assumed a position on the Company's board of directors in
connection with the execution of the Securities Purchase Agreement. Under the
Securities Purchase Agreement, the Company issued a Series A Convertible
Debenture in the amount of $500,000. The debenture bore interest at five percent
and was originally due October 23, 1996. The debenture was ultimately converted
into 166,667 shares of Series A Preferred Stock on September 25, 1997.
Series B Convertible Debentures - On June 18, 1997, the Company entered into a
Convertible Debenture Purchase Agreement (the "Agreement") whereby an unrelated
investment entity agreed to purchase up to an aggregate principal amount of
$10,000,000 of the Company's Series B Convertible Debentures. The debentures
were due June 18, 2007, bore interest at five percent and were convertible into
shares of the Company's common stock at anytime after issuance at the holder's
option. The debentures were convertible into shares of the Company's common
stock at the lesser of $6.81 or the average of the per share market value for
the five trading days immediately preceding the conversion date multiplied by 90
percent for any conversion on or prior to the 120th day after the original issue
date and 87.5 percent for any conversion thereafter. On June 18, 1997, the
Company received $3,000,000 in proceeds related to the issuance of Series B
Convertible Debentures. Using the conversion terms most beneficial to the
investor, the Company recorded a prepaid financing cost of approximately
$427,900 to be amortized as additional interest expense over the 120 day period
commencing June 18, 1997. As part of the same transaction, the Company also
issued to the investor a warrant to purchase up to 250,000 shares of common
stock at any time prior to June 18, 2002, at the exercise price of $8.28 per
F-21
<PAGE>
Fonix Corporation
[A Development Stage Company]
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
share. The Company recorded the fair value of the warrants, totaling $897,750,
as a charge to interest expense. The fair value of the warrants was determined
as of the date of grant using the Black-Scholes pricing model assuming the
following: dividend yield of 0 percent; expected volatility of 65 percent; risk
free interest rate of 5.9 percent and an expected life to exercise of five
years. On July 31, 1997 and September 26,1997, $500,000 and $350,000 of the
Series B Convertible Debentures together with interest earned thereon were
converted into 87,498 and 58,249 shares of common stock, respectively.
Effective September 30, 1997, the Company and the Series B Convertible Debenture
holders agreed to modify the Agreement to provide that the holders exchange all
the outstanding debentures in the amount of $2,150,000 and accrued interest
thereon in the amount of $28,213 into 108,911 shares of Series B Convertible
Preferred Stock that would have essentially the same terms as the debentures and
that any additional purchases under the Agreement would be for the purchase of
Series B Convertible Preferred Stock. In connection with the extinguishment of
the Series B Convertible Debenture and the issuance of Series B Convertible
Preferred Stock, the Company recorded all unamortized prepaid financing costs as
a loss on extinguishment of debt. Also in connection with this modification, the
Company issued an additional warrant to purchase up to 175,000 shares of common
stock at any time prior to October 24, 2002, at an exercise price of $7.48 per
share. In connection with the issuance of that warrant, the Company recorded the
fair value of the warrant, totaling $661,850 as an additional loss on
extinguishment of debt. The fair value of the warrants was determined as of the
date of the grant using the Black-Scholes pricing model assuming the following:
dividend yield of 0 percent; expected volatility of 65 percent; risk free
interest rate of 5.8 percent and expected life to exercise of 5 years.
9. PREFERRED STOCK
In 1995, the Company's board of directors adopted a resolution to amend the
certificate of incorporation to provide for the issuance of preferred stock and
give the board of directors authority to fix the rights, preferences and
restrictions of any series of preferred stock. At the same time, the board of
directors authorized, subject to approval by the Company's shareholders of the
amendment to the certificate of incorporation, a class of Series A Convertible
Preferred Stock. The Series A Convertible Preferred Stock authorized in 1995 was
issued shortly thereafter. In August 1997, a majority of the shareholders of the
Company approved the amendment to the Company's certificate of incorporation
authorizing and approving the issuance of preferred stock in such series and
having such terms and conditions as the Company's board of directors may
designate. The amendment became effective September 24, 1997. Thereafter, the
Company's board of directors adopted resolutions establishing Series B
Convertible Preferred Stock, Series C Convertible Preferred Stock, Series D
Convertible Preferred Stock and Series E Convertible Preferred Stock in
connection with certain capital fund-raising in 1997 and 1998, as described
below.
Series A Convertible Preferred Stock - In September 1997, the Series A
Convertible Debenture was converted into 166,667 shares of Series A Convertible
Preferred Stock. The holder of the Series A Convertible Preferred Stock has the
same voting rights as common stockholders, has the right to elect one person to
the board of directors and receives a one time preferential dividend of $2.905
per share of Series A Convertible Preferred Stock prior to the payment of any
dividend on any class or series of stock. At the option of the holder, each
share of Series A Convertible Preferred Stock is convertible into one share of
common stock and in the event that the common stock price has equaled or
exceeded $10 for a fifteen day period, the Series A Convertible Preferred Stock
shares are automatically converted into common stock. In the event of
liquidation, the holder is entitled to a liquidating distribution of $36.33 per
share and a conversion of Series A Convertible Preferred Stock at an amount
equal to 1.5 shares of common stock for each share of Series A Convertible
Preferred Stock.
Series B Convertible Preferred Stock - Effective September 30, 1997, the Company
and the Series B Convertible Debenture holders agreed to exchange all then
outstanding Series B debentures in the aggregate amount of $2,150,000 and
accrued interest thereon in the amount of $28,213 into 108,911 shares of Series
B Convertible Preferred Stock. Dividends accrue on the stated value ($20 per
share) of Series B Convertible Preferred Stock at a rate of five percent
F-22
<PAGE>
Fonix Corporation
[A Development Stage Company]
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
per year, are payable quarterly in cash or common stock, at the option of the
Company, and are convertible into shares of the Company's common stock at any
time after issuance at the holders' option. In the event of liquidation, the
holders of the Series B Convertible Preferred Stock are entitled to an amount
equal to the stated value plus accrued but unpaid dividends whether declared or
not. The holders of Series B Convertible Preferred Stock have no voting rights.
The Series B Convertible Preferred Stock, together with dividends accrued
thereon, may be converted into shares of the Company's common stock at the
lesser of $6.81 or the average of the per share market value for the five
trading days immediately preceding the conversion date multiplied by 90 percent
for any conversion on or prior to the 120th day after the original issue date
and 87.5 percent for any conversion thereafter. Using the conversion terms most
beneficial to the holder, the Company recorded a dividend of $219,614 which
represents a discount of 10 percent, which is available to the holder upon
issuance. The additional 2.5 percent discount of $68,509 was amortized as a
dividend over the remaining days in the original 120 day vesting period of the
Series B Convertible Debentures. Prior to the actual issuance of the Series B
Convertible Preferred Stock in exchange for the outstanding balance under the
debenture, the holder converted the balance of $2,150,000, and related
dividends, into 431,679 shares of common stock.
On October 24, 1997, the Company sold an additional 125,000 shares of Series B
Convertible Preferred Stock for $2,500,000 less $145,000 in related offering
costs. Using the conversion terms most beneficial to the holder, the Company
recorded a dividend of $576,667 which represents a discount of 10 percent, which
is available to the holder on or before 120 days subsequent to closing. A 2.5
percent discount of $87,905 was amortized as a dividend over 120 days. As a
condition for issuing preferred stock, the holder was granted a put option by
SMD, L.L.C. ("SMD"), a company which is controlled by three shareholders who are
officers or directors of Fonix. The put option requires SMD to purchase the
Series B Convertible Preferred Stock from the holder at the holder's option but
only in the event that the common stock of Fonix is removed from listing on the
NASDAQ Small Cap Market or any other national securities exchange. In addition,
Fonix has not entered into any type of agreement which would require Fonix to
reimburse SMD should SMD be required to purchase the Series B Convertible
Preferred Stock from the holder. In connection with this put option, the Company
recorded a financing expense and a corresponding capital contribution of
$125,000. As of December 31, 1997, 97,500 of the Series B Convertible Preferred
Stock and dividends earned thereon had been converted into 355,188 shares of
common stock. In January 1998, the remaining 27,500 shares of Series B
Convertible Preferred Stock and dividends earned thereon were converted into
193,582 shares of common stock.
Series C Convertible Preferred Stock - Effective September 30, 1997, the Company
entered into an agreement with an unrelated investment entity whereby that
entity agreed to purchase 187,500 shares of the Company's Series C Convertible
Preferred Stock for $3,750,000. The cash purchase price was received in October
1997. Dividends accrue on the stated value ($20 per share) of Series C
Convertible Preferred Stock at a rate of five percent per year, are payable
quarterly in cash or common stock, at the option of the Company, and are
convertible into shares of the Company's common stock at anytime after issuance
at the holders' option. In the event of liquidation, the holders of the Series C
Convertible Preferred Stock are entitled to an amount equal to the stated value
($20 per share) plus accrued but unpaid dividends whether declared or not. The
holders of Series C Convertible Preferred Stock have no voting rights. The
Series C Convertible Preferred Stock, together with dividends accrued thereon,
may be converted into shares of the Company's common stock at the lesser of
$5.98 or the average of the five lowest closing bid prices for the 15 trading
days preceding the date of any conversion notice multiplied by 91 percent for
any conversion on or prior to the 120th day after the original issue date, 90
percent for any conversion between 121 and 180 days and 88 percent for any
conversion thereafter. Using the conversion terms most beneficial to the holder,
the Company recorded a dividend of $1,060,718 which represents a discount of
nine percent, which is available to the holder on or before 120 days subsequent
to closing. The additional three percent discount of $164,002 was amortized as a
dividend over 180 days. As a condition for issuing preferred stock, the Series C
Convertible Preferred Stockholder was granted a put option by SMD. The put
option requires SMD to purchase the Series C Convertible Preferred Stock from
the holder at the holder's option but only in the event that the common stock of
Fonix is removed from listing on the NASDAQ Small Cap Market or any other
national securities exchange. In addition, Fonix has not entered into any type
of agreement which would require Fonix to reimburse SMD should SMD be required
to purchase the preferred stock from the holder. In connection with this put
option, the Company recorded a financing expense and a corresponding capital
contribution
F-23
<PAGE>
Fonix Corporation
[A Development Stage Company]
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
of $375,000. Associated with the issuance of the Series C Convertible Preferred
Stock, the Company issued a warrant to purchase up to 200,000 shares of common
stock at any time prior to October 24, 2000, at the exercise price of $7.18 per
share. The Company recorded the fair value of the warrant of $600,000 as
determined as of October 24,1997 using the Black-Scholes pricing model assuming
the following: dividend yield of 0 percent; expected volatility of 65 percent;
risk free interest rate of 5.8 percent and expected life to exercise of 3 years.
During the year ended December 31, 1997, the Company issued 17,198 shares of
common stock upon conversion of 2,500 shares of Series C Convertible Preferred
Stock and related accrued dividends. During 1998, the balance of 185,000 shares
of Series C Convertible Preferred Stock and related dividends were converted
into 1,295,919 shares of the Company's common stock.
Series D Convertible Preferred Stock - On August 31, 1998, the Company entered
into an agreement with investors whereby the Company issued 500,000 shares of
the Company's Series D Convertible Preferred Stock for $10,000,000.
Additionally, the Company issued to certain investors a total of 608,334 shares
of Series D Convertible Preferred Stock (i) in return for their relinquishment
of their contractual right to receive Reset Shares in connection with the March
1998 offering (see Note 10), and as (ii) an additional cost of raising the
$10,000,000 from the Series D Convertible Preferred Stock placement. Dividends
accrue on the stated value ($20 per share) of Series D Convertible Preferred
Stock at the rate of four percent per year, are payable annually or upon
conversion, in cash or common stock, at the option of the Company, and are
convertible into shares of the Company's common stock at the holder's option any
time. Each month the holders of the Series D Convertible Preferred Stock may not
convert more than 25 percent of the total number of shares of Series D
Convertible Preferred Stock originally issued to such holders on a cumulative
basis. For example, during the first month a holder may convert up to 25 percent
of the total Series D Convertible Preferred Stock issued to the holder, and
during the following month that same holder may convert, on an aggregate to date
basis, up to 50 percent of the total number of shares of Series D Convertible
Preferred Stock held by the holder. Additionally, each month, the holders may
convert up to 50 percent of the total number of shares of Series D Convertible
Preferred Stock originally issued to such holders on a cumulative basis, if both
of the following conditions are satisfied: the average daily trading volume of
the Company's common stock is more than 500,000 shares for the 10-trading-day
period before the conversion; and the average per share closing bid price for
such 10-trading-day period has not decreased by more than five percent during
that 10-trading-day period. Any outstanding shares of Series D Convertible
Preferred Stock as of August 31, 2001 automatically will be converted at the
conversion price most beneficial to the holders on such date. In the event of
liquidation, the holders of the Series D Convertible Preferred Stock are
entitled to an amount equal to the stated value ($20 per share) plus accrued but
unpaid dividends whether declared or not. The holders of Series D Convertible
Preferred Stock have no voting rights. The Series D Convertible Preferred Stock,
together with dividends accrued thereon, may be converted into shares of the
Company's common stock at the lesser of: $3.50 per share; or the lesser of 110
percent of the average per share closing bid price for the fifteen trading days
immediately preceding the date of issuance of the Series D Convertible Preferred
shares; or 90 percent of the average of the three lowest per share closing bid
prices during the 22 trading days immediately preceding the conversion date. In
the event that the holders convert at the $3.50 per share price, the Company is
obligated to issue warrants to purchase 0.8 shares of common stock for each
share of Series D Convertible Preferred Stock converted to common stock. Using
the conversion terms most beneficial to the holder, the Company is amortizing a
beneficial conversion feature of $3,638,147 as a dividend over a 180 day-period.
Subsequent to December 31, 1998, 45,000 shares of Series D Convertible Preferred
Stock and related dividends were converted into 741,749 shares of common stock.
Series E Convertible Preferred Stock - Effective as of September 30, 1998, the
Company entered into an agreement with two of the investors who purchased the
Series D Convertible Preferred Stock whereby the Company issued 100,000 shares
of the Company's Series E Convertible Preferred Stock for $2,000,000.
Additionally, the Company issued to the purchasers of the Series E Convertible
Preferred Stock a total of 150,000 additional shares of Series E Convertible
Preferred Stock in exchange for which those purchasers surrendered a total of
150,000 shares of Series D Convertible Preferred Stock. Dividends accrue on the
stated value ($20 per share) of Series E Convertible Preferred Stock at a rate
of four percent per year, are payable annually or upon conversion, in cash or
common stock, at the option of the Company, and are convertible into shares of
the Company's common stock at any time at the holder's option. Any outstanding
shares of Series E Convertible Preferred Stock as of September 30, 2001 are
automatically converted at the
F-24
<PAGE>
Fonix Corporation
[A Development Stage Company]
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
conversion price most beneficial to the holders on such date. In the event of
liquidation, the holders of the Series E Convertible Preferred Stock are
entitled to an amount equal to the stated value ($20 per share) plus accrued but
unpaid dividends whether declared or not. The holders of Series E Convertible
Preferred Stock have no voting rights. The Series E Convertible Preferred Stock,
together with dividends accrued thereon, may be converted into shares of the
Company's common stock at the lesser of: $3.50 per share; or the lesser of 110
percent of the average per share closing bid price for the 15 trading days
immediately preceding the date of issuance of the Series E Convertible Preferred
shares; or 90 percent of the average of the three lowest per share closing bid
prices during the 22 trading days immediately preceding the conversion date. If
the Investors convert at the $3.50 per share price, the Company is obligated to
issue warrants to purchase 0.8 shares of common stock for each share of Series E
Convertible Preferred Stock converted to common stock. Using the conversion
terms most beneficial to the holder, the Company recorded a preferred stock
dividend of $968,047 for the beneficial conversion feature of the Series E
Convertible Preferred Stock. As of December 31, 1998, 114,928 shares of Series E
Convertible Preferred Stock and related dividends had been converted into
2,591,733 shares of common stock. Subsequent to December 31, 1998, 122,572
shares of Series E Convertible Preferred Stock and related dividends were
converted into 3,042,145 shares of common stock.
10. COMMON STOCK AND COMMON STOCK SUBJECT TO REDEMPTION
Common Stock - During the year ended December 31, 1998, the Company issued
20,740,605 shares of common stock. Of such shares, 4,000,000 shares were issued
in connection with a private placement transaction, 10,944,081 shares were
issued in connection with the acquisitions of AcuVoice, Articulate and Papyrus
(see Note 2) (of which 2,691,681 shares are held in escrow), 4,081,234 shares
were issued upon the conversion of preferred stock and related dividends,
1,390,476 shares were issued in connection with the restructuring of reset
rights, 265,000 shares were issued upon the exercise of previously granted
warrants and options, 35,000 shares were issued in payment of a loan origination
fee (see Note 6) and 24,814 shares were issued for the purchase of a patent.
On March 12, 1998, the Company completed a private placement offering of up to
6,666,666 shares of its restricted common stock. The total purchase price to be
paid by the investors pursuant to the offering was $30,000,000. Of that amount,
$15,000,000 was received by the Company on March 12, 1998, in return for which
the Company issued a total of 3,333,333 shares of restricted common stock.
Finders' fees of $870,000 were paid in connection with the $15,000,000 received.
The remainder of the purchase price was to be paid by the investors on July 27,
1998 (60 days after the effectiveness of a registration statement that the
Company filed with the Securities and Exchange Commission covering the common
stock issued and issuable to the investors) provided that certain conditions
were satisfied. As of the July 27, 1998, the certain conditions precedent to
receiving the additional funding were not met. In separate transactions in June
and August 1998, certain investors paid to the Company a total of $3,000,000 in
return for which the Company issued 666,667 additional shares under the terms
and conditions set forth in the offering. Finders' fees of $163,846 were
incurred in connection with the $3,000,000 received. No other payment has been
received by the Company pursuant to the offering, and the Company does not
expect any further payment to be made.
The investors acquired certain "reset rights" in connection with the offering
pursuant to which the investors would receive additional shares of restricted
common stock ("Reset Shares") for no additional consideration if the average
market price of the Company's common stock for the 60-day period following the
effective date of the related registration statement or the second funding date
did not equal or exceed $5.40 per share. On August 31, 1998, the Company and the
investors in the offering restructured the reset provision whereby the Company
issued 608,334 shares of Series D Convertible Preferred Stock and 1,390,476
shares of common stock for (i) the relinquishment of the investors' contractual
right to receive Reset Shares in connection with the $15,000,000 received in
March 1998, and the $3,000,000 received in June and August 1998, and (ii) a
financing cost in connection with the issuance of 500,000 shares of Series D
Convertible Preferred Stock. The Company recorded an expense of $6,111,577 for
the difference between the Company's original obligation to issue reset shares
and the fair value of the shares that were actually issued in settlement for the
relinquishment of the reset provision and recorded a preferred stock dividend of
$1,000,000 related to financing costs in connection with the issuance of 500,000
shares of Series D Convertible Preferred Stock.
F-25
<PAGE>
Fonix Corporation
[A Development Stage Company]
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Registration Rights and Reserved Shares - During 1997, 1998 and 1999, the
Company entered into registration rights agreements with investors under which
the Company agreed to register the common stock issuable upon the conversion of
all series of preferred stock and debentures and the exercise of warrants. The
Company covenanted to reserve out of its authorized and unissued shares of
common stock no less than that number of shares that would be issuable upon the
conversion of all series of preferred stock and debentures and any dividends and
interest then payable in stock thereon and the exercise of warrants. As of
December 31, 1998, the Company has reserved 31,887,259 shares of common stock
for this purpose. Nevertheless, the Company does not presently have sufficient
authorized capital to enable it to issue all of the common stock it would be
required to issue if all the presently issued and outstanding convertible
preferred stock debentures, options, warrants, and other convertible securities
were converted or exercised. The Company is in the process of attempting to
obtain shareholder approval of an amendment to the Company's certificate of
incorporation that would sufficiently increase the Company's authorized capital,
including common stock.
Voting Trust - As of December 31, 1998, 25,657,749 shares of the Company's
outstanding common stock were held in a voting trust (the "Voting Trust") as to
which the President and Chief Executive Officer of the Company is the sole
trustee. Persons who have deposited their shares of the Company's common stock
into the Voting Trust have dividend and liquidation rights in proportion to the
number of shares of the Company's common stock they have deposited in the Voting
Trust, but have no voting rights with respect to such shares. All voting rights
associated with the shares deposited into the Voting Trust are exercisable
solely and exclusively by the trustee of the Voting Trust. The Voting Trust
expires, unless extended according to its terms, on the earlier of September 30,
1999 or any of the following events: (i) the trustee terminates it; (ii) the
participating stockholders unanimously terminate it; or (iii) the Company is
dissolved or liquidated.
Common Stock Subject to Redemption - On December 21, 1998, the Company entered
into a private placement securities agreement. Pursuant to the agreement, the
Company received $1,980,000 in net proceeds in exchange for 1,801,802 shares of
redeemable common stock, an equal number of "Repricing Rights" and warrants to
purchase 200,000 shares of common stock. Each Repricing Right entitles the
holder to receive a number of additional shares of common stock for no
additional consideration according to a formula ("Repricing Rights") based on
the lowest closing bid price of the Company's common stock, as quoted by the
NASDAQ Stock Market, during the 15 consecutive trading days immediately
preceding the exercise date and a repricing price, as defined, ranging from
$1.3875 to $1.4319 depending upon the date of the exercise. The repricing rights
became exercisable on March 21, 1999.
Each holder of redeemable common stock has the right ("Repurchase Right"), based
on certain conditions, to require the Company to repurchase all or a portion of
the holder's common shares or repricing rights. The Repurchase Rights may only
be exercised simultaneously with or after the occurrence of a major transaction
or triggering event as defined in the private placement agreement. Major
transactions and triggering events consist of, among others, certain
consolidations, mergers or other business combinations, the sale or transfer of
all or substantially all the Company's assets, a purchase, tender or exchange
offering of more than 40 percent of the Company's outstanding common stock made
and accepted, the failure to have a related registration statement declared
effective prior to 180 days after the closing date or a suspension from listing
or delisting of the Company's common stock for a period of three days.
The repurchase price for the common stock is $ 1.3875 per share. The repurchase
price for the Repricing Rights is based on a formula using the Repricing Rate
and the last reported sale price of the Company's common stock on the date of
the exercise of the repurchase right.
The warrants have an exercise price of $1.67 per share and a term of three
years. The Company assigned a fair value of $150,000 to the warrants as
determined on December 21, 1998 using the Black-Scholes pricing model assuming a
dividend yield of 0 percent, expected volatility of 85 percent, a risk free
interest rate of 4.5 percent and an expected life of 3 years.
F-26
<PAGE>
Fonix Corporation
[A Development Stage Company]
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
During the year ended December 31, 1997, the Company issued 1,957,312 shares of
common stock. Of such shares, 150,000 were issued to an unrelated private
investor, 265,000 were issued upon the exercise of previously granted warrants
and options, 145,747 were issued upon conversion of convertible debentures,
804,065 were issued upon the conversion of preferred stock and 592,500 were
issued to unaffiliated individuals for services rendered valued at $3,812,971
based on the fair market value of the shares at the time of issuance.
During the year ended December 31,1996, the Company issued 11,741,242 shares of
common stock to unrelated private investors pursuant to various stock purchase
agreements and 60,000 shares were issued upon the exercise of warrant. In
connection with these stock issuances, the Company issued 420,000 shares of
common stock valued at $901,520 as payment of finders' fees to unrelated third
parties.
11. STOCK OPTIONS AND WARRANTS
Common Stock Options - On June 1, 1998, the Company's board of directors
approved the 1998 Stock Option and Incentive Plan for directors, employees and
other persons acting on behalf of the Company, under which the aggregate number
of shares authorized for issuance is 10,000,000. The Company's shareholders
approved the plan on July 14, 1998. The plan is administered by a committee
consisting of two or more directors of the Company. The exercise price for
options granted under the plan is the closing market price of the common stock
on the date the options are granted. The option term is ten years from the date
of grant. As of December 31, 1998, the number of shares available for grants
under this plan is 3,585,218.
On March 10, 1997, the Company's board of directors approved the 1997 Stock
Option and Incentive Plan for directors, employees and other persons acting on
behalf of the Company, under which the aggregate number of shares authorized for
issuance is 7,500,000. The plan is administered by a committee consisting of two
or more directors of the Company. The exercise price of such options is the
closing market price of the stock on the date the options are granted. The
option term is ten years from the date of grant. As of December 31, 1998, the
number of shares available for grants under this plan is 1,812,000.
In April 1996, the Company's board of directors approved the 1996 Directors'
Stock Option Plan, under which the aggregate number of shares authorized for
issuance is 5,400,000. The shareholders of the Company approved the plan at
their annual meeting in July 1996. The plan is administered by a committee
consisting of two or more directors of the Company. The plan provides that each
director shall receive options to purchase 200,000 shares of common stock for
services rendered as a director during each entire calendar year or portion of a
calendar year in excess of six months. The exercise price of such options is the
closing market price of the stock on the date the options are granted. The
option term is ten years from date of grant. As of December 31, 1998, the number
of shares available for granting under this plan is 1,800,000.
In December 1998, the Company granted options to purchase 2,800,000 shares of
common stock to members of the board of directors. Of the 2,800,000 shares,
1,400,000 were for services performed in 1998 and 1,400,000 were for services to
be performed in 1999 providing the directors serve six months in 1999.
In April 1996, the Company's board of directors approved a Long-Term Stock
Investment and Incentive Plan for officers, key employees and other persons
acting on behalf of the Company under which the aggregate number of shares
authorized for issuance is 900,000 shares. The exercise price of these options
is the closing market price of the stock on the date the options are granted.
The term of the plan is ten years and options are subject to a three-year
vesting schedule, pursuant to which one-third of the total number of options
granted may be exercised each year. As of December 31, 1998, the number of
shares available for grant under this plan is 725,000.
F-27
<PAGE>
Fonix Corporation
[A Development Stage Company]
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
A summary of options granted under the Company's various stock option plans for
the years ended December 31, 1998, 1997 and 1996 is presented below:
<TABLE>
<CAPTION>
1998 1997 1996
---------------------------- -------------------------------- ------------------------------
Weighted Weighted Weighted
Average Average Average
Stock Exercise Stock Exercise Stock Exercise
Options Price Options Price Options Price
-------------- ----------- ---------------- ------------- ---------------- ---------
<S> <C> <C> <C> <C> <C> <C>
Total options outstanding
at beginning of year 10,565,000 $ 5.38 4,626,000 $ 4.07 - $ -
Granted 6,414,782 2.08 6,009,000 6.38 4,626,000 4.07
Exercised (35,000) 6.00 (15,000) 2.97 - -
Forfeited (1,067,000) 4.56 (30,000) 7.66 - -
Canceled - - (25,000) 5.00 - -
-------------- ---------------- ----------------
Total options outstanding
at end of year 15,877,782 4.10 10,565,000 5.38 4,626,000 4.07
============== ================ ================
Total options exercisable
at end of year 9,524,766 5.11 5,392,675 5.05 2,000,000 4.06
============== ================ ================
Weighted average fair
value of options granted
during the year $ 1.98 $ 6.38 $ 4.07
</TABLE>
A summary of options outstanding and options exercisable under the Company's
various stock option plans at December 31, 1998 is presented below:
<TABLE>
<CAPTION>
Options Outstanding Options Exercisable
- ----------------------------------------------------------- -----------------------------------
Weighted
Average Weighted Weighted
Range of Remaining Average Average
Exercise Number Contractual Exercise Number Exercise
Prices Outstanding Life Price Exercisable Price
- ------------ -------------- ---------- ---------------- --------------- ----------------
<S> <C> <C> <C> <C> <C>
$0.08-1.18 4,886,832 9.9 years $ 1.11 425,422 $ 1.13
2.97-4.06 4,199,000 7.5 years 3.98 3,917,669 4.02
5.00-6.50 6,471,950 8.7 years 6.28 4,865,008 6.21
7.13-8.50 320,000 8.2 years 7.17 316,667 7.16
$0.08-8.50 15,877,782 8.7 years $ 4.10 9,524,766 $ 5.11
</TABLE>
The Company accounts for its stock option plans as they relate to employees and
directors under Accounting Principles Board Opinion No. 25, and therefore, no
compensation expense has been recognized in the accompanying consolidated
statements of operations. Had compensation expense for these options been
determined in accordance with the method prescribed by SFAS No. 123, "Accounting
for Stock Based Compensation", the Company's net loss per common share
F-28
<PAGE>
Fonix Corporation
[A Development Stage Company]
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
would have been increased to the pro forma amounts indicated below for the years
ended December 31, 1998, 1997 and 1996:
<TABLE>
<CAPTION>
1998 1997 1996
------------- ------------- -------------
<S> <C> <C> <C>
Net loss attributable to common stockholders:
As reported $47,916,031 $ 25,175,939 $ 7,829,508
Pro forma 56,576,232 48,870,670 20,289,706
Basic and diluted net loss per common share:
As reported $ (0.91) $ (0.59) $ (0.21)
Pro forma (1.08) (1.15) (0.55)
</TABLE>
The fair value of options and warrants is estimated on the date granted using
the Black-Scholes pricing model with the following weighted-average assumptions
used for grants during 1998, 1997 and 1996: Risk-free interest rate of 4.8
percent, 5.6 percent and 6.5 percent for 1998, 1997 and 1996, respectively;
expected dividend yield of 0 percent for 1998, 1997 and 1996; expected exercise
lives of 5 years, 5 years and 10 years for 1998, 1997 and 1996, respectively;
expected volatility of 85 percent, 75 percent and 103 percent for 1998, 1997 and
1996, respectively. The estimated fair value of options granted is subject to
the assumptions made, and if the assumptions were to change the estimated fair
value amounts could be significantly different.
Warrants - A summary of warrants granted by the Company during the years ended
December 31, 1998, 1997 and 1996 is presented below:
<TABLE>
<CAPTION>
1998 1997 1996
--------------------- --------------------- ---------------------
Weighted Weighted Weighted
Average Average Average
Exercise Exercise Exercise
Shares Price Shares Price Shares Price
---------- ---------- ---------- ---------- ---------- ----------
<S> <C> <C> <C> <C> <C> <C>
Total outstanding at beginning of year 1,175,000 $ 6.39 450,000 $ 1.63 410,000 $ 0.93
Granted 1,200,000 16.94 975,000 6.92 100,000 3.24
Exercised (230,000) 1.28 (250,000) 1.40 (60,000) 0.50
Forfeited (220,000) 9.14 - -
Total outstanding at end of year 1,925,000 13.08 1,175,000 6.39 450,000 1.63
Total exercisable at end of year 1,925,000 13.08 1,175,000 6.39 450,000 1.63
</TABLE>
12. RELATED-PARTY TRANSACTIONS
Employee Advances - The Company advanced funds to certain executives and
employees totaling $67,231 as of December 31, 1998. Subsequent to that date,
certain executives of the Company have advanced funds totaling approximately
$306,000 to the Company. These advances have been used to reduce current
obligations of the Company.
Guarantee of Company Obligations and Related Indemnity Agreement -Two of the
executive officers and directors and the chairman of the board of directors of
the Company (the "Guarantors") have guaranteed certain obligations of the
Company. As security for some of the guarantees, the Guarantors have also
pledged shares of Fonix common stock beneficially owned by them. The guaranteed
obligations and the related pledged Fonix shares are summarized as follows:
F-29
<PAGE>
Fonix Corporation
[A Development Stage Company]
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
Amount Shares
Guaranteed Pledged
------------- --------------
<S> <C> <C>
As of December 31, 1998:
Revolving bank note in excess of the $ 222,380 3,500,000
pledged certificate of deposit,
credit cards payable, and accrued interest
Note payable 560,000 -
Guarantees issued after December 31, 1998:
Series C 5% Convertible Debentures 6,500,000 6,000,000
Accounts payable - legal fees 147,000 100,000
</TABLE>
In consideration for the pledge of Fonix common shares as collateral for the
Series C 5% Convertible Debentures, the board of directors authorized the
issuance, to the guarantors of one common stock purchase warrant for every three
shares pledged. The common stock purchase warrants have a term of 10 years and
an exercise price of 125 percent of the closing bid price of the Company's
common stock on January 29, 1999, the date of issuance of the debentures. The
warrants are not exercisable for at least six months after the date of issuance.
In addition, the Company has agreed to indemnify the Guarantors if they are
required to pay any sums for the benefit of the Company under their guaranty of
the Series C 5% Convertible Debentures. The indemnity agreement provides that
the Company will issue shares of the Company's common stock of sufficient value
to reimburse the guarantors in full, plus interest at 10 percent per annum, for
all costs associated with meeting the guarantee commitment, including any income
taxes resulting therefrom.
Subsequent to December 31, 1998, 143,230 of the pledged shares were sold by the
bank and the proceeds were used to pay the outstanding balance related to the
credit cards.
Studdert Companies Corp. - Studdert Companies Corp. ("SCC") is a Utah
corporation that provides investment and management services. The officers,
directors and owners of SCC are directors and executive officers of the Company
and each of whom beneficially owns more than 10 percent of the Company's issued
and outstanding common stock. Between June 1994, when the Company commenced its
present business of developing its ASR technologies, and April 30, 1996, the
Company did not pay or award any compensation in any form directly to the
Company's executive officers. Rather, in June 1994, the Company entered into an
Independent Consulting Agreement (the "SCC Agreement") with SCC pursuant to
which SCC rendered certain management and financial services to the Company.
Pursuant to the SCC Agreement, between January and July 1995, SCC invoiced the
Company for services rendered. By July 1995, the Company owed SCC approximately
$1,417,000 pursuant to the terms of the SCC Agreement. On July 31, 1995, the
Company issued warrants to purchase up to 3,700,000 shares of the Company's
common stock to SCC. The purchase price of the warrants was $.033 per share of
common stock, or an aggregate of $122,100. On August 11, 1995, SCC exercised the
warrants at an exercise price of $0.35 per share. Both the $122,100 purchase
price and the $1,295,000 aggregate exercise price for the warrants were
satisfied by the cancellation of amounts invoiced to the Company by SCC pursuant
to the SCC Agreement during the fiscal year ended December 31, 1994 and the
period between January 1, 1995 and August 11, 1995. Such cancellation was
accomplished on a dollar-for-dollar basis.
Between August 1995 and October 1995, SCC continued to invoice the Company for
its $50,000 monthly management fee. On October 23, 1995, the Company entered
into an investment agreement (the "Beesmark Agreement") with Beesmark. In
connection with the Company's execution of the Beesmark Agreement, SCC and the
Company agreed that any then accrued but unpaid balance due to SCC for
management services rendered under the SCC Agreement would be placed on
"conditional status" and deferred until the Company successfully completed
certain developmental milestones set forth in the Beesmark Agreement, at which
time such amounts would be due and payable in full. With respect to management
services to be rendered by SCC after the closing of the Beesmark Agreement, SCC
agreed that the Company would pay only $30,000 of the monthly invoiced $50,000,
the balance to be placed on conditional status.
F-30
<PAGE>
Fonix Corporation
[A Development Stage Company]
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Thus, of the total $600,000 invoiced to the Company by SCC during the year ended
December 31, 1995, the Company paid SCC $90,000 in cash; $257,000 of accrued but
unpaid amounts were placed on conditional status under the Beesmark Agreement;
and $253,000 was canceled in partial payment of the exercise price of the SCC
Warrants. In addition to the amounts invoiced by SCC for management fees during
the 1995 fiscal year, the Company also reimbursed SCC for actual expenses
incurred in the amount of $337,405. Thus, at December 31, 1995, the Company owed
SCC $257,000 in management fees, all of which was on conditional status under
the terms of the Beesmark Agreement and was payable to SCC only in the event
that the Company achieved the developmental milestones set forth in the Beesmark
Agreement. At December 31, 1995, the Company also owed SCC $3,825 for expenses
incurred. Additionally, during the year ended December 31, 1995, SCC charged a
total of $70,915 in capital raising fees to the Company. Of that amount, $49,576
was written off by SCC in connection with the Beesmark Agreement, and $21,339
was paid to SCC.
Between January 1, 1996 and April 30, 1996, SCC invoiced the Company for
services under the SCC Agreement in the amount of $200,000. Of that amount,
$80,000 was placed on conditional status pursuant to the Beesmark Agreement and
$120,000 was paid to SCC. On April 30, 1996, the disinterested members of the
Company's board of directors authorized the Company to enter into an agreement
with SCC modifying the SCC Agreement effective May 1, 1996. Under the SCC
Agreement, as modified, SCC no longer invoiced the Company for management
services, but continued to invoice the Company for reimbursement of actual
expenses incurred on the Company's behalf. SCC and the Company agreed that any
amounts invoiced under the SCC Agreement but placed on conditional status
pursuant to the Beesmark Agreement would remain outstanding obligations of the
Company payable only if the Company achieved the milestones specified in the
Beesmark Agreement. The Company further agreed to pay any then accrued but
unpaid amounts invoiced under the SCC Agreement, including amounts owed and
carried over from the year ended December 31, 1995, which amounts totaled
$5,862, as well as outstanding amounts for expenses incurred. In September 1996,
Beesmark made the last of the funding payments provided for under the terms of
the Beesmark Agreement. On February 10, 1997, the Company paid to SCC the entire
balance due to SCC for accrued management fees in the amount of $337,000. Thus,
during the year ended December 31, 1996, the Company paid to SCC a total of
$120,000 for management fees and SCC was reimbursed for actual expenses incurred
on the Company's behalf in the amount of $740,052. During 1996, the Company made
no payments to SCC for capital raising activities. The Company and SCC have
agreed to extend the SCC Agreement, at least insofar as the Company has agreed
to reimburse SCC for actual expenses incurred on behalf of the Company through
December 1998.
The Company paid no compensation in any form directly to any of its executive
officers during fiscal 1995 and until April 1, 1996. However, as the principals
of SCC, during such periods, the Company's executive officers received a portion
of the amounts paid by the Company to SCC under the SCC Agreement.
Related-party transactions with SCC not otherwise disclosed herein as of and for
the years ended December 31, 1998, 1997 and 1996 were as follows:
1998 1997 1996
------------- ------------- ---------------
Expenses:
Management fees $ - $ - $ 200,000
Rent 117,228 77,203 52,000
Liabilities:
Accounts payable - - 411,743
Accrued liabilities - 459,502 1,350,000
The Company rents office space under a month-to-month lease from SCC and the
lease from SCC is guaranteed by the three officers, owners and directors of SCC.
The lease requires monthly payments of $10,368. The Company believes the terms
of the related-party lease are at least as favorable as the terms that could
have been obtained from an
F-31
<PAGE>
Fonix Corporation
[A Development Stage Company]
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
unaffiliated third party in a similar transaction.
Beesmark Investments, L.C. - On October 23, 1995, the Company, Beesmark and a
director entered into the Beesmark Agreement. The director did not occupy such
position when the Beesmark Agreement was negotiated and executed. The director
also is a co-manager of and has an indirect pecuniary interest in a portion of
Beesmark's assets. Pursuant to the Beesmark Agreement, Beesmark agreed to
provide a total of $6,050,000 of funding to the Company over a period of
approximately 11 months, provided that during that time the Company was able to
timely meet, to Beesmark's satisfaction, specified developmental milestones. In
return for the funding provided to Beesmark, the Company agreed to issue
11,562,500 shares of common stock at a price of $0.48 per share and a $500,000
Series A Convertible Subordinated Debenture that is convertible into either
166,667 shares of Series A Convertible Preferred Stock or 166,667 shares of the
Company's common stock. During the year ended December 31, 1996, Beesmark paid
all installments payable by Beesmark under the Beesmark Agreement, and the
Company issued, in the increments specified, all of the securities issuable to
Beesmark under the Beesmark Agreement.
SMD, L.L.C. - From September 4, 1997, through October 15, 1997 and again on
December 31, 1997, the Company, borrowed funds from SMD, L.L.C., a company owned
by three directors and executive officers of the Company (each of whom
beneficially owns more than 10 percent of the Company's issued and outstanding
common stock) pursuant to a revolving, unsecured promissory note, bearing
interest at the rate of 12 percent per annum. The aggregate of all amounts
loaned under the note was $2,000,000 and the highest outstanding balance at any
one time was $1,550,000. All amounts were repaid, together with $5,542 in
interest in 1998. The loan and its terms were approved by the independent
members of the board of directors of the Company.
K.L.S. Enviro Resources, Inc. - Between May 1996 and August 1996, as part of the
Company's short-term cash management policy, the Company entered into a series
of loan transactions with KLSE, an entity which then was unaffiliated with the
Company. The Company was introduced to KLSE by an unaffiliated third party. As
of August 12, 1996, the Company had loaned to KLSE a total of $1,900,000, which
loans were due upon demand, bore interest at the rate of 12 percent per annum,
required the payment of certain loan origination fees, and were secured by
substantially all of the assets of KLSE, except its real property. The first of
the loans from the Company in the amount of $710,000 was made on May 16, 1996
and the last advance prior to August 12, 1996, in the amount of $590,000, was
made on July 16, 1996. Pursuant to the terms of the promissory note representing
the $710,000 advanced by the Company to KLSE in May 1996, all or part of the
balance due under that note was convertible at the option of the holder of the
note to 2,366,667 shares of the restricted common stock of KLSE at the rate of
$.30 per share. Similarly, the remaining $1,190,000 owed to the Company,
represented by four separate promissory notes, was convertible into a total of
2,975,000 shares of KLSE restricted common stock at the rate of $.40 per share.
KLSE also entered into a registration rights agreement with the Company. In
connection with that course of financing, a director and executive officer of
the Company assumed a position on KLSE's board of directors, effective July 10,
1996.
On September 30, 1996, SMD advanced debt financing (the "SMD Loan") to KLSE (see
below) in the amount of $1,673,730. The SMD Loan was due on demand, bore
interest at the rate of 12 percent per annum and was secured by the assets of
KLSE, except its real property. The proceeds of the SMD Loan enabled KLSE to pay
the Company $1,673,700 in satisfaction of all then-outstanding balances due the
Company except a balance of $272,156 due and owing under the first promissory
note from KLSE to the Company in the amount of $710,000. In return for the
provision of the SMD Loan to KLSE, SMD acquired warrants to purchase 6,600,000
shares of KLSE restricted Common Stock at the exercise price of $.40 per share.
These warrants have never been exercised.
Based upon certain changed circumstances at KLSE, on October 29, 1996, the
Company made an additional loan of $200,000 to KLSE. That additional advance was
repaid in full, with accrued interest, by KLSE on December 24, 1996. Also, on
December 31, 1996 the Company sold for cash and assigned $270,000 of the balance
due under the $710,000 promissory note to Ballard Investment Company, a Utah
limited partnership unaffiliated with the Company. Also, on December 31, 1996,
KLSE paid the Company the balance of approximately $10,500 due and owing under
the $710,000
F-32
<PAGE>
Fonix Corporation
[A Development Stage Company]
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
promissory note. Since December 31, 1996, KLSE has not been indebted to the
Company in any amount nor has the Company had any beneficial interest in KLSE.
Synergetics - Through December 1998, a director and the chief executive officer
of the Company was also one of seven directors of Synergetics, Inc. In addition,
three executive officers and directors of the Company owned shares of the common
stock of Synergetics, although such share ownership in the aggregate constituted
less than 5 percent of the total shares of Synergetics common stock issued and
outstanding. Effective December 31,1998, the chief executive officer and
director of the Company resigned from the board of Synergetics and the three
executive officers and directors relinquished all ownership of Synergetics
shares. The Company engages Synergetics to provide assistance to Fonix in the
development of its ASR technologies (see Note 14).
Voice Information Associates, Inc. - A director and executive officer of the
Company is also the founder and president of Voice Information Associates, Inc.
("VIA"), a consulting group providing strategic technical, market evaluation,
product development and corporate information to the speech recognition
industry. During 1997, the Company paid approximately $110,000 in consulting
fees to VIA for services provided to the Company. No payments were made by the
Company to VIA in 1998.
Other Transactions - During 1996, disinterested members of the Company's board
of directors authorized the Company to reimburse certain officers for all taxes
payable by the officers in conjunction with the 1995 exercise of 3,700,000
warrants by a company owned by the officers. The total amount authorized to be
reimbursed was $1,150,000 in 1997 and $1,350,000 in 1996. During the years ended
December 31, 1998 and 1997, the Company paid $340,516 and $2,159,484,
respectively, of the authorized reimbursements.
13. STATEMENT OF WORK
On February 11, 1998, the Company entered into a First Statement of Work and
License Agreement with Siemens Semiconductor Group of Siemens Aktiengesellschaft
("Siemens") under which the Company and Siemens are jointly pursuing the
development of Siemens' integrated circuits incorporating ASR and other related
technologies for use in certain telecommunications applications. On February 20,
1998, the Company received $2,691,066 in cash from Siemens. Of that amount: (1)
$1,291,712 was paid to the Company as a non-refundable payment to license
certain ASR technologies for which the Company has no further obligation; (2)
$322,928 was paid to purchase warrants to acquire 1,000,000 shares of restricted
common stock at an average exercise price of $20 per share with expiration dates
ranging from December 31, 1998 to December 31, 1999; and (3) $1,076,426 was paid
to the Company to acquire, if Siemens so elected, shares of the Company's
restricted common stock or to become a non-refundable license payment. In June
1998, Siemens elected to apply the $1,076,426 portion as a non-refundable
payment to license certain ASR technologies for which the Company has no further
obligation. The Company recorded the $2,368,138 license payments as revenue
during the year ended December 31, 1998.
14. PRODUCT DEVELOPMENT AND RESEARCH
Synergetics - In October 1993, the Company entered into an agreement with
Synergetics (the "Synergetics Agreement"), a research and development entity,
whereby Synergetics was to develop certain technologies related to the Company's
ASR technologies. The Chief Executive Officer of the Company was one of seven
members of the board of directors of Synergetics, and three executive officers
and directors and 10 percent beneficial owners of the Company owned less than
five percent of the common stock of Synergetics. Under the terms of the
Synergetics Agreement, as subsequently modified, the Company acquired
intellectual property rights, technologies and technology rights that were
developed by Synergetics. The Company agreed to provide all funding necessary
for Synergetics to develop commercially viable technologies. There was no
minimum requirement or maximum limit with respect to the amount of the funding
to be provided by the Company. However, under the terms of the Synergetics
Agreement, the Company was obligated to use
F-33
<PAGE>
Fonix Corporation
[A Development Stage Company]
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
its best efforts in raising the necessary funding for the engineering,
development and marketing of the ASR technologies. As part of the Synergetics
Agreement, the Company agreed to pay Synergetics a royalty of 10 percent of net
revenues from sales of the Company's products incorporating Synergetics'
"VoiceBox" speech recognition technologies or technologies derived therefrom
(the "Royalty"). As of December 31, 1998, the Company had not yet licensed or
sold its technologies, and consequently, had not made any royalty payments.
Under the terms of the Synergetics Agreement, the Company paid to Synergetics
$1,128,433, $2,819,427, and $4,758,012 in 1998, 1997 and 1996, respectively, for
research and development efforts.
Until March 1997, Synergetics had compensated its engineers, employees, members
of its development team, and other financial backers (collectively, the
"Developers"), in part, with the issuance of "Project Shares" granting the
holders of such shares the right, within limits, to share pro rata in future
royalty payments. In addition to issuance of Project Shares, Synergetics had
made advances to some members of its project team on a non-recourse basis.
Repayment of the advances was secured by future disbursements under the Project
Shares.
On March 13, 1997, the Company and Synergetics signed a Memorandum of
Understanding (the "MOU") which manifested their agreement in principle that the
Royalty should be canceled in exchange for the offering and issuance by the
Company of warrants to purchase up to 4,800,000 shares of the Company's common
stock. Certain of the employees and independent contractors then engaged by
Synergetics became full-time employees or independent contractors of the
Company. The majority shareholder and president of Synergetics became a
full-time consultant to the Company. Since March 14, 1997, the Company has been
conducting the majority of the research and development of the ASR technologies
at its own research facility staffed by its own employees, including some
Developers who have been employees of the Company since March 14, 1997.
On April 6, 1998, the Company and Synergetics entered into a Royalty
Modification Agreement, which provides for the Company to make an offer of
exchange of the Company's warrants to purchase common stock with a $10 per share
exercise price for the project shares at a rate of one warrant to purchase 800
common shares for each project share. The warrants would not be exercisable
until the earlier of (1) the date the Company's common stock is trading for a
period of 15 consecutive trading days at a minimum of $37.50 per share or (2)
September 30, 2000. The offer of the warrants cannot be made by the Company
until a registration statement covering the total number of warrants issuable
upon the exercise of the warrants has been declared effective by the U.S.
Securities and Exchange Commission. Upon the tender to Synergetics of any
Project Shares the related Royalty commitment will be canceled. Pending
completion of the registration statement and issuance of the warrant, the
Company will not pay any royalties to Synergetics.
IMC-2 - In March 1998, the Company entered into a professional services
agreement with IMC-2, a research and development entity, to provide assistance
to Fonix in the continuing development of specific ASR technologies. The
president of IMC-2 is also the president of Synergetics and Adiva. The agreement
is for a term of 36 months and requires the Company to make monthly payments of
$22,000. Future noncancellable payments under this agreement are $264,000,
$264,000 and $44,000 for the years ended December 31, 1999, 2000 and 2001. Under
the terms of the agreement, Fonix expended $220,000 in 1998 for research and
development efforts.
Adiva- During 1998, the Company utilized the research and development services
of Adiva. The president of Adiva is also the president of Synergetics and IMC-2.
During 1998, the Company expended $600,174 for services provided.
Advocast - In July 1997, the Company entered into an arrangement with Advocast,
Inc. ("Advocast") an Internet research and development entity, whereby Advocast
assisted Fonix in development of technologies to create and locate searchable
data bases on the Internet through the use of interactive video and voice
technologies. Under the terms of the arrangement Fonix paid $816,750 and
$705,005 in 1998 and 1997, respectively, for research and development efforts.
On November 25, 1998, in consideration for the research and development payments
received from Fonix through that date, Advocast issued 60,200 shares of Advocast
Series A 6% Convertible Preferred Stock. The Advocast shares, if
F-34
<PAGE>
Fonix Corporation
[A Development Stage Company]
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
converted, represent less than 20 percent of the total outstanding shares of
Advocast voting common stock. Advocast is a development stage company with
minimal operations and there is substantial uncertainty as to the value of the
Advocast shares. The Company has therefore determined that there is not
sufficient marketability in Advocast shares to determine their value. As a
result, the Company has not recorded a value for the Advocast shares in the
accompanying consolidated financial statements.
15. INCOME TAXES
At December 31, 1998 and 1997, net deferred income tax assets, before
considering the valuation allowance, totaled $24,325,269 and $15,746,597,
respectively. The amount of and ultimate realization of the benefits from the
deferred income tax assets is dependent, in part, upon the tax laws in effect,
the Company's future earnings, and other future events, the effects of which
cannot be determined. The Company has established a valuation allowance for all
deferred income tax assets not offset by deferred income tax liabilities due to
the uncertainty of their realization. Accordingly, there is no benefit for
income taxes in the accompanying consolidated statements of operations. The net
change in the valuation allowance was an increase of $8,529,870 for the year
ended December 31, 1998.
The Company has available at December 31, 1998, unused federal net operating
loss carryforwards of approximately $62,916,000 and unused state net operating
loss carryforwards of approximately $63,295,000 which may be applied against
future taxable income, if any, and which expire in various years from 2008
through 2018. The Internal Revenue Code contains provisions which likely could
reduce or limit the availability and utilization of these net operating loss
carryforwards. For example, limitations are imposed on the utilization of net
operating loss carryforwards if certain ownership changes have taken place or
will take place. The Company has not performed an analysis to determine whether
any such limitations have occurred.
The temporary differences and carryforwards which give rise to the deferred
income tax assets (liabilities) as of December 31, 1998 and 1997 are as follows:
<TABLE>
<CAPTION>
1998 1997
--------------- -----------------
<S> <C> <C>
Deferred income tax assets:
Net operating loss carryforwards:
Federal $ 21,391,555 $ 14,030,670
State 2,088,746 1,312,988
Research and development credits 694,239 275,927
Accrued bonus liabilities 150,729 127,012
--------------- -----------------
Total deferred income tax assets before
valuation allowance 24,325,269 15,746,597
Valuation allowance (24,176,653) (15,646,783)
--------------- -----------------
Net deferred income tax assets 148,616 99,814
--------------- -----------------
Deferred income tax liabilities:
Depreciation (148,316) (99,514)
Intangibles (300) (300)
--------------- -----------------
Total deferred income tax liabilities (148,616) (99,814)
$ - $ -
=============== =================
</TABLE>
F-35
<PAGE>
Fonix Corporation
[A Development Stage Company]
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
A reconciliation of income taxes at the federal statutory rate to the Company's
effective rate is as follows:
<TABLE>
<CAPTION>
Year Ended December 31,
-----------------------
1998 1997 1996
---- ---- ----
<S> <C> <C> <C>
Federal statutory income tax rate 34.0 % 34.0 % 34.0 %
State and local income tax rate,
net of federal benefit 3.3 3.3 3.3
Valuation allowance (37.3) (37.3) (37.3)
Effective income tax rate - % - % - %
</TABLE>
16. COMMITMENTS AND CONTINGENCIES
Employment Agreements - In January 1998, the Company entered into employment
contracts with two employees which expire in January 2001. The minimum annual
salary payments required by these contracts total $405,000. In connection with
these agreements, these individuals were granted options to purchase 360,000
shares of the Company's common stock at $3.34 per share. These options have a
ten-year life and are subject to a three-year vesting schedule, pursuant to
which one-third of the total number of options granted may be exercised each
year. One-third of the options are vested on the date of grant. In the event
that, during the contract term, both a change of control occurs, and within six
months after such change in control occurs, the executive's employment is
terminated by the Company for any reason other than cause, death or retirement,
the executive shall be entitled to receive an amount in cash equal to all base
salary then and thereafter payable within thirty days of termination. In January
1999, the Company announced a major cost reduction program for the Company's
1999 operating year wherein the compensation of two employees referred to above
was reduced 30 percent effective February 1999.
Executive Employment Agreements - On November 1, 1996, the Company entered into
employment contracts with three executive officers (one of whom is no longer an
executive officer) which expire on December 31, 2001. The annual base salary
compensation for each executive officer for the years ended December 31, 1999,
2000 and 2001 is $425,000, $550,000 and $750,000, respectively.
Additionally, each executive officer is entitled to annual performance-based
incentive compensation payable on or before December 31 of each calendar year
during the contract term. During the first three years of the contract term, the
performance-based incentive compensation is determined in relation to the market
price of the Company's common stock, adjusted for stock dividends and splits. If
the price of the Company's common stock maintains an average price equal to or
greater than the level set forth below over a period of any three consecutive
months during the calendar year, the performance-based incentive compensation
will be paid in the corresponding percentage amount of annual base salary for
each year as follows:
Quarterly Average Stock Price Percentage Bonus
----------------------------- ------------------
$10.00 30%
$12.50 35%
$15.00 40%
$20.00 45%
$25.00+ 50%
The annual base salary and performance-based incentive compensation for the
final two contract years will be subject to review by the Company's board of
directors.
F-36
<PAGE>
Fonix Corporation
[A Development Stage Company]
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
In the event that, during the contract term, both a change of control occurs,
and within six months after such change in control occurs, the executive's
employment is terminated by the Company for any reason other than cause, death,
or retirement, the executive shall be entitled to receive an amount in cash
equal to all base salary then and thereafter payable within thirty days of
termination.
In January 1999, the Company announced a major cost reduction program for the
Company's 1999 operating year wherein the compensation of the two remaining
officers will be reduced to $297,500 commencing February 1999. At the same time,
Stephen M. Studdert resigned as the Company's Chief Executive Officer and
entered into a separation agreement pursuant to which Mr. Studdert will be paid
$250,000 per year through January 31, 2001 and $100,000 for the year ended
January 31, 2002. Additionally, his employment contract was canceled.
Professional Services Agreement - Effective May 7, 1998, the Company entered
into a one-year professional services agreement with a public relations firm.
The minimum monthly retainer is $15,000 per month. In connection with this
agreement, the firm was granted options to purchase 100,000 shares of the
Company's common stock at $3.75 per share. The options have a ten-year term and
are fully vested. In connection with this transaction, the Company recorded
$320,100 of consulting expense, of which $106,700 is deferred as of December 31,
1998, to be recognized ratably over the life of the agreement.
Operating Lease Agreements - The Company leases certain facilities and equipment
used in its operations. The amount of commitments for noncancellable operating
leases in effect at December 31, 1998, were as follows:
Years ending December 31,
-------------------------
1999 $1,043,342
2000 677,073
2001 685,275
2002 696,162
2003 507,308
Thereafter 293,664
----------
Total $3,902,824
==========
The Company incurred rental expense of $868,110, $416,798 and $103,139 during
1998, 1997 and 1996, respectively, related to these leases.
In March 1999, the Company entered into an agreement to lease approximately
3,780 square feet of office space in Cleveland, Ohio for sales and installation
personnel. The lease is for three years at a monthly rate of $4,260 and is
effective May 1, 1999.
Capital Lease Obligation - Future minimum lease payments of $56,260 for
equipment held under a capital lease arrangement as of December 31, 1998 are due
in 1999. The present value of these future minimum lease payments is $52,225.
Total assets held under the capital lease arrangement were $150,208 with
accumulated depreciation of $48,737 as of December 31, 1998.
AcuVoice - In connection with the AcuVoice acquisition, AcuVoice and its founder
made certain representations and warranties to the Company. One of those
representations focused on the scope of a license agreement previously entered
into by AcuVoice and General Magic for use by General Magic of AcuVoice's
text-to-speech software in General Magic's Serengeti product. After the AcuVoice
acquisition closed, the Company determined that AcuVoice and its founder had
breached the representation concerning the General Magic license agreement.
Under the terms of the
F-37
<PAGE>
Fonix Corporation
[A Development Stage Company]
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
AcuVoice acquisition agreement, on March 12, 1999, the Company submitted a claim
for the 80,000 shares deposited into the escrow account by the former
stockholders of AcuVoice. The founder, as agent for the former stockholders of
AcuVoice, denied the claim. The Company is presently preparing, a response to
the founder's denial of the claim. If the founder continues to deny the claim
after review of the Company's response, the Company will seek to arb its claim
pursuant to the terms of the AcuVoice acquisition agreement. The Company is
presently considering other possible remedies against the founder and the other
former directors of AcuVoice.
General Magic, Inc. - On September 23, 1997, AcuVoice entered into a license
agreement with General Magic, Inc. ("General Magic") wherein AcuVoice granted
General Magic a perpetual, irrevocable, worldwide license in a specific field of
use to use, reproduce, publicly display and distribute AcuVoice's TTS software
in connection with General Magic's voice accessed integrated network service,
also known as the Serengeti product. The license is exclusive for the first
three years and non-exclusive thereafter. Under the terms of the license
agreement, the Company is entitled to royalty payments based upon monthly
subscriber revenue from the use of the integrated network service. Additionally,
the Company granted an option to General Magic to purchase the then current TTS
source code and all source code documentation for a cash payment of $2,500,000
and $2,500,000 in General Magic common stock.
17. LITIGATION
Clarke - On August 28, 1998, John R. Clarke and Perpetual Growth Fund, a company
Clarke's spouse purportedly owns, commenced an action against Fonix in federal
court for the Southern District of New York. Clarke and Perpetual Growth assert
claims for breach of contract relating to certain financing Fonix received
during 1998. Specifically, Clarke and Perpetual Growth allege that they entered
into a contract with Fonix under which Fonix agreed to pay them a commission of
five percent of all financing provided to Fonix by Southridge Capital Management
or its affiliates. Clarke and Perpetual claim that they are entitled to
commissions with respect to approximately $3,000,000 of equity financing to
Fonix in July and August 1998, and Fonix's offerings of Series D and Series E
preferred stock, totaling together $12,000,000, in August and September 1998.
Fonix believes that the Clarke lawsuit is without merit and filed a motion to
dismiss based upon the court's lack of personal jurisdiction over Fonix. The
court granted Fonix's motion to dismiss, on a conditional basis, subject to the
right of Clarke and Perpetual Growth to produce additional evidence which would
establish jurisdiction of the New York court over Fonix. Clarke and Perpetual
Growth filed a motion with the New York court that sought to establish a factual
and legal basis for the New York court's exercise of jurisdiction over Fonix.
However, the court denied that motion. In the interim, Fonix filed a suit
against Clarke and Perpetual Growth in federal court for the Central District of
Utah seeking a declaratory judgment that it does not owe any money to Clarke and
Perpetual Growth. Now that the action in New York has been dismissed, Fonix
intends to vigorously pursue the Utah action. However, Clarke and Perpetual
Growth could prevail in the lawsuit, in which case Fonix may be required to pay
significant amounts of money damages or other amounts awarded by the court. At a
minimum, the ongoing nature of this action will result in some diversion of
management time and effort from the operation of the business.
Papyrus - After the Papyrus acquisition closed, the Company investigated some of
the representations and warranties made by Papyrus to induce the Company to
acquire Papyrus. The Company determined that certain of the representations made
by Papyrus and their executive officers were false. At about the same time, the
Company began negotiations with the former executive officers of Papyrus, which
negotiations, among other things, included discussions regarding rescission of
the Papyrus acquisition. On February 26, 1999, the Company filed an action
against Papyrus in the United States District Court for the District of Utah,
Central Division (the "Utah Action"). In the Utah Action, the Company alleged
claims for misrepresentation, negligent misrepresentation, breach of contract,
breach of the implied covenant of good faith and fair dealing and rescission. On
March 11, 1999, three of the former shareholders of Papyrus filed an action
against the Company in the United States District Court for the District of
Massachusetts (the "Massachusetts Action"), alleging a default under the terms
of the promissory notes issued to them in connection with the Papyrus
Acquisition. On April 2, 1999, the three former Papyrus shareholders filed an
amended complaint against the Company
F-38
<PAGE>
Fonix Corporation
[A Development Stage Company]
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
seeking additional remedies including violation of Massachusetts unfair and
deceptive acts and practices statutes and copyright infringement. On April 8,
1999, a fourth former Papyrus shareholder filed an action against the Company
alleging a default under the terms of the promissory notes issued to him in
connection with the Papyrus acquisition and seeking additional remedies
including violation of Massachusetts unfair and deceptive acts and practices
statutes and copyright infringement. Subsequently, the Company has entered into
agreements with the four former Papyrus shareholders for dismissal of the
actions and cancellation of the promissory notes upon payment to the former
shareholders of $1,122,209 (the "Settlement Payment") an amount equal to
approximately 73 percent of the balance due them under the notes issued to them
in the Papyrus acquisition, and return for cancellation by the Company of
970,586 shares of restricted common stock issued to them in the Papyrus
acquisition. The Company must pay the Settlement Payment before May 16, 1999. If
it does not, the Company and the four former Papyrus shareholders are free to
pursue their respective claims.
Apple Computer, Inc. - In February 1993, Articulate received a patent (the "303
patent") for a product which would allow the user of an Apple Macintosh to
create spoken commands which the computer would recognize and respond to. Soon
after the 303 patent was issued, Articulate put Apple Computer, Inc ("Apple") on
notice that Apple's "PlainTalk" product infringed the 303 patent. When Apple
ignored Articulate's notices, Articulate sued Apple. Apple responded to the suit
by suing Articulate and Dragon Systems, Inc., which suit was subsequently
dismissed. The Company acquired Articulate's claims against Apple in the
Articulate acquisition (see Note 2). The Company has completed discovery in the
action pending against Apple and is awaiting the scheduling of a trial.
In addition to the above, the Company is involved in various lawsuits, claims
and actions arising in the ordinary course of business. In the opinion of
management, after consultation with legal counsel, the ultimate disposition of
these matters will not materially affect the consolidated financial position or
results of operations of the Company.
18. EMPLOYEE PROFIT SHARING PLAN
The Company has a 401(k) profit sharing plan covering essentially all of its
full-time employees. Under the plan, employees may reduce their salaries, in
amounts allowed by law, and contribute the salary reduction amount to the plan
on a pretax basis. The plan also allows the Company to make matching and profit
sharing contributions as determined by the board of directors. To date, no
matching or profit sharing contributions have been made by the Company.
19. REPORTABLE SEGMENTS
The Company is organized into two business segments based primarily on the
nature of the Company's products and customers. Each segment is separately
managed because its customers require different technology solutions and
marketing strategies.
The Company's HealthCare Solutions Group (HSG) includes the development,
manufacture, sale and maintenance of its voice recognition product to the
healthcare industry marketed under the PowerScribe(R) trademark. The Company's
Interactive Technologies Solutions Group (ITSG) includes the development of
relationships with third parties who can incorporate Fonix technologies into
their own products or product development efforts. These products include speech
recognition technology licensing including speech-to-text (STT) and
text-to-speech (TTS) applications.
The accounting policies of the segments are the same as those described in the
summary of significant accounting policies. These operating segments are
components for which separate information is available that is evaluated by the
Company's chief operating decision maker in deciding how to allocate resources
and in assessing performance.
F-39
<PAGE>
Fonix Corporation
[A Development Stage Company]
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The following table reflects certain financial information relating to each
reportable segment for each of the years ended December 31, 1998, 1997 and 1996:
<TABLE>
<CAPTION>
1998 1997 1996
---------------- -------------- --------------
<S> <C> <C> <C>
Revenues:
HSG - PowerScribe $ 284,960 $ - $ -
ITSG - STT and TTS 2,604,724 - -
---------------- -------------- --------------
Total revenues $ 2,889,684 $ - $ -
================ ============== ==============
Gross margin:
HSG - PowerScribe $ 244,056 $ - $ -
ITSG - STT and TTS 2,569,284 - -
---------------- -------------- --------------
Total gross margin $ 2,813,340 $ - $ -
================ ============== ==============
Research and development expenses:
HSG - PowerScribe $ 4,360,619 $ - $ -
ITSG - STT and TTS 21,896,365 6,816,798 4,758,012
---------------- -------------- --------------
Total research and development expenses $ 26,256,984 $ 6,816,798 $ 4,758,012
================ ============== ==============
Depreciation and amortization:
HSG - PowerScribe $ 856,253 $ - $ -
ITSG - STT and TTS 2,429,180 405,209 83,183
---------------- -------------- --------------
Total depreciation and amortization $ 3,285,433 $ 405,209 $ 83,183
================ ============== ==============
Other operating expenses:
HSG - PowerScribe $ 1,246,377 $ - $ -
ITSG - STT and TTS 8,579,969 12,791,399 3,447,217
---------------- -------------- --------------
Total other operating expenses $ 9,826,346 $ 12,791,399 $ 3,447,217
================ ============== ==============
Loss from operations:
HSG - PowerScribe $ 6,219,193 $ - $ -
ITSG - STT and TTS 30,336,230 20,013,406 8,288,412
---------------- -------------- --------------
Total loss from operations $ 36,555,423 $ 20,013,406 $ 8,288,412
================ ============== ==============
Long-lived assets:
HSG - PowerScribe $ 19,561,867 $ - $ -
ITSG - STT and TTS 21,582,566 1,706,230 1,332,757
----------------- -------------- --------------
Total long-lived assets $ 41,144,433 $ 1,706,230 $ 1,332,757
================= ============== ==============
</TABLE>
All of the Company's revenues for 1998 were sourced from the United States. Of
the $2,889,684 in revenues for 1998, $2,368,138 was from one customer, Siemens,
in connection with non-refundable license payments under a Statement of Work and
License Agreement. The remaining amount of revenue was primarily from hospital
and medical centers in the eastern United States in connection with sales of the
Company's PowerScribe(R) suite of products.
F-40
<PAGE>
Fonix Corporation
[A Development Stage Company]
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
20. SUBSEQUENT EVENTS
Related Party Notes Payable - Subsequent to December 31, 1998, the Company
issued unsecured notes payable to an executive officer in the amount of $68,691
for cash used as working capital by the Company. These notes bear interest at 10
percent and are due on July 31, 1999.
Recent Financing Activities - On January 29, 1999, the Company entered into a
Securities Purchase Agreement with four investors pursuant to which the Company
sold its Series C 5% Convertible Debentures in the aggregate principal amount of
$4,000,000. The outstanding principal amount of the debentures is convertible at
any time at the option of the holder into shares of the Company's common stock
at a conversion price equal to the lesser of $1.25 or 80 percent of the average
of the closing bid price of the Company's common stock for the five trading days
immediately preceding the conversion date. The Company also issued 400,000
warrants in connection with this financing. On March 3, 1999, the Company
executed a supplemental agreement pursuant to which the Company agreed to sell
another $2,500,000 principal amount of Series C 5% Convertible Debentures on the
same terms and conditions as the January 29, 1999 agreement, except no
additional warrants were issued. The obligations of the Company for repayment of
the debentures, as well as its obligation to register the common stock
underlying the potential conversion of the debentures and the exercise of the
warrants issued in these transactions, are personally guaranteed by the
Guarantors. These personal guarantees are secured by a pledge of 6,000,000
shares of Fonix common stock beneficially owned by them. The Company has entered
into an indemnity agreement with the Guarantors relating to this and other
guarantees and pledges (see Note 12). In connection with second funding, the
Company agreed to pledge, as collateral for repayment of the debentures, a lien
on the patent covering the Company's ASR technologies.
Subsequent to the second funding, the holders of the debentures notified the
Company and the Guarantors that the Guarantors were in default under the terms
of the pledge and that the holders intended to exercise their rights to sell
some or all of the pledged shares of the Guarantors. At the present time, the
Company has no knowledge of sales of the Guarantors' shares by the holders.
However, if the holders proceed to sell some or all of the Guarantors' shares,
the Company may be obligated, under its indemnity agreement, to issue
replacement shares to the Guarantors for all shares sold by the holders and
reimburse Guarantors for any costs incurred as a result of the holders' sales of
Guarantors' shares.
One of several events described in the Securities Purchase Agreement as a
"Triggering Event" is the suspension from listing or delisting of the Company's
common stock from the Nasdaq SmallCap Market for a period of three trading days.
In March 1999, trading in the Company's common stock was temporarily halted for
more than three days. Trading resumed within five trading days, and the Company
has not been notified that the holders of the Series C 5% Convertible Debentures
desire to exercise any rights they may have under the agreement.
Issuance of Stock Options - On February 15, 1999, the Company granted an
aggregate of 762,500 stock options to various employees of the Company. These
options have a ten-year life, an exercise price of $1.53 per share and vested on
the grant date.
F-41
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the registrant has duly caused this Amendment No. 1 to the Annual
Report on Form 10-K for the year ended December 31, 1998, to be signed on its
behalf by the undersigned, thereunto duly authorized, on this 11th day of
August, 1999.
Fonix Corporation
Date: August 11, 1999 /s/ Roger D. Dudley
---------------------------- ---------------------------
Roger D. Dudley
Executive Vice President
CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS
As independent public accountants, we hereby consent to the incorporation by
reference in Registration Statement Nos. 333-31425, 333-40603 and 333-50265 on
Form S-3 and 333-11549, 333-25925, 333-37137 and 333-74769 on Form S-8 of Fonix
Corporation of our report dated April 14, 1999 included in Fonix Corporation's
Form 10-K (Amendment No. 1) for the year ended December 31, 1998.
/s/ Arthur Andersen LLP
ARTHUR ANDERSEN LLP
Salt Lake City, Utah
August 10, 1999
INDEPENDENT AUDITORS' CONSENT
We consent to the incorporation by reference in Registration Statement Nos.
333-31425, 333- 40603, and 333-50265 on Form S-3 and 333-11549, 333-25925,
333-37137, and 333-74769 on Form S-8 of fonixTM corporation of our report dated
March 28, 1997, appearing in this amended Annual Report on Form 10-K/A of
fonixTM corporation for the year ended December 31, 1998.
/s/ DELOITTE & TOUCHE LLP
Deloitte & Touche LLP
Salt Lake City, Utah
August 10, 1999
CONSENT OF INDEPENDENT ACCOUNTANTS
We hereby consent to the incorporation by reference of our report dated March 4,
1996 included in this Form 10-K/A of Fonix Corporation for the year ended
December 31, 1998 (relating to the financial statements of Fonix Corporation for
the period from the date of inception on October 1, 1993 through December 31,
1995 (which financial statements are not separately presented in the Form 10-
K), into the Company's previously filed Registration Statements File Nos.
333-31425, 333-40603 and 333-50265 on Form S-3 and 333-11549, 333-25925,
333-37137 and 333-74769 on Form S-8.
/s/ Pritchett, Siler & Hardy, P.C.
PRITCHETT, SILER & HARDY, P.C.
Salt Lake City, Utah
August 11, 1999
