UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[X] Quarterly report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934 for the quarterly period ended March 31, 1999
[ ] Transition Report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934 for the transition period from
to . ------------------
------------------------
Commission file number 0-23862
Fonix Corporation
(Exact name of registrant as specified in its charter)
Delaware 22-2994719
(State of Incorporation) (I.R.S. Employer Identification No.)
60 East South Temple Street, Suite 1225
Salt Lake City, UT 84111
(Address of principal executive offices and zip code)
(801) 328-0161
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or Section 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 or No
As of May 19, 1999, 70,660,944 shares of common stock, par value $.0001 per
share, were issued and outstanding.
<PAGE>
Fonix Corporation
[A Development Stage Company]
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)
<TABLE>
<CAPTION>
ASSETS
March 31, December 31,
1999 1998
----------- -------------
<S> <C> <C>
Current assets:
Cash and cash equivalents $ 76,885 $ 20,045,539
Notes receivable - 245,000
Accounts receivable, net of allowance for doubtful accounts of $22,526 and $8,115, respectively 1,146,727 219,908
Prepaid expenses 145,924 51,866
Inventory 88,070 77,386
Interest and other receivables 33,127 8,276
Employee advances 3,109 67,231
------------ ------------
Total current assets 1,493,842 20,715,206
Property and equipment, net of accumulated depreciation of $1,430,367 and $1,195,390, respectively 2,166,005 2,328,012
Intangible assets, net of accumulated amortization of $3,895,358 and $2,599,554, respectively 37,471,697 38,816,421
Other assets 129,819 130,288
------------ ------------
Total assets $ 41,261,363 $ 61,989,927
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Bank overdraft $ 167,882 $ 138,034
Revolving notes payable 50,000 20,038,193
Notes payable - related parties 7,170,410 8,491,880
Notes payable - other 560,000 560,000
Accounts payable 3,708,273 3,536,074
Accrued liabilities 1,691,058 981,774
Accrued liabilities - related parties 1,159,139 900,004
Deferred revenues 846,429 695,997
Capital lease obligation - current portion 44,382 52,225
------------ ------------
Total current liabilities 15,397,573 35,394,181
Capital lease obligation, net of current portion 28,340 -
Series C 5% Convertible Debentures 6,500,000 -
------------ ------------
Total liabilities 21,925,913 35,394,181
------------ ------------
Common stock and related repricing rights subject to redemption; 1,801,802 shares and
repricing rights outstanding (aggregate redemption value of $2,500,000) 1,830,000 1,830,000
------------ ------------
Commitments and contingencies (Notes 5, 6, 7, 9, 12, 13 and 15)
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 D, 4% cumulative convertible; 990,834 shares outstanding in 1999
(aggregate liquidation preference of $20,293,495) 22,902,972 22,200,936
Series E, 4% cumulative convertible; 90,000 shares outstanding in 1999
(aggregate liquidation preference of $1,827,249) 2,153,357 3,257,886
Common stock, $.0001 par value; 100,000,000 shares authorized;
65,837,475 and 64,324,480 shares outstanding, respectively 6,584 6,432
Additional paid-in capital 91,872,264 88,517,711
Outstanding warrants 3,453,147 3,323,258
Deferred consulting expense (26,675) (106,700)
Deficit accumulated during the development stage (103,356,199) (92,933,777)
------------ ------------
Total stockholders' equity 17,505,450 24,765,746
------------ ------------
Total liabilities and stockholders' equity $ 41,261,363 $ 61,989,927
============ ============
</TABLE>
See accompanying note to condensed consolidated
financial statements.
2
<PAGE>
Fonix Corporation
[A Development Stage Company]
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
<TABLE>
<CAPTION>
October 1,
1993
Three Months Ended (Inception) to
March 31, March 31,
------------------
1999 1998 1999
------------- -------------- -------------
<S> <C> <C> <C>
Revenues $ 1,110,332 $ 1,295,785 $ 4,000,016
Cost of revenues 225,439 - 301,783
------------- -------------- -------------
Gross margin 884,893 1,295,785 3,698,233
------------- -------------- -------------
Expenses:
Selling, general and administrative 3,675,561 1,380,080 35,993,093
Product development and research 2,971,279 2,701,203 34,529,320
Amortization of goodwill and purchased core technology 1,287,581 98,783 3,828,734
Purchased in-process research and development - 9,315,000 13,136,000
------------- -------------- -------------
Total expenses 7,934,421 13,495,066 87,487,147
------------- -------------- -------------
Loss from operations (7,049,528) (12,199,281) (83,788,914)
------------- -------------- -------------
Other income (expense)
Interest income 22,046 271,477 3,689,437
Interest expense (2,267,379) (311,924) (7,647,028)
Cancellation of common stock reset provision - - (6,111,577)
------------- -------------- -------------
Total other income (expense), net (2,245,333) (40,447) (10,069,168)
------------- -------------- -------------
Loss before extraordinary items (9,294,861) (12,239,728) (93,858,082)
Extraordinary items:
Loss on extinguishment of debt - - (881,864)
Gain on forgiveness of debt - - 30,548
------------- -------------- -------------
Net loss $ (9,294,861) $ (12,239,728) $(94,709,398)
============= ============== =============
Basic and diluted net loss per common share $ (0.16) $ (0.27)
============= ==============
</TABLE>
See accompanying note to condensed consolidated
financial statements.
3
<PAGE>
Fonix Corporation
[A Development Stage Company]
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Increase (Decrease) in Cash and Cash Equivalents
<TABLE>
<CAPTION>
October 1,
1993
Three Months Ended (Inception) to
March 31, March 31,
------------------------------
1999 1998 1999
------------- -------------- -------------
<S> <C> <C> <C>
Cash flows from operating activities:
Net loss $ (9,294,861) $ (12,239,728) $(94,709,398)
Adjustments to reconcile net loss to net cash
used in operating activities:
Issuance of common stock for services - - 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 1,995,760 - 12,074,674
Non-cash compensation expense related to issuance
of stock options 92,565 - 2,588,865
Non-cash expense related to issuance of notes payable
and accrued expense for services - - 857,000
Non-cash exchange of notes receivable for services - - 150,000
Non-cash portion of purchased in-process research and development - 8,814,768 13,136,000
Write-off of assets received in acquisition - - 1,281
Depreciation and amortization 1,579,701 235,252 5,355,155
Extraordinary loss on extinguishment of debt - - 881,864
Extraordinary gain on forgiveness of debt - - (30,548)
Changes in assets and liabilities, net of effects of acquisitions:
Accounts receivable (926,819) - (1,075,317)
Employee advances (3,864) - (71,095)
Interest and other receivables (16,851) 19,314 (22,334)
Inventory (10,684) - (30,905)
Prepaid assets (94,058) (36,517) (141,524)
Other assets 469 - (119,376)
Accounts payable 417,024 138,642 5,430,760
Accrued liabilities 709,284 (90,817) 1,351,073
Accrued liabilities - related party 259,135 (238,355) 406,894
Deferred revenues 150,432 - 231,698
------------- ------------- ------------
Net cash used in operating activities (5,142,767) (3,296,634) (48,146,872)
------------- ------------- ------------
Cash flows from investing activities, net of effects of acquisitions:
Acquisition of subsidiaries, net of cash acquired - (7,246,119) (15,323,173)
Purchase of property and equipment (38,025) (255,259) (3,374,495)
Investment in intangible assets - - (164,460)
Issuance of notes receivable - (200,000) (3,228,600)
Payments received on notes receivable 245,000 - 2,128,600
------------- ------------- ------------
Net cash provided by (used in) investing activities 206,975 # (7,701,378) - (19,962,128)
------------- ------------- ------------
Cash flows from financing activities:
Bank overdraft 29,848 - 167,882
Net proceeds (payment) from revolving note payable (19,988,193) (4,504,265) 750
Net proceeds (payments) from revolving note payable - related parties (1,506,309) (514,601) (1,424,668)
Proceeds from other notes payable - - 2,911,667
Payments on other notes payable - - (1,779,806)
Principal payments on capital lease obligation (14,448) (11,687) (107,154)
Proceeds from advances - 1,076,426 -
Proceeds from issuance of convertible debentures, net 6,446,240 - 9,631,240
Proceeds from sale of warrants - 322,928 1,072,928
Proceeds from sale of common stock, net - 14,340,000 38,175,700
Proceeds from sale of preferred stock, net - - 17,707,346
Proceeds from sale of common stock and related repricing rights
subject to redemption, net - - 1,830,000
------------- ------------- ------------
Net cash provided by (used in) financing activities (15,032,862) 10,708,801 68,185,885
------------- ------------- ------------
Net (decrease) increase in cash and cash equivalents (19,968,654) (289,211) 76,885
Cash and cash equivalents at beginning of period 20,045,539 20,501,676 -
------------- ------------- ------------
Cash and cash equivalents at end of period $ 76,885 $ 20,212,465 $ 76,885
============= ============= ============
</TABLE>
See accompanying note to condensed consolidated
financial statements.
4
<PAGE>
Fonix Corporation
[A Development Stage Company]
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (continued)
(Unaudited)
<TABLE>
<CAPTION>
October 1,
1993
Three Months Ended (Inception) to
March 31, March 31,
<S> <C> <C> <C>
Supplemental disclosure of cash flow information: 1999 1998 1999
Cash paid during the period for interest $ 142,701 $ 311,863 $ 3,572,707
</TABLE>
Supplemental Schedule of Non-cash Investing and Financing Activities:
For the Three Months Ended March 31, 1999:
The Company entered into a capital lease obligation for equipment in
the amount of $34,945.
Advances to employees totaling $59,986 were applied as payments on a
related-party note payable.
A total of 143,230 shares previously pledged to a bank by certain
officers and directors of the Company as collateral for Company credit
card debt were sold by the bank and the proceeds were used to pay the
debt and the related accrued interest in full totaling $244,824.
Preferred stock dividends of $905,090 were recorded related to the
beneficial conversion features of convertible preferred stock.
Preferred stock dividends of $222,471 were accrued on convertible
preferred stock.
A total of 17,500 shares of Series D convertible preferred stock and
related dividends of $5,833 were converted into 426,464 shares of
common stock.
A total of 45,072 shares of Series E convertible preferred stock and
related dividends of $12,019 were converted into 1,086,531 shares of
common stock.
For the Three Months Ended March 31, 1998:
Preferred stock dividends of $131,660 were recorded related to the
beneficial conversion features of Series B and Series C convertible
preferred stock.
A total of 27,500 shares of Series B 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 Preferred Stock and related
dividends of $123,129 were converted into 1,295,919 shares of common
stock.
The Company issued 2,692,216 shares of common stock (having a quoted
market value of $16,995,972) in connection with the acquisition of
AcuVoice, Inc.
See accompanying note to condensed consolidated
financial statements.
5
<PAGE>
Fonix Corporation
(A Development Stage Company)
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation - The accompanying unaudited condensed consolidated
financial statements of Fonix Corporation and subsidiaries (collectively the
"Company") have been prepared by the Company pursuant to the rules and
regulations of the Securities and Exchange Commission. Certain information and
footnote disclosures normally included in financial statements prepared in
accordance with generally accepted accounting principles have been condensed or
omitted pursuant to such rules and regulations, although the Company believes
that the following disclosures are adequate to make the information presented
not misleading.
These condensed consolidated financial statements reflect all adjustments
(consisting only of normal recurring adjustments) that, in the opinion of
management, are necessary to present fairly the financial position and results
of operations of the Company for the periods presented.
Operating results for the three months ended March 31, 1999 are not necessarily
indicative of the results that may be expected for the year ending December 31,
1999. The Company suggests that these condensed consolidated financial
statements be read in conjunction with the consolidated financial statements and
the notes thereto included in the Company's Annual Report on Form 10-K for the
year ended December 31, 1998.
Recently Enacted Accounting Standards - In June 1998, the Financial Accounting
Standards Board issued Statement of Financial Accounting Standards ("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 is 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.
Reclassifications - Certain reclassifications have been made in the prior period
consolidated financial statements to conform with the current period
presentation.
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 period.
At March 31, 1999 and 1998, there were outstanding common stock equivalents to
purchase 44,358,188 and 13,951,667 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.
6
<PAGE>
The following table is a reconciliation of the net loss numerator of basic and
diluted net loss per common share for the three months ended March 31, 1999 and
1998:
<TABLE>
<CAPTION>
1999 1998
------ -----
Per Per
Share Share
Amount Amount Amount Amount
------ ------ ------ ------
<S> <C> <C> <C> <C>
Net loss $ (9,294,861) $(12,239,728)
Preferred stock dividends (1,127,561) (131,660)
------------- --------------
Net loss attributable to common
stockholders $(10,422,422) $(0.16) $(12,371,388) $(0.27)
============= ======= ============= =======
Weighted average common shares
outstanding 64,476,886 45,740,942
============== ==============
</TABLE>
2. ACQUISITIONS
The Company acquired AcuVoice, Inc. ("AcuVoice") in March 1998. 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. In
addition, the Company acquired Papyrus Associates, Inc. ("PAI") and Papyrus
Development Corporation ("PDC") (together with PAI, "Papyrus") in October 1998.
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. The products and services formerly provided by AcuVoice
and Papyrus are now provided by the Company's Interactive Technologies Solutions
Group.
The Company also 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 under the PowerScribe(R) trade
name. These same products and services are now provided by the Company's
HealthCare Solutions Group.
All three acquisitions were accounted for as purchases.
The following unaudited pro forma financial statement data for the three months
ended March 31, 1998 present the results of operations of the Company as if the
acquisitions of AcuVoice, Articulate and Papyrus had occurred at January 1,
1998. The pro forma results have been prepared for comparative purposes only and
do not purport to be indicative of what would have occurred had the acquisitions
been made at January 1, 1998 or of future results. Purchased in-process research
and development related to the acquisitions of AcuVoice and ASI of $9,315,000
and $3,821,000, respectively, were recorded at the date of the acquisitions and
are not presented in the following pro forma financial statement data since they
are non-recurring charges directly attributable to the acquisitions.
7
<PAGE>
<TABLE>
<CAPTION>
Pro Forma
Three Months Ended
March 31, 1998
---------------------
<S> <C>
Revenues $ 1,625,764
Loss before extraordinary items (5,425,339)
Net loss (5,425,339)
Basic and diluted net loss
per common share (0.11)
</TABLE>
3. CERTIFICATE OF DEPOSIT
At December 31, 1998, the Company maintained a $20,000,000 short-term
certificate of deposit at a bank which was included in cash and cash
equivalents. This certificate was pledged as collateral on a revolving note
payable (see Note 5). 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. INTANGIBLE ASSETS
Intangible assets consist of purchased core technology and goodwill in
connection with the acquisition of AcuVoice, Articulate and Papyrus 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 ranging from five to eight years. Total accumulated amortization was
$3,895,358 and $2,599,554 at March 31, 1999 and December 31, 1998, respectively.
The Company evaluates, at each balance sheet date, whether events and
circumstances have occurred that indicate possible impairment of long-lived
assets which may require reduction in the book value of such assets. The Company
uses an estimate of future undiscounted net cash flows of the related asset or
group of assets over the remaining life in measuring whether the assets are
recoverable. The Company assesses impairment of long-lived assets at the lowest
level for which there are identifiable cash flows that are independent of other
groups of assets. As of March 31, 1999, the Company does not believe any of its
long-lived assets are impaired. However, the amount of goodwill and other
long-lived assets considered realizable could be reduced in the near term based
on changing conditions and the Company's success in funding further marketing
and development of its products and technologies.
5. REVOLVING AND OTHER NOTES PAYABLE
At December 31, 1998, the Company had a revolving note payable to a bank in the
amount of $19,988,193. This note was due January 8, 1999, bore an interest rate
of 6.00 percent, and was secured by a certificate of deposit in the amount of
$20,000,000 (see Note 3). 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 March 31, 1999, the Company had an unsecured revolving note payable to a bank
in the amount of $50,000. Amounts loaned under the revolving note payable are
limited to $50,000. The weighted average outstanding balance during the three
months ended March 31, 1999 was $50,000. The weighted average interest rate was
9.75 percent during this period. This note is payable on demand, matures April
1, 2007, bears interest at the bank's prime rate plus 2.0 percent (9.75 percent
at March 31, 1999) and requires interest to be paid monthly.
8
<PAGE>
At March 31, 1999, the Company had a note payable to a lender in the amount of
$560,000 which bears interest at 18 percent per year, which interest is payable
monthly. The note payable was originally due January 2, 1999 and is secured by
certain accounts receivable of the Company. The Company has extended the due
date to May 28, 1999 by agreeing to pay the lender accrued interest plus a fee
of $5,600. The Company anticipates that it will request additional extensions
of the due date. The note is personally guaranteed by two officers and
directors and a member of the Board of Directors of the Company. The Company
anticipates that it will enter into an indemnity agreement with these three
individuals relating to this and other guarantees and pledges (see Note 9).
6. RELATED-PARTY NOTES PAYABLE
At March 31, 1999, the Company had unsecured demand notes payable outstanding to
former Articulate stockholders in the aggregate amount of $4,658,980 related to
the acquisition of Articulate in 1998. These notes were payable on demand any
time after November 30, 1998. In December 1998, the holder of a $407,971 note
demanded payment. In connection with this demand, the Company paid the holder a
partial payment of $50,000 in 1998 and the holder agreed to extend the date on
which demand could be made to March 15, 1999 and increase the interest rate to
11 percent per year. No additional demand has been given for payment of this
note. In 1998, the Company also negotiated extensions of $1,715,775 of the notes
to May 30, 1999 and adjusted the interest rate to 10 percent per year. During
the three months ended March 31, 1999 and subsequent to March 31, 1999, the
Company made partial payments of $50,000 and $175,000 on a $2,535,235 note and
agreed to pay the balance in connection with a sale of one of its operating
segments (see Note 15).
At March 31, 1999, the Company had unsecured demand notes payable outstanding to
former Articulate employees in the aggregate amount of $452,900 and an accrued
liability of $404,100 to the same employees. Both amounts are related to
incentive compensation granted to the employees for continued employment with
the Company after the acquisition of Articulate in 1998. 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. The
Company has agreed to pay interest on these notes at 9 percent per year after
November 1, 1998. No demand for payment has been made for the $404,100 by the
former Articulate employees.
At March 31, 1999, the Company had unsecured demand notes payable to former
Papyrus stockholders in the aggregate amount of $1,710,000, which notes were
issued in connection with the acquisition of Papyrus in 1998. The notes were
payable in various installments from February 28, 1999 through September 30,
1999. In April, 1999, the Company entered into agreements with five former
Papyrus shareholders to reduce the aggregate amounts payable to them under these
notes from $1,632,375 to $1,188,909, which amounts will be paid in connection
with a sale of one of the Company's operating segments (see Note 15). The
aggregate remaining balance of $77,625 of the notes payable to former
shareholders of Papyrus will also be paid at the closing of the sale of the
operating segment.
At March 31, 1999, the Company had an unsecured revolving note payable in the
amount of $184,839 in principal and $5,929 in accrued interest to SMD, a company
owned by two individuals who are executive officers and directors and one
individual who is a director of the Company and who each beneficially own more
than 10 percent of the Company's common stock. The weighted average balance
outstanding during the three months ended March 31, 1999 was $53,398. 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 during the
period ended March 31, 1999 was $184,839. In 1999, advances to the three
individuals in the amount of $59,986 were applied as a partial payment of this
note.
In December 1998, two individuals who are executive officers and directors and
one individual who is a director of the Company ("Guarantors") guaranteed
certain obligations of the Company (see Note 9). As security for some of the
guarantees, the Guarantors also pledged shares of Fonix common stock
beneficially owned by them. In March 1999, 143,230 of the shares previously
pledged by the Guarantors to a bank were sold by the bank and the proceeds were
used to pay Company credit card balances and the related accrued interest in
full totaling $244,824. These amounts are now included in the unsecured
revolving note payable to SMD described above.
9
<PAGE>
At March 31, 1999, the Company had 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 11). This note is payable on demand.
At March 31, 1999, the Company had 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. The holder of this note agreed to
extend the due date to June 30, 1999.
At March 31, 1999, the Company had an unsecured note payable to an officer of
the Company in the amount of $43,691 which bears interest at an annual rate of
10 percent and is due on or before July 31, 1999. Subsequent to March 31, 1999
this same officer advanced an additional $25,000 to the Company under similar
terms.
The Company believes the terms of the related-party revolving notes payable are
at least as favorable as the terms that could have been obtained from unrelated
third parties in similar transactions.
7. SERIES C 5% CONVERTIBLE DEBENTURES
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 holders 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 recorded $687,500 as interest expense
upon the issuance of the debentures in connection with this beneficial
conversion feature. The Company also issued 400,000 warrants to purchase an
equal number of the Company's common stock at a strike price of $1.25 per share
in connection with this financing. The warrants are exercisable for a period of
three years from the date of grant. The estimated fair value of the warrants of
$192,000, as computed under the Black-Scholes pricing model, was recorded as
interest expense upon the issuance of the debentures. 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 Company recorded $1,062,500 as
interest expense upon the issuance of the supplemental debentures in connection
with its beneficial conversion feature. 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 (see Note 9). In connection with the March 3, 1999 funding, the
Company agreed to grant a lien on the patent covering the Company's Automated
Speech Recognition ("ASR") technologies as collateral for repayment of the
debentures. However, to date no lien on the patent has been granted.
Subsequent to the March 3, 1999 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 in favor of the
Guarantors, to issue replacement shares to the Guarantors for all shares sold by
the holders and reimburse the Guarantors for any costs incurred as a result of
the holder's sales of Guarantors' shares (see Note 9).
8. STOCKHOLDERS' EQUITY
Series D and E Preferred Stock - During the three months ended March 31, 1999,
17,500 shares of Series D Convertible Preferred Stock and 45,072 shares of
Series E Convertible Preferred Stock together with related
10
<PAGE>
dividends on each were converted into 426,464 shares and 1,086,531 shares,
respectively, of the Company's common stock.
On February 3, 1999, certain holders of Series D and Series E preferred stock
forwarded conversion notices to the Company converting (i) 27,500 shares of
Series D preferred stock and related dividends into 315,379 shares of common
stock and (ii) 77,500 shares of Series E preferred stock and related dividends
into 1,955,346 shares of common stock. Due to an error in the conversion
calculations and a subsequent delay in receiving further clarifying instructions
from the holders, the common shares issuable upon such conversions were never
issued to the Series D and Series E holders, although the Company's records
reflected that such shares had been issued. Subsequent to April 15, 1999,
because the common stock had not been received, the Series D and Series E
holders rescinded the February 3 conversions, which the holders were legally
entitled to do under the terms and conditions of the Series D and E preferred
stock agreements. The effects of this recission have been retroactively
reflected in the accompanying condensed consolidated financial statements and
these Notes.
Common Stock Options - During the three months ended March 31, 1999, the Company
granted 753,000 stock options to employees and 9,500 stock options to two
consultants at exercise prices ranging from $1.28 to $1.78 per share. The term
of all options granted during this three month period is ten years from the date
of grant. Of the stock options issued, 725,834 vested immediately, 18,334 vest
six months after issuance and 18,332 vest one year after issuance. The weighted
average fair value of the options granted to employees during the three months
ended March 31, 1999 was $1.31 per share using the Black-Scholes pricing model.
Had compensation expense on these options been recorded in accordance
with the method prescribed by SFAS No. 123, "Accounting for Stock-Based
Compensation", the Company's net loss would have been $11,406,432 or $0.18 per
share. As of March 31, 1999, the Company had a total of 16,419,282 options
outstanding.
9. RELATED-PARTY TRANSACTIONS
Related-party transactions with entities owned by three individuals who are
directors and executive officers of the Company and each of whom beneficially
own more than 10 percent of the Company's issued and outstanding common stock
not otherwise disclosed herein as of and for the three months ended March 31,
1999 and 1998 were as follows:
<TABLE>
<CAPTION>
1999 1998
------ -----
<S> <C> <C>
Expenses:
Base rent $ 31,104 $ 23,130
Liabilities:
Accrued liabilities - 222,147
</TABLE>
The Company rents office space under a month-to-month lease from Studdert
Companies Corporation (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 unaffiliated
third party in a similar transaction.
Guarantee of Company Obligations and Related Indemnity Agreement - The
Guarantors have guaranteed certain obligations of the Company (see Notes 5, 6
and 7). 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 as of March 31, 1999 are as
follows:
<TABLE>
<CAPTION>
Amount Shares
Guaranteed Pledged
---------- --------
<S> <C> <C>
Series C 5% Convertible Debentures $ 6,500,000 6,000,000
Note payable 560,000 -
Accounts payable - legal fees 147,000 100,000
</TABLE>
11
<PAGE>
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. Additionally, 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. However, subsequent to
the Board of Directors' authorization, the Guarantors declined to accept the
warrants and they were not issued.
The Company anticipates that in the future the Guarantors may request that the
Company provide indemnity and/or compensation for the guarantees, advances
and/or pledges by the Guarantors for the benefit of the Company. To the extent
such requests, if any, are reasonable and of a nature similar to what the
Company would grant to unrelated parties in similar transactions, the Company
presently anticipates that it will consider such requests.
At March 31, 1999, the Company had unsecured advances from a bank in the form of
a bank overdraft in the approximate amount of $136,000 that were personally
guaranteed by an officer of the Company. Subsequent to March 31, 1999, the
overdraft was reduced to zero.
10. 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: (a)
$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; (b)
$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 (c) $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. The
Company recorded $1,291,712 of the license payments as revenue during the three
months ended March 31, 1998. 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. As of March 31,
1999, 400,000 of the warrants originally issued had expired and 600,000 of the
warrants remain outstanding at an average exercise price of $25 per share.
11. 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. Under the terms of the Synergetics agreement, the Company
expended $186,455 and $435,957 during the three months ended March 31, 1999 and
1998, respectively.
IMC2 - In March 1998, the Company entered into a professional services agreement
with IMC2, a research and development entity, to provide assistance to Fonix in
the continuing development of specific ASR technologies. The President of IMC2
is also the President of Synergetics. The professional services agreement is for
a term of 36 months and requires the Company to make monthly payments of
$22,000. Under the terms of the agreement, the Company expended $66,000 in the
three months ended March 31, 1999. The Company did not expend any funds under
this arrangement during the three months ended March 31, 1998.
Adiva- Beginning in 1998, the Company utilized the research and development
services of Adiva. The president of Adiva is also the president of Synergetics
and IMC2. The Company expended $63,395 during the three months
12
<PAGE>
ended March 31, 1999 for research and development efforts. The Company did not
expend any funds under this arrangement during the three months ended March 31,
1998.
12. 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 are vested on the date of
grant and one-third vests each year thereafter. 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 two employees referred to above agreed that their
compensation would be 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
pursuant to the contracts with each executive officer for the year ended
December 31, 1999 is $425,000.
In January 1999, the Company announced a major cost reduction program for the
Company's 1999 operating year wherein the two remaining executive officers
agreed that their annual compensation would 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 described above 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 was $15,000 per month. Subsequent to March 31,
1999, the Company negotiated a termination of this agreement for a cash payment
of approximately $33,000. The Company will expense the remaining deferred
consulting expense in the period the agreement was terminated.
Operating Lease Agreement - In March 1999, the Company entered into an agreement
to lease office space in Cleveland, Ohio for sales and installation personnel.
The lease is for three years at a monthly rate of $4,260 and becomes effective
May 1, 1999.
Future aggregate minimum obligations under this operating lease are as follows:
<TABLE>
<CAPTION>
Years ending December 31,
- - -------------------------
<S> <C>
1999 $ 34,080
2000 51,120
2001 51,120
2002 17,040
----------
Total $153,360
</TABLE>
Capital Lease Obligations - In January 1999, the Company entered into a
noncancellable capital lease arrangement for telephone equipment at its facility
in Woburn, Massachusetts.
Future aggregate minimum obligations under this capital lease are as follows:
13
<PAGE>
<TABLE>
<CAPTION>
Years ending December 31,
- - -------------------------
<S> <C>
1999 $ 8,265
2000 9,016
2001 9,016
2002 9,016
2003 9,016
Thereafter 751
-----------
Total future minimum lease payments 45,080
Less amounts representing interest (10,135)
-----------
Present value of future minimum lease payments $ 34,945
===========
</TABLE>
Royalty Agreements - The Company has entered into various technology license
agreements. Generally, the agreements require the Company to pay royalties at
specified dollar amounts in connection with each product sold that utilizes
technologies licensed by the Company under these agreements. The royalty
expense is accrued at the time product revenues incorporating the licensed
technologies are recognized. Royalty expense of $46,877 was incurred during
the three months ended March 31, 1999 in connection with these agreements. There
were no sales of products incorporating these licensed technologies during the
three months ended March 31, 1998.
13. 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
asserted 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. Clarke and Perpetual Growth have
appealed the dismissal. Fonix has 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, the lawsuit in New York could be reinstated on appeal
and Clarke and Perpetual Growth could prevail in that lawsuit, in which case
Fonix may be required to pay significant amounts of money damages awarded by the
court.
Papyrus - After the Papyrus acquisition closed in October 1998, 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 appear to be
false. At about the same time, the Company began negotiations with the former
executive officers of Papyrus. On February 26, 1999, the Company filed an action
against Papyrus in the United States District Court for the District of Utah,
Central Division, wherein 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, 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 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
14
<PAGE>
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. On April 13, 1999, a
fifth former Papyrus shareholder filed a similar action in Massachusetts.
Subsequently, the Company has entered into agreements with the five former
Papyrus shareholders for dismissal of the actions and cancellation of the
promissory notes upon payment to the former shareholders of $1,188,909 (the
"Settlement Payment") and return for cancellation by the Company of
approximately 970,000 shares of restricted common stock issued to the five
former shareholders in the acquisition. The Company must pay the Settlement
Payment on or before July 15, 1999 or the Company and the five 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. 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.
14. 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 a 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 which can incorporate Fonix products and
technologies into their own products or product development efforts. These
products and technologies include ASR, handwriting and text-to-speech
applications.
The following tables reflect certain financial information relating to each
business segment for each of the three months ended March 31, 1999 and 1998, and
as of March 31, 1999, and December 31, 1998:
15
<PAGE>
<TABLE>
<CAPTION>
Three Months Three Months
Ended March 31, Ended March 31,
1999 1998
------------------- --------------------
Revenues:
<S> <C> <C>
HSG $ 1,056,526 $ -
ITSG 53,806 1,295,785
------------------- --------------------
$ 1,110,332 $ 1,295,785
=================== ====================
Gross margin:
HSG $ 836,378 $ -
ITSG 48,515 1,295,785
------------------- --------------------
$ 884,893 $ 1,295,785
=================== ====================
Product development and research expenses:
HSG $ 458,453 $ -
ITSG 2,512,826 2,701,203
------------------- --------------------
$ 2,971,279 $ 2,701,203
=================== ====================
Selling, general and administrative expenses:
HSG $ 930,491 $ -
ITSG 2,745,070 1,380,080
------------------- --------------------
$ 3,675,561 $ 1,380,080
=================== ====================
Amortization of goodwill and purchased core technology:
HSG $ 621,664 $ -
ITSG 665,917 98,783
------------------- --------------------
$ 1,287,581 $ 98,783
=================== ====================
Purchased in-process research and development:
HSG $ - $ -
ITSG - 9,315,000
------------------- --------------------
$ - $ 9,315,000
=================== ====================
Loss from operations:
HSG $ 1,174,230 $ -
ITSG 5,875,298 12,199,281
------------------- --------------------
$ 7,049,528 $ 12,199,281
=================== ====================
</TABLE>
<TABLE>
<CAPTION>
As of March 31, As of December 31,
1999 1998
------------------- --------------------
<S> <C> <C>
Assets:
HSG $ 20,016,726 $ 19,760,394
ITSG 21,244,637 42,229,533
------------------- --------------------
$ 41,261,363 $ 61,989,927
=================== ====================
</TABLE>
15. SUBSEQUENT EVENTS
Recent Financing Activities - On April 22, 1999, the Company entered into a loan
agreement with an unaffiliated entity pursuant to which the Company received
proceeds in the aggregate amount of $1,000,000. This note is payable in full
including accrued interest on July 28, 1999 and bears interest at the prime
rate, as published in The Wall Street Journal under the heading "Money Rates,"
plus 2.0 percent (9.75 percent at April 22, 1999). The loan is secured by all
the assets of Fonix/Articulate, Inc., a wholly owned subsidiary, including its
intellectual property
16
<PAGE>
rights represented by patents, copyrights and trademarks. On May 14, 1999, an
additional $100,000 was advanced under the terms of this note.
Conversion of Series D and Series E Preferred Stock - Subsequent to March 31,
1999, 18,500 shares of Series D Convertible Preferred Stock and 46,500 shares of
Series E Convertible Preferred Stock and related dividends on each were
converted into 862,015 and 2,159,652 shares of the Company's common stock,
respectively. After the above conversions, 972,334 shares of Series D and 43,500
shares of Series E Convertible Preferred Stock remain outstanding.
Resignation of Stephen M . Studdert as Chairman - Effective April 30, 1999,
Stephen M. Studdert resigned as Chairman of the Board of Directors of the
Company and Thomas A. Murdock, the Chief Executive Officer of the Company, was
elected Chairman. Mr. Studdert continues as a member of the Board of Directors.
Sale of an Operating Segment - At the present time the Company is in
negotiations regarding the sale of one of its operating segments. There can be
no assurance that these negotiations will result in any agreement to sell the
related operating segment.
Advance of Funds from Directors, Officers and Employees - Subsequent to March
31, 1999, two directors and an executive officer of the Company advanced $49,779
to pay for certain Company operating expenses. These advances have been repaid
by the Company. Additionally, subsequent to March 31, 1999, another group of
officers and employees of the Company have advanced $72,496 to pay for certain
Company operating expenses. The Company has verbally agreed to repay these
advances from the first available cash flow and to pay interest of 8.5 percent
per year for the period the advances remain unpaid.
Sublease of Office Facilities - Effective May 14, 1999 the Company entered
into an agreement to sublease 10,224 square feet of its Draper, Utah facility to
an unrelated third party. The agreement requires the sublessee to pay 40
percent of the Company's obligation under the primary lease agreement through
December 31, 2000. The sublessee has the option to extend the term by two
additional three-month periods.
General Magic Licensing - On May 17, 1999, the Company completed a renegotiation
of its license agreement with General Magic, Inc., to use AcuVoice's
text-to-speech software. Under the amended agreement, the Company agreed to
license the present version of the AcuVoice text-to-speech software source code
to General Magix, Inc., and reduce the future royalties from General Magic for
sales of its products and services incorporating the text-to-speech software.
General Magic agreed to pay $250,000 in cash, which payment is to be received
over a five month period, and relinquished its exclusive rights to the software
through September 23, 2000.
17
<PAGE>
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
THIS QUARTERLY REPORT ON FORM 10-Q 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 IN THE COMPANY'S ANNUAL REPORT ON FORM 10-K FOR THE YEAR ENDED
DECEMBER 31, 1998.
Overview
Fonix is a development-stage company engaged in marketing and development of
proprietary automated speech recognition ("ASR"), text-to-speech ("TTS") and
handwriting recognition technologies and products which may be licensed in whole
or in part to third parties. The Company aims to make commercially available a
comprehensive package of products and technologies that allow humans to interact
with computer and other electronic products in a more efficient, intuitive and
natural way rather than through traditional methods such as the keyboard.
Specifically, Fonix has developed proprietary automated speech recognition and
related technologies such as text-to-speech (speech synthesis), handwriting
recognition and speech compression. These technologies, as developed to date,
use speech recognition techniques that include the use of a proprietary neural
network method. Neural networks are computer-based methods which simulate
the way the human brain processes information. Fonix licenses its technologies
to and has entered into co-development relationships and strategic alliances
with third parties including producers of application software, operating
systems, computers and microprocessor chips.
Automated Speech Recognition
Presently available traditional voice recognition technologies have been used in
a variety of products for industrial, telecommunications, business and personal
applications. Speech recognition algorithms in software have been developed and
refined over the past several years. However, the increase in processing speed
and memory capacity of personal computers has accounted for much of the
improvement in traditional speech recognition systems during that period. This
improvement includes vocabulary size, recognition accuracy and continuous speech
recognition ability. Currently available speech recognition systems for personal
computers include speech command systems for navigating the Windows(R) interface
and inexpensive, discrete word dictation systems offered by Dragon Systems, IBM,
Lernout & Hauspie and others. Recently, general and specific vocabulary
continuous speech dictation systems also have been introduced by Philips, IBM,
Dragon Systems and others. In addition, telephony applications with menu choice
systems and small vocabulary dialogue systems have been demonstrated by Nuance,
Nortel and others.
Despite the nominal advances in performance of such presently available systems,
there are significant limitations inherent in all of these systems, each of
which continues to use traditional approaches generally based on Hidden Markov
Models ("HMM") technology. These traditional approaches have not advanced
appreciably since the late 1980s. Applications based on such traditional speech
recognition systems for personal computers all require close-talking microphones
in relatively low noise environments and a formal speaking style to achieve
acceptable accuracy. In so-called continuous dictation systems, significant
adaptation to user speech, speaking style, and content area also are required.
These traditional systems are generally restricted to speech recognition for a
single individual dictating in a quiet environment; presently available
telephony-based systems are even more limited in general functionality.
The present industry standard methodology, the HMM, uses a general template or
pattern matching technique based on statistical language models. Massachusetts
Institute of Technology researcher Dr. Victor Zue has noted that
speech-recognition systems based on such technology
"utilize little or no specific-speech knowledge, but rely instead
primarily on general-purpose pattern-recognition algorithms. While
such techniques are adequate for a small class of wellconstrained
speech recognition problems, their extendibility to multiple
speakers, large vocabularies, and/or continuous speech is highly
questionable. In fact, even for the applications
18
<PAGE>
that these devices are designed to serve, their performance typically
falls far short of human performance."
HMM's widely recognized weaknesses are many: (i) it does not meet the needs for
many mass market implementations, (ii) it has limited input feature types,
(iii) it accounts for only limited context, (iv) it has limited ability to
generalize acoustic and language structure, (v) it requires training data
from the end-user for acceptable performance, (vi) models become extremely
large and complex as vocabulary grows, and (vii) there is a lack of hardware
parallel processing capability.
In contrast to HMM, Fonix researchers have developed what the Company believes
to be a fundamentally new approach to the analysis of human speech sounds and
the contextual recognition of speech. The core Fonix automated speech
recognition technologies (the "ASRT" or "Core Technologies") attempt to
approximate the techniques employed by the human auditory system and language
understanding centers in the human brain. The ASRT use information in speech
sounds perceptible to humans but not discernible by current automated speech
recognition systems. They also employ neural net technologies (artificial
intelligence techniques) for identifying speech components and word sequences
contextually, similar to the way in which scientists believe information is
processed by the human brain. As presently developed, the ASRT are comprised of
several components including a phonetic sound representation recognition engine,
audio signal processing, a feature extraction process, a phoneme estimation
process, and a linguistic process consisting of two components, one of which is
expert- or rule-based and one of which is based on proprietary neural net
technologies, that are designed to interpret human speech contextually.
Fonix believes the reliable recognition of natural, spontaneous speech spoken by
one or more individuals in a variety of common environments by means of a
conveniently placed microphone, all based on its ASRT, will significantly
improve the performance, utility and convenience of applications currently based
on traditional HMM technology such as computer interface navigation, data input,
text generation, telephony transactions, continuous dictation and other
applications. Additionally, the Company believes that its ASRT will make
possible major new speech recognition applications such as the transcription of
business meetings and conversations, real-time speech-to-speech language
translation, natural dialogues with computers for information access and
consumer electronic devices controlled by natural language.
Thus, the Company believes that its ASRT offers unique speech processing
techniques that will complement and significantly enhance currently available
speech recognition systems. Through its Interactive Technologies Solutions
Group, Fonix intends to continue to license its ASRT, to continue to co-develop
the ASRT with research and development groups in industry and academia and
ultimately to market a suite of Fonix-branded technologies and products. In the
long term, the Company anticipates that automated speech recognition systems
employing the Company's unique ASRT will set the industry standard for all
automated speech recognition applications because of its anticipated capacities
to overcome the weaknesses of HMM. In addition, the Company expects that certain
elements of its Core Technologies will have industry-leading applications in
non-speech recognition industries, market segments and disciplines such as
artificial intelligence and data compression. Although these plans represent
management's beliefs and expectations based on its current understanding of the
market and its experience in the industry, there can be no assurance that actual
results will meet these expectations. See "Certain Significant Risk Factors." In
the last two fiscal years, the Company has expended $13,620,748 and $7,066,294
on research and development activities. Since its inception (October 1, 1993),
the Company has spent $34,529,320 on research and development of the ASRT. The
Company expects that a substantial part of its capital resources will continue
to be devoted to research and development of the ASRT and other proprietary
technologies for the foreseeable future.
HealthCare Solutions Group Products
The three PowerScribe products now being sold by the HealthCare Solutions Group
are PowerScribeRAD, PowerScribeRAD Software Development Kit ("SDK")TM, and
PowerScribeEM. PowerScribe products use state-of-the-art continuous speech
recognition engines licensed from Dragon Systems, Inc., which enables a user to
dictate naturally and continuously without having to pause between words.
PowerScribe incorporates customized medical language models gleaned from
millions of words sampled from medical specialty departments across North
America.
19
<PAGE>
PowerScribe products have been designed as mission-critical applications to
operate as an open and scalable continuous speech reporting and charting system.
PowerScribe products utilize core technologies from Microsoft's Back Office(R)
applications development suite and rely on Windows NT(R), Open Database
Connectivity (ODBC) and SQL Server(R) as the foundation operational elements.
PowerScribeRAD for Radiology Reporting
PowerScribeRAD enables the full automation of the radiology reporting process
and replaces existing digital dictation and transcription systems.
PowerScribeRAD permits the dictation of radiology reports directly into text,
with edit, approve, and sign functions accomplished within a matter of minutes;
thereby significantly reducing transcription costs and report turnaround time.
Once reports are dictated, they may be automatically stored in the Radiology
Information System ("RIS"), the Hospital Information System ("HIS") or
PowerScribeRAD's own report repository.
PowerScribeEM for Emergency Medicine Reporting
PowerScribeEM is a completely integrated emergency medicine dictation and
transcription system which allows emergency department professionals to dictate
their reports directly into text in the first total solution for capturing and
documenting emergency medicine clinical encounters. PowerScribeEM minimizes
training and the need for healthcare professionals to modify their work styles.
PowerScribe includes post-processing of the text for organization into a typical
structured emergency medicine report. PowerScribeEM seamlessly handles the
overall workflow of an emergency department. Once reports are dictated, reports
are either automatically stored in the HIS or in PowerScribe's own report
repository for further analysis at a later date.
PowerScribe Radiology SDK for User Development Applications
The PowerScribe Radiology SDK allows users to integrate the full functionality
of the PowerScribeRAD system into the user's own radiology applications. For
radiology environments such as a RIS or Picture Archival Communication System
("PACS") the PowerScribe SDK allows users to develop a completely integrated
dictation and transcription system utilizing continuous speech recognition.
Using this SDK, the PowerScribeRAD client functionality can be embedded into the
user's application while also customizing the user interface and report workflow
to meet specific application needs. The PowerScribeRAD SDK supports multiple
development environments including Microsoft(R) Visual Basic, C++ and the
Microsoft(R) Internet Explorer environment. The SDK includes an Active-X
composite control along with sample code and developer documentation.
Interactive Solutions Group Products
The Interactive Technologies Solutions Group offers products and technologies
which include automated speech recognition, text-to-speech, and handwriting
recognition for a variety of hardware and software platforms. The marketing
direction for the Interactive Technologies Solutions Group is to form
relationships with third parties who can incorporate Fonix technologies 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 Fonix presently has such
relationships and with which it may have similar relationships in the future
include participants in the application software, operating systems, computer,
microprocessor chips, consumer electronics, automobile, telephony and health
care technology market sectors. Interactive Technologies Group products include
AcuVoice AV 1700, AV 2001 text-to-speech systems, and Allegro handwriting
recognition.
Embedded Technologies
Fonix has developed an application development tool, the Fonix Advanced
Application Speech Toolkit (FAAST(TM)) which allows developers to simulate,
prototype and create code for embedded applications using Fonix' human computer
interaction technologies. This system currently supports Fonix speech
recognition for command and control applications and Fonix AcuVoice
text-to-speech engines for both very high quality limited vocabulary and high
quality unlimited vocabulary applications. The system is designed to support a
number of popular microprocessors and operating systems for embedded
applications. Currently, FAAST supports the Siemens
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TriCore micro-controller. The beta version of the FAAST system will be available
for developers in June 1999. An alpha version of the system is currently being
used internally at Fonix to support the development of embedded systems
applications for several companies including consumer electronic, automotive,
and cell phone devices.
Core Speech Recognition Technologies
Since 1994 Fonix has pursued the development of a "3rd Generation" automated
speech recognition technology to overcome the limitations of currently available
commercial speech recognition systems. This development has yielded a
proprietary ASR system utilizing a unique front-end analysis of the acoustic
speech signal, a neural net based phoneme identifier, and a completely novel
neural net architecture for back-end language modeling. The latter component is
the MULTCONS or multi-level constraint satisfaction network. These developments
have been the subject of two issued patents. In addition, the Company has
acquired a related patent covering portions of this technology. Portions of this
technology are currently being employed in Fonix embedded systems applications.
Text-to-Speech (Speech Synthesis)
In 1986 AcuVoice began to develop and market a new approach to synthesized
speech, a system using actual recordings of "units" of human speech (i.e., the
sound pulsation). Since the unit of speech consists of more than one phoneme
(sound), AcuVoice's approach has been called a "large segment concatenative
speech synthesis" approach. Other companies such as DEC and AT&T began in the
early 1960s and continue until the present to use a system called "parametric
speech synthesis." Parametric systems are plagued with problems of speech
quality, because their unit is not an actual recording, but a computer's version
of what a human voice sounds like. Poor speech quality also occurs because the
parametric unit consists, for the most part, of a single phoneme, such as the
"t" in the word "time."
Although as early as 1994 AcuVoice released versatile prototypes of its system,
it was not until early 1996 that the AcuVoice Speech Synthesizer was ready for
sale into the telecommunications, multi-media, educational and assistive
technology markets. AcuVoice won awards as "best text-to-speech" product at the
Computer Technology Expo '97 and '98 and the best of show award at AVIOS '97.
Presently AcuVoice products are sold to end-users, systems integrators and OEMs.
Fonix text-to-speech products include those developed by AcuVoice and those
developed by Fonix. All are sold under the AcuVoice brand name. The products
include the AcuVoice AV 1700 TTS system for end-user desktop and laptop system
use. The AcuVoice AV 2001 SDK is a software development kit for developers of
telephony applications. Run-time software licenses for the AV 2001 are offered
for applications developed with the SDK.
The SDK supports major computer telephony platforms.
Handwriting Recognition
Prior to the Papyrus Acquisition in October 1998, PAI developed and began
selling handwriting recognition software including the Allegro handwriting
recognition software. The Allegro handwriting recognition software is a single
letter recognition system like the popular Graffiti handwriting recognition
software for the PalmPilot PDA. However, Allegro's alphabet is all natural in
appearance as lower case letters. Because the letters are written in the
standard way in almost all instances, the Allegro system is easy to use and
requires practically no learning. Allegro is sold by Purple Software in England
for the Psion Series 5 hand-held PC. This software has also been licensed to
Philips for its popular smart cell phone. Allegro is also the subject of a sales
agreement with Lucent Technologies for use in its Inferno operating system.
Papyrus has also developed cursive handwriting recognition software which
recognizes naturally-written whole words. This cursive technology is only
available as a licensed product to OEM customers. Both the Allegro and the
cursive handwriting recognition software are user independent and require no
training on the software.
In March 1998, the Company expanded its suite of human-computer interaction
technologies by acquiring the award-winning voice synthesis technologies of
AcuVoice, Inc. ("AcuVoice"). The business operations previously conducted by
AcuVoice are now part of the Company's Interactive Technologies Solutions Group.
During the three months ended March 31, 1999, the Company received in the
aggregate, $53,806 in revenue from licensing or sale of the AcuVoice
technologies and products compared to pro-forma revenue of $46,735 for the
comparable three
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month period of 1998.
In September 1998, the Company acquired Articulate Systems, Inc. ("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 three months ended March 31,
1999, the Company received in the aggregate, $1,056,526 in revenue from sales of
the PowerScribe Radiology product marketed by the HealthCare Solutions Group
compared to pro-forma revenue of $142,782 for the comparable three month period
of 1998.
In October 1998, the Company acquired the Papyrus Companies. 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 from its
facilities in Woburn, Massachusetts. During the three months ended March 31,
1999, the Company received no revenue from licensing or sale of the Papyrus
technologies compared to pro-forma revenue of $140,462 for the comparable three
month period of 1998.
The Company markets its previously developed ASR technologies, together with TTS
technologies and products acquired from AcuVoice and handwriting recognition
technologies and products acquired from Papyrus through its Interactive
Technologies Solutions Group. The present marketing direction for the
Interactive Technologies Solutions Group is to form relationships with third
parties which 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 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 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
PowerScribe Radiology and PowerScribeEM, are marketedto major hospitals and
medical centers nationwide.
In addition to the transactions involving AcuVoice, Articulate and Papyrus in
1998, the Company was also in negotiations to acquire several other speech
technology-related companies. The Company terminated all such acquisition
discussions in late 1998.
Resignation of Chairman of the Board
Effective April 30, 1999, Stephen M. Studdert resigned as Chairman of the Board
of Directors of the Company and Thomas A. Murdock, the Chief Executive Officer
of the Company, was elected Chairman. Mr. Studdert continues as a member of the
Board of Directors.
Year 2000 Issue
Many computer systems and software products are coded to accept only two digit
entries in the date code field. These date code fields will need to accept four
digit entries to distinguish 21st century dates from 20th century dates. As a
result, many companies' software and computer systems will need to be upgraded
or replaced in order to comply with such Year 2000 requirements. Fonix is
subject to the risk that problems encountered with Year 2000 issues, either in
its internal systems, technologies and products, or in external systems could
adversely affect its operations and financial condition.
In the ordinary course of its business, Fonix tests and evaluates its
technologies and software and hardware
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products. Fonix believes that its technologies and products generally are Year
2000 compliant, meaning that the use or occurrence of dates on or after January
1, 2000 will not materially affect the performance of such technologies or
products with respect to four digit date dependent data or the ability of such
products to correctly create, store, process, and output information related to
such data. However, Fonix may learn that certain of its technologies or products
do not contain all necessary software routines and codes necessary for the
accurate calculation, display, storage, and manipulation of data involving
dates. In addition, Fonix has warranted or expects to warrant that the use or
occurrence of dates on or after January 1, 2000 will not adversely affect the
performance of its technologies or products with respect to four digit date
dependent data or the ability to create, store, process, and output information
related to such data. If the end users of any of Fonix's technologies or
products experience Year 2000 problems, those persons could assert claims for
damages.
Fonix uses third-party equipment and software that may not be Year 2000
compliant. Fonix is presently conducting a review of key products provided by
outside vendors to determine if their products are Year 2000 compliant. Although
that process is not yet completed, Fonix presently believes that all software
provided by third parties that is critical to its business is Year 2000
compliant. Fonix expects to complete its review of all internal systems for Year
2000 compliance by June 30, 1999. If this third-party equipment or software does
not operate properly with regard to the Year 2000 issue, Fonix may incur
unexpected expenses to remedy any problems. Such costs may materially adversely
affect Fonix's business, operating results, and financial condition. In
addition, if Fonix's key systems, or a significant number of its systems, fail
as a result of Year 2000 problems Fonix could incur substantial costs and
disruption of its business. Fonix may also experience delays in implementing
Year 2000 compliant software products. Any of these problems may materially
adversely affect Fonix's business, operating results or financial condition.
In addition, the purchasing patterns of Fonix's licensees, potential licensees,
customers and potential customers may be affected by Year 2000 issues. Many
companies are expending significant resources to correct their current software
systems for Year 2000 compliance. These expenditures may result in reduced funds
available to license Fonix technologies or to purchase other Fonix products.
This may adversely affect Fonix's business, operating results, and financial
condition.
Results of Operations
Three months ended March 31, 1999 compared with three months ended March 31,
1998
During the three months ended March 31, 1999, the Company recorded revenues of
$1,110,332, a decrease of $185,453 over the same period in the previous year. In
the 1998 comparable period the Company received its first revenues of
$1,295,785, of which, $1,291,712 was paid by Siemens as a non-refundable license
fee. The 1999 revenues are primarily from sales and licensing fees related to
the PowerScribe dictation product and TTS technologies and products.
The Company incurred product development and research expenses of $2,971,279
during the three months ended March 31, 1999, an increase of $270,076 over the
same period in the previous year. This increase was due primarily to the
addition of product development and research personnel, equipment, facilities
and the operations of the Interactive Technologies and HealthCare Solutions
Groups. The Company anticipates similar or increased product development and
research costs as it continues to develop and market the applications and
products offered by its HealthCare Solutions and Interactive Technologies
Solutions Groups.
Selling, general and administrative expenses were $3,675,561 and $1,380,080 ,
respectively, for the three months ended March 31, 1999 and 1998. Salaries,
wages and related costs were $2,093,626 and $716,550 for the three months ended
March 31 1999 and 1998, respectively, an increase of $1,377,076. This increase
is attributable to increases in personnel costs resulting from the acquisitions
of AcuVoice, Articulate and Papyrus. Legal and accounting expenses increased
$238,692, marketing expenses increased $336,668 and consulting and outside
services increased by $94,094.
Amortization of goodwill and purchased core technologies were $1,287,581 and
$98,783 , respectively, for the three months ended March 31, 1999 and 1998
representing an increase of $1,188,798. This increase is primarily attributable
to the amortization of intangible assets acquired in connection with the
acquisitions of AcuVoice,
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Articulate and Papyrus.
The Company incurred losses from operations of $7,049,528 and $12,199,281 during
the three months ended March 31, 1999 and 1998, respectively. The decrease in
losses from operations is due primarily to the $9,315,000 charge for in-process
research and development costs during the three months ended March 31, 1998,
offset in part by increases in general and administrative expenses and
amortization expense. 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 1999, assuming
availability of working capital.
Net other expense was $2,245,333 for the three months ended March 31, 1999, an
increase of $2,204,886 over the three months ended March 31, 1998. This increase
was due primarily to increased interest expense of $1,955,455 due to financing
costs associated with the issuance of the Series C 5% Convertible Debentures.
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 or sales of existing
technologies or businesses 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 into 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 $13,903,731 at March 31, 1999
compared to negative working capital of $14,678,975 at December 31, 1998. The
current ratio was 0.10 at March 31, 1999, compared to 0.59 at December 31, 1998.
Current assets decreased by $19,221,364 to $1,493,842 from December 31, 1998 to
March 31, 1999. Current liabilities decreased by $19,996,608 to $15,397,573
during the same period. The increase in working capital from December 31, 1998
to March 31, 1999, was primarily attributable to the payment of notes payable
and other accrued liabilities from the proceeds of the Series C 5% Convertible
Debentures. Total assets were $41,261,363 at March 31,1999 compared to
$61,989,927 at December 31, 1998.
During the three months ended March 31, 1999, the Company granted 753,000 stock
options to various employees and 9,500 stock options to two consultants at
exercise prices ranging from $1.28 to $1.78 per share. The term of all options
granted during this three month period is ten years from date of grant. As of
March 31, 1999, the Company had a total of 16,419,282 options outstanding.
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. 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'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. The warrants entitle the holders to
purchase up to 400,000 shares of the Company common stock at an exercise price
of $1.25 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
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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 (director of the Company) (collectively, "Guarantors"). The personal
guarantees of these Guarantors 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 certain ASR technologies. 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 of Fonix common stock
given by Guarantors, the Company agreed to indemnify and hold them harmless in
the event of a default that results in any payment or other liability or damage
incurred by any of them. In consideration for the guaranty and pledge by
Guarantors, the Company also 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. However, the Guarantors have declined the grant of these warrants. On or
about April 6, 1999, the holders of the Debentures notified the Company and
Guarantors that 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
Guarantors' shares by the holders of the debentures. However, if the holders
proceed to sell some or all of Guarantors' shares, the Company may be obligated
under its indemnity agreement in favor of Guarantors to issue shares to the
Guarantors in replacement of all shares sold by the holders and to reimburse
Guarantors for any income tax liability incurred as a result of the holders'
sales of Guarantors' shares.
During the three months ended March 31, 1999, 17,500 shares of Series D
Convertible Preferred Stock and 45,072 shares of Series E Convertible Preferred
Stock and related dividends were converted into 426,464 shares and 1,086,531
shares, respectively, of the Company's common stock.
At December 31, 1998, the Company had a revolving note payable to a bank in the
amount of $19,988,193. This note was due January 8, 1999, bore an interest rate
of 6.00 percent, and was secured by a certificate of deposit in the amount of
$20,000,000. 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 March 31, 1999, the Company had an unsecured revolving note payable to a bank
in the amount of $50,000. Amounts loaned under the revolving note payable are
limited to $50,000. The weighted average outstanding balance during the three
months ended March 31, 1999 was $50,000. The weighted average interest rate was
9.75 percent during this period. 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
March 31, 1999) and requires interest to be paid monthly.
At March 31, 1999, the Company had a note payable to a lender in the amount of
$560,000 which bears interest at 18 percent per annum, which interest is payable
monthly. The note payable was originally due January 2, 1999 and is secured by
certain accounts receivable of the Company's HealthCare Solutions Group. The
Company has extended the due date through May 28, 1999 by paying the lender
accrued interest plus a fee of $5,600. The Company anticipates that it will
request additional extensions of the due date. The note is personally guaranteed
by two officers and a member of the Board of Directors of the Company.
At March 31, 1999, the Company had unsecured demand notes payable outstanding to
former Articulate stockholders in the aggregate amount of $4,658,980 related to
the acquisition of Articulate in 1998. These notes were payable on demand any
time after November 30, 1998. In December 1998, the holder of a $407,971 note
demanded payment. In connection with this demand, the Company paid the holder a
partial payment of $50,000 in 1998 and the holder agreed to extend the date on
which demand could be made to March 15, 1999 and increase the interest rate to
11 percent per year. No additional demand has been given for payment of this
note. In 1998, the Company also negotiated extensions of $986,481 of the notes
to May 30, 1999 and adjusted the interest rate to 10 percent per year. During
the three months ended March 31, 1999 and subsequent to March 31, 1999, the
Company made partial payments of $50,000 and $175,000 respectively, on a
$2,535,235 note and agreed to pay the balance in connection with a sale of one
of its operating segments.
At March 31, 1999, the Company had unsecured demand notes payable outstanding to
former Articulate employees in the aggregate amount of $452,900 and an accrued
liability of $404,100 to the same employees. Both amounts are related to
incentive compensation granted the employees for continued employment with the
Company after the acquisition of Articulate in 1998. The demand notes bear
interest at an annual rate of 8.5 percent and were payable
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upon demand after November 1, 1998. None of the holders of these notes has
demanded payment. The Company has agreed to pay interest on these notes at 9
percent per year after November 1, 1998. No demand for payment has been made for
the $404,100 by the former Articulate employees.
At March 31, 1999, the Company had unsecured demand notes payable to former
Papyrus stockholders in the aggregate amount of $1,710,000, which notes were
issued in connection with the acquisition of Papyrus in 1998. The notes were
payable in various installments from February 28, 1999 through September 30,
1999. In April 1999, the Company entered into agreements with five former
Papyrus shareholders to reduce the aggregate amounts payable to them under these
notes from $1,632,375 to $1,188,909, which amounts will be paid in connection
with a sale of one of the Company's operating segments. The aggregate remaining
balance of $77,625 of the notes payable to former shareholders of Papyrus will
also be paid at the closing of the contemplated sale of the operating segment.
At March 31, 1999, the Company had an unsecured revolving note payable in the
amount of $184,839 in principal and $5,929 in accrued interest to SMD, a company
owned by two individuals who are executive officers and directors and one
individual who is a director of the Company and who each beneficially own more
than 10 percent of the Company's common stock. The weighted average balance
outstanding during the three months ended March 31, 1999 was $53,398. 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 during the
period ended March 31, 1999 was $184,839. In 1999, advances to the three
individuals in the amount of $59,986 were applied as a partial payment of this
note.
In December 1998, two individuals who are executive officers and directors and
one individual who is a director of the Company ("Guarantors") guaranteed
certain obligations of the Company. As security for some of the guarantees, the
Guarantors also pledged shares of Fonix common stock beneficially owned by them.
In March 1999, 143,230 of the shares previously pledged by the Guarantors to a
bank were sold by the bank and the proceeds were used to pay Company credit card
balances and the related accrued interest in full totaling $244,824. These
amounts are now included in the unsecured revolving note payable to SMD
described above.
At March 31, 1999, the Company had 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 March 31, 1999, the Company had 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. The holder of this note agreed to
extend the due date to June 30, 1999.
At March 31, 1999, the Company had an unsecured note payable to an officer of
the Company in the amount of $43,691 which bears interest at an annual rate of
10 percent and is due on or before July 31, 1999. Subsequent to March 31, 1999,
this same officer advanced an additional $25,000 to the Company under similar
terms.
On April 22, 1999, the Company entered into a loan agreement with an
unaffiliated entity pursuant to which the Company received proceeds in the
aggregate principal amount of $1,000,000. This note is payable in full including
accrued interest on July 28, 1999 and bears interest at the prime rate as
published in The Wall Street Journal under the heading "Money Rates" plus 2.0
percent (9.75 percent at April 22, 1999). The loan is secured by all the assets
of Fonix/ASI Corporation, a wholly owned subsidiary of the Company, including
its intellectual property rights represented by patents, copyrights and
trademarks. On May 14, 1999, an additional $100,000 was advanced under the terms
of this note. . The Company anticipates that it will need to raise additional
funds to satisfy its cash requirements during the next twelve months. 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 three quarters 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. Scientific research and development,
corporate operations and marketing expenses will continue to require additional
capital. The Company therefore intends to continue to rely primarily on
financing through sales of its equity and debt securities to satisfy future
capital requirements until such time as the Company
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is able to enter into additional third-party licensing or co-development
arrangements such that it will be able to finance ongoing operations out of
license, royalty and sales revenues. There can be no assurance that the Company
will be able to sell its equity and debt securities such that sufficient
operating capital will be available when and in the amounts needed. 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) will result in dilution to the
stockholders of the Company which could be substantial.
The Company presently has no plans to purchase any new research and development
or office facilities.
Outlook
Corporate Objectives, Technology Vision and Acquisition Strategy
The Company has positioned itself as a developer of "next generation" speech and
human-computer interface technologies that will provide multiple product
solutions for business, consumer and service applications. The fonix management
team has assembled leading talents in the ASR, TTS, handwriting recognition and
other arenas related to these technologies. The Board of Directors and
management have developed a business strategy that identifies the Company's
strengths and objectives, outlines a vision of the next major market
opportunities in the computer, telephony and electronics industries and
articulates a corporate and technology strategy that includes strategic
alliances, collaborative development agreements, strategic acquisitions and,
ultimately, marketing a suite of Fonix-branded products.
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 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 and 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
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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 Oregon Graduate Institute 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 the Company's Annual Report on Form 10-K for the year ended
December 31, 1998.
Special Note Regarding Forward-Looking Statements
Certain statements contained herein under, "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 and potential applications of the Company's
technologies, (iv) the results of research and development efforts, and (v) 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 in the Company's Annual
Report on Form 10-K for the year ended December 31, 1998.
PART II - OTHER INFORMATION
Item 1. Legal Proceedings
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
asserted 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
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<PAGE>
personal jurisdiction over Fonix. The court granted Fonix's motion to dismiss.
Clarke and Perpetual Growth have appealed the dismissal. Fonix has 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, the lawsuit in New York
could be reinstated on appeal and Clarke and Perpetual Growth could prevail in
that lawsuit, in which case Fonix may be required to pay significant amounts of
money damages awarded by the court.
Papyrus - After the Papyrus acquisition closed in October 1998, 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 appear to be
false. At about the same time, the Company began negotiations with the former
executive officers of Papyrus. On February 26, 1999, the Company filed an action
against Papyrus in the United States District Court for the District of Utah,
Central Division, wherein 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, 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 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. On
April 13, 1999, a fifth former Papyrus shareholder filed a similar action in
Massachusetts. Subsequently, the Company has entered into agreements with the
five former Papyrus shareholders for dismissal of the actions and cancellation
of the promissory notes upon payment to the former shareholders of $1,188,909
(the "Settlement Payment") and return for cancellation by the Company of
approximately 970,000 shares of restricted common stock issued to the five
former shareholders in the acquisition. The Company must pay the Settlement
Payment on or before July 15, 1999 or the Company and the five 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. 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.
Item 2. Changes in Securities
c. Unregistered sales of equity securities during the quarter (other
than in reliance on Regulation S).
Recent Sales of Unregistered Securities. During the quarter ended
March 31, 1999, the Company issued equity securities that were not registered
under the Securities Act of 1933, as amended (the "Act"), other than
unregistered sales in reliance on Regulation S under the Act, as follows:
During the three months ended March 31, 1999, 17,500 shares
of Series D Convertible Preferred Stock and 45,072 shares of Series E
Convertible Preferred Stock together with related dividends on each
were converted into 426,464 shares and 1,086,531 shares,
respectively, of the Company's common stock.
29
<PAGE>
On January 29, 1999, the Company sold Debentures in the
aggregate principal amount of $4,000,000 to four investors. The
outstanding principal amount of the Debentures is convertible at any
time at the option of the holder into shares of Fonix 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 Fonix common stock for the five trading
days immediately preceding the conversion date. The Company also issued
warrants to purchase 400,000 shares of common stock in connection with
this financing. The warrants are exercisable at a price of $1.25 per
share and have a three year term. On March 3, 1999, the Company
executed a Supplemental Agreement with the same four investors,
pursuant to which the Company sold another $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. The Company
issued all of the Debentures without registration under the 1933 Act in
reliance on Section 4(2) or Regulation D. The Debentures were issued as
restricted securities and the Debentures were stamped with a
restrictive legend to prevent any resale without registration under the
1933 Act or pursuant to an exemption.
Item 6. Exhibits and Reports on Form 8-K
a. Exhibits: The following Exhibits are filed with this Form 10-Q
pursuant to Item 601(a) of Regulation S-K:
Exhibit No. Description of Exhibit
(2) Agreement and Plan of Reorganization among the
Company, fonix Acquisition Corporation and
AcuVoice dated as of January 13, 1998,
incorporated by reference from the Company's
Current Report on Form 8-K, filed March 20, 1998
(3)(i) Articles of Incorporation of the Company which
are incorporated by reference from the Company's
Registration Statement on Form S-18 dated as of
September 12, 1989
(3)(ii) Certificate of Amendment of Certificate of
Incorporation dated as of March 21, 1994, which
is incorporated by reference from the Company's
Annual Report for the Fiscal Year Ended December
31, 1994 on Form 10-KSB
(3)(iii) Certificate of Amendment of Certificate of
Incorporation dated as of May 13, 1994, which is
incorporated by reference from the Company's
Annual Report for the Fiscal Year Ended December
31, 1994 on Form 10-KSB
(3)(iv) Certificate of Amendment of Certificate of
Incorporation dated as of September 24, 1997,
which is incorporated by reference from the
Company's Quarterly Report on Form 10-Q for the
period ended September 30, 1997
(3)(v) The Company's Bylaws, as amended, which are
incorporated by reference from the Company's
Annual Report for the Fiscal Year Ended December
31, 1994 on Form 10-KSB
(4)(i) Description of the Company's common stock and
other securities and specimen certificates
representing such securities which are
incorporated by reference from the Company's
Registration Statement on Form S-18 dated as of
September 12, 1989, as amended
(4)(ii) Certificate of Designation of Rights and
Preferences of Series A Preferred Stock, filed
with the Secretary of State of Delaware on
September 24, 1997, which is incorporated by
reference from the Company's Quarterly Report on
Form 10-Q for the period ended September 30, 1997
(4)(iii) Certificate of Designation of Rights and
Preferences of Series B Convertible Preferred
Stock, filed with the Secretary of State of
Delaware on October 27, 1997, which is
incorporated by reference from the Company's
Quarterly Report on Form 10-Q for the period
ended September 30, 1997
(4)(iv) Certificate of Designation of Rights and
Preferences of 5% Series C Convertible Preferred
Stock, filed with the Secretary of State of
Delaware on October 24, 1997, which is
incorporated by reference from the Company's
Quarterly Report on Form 10-Q for the period
ended September 30, 1997
(10)(i) Product Development and Assignment Agreement
dated as of October 16, 1993 between Phonic
Technologies, Inc. and Synergetics, Inc., which
is incorporated by reference from the Company's
Current Report on Form 8-K dated as of June 17,
1994
(10)(ii) Re-Stated Product Development and Assignment
Agreement dated as of March 30, 1995, between
fonix Corporation and Synergetics, Inc., which is
incorporated by reference from the Company's
Annual Report for the Fiscal Year Ended December
31, 1994 on
30
<PAGE>
Form 10-KSB
(10)(iii) Memorandum of Understanding dated as of March 13,
1997, by and among the Company, Synergetics, Inc.
and C. Hal Hansen, which is incorporated by
reference from the Company's Annual Report on
Form 10-KSB for the fiscal year ended December
31, 1996
(10)(iv) Employment Agreement by and between the Company
and Stephen M. Studdert, which is incorporated by
reference from the Company's Annual Report on
Form 10-KSB for the fiscal year ended December
31, 1996
(10)(v) Employment Agreement by and between the Company
and Thomas A. Murdock, which is incorporated by
reference from the Company's Annual Report on
Form 10-KSB for the fiscal year ended December
31, 1996
(10)(vi) Employment Agreement by and between the Company
and Roger D. Dudley, which is incorporated by
reference from the Company's Annual Report on
Form 10-KSB for the fiscal year ended December
31, 1996
(10)(vii) Convertible Debenture Purchase Agreement dated as
of June 18, 1997 between the Company and
Southbrook International Investments, Ltd.,
incorporated by reference from Amendment No. 1 to
the Quarterly Report on Form 10-Q for the period
ended June 30, 1997
(10)(viii) Amended and Restated Purchase Agreement effective
as of September 30, 1997 and dated as of October
24, 1997 by and between the Company and
Southbrook International Investments, Ltd., which
is incorporated by reference from the Company's
Quarterly Report on Form 10-Q for the period
ended September 30, 1997
(10)(ix) Convertible Preferred Stock Purchase Agreement
effective as of September 30, 1997 and dated as
of October 24, 1997 by and among the Company and
JNC Opportunity Fund Ltd. and Diversified
Strategies Fund, L.P., which is incorporated by
reference from the Company's Quarterly Report on
Form 10-Q for the period ended September 30, 1997
(10)(x) Restated Master Agreement for Joint Collaboration
between the Company and Siemens, dated November
14, 1997, as revised, which is incorporated by
reference from the Company's Annual Report on
Form 10-K for the year ended December 31, 1997
(10)(xi) Restated First Statement of Work and License
Agreement between the Company and Siemens, dated
February 11, 1998, as revised, which is
incorporated by reference from the Company's
Annual Report on Form 10-K for the year ended
December 31, 1997
(10)(xii) Master Technology Collaboration Agreement between
the Company and OGI, dated October 14, 1997,
which is incorporated by reference from the
Company's Annual Report on Form 10-K for the year
ended December 31, 1997
(10)(xiii) Common Stock Purchase Agreement among the Company
and JNC Opportunity Fund Ltd. and Diversified
Strategies Fund, LP, dated as of March 9, 1998,
which is incorporated by reference from the
Company's Annual Report on Form 10-K for the year
ended December 31, 1997
(10)(xiv) Common Stock Purchase Agreement between the
Company and Thomson Kernaghan & Co., dated as of
March 9, 1998, which is incorporated by reference
from the Company's Annual Report on Form 10-K for
the year ended December 31, 1997
(10)(xv) Royalty Modification Agreement among the Company
and Synergetics, dated as of April
31
<PAGE>
6, 1998, which is incorporated by
reference from the Company's Annual
Report on Form 10-K for the year ended
December 31, 1997
(10)(xvi) Purchase Agreement with John Oberteuffer and the
Company dated April 9, 1998, which is
incorporated by reference from the Company's
Annual Report on Form 10-K for the year ended
December 31, 1997
(10)(xvii) Employment Agreement by and between the Company
and John A. Oberteuffer, which is incorporated by
reference from the Company's Annual Report on
Form 10-K for the year ended December 31, 1997
(10)(xviii) First Amendment to Master Agreement for Joint
Collaboration between the Company and Siemens,
dated February 13, 1998, which is incorporated by
reference from the Company's Annual Report on
Form 10-K for the year ended December 31, 1997
(10)(xix) Second Amendment to Master Agreement for Joint
Collaboration between the Company and Siemens,
dated March 13, 1998, which is incorporated by
reference from the Company's Annual Report on
Form 10-K for the year ended December 31, 1997
(27) Financial Data Schedule
(B) Reports filed on Form 8-K during the three month period ended March 31,
1999:
On January 7, 1999, the Company filed a Current Report on Form 8-K to
announce the closing of a private placement of the Company's restricted common
stock.
32
<PAGE>
SIGNATURES
In accordance with the requirements of the Exchange Act, the
registrant caused this report to be signed on its behalf by the undersigned,
thereunto duly authorized.
Fonix Corporation
Date: May 19, 1998 /s/ Douglas L. Rex
--------------------------------------- -----------------------
Douglas L. Rex,
Chief Financial Officer
33
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