U.S. SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-KSB
[ X ] Annual report under Section 13 or 15(d) of the Securities
Exchange Act of 1934 [Fee Required] for the fiscal year ended:
May 31, 1996
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[ ] Transition report under Section 13 or 15(d) of the Securities
Exchange Act of 1934 [No Fee Required] for the transition period
from to
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COMMISSION FILE NUMBER: 0 -24058
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TOUCH TONE AMERICA, INC.
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(Name of small business issuer in its charter)
California 33-0424087
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(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
4110 N. Scottsdale Road
Suite 170
Scottsdale, Arizona 85251
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(Address of principal executive offices) (Zip Code)
Issuer's telephone number: (800) 535-2211
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Securities registered under Section 12(b) of the Act: None
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Securities registered under Section 12(g) of the Act:
Common Stock, no par value
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Check whether the issuer (1) filed all reports required to be filed by
Section 13 or 15(d) of the Securities Exchange Act of 1934 during the past
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 at least the past 90 days. Yes X No
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Check if there is no disclosure of delinquent filers pursuant to Item 405
of Regulation S-B contained herein, and will not be contained, to the best
of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-KSB or any amendment
to this Form 10-KSB. [ X ]
Issuer's revenues for its most recent fiscal year: $2,238,000
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Aggregate market value of voting stock held by non-affiliates as of
September 5, 1996: $21,833,787
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Shares of Common Stock, no par value, outstanding as of September 5, 1996:
3,319,300
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Documents incorporated by reference: Exhibits to Issuer's Registration
Statement on Form SB-2, No. 33-80131.
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TOUCH TONE AMERICA, INC.
FORM 10-KSB
PART I
ITEM 1. DESCRIPTION OF BUSINESS.
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(a) BUSINESS DEVELOPMENT.
Touch Tone America, Inc. (the "Company") was organized under the laws
of the State of California in 1990, and currently provides long distance,
Internet services, local dedicated access and other telecommunication
products. The Company currently has a small long distance customer base
located primarily in the Western and Southwestern markets of the United
States. Due to intense competition in the long distance industry, the
Company and GetNet, its wholly-owned subsidiary, have redirected the
current emphasis of the Company to develop an Internet "backbone" which
consists of a centralized high-speed computer network that connects smaller
computer networks around the United States. With the development of the
backbone, the Company will be able to offer a full range of Internet
services to Internet Access Providers and individual customer accounts.
Management believes the Internet to be a source of meeting its WilTel
carrier commitment described below and a potential revenue source to offset
increasing losses from operations particularly in the long distance
segment.
In May 1996, the Company completed its initial public offering of
securities from which it received net proceeds of approximately $5,830,000
from the sale of 1,725,000 shares of Common Stock (the "Public Shares") and
1,725,000 Common Stock Purchase Warrants (the "Public Warrants")
(collectively, the "Public Shares and Warrants"). As of September 5, 1996,
the Company had approximately $2.4 million still available from the
proceeds of the public offering. The Company intends to use its remaining
funds for future Internet development (including the completion of the
initial stage of the backbone) and marketing of its long distance services.
There can be no assurance these remaining funds will be sufficient to fund
the Company's future development and the continued payment of existing
carrier commitments and general and administrative expenses.
As discussed in "Commitments," the Company has, in the past, entered
into sales volume commitments with its service providers which have
exceeded its current sales volumes. The Company has renegotiated two
significant commitments under which it was experiencing substantial
shortfalls. Under the revised agreements, the Company's future commitment
for these contracts has been eliminated. The Company, however, has a
continuing commitment with AT&T to provide long distance service of
$1,800,000 annually, which, as of year end, it was satisfactorily meeting.
However, subsequent to year end, monthly revenues under this commitment
have declined and the Company will be unable to continue to meet this
commitment unless related revenues increase. Therefore, an additional loss
accrual may be recorded in the fiscal year ending May 31, 1997. In
addition, the Company has commitments, primarily with WilTel, to lease a
minimum of $70,000 per month of telecommunication circuits in connection
with its Internet Backbone. The Company's revenues currently do not
support these commitments. There can be no assurances that the Company's
revenues will be sufficient to cover the Company's monthly commitments.
The Company's financial statements have been prepared assuming that
the Company will continue operating as a going concern, which contemplates
the realization of assets and liquidation of liabilities in the normal
course of business. The Company's ability to continue as a going concern
is dependent upon several factors, including meeting the terms of its
commitments and achieving and maintaining profitable operations. As a
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result of the above service commitments and continuing operating losses,
the Company's independent auditors included a "going concern" paragraph
with respect to the audited financial statements as of and for the year
ended May 31, 1996.
To increase revenues to a sufficient level to meet its carrier
commitments, general and overhead expenses and future expansion, the
Company is actively seeking acquisition candidates (as set forth below)
with existing customer and revenue bases. The Company will attempt to
issue shares of its authorized, but unissued, Common Stock to acquire
customer bases and/or assets of acquisition candidates and retain its
existing cash for further development of its long distance marketing
program and the Internet backbone. There can be no assurance that the
Company will be successful in this regard.
On September 4, 1996, Michael J. Canney, the Company's Chief Executive
Officer, authorized the execution of a letter of intent to enter into a
business combination with Arcada Communications, Inc., a privately-held
long distance telecommunications service company based in Seattle,
Washington. Upon completion of the transaction, Arcada will become a
wholly-owned subsidiary of the Company and majority shareholder. It is
also anticipated that Arcada will have a majority of the members of the
Board of Directors and will assume control of daily operations. Execution
of a definitive agreement is subject to further due diligence by both
companies and approval of the Company's shareholders.
(b) BUSINESS OF ISSUER.
GENERAL
In its early operations, the Company concentrated solely on providing
long distance services pursuant to its contractual agreement with AT&T.
When new legislation was implemented allowing competition in the local
markets, the Company entered into a reseller agreement with ICG Services,
Inc. ("ICG") as an agent with the ability to originate long distance calls
from and between ICG switches. This agreement allowed the Company to make
the transition from long distance reseller to long distance provider. A
long distance provider typically has a network of fiber optic or copper
lines connected to switching equipment, regionally or nationally, that
carries long distance traffic. A long distance reseller buys or leases
network capacity from a long distance provider and then offers the long
distance service to customers under their own name. The agreement with ICG
allows the Company to provide its current and future customers local
calling as deregulation permits at reduced rates.
As a carrier of long distance services, the Company attempts to reduce
its variable costs of access to long distance transmission facilities and
services. As a long distance carrier, the Company offers its customers
the routing equipment and phone lines of the large carriers, such as AT&T,
WilTel and other carriers which the Company may contract with in the
future. Profits, if any, are derived from the difference between the cost
per minute of access bought from the carrier and the cost per minute sold
to the customer.
The Company offers commissions to agents at rates between 7% and 32%,
payable as long as the customer utilizes the Company's services. The
agents are allowed to sell the Company's services to customers of any size.
Commissions are paid only after the customer has fully paid the Company's
invoices for monthly long distance usage sent to the customer. The Company
does not pay signing bonuses to agents. For the 10 months ended May 31,
1995 and the 12 months ended May 31, 1996, the Company paid $265,000 and
$299,000 (including a $75,000 settlement payment to resolve past
differences), respectively, in commissions to its most significant agent.
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On September 25, 1995, the Company entered into a three (3) year
agreement with Paging Network of Arizona, Inc. ("PageNet") to act as a
reseller of one-way paging services including tone only, digital display
and alphanumeric paging services. The agreement allows the Company to
offer other services offered by PageNet, which includes personal 800
numbers, mini mail, page mail, and custom greeting features. The Company
believes the agreement will allow the Company to satisfy business as well
as consumer demand for advanced personal messaging and future innovations
in the wireless communications industry. To date, the sale of paging
services has been insignificant.
In November 1995, the Company acquired all the outstanding stock of
GetNet International, Inc. of Phoenix, Arizona ("GetNet"). GetNet is a
provider of Internet access services to individuals and businesses in
Arizona and other parts of the United States. GetNet currently offers
subscribers complete Internet access which is comprised of front-end
software, integrated with high quality access service and 24-hour customer
support. GetNet's high-speed digital telecommunications network provides
subscribers with direct access to the full range of Internet applications
and resources including E-mail, file transfer, World Wide Web sites, USENET
news groups and database information (including graphics, data and public
domain software). The Company bills Internet services as a line item on
the Company's long distance and local access bills. See "Internet
Services" and "Internet Backbone" below.
LONG DISTANCE DIVISION
LONG DISTANCE INDUSTRY OVERVIEW AND COMPETITION
Since the break-up of AT&T in 1984, the domestic long distance market
has roughly doubled to an estimated $65 billion in annual revenues. AT&T
has remained dominant, with MCI and Sprint increasing their market shares.
These three companies constitute what generally is regarded as the first-
tier in the long distance market. Large regional long distance companies,
some with national capabilities, such as LDDS Communications, Inc.
("LDDS"), Allnet Communication Services, Inc. ("Allnet"), Cable & Wireless
Communications, Inc. and LCI International, constitute the second-tier of
the industry.
First- and second-tier companies, (most notably AT&T, MCI, Sprint and
WilTel) actively have been providing long distance products for resale for
a number of years in order to capture additional incremental traffic
volume. WilTel is a first-tier company and is the fourth largest long
distance company in the United States.
Long distance companies can be categorized by several criteria. One
criteria is between facilities-based companies and non-facilities-based
companies, or resellers. Facilities-based companies own transmission
facilities, such as fiber optic cable, copper wires or digital microwave
equipment. Profitability for facilities-based carriers is dependent not
only upon their ability to generate revenues but also upon their ability to
manage complex networking and transmission costs. Substantially all of the
first- and second-tier long distance companies are facilities-based
carriers and generally offer service nationwide. Most facilities-based
carriers in the third-tier of the market generally offer their service only
in a limited geographic area. Some facilities-based carriers contract with
other facilities-based carriers to provide transmission where they have
geographic gaps in their facilities. Similarly, non-facilities-based
companies contract with facilities-based carriers to provide transmission
of their customers' long distance traffic. Pricing in such contracts is
typically either on a fixed rate lease basis or a call volume basis.
Profitability for non-facilities-based carriers is based primarily on their
ability to generate and retain sufficient revenue volume to negotiate
attractive pricing with one or more facilities-based carriers.
A second distinction among long distance companies is that of switched
versus switchless carriers. Switched carriers have one or more switches,
i.e. computers that direct telecommunications traffic in accordance with
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programmed instructions. All of the facilities-based carriers are switched
carriers, as are many non-facilities-based companies. Switchless carriers
depend on one or more facilities-based carrier to provide both transmission
capacity and switch facilities. In addition, switchless resellers enjoy
the benefit of offering their service on a nationwide basis, assuming that
their underlying carrier has a nationwide network.
Competition in the long distance industry is based upon pricing,
customer service, network quality and value-added services such as voice
mail, calling cards and debit cards. The success of a non-facilities-based
carrier depends almost entirely upon the amount of traffic that it can
commit to the underlying carrier; the larger the commitment, the lower the
cost of service. Subject to contract restrictions and customer brand
loyalty, resellers may competitively bid their traffic among other national
long distance carriers to gain improvement in the cost of service. The
non-facilities-based carrier devotes its resources entirely to marketing,
operations and customer service, deferring the costs of network maintenance
and management to the underlying carrier.
The relationship between carriers, such as the Company, and the major
underlying carriers is predicated primarily upon the pricing strategies of
the first-tier companies, which has resulted historically in higher rates
to the small business customer. Small customers typically are not able to
make the volume commitments necessary to negotiate reduced rates under
individualized contracts. The higher rates result from the higher cost of
credit, collection, billing and customer service per revenue dollar
associated with small billing level long distance customers. By committing
to large volumes of traffic, the Company is guaranteeing traffic to the
underlying carrier and therefore receives a lower rate than is generally
available. The successful, smaller facilities-based carrier efficiently
markets its own long distance product, processes orders, verifies credit
and provides customer service to large numbers of accounts.
LONG DISTANCE STRATEGY
The Company will attempt to reduce the current burden of its carrier
commitments and compete in the long distance industry through acquisitions
of other existing long distance companies and/or their customer accounts.
The Company believes, based on information obtained from the
Telecommunications Resellers Association, that there are in excess of 1,000
small- to medium-sized long distance resellers operating throughout the
United States which are similar to the Company in terms of operating
revenues and customer base. The Company believes acquisition(s) would
enable the Company to increase its operating efficiency without a
significant increase in overhead by eliminating duplicate overhead and the
enhanced use of the Company's existing personnel. Acquisitions may include
both switched and switchless resellers of long distance.
On September 4, 1996, Michael J. Canney, the Company's President and
Chief Executive Officer, authorized the execution of a letter of intent to
enter into a business combination with Arcada Communications, Inc., a
privately-held long distance telecommunications service company based in
Seattle, Washington. Upon completion of the transaction, Arcada will
become a wholly-owned subsidiary of the Company and majority shareholder.
Arcada will assume day to day management of the Company and control of the
Company's Board of Directors. Execution of a definitive agreement is
subject to further due diligence and approval of both companies board of
directors and shareholders.
LONG DISTANCE PRODUCTS AND SUPPLIERS
In October 1995, the Company signed an agreement for a two year period
with WilTel for long distance, calling card and point-to-point services.
The agreement allows the Company to act as a long distance carrier in the
completion of long distance and calling card calls. In addition, the
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Company orders ATM permanent virtual circuits ("PVCs") for the GetNet
Internet backbone from WilTel. The monthly costs of these circuits is
applied to the WilTel monthly usage commitment and lowers the Company's
cost per minute for long distance services. The Company will bill its
customers for all calls that the Company routes via the WilTel network.
The Company's previous primary provider of underlying long distance
services is AT&T for both outbound and inbound services as noted elsewhere
herein. The Company has committed to a large annual dollar usage
commitment ($1.8 million) for Software Defined Network ("SDN"). The SDN
product was designed by AT&T to allow large, multi-location businesses the
ability to create a long distance network by receiving one bill from AT&T
for the collective usage of the locations. AT&T also provides the customer
with the ability to manage their network by issuing their own calling card
numbers and account codes, and designating which locations would receive
bills and which would not. By combining their locations on one bill the
customer is able to receive larger volume discounts. Under this contract,
the Company has committed to sell a certain amount in AT&T long distance
each year. If the Company does not meet this commitment level in a given
year, it has agreed to pay AT&T penalties that are dependent upon the
degree to which the Company is short of those commitments. If AT&T
terminates the contract due to the Company's failure to pay the charges due
thereunder, the contract provides that the Company will be liable for the
minimum usage commitment charges to be incurred over the remaining term of
the contract. AT&T currently bills the Company's customers directly for
its SDN services.
The Company is currently evaluating the AT&T agreement as it believes
the rates charged by AT&T under the agreement to be less favorable than is
available from other carriers. Those rates also make it difficult for the
Company to recruit and maintain existing agents who can offer their
customers lower rates with other long distance companies.
LONG DISTANCE RATES AND CHARGES
The Company charges customers primarily on a 18 second initial rate
and 6 second intervals thereafter irrespective of the volume of usage, the
distance of the call, the time of day of the call and the origination
region of the call. The rates charged are not affected by the particular
transmission facilities selected by the network switching centers for
transmission of the call. Different rates are applied to inbound
origination telephone services than to outbound termination telephone
services. The product line includes general 1+ dialing origination and
"800" service which the Company's customers use to receive and pay for
calls from their respective customers and potential customers. The Company
believes that its rates are generally lower than those charged by AT&T and
competitive with or below those charged by other long distance carriers.
In addition, the Company may offer promotional discounts based upon either
duration of commitment to purchase services or incremental increases in
service. Volume discounts are also offered based upon amount of monthly
usage in the day, evening and night periods and based solely on total
volume of usage. The rates offered by the Company may be adjusted by AT&T
in the future as interexchange carriers continue to adjust their rates.
LONG DISTANCE CUSTOMERS
The Company markets its long distance services primarily to small
business customers with monthly long distance bills of less than $10,000.
Currently, the monthly long distance phone bills for the Company's
customers range from under $100 to $5,000, and for the 12 months ended May
31, 1996, the monthly long distance phone bill for an average Company
customer was approximately $350 to $400. Sales to customers as set forth
below are made by independent agents who directly contact potential
customers and are paid on a commission basis as long as the Company
receives revenues from that customer. The Company does not have contracts
with its customers, vis-a-vis its agents, but receives written or verbal
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authorization from new customers in connection with their order for
services as per FCC regulations.
LONG DISTANCE MARKETING
The Company historically has relied on its network of independent
marketing agents to market its long distance products. Independent
marketing agents are companies that market the Company's long distance
products directly to business customers as authorized agents or sales
agents of the Company and receive a continuing commission based on the
monthly usage of the customer accounts that they have brought to the
Company. The Company provides its independent marketing agents with
promotional materials and products and offers training programs by Company
employees. The Company solicits independent marketing agents primarily
through telecommunications trade periodicals and trade shows.
For the ten months ended May 31, 1995, one sales agent, TMO, accounted
for approximately 42% of the Company's revenues on which it received
commissions of 32%. For the fiscal year ended May 31, 1996, TMO accounted
for approximately 36% of the Company's revenues. At this level of
commissions, the Company does not receive any gross margin on the sales
originated by this agent, but as a result of this relationship, experiences
greater gross margin on the other agents' sales due to volume discounts
from AT&T.
The Company currently does not engage in advertising directly to end
users of long distance services, although the Company distributes a limited
amount of printed marketing materials to prospective users on a selected
basis. If the Company is successful in its acquisition program, the
Company will evaluate the development of internal telemarketing operations
to sell back into the existing and future customer bases.
INTERNET DIVISION
INTERNET OVERVIEW AND COMPETITION
Use of the Internet has grown rapidly since the commercialization of
the Internet in the early 1990s. According to industry sources, there were
approximately 37 million Internet users in the United States and Canada in
1995. The rapid growth in popularity of the Internet, the Company
believes, is in large part due to the continuing penetration of computers
into U.S. households. The Company also believes an increasing percentage
of computer owners also own modems, which are now pre-installed in a
growing number of new computers. Other industry sources note that it is
estimated in 1995, approximately 70 million people own computers worldwide
and approximately 39% of all households in the United States own computers.
The Company believes that this growth is accompanied by increasing use of
the computer for communications such as facsimile transmissions and E-mail.
In addition, there has been substantial growth of the informational,
entertainment and commercial applications and resources of the Internet and
the growing awareness of such resources among individuals. Many computers
connected to the Internet are repositories of vast amounts of information,
graphics and public domain software. Through an Internet connection, users
can access commercial, educational and governmental databases,
entertainment software, photographs and videos, newspapers, magazines,
library card catalogs, industry newsletters, weather updates and other
information. Traditional and emerging Internet applications are also
increasing in popularity, including E-mail, File Transfer Protocol ("FTP"),
web sites on the World Wide Web and USENET news groups. Finally, new
applications are being created by individuals, educational institutions and
companies and are made available at little or no cost through the Internet.
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The increased availability of user-friendly navigational and utility
programs provides easier access to the Internet's resources. Internet use
is also being promoted by the development of software tools that simplify
access to the Internet's applications and resources. Navigational and
search tools such as Gopher, Archie, Veronica and WAE, as well as new
browsing programs and search tools such as Mosiac, help users access
information from the Internet. The foregoing navigational and utility
programs are not products of the company nor any affiliate of the Company.
The market for Internet access services is extremely competitive, and
the Company expects that competition in this market will intensify in the
future. The Company's current and prospective competitors include many
large companies that have substantially greater market presence and
financial, technical, marketing and other resources than the Company. The
Company competes or expects to compete directly or indirectly with the
following categories of companies: (1) national and regional commercial
Internet service providers, such as PSI, BBN and UUNET, (2) established on-
line services companies which currently offer or are expected to offer
Internet connectivity; such as America Online ("AOL"), CompuServe, Prodigy,
GEnie and Delphi, (3) computer hardware and software and other technology
companies, such as IBM and Microsoft, (4) national long distance carriers,
such as AT&T, MCI and Sprint that currently offer electronic messaging
services, (5) regional telephone companies, such as Pacific Bell, which
recently announced a service to provide Internet access, and (6) non-profit
or educational Internet service providers.
Although some of the established on-line services companies and
telecommunications companies currently offer only limited Internet access
such as World Wide Web browsing, many of these services have announced
plans to offer expanded Internet access such as the ability to transfer
files via the Internet. The Company expects that all of the major on-line
services companies will eventually compete fully in the Internet access
market. Certain companies, including AOL, BBN and PSI, have obtained or
expanded their Internet access products and services as a result of
acquisitions. In addition, the Company believes that new competitors,
including large computer hardware and software, media and
telecommunications companies, such as the regional telephone companies,
will enter the Internet access market, resulting in even greater
competition for the Company. For example, Microsoft introduced an Internet
access solution, including front-end software and an on-line service,
called "Microsoft Network," that is expected to be competitive with the
Company's services. The application software for this on-line service has
been bundled with the Microsoft's Windows 95 operating system, which may
give the service a significant advantage over on-line and Internet services
from other providers, including the Company. In connection with its plans
to enter that Internet access market, Microsoft recently announced a
strategic alliance with UUNET (including the purchase of a minority
investment in UUNET by Microsoft) that will give Microsoft customers access
to the Internet through UUNET's POPs. In addition, IBM's most recent
version of its OS/2 operating system software includes Internet utilities,
and IBM offers Internet access through its own private communications
network. Furthermore, MCI has also recently entered the Internet access
market. The ability of these competitors or others to bundle services and
products with Internet connectivity services could place the Company at a
significant competitive disadvantage. Increased competition, price or
otherwise, could result in erosion of the Company's market share, and may
require price reductions and increased spending on marketing and product
development. Any of these events could have a material adverse effect on
the Company's financial condition and operating results.
The potential impact of the Internet on the future of long distance
with regard to the origination and termination of long distance calls is
currently unknown as the Internet and its potential uses continues to
rapidly evolve. Issues such as bandwidth availability, which affects sound
quality and the potential regulation of the Internet, if possible, make it
impossible for the Company to determine the long term potential impact.
However, the Company believes quality of long distance calling on the
Internet will become a reality in the future.
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INTERNET SERVICES
In November 1995, the Company acquired GetNet for 400,000 shares of
the Company's Common Stock in exchange for all of the then issued and
outstanding shares of GetNet. The Company operates GetNet, its wholly-
owned subsidiary, as a separate division; however it is a part of the total
communications package offered to its customers.
GetNet is a provider of Internet services to various individuals and
businesses in the United States. The Company offers subscribers complete
Internet access comprised of front-end software integrated with high
quality access service and 24-hour customer support. The Company's high-
speed, digital telecommunications network provides subscribers with direct
access to the full range of Internet applications and resources including
E-mail, World Wide Web sites, USENET news groups and database information
(including graphics, data and public domain software). GetNet's front-end
software features a point-and-click graphical user interface, providing
subscribers with an easy-to-use access to the Internet's applications and
resources. GetNet has experienced positive growth in its subscriber base
since inception.
INTERNET BACKBONE
The Company currently is attempting to establish and maintain a
nationwide, high-speed digital network, known as a "backbone," connecting
the main Internet NAPs (network access points) located throughout the
United States. A Cisco 7000 series router will be installed at each NAP
which will allow the Company a direct connection to the Internet. Regional
exchange points ("REPs") will be created using the Cisco 4700 router. This
connection to these NAPs will allow the Company to provide Internet access
to other Internet Service Providers ("ISPs"), government and educational
institutions as well as customers of all sizes anywhere in the world. The
Company's network will be designed to provide high quality, reliable and
fast access service, and will be designed to support expansion in both the
number of subscribers it may handle and the increasing data traffic
associated with those subscribers. In addition, the Company believes that
its network will be upgradable and will in the future, be able to support
new types of data traffic, such as sound and video. The Company has an
agreement with WilTel (Worldcom) to provide circuits for the network as
well as long distance lines. The Company provides its customers with on-
going customer support 24 hours a day, seven days per week as of September
5, 1996. The Company estimates the total proceeds from the public offering
utilized for the development of the Internet backbone and the marketing of
related GetNet Internet products is approximately $1,000,000. The Board of
Directors has allocated more of the public offering proceeds to the
development of the Internet backbone. The increased expenditures are based
on management's assessment of the potential revenue source of the backbone
and as a means to meet carrier commitments to WilTel.
INTERNET APPLICATIONS
GetNet provides its subscribers with access to the full range of
available Internet applications which include E-mail. E-mail allows an
Internet user to exchange messages with any other user who has an E-mail
address. Messages can be sent almost instantly to designated individuals
or groups on a mailing list.
The World Wide Web is a browsing and searching system comprised of
thousands of computer servers, referred to as home pages, each linked by a
special communications protocol called Hypertext. This open protocol
allows Internet users to view and access text, graphics, video and audio
resident on a home page or to connect instantaneously to related and linked
information on the same server or other home pages. Since the Internet is
an open system, any company can create a home page on the World Wide Web in
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order to provide users with product or service information. Users can then
solicit more information and, in some cases, make purchases electronically.
Browsing programs such as Netscape and Mosaic have helped contribute to the
rapid growth of the World Wide Web. The Company expects the World Wide Web
to continue to grow rapidly as more businesses and consumers become aware
of the advantages of communications on the Internet. Neither Netscape nor
Mosaic are products of the Company nor an affiliate of the Company.
USENET News Groups is a network of thousands of computers attached to
the Internet that provide fortune, or news groups, that allow users to
exchange information on a variety of topics of shared interest. Internet
users can seek or provide information on diverse topics ranging from sports
or other hobbies, to job opportunities, to restaurant and travel
suggestions.
In addition, many of the computers connected to the Internet are
repositories for vast and growing amounts of data, graphics, public domain
software and other programs that have been made available to the public.
For example, with an Internet connection, a user can access commercial,
educational and government databases, newspapers, magazines, library card
catalogs, industry newsletters, weather updates, and other information.
Gopher, Archie, Veronica, WAIS and Telnet are Internet products that assist
a user in searching these databases and retrieving data. In addition,
customer support is available on-line by calling GetNet or in several
manuals dedicated to Internet users, to aid in their attempts to utilize
the functions of these products.
The Internet can also be easily used to move electronic files
(including data, programs or text) from one computer to another. This can
be very useful for parties that collaborate on data files where the parties
are separated by great distances. Unlike a transmission via a fax machine,
data transferred over the Internet remains in digital format and does not
need to be re-entered by a receiving party. It can be manipulated and then
re-transmitted to other Internet users.
INTERNET SERVICE PROVIDERS
With the growth and increasing commercialization of the Internet, a
number of companies, including GetNet, have emerged to provide Internet
software and access services. Access providers vary widely in the
geographic coverage, customer focus and levels of Internet access provided
to subscribers. For example, many access providers are regional in scope,
requiring subscribers outside a local or regional calling area to incur
long distance charges. Access providers may also concentrate on certain
types of subscribers such as businesses or individuals which differ
substantially in the type of service and support required.
Providers may also differ according to whether they provide direct or
non-direct access to the Internet. Direct access through Internet
protocols such as SLIP (Serial Line Interface Protocol) or PPP (Point-to-
Point Protocol) enable users to establish direct connections to other
computers on the Internet including Web sites or other users. A number of
the major on-line service providers, such as AOL and Prodigy, currently
offer non-direct access to the Internet which requires users to access the
Internet through a host computer controlled by the service provider. Under
this type of service, users are dependent on the service provider to
determine which Internet applications are available to them. Other
regional and national Internet access providers generally offer direct
Internet access to customers which enables users to access the full range
of Internet resources.
It is GetNet's intention to become a "gateway" Internet provider by
building a fully redundant backbone network of routers, servers, and point-
to-point connections anchored at strategic NAPs (Network Access Points)
located throughout the country. This backbone network gives GetNet the
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ability to resell Internet connections to other ISPs (Internet Service
Providers) and large institutions requiring larger amounts of bandwidth
than can be provided by most ISPs.
Subsequent to May 31, 1996, the Company completed the initial phase of
building its Internet backbone, which is comprised of two Network Access
Points ("NAPs") in Santa Clara, California and Washington, D.C. In
addition, the Company has installed network Points of Presence ("POPs") in
three other cities; Phoenix, Arizona; Baltimore, Maryland; and Pittsburgh,
Pennsylvania. A POP consists of routers that provide access to and egress
from the backbone.
As funds are available the Company intends to increase the numbers of
NAP and POP connections onto its backbone.
Due to limited availability of funds, the Company has not yet been
able to aggressively market its Internet backbone services to commercial
users.
Currently, GetNet provides individuals seeking direct access to the
Internet with front-end software integrated with high quality access
service and 24-hour a day customer support. GetNet has adopted a value
pricing strategy of charging subscribers various flat monthly fees for
Internet connectivity service. GetNet believes that its value pricing
attracts subscribers to and encourages their use of the Internet. Through
GetNet, users can also bypass the complex UNIX commands normally associated
with the Internet through an easy-to-use, point-and-click, Windows-based
graphical user interface.
GetNet's objective is to capitalize on the growing demand for Internet
services and gain market share by aggressively building its subscriber base
of small users, other ISPs and large institutions. The Company believes
that by continuing to expand its subscriber base through providing high
quality software and services it can build a nationwide brand identity,
increase customer loyalty and achieve higher retention rates.
INTERNET MARKETING
The Company's marketing plan is to capitalize on the growing demand
for Internet services and gain market share by building its backbone
network and customer base through direct sales by its own sales personnel
and agents responding to inbound calls and E-mail largely generated by
referrals from other GetNet subscribers as a result of local businesses
advertising their websites located on GetNet's service. The Company and
GetNet will continue to educate and promote Internet services through its
existing base of long distance agents and the hiring of additional direct
sales personnel. The Company believes that by continuing to expand its
backbone network and agreements with third party carriers for global access
to the backbone, it can build an international identity and increase
customer loyalty and achieve higher customer retention rates.
The Company is also focused on providing access services to the
individual subscriber market, which continues to be the fastest growing
segment of the Internet market. In the past, individual users have had
difficulty accessing the Internet because of the difficulty in integrating
software packages and services from different vendors. The Company's
strategy is to establish a high-quality, nationwide name identity in this
market by offering a complete Internet solution comprised of easy-to-use
front-end software, integrated with high quality access service and 24-
hour-a-day customer support.
The Company has adopted a flat rate pricing structure which the
Company believes encourages usage by eliminating subscribers' concerns
about incurring significant hourly charges, which has the potential to
increase
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subscriber retention rates. The Company believes that its value price
point will help attract new subscribers and facilitate rapid penetration of
the individual subscriber market.
The Company is currently developing a high speed, digital network
which will allow it to resell the network's bandwidths to other ISPs and
large institutions. GetNet believes that although the subscriber market
remains viable, the development of websites and business solutions for
larger customers such as E-mail, FTP and World Wide Web advertising will
generate larger profit margins.
LOCAL ACCESS DIVISION
LOCAL ACCESS INDUSTRY OVERVIEW AND COMPETITION
Until 1984, AT&T largely monopolized telephone services in the United
States. Technological developments gradually enabled others to compete
with AT&T. In 1984, AT&T was required to divest its local telephone
systems (the "Divestiture"), which created the present structure of the
telecommunications industry. As part of the Divestiture, AT&T's former
local telephone systems were organized into seven regional Bell operating
companies while AT&T retained its long distance services operations. The
separation of the RBOCs from AT&T's long distance services created two
distinct telecommunications market segments: local exchange and long
distance. The Divestiture decreed direct, open competition in the long
distance segment, but retained regulated monopolies for local exchange
services, provided within geographically defined local access transport
areas ("LATAs").
The local exchange market for telephone services in the United States
is reported to have generated approximately $87.0 billion in revenue in
1992. The market for local exchange services consists of a number of
distinct service components. These service components are defined by
specific regulatory tariff classifications including: (i) local network
services, which generally include basic dial tone charges and private line
services ($39.9 billion of revenue in 1992); (ii) network access services,
which consist of access charges received by local exchange carriers from
long distance carriers ($20.4 billion of revenue in 1992 excluding $6.1
billion of end user access revenue); (iii) long distance network services,
which include the variable portion of charges received by local exchange
carriers for intra-LATA long distance calls ($12.9 billion of revenue in
1992); and (iv) other varied services ($7.7 billion of revenue in 1992).
Before the emergence of competitive access providers such as ICG, there was
virtually no competition in the local exchange markets.
Several factors have promoted competition in the local exchange
market, including: (i) customer demand for an alternative to the local
telephone companies' monopoly, partly stimulated by the development of
competitive activities in the long distance telephone market; (ii)
technological advances in the transmission of data and video requiring
greater capacity and reliability levels than the local telephone companies'
copper-based twisted-pair networks were able to accommodate; (iii) outmoded
local telephone networks resulting from their monopoly position and rate of
return-based pricing structure which provided little incentive to upgrade
their networks; and (iv) the significant access charges that long distance
telephone carriers pay for access to the local telephone networks.
Numerous new entrants to the telecommunications services market now offer
customers diverse service options. The local telephone companies generally
have reacted by restricting interconnection with their networks by new
competitive equipment or service providers. However, government regulatory
policies have increasingly mandated that the local telephone companies
allow these new market entrants to access and utilize the local telephone
networks to provide competing services.
Competitors in the local exchange market, designated as "competitive
access providers" ("CAPs") by the FCC, were first established in the mid-
1980s. In New York City, Chicago and Washington, D.C., newly formed
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companies installed fiber optic cable connecting long distance telephone
carriers' POPs within a metropolitan area and, in some cases, connecting
end users (primarily large businesses and government entities) with long
distance carrier POPs. The greater capacity and economies of scale
inherent in fiber optic cable enabled the CAPs to offer customers less
expensive and higher quality special access and private line services than
the local telephone companies could provide with their more antiquated
copper-based transmission facilities.
The Company believes that the current trend toward enhanced
competition, both at the federal and state levels, will continue to open to
competition an increasing portion of the local exchange market. The
California Public Utilities Commission has agreed to let long distance
carriers enter the local phone market breaking the monopoly held by Pacific
Bell and GTE California. Additionally, the California legislature has
approved local competition and is currently developing rules to govern
competition. This additional competition may stimulate growth in this
market, much as the overall total long distance market grew as competition
increased.
The Company is unable, at this point in the deregulation of the local
market, to accurately comment on the expected level of competition with
respect to fees charged for the origination and termination of local call
traffic, bypassing origination fees charged by BOCs or direct connections
to switches from customer premises. These issues are being discussed and
determined by the various network providers such as AT&T and regulatory
agencies such as the state Public Utilities Commission and Federal
Communications Commission, not by resellers such as the Company.
LOCAL ACCESS STRATEGY
On February 17, 1995 and as amended in March 1996, the Company entered
into a reseller agreement with ICG Access Services, Inc. ("ICG") of Denver,
Colorado. The Company's agreement with ICG allows the Company to enter
into the local access market in select cities currently serviced by ICG
circuits and fiber optic lines. Currently, the Company can provide its
customers with dedicated access services to facilitate the completion of
long distance calls to select long distance carriers via ICG switches.
Deregulation will offer local calling and enhanced local services such as
city wide networking, voice mail and calling features such as call waiting,
call forwarding and conference calling. The Company believes that it will
continue to benefit from the increasing telecommunications demands of
business and government entities that result from computerized data
processing, lower rates for long distance services and growth in voice
communications traffic, automated transaction processing and video
applications.
ICG is one of the largest competitive access providers in the United
States and the leading CAP nationwide in Tier II and Tier III markets
(cities with populations of between 250,000 and 2,000,000) based on the
number of markets served. CAPs enable high volume customers to connect
their internal telephone and data transmission systems directly to their
long distance carriers, thereby bypassing all or most of the local
telephone company's network. ICG's affiliates also provide domestic and
international satellite transmission services and a wide range of network
systems integration services. The combination of these services enables
ICG to transmit voice, video and data from the desktop to locations within
the same building or city, or to cities across the United States and around
the world.
ICG commenced operation of its first competitive access network in
Denver in May 1991 and now operates additional competitive access networks
serving Charlotte, Cleveland, Colorado Springs, Dayton, Louisville,
Phoenix, Nashville, Birmingham, Melbourne/Orlando, Florida and 20 cities
serving the San Francisco and Los Angeles metropolitan areas. A
competitive access network is comprised of fiber optic cables connecting a
Competitive Access Provider's switching equipment to the switching
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equipment of long distance companies and LECs. The competitive access
network is designed to allow an alternate path for routing local and long
distance calls and for the ability to use this alternate routing to compete
in local services market with the LECs. ICG's operating networks have
grown substantially from 1992 to 1994. ICG's competitive access networks
provide network reliability and redundancy and provide services at charges
to the customer which are equal to or lower than those of local telephone
companies. In providing network systems integration services, ICG designs,
engineers and manages the installation and maintenance of its own fiber
optic networks, as well as the local area networks of third-party
customers.
LOCAL ACCESS MARKETING
The Company will attempt to market its local access product through
independent marketing agents. The Company has only attempted limited
marketing activities of ICG products and the Company expects intense
competition from numerous providers such as PCS and cellular phone
companies in the local access markets; however, the Company is unable at
this time to access this form of competition because of the limited number
of PCS licenses granted to date and the ability of the cellular market to
handle both local and long distance calls with the quality demanded by
consumers.
As of September 5, 1996, the Company's current sales of local access
pursuant to the ICG agreement are insignificant.
WIRELESS DIVISION
In September 1995, the Company entered into an agreement with Paging
Network of Arizona, Inc. ("PageNet") to act as a reseller of one way paging
services including tone only, digital and alphanumeric paging services.
The agreement further allows the Company to offer other services offered by
PageNet which includes personal 800 numbers, mini mail, page mail, and
custom greeting features. The Company has had insignificant customer sales
of the PageNet product and has undertaken only minimal marketing activities
in this regard.
GOVERNMENT REGULATION
LONG DISTANCE AND LOCAL ACCESS
The terms and conditions under which the Company provides
telecommunications services are subject to government regulation. Federal
laws and FCC regulations apply to interstate and international
telecommunications, while particular state regulatory authorities have
jurisdiction over intrastate telecommunications.
FEDERAL
The Company is classified by the FCC as a non-dominant carrier. Among
domestic carriers, only AT&T and the LECs are classified as dominant
carriers. As a consequence, the FCC regulates many of their rates, charges
and services to a greater degree than the Company's, although AT&T has
requested that it be reclassified as a non-dominant carrier and the FCC is
reviewing this issue. If AT&T's designation as a dominant carrier were
terminated, certain pricing restrictions and regulatory oversight that
currently apply to AT&T would be eliminated which would make it easier for
AT&T to more aggressively compete directly with the Company for low volume
long distance customers. International carriers may also be classified as
dominant if they are affiliated with foreign carriers with substantial
market share. The FCC has generally not chosen to exercise its statutory
power to regulate the charges, practices, classifications or regulations of
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non-dominant carriers, although it has the power to do so. The FCC retains
the jurisdiction to act upon complaints against any common carrier for
failure to comply with its statutory obligations. The FCC also has the
authority to impose more stringent regulatory requirements on the Company
and change its regulatory classification; however, the Company is unaware
of changes in any FCC policies except as noted below.
Dominant and non-dominant carriers must maintain tariffs on file with
the FCC. Although the tariffs of non-dominant carriers, and the rates and
charges they specify, are subject to FCC review, they are presumed to be
lawful and are seldom contested. Until recently, domestic non-dominant
carriers were permitted by the FCC to file tariffs with a "reasonable range
of rates" instead of the detailed schedules of individual charges required
of dominant carriers. In reliance on the FCC's past practice of allowing
relaxed tariff-filing requirements for non-dominant domestic carriers, the
Company and many of its competitors did not maintain detailed rate
schedules for domestic offerings in their tariffs. As a domestic non-
dominant carrier, the Company is permitted to make tariff filings on a
single day's notice and without cost support to justify specific rates.
The Company could be held liable for damages for its failure to do so, and
such an outcome could have a material adverse effect on it. Resale
carriers are also subject to a variety of miscellaneous regulations that,
for instance, govern the documentation and verifications necessary to
change a consumer's long distance carrier, limit the use of "800" numbers
for pay-per-call services, require disclosure of operator services and
restrict interlocking directors and management.
To date, the FCC has exercised its regulatory authority to control
rates only with respect to the rates of dominant carriers, and it has
increasingly relaxed its control in this area. As an example, although
AT&T is classified as a dominant carrier, the FCC has exempted most of its
services, including virtually all of the carrier's commercial and "800"
services, from rate regulation because the FCC believes that these services
are subject to adequate competition. Similarly, the FCC has required
reduced local transport charges (i.e., the fee for use of the LEC
transmission facilities connecting the LEC's central offices and the
interexchange carrier's access point). In addition, the LECs are being
afforded a degree of pricing flexibility in setting access charges where
adequate competition exists.
The RBOCs are currently prohibited from providing inter-LATA
interexchange telecommunication services. Several motions to remove or
modify this restriction, in whole or in part, are currently pending before
the United States District Court for the District of Columbia. Many
industry observers believe that legislation will be enacted which will
authorize RBOCs to provide inter-LATA interexchange telecommunication
services, and separate bills to this effect have been passed by the House
of Representatives and Senate in 1995. The separate bills will be
considered by a conference of the House of Representatives and Senate.
Such legislation, if passed, may or may not include safeguards against
anti-competitive conduct. Anti-competitive conduct could result from an
RBOC taking advantage of its access to all customers on its existing
network as well as its potentially lower costs related to and control of
the facilities used for termination and origination of calls within its
territory. The Company is unable to predict whether any particular form of
legislation will be enacted and, if enacted, the impact that any such
legislation would have on the Company's business and prospects.
In February 1996, Congress passed legislation which will substantially
deregulate the telecommunications industry. The bill will have far-
reaching impact on the telecommunications industry and the Company's
business in particular. The bill will allow the seven regional Bell
companies into the long distance phone business after they have proven to
the FCC that they have opened their local phone networks to new
competitors. The Company believes that the increased competition will have
the effect of lowering prices overall and may provide the Company the
ability to offer lower costs to its customers. The bill will affect local
access service by opening local phone markets to new competitors such as
AT&T, MCI and cable TV companies and the BOC's would lose control of their
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current monopoly over local phone customers. Prices may rise initially as
competitors may not have the ability to spend the large amount of funds
necessary to build their own networks and consequently they will be forced
to lease Bell lines and resell service instead. State regulation will
still dictate how the new local access and rates take place. The Company
will face increased competition but for the short term is able to utilize
its ICG relationship to enter the local access market.
STATE
The intrastate long distance telecommunications operations of the
Company are also subject to various state laws and regulations, including
prior certification, notification and registration requirements.
Currently, the Company is certified and tariffed where required to provide
intrastate service to customers throughout the United States except for
five states. The Company is subject to and complies with varying levels of
regulation in the states in which it provides intrastate
telecommunications. The vast majority of the states require the Company to
apply for certification to provide telecommunication services, or at least
to register or to be found exempt from regulation, before commencing
intrastate service. The vast majority of states also require the Company
to file and maintain detailed tariffs listing their rates for intrastate
service. Many states also impose various reporting requirements and/or
require prior approval for transfers of control of certified carriers,
assignments of carrier assets, including customer bases, carrier stock
offerings, mergers and acquisitions and incurrence by carriers of
significant debt obligations. Certificates of authority can generally be
conditioned, modified, canceled, terminated or revoked by state regulatory
authorities for failure to comply with state law and/or the rules,
regulations, and policies of the state regulatory authorities. Fines and
other penalties, including the return of all monies received for intrastate
traffic from residents of a state, may be imposed for such violations. The
Company believes it is currently in compliance with applicable state
regulations and has filed for the ability to sell services in the states
necessary to sell its services.
INTERNET SERVICES
The Company's Internet services are not currently subject to direct
regulation by any government agency, other than regulations applicable to
businesses generally, and there are currently few laws or regulations
directly applicable to access to or commence on the Internet. However, due
to the increasing popularity and use of the Internet, it is possible that
a number of laws and regulations may be adopted with respect to the
Internet, covering issues such as user privacy, pricing and characteristics
and quality of products and services. For example, the Exon Bill (which
was recently approved by the Senate) would prohibit distribution of
obscene, lascivious or indecent communications on the Internet. The
adoption of any such laws or regulations may decrease the growth of the
Internet, which could in turn decrease the demand for the Company's
products and increase the Company's cost of doing business or otherwise
have an adverse effect on the Company's business, operating results or
financial condition. Moreover, the applicability to the Internet of
existing laws governing issues such as property ownership, libel and
personal privacy is uncertain. Further, due to the encryption technology
contained in the Company's products, such products are subject to U.S.
export controls. There can be no assurance that such export controls,
either in their current form or as may be subsequently enacted, will not
limit the Company's ability to distribute products outside of the United
States or electronically.
The new telecommunications bill includes provisions that would
prohibit online services or users from transmitting indecent material
without restricting minors access. Online providers are required to make
a "good faith" effort to provide users with a means to screen out
pornographic material. The Company, as a result, will be required to
develop screening programs; however, the Company is optimistic that the
deregulation may provide lower online prices for its customers.
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EMPLOYEES
As of September 5, 1996, the Company and GetNet had thirty (30) full
time employees, including Michael J. Canney, the Company's President,
Chairman of the Board and Chief Executive Officer; David J. Smith, the
Company's Chief Financial Officer and Secretary/Treasurer; and four (4)
individuals responsible for sales.
ITEM 2. PROPERTIES.
- -------------------
The Company currently leases office space consisting of 3,000 square
feet at 4110 N. Scottsdale Road, Suite 170, Scottsdale, Arizona 85251 at
approximately $5,000 per month pursuant to a three (3) year lease. The
Company believes that its facilities are adequate to meet its current
needs. GetNet, the Company's wholly-owned subsidiary, leases office space
at 7325 North 16th Street, Suite 140, Phoenix, Arizona 85020 under a
noncancellable operating lease. In April 1996, GetNet entered into a three
(3) year extension of its lease for approximately $2,000 per month. In
addition, in June 1996 GetNet entered into a five (5) year, 1,700 square
foot lease at $2,800 per month for its network operations center.
ITEM 3. LEGAL PROCEEDINGS.
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The Company is not a party to any material legal proceedings and no
such proceedings are known to be contemplated except:
* A lawsuit has been filed in the Superior Court of the State of
Arizona, Maricopa County by the Company against Jonathan Miller
and Janeece Miller, husband and wife, on August 30, 1996. The
complaint details various causes of action against Mr. Miller, in
his capacity as a former Officer and Director of the Company.
The Company has alleged Mr. Miller is responsible to the Company
for $360,835.90 in damages to the Company. Mr. Miller has until
September 20, 1996 to file an answer. The Company is, and will
vigorously pursue this legal action.
* Janeece Miller, the wife of Mr. Miller, filed a request with the
American Arbitration Association regarding an alleged breach of
her employment agreement. She has made a claim for $32,500 plus
attorney's fees and costs as part of her severance package. This
request was filed with the Arbitration Association on July 31,
1996 and the Company has responded, consenting to the arbitration
and contesting the allegations in the complaint, asserting that
Ms. Miller voluntarily resigned her employ with the Company and
that the terms of the severance package do not apply in her
situation. A hearing will be set and the Company will defend the
complaint.
* Subsequent to May 31, 1996, an unknown party fraudulently charged
over $1,000,000 in long distance charges on the Company's
account. The Company is currently investigating the matter and
has contacted the carrier, AT&T, who denies any responsibility.
The Company believes it has recourse in the matter, and will not
be held responsible for these charges, but the outcome of this
matter cannot be predicted at this time.
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ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
During the fourth quarter of the most recently completed fiscal year,
the Company did not submit any matter to a vote of its shareholders. It is
anticipated that the Company will hold its Annual Meeting of Shareholders
in the Fall of 1996 to elect Directors and vote on the Arcada business
combination.
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PART II
ITEM 5. MARKET PRICE OF THE REGISTRANT'S COMMON STOCK AND RELATED SECURITY
- ---------------------------------------------------------------------------
HOLDER MATTERS.
- --------------
(a) MARKET INFORMATION.
The Company's Public Shares and Warrants were approved for listing on
the Nasdaq SmallCap Market-SM, effective May 17, 1996, and trade under the
symbols "TONE" and "TONEW."
The range of high and low bid quotations for the Company's Public
Shares since listing on Nasdaq were obtained from the National Quotation
Bureau and are provided below. The volume of trading in the Company's
Common Stock has been limited and the bid and ask prices as reported may
not be indicative of the value of the Public Shares or the existence of an
active trading market. These over-the-counter market quotations reflect
inter-dealer prices without retail markup, markdown or commissions and may
not necessarily represent actual transactions.
Common Warrants
------ --------
1996 Fiscal Year High Bid Low Bid High Bid Low Bid
---------------- -------- ------- -------- -------
Fourth Quarter
(from May 17, 1996) . . . . . . . $7.88 $5.13 $4.75 $2.00
1997 Fiscal Year
----------------
First Quarter
(through September 5, 1996) . . . $7.38 $6.25 $4.50 $3.13
On September 5, 1996, the last reported bid and asked prices for the
Public Shares were $6.50 and $6.88 respectively, and the last reported bid
and asked prices for the Warrants were $3.75 and $4.75, respectively.
(b) HOLDERS.
The number of record holders of the Company's Common Stock on
September 5, 1996 was approximately 750.
(c) DIVIDENDS.
The Company has never paid dividends with respect to its Common Stock
and currently does not have any plans to pay cash dividends in the future
as it intends to retain future earnings to finance the growth of the
business. There are no contractual restrictions on the Company's present or
future ability to pay dividends. Future dividend policy is subject to the
discretion of the Board of Directors and is dependent upon a number of
factors, including future earnings, capital requirements and the financial
condition of the Company.
ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS
- ---------------------------------------------
The following discusses the financial results for the fiscal year
ended May 31, 1996 and the ten month period ended May 31, 1995, and should
be read in conjunction with the financial statements and notes thereto
under Item 13 of this report.
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GENERAL
The Company's net revenues were approximately $2.2 million for the
year ended May 31, 1996 and $2.0 million for the ten months ended May 31,
1995.
As discussed in "Commitments," the Company has, in the past, entered
into sales volume commitments with its service providers which have
exceeded its current sales volumes. The Company has renegotiated two
significant commitments under which it was experiencing substantial
shortfalls. Under the revised agreements, the Company's future commitment
for these contracts has been eliminated. The Company, however, has a
continuing commitment with AT&T to provide long distance service of
$1,800,000 annually, which, as of year end, it was satisfactorily meeting.
However, subsequent to year end, monthly revenues under this commitment
have declined and the Company will be unable to continue to meet this
commitment unless related revenues increase. Therefore, an additional loss
accrual may be recorded in the fiscal year ending May 31, 1997. In
addition, the Company has service commitments, primarily with WilTel, to
lease a minimum of $70,000 per month of telecommunication circuits in
connection with its Internet backbone. This amount increases to $95,000 in
January 1997. The Company's revenues currently do not support this
commitment. There can be no assurances that the Company's revenues will be
sufficient to cover the Company's monthly commitments.
The Company's financial statements have been prepared assuming that
the Company will continue operating as a going concern, which contemplates
the realization of assets and liquidation of liabilities in the normal
course of business. The Company's ability to continue as a going concern
is dependent upon several factors, including meeting the terms of its
commitments and achieving and maintaining profitable operations. As a
result of the above service commitments and continuing operating losses,
the Company's independent auditors included a "going concern" paragraph
with respect to the audited financial statements as of and for the year
ended May 31, 1996.
THE GETNET ACQUISITION
In November 1995, the Company acquired all the outstanding stock of
GetNet International, Inc. ("GetNet") of Phoenix, Arizona in exchange for
400,000 shares of the Company's Common Stock. GetNet is a provider of
Internet access services to individuals and businesses in Arizona and other
parts of the United States. GetNet is in the process of constructing a
national Internet backbone with Points of Presence ("POP's") in Phoenix,
Arizona; Santa Clara, California; Pittsburgh, Pennsylvania; Baltimore,
Maryland; and Washington, D.C. This backbone is anticipated to be in
service in September 1996. GetNet also offers subscribers complete
Internet access consisting of front-end software, integrated with high
quality access service and 24-hour customer support. GetNet's high-speed
digital network provides subscribers with direct access to the full range
of Internet applications and resources including E-mail, World Wide Web
sites, USENET news groups and database information (including graphics,
data and public domain software). GetNet's front-end software features a
point-and-click graphical user interface providing subscribers with easy-
to-use access to the Internet's applications and resources. Revenues from
GetNet for the period from its acquisition on November 1, 1995 to May 31,
1996 were $287,000.
CHANGE OF MANAGEMENT
In April 1996, Mr. Vaughan, the Company's former Chairman of the Board
and Chief Executive Officer, brought to the attention of the Company's
auditors a previously undisclosed letter agreement signed by Mr. Miller
(the Company's former President and Director), with a significant sales
agent, which provided for a retroactive increase in the sales agent's
commissions to 50% from 32%. This agreement and its potential
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ramifications has subsequently been thoroughly reviewed by the Company's
Board of Directors and the following actions were taken on behalf of the
Company.
The Board of Directors, with the concurrence and support of Messrs.
Miller and Vaughan, determined it appropriate to bring in an experienced
manager to institute tighter controls in the areas of finance, overhead,
carrier commitments and corporate governance. Accordingly, Mr. Michael
Canney was appointed President, Chairman of the Board and Chief Executive
Officer. Mr. Miller resigned as a Director and Officer, and Mr. Vaughan
also resigned as a Director and Officer, but continues to serve as a
consultant to the Company in locating and negotiating potential future
mergers and acquisitions. In connection with their resignation, their
employment agreements were terminated. Subsequently in June 1996, Mr.
Vaughan entered into an eighteen month consulting contract with the
Company. (See "Commitments").
The Company also obtained an updated agreement with the sales agent
which substantially reaffirmed the Company's prior sales commission
arrangement with the sales agent.
In September 1996, the Company terminated Stephen Shearin and Jonathan
Mazinter, two (2) Officers of GetNet, who were also two (2) of the three
(3) original founding shareholders of GetNet. The Company is unable at
this time to predict the ultimate effect of these terminations. As of the
date of this report, Mr. Shearin remains a Director of the Company.
RESULTS OF OPERATIONS
THE COMPANY - FOR THE YEAR ENDED MAY 31, 1996 COMPARED TO THE TEN MONTHS
ENDED MAY 31, 1995.
Revenue from operations for the year ended May 31, 1996 was
$2,238,000, compared to revenues of $1,952,000 during the ten months ended
May 31, 1995, which had two fewer months than fiscal 1996 due to a change
in year end in 1995. Therefore, monthly revenues actually decreased for
the year ended May 31, 1996 based on a comparable twelve month period. The
Company currently has an "SDN" contract which extends through July 1999
with AT&T. Due to competition within the telecommunications industry the
price the Company is required to pay AT&T has, subsequent to May 31, 1996,
become less competitive than the current market price for comparative
service. The Company is hopeful it will be able to renegotiate its
contract with AT&T to obtain a more favorable rate per minute and
commitment level, and replace its existing SDN contract. However, there is
no assurance that the Company will be able to ultimately renegotiate its
existing contract. If the Company is unable to re-negotiate its contract
with AT&T, the Company intends to find another long distance reseller with
a substantial SDN base and negotiate a favorable transfer of the Company's
SDN distance base and obligations to that SDN reseller.
The Company expects to experience most of its future growth through
acquisitions of long distance customer bases and regional switch-based
carriers as well as through the growth of its Internet services, especially
its backbone facilities and services which will be in service September
1996.
Cost of sales for the year ended May 31, 1996 was $1,406,000,
resulting in a gross margin of approximately $832,000 or 37% of net
revenue. The gross margin for the ten months ended May 31, 1995 was
$642,000, approximately 33% of net revenue. The gross margin percentage
has remained relatively constant as the Company has achieved the highest
margin currently allowed on its AT&T contract for incremental sales. The
AT&T contract is structured on a tiered discount with the more volume
achieved, the greater the discount. The Company's current tier structure
is as follows: on the first $10,000 the Company bills, a discount of 10% is
generated; between $10,000 and $75,000 that the Company bills a discount of
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32% is generated; billings above $75,000 the Company generates a discount
of 35%.
Financial statements ended May 31, 1996 reflect the inclusion of seven
months operations of GetNet which was acquired effective November 1, 1995.
GetNet's sales were $287,000 for these seven months with cost of sales of
$122,000. GetNet is still a development stage company and has not yet
begun to develop its market.
Additionally, in October 1995 the Company entered into a carrier
agreement with WilTel that allows the Company to provide a full range of
long distance, calling card and point-to-point services at more favorable
rates than are currently being experienced. This contract will also allow
the Company to order ATM Permanent Virtual Circuits ("PVC") for the GetNet
backbone network. The Company could realize greater volume discounts in
the future as a result of these circuits assuming the Company meets its
minimum commitments under its WilTel agreement (see "Commitments") and its
AT&T long distance commitment (see prior comment regarding the declining
service on AT&T). The new contract will allow the Company to function as
a long distance carrier as compared to being a long distance reseller. The
new contract allows the Company to access the WilTel network and offer
services at a flat rate per minute. As a result the Company could directly
bill its customers for long distance services, however, the Company intends
to leave the billing option open in order to see what billing facilities a
merger or acquisition candidate is using.
Revenues through May 31, 1996 on WilTel have been insignificant,
however, as the Company is able to further market its Internet services,
revenues on WilTel are expected to substantially increase.
The Company has entered into a contract with ICG Access Services, Inc.
("ICG") of Denver, Colorado to act as the reseller of ICG services which
include the ability to connect internal telephone and data transmission
services directly to long distance carriers, thus allowing the Company to
bypass part or all of the local telephone company's network. ICG's
affiliated companies also provide domestic and international satellite
transmission services and a wide range of network integration system
services. The Company believes it will benefit from the agreement with ICG
because it allows the Company the ability to offer its present and future
customers competitive rates and services in the local access markets
currently dominated by the Bell companies ("Baby Bells") and in the process
achieve additional customers for its long distance services. Due to the
lack of capital, the Company has not been able to actively market ICG
services, therefore its related revenues to date have not been significant.
The Company intends to pursue its relationship with ICG for future local
access endeavors, however, at present this is not a major focus of activity
for the Company.
Selling expenses increased to $620,000 or 28% of net revenues for the
year ended May 31, 1996 from $337,000, or approximately 17% of net revenues
for the prior ten month fiscal year. The increase in selling expenses as
a percent of revenue is attributed to the higher commissions earned by one
of the Company's agents that contributed a significant volume of customer
usage. The sales agent, TMO Communications, Inc. of Phoenix, Arizona
("TMO"), accounted for approximately 36% of revenues for the year ended May
31, 1996 and receives commissions of approximately 32%. At this level, the
Company does not receive gross margin on sales originated by this agent,
but as a result, experiences greater gross margin on other Company revenues
due to volume discounts by AT&T. In addition, in April 1996, the Company
agreed to pay TMO an additional $75,000 to settle past misunderstandings
between the Company and TMO with respect to the amount of commissions due
TMO. Management believes the selling expenses attributed to Company agent
commissions will decrease as a percentage of net revenues if a new contract
with AT&T is negotiated; however, selling expenses in general will increase
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because of marketing efforts and variety of services offered. GetNet's
selling expenses were $17,000 for the period ended May 31, 1996, or 6%, of
its sales.
Under the Company's current contract with independent sales agents for
reselling long distance services, commissions are paid as long as the
Company receives revenues from the customer. The Company intends to revise
this arrangement for new agents to provide for continuing commission
payments only if certain sales levels are maintained, however, no such
contracts have been entered into.
For marketing GetNet services, the Company has four full time sales
agents on staff. These persons are paid a combination of salary and
commissions.
General and administrative expenses increased to $1,853,000 or 83% of
net revenue for the year ended May 31, 1996 compared to $507,000 or 26% for
the ten months ended May 31, 1995. During fiscal 1996, the Company paid
increased salaries and benefits to its employees of approximately
$1,074,000 compared to $374,000 in fiscal 1995, primarily as a result of
additional employees, including GetNet employee related expense since
November 1, 1995 (date of acquisition) of approximately $311,000. The
remaining $646,000 increase in general and administrative costs between the
two periods is mainly due to increased office and travel costs associated
with the anticipated growth of the Company and increased internal costs
associated with the Company's offerings of securities, attempted
acquisitions and the inclusion of GetNet's other general and administrative
expense from November 1, 1995, which totaled $115,000. Also included in
general and administrative expense is bad debt expense, which increased by
$162,000 in fiscal 1996, and amortization expense, which increased by
approximately $100,000 related to the GetNet acquisition. Since May 1996,
the Company has reduced its number of personnel due to decreasing revenues.
Total general and administrative expense, relative to fiscal 1996 is,
however, expected to increase due to compensation commitments to Officers
of the Company and a contract entered into with a significant consultant
(who previously was the Chairman of the Board and an Officer) of $15,000
per month. See "Commitments."
The Company also incurred $471,000 of expense under its agreement with
ICG during the year ended May 31, 1996; only $32,000 was incurred in the
ten month period ended May 31, 1995, as the contract was entered into in
late February 1995. This amount is recorded as a period expense under
operating expenses, as the Company experienced insignificant revenues
associated with this contract. Such revenues (approximately $34,000) have
been offset against the expense. See "Commitments."
The Company also expensed $400,000 during the year ended May 31, 1996
based on a settlement of a past contingent liability on failing to meet its
prior minimum commitment for selling "800" services with AT&T. When the
Company pays this liability, it will no longer have a minimum future
commitment level for "800" services. See "Commitments."
Interest expense increased from $12,000 in fiscal 1995 to $172,000 in
fiscal 1996 primarily as a result of 70,000 shares of common stock being
issued after year end to satisfy an outstanding debt of $210,000. The
difference of approximately $250,000 between the then market price of
common stock and the related debt is being expensed in operations over the
period the note was outstanding. For the year ended May 31, 1996, $125,000
was expensed and the balance will be expensed in the first quarter of
fiscal 1997.
In January 1996, the Company abandoned a planned acquisition of
another reseller of telecommunication services. For the year ended May 31,
1996, the costs associated with this planned acquisition of $115,000 have
been expensed in operations.
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The Company had a net loss of ($2,802,000) for the year ended May 31,
1996. For the ten months ended May 31, 1995, the Company had a net loss of
($294,000). The increase in net loss between periods is directly
attributed to the expense associated with not meeting minimum service
commitment levels with its carriers, the significant increase in selling,
general and administrative costs in fiscal 1996 which included indirect
costs associated with the cost of raising additional capital, hiring of
additional personnel, and other reasons discussed above.
THE COMPANY - FOR THE TEN MONTHS ENDED MAY 31, 1995 COMPARED TO THE YEAR
ENDED JULY 31, 1994.
In fiscal 1995, the Company changed its year end to May 31. The
comparisons included herein are for the ten months ended in fiscal 1995
compared to the twelve months in 1994.
Revenue from operations for the ten months ended May 31, 1995 was
$1,952,000. Revenue increased $491,000 from revenues during the fiscal
year ended July 31, 1994 or approximately 34% over fiscal 1994. The
increase in revenues is attributed to sales of new customer accounts and
increased efforts on the part of management to stimulate sales production
from its marketing agents and in particular the addition of a new selling
agent in August 1994 as discussed below.
Cost of sales for the ten months ended May 31, 1995 was $1,310,000
which is reflective of the increased revenue for that period, resulting in
a gross margin of approximately 642,000 or 33% of net revenue. The gross
margin for fiscal 1994 was $287,000 or approximately 20% of net revenue.
The increase in gross margin is the result of the Company attaining higher
levels of discount because of increased volume on its AT&T contract. Also
in July 1994 the Company's contract with AT&T was upgraded to provide a
greater discount. The AT&T contract is structured on a tiered discount
with the more volume achieved, the greater the discount.
Selling expenses increased to $337,000 or 17% of net revenues for the
ten months ended May 31, 1995 from $135,000, or approximately 9% of net
revenues for the prior year. The increase in selling expenses as a percent
of revenue is attributed to the higher commissions earned by one of the
Company's agents that contributed a significant volume of customer usage
(as discussed below). Management believes the selling expenses attributed
to Company agent commissions will decrease as a percentage of net revenues
if the new contract with AT&T is in effect; however, selling expenses in
general will increase because of marketing efforts and variety of services
offered.
In August 1994, the Company entered into an agreement with an
independent sales agent, TMO Communications, whereby the agent receives
commissions of approximately 32% on sales it originates. As previously
indicated, at this level, the Company realized no direct profit during
fiscal 1995 from the sales generated by the agent. For the ten months
ended May 31, 1995, the sales originated by the agent have accounted for
42% of Company sales. Also during this period, the Company has recorded a
related expense to the agent of approximately $265,000.
The Company also uses other independent agents who directly contact
potential customers and are paid on a commission basis as long as the
Company receives revenue from that customer. Management believes it may
decrease its cost of sales in the upcoming year if the Company bills its
customers directly, and if a new contract can be negotiated with AT&T.
General and administrative expenses increased to $507,000 or 26% of
net revenue for the ten months ended May 31, 1995 compared to $292,000 or
20% for the year ended July 31, 1994. The increase includes $56,000 of
non-monetary consideration recorded during 1995 in connection with the
issuance of 160,000 shares of Common Stock by the Company to an
Officer/Director valued at $40,000 (discussed below) and shares of Common
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Stock which were granted by the Company's major shareholders to certain
non-employees for minor services provided to the Company generally during
the period ended May 31, 1995. During 1995, the Company paid increased
salaries and benefits to its Officers of $255,000 (including Common Stock
discussed above valued at $40,000) compared to $98,000 in 1994, principally
due to the addition of one new Officer and Director. Pursuant to the
Company's employment agreement with a former Officer/Director, $50,000 has
also been expensed under a $90,000 commitment pursuant to his employment
agreement which was to be paid from proceeds of the public offering. When
the Officer/Director resigned in April 1996, he agreed to forgo payment of
the $90,000. This amount was in addition to the current salary expense.
Employment expense to the Company's Officers and Directors is expected to
decrease in the future based on the resignation of two Officers and
Directors in April 1996.
The Company had a net loss of ($294,000) for the ten months ended May
31, 1995. For the year ended July 31, 1994, the Company had a net loss of
($154,000). The increase in net loss between periods is directly
attributed to the significant increase in general and administrative costs
in 1995 which included the indirect costs associated with the cost of
raising additional capital, hiring of additional personnel and reasons
discussed above.
LIQUIDITY AND CAPITAL RESOURCES
The Company's cash position at May 31, 1996 was $5,278,000 and net
working capital was $3,365,000. The Company's cash position reflects the
receipt of the Company's public offering in the sale of its Common Stock
completed in May 1996. Included in the Company's current liabilities are
$186,000 associated with an initial payment from AT&T when its long
distance contract was initiated plus an additional $400,000 obligation due
to AT&T in settlement of not meeting past service commitments. Also
included in the Company's current liabilities are approximately $180,000 in
accrued network costs due ICG. Subsequent to May 31, 1996, $432,000 of
these commitments have been paid, including $180,000 which was subsequently
satisfied by the issuance of 45,000 shares of Common Stock.
Cash used in operations for the Company totaled ($1,891,000) during
the year ended May 31, 1996 as compared to $206,000 provided by operations
for the ten months ended May 31, 1995. This increase in cash outflows can
be primarily attributed to a loss from operations, partially offset by the
current period non-cash expenses resulting from an increase in the bad debt
allowance and the aborted acquisition of Telcom. The Company also
increased collection efforts which reduced accounts receivable and paid
certain payables from proceeds of the public and private offerings
resulting in a decrease in accounts payable. Accrued expenses increased as
a result of an increase in the Company's obligation to ICG and the
settlement of the AT&T commitment liability discussed above.
Cash flows used in investing activities consisted primarily of
additions to equipment of $101,000 in the year ended May 31, 1996. The
Company also incurred acquisition costs of $25,000 related to the GetNet
acquisition in fiscal 1996 and $95,000 in fiscal 1995 related to the NTM
acquisition which was later canceled.
Cash flows from financing activities were $6,783,000 during the year
ended May 31, 1996 as compared to $343,000 for the ten months ended May 31,
1995. Cash flows during the year ended May 31, 1996 were primarily
attributed to the completion of receipt of proceeds from the issuance of
Common Stock, but was partially offset by costs incurred in connection with
the Company's private and public stock offerings. In May 1996, the Company
completed its public offering of its Common Stock whereby it sold 1,725,000
shares of Common Stock and Warrants and received net proceeds of
approximately $5,830,000. In November 1995, the Company completed a
private placement of its Common Stock whereby it sold 350,000 shares of
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Common Stock. The net proceeds of approximately $600,000 from this
offering were used primarily to cover costs associated with the Company's
public offerings and other working capital needs. Cash flows used in
financing activities during the year ended May 31, 1996 were primarily
attributed to debt repayments.
Under the Company's current arrangement with AT&T, customer billings
and collections are performed by AT&T. Accounts receivable represents the
amount the Company's customers owe for actual usage. However, the amount
the Company will receive from AT&T will be offset by the payable due to
AT&T for the cost of providing the service, which is reflected as an
account payable in the financial statements. The net of the receivable and
payable is the gross margin the Company receives. AT&T is currently
responsible for maintaining the Company's account receivable accounts and
withholds payments to the Company for customer accounts over 30 days past
due. Such amounts withheld from the Company are offset by the gross margin
otherwise payable to the Company.
COMMITMENTS
OPERATING LEASES
The Company leases its office facilities and certain equipment under
non-cancelable operating leases. Rent expense for the year ended May 31,
1996 was $63,000 and for the ten months ended May 31, 1995 was $26,000.
For fiscal 1997, total operating lease commitments total approximately
$118,000 as of May 31, 1996.
CAPITAL LEASES
The Company leases certain equipment which have been recorded as
capital leases. Obligations under these capital leases have been recorded
at the present value of future minimum lease payments, discounted at rates
ranging from 19.6% to 23%. The capitalized cost of $231,000 less
accumulated amortization of $31,000 at May 31, 1996 is included in property
and equipment.
The future minimum lease payments under the capital leases total
approximately $264,000 including interest, with payments extending through
2001.
TELECOMMUNICATIONS CIRCUIT LEASES
The Company leases certain telecommunications circuits, primarily in
connection with its Internet backbone, under non-cancelable operating
leases. Lease expense for both the ten months ended May 31, 1995 and for
the year ended May 31, 1996 was nominal as most of these leases were
entered into subsequent to May 31, 1996. As of August 9, 1996, future
minimum lease obligations under leases with lease terms in excess of one
year are as follows:
For the Year Ended May 31,
--------------------------
1997 $ 647,000
1998 1,129,000
1999 1,129,000
2000 549,000
2001 43,000
Thereafter 205,000
----------
$3,702,000
==========
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Included in the above amounts is a three-year commitment beginning in
January 1997 with WilTel, whereby the Company is required to lease a
minimum of $70,000 per month of telecommunication circuits. Under this
agreement, all costs incurred are not only applied dollar-for-dollar
against this commitment, but are also concurrently credited 1-1/2 times
actual usage against the Company's long distance service commitment
described below.
The Company is obligated to pay for actual usage of telecommunication
circuits, which for August 1996 approximated $70,000. This amount will
increase to approximately $95,000 in January 1997, when the minimum
commitment level increases, irrespective of related revenue from the
Company's Internet users, which was nominal for August 1996.
SERVICE COMMITMENTS
The Company has signed the following agreements:
* Five-year commitment beginning August 1, 1994 with AT&T Software
Defined Network ("SDN") to sell $1.8 million annually.
* A commitment (as revised) beginning November 30, 1994 with AT&T
to sell $1.2 million of "800" service annually, which will be
terminated upon the payment to AT&T of $586,000.
* In late October 1995, the Company entered into a two-year
commitment with WilTel to be a reseller of its long distance
services. Minimum commitments of $50,000 per month commence in
August 1996 of this agreement.
* In September 1995, the Company entered into an immaterial
financial commitment with PageNet for the purchase of pagers.
If the Company does not meet the commitment level under its service
agreements, it will be subject to penalties that are dependent upon the
degree to which the Company is short of these commitments. Additionally,
if AT&T terminates the contract due to the Company's failure to pay for the
commitment charges provided therein, the contract provides that the Company
will be liable for the minimum usage commitment charges to be incurred over
the remaining term of the contract. In general, the Company is also
required to meet the annual commitment or pay the difference. As
previously indicated, at year end the Company was meeting its SDN
commitment. The Company is hopeful it will be able to renegotiate this
contract for more favorable rates; however, the Company has not entered
into any negotiations with AT&T and there can be no assurance that it will
be successful in this regard. Competition in the long distance industry
has made meeting this commitment more difficult after year end. Such that,
unless related revenues increase, the Company will not be able to meet this
commitment in the forthcoming fiscal year. In which event, the Company
would be required to record an estimated loss accrual, based on estimated
future losses for the term of the agreement.
The "800" service commitment exceeded the Company's current sales
volume. Therefore in April 1996, the Company negotiated a release under
this commitment, whereby it agreed to pay AT&T the $186,000 the Company
initially received upon signing its contract plus $400,000 payable at
$33,333 per month beginning in June 1996. If it does not meet this
commitment it will be obligated to pay its shortfall of approximately
$1,027,000 less amounts previously paid from the proceeds of this offering.
The $186,000 has subsequently been paid and the Company is current on its
monthly payments. Revenues associated with the "800" service has been
insignificant.
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The Company has a commitment with WilTel to begin in August 1996 to
sell $50,000 per month of long distance services. This currently
substantially exceeds the Company's current level of service. The Company
will effectively meet this commitment as a result of its lease commitments
for telecommunication circuits with WilTel.
EQUIPMENT PURCHASES
Subsequent to May 31, 1996, the Company has purchased certain routers,
modems and terminal servers for the "Internet backbone" which totalled
approximately $500,000. The Company has no other significant commitments
to purchase equipment.
EMPLOYMENT AND CONSULTING AGREEMENTS
In August 1995, the Company entered into employment agreements with
Robert C. Vaughan and Jonathan Miller, former Officers and Directors of the
Company. The agreements provided for base salaries per year of $120,000
and $80,000, respectively, and options to purchase 50,000 shares of the
Company's Common Stock the first year and 50,000 shares the second year at
$5.00 per share. In addition, Mr. Vaughan was to receive $90,000 from
proceeds of the public offering for services rendered pursuant to his
employment agreement. The agreements were terminated in April 1996 when
Messrs Vaughan and Miller resigned as Officers and Directors. While they
no longer receive salaries, they did retain their option rights.
Michael J. Canney, the Company's President, deemed it advisable that
Mr. Vaughan continue as a consultant to the Company pursuant to an amended
consulting agreement dated June 5, 1996, and is to be paid a monthly fee of
$15,000 for a period of eighteen months. In addition to being reimbursed
for expenses, Mr. Vaughan will be paid on a standard "Lehman-scale" for
successful mergers for which he is responsible. The scale is computed
based on valued at 5% of the first $1,000,000; 4% of the second $1,000,000;
3% on the third million; 2% of the fourth million; and 1% of all over four
million of the total value of the acquisition.
Mr. Michael Canney became the new President and Chief Executive
Officer in April 1996 under a written employment agreement which he will
receive an annual salary of $120,000 plus options for 100,000 shares of
Common Stock exercisable at $4.00 per share. The Company also has
employment agreements with certain other employees of the Company. Total
annual commitments under these employment agreements in fiscal 1997 are
approximately $480,000.
CONTINGENCY
Subsequent to May 31, 1996, an unknown party fraudulently charged over
$1,000,000 in long distance charges on the Company's account. The Company
is currently investigating the matter and has contacted the carrier, AT&T,
who denies any responsibility. The Company believes it has recourse in the
matter, and will not be held responsible for these charges, but the outcome
of this matter cannot be predicted at this time.
IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS
In March 1995, the Financial Accounting Standards Board issued a new
statement titled "Accounting for Impairment of Long-Lived Assets." This
new standard is effective for years beginning after December 15, 1995 and
would change the Company's method of determining impairment of long-lived
assets. Although the Company has not performed a detailed analysis of the
impact of
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this new standard on the Company's financial statements, the Company does
not believe that adoption of the new standard will have a material effect
on the financial statements.
In October 1995, the Financial Accounting Standards Board issued a new
statement titled "Accounting for Stock-Based Compensation" (FAS 123). The
new statement is effective for fiscal years beginning after December 15,
1995. FAS 123 encourages, but does not require, companies to recognize
compensation expense for grants of stock, stock options, and other equity
instruments to employees based on fair value. Companies that do not adopt
the fair value accounting rules must disclose the impact of adopting the
new method in the notes to the financial statements. Transactions in
equity instruments with non-employees for goods or services must be
accounted for on the fair value method. The Company currently does not
intend to adopt the fair value accounting prescribed by FAS 123, and will
be subject only to the disclosure requirements prescribed by FAS 123.
However, the Company intends to continue its analysis of FAS 123 and may
elect to adopt its provisions in the future.
ITEM 7. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
- ----------------------------------------------------
The Company's audited financial statements are included and follow at
Item 13 of this report.
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PART III
ITEM 9. DIRECTORS AND EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS;
- -------------------------------------------------------------------------
COMPLIANCE WITH SECTION 16(A) OF THE EXCHANGE ACT.
- -------------------------------------------------
(a)(b) IDENTIFICATION OF DIRECTORS, EXECUTIVE OFFICERS AND
SIGNIFICANT EMPLOYEES.
The following sets forth certain information with respect to the
officers and directors of the Company.
Tenure as Officer
Name Age Position or Director
- ---- --- -------- -----------------
Michael J. Canney 65 Chairman of the Board of Director on January
Directors, President and 12, 1996 and Officer
Chief Executive Officer from April 8, 1996
to present
David J. Smith 43 Chief Financial Officer From October 2, 1995
and Secretary/Treasurer to present
Mathew J. Barletta 30 Director From September 12, 1995
to present
Norman B. Walko 56 Director From November 1, 1995
to present
Stephen P. Shearin 31 Director From November 29, 1995
to present
Benjamin W. Bronston 32 Director From June 7, 1996 to
present
All Directors hold office until the next annual meeting of
shareholders or until their successors have been duly elected and
qualified. Executive officers of the Company are appointed by and serve at
the discretion of the Board of Directors. The Board of Directors has
appointed a compensation committee and an audit committee for the upcoming
fiscal year.
MICHAEL J. CANNEY. Mr. Canney has served as a Director of the Company
from January 1996 to the present and in April 1996 became President and
Chief Executive Officer. From February 1966 to August of 1987 Mr. Canney
was employed by Mountain Bell, (later known as U.S. West) in Albuquerque,
New Mexico and Denver, Colorado in various management capacities. While at
Mountain Bell, Mr. Canney served in various capacities including director
of marketing, director of mechanized systems, and director of contract
negotiations and purchasing. Mr. Canney presently devotes full time to the
Company.
DAVID J. SMITH. Mr. Smith joined the Company in September 1995 as a
consultant in the accounting and finance division. In October 1995 he was
appointed Chief Financial Officer and in June 1996 Secretary/Treasurer.
From September 1994 until July 1995, Mr. Smith served as
Controller/Accounting Manager for the Phoenix, Arizona branch of Poe &
Brown Insurance, a nationwide insurance agency/brokerage based in Daytona
Beach, Florida. From July 1982 until September 1994, Mr. Smith served as
Controller for Alliance Insurance Group, a regional insurance
agency/brokerage based in Phoenix, Arizona. Mr. Smith currently devotes
full time to the Company.
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MATHEW J. BARLETTA. Mr. Barletta has been a Director of the Company
from September 12, 1995 to the present. From July 1993 to the present, Mr.
Barletta has been the ATM Product Marketing Engineer for Cisco Systems,
Inc. of San Jose, California. From March 1989 to July 1993 Mr. Barletta
was a member of the technical staff for AT&T Bell Laboratories in Liberty
Corner, New Jersey.
NORMAN B. WALKO. Mr. Walko has been a Director of the Company from
November 1995 to the present. Recently he joined Next Wave Telecom as Vice
President in charge of the Southeast Region. From March 1994 to the
present Mr. Walko has been Chief Operating Officer of QuestCom
Communications of Portola Valley, California, a company formed to
participate in wireless telecommunications license auctions. From June
1992 to February 1994, he was General Manager, Central/North Florida with
McCaw Cellular Communications, Inc. of Kirkland Washington, a company
engaged in cellular telephone service. From March 1989 to June 1992, Mr.
Walko was employed by U.S. West Corporation as a general manager. Mr.
Walko received a B.S. in Computer Science from Purdue University and a
M.B.A. in Marketing from the University of Southern California.
STEPHEN P. SHEARIN. Mr. Shearin has served as a Director of the
Company since November 1995. Mr. Shearin founded GetNet in 1994 and served
as the President of GetNet until August 1996 when he was terminated by the
Company. From 1991 to 1994, Mr. Shearin managed Shearin Tile Co. while
also founding GetNet. From 1986 to 1991, Mr. Shearin owned and operated
Aqua Videos while in the U.S. Virgin Islands.
BENJAMIN W. BRONSTON. Mr. Bronston has served as a Director since
June 7, 1996. Mr. Bronston has practiced telecommunications and corporate
law for the past five (5) years.
KEY EMPLOYEES
GEORGE D. WOOD. Dr. Wood joined the Company as a member of the
technical staff in November 1995. From July 1983 to June of 1985, Dr. Wood
was employed as a programmer in the product systems group at Carnegie
Mellon University doing artificial intelligence research; from June 1985 to
August 1988, he was a senior research assistant at Harvard Law School and
from August 1988 to the present he has worked as a consultant to various
companies, including GetNet. Dr. Wood received a Masters Degree from the
Arizona State University in 1976 and a Ph.D. from the University of Arizona
in 1982.
LIMITED LIABILITY AND INDEMNIFICATION OF DIRECTORS
In accordance with the California General Corporation Law, the Company
has included a provision in its Articles of Incorporation to limit the
personal liability of its directors for violations of their fiduciary duty.
The provision eliminates directors liability to the Company or its
stockholders for monetary damages, except (i) for any breach of the
director's duty of loyalty to the Company or its stockholders, (ii) for
acts or omissions not in good faith or which involve intentional misconduct
or a knowing violation of law, (iii) for unlawful payment of dividends or
unlawful stock purchases or redemptions, or (iv) for any transaction from
which a director derived an improper personal benefit.
Additionally, in accordance with the California General Corporation
Law, the Company's Articles of Incorporation and Bylaws indemnify its
directors against liability which they may incur in their capacity as a
director against judgments, penalties, fines, settlements and reasonable
expenses incurred in connection with threatened, pending or completed
civil, criminal, administrative, or investigative proceedings by reason of
the fact that he is or was a director, officer, employee, fiduciary or
-31-
________________________________________________________________________
<PAGE>
agent of the Company if such director acted in good faith and in a manner
reasonably believed to be in the best interests of the Company.
Insofar as indemnification for liabilities arising under the
Securities Act of 1933 (the "Act") may be permitted to directors, officers
and controlling persons of the small business issuer pursuant to the
foregoing provisions, or otherwise, the Company has been advised that in
the opinion of the Securities and Exchange Commission, such indemnification
is against public policy as expressed in the Act and is, therefore,
unenforceable.
(c) FAMILY RELATIONSHIPS.
There are no family relationships among any of the Company's officers
and directors.
(d) INVOLVEMENT IN CERTAIN LEGAL PROCEEDINGS.
No officer, director, significant employee, promoter or control person
of the Company has been involved in any event of the type described in Item
401(d) of Regulation S-B during the past five years.
(e) COMPLIANCE WITH SECTION 16(A) OF THE EXCHANGE ACT.
Section 16(a) of the Securities Exchange Act of 1934 requires the
Company's directors and officers, and persons who own more than 10% of a
registered class of the Company's equity securities, to file reports of
ownership and changes in ownership with the Securities and Exchange
Commission ("SEC"). Officers, directors and greater than 10% stockholders
are required by SEC regulation to furnish the Company with copies of all
Section 16(a) forms they file. Based solely on the Company's review of the
copies of such forms received by it during the fiscal year ended May 31,
1996, and written representations that no other reports were required, the
Company believes that except as described below each person who, at any
time during such fiscal year, was a director, officer or beneficial owner
of more than 10% of the Company's Common Stock complied with all Section
16(a) filing requirements during such fiscal year or prior fiscal years.
ITEM 10. EXECUTIVE COMPENSATION
- --------------------------------
(a) GENERAL.
In April 1996, the Company entered into a two (2) year employment
agreement with Michael J. Canney, an Officer and Director of the Company.
Mr. Canney's agreement provides, in part, to earn an annual salary of
$120,000; 100,000 stock options exercisable over a five year period at
$4.00 per share; and a housing allowance of $1,500 per month. As of the
date of this report, Mr. Canney has not exercised any stock options.
(b) SUMMARY COMPENSATION TABLE.
The following table sets forth all compensation paid or accrued by the
Company for services of Michael J. Canney, the Company's President and
Chief Executive Officer, for the fiscal year ended May 31, 1996, during the
ten months ended May 31, 1995 and the fiscal year ended July 31, 1994. No
Officer other than Mr. Canney received cash compensation from the Company
in excess of $100,000 during such fiscal years.
SUMMARY COMPENSATION TABLE
<TABLE>
<CAPTION>
Annual Compensation Long Term Compensation Awards
Other Re- All
Name Annual stricted LTIP Other
and Compen- Stock Options/ Pay- Compen-
Principal Salary Bonus sation Award(s) SARs outs sation
Position Year(1) ($) ($) ($) ($) (#) ($) ($)
- ------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Michael J. Canney 1996 $20,000 $ 0 $ 0 N/A -0- N/A $3,000
President and Chief 1995 $ 0 $ 0 $ 0 -- -0- -- $ 0
Executive Officer 1994 $ 0 $ 0 $ 0 -- -0- -- $ 0
</TABLE>
- --------------------
(1) Periods presented are for the years ended May 31, 1996, the ten months
ended May 31, 1995 and the year ended July 31, 1994.
COMPENSATION OF DIRECTORS
The non-employee directors of the Company will receive $250 for each
meeting they attend plus expenses. Directors may also receive options as
designated by the Board of Directors.
(c) OPTION/SAR GRANTS TABLE.
OPTIONS GRANTED
The following table sets forth the options that have been granted to
Michael J. Canney, the Company's President and Chief Executive Officer,
listed in the Executive Compensation Table.
Option/SAR Grants
-----------------
Individual Grants
- ---________________________________________________________________________
% of Total
Options/ Options/SARs Exercise
SARs Granted to or Base
Granted Employees Price Expiration
Name (#) in Fiscal Year ($/Share) Date
------ ------ -------------- -------- ------
Michael J. Canney, 250,000 (1) 36% $4.00 3/01
President and Chief
Executive Officer
- --------------------
(1) Of the 250,000 options, 125,000 options are currently exercisable,
50,000 become exercisable in September 1996 and 75,000 become
exercisable in March 1997.
In November 1995, the Company granted 60,000 options exercisable at
$2.00 per share for a five year period. The options were granted to Joseph
Monnig, a significant long distance sales agent, to provide long distance
consulting and assistance with the Company's long distance agents.
-33-
________________________________________________________________________
<PAGE>
In April 1995, the Company granted 15,900 options exercisable at $3.00
per share for a five year period to certain non-affiliated persons, who
have provided short term loans to the Company in the past.
In March 1996, the Company granted a total of 450,000 warrants to
purchase Common Stock to Messrs Walko, Canney and Barletta, Directors
(150,000 each) of the Company. The warrants are exercisable for a five (5)
year period at $4.00 per warrant. Each Director's warrants become
exercisable as follows: 25,000 commencing in March 1996; 50,000 in six (6)
months; and 75,000 after one(1) year.
In March 1996, the Company granted 100,000 warrants to purchase Common
Stock to Norbert Zealander, a member of the audit committee. The Warrants
are exercisable for a five (5) year period at $4.00 per warrant, pursuant
to the following schedule: 25,000 in March, 1996; 25,000 in September,
1996; and 50,000 in March, 1997.
In connection with its recent public offering, the Company granted the
underwriter, Barron Chase Securities, Inc., warrants to purchase 150,000
shares of Common Stock and 150,000 Warrants at an exercise price of $6.00.
The warrants are exercisable through May 17, 2001.
(d) AGGREGATED OPTION/SAR EXERCISE AND FISCAL YEAR-END OPTION/SAR
VALUE TABLE.
Not applicable.
(e) TERM INCENTIVE PLAN ("LTIP") AWARDS TABLE.
Not applicable.
(f) COMPENSATION OF DIRECTORS.
Non-Employee Directors received $250 per meeting attended plus
expenses. Employee Directors receive only reimbursement for out-of-pocket
expenses.
(g) EMPLOYMENT CONTRACTS AND TERMINATION OF EMPLOYMENT AND CHANGE-IN-
CONTROL ARRANGEMENTS.
None.
(h) REPORTING ON REPRICING OF OPTIONS/SARS.
Not Applicable.
-34-
________________________________________________________________________
<PAGE>
ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
- ------------------------------------------------------------------------
(a)(b) SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT.
The following table sets forth, as of September 5, 1996 the ownership
of the Company's Common Stock by (i) each Director of the Company, (ii) all
Executive Officers and Directors of the Company as a group, and (iii) all
persons known by the Company to own more than 5% of the Company's Common
Stock.
Beneficial Ownership (1)
------------------------
Name and Address Shares Percent
- ---------------- ------ -------
Michael J. Canney 125,000 (2) 3.8%
4110 N. Scottsdale Road
Suite 170
Scottsdale, Arizona 85251
Jonathan P. Miller 260,000 (3) 7.8%
4110 N. Scottsdale Road
Suite 170
Scottsdale, Arizona 85251
Janeece Miller 260,000 (4) 7.8%
4110 N. Scottsdale Road
Suite 170
Scottsdale, Arizona 85251
Robert C. Vaughan 210,000 (5) 6.3%
4110 N. Scottsdale Road
Suite 170
Scottsdale, Arizona 82551
Stephen P. Shearin 114,516 3.5%
4110 N. Scottsdale Road
Suite 170
Scottsdale, Arizona 85251
Mathew J. Barletta 25,000 (6) 0.7%
4110 N. Scottsdale Road
Suite 170
Scottsdale, Arizona 85251
Norman B. Walko 25,000 (7) 0.7%
4110 N. Scottsdale Road
Suite 170
Scottsdale, Arizona 85251
Benjamin W. Bronston 25,000 (8) 0.7%
4110 N. Scottsdale Road
Suite 170
Scottsdale, Arizona 85251
All Executive Officers and
Directors as a group (5 persons) 314,516 9.5%
-35-
- ----------------------------------------------------------------------------
<PAGE>
- --------------------------------
(1) Calculated pursuant to Rule 13d-3(d) of the Securities Exchange Act of
1934. Unless otherwise stated below, each such person has sole voting
and investment power with respect to all such shares. Under Rule 13d-
3(d), shares not outstanding which are subject to options, warrants,
rights or conversion privileges exercisable within 60 days are deemed
outstanding for the purpose of calculating the number and percentage
owned by such person, but are not deemed outstanding for the purpose
of calculating the number and percentage owned by each other person
listed.
(2) Represents 125,000 options currently exercisable.
(3) Includes 100,000 shares owned directly by Mr. Miller and 100,000 owned
indirectly by virtue of his wife's ownership of said shares and
includes 50,000 options to purchase shares of the Company's Common
Stock owned by Mr. Miller and 10,000 options currently exercisable by
his wife, Janeece Miller.
(4) Includes 100,000 shares owned by Ms. Miller and 100,000 shares owned
indirectly by virtue of her husband's ownership of said shares and
10,000 options currently exercisable and 50,000 options currently
exercisable owned by her husband, Jonathan Miller.
(5) Includes 50,000 options currently exercisable.
(6) Includes 25,000 options currently exercisable.
(7) Includes 25,000 options currently exercisable.
(8) Includes 25,000 options currently exercisable.
(c) CHANGES IN CONTROL.
There is no arrangement or understanding known to the Company,
including any pledge by any person of securities of the Company, the
operation of which may at a subsequent date result in a change in control
of the Company except if the Arcada business combination is approved by
shareholders at an anticipated Fall 1996 meeting of shareholders. Arcada
management will assume control of the Company's day-to-day operations and
control of the Board of Directors.
-36-
________________________________________________________________________
<PAGE>
ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
- --------------------------------------------------------
(a)(b) TRANSACTIONS WITH MANAGEMENT AND OTHERS.
In November 1995, the Company issued 400,000 shares of Common Stock to
all the shareholders of GetNet to acquire all their issued and outstanding
shares of GetNet. The shares were issued at a ratio of one (1) share of
the Company's Common Stock for each 13.916 shares of GetNet. Mr. Shearin,
who subsequently became a Director of the Company, was a shareholder of
GetNet, and received a total of 114,516 shares of the Company in this
transaction.
In November 1995 and March 1996, the founding shareholders, Jonathan
Miller, Janeece Miller, Carl Peterson and Carol Peterson agreed to
surrender to the Company's treasury shares of Common Stock. Mr. Miller
surrendered 159,550 shares; Mrs. Miller 159,550 shares; Mr. Peterson
220,050 shares; and Mrs. Peterson 222,050 shares and no consideration was
given by the Company for the surrender of such shares. The shares were
surrendered and interest forgiven as a condition for the public offering.
(c) TRANSACTIONS WITH PROMOTERS.
See (a) (b) above.
PART IV
ITEM 13. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.
- --------------------------------------------------------------------------
(a) The following documents are filed as a part of this Form 10-KSB:
1. Consolidated Financial Statements of Touch Tone America, Inc.:
Independent Auditor's Report
Consolidated Balance Sheet - May 31, 1996
Consolidated Statement of Operations - Ten months ended May 31,
1995 and year end May 31, 1996
Consolidated Statement of Changes in Stockholders' Equity - For
the period from August 1, 1995 through May 31,1996
Consolidated Statement of Cash Flows - Ten months ended May 31,
1995 and year end May 31, 1996
Notes to Consolidated Financial Statements
-37-
________________________________________________________________________
<PAGE>
4. Exhibits required to be filed are listed below and, except where
incorporated by reference, immediately follow the Financial Statements.
Exhibit No. Description
----------- -----------
1.1 Form of Underwriting Agreement between the Company and
Barron Chase Securities, Inc.(1)
1.2 Form of Representative's Warrant Agreement Option or
Warrant Agreement.(1)
1.3 Form of Agreement Among Underwriters.(1)
1.4 Form of Selected Dealer Agreement.(1)
3.1 Certificate of Incorporation dated July 31, 1990 and
Amendments thereto.(1)
3.2 Bylaws.(1)
3.3 Form of Specimen Common Stock Certificate.(1)
3.4 Form of Specimen Warrant Certificate.(1)
4.0 Warrant Agreement between the Company and American
Securities Stock Transfer, Inc.(1)
10.1 Acquisition Agreement and addendum thereto between the
Company and National Telcom Management, Inc.(1)
10.2 Financial Advisory Agreement between the Company and
Barron Chase Securities, Inc.(1)
10.3 Form of Merger and Acquisition Agreement between the
Company and Barron Chase Securities, Inc.(1)
10.4 Agreement between AT&T and the Company.(1)
10.5 Telecommunications Services Agreement between WilTel
and the Company.(1)
10.6 Sales and Distribution Agreement between Paging
Network of Arizona and the Company.(1)
10.7 Employment Agreement with Jonathan Miller and the
Company.(1)
10.8 Employment Agreement with Robert C. Vaughan and the
Company.(1)
10.9 Employment Agreement with David J. Smith and the
Company.(1)
-38-
________________________________________________________________________
<PAGE>
10.10 Agreement between TMO Communications and the
Company.(1)
10.11 National Reseller Agreement between the Company and
ICG Access Services, Inc.(1)
10.12 Release and Settlement Agreement between AT&T and
Touch Tone America, Inc.(1)
10.13 Release and Settlement Agreement between ICG Access
Services, Inc. and Touch Tone America, Inc.(1)
10.14 Agreement with TMO and the Company dated April 18,
1996.(1)
10.15 Employment Agreement between Michael J. Canney and the
Company.(1)
10.16 Consulting Agreement between Robert C. Vaughan and the
Company.(1)
- -----------------------
(1) Incorporated by reference from the like numbered exhibits filed
with the Registrant's Registration Statement on Form SB-2, No. 33-8031.
(b) During the last quarter of the period covered by this report the
Company did not file any current Reports on Form 8-K.
(c) Required exhibits are attached hereto and are listed in Item
13(a)(3) of this Report.
(d) Required financial statement schedules are listed and included in
Item 13(a)(2) of this Report.
-39-
________________________________________________________________________
<PAGE>
TOUCH TONE AMERICA, INC. AND SUBSIDIARY
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
PAGE
----
INDEPENDENT AUDITOR'S REPORT . . . . . . . . . . . . . . . . . . F-2
CONSOLIDATED BALANCE SHEET - May 31, 1996 . . . . . . . . . . . F-3
CONSOLIDATED STATEMENTS OF OPERATIONS - For the Ten Months
Ended May 31, 1995 and the Year Ended May 31, 1996. . . . . F-4
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY - For
the Period from August 1, 1994 through May 31, 1996 . . . . F-5
CONSOLIDATED STATEMENTS OF CASH FLOWS - For the Ten Months
Ended May 31, 1995 and the Year Ended May 31, 1996. . . . . F-6
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS . . . . . . . . . . . F-7
F-1
_______________________________________________________________________
<PAGE>
INDEPENDENT AUDITOR'S REPORT
Board of Directors
Touch Tone America, Inc.
Phoenix, Arizona
We have audited the accompanying consolidated balance sheet of Touch Tone
America, Inc. as of May 31, 1996, and the related consolidated statements
of operations, stockholders' equity and cash flows for the ten months ended
May 31, 1995 and for the year ended May 31, 1996. These consolidated
financial statements are the responsibility of the Company's management.
Our responsibility is to express an opinion on these consolidated financial
statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the consolidated financial
statements are free of material misstatement. An audit includes examining,
on a test basis, evidence supporting the amounts and disclosures in the
consolidated financial statements. An audit also includes assessing the
accounting principles used and significant estimates made by management, as
well as evaluating the overall consolidated financial statement
presentation. We believe that our audits provide a reasonable basis for
our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial
position of Touch Tone America, Inc. as of May 31, 1996, and the results of
their operations and their cash flows for the ten months ended May 31, 1995
and for the year ended May 31, 1996, in conformity with generally accepted
accounting principles.
The accompanying consolidated financial statements have been prepared
assuming that the Company will continue as a going concern. As discussed
in Note 2 to the consolidated financial statements, the Company has
incurred losses from operations and has entered into significant sales
volume commitments. These factors raise substantial doubt about the
Company's ability to continue as a going concern. Management's plans in
regard to these matters are also described in Note 2. The financial
statements do not include any adjustments that might result from the
outcome of these uncertainties.
Hein + Associates LLP
Denver, Colorado
August 9, 1996
F-2
_______________________________________________________________________
<PAGE>
TOUCH TONE AMERICA, INC. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEET
May 31,
1996
-------
ASSETS
------
CURRENT ASSETS:
Cash $5,278,000
Trade receivables, net allowance for
doubtful accounts of $124,000 264,000
----------
Total current assets 5,542,000
EQUIPMENT, net of accumulated depreciation of $62,000 429,000
OTHER:
Intangibles, net of accumulated amortization of $97,000 738,000
Refundable deposits 76,000
Prepaid expenses 143,000
----------
TOTAL ASSETS $6,928,000
==========
LIABILITIES AND STOCKHOLDERS' EQUITY
------------------------------------
CURRENT LIABILITIES:
Accounts payable $ 477,000
Accrued liabilities 1,170,000
Deferred revenues 76,000
Notes payable to stockholders 393,000
Current portion of capital lease obligations 61,000
----------
Total current liabilities 2,177,000
DEFERRED REVENUE 25,000
CAPITAL LEASE OBLIGATIONS, net of current portion 134,000
COMMITMENTS (NOTE 5)
COMMON STOCK AND OTHER STOCKHOLDERS' EQUITY:
Preferred stock, no par value, 10,000,000 shares
authorized; none outstanding -
Common stock, no par value, 100,000,000 shares
authorized, 3,204,300 shares issued and outstanding 7,945,000
Accumulated deficit (3,353,000)
----------
Total stockholders' equity 4,592,000
----------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $6,928,000
==========
See accompanying notes to these consolidated financial statements.
F-3
_______________________________________________________________________
<PAGE>
TOUCH TONE AMERICA, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE
TEN MONTHS FOR THE
ENDED YEAR ENDED
MAY 31, MAY 31,
1995 1996
-------- --------
NET REVENUES:
Long distance resell $ 1,952,000 $ 1,951,000
Internet access - 287,000
----------- -----------
1,952,000 2,238,000
COST OF SALES
Long distance resell (1,310,000) (1,284,000)
Internet access - (122,000)
----------- -----------
(1,310,000) (1,406,000)
----------- -----------
GROSS MARGIN 642,000 832,000
OPERATING EXPENSES:
Selling 337,000 620,000
General and administrative 507,000 1,853,000
Excess volume commitments 32,000 871,000
----------- -----------
876,000 3,344,000
----------- -----------
LOSS FROM OPERATIONS (234,000) (2,512,000)
OTHER INCOME (EXPENSE):
Interest expense, primarily stockholders (12,000) (172,000)
Absorbed offering and acquisition costs (48,000) (118,000)
----------- -----------
(60,000) (290,000)
----------- -----------
NET LOSS $ (294,000) $(2,802,000)
=========== ===========
LOSS PER SHARE $ (.19) $ (1.81)
=========== ===========
WEIGHTED AVERAGE COMMON SHARES
AND EQUIVALENTS 1,508,000 1,552,000
=========== ===========
See accompanying notes to these consolidated financial statements.
F-4
_______________________________________________________________________
<PAGE>
TOUCH TONE AMERICA, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
<TABLE>
<CAPTION>
COMMON STOCK PREFERRED
------------------ STOCK ACCUM-
NUMBER ISSUANCE ULATED
OF SHARES AMOUNT COSTS DEFICIT TOTAL
-------- -------- -------- -------- --------
<S> <C> <C> <C> <C> <C>
BALANCE, August 1, 1994 2,785,000 $ 2,000 $ - $(257,000) $(255,000)
Surrender of common stock (1,651,000) - - - -
Grants of common stock
by stockholders - 16,000 - - 16,000
Common stock issued to
officer/director for
services 160,000 40,000 - - 40,000
Common stock issued
for cash 11,000 15,000 - - 15,000
Issuance cost of redeemable
preferred stock - - (108,000) - (108,000)
Net loss - - - (294,000) (294,000)
--------- -------- -------- --------- ---------
BALANCE, May 31, 1995 1,305,000 73,000 (108,000) (551,000) (586,000)
Issuance of common stock
in a private placement,
net of offering costs 350,000 600,000 - - 600,000
Issuance of common stock
for acquisition of GetNet 400,000 800,000 - - 800,000
Surrender of common stock (763,200) - - - -
Issuance of common stock
and warrants in a public
offering, net of offering
costs 1,725,000 5,830,000 - - 5,830,000
Conversion of redeemable
preferred stock to
common stock 187,500 642,000 108,000 - 750,000
Net loss - - - (2,802,000) (2,802,000)
--------- --------- -------- ---------- ----------
BALANCE, May 31, 1996 3,204,300 $7,945,000 $ - $(3,353,000)$4,592,000
========= ========== ======== =========== ==========
</TABLE>
See accompanying notes to these consolidated financial statements.
F-5
_______________________________________________________________________
<PAGE>
TOUCH TONE AMERICA, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE
TEN MONTHS FOR THE
ENDED YEAR ENDED
MAY 31, MAY 31,
1995 1996
-------- --------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss $ (294,000) $(2,802,000)
Adjustments to reconcile net loss to net
cash from operating activities:
Depreciation and amortization 2,000 129,000
Common stock for services 56,000 -
Bad debt expense 17,000 185,000
Absorbed acquisition costs 48,000 118,000
Change in assets and liabilities:
Decrease (increase) in:
Trade receivables (311,000) 128,000
Other assets - (214,000)
Increase (decrease) in:
Accounts payable 274,000 (71,000)
Accrued liabilities 422,000 625,000
Deferred revenue and other (8,000) 11,000
----------- -----------
Net cash provided by (used in)
operating activities 206,000 (1,891,000)
CASH FLOWS FROM INVESTING ACTIVITY:
Acquisition costs incurred (95,000) (25,000)
Purchase of equipment - (101,000)
----------- -----------
Net cash used in investing activities (95,000) (126,000)
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from note payable 50,000 -
Payment of note payable (50,000) -
Payment of capital lease obligations - (100,000)
Proceeds from notes payable to stockholders - 210,000
Payment of notes payable to stockholders (24,000) -
Proceeds from issuance of redeemable
preferred stock 637,000 113,000
Proceeds from issuance of common stock 15,000 7,816,000
Offering costs incurred (285,000) (1,256,000)
----------- -----------
Net cash provided by financing
activities 343,000 6,783,000
----------- -----------
NET INCREASE IN CASH 454,000 4,766,000
CASH, beginning of period 58,000 512,000
----------- -----------
CASH, end of period $ 512,000 $ 5,278,000
=========== ===========
See accompanying notes to these consolidated financial statements.
F-6
_______________________________________________________________________
<PAGE>
TOUCH TONE AMERICA, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. NATURE OF OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES:
--------------------------------------------------------
NATURE OF OPERATIONS - The consolidated financial statements include
the accounts of Touch Tone America, Inc. (Touch Tone) and from
November 1, 1995, GetNet International, Inc. (GetNet) (collectively
referred to as "the Company"). Touch Tone acquired the outstanding
common stock of GetNet effective November 1, 1995 as more fully
described in Note 3.
Touch Tone is engaged in the reselling of long distance
telecommunications products and services primarily in the western and
southwestern United States. As a reseller of long distance services,
Touch Tone offers its customers the use of routing equipment and phone
lines of large carriers; in turn, the large carriers offer Touch Tone
volume discounts based on the use of this equipment. Touch Tone was
incorporated as a California corporation in 1990. Touch Tone
previously had a July 31 year-end. In fiscal 1995, Touch Tone changed
its year-end to May 31. Therefore, the 1995 financial statements only
include the financial operations for the ten months ended May 31,
1995.
GetNet is a provider of Internet and World Wide Web access services to
individuals and businesses in Arizona and other parts of the United
States. The Internet is a network of millions of computers around the
world which are able to communicate with one another, as well as
access the World Wide Web which is a system of documents on a
multitude of subjects.
PRINCIPLES OF CONSOLIDATION - The consolidated financial statements
include the accounts of Touch Tone and its subsidiary, GetNet as
described above. All significant intercompany accounts and
transactions have been eliminated in consolidation.
BASIS OF ACCOUNTING - The accompanying consolidated financial
statements have been prepared on the accrual basis of accounting.
Customer billings and collections for long distance services are
performed by a third party service provider (Provider). Accounts
receivable represents the amount the Company's customers owe for
actual usage. However, the amount the Company will receive from the
Provider will be offset by the payable due to the Provider for the
cost of providing the service, which is included in accounts payable
in the financial statements. The net of the receivable and payable is
the margin the Company receives. The Provider is responsible for
maintaining the Company's long distance accounts receivable and
withholds payments to the Company for past due customer amounts. Such
amounts withheld from the Company are offset by the margin otherwise
paid to the Company. Bad debt expense is included with general and
administrative expenses.
EQUIPMENT - Equipment is recorded at cost. Depreciation is computed
using the straight-line method over the estimated useful life of the
equipment, generally five years. Repairs and maintenance are charged
to expense as incurred. Material expenditures, which increase the
life of an asset, are capitalized and depreciated over the estimated
remaining useful life of the asset. The cost of equipment sold, or
otherwise disposed of, and the related accumulated depreciation or
amortization are removed from the accounts, and any gains or losses
are reflected in current operations.
F-7
_____________________________________________________________________
<PAGE>
TOUCH TONE AMERICA, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
INCOME TAXES - The Company accounts for income taxes under the
liability method of SFAS No. 109, whereby current and deferred tax
assets and liabilities are determined based on tax rates and laws
enacted as of the balance sheet date. Deferred tax expense or benefit
represents the change in the deferred tax asset/liability balance.
REVENUE RECOGNITION - The Company recognizes revenue during the period
of performance of the related services. Deferred revenues consist of
the following:
* Funds paid by AT&T to Touch Tone at the initiation of a contract
of $42,000, deferred initially and recognized as a reduction to
cost of sales ratably over the life of the contract as earned.
A total of $1,000 and $16,000 was recognized during the ten
months ended May 31, 1995 and the year ended May 31, 1996,
respectively.
* Current month's advance billings by GetNet for subscriber
services and revenue received in advance for services under
contract. This amount will be recognized as revenue when earned.
INTANGIBLES - Intangibles represent the excess of the purchase price
paid over the net liabilities acquired in the GetNet acquisition of
$835,000. This amount is being amortized over five years.
CONCENTRATION OF CREDIT RISK - Credit risk represents the accounting
loss that would be recognized at the reporting date if counterparties
failed completely to perform as contracted. Concentrations of credit
risk (whether on or off balance sheet) that arise from financial
instruments exist for groups of customers or counterparties when they
have similar economic characteristics that would cause their ability
to meet contractual obligations to be similarly effected by changes in
economic or other conditions. The Company does not have a significant
exposure to any individual customer or counterparty.
At May 31, 1996, the Company's cash balance at one financial
institution was in excess of FDIC insured limits by approximately
$5,190,000.
USE OF ESTIMATES - The preparation of the Company's consolidated
financial statements in conformity with generally accepted accounting
principles requires the Company's management to make estimates and
assumptions that affect the amounts reported in these financial
statements and accompanying notes. Actual results could differ from
those estimates. The Company makes significant estimates as to the
amortization period used for its intangibles. Due to the
uncertainties inherent in the life of intangibles, especially in light
of increased competition and technology changes, it is reasonably
possible that the estimated life of intangibles could materially
change in the forthcoming year.
FAIR VALUE OF FINANCIAL INSTRUMENTS - The estimated fair values for
financial instruments under SFAS No. 107, DISCLOSURES ABOUT FAIR VALUE
OF FINANCIAL INSTRUMENTS, are determined at discrete points in time
based on relevant market information. These estimates involve
uncertainties and cannot be determined with precision. The estimated
fair values of the Company's financial instruments, which includes
cash and cash equivalents, trade receivables, accounts payable, and
notes payable to stockholders, approximates the carrying value in the
financial statements at May 31, 1996.
LOSS PER SHARE - Loss per share is generally computed based on the
weighted average number of shares outstanding. However, for the
periods presented, common and common equivalent shares including the
F-8
_______________________________________________________________________
<PAGE>
TOUCH TONE AMERICA, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
common stock underlying the redeemable preferred stock and common
stock options (using the treasury stock method and the public offering
price) have been included in the weighted average calculation, as if
they were outstanding for the entire period through December 31, 1995.
IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS - In March 1995, the
Financial Accounting Standards Board issued a new statement titled
"Accounting for Impairment of Long-Lived Assets." This new standard
is effective for years beginning after December 15, 1995 and would
change the Company's method of determining impairment of long-lived
assets. Although the Company has not performed a detailed analysis of
the impact of this new standard on the Company's consolidated
financial statements, the Company does not believe that adoption of
the new standard will have a material effect on the consolidated
financial statements.
In October 1995, the Financial Accounting Standards Board issued a new
statement titled "Accounting for Stock-Based Compensation" (FAS 123).
The new statement is effective for fiscal years beginning after
December 15, 1995. FAS 123 encourages, but does not require,
companies to recognize compensation expense for grants of stock, stock
options, and other equity instruments to employees based on fair
value. Companies that do not adopt the fair value accounting rules
must disclose the impact of adopting the new method in the notes to
the financial statements. Transactions in equity instruments with
non-employees for goods or services must be accounted for on the fair
value method. The Company currently does not intend to adopt the fair
value accounting prescribed by FAS 123, and will be subject only to
the disclosure requirements prescribed by FAS 123. However, the
Company intends to continue its analysis of FAS 123 and may elect to
adopt its provisions in the future.
2. CONTINUED OPERATIONS:
--------------------
The accompanying consolidated financial statements have been prepared
assuming that the Company will continue operating as a going concern,
which contemplates the realization of assets and liquidation of
liabilities in the normal course of business. The Company has
incurred significant losses since inception. Furthermore, as
discussed in Note 5, the Company has entered into sales volume
commitments with service providers.
The Company renegotiated two significant commitments under which it
was experiencing substantial shortfalls. Under the revised
agreements, the Company's future commitment has been eliminated. The
Company, however, has a continuing service commitment with AT&T of
$1,800,000 annually, which it was currently satisfactorily meeting at
year-end. However, as discussed in Note 5, subsequent to year-end,
monthly revenues under this commitment have declined, and unless
related revenues increase the Company will be unable to continue to
meet this commitment. Therefore, an additional loss accrual may be
recorded in fiscal 1997.
The Company's ability to continue as a going concern is dependent upon
several factors, including meeting its future carrier commitments, and
ultimately achieving and maintaining profitable operations. The
Company is also aggressively working to increase revenues, which it
believes will ultimately lead to profitable operations and enable the
Company to meet its continuing service commitments. The accompanying
consolidated financial statements do not include any adjustments that
might result from the outcome of these uncertainties.
F-9
_______________________________________________________________________
<PAGE>
TOUCH TONE AMERICA, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
3. ACQUISITIONS
------------
In August 1996, the Company entered into a letter of intent to merge
with Arcada Communications Inc. (Arcada), based in Seattle,
Washington, whereby the Company would issue to Arcada a $1,500,000
promissory note and 12,500,000 shares of the Company's common stock.
As a result, Arcada would acquire control of both management and the
board of directors of the Company. The completion of the merger is
subject to completion of a merger agreement and approval by the board
of directors and shareholders of both companies.
In November 1995, the Company acquired the outstanding common stock of
GetNet through the issuance of 400,000 shares of its common stock,
which was valued at $800,000. This acquisition was accounted for
under purchase method of accounting. The excess of the purchase price
over the net liabilities acquired of approximately $835,000 will be
amortized over a period not to exceed five years. All other assets
and liabilities were recorded at book values, which approximated fair
value. Unaudited pro-forma financial information is provided below:
FISCAL YEAR FISCAL YEAR
1995 1996
----------- -----------
Net Revenues $ 2,067,000 $ 2,388,000
=========== ===========
Net Loss $ (724,000) $(2,823,000)
=========== ===========
Net Loss per Share $ (.24) $ (1.88)
=========== ===========
The above pro-forma financial information assumes the acquisition
occurred at the beginning of the period presented. This information
is not necessarily indicative of the financial results which would
have resulted if the acquisition had occurred at such earlier date nor
of future finanical operating results.
In August 1995, the Company entered into an acquisition agreement with
National Telcom Management, Inc. (NTM) to purchase NTM's long distance
customer base (Telcom). In January 1996, the Company terminated the
contract with NTM and forfeited a $90,000 deposit previously paid.
Accordingly, this amount and other costs associated with the
acquisition of approximately $25,000 has been shown as an expense in
the accompanying financial statements.
F-10
_______________________________________________________________________
<PAGE>
TOUCH TONE AMERICA, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
4. NOTES PAYABLE TO STOCKHOLDERS:
-----------------------------
Notes payable to stockholders consist of the following:
Notes payable to stockholder with a stated interest
rate of 30% per annum, unsecured which was repaid
subsequent to year-end through the issuance of
70,000 shares of common stock. As a result, the
Company will record interest and finance charges
totaling $250,000, based upon the value of the shares
issued, of which $125,000 is included in accrued
liabilities based on the period the note was
outstanding. The balance will be expensed in fiscal
1997.
$210,000
Notes payable to stockholders with interest at 10% and
12%, principal and interest was paid after year end.
183,000
--------
Total $393,000
========
Interest expense to stockholders for the ten months ended May 31, 1995
and for the year ended May 31, 1996 totaled $12,000 and $172,000,
respectively. Accrued interest of $127,000 was included in accrued
liabilities at May 31, 1996.
5. COMMITMENTS:
-----------
OPERATING LEASES - The Company leases its office facilities and
certain equipment under non-cancelable operating leases. Rent expense
for the ten months ended May 31, 1995 and for the year ended May 31,
1996 was $26,000 and $63,000, respectively. At May 31, 1996, future
lease obligations under leases with lease terms in excess of one year
are as follows:
For the Year Ended May 31,
--------------------------
1997 $ 118,000
1998 121,000
1999 78,000
2000 37,000
2001 37,000
Thereafter 3,000
---------
$ 394,000
=========
F-11
_______________________________________________________________________
<PAGE>
TOUCH TONE AMERICA, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
CAPITAL LEASES - The Company leases certain equipment which have been
recorded as capital leases. Obligations under these capital leases
have been recorded at the present value of future minimum lease
payments, discounted at rates ranging from approximately 20% to 23%.
The capitalized cost of $231,000 less accumulated amortization of
$31,000, are included in property and equipment at May 31, 1996. The
following is a schedule of future minimum lease payments under capital
leases at May 31, 1996:
For the Year Ended May 31,
--------------------------
1997 $ 95,000
1998 80,000
1999 44,000
2000 30,000
2001 15,000
---------
Future minimum lease payment 264,000
Less amount representing interest (69,000)
---------
Present value of net minimum lease payments 195,000
Less current portion (61,000)
---------
$ 134,000
=========
TELECOMMUNICATIONS CIRCUIT LEASES - The Company leases certain
telecommunication circuits, primarily in connection with its Internet
backbone, under non-cancelable operating leases. Lease expense for
both the ten months ended May 31, 1995 and for the year ended May 31,
1996 was nominal as most of these leases were entered into subsequent
to May 31, 1996. As of August 9, 1996, future minimum lease
obligations under leases with lease terms in excess of one year are as
follows:
For the Year Ended May 31,
--------------------------
1997 $ 647,000
1998 1,129,000
1999 1,129,000
2000 549,000
2001 43,000
Thereafter 205,000
----------
$3,702,000
==========
Included in the above amounts is a three-year commitment beginning in
January 1997 with WilTel, whereby the Company is required to lease a
minimum of $70,000 per month of telecommunication circuits. Under
this agreement, all costs incurred are not only applied dollar-for-
dollar against this commitment, but are also concurrently credited 1-
1/2 times actual usage against the Company's long distance service
commitment described below.
F-12
_______________________________________________________________________
<PAGE>
TOUCH TONE AMERICA, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The Company, however, is obligated to pay for actual monthly usage of
telecommunication circuits, which for August 1996 approximated $70,000
(unaudited), irrespective of the related usage by the Company's
Internet customers which was nominal for August 1996.
SERVICE COMMITMENTS - The Company signed the following commitments:
* A commitment which commenced in November 1994 (as revised)
with AT&T to sell $1,200,000 of "800" service annually,
which will be terminated with the payment to AT&T of
$586,000 with no minimum commitments thereafter.
* Five-year commitment beginning August 1994 with AT&T
Software Defined Network (SDN) to sell $1.8 million
annually.
* Two-year commitment beginning October 1995 with WilTel to be
a reseller of its long distance services. Minimum
commitments of $50,000 per month to commence in August 1996.
* Three-year commitment beginning September 1995 with Paging
Network of Arizona, Inc. to be a reseller of paging
services. The Company is required to resell a minimum
number of paging service agreements by various dates or
otherwise risk termination of its agreement. The Company
does not consider this commitment to be significant to
future operations.
The Company was not meeting its "800" service agreement commitment
with AT&T, and consequently, in April 1996, the Company entered into
a revised agreement with AT&T, which provided for the repayment in
June 1996 of $186,000 paid by AT&T on the signing of the initial
agreement and $400,000 over twelve months beginning in June 1996. If
the Company does not make the payments as required, the Company will
be obligated to pay $1,027,000, less amounts previously paid. During
the year ended May 31, 1996, the Company has recorded $400,000 of
expense in connection with settlement of this commitment. As of
August 9, 1996, the Company is current in its payments to AT&T.
The Company also has a continuing commitment with AT&T to provide long
distance service of $1,800,000 annually, which as of May 31, 1996, it
was satisfactorily meeting. However, subsequent to year-end, monthly
revenues have declined and unless related revenues increase the
Company will be unable to continue to meet the minimum amount of this
commitment (which is 80% of the total commitment). Therefore, an
additional loss accrual may be recorded in fiscal 1997, however, an
estimate of such loss, if any, cannot be made at this time. The
Company is hopeful it will be able to renegotiate its contract with
AT&T to obtain a more favorable rate per minute and commitment level
and replace its existing SDN contract. However, there is no assurance
that the Company will be able to ultimately renegotiate its existing
contract.
The Company has a commitment with WilTel which commenced in August
1996 to sell $50,000 per month of long distance services. This
substantially exceeds the Company's current level of service. The
Company will effectively meet this commitment as a result of its
telecommunication circuit leases.
The Company has an agreement with ICG Access Services, which was
revised in March 1996. Under the old agreement, the Company was
required to utilize ICG services or pay ICG the difference between
the amount utilized and the minimum monthly commitment. During the
periods ended May 31, 1996 and May 31, 1995, the Company has recorded
F-13
__________________________________________________________________________
<PAGE>
TOUCH TONE AMERICA, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
$462,000 and $32,000, respectively, of expense under this initial
agreement. In March 1996, the Company renegotiated its agreement with
ICG whereby it agreed to pay its then current obligation of
approximately $430,000 with $250,000 from proceeds of public offering
and the issuance of 45,000 shares valued at $180,000. At May 31,
1996, the Company has an accrued liability to ICG of approximately
$180,000 which represents the 45,000 shares which were issued
subsequent to year-end. There has been relatively insignificant
revenue associated with this expense as the Company has only began
marketing services under the ICG agreement on a very limited basis.
EMPLOYMENT AGREEMENTS - During the year ended May 31, 1996, the
Company entered into employment agreements with various individuals.
As of May 31, 1996, the base salary under these agreements aggregate
approximately $480,000 in fiscal 1997 and $225,000 in fiscal 1998.
The Company may terminate the agreements for cause. If terminated for
any other reason, the Company will pay six months salary and benefit
allowance if termination occurs in the first year of the agreement and
nine months salary and benefit allowance if after the first year. In
connection with the employment agreements, certain options were
granted as discussed in Note 6. In April 1996, two of the Company's
officers resigned and terminated their employment agreements and the
Company hired a new president/chief executive officer. Furthermore,
in July 1996, two employees were terminated without cause, but agreed
to terminate their employment agreements for a total of $36,000 in
compensation which will be expensed in fiscal 1997. The above
commitments have been revised to reflect these changes.
In April 1996, the Company entered a consulting agreement with the
former chief executive officer of the Company to assist the Company in
mergers and acquisitions. Under this agreement, the Company will pay
a base compensation of approximately $15,000 per month, which under an
amended agreement in June 1996 has been extended through October 1997,
plus additional compensation based on the level of success of future
endeavors.
6. CAPITAL STOCK:
-------------
PREFERRED STOCK - In June 1995, the Company completed a private
placement of the Company's Series A Convertible Preferred Stock. The
Company received $642,000, net of offering costs of $108,000, from
issuing 150,000 shares of convertible preferred stock. The shares
were redeemed from $750,000 proceeds received in the Company's public
offering plus 187,500 shares of common stock.
The Company has authorized, but unissued 10,000,000 shares of
preferred stock, which may be issued in such series and with such
preferences as determined by the Company's Board of Directors.
COMMON STOCK - In March 1995, the Company restructured its capital
accounts, whereby it revised its articles to increase the authorized
shares and changed its common stock to a "no par value." Furthermore,
the Company declared an approximate 1 for 185 reverse stock split.
For financial statement presentation purposes, shares outstanding and
all common shares references have been restated to reflect this split,
as if it occurred at the beginning of the period presented.
During the ten months ended May 31, 1995, a prior shareholder
surrendered 1,393,000 shares of common stock when the Company repaid
a then outstanding $23,000 debt. Another shareholder also surrendered
F-14
_________________________________________________________________________
<PAGE>
TOUCH TONE AMERICA, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
258,000 shares of common stock for an agreement to repay an
outstanding debt plus accrued interest totaling $41,000. The
surrendered shares were canceled by the Company.
During the ten months ended May 31, 1995 the founding shareholders
transferred 62,300 of their shares of common stock to persons who in
the past provided certain limited consulting assistance to the
Company. For financial statement presentation purposes, the value of
such services has been reflected as an expense in the financial
statement with an offset to capital, as if such shares had been issued
directly by the Company.
The Company also issued 60,000 and 100,000 shares of common stock for
services in February and May 1995 to an officer/director. For
financial statement presentation purposes, such shares have been
recorded based on the estimated value of the services rendered
(aggregating $40,000), which approximated the value of the common
stock at the time of issuance, as determined by the Company's Board of
Directors.
In April 1995, the Company sold 11,000 shares of common stock to an
unrelated party based on a prior agreement to issue common stock at a
price 50% of an initial public offering price.
In November 1995, the Company completed a private placement of its
common stock whereby it sold 350,000 shares of common stock for
$700,000. The Company incurred costs associated with this offering of
approximately $100,000.
Pursuant to an understanding with the Company's Representative, in
November 1995 and March 1996, the founding shareholders surrendered an
aggregate of 763,200 shares of common stock back to the Company.
In May 1996, the Company completed a public offering of its common
stock and warrants whereby it sold 1,725,000 shares of common stock at
$4 per share and 1,725,000 warrants at $.125 per warrant. Net
proceeds, after offering costs, was approximately $5,830,000. Each
warrant enables the holder to purchase one share of common stock at
the public offering price of $4 per share through May 1997. The
Company may redeem the warrants at $.25 per warrant, under certain
circumstances. The Representative to the offering also received a
warrant for the purchase of 150,000 shares of common stock and
150,000 warrants exercisable at $4.80 per share for four years
commencing May 1997. At the closing of the public offering, the
Company engaged the Representative as a financial advisor to the
Company for a fee of $108,000 which is reflected as an other asset and
will be amortized over three years.
Also, see Note 3 for the common stock issued in connection with the
GetNet acquisition.
COMMON STOCK OPTIONS AND DIRECTOR WARRANTS - In April 1995, the
Company issued common stock options to certain persons who had
previously loaned funds to the Company. The options, which are
currently exercisable, entitle these persons to purchase an aggregate
15,900 shares of common stock for $3.00 per share for five years. As
of May 31, 1996, no options have been exercised.
F-15
_________________________________________________________________________
<PAGE>
TOUCH TONE AMERICA, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
In April 1996, the Company issued common stock options to an
independent significant sales agent (see Note 8). These options,
which are currently exercisable, entitle this sales agent to purchase
an aggregate of 60,000 shares of common stock for $2.00 per share over
five years. As of May 31, 1996, no options have been exercised.
As part of the various employment agreements, stock options were
granted to purchase a total of 540,000 shares. At May 31, 1996, no
options are exercisable. Options for 270,000 shares become
exercisable during fiscal 1997, with the remainder becoming
exercisable in fiscal 1998, at prices ranging from $4 to $6 per share
and generally expire one year after becoming exercisable. As
discussed in Note 5, in July 1996, two employees with employment
agreements were terminated. Under their termination agreements, the
terms of their options, previously issued, were amended and have been
reflected in the above figures.
During fiscal 1996, the Company issued 600,000 warrants to new
directors and 100,000 warrants to a member of the Company's
compensation committee to purchase common stock. The warrants have an
exercise price of $4.00 per share for a period of five years, with
125,000 warrants currently exercisable, 225,000 warrants vesting in
six months, and the balance vesting in one year. One of the new
directors became president of the Company in April 1996. As of
May 31, 1996, no options have been exercised.
7. INCOME TAXES:
------------
As of May 31, 1996, the Company has a net operating loss (NOL)
carryforward for tax reporting purposes of approximately $3,200,000,
however, a substantial portion may be limited due to changes in
ownership of the Company in fiscal 1995 and 1996, pursuant to Section
382 of the Internal Revenue Code, stemming primarily from the
issuances of common stock in its public and private offerings and the
acquisition of GetNet. This NOL expires in the years 2009 through
2011.
Deferred income taxes are provided for differences between the tax and
book basis of assets and liabilities as a result of temporary
differences in the recognition of revenues or expenses for tax and
financial reporting purposes, which relates primarily to certain items
not currently deductible for tax purposes until paid.
Deferred tax assets resulting from these differences consist of the
following:
Net operating loss carryforward $ 1,248,000
Other 72,000
-----------
Total 1,320,000
Less valuation allowance (1,320,000)
----------
Net deferred tax asset $ -
==========
The valuation allowance for deferred tax assets increased from
$195,000 at May 31, 1995 to $1,320,000 at May 31, 1996, due primarily
to an increase in the Company NOL carryforwards.
F-16
_________________________________________________________________________
<PAGE>
TOUCH TONE AMERICA, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
8. SIGNIFICANT SALES AGENT RELATIONSHIP:
------------------------------------
The Company has an agreement with an independent sales agent, whereby
the agent receives maximum commissions of approximately 32% on sales
it originates. At current sales levels, the Company does not realize
a direct profit from the sales generated by the agent. Indirectly,
however, the Company realizes more profit on its other monthly usage
as a result of the increased discounts resulting from the increased
usage received from the Company's provider. Also, if the Company
successfully renegotiates its contract with its provider, the Company
believes it will then directly realize additional profit on sales
originated by the agent, if a greater discount can be obtained from
the provider. Payment of the commissions to the agent is secured by
the customer base generated by the sales agent. For the ten months
ended May 31, 1995 and the year ended May 31, 1996, the sales
originated by the agent have accounted for 42% and 36%, respectively,
of company sales. During these periods, the Company has recorded a
related expense to the agent of approximately $265,000 and $299,000,
respectively, which includes $75,000 paid in fiscal 1996 to settle
past misunderstandings between the parties.
9. SUPPLEMENTAL CASH FLOW INFORMATION:
----------------------------------
The supplemental cash flow information is as follows:
FOR THE
TEN MONTHS FOR THE
ENDED YEAR ENDED
MAY 31, MAY 31,
1995 1996
-------- --------
Equipment acquired through capital
leases $ 24,000 $ 265,000
========= =========
Issuance of preferred stock for
receivables $ 113,000 $ -
========= =========
Issuance of common stock for GetNet
acquisition $ - $ 800,000
========= =========
Conversion of preferred stock into
common stock $ - $ 750,000
========= =========
F-17
__________________________________________________________________________
<PAGE>
TOUCH TONE AMERICA, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
10. SEGMENT INFORMATION:
-------------------
The Company's principal operations are in the long distance resell and
Internet access industries. The following is selected information for
fiscal 1996 about the Company's industry segments. Since GetNet was
acquired in November 1995, segment information is not included for the
ten months ended May 31, 1995.
Long
Distance Internet
Year Ended May 31, 1996 Resell Acess Consolidated
----------------------- ----------- ----------- -----------
Revenue $ 1,951,000 $ 287,000 $ 2,238,000
Loss from operations (2,092,000) (420,000) (2,512,000)
Depreciation and
amortization 11,000 119,000 130,000
Capital expenditures 106,000 260,000 366,000
Identifiable assets 5,832,000 1,096,000 6,928,000
11. SUBSEQUENT EVENTS (UNAUDITED):
-----------------------------
Subsequent to year-end, an unknown party fraudulently charged over
$1,000,000 in long distance charges on the Company's account. The
Company is currently investigating the matter and has contacted the
carrier, AT&T, who denies any responsibility. The Company believes it
has recourse in the matter, and will not be held responsible for these
charges, but the outcome of this matter cannot be predicted at this
time.
F-18
_________________________________________________________________________
<PAGE>
SIGNATURES
----------
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be
signed on its behalf by the undersigned thereunto duly authorized.
Date: September 5, 1996 TOUCH TONE AMERICA, INC.
By /s/ Michael J. Canney
-----------------------------
Michael J. Canney, President
Pursuant to the requirements of the Securities Exchange Act of
1934, this report has been signed below by the following persons on behalf
of the Registrant and in the capacities and on the dates indicated.
Signature Title Date
/s/ Michael J. Canney President, Principal September 5, 1996
- ------------------------ Executive Officer
Michael J. Canney
/s/ David J. Smith Principal Financial September 5, 1996
- ------------------------ and Accounting Officer
David J. Smith
/s/ Mathew J. Barletta Director September 5, 1996
- ------------------------
Mathew J. Barletta
- ----------------------- Director September ___, 1996
Stephen P. Shearin
/s/ Norman B. Walko Director September 5, 1996
- ------------------------
Norman B. Walko
/s/ Benjamin W. Bronston Director September 5, 1996
- ------------------------
Benjamin W. Bronston
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
Balance Sheet as of May 31, 1996 and Statement of Operations
for the year then ended.
</LEGEND>
<S> <C>
<PERIOD-TYPE> 12-MOS
<FISCAL-YEAR-END> MAY-31-1996
<PERIOD-START> JUN-1-1995
<PERIOD-END> MAY-31-1996
<CASH> 5,278,000
<SECURITIES> 0
<RECEIVABLES> 368,000
<ALLOWANCES> (124,000)
<INVENTORY> 0
<CURRENT-ASSETS> 5,542,022
<PP&E> 491,000
<DEPRECIATION> (62,000)
<TOTAL-ASSETS> 6,928,000
<CURRENT-LIABILITIES> 2,177,000
<BONDS> 0
0
0
<COMMON> 7,945,000
<OTHER-SE> (3,353,000)
<TOTAL-LIABILITY-AND-EQUITY> 6,928,000
<SALES> 2,238,000
<TOTAL-REVENUES> 2,238,000
<CGS> (1,406,000)
<TOTAL-COSTS> (1,406,000)
<OTHER-EXPENSES> (3,462,000)
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