SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549-1004
---------------------------
FORM 10-QSB
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the quarterly period ended December 31, 2004
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from ___ to ___
Commission File Number: 0-28403
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Avalon Digital Marketing Systems, Inc.
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(Exact name of registrant as specified in its charter)
Delaware 77-0511097
----------------------------- -----------------------
(State or other (I.R.S. Employer
jurisdiction of Identification No.)
incorporation or
organization)
5255 N. Edgewood Drive, Suite 250, Provo, UT 84604
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(Address of principal executive offices)
(801) 225-7073
--------------
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [ ] No [X]
Indicate by checkmark whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X]
Indicate by check mark whether the registrant has filed all documents
and reports required to be filed by Section 12, 13 or 15(d) of the Securities
and Exchange Act of 1934 subsequent to the distribution of securities under a
plan confirmed by a court. Yes [ ] No [X]
The number of shares outstanding of each of the Registrant's classes of
common stock, as of the latest practicable date:
Class Outstanding at May 16, 2005
------------------------------------- -------------------------------
Common Stock, $.0001 par value 1,175,725
PART I
FINANCIAL INFORMATION
Item 1. Financial Statements
Avalon Digital Marketing Systems, Inc.
Unaudited Consolidated Balance Sheet
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Successor
Company
-----------------
As of
December 31,
2004
-----------------
Assets
Current assets:
Cash $ 370,388
Receivables, net:
Contract 87,650
Trade 15,538
Retainages 28,700
Prepaid assets 31,100
-----------------
Total current assets 533,376
Fixed assets, net 190,605
Reorganization value in excess of amounts
allocable to identifiable assets 1,972,340
Deposits 1,250
-----------------
Total assets $ 2,697,571
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Liabilities and Shareholders' Equity
Liabilities not subject to compromise:
Current liabilities:
Accounts payable and accrued liabilities $ 281,774
Estimated receivable repurchase obligation 116,815
-----------------
Total current liabilities 398,589
Long-term notes payable 1,367,573
Liabilities subject to compromise (Note 3) -
Commitments and contingencies (Note 7)
Preferred stock subject to compromise:
Series D Preferred stock, par value $0.001,
10,000,000 shares authorized,
1,000,000 shares issued at June 30, 2004,
respectively -
Shareholders' equity:
Common stock, $0.0001 par value,10,000,000
shares authorized, 1,175,725 shares
issued and outstanding at December 31, 2004. 1,175
Old Common stock, $0.001 par value, 75,000,000
shares authorized, 8,713,279 shares issued
and outstanding at June 30, 2004 -
Additional paid-in capital 930,234
Retained earnings -
-----------------
Total shareholders' equity 931,409
-----------------
Total liabilities and shareholders' equity $ 2,697,571
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The accompanying notes are an integral part of these consolidated
financial statements.
1
Avalon Digital Marketing Systems, Inc.
Unaudited Consolidated Statement of Operations
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Predecessor Company
-------------------------------------------------------------------------------
Three-Month Period Ended Six-Month Period Ended
December 31, December 31,
------------------------------------ -----------------------------------------
2004 2003 2004 2003
-------------- -------------------- ------------------- --------------------
Revenues $ 281,755 $ 528,370 $ 538,727 $ 1,114,339
Cost of goods sold 12,517 42,536 30,871 122,591
-------------- -------------------- ------------------- --------------------
Gross profit 269,238 485,834 507,856 991,748
-------------- -------------------- ------------------- --------------------
Selling, general and administrative 576,074 667,134 1,066,637 1,437,729
Bad debt expense 6,370 12,831 11,827 30,928
Settlement expense - - - 249,500
-------------- -------------------- ------------------- --------------------
Total operating expenses 582,444 679,965 1,078,464 1,718,157
-------------- -------------------- ------------------- --------------------
Loss from operations (313,206) (194,131) (570,608) (726,409)
Interest income 6,706 38,936 19,183 91,168
Interest expense (15,278) (53,851) (36,045) (126,986)
Reorganization items, net 8,254,042 - 8,254,042 -
------------------------------------- ----------------------------------------
Net income (loss) from continuing operations before
income taxes 7,932,264 (209,046) 7,666,572 (762,227)
(Provision) benefit for income taxes:
Current - - - -
Deferred - - - -
-------------- -------------------- ------------------- --------------------
Net income (loss) $ 7,932,264 $ (209,046) $ 7,666,572 $ (762,227)
============== ==================== =================== ====================
The accompanying notes are an integral part of these consolidated
financial statements.
2
Avalon Digital Marketing Systems, Inc.
Unaudited Consolidated Statement of Equity
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Series D Preferred Common stock Additional
--------------------------- ---------------------- Paid-in Retained
Shares Amount Shares Amount Capital Earnings Total
------------ ------------ ------------------------ ------------- -------------- ---------------
Balance at June 30, 2004
(Predecessor Company) 1,000,000 1,000 8,713,279 8,713 $ 22,618,580 $ (32,258,993) $ (9,630,700)
Net loss 0 7,666,572 7,666,572
Conversion of
preferred securities (1,000,000) (1,000) 1,000,000 1,000 - - -
Issuance of warrant in
conjuction with
Convertible Note 1,000 1,000
Issuance of warrant in
conjuction with
settlement of
secured note 500 500
Issuance of Sucessor
common stock 1,175,725 1,175 930,234 - 931,409
Application of fresh-start
reporting (Note 4):
Cancellation of
Predecessor common stock (9,713,279) (9,713) (22,620,080) (22,629,793)
Elimination of
Predecessor accumulated
deficit 24,592,421 24,592,421
------------ ------------ ------------------------ ------------- -------------- ---------------
Balance at December 31, 2004
(Successor Company) $ - $ - $ 1,175,725 $ 1,175 $ 930,234 $ 0 $ 931,409
The accompanying notes are an integral part of these consolidated
financial statements.
3
Avalon Digital Marketing Systems, Inc.
Unaudited Consolidated Statement of Cash Flows
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Six Months Ended
December 31, December 31,
2004 2003
------------------- --------------------
Cash flows from operating activities:
Net income (loss) $ 7,666,572 $ (762,227)
Adjustments to reconcile net loss to net cash
(used in) provided by operating activities:
Allowance for doubtful acounts 11,827 30,928
Depreciation and amortization 103,687 141,431
Recovery of A/R previously allowed for (21,976) (104,753)
Loss on impairment of goodwill - 43,200
Effect of the plan of reorganization and
revaluation of assets and liabilities (8,254,042) -
Reorganization items settled in cash (903,598) -
Amortization of debt discount 17,830 44,780
Issuance of stock related to settlement (Note 6) - 249,500
Contract receivables, net 220,743 441,772
Trade receivables 25,332 (49,594)
Retainages receivable - (7,777)
Prepaid assets (23,954) (22,512)
Deposits - (13,250)
Accounts payable 271,811 431,741
Deferred revenue - (141,451)
------------------- --------------------
Net cash provided by (used in) operating activities (885,768) 281,788
------------------- --------------------
Cash flows from investing activities:
Proceeds from sale of property and equipment - 2,545
------------------- --------------------
Net cash (used in) provided by investing activities - 2,545
------------------- --------------------
Cash flows from financing activities:
Borrowings on line of credit - 2,463
Proceeds from notes payable 1,337,813
Repayments on note payable (132,186) (195,741)
------------------- --------------------
Net cash (used in) financing activities 1,205,627 (193,278)
------------------- --------------------
Net increase (decrease) in cash 319,859 91,055
Cash, beginning of year 50,529 1,734
------------------- --------------------
Cash, end of year $ 370,388 $ 92,789
=================== ====================
Supplemental disclosures of cash flow information:
Interest paid $ - $ -
Income taxes paid $ - $ -
=================== ====================
Supplemental disclosures of non-cash financing activities:
Issuance of common stock for preferred stock $ 1,000 $ -
The accompanying notes are an integral part of these consolidated
financial statements.
4
Avalon Digital Marketing Systems, Inc.
Notes to Unaudited Consolidated Financial Statements
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1. BUSINESS AND ORGANIZATION
On September 5, 2003 (the "Petition Date"), Avalon Digital Marketing
Systems, Inc. (the "Company") filed a voluntary petition for reorganization
under Chapter 11 of the United States Bankruptcy Code (the "Bankruptcy Code") in
the United States Bankruptcy Court for the District of Utah, Central Division
(the "Bankruptcy Court"). The Company recently emerged from Chapter 11
Bankruptcy by obtaining confirmation of its Plan, which has become effective,
and received a concurrent debt infusion of approximately $1.3 million. The
Bankruptcy Court entered an order on November 3, 2004 confirming the Company's
First Amended Plan of Reorganization Pursuant to Chapter 11 of the United States
Bankruptcy Code (the "Plan"). The Plan became effective on November 18, 2004,
with the closing of the financing and related confirmation matters effective
December 9, 2004. All conditions required for adoption of fresh-start reporting
were met on November 18, 2004 and the Company selected December 31, 2004 as the
date to adopt the accounting provisions of fresh-start reporting. As a result,
the fair value of the Predecessor Company's assets became the new basis for the
Successor Company's consolidated balance sheet as of December 31, 2004, and all
results of operations beginning January 1, 2005 are those of the Successor
Company.
The Company was formed as a result of a merger between MindArrow
Systems, Inc. ("MindArrow") and Category 5 Technologies, Inc. ("Category 5") on
September 30, 2002.
Category 5 was founded in 1998 as Executive Credit Services LLC and
incorporated under the name ePenzio, Inc. ("ePenzio") in May 2000. On May 29,
2001, Network Investor Communications, Inc. ("NWIC") acquired all of the
outstanding shares of ePenzio, and effective July 23, 2001, NWIC changed its
name to Category 5 Technologies, Inc. For accounting purposes the business
combination with NWIC was treated as a reverse merger or a recapitalization of
ePenzio, with ePenzio being treated as the accounting acquirer. On September 30,
2002, MindArrow acquired all of the outstanding shares of Category 5 and changed
its name to Avalon Digital Marketing Systems, Inc. For accounting purposes, the
business combination with MindArrow was treated as a reverse acquisition, with
Category 5 being the acquirer.
The Company develops and provides software and services that enable its
clients to communicate and sell more effectively and efficiently over the web,
via email, and through other digital channels.
The Predecessor Company's business included the small business and
large enterprise sales channels.
The small business channel was the primary source of historical
revenues, and provided small businesses with merchant services and digital
marketing software, primarily marketed through workshops.
Small business operations consisted primarily of the Category 5
subsidiary. In March 2003, the Company stopped selling its products through
seminars, and refocused on selling software and services through alternative
distribution methods. The large enterprise operations consisted primarily of the
former MindArrow clientele. In June 2003, the Company sold certain of the assets
from its large enterprise operations to Silverpop Systems, Inc. After the sale,
the Company changed its focus to software-based solutions for its small business
customers.
Company revenues were derived from the production and delivery of rich
media messages and software license fees. Production services include theme
development, design and layout, special effects, hyperlink recommendations,
hyperlink page design and creation, custom programming, reporting and sales
cycle consultation.
The Company currently sells its products and services through a direct
sales force and a small network of sales affiliates.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation
The accompanying unaudited consolidated financial statements of Avalon
Digital Marketing Systems, Inc, ("AVALON" or "the Company") were prepared in
accordance with U.S. generally accepted accounting principles (US GAAP) for
interim financial information and with the instructions to Form 10-QSB.
Accordingly, these financial statements do not include all of the information
and footnote disclosures required by US GAAP for complete financial statements.
In the opinion of management, the accompanying unaudited consolidated financial
5
Avalon Digital Marketing Systems, Inc.
Notes to Unaudited Consolidated Financial Statements
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statements contain all adjustments (consisting of only normal recurring
adjustments) necessary to fairly present the Company's financial position as of
December 31, 2004 and June 30, 2004, its results of operations for the three and
six months ended December 31, 2004 and 2003, and its cash flows for the six
months ended December 31, 2004 and 2003. The results of operations for period
ended December 31, 2004 may not be indicative of the results that may be
expected for the year ending June 30, 2005.
Going Concern
Historically, the Company has incurred net losses and negative cash
flows from the operating activities. During the three months ended December 31,
2004, the Company emerged from bankruptcy as a Successor Company and had
negative cash flows of $2,820,093 from operating activities. At December 31,
2004, the Company had a deficit in working capital. The Company's ability to
meet its obligations as they come due is dependent upon its ability to obtain
additional financing as required, and ultimately to achieve and sustain
profitability. These conditions raise substantial doubt about the Company's
ability to continue as a going concern.
The Company will continue to attempt to raise capital through private
equity or debt offerings, as well as from institutional investors until
internally generated profitability is achieved.
There can be no assurance that the Company will be successful in
executing its plans to obtain additional debt or equity financing. If the
Company is unable to obtain additional debt or equity financing, it may be
unable to continue operating.
Fresh-start reporting
For the period subsequent to the Petition Date, the accompanying
consolidated financial statements have been prepared in accordance with the
American Institute of Public Accountant's Statement of Position 90-7, "Financial
Reporting by Entities in Reorganization Under the Bankruptcy Code" ("SOP 90-7").
Accordingly, all pre-petition liabilities subject to compromise have been
segregated in the consolidated balance sheet and classified as liabilities
subject to compromise at the estimated amounts of allowable claims. Liabilities
not subject to compromise are separately classified as current and non-current.
Interest has not been accrued on debt subject to compromise subsequent to the
Petition Date. Reorganization items include the expenses, realized gains and
losses, and provisions for losses resulting from the reorganization under the
Bankruptcy Code, and are reported separately as reorganization items in the
Company's consolidated statement of operations. Cash used for reorganization
items is disclosed separately in the consolidated statement of cash flows.
Principles of consolidation
The accompanying consolidated financial statements include the accounts
of the Company and its wholly-owned subsidiaries. All significant inter-company
account balances and transactions have been eliminated in consolidation.
Concentration of Credit Risk
Financial instruments that potentially subject the Company to
significant concentration of credit risk consist primarily of cash, cash
equivalents, and accounts receivable. Substantially all of the Company's cash
and cash equivalents are held in one financial institution. As of December 31,
2004 and June 30, 2004, the carrying amounts of cash were $370,388 and $50,524,
respectively. The Company maintains its cash in bank deposit accounts and may
exceed federally insured limits. The Company has not experienced any losses in
these accounts and believes it is not exposed to significant credit risk on cash
account balances.
The Company performs ongoing credit evaluations of its customers and
will maintain reserves for potential credit losses as the need arises.
In the normal course of business the Company has historically sold
certain of its receivables to financing companies. The Company's sales of
receivables to financing companies include limited recourse provisions, which
are deemed non-hedging derivatives pursuant to the provisions of the Financial
Accounting Standards Board's Statement of Financial Accounting Standards No.
133, "Accounting for Derivative Instruments and Hedging" ("SFAS No. 133"). The
purpose of the limited recourse provisions are normal in the course of business
and are meant to facilitate the sale of receivables to financing companies. The
fair value of the recourse liability has been determined using a best estimate
method, and the fair value estimate is based on historical recourse rates
experienced by the Company. The fair value of the recourse obligation at
December 31, 2004 and June 30, 2004 is $116,815 and $138,791, respectively.
6
Avalon Digital Marketing Systems, Inc.
Notes to Unaudited Consolidated Financial Statements
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Use of estimates
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from these estimates.
Cash and cash equivalents
Cash equivalents include short-term, highly liquid instruments with
original maturities of 90 days or less. At December 31, 2004, the Company's cash
and cash equivalents were held by one financial institution. The Company does
not believe that, as a result of this concentration, it is subject to any
unusual financial risk beyond the normal risk associated with commercial banking
relationships.
Property and equipment
Property and equipment are recorded at cost and depreciated using the
straight-line method over the estimated useful lives of the related assets as
follows:
Years
----------
Furnitures and fixtures 5-7
Computer hardware and software 3
Machinery and equipment 5-7
Leasehold improvements are amortized over the shorter of the term of
the related leases or estimated service lives. Upon sale or retirement of
assets, cost and related accumulated depreciation are removed from the balance
sheet and the resulting gain or loss is reflected in operations.
Impairment of assets
The Company reviews property and equipment and other long-lived assets
for impairment whenever events or changes in circumstances indicate that the
carrying amount of an asset may not be recoverable. Recoverability is measured
by comparison of the asset's carrying amount to future undiscounted net cash
flows the asset is expected to generate. Cash flow forecasts are based on trends
of historical performance and management's estimate of future performance,
giving consideration to existing and anticipated competitive and economic
conditions. If an asset is considered to be impaired, the impairment to be
recognized is measured by the amount by which the carrying amount of the asset
exceeds the projected discounted future cash flows arising from the asset or its
fair value, whichever is more determinable.
Fair value of financial instruments
The Company's financial instruments generally consist of cash,
short-term investments, receivables, payables, loans from stockholders,
convertible notes, line of credit and capital lease. The carrying amount of
cash, short-term investments, and payables approximates fair value due to the
short-term nature of these items. The loan from stockholder's convertible notes,
line of credit and capital lease also approximate fair value based on
evaluations of market interest rates and the short-term nature of the payable.
7
Avalon Digital Marketing Systems, Inc.
Notes to Unaudited Consolidated Financial Statements
--------------------------------------------------------------------------------
Estimated receivable repurchase obligation
In the normal course of business the Company sells its receivables to
financing companies. The Company's sales of receivables to financing companies
include limited recourse provisions, which are deemed non-hedging derivatives
pursuant to the provisions of Statement of Financial Accounting Standards No.
133 ("SFAS No. 133"), "Accounting for Derivative Instruments and Hedging." The
purpose of the limited recourse provisions are normal in the course of business
and are meant to facilitate the sale of receivables to financing companies. The
fair value of the recourse liability has been determined using a best estimate
method, and the fair value estimate was based on historical recourse rates
experienced by the Company. The fair value of the recourse obligation at
December 31, 2004 and June 30, 2004 is $116,815 and $138,741, respectively.
Increases and decreases in the recourse liability are recorded as reductions and
increases of revenue, respectively.
Revenue recognition
Revenue from the sale of products is recognized when the following four
criteria are met: persuasive evidence of an arrangement exists; products are
shipped and the customer takes ownership and assumes the risk of loss; the
selling price is fixed or determinable; and collectibility is reasonably
assured.
Revenue from lead generation or email delivery consulting is recognized
when the consulting or production services are rendered and messages are
delivered. Revenue from media sales is recognized upon placing advertisements.
Revenue from other consulting is recognized as the services are rendered.
The Company records cash receipts from clients and billed amounts due
from clients in excess of revenue recognized as deferred revenue. The timing and
amount of cash receipts from clients can vary significantly depending on
specific contract terms and can therefore have a significant impact on the
amount of deferred revenue in any given period.
Goodwill and Intangible Assets
Identifiable intangible assets acquired in a business combination are
recorded separately from goodwill if they arise from contractual or other legal
rights or are separable from the acquired entity and can be sold, transferred,
licensed, rented or exchanged, either individually or as part of a related
contract, asset or liability. Goodwill, as well as other intangible assets with
indefinite lives, are not amortized and will be tested for impairment annually
and whenever there is an impairment indicator. All acquired goodwill is assigned
to reporting units for purposes of impairment testing and segment reporting.
Income taxes
Income taxes are accounted for under the asset and liability method.
Deferred income tax assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
bases using enacted tax rates in effect for the year in which the differences
are expected to affect taxable income. Valuation allowances are established when
necessary to reduce deferred tax assets to the amounts expected to be ultimately
realized. Income tax expense (benefit) is the tax payable (receivable) for the
period plus the change during the period in the deferred tax assets and
liabilities.
Stock-based compensation
The Company measures compensation expense for its equity incentive plan
using the intrinsic value method prescribed by Accounting Principles Board
Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25"), and
provides pro forma disclosures of net income as if the fair value based method
prescribed by Statement of Financial Accounting Standards No. 123, "Accounting
for Stock-Based Compensation" ("SFAS 123"), had been applied. Stock-based awards
to non-employees are accounted for under the provisions of SFAS No. 123 and
related pronouncements.
8
Avalon Digital Marketing Systems, Inc.
Notes to Unaudited Consolidated Financial Statements
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In December 2002, the Financial Accounting Standards Board ("FASB")
issued SFAS No. 148, "Accounting for Stock Based Compensation - Transition and
Disclosure" ("SFAS No. 148"), which became effective for fiscal years ended
after December 15, 2002. SFAS No. 148 requires that certain pro forma
information be presented in the summary of significant accounting policies note
to the consolidated financial statements, assuming the Company recognized it
stock-based compensation using the fair value method.
The Company has not provided pro forma disclosures as defined by SFAS
No. 148 for 2004 and 2003 as there were no stock option issuances and proforma
impact.
Earnings per share
Basic net earnings (loss) per share is computed using the weighted
average number of common shares outstanding during the period. Diluted net
earnings (loss) per share is computed using the weighted average number of
common shares during the period plus dilutive potential common shares. Dilutive
potential common shares include the incremental common shares issuable upon the
exercise of stock options and warrants (using the treasury stock method) and the
incremental common shares issuable upon conversion of convertible preferred
stock and notes payable (using the if-converted method). Potential common shares
in the diluted net earnings (loss) per share computation are excluded where
their effect would be anti-dilutive.
Historical earning per share information has not been presented. The
Company does not believe that this information is relevant in any material
respect for users of its financial statements because all existing equity
interests were eliminated (without a distribution) upon consummation of the Plan
of Reorganization.
Internal use software
The Company capitalizes software development costs incurred from the
time technological feasibility of the software is established until the software
is ready for use to provide processing services to customers. Research and
development costs and other computer software maintenance costs related to
software development are expensed as incurred.
Recently issued Accounting Pronouncements
In December 2004, the FASB issued SFAS No. 153, Exchanges of
Nonmonetary Assets, which amends Accounting Principles Board (APB) Opinion No.
29, Accounting for Nonmonetary Transactions. The guidance in APB Opinion 29 is
based on the principle that exchanges of nonmonetary assets should be measured
based on the fair value of the assets exchanged. The guidance in APB Opinion 29,
however, included certain exceptions to that principle. SFAS 153 amends APB
Opinion 29 to eliminate the exception for nonmonetary exchanges of similar
productive assets and replaces it with a general exception for exchanges of
nonmonetary assets that do not have commercial substance. A nonmonetary exchange
has commercial substance if the future cash flows of the entity are expected to
change significantly as a result of the exchange. SFAS 153 is effective for
fiscal periods beginning after June 15, 2005. We do not expect that the adoption
of SFAS 153 will have a material impact on our financial position or results of
operations.
On December 16, 2004, the Financial Accounting Standards Board ("FASB")
published Statement of Financial Accounting Standards No.123 (Revised 2004),
Share Based Payment ("SFAS 123R"). SFAS 123R requires that compensation cost
related to share-based payment transactions be recognized in the financial
statements. Share-based payment transactions within the scope of SFAS 123R
include stock options, restricted stock plans, performance-based awards, stock
appreciation rights, and employee share purchase plans. The provisions of SFAS
123R are effective as of the first interim period that begins after December 15,
2005. Accordingly, the Company will implement the revised standard in the first
quarter of fiscal year 2006. Currently, the Company accounts for its share-based
payment transactions under the provisions of APB 25, which does not necessarily
require the recognition of compensation cost in the financial statements.
Management is assessing the implications of this revised standard and the effect
of the adoption of SFAS 123R will have on our financial position, results of
operations, or cash flow.
Reclassifications
Certain amounts in the prior period financial statements have been
reclassified to be consistent with the current year presentation.
9
Avalon Digital Marketing Systems, Inc.
Notes to Unaudited Consolidated Financial Statements
--------------------------------------------------------------------------------
3. VOLUNTARY REORGANIZATION UNDER CHAPTER 11
Bankruptcy Proceedings
On September 5, 2003, the Company filed a voluntary petition for relief
under Chapter 11 of the Bankruptcy Code in the Bankruptcy Court. Under Chapter
11, certain claims against the Company in existence prior to the filing of the
petition for relief under the Bankruptcy Code were stayed while the Company
continues business operating as Debtor-In-Possession. Those claims were
reflected in the June 30, 2004 consolidated balance sheets as liabilities and
preferred stock subject to compromise. Prior to the application of fresh-start
reporting, the Company's June 30, 2004 consolidated balance sheet included the
related balances subject to compromise described in the table below. However,
the adoption of fresh-start reporting results in the settlement of such balances
based on the estimated payment amounts pursuant to the Plan with the difference
recorded as a reorganization gain in the consolidated statement of operations
for the six months ended December 31, 2004.
The Company continued to operate its business as Debtor-In-Possession
through November 18, 2004. As a consequence of the bankruptcy filing, most
litigation against the Company was stayed.
The Company filed the Plan on May 28, 2004 and the Plan was confirmed
by the Bankruptcy Court on November 3, 2004, and was consummated on November 18,
2004. A summary of the significant provisions of the Plan is set forth below:
o All common and preferred equity shares of the Company (and all
stock options and warrants) were cancelled;
o All debt securities of the Company were settled and cancelled;
o Unexpired leases and executory contracts of the Company were
assumed or rejected in accordance with the Plan;
o The Company issued $1.338 million principal amount of 3% Secured
Convertible Promissory Notes due 2007;
o Pursuant to the Plan, approximately 1.1 million shares of new
Company common stock were issued to settle the claims of general
unsecured creditors, 73,483 shares of new Company common stock
were issued to the former shareholders of the Company.
Additionally, approximately 6.2 million shares of new Company
common stock have been authorized and reserved relating to
convertible promissory notes and new warrants issued by the
Company on December 9, 2004 in connection with the Company's
emergence from bankruptcy;
o Approximately 300,000 shares of new Company common stock were
authorized and reserved for issuance to the secured creditor of
the Predecessor Company.
o Total payments of approximately $904,000 in cash were estimated in
the Plan to be paid to settle certain claims against the Company
and administrative expenses related to the Bankruptcy Proceedings;
and
o The distribution provisions of the Plan allowed the Company to
settle and discharge the allowed claims of certain classes of
creditors in cash and stock, as described above.
Plan of Reorganization
The following briefly summarizes the classification and treatment of
claims and equity interests under the Plan:
Claims estimated to be fully recoverable
o Administrative expenses and other priority claims, secured tax
claims and other secured claims were to be paid in cash.
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Avalon Digital Marketing Systems, Inc.
Notes to Unaudited Consolidated Financial Statements
--------------------------------------------------------------------------------
o Obligations incurred in the ordinary course of business during the
pendency of the Chapter 11 cases or approved by the Bankruptcy
Court and pre-existing obligations assumed by the Company were
paid in full when due.
Claims having an estimated recovery of less than 100%
o Company general unsecured claims were settled and discharged by
the payment of $245,000 in cash to a trust established for the
benefit of creditors (the "Creditors Trust"), by transferring
certain litigation rights and claims to the Creditors Trust (which
transfer has occurred) and by the distribution of approximately
127 shares of common stock of the Successor Company for each
$1,000 of allowed claim and cash equal to 2.31% of the allowed
claim.
o Company's common stockholders were to receive approximately 1
share of common stock in the Successor Company for approximately
each 132 shares of common stock held in the Predecessor Company.
Claims receiving no compensation
o Company subordinated claims received no distribution.
Dividends or Stock Repurchases
o No amounts were distributed in cash in the form of dividends or
stock repurchases.
Liabilities Subject To Compromise
Liabilities subject to compromise represent the liabilities of the
Company incurred prior to the Petition Date, except those that were not impaired
under the Plan. Liabilities subject to compromise consisted of the following at
December 31, 2004:
Pre-petition accounts payable and accrued liabilities $ 7,148,241
Notes payable 2,187,289
Other liabilities 743,805
----------------
Total liabilities subject to compromise $ 10,079,335
================
For the amounts reported as liabilities subject to compromise in the
table above, the Company will reconcile recorded pre-petition liabilities with
the actual claims filed by creditors. In some individual instances and in total,
claims filed by creditors are in excess of the amounts recorded by the Company's
debtors. The Company has recorded an estimate of allowed claims based on the
reconciliation work that has been completed to date. However, given the size and
complexity of the Chapter 11 cases, there is some uncertainty as to the ultimate
liability that will be negotiated with creditors for these pre-petition claims,
and, the final liability upon completion of the reconciliation and negotiation
with claimants at a future date may be significantly higher or lower than
management's current estimate. The Company's debtors and the Creditors Trust
intend to contest claims to the extent they exceed the amounts the Company's
debtors believe are due and to the extent an objection would have a material
effect on pro-rata distribution.
During the six months ended December 31, 2004, the Predecessor Company made
adjustments to liabilities subject to compromise for additional liabilities
recognized under the Plan. The following table identifies the changes in the
Predecessor Company's liabilities subject to compromise prior to the adoption of
fresh-start reporting on December 31, 2004:
11
Avalon Digital Marketing Systems, Inc.
Notes to Unaudited Consolidated Financial Statements
--------------------------------------------------------------------------------
Liabilities subject to compromise as of June 30, 2004 $ 9,449,617
Additions:
Additional liabilities 629,718
---------------
Liabilities subject to compromise as of December 31, 2004 $ 10,079,335
===============
No interest expense related to pre-petition debt has been accrued following the
Petition Date as none of the allowed claims against the Company has underlying
collateral in excess of the principal amount of debt.
Reorganization items, net
Following the filing of the Chapter 11 cases, the Company commenced a
comprehensive reorganization process, together with its financial and legal
advisors, to review and analyze its businesses, contracts and leases to
determine if any of these owned assets should be divested and which contracts
and leases should be rejected or assumed during the Chapter 11 cases.
Reorganization items consisted primarily of $8,254,042 related to the
effects of the plan of reorganization and fresh-start reporting,
Included in reorganization items, net for the quarter ended December
31, 2004 was the Company's gain recognized from the effects of the Plan. The
gain results from the difference between the Company's carrying value of
remaining pre-petition liabilities, minority interests and common stock subject
to compromise and the amounts to be distributed pursuant to the Plan. The gain
from the effects of the Plan and the application of fresh-start reporting is
comprised of the following:
Discharge of liabilities subject to compromise $ 10,079,335
Discharge of common stock subject to compromise 8,539
Issuance of new common stock (930,234)
Amounts settled in cash (903,598)
----------------
Gain from the effects of the Plan $ 8,254,042
================
4. FRESH-START REPORTING
In accordance with SOP 90-7, the Company adopted fresh-start reporting
as of the close of business on December 31, 2004. The consolidated balance sheet
as of December 31, 2004 gives effect to allocations to the carrying value of
assets or amounts and classifications of liabilities that were necessary when
adopting fresh-start reporting. As discussed below, these allocation adjustments
recorded to the carrying amounts of assets and liabilities in the December 31,
2004 consolidated balance sheet are subject to adjustment as estimated
valuations are finalized.
The consolidated balance sheet included in this Quarterly Report on
Form 10-QSB reflects the implementation of the Plan as if the Plan had been
effective on December 31, 2004. Reorganization adjustments have been recorded in
the consolidated balance sheet to reflect the discharge of debt and the adoption
of fresh-start reporting in accordance with SOP 90-7.
These estimates of fair value have been reflected in the Company's
consolidated balance sheet as of December 31, 2004. However, as these estimates
are finalized, the allocations of fair value in the Company's balance sheet
could result in additional adjustments to the fair value of assets or present
value of estimated liabilities during the allocation period while the Company
continues to obtain information necessary to complete its final allocation.
These adjustments could result from additional information related to the
assumptions and estimates used in determining the fair value of long-lived
assets. Potential allocation adjustments to the Company's assets include
estimates used for the fair value of contracts, property, plant and equipment.
12
Avalon Digital Marketing Systems, Inc.
Notes to Unaudited Consolidated Financial Statements
--------------------------------------------------------------------------------
In applying fresh-start reporting, the Company followed these
principles:
o Each liability existing as of the fresh-start reporting date has
been stated at the present value of the amounts to be paid,
determined at appropriate current interest rates. Deferred revenue
was adjusted to reflect the fair value of future costs of
contractual performance obligations plus a normal profit margin.
o The Company is evaluating the fair value of property, plant and
equipment assets and will reclass from the intangible upon final
determination.
The following table identifies the adjustments recorded to the
Company's December 31, 2004 consolidated balance sheet as a result of
implementing the Plan and applying fresh-start reporting (in millions):
13
Avalon Digital Marketing Systems, Inc.
Notes to Unaudited Consolidated Financial Statements
--------------------------------------------------------------------------------
Adjustments to Record
Predecessor Confirmation of Plan Successor
Company ----------------------------------------- Company
December 31, Debt Exchange Fresh December 31,
2004 Discharge of Stock Start 2004
------------------- -------------- ---------- -------------- -------------------
Assets
Current assets:
Cash $ 1,273,986 $ (903,598) $ 370,388
Receivables, net:
Contract 87,650 87,650
Trade 15,538 15,538
Retainages 28,700 28,700
Prepaid assets 31,100 31,100
------------------- -------------------
Total current assets 1,436,974 533,376
Fixed assets, net 190,605 190,605
Identifiable intangible assets, net - -
Reorganization value in excess of amounts allocable
to identifiable assets - 1,972,340 1,972,340
Deposits 1,250 1,250
------------------- -------------------
Total assets $ 1,628,829 $ 2,697,571
------------------- -------------------
Liabilities and Shareholders' Deficit
Liabilities not subject to compromise:
Current liabilities:
Accounts payable and accrued liabilities $ 281,774 281,774
Deferred revenue - -
Notes payable 1,367,573 1,367,573
Estimated receivable repurchase obligation 116,815 116,815
Deferred taxes - -
------------------- -------------------
Total current liabilities 1,766,162 1,766,162
Liabilities subject to compromise 10,079,335 (10,079,335) -
Commitments and contingencies (Notes 15)
Preferred stock subject to compromise 1,000 (1,000) -
Shareholders' deficit:
Common stock - new (Successor) - 1,175 1,175
Common stock - old (Predecessor) 8,713 (8,713) -
Additional paid-in capital 22,620,080 930,234 (22,620,080) 930,234
Retained deficit (32,846,463) 9,175,738 (921,696) 24,592,421 -
------------------- -------------------
Total shareholders' deficit (10,216,670) 931,409
------------------- -------------------
Total liabilities and shareholders' deficit $ 1,628,827 $ 2,697,571
------------------- -------------------
5. RECEIVABLES
Contracts Receivable
Contracts receivable consist of amounts due from customers of the Small
Business sales channel. The customers have typically entered into 36-month
installment contracts and the portion of the balance that is due within one year
is included in the current balance. The allowance for doubtful accounts is
estimated using the Company's experience in collecting from these customers. At
December 31, 2004 and June 30, 2004, contracts receivable consisted of the
following:
14
Avalon Digital Marketing Systems, Inc.
Notes to Unaudited Consolidated Financial Statements
--------------------------------------------------------------------------------
December 31, June 30,
2004 2004
------------------ -----------------
Contract receivables - current $180,836 $ 440,057
Allowance for doubtful accounts (93,186) (119,837)
------------------ -----------------
Contract receivables - current, net $ 87,650 $ 320,220
================== =================
6. NOTES PAYABLE
Liabilities Not Subject to Compromise
Line of Credit
In August 2002, the Company, through its wholly-owned subsidiary,
ePenzio, Inc., renewed its revolving line of credit with Zions First National
Bank (the "Zions Facility") and increased the amount of the credit facility to
$2 million. The annual interest rate applied to the unpaid principal balance of
the Zions Facility is 1% over Prime. The Zions Facility is secured by all
inventory, chattel paper, accounts and general intangibles owned by the Company
on or after September 11, 2001. As of December 31, 2004 and June 30, 2004, the
Company had a balance of $0.00 and $36,556 under the Zions Facility. In January
2003, with permission of the Bankruptcy Court and in exchange for an advance of
$250,000 on the line, the Company designated a recurring revenue stream in the
amount of approximately $40,000 per month for repayment of the outstanding
balance on the line. The entire amount outstanding under the Zions Facility was
subsequently repaid in full prior to December 31, 2004.
Secured Promissory Notes
On June 30, 2003, the Company received a $300,000 bridge loan from an
investor affiliated with a significant stockholder and who is a former director
(Note 8). Interest in the amount of $75,000 was deemed to be accrued and owing
in full upon entering into the bridge loan. Additionally, interest at the rate
of 25% per annum accrued on all amounts owning under the bridge loan on and
after the maturity date. The bridge loan was secured by all assets of the
Company, and matured on June 30, 2004. As consideration for entering into the
bridge loan the Company issued warrants to purchase 300,000 shares of common
stock at $0.22 per share. The Creditors Committee in the Company's bankruptcy
proceedings disputed the amount and validity of the bridge loan during the
pendency of the bankruptcy proceedings. The bridge loan and all disputes
relating to the bridge loan were settled pursuant to an agreement approved by
the Bankruptcy Court and was considered satisfied on December 9, 2004 from the
proceeds of the bankruptcy financing.
On November 30, 2004, in conjunction with the Plan of Reorganization,
the Company issued a secured promissory note in the amount of $29,860 to a
former secured creditor affiliated with two current employees of the Company.
Interest on the note accrues at a rate of 6% per annum. The entire balance is to
be repaid in three equal monthly installments beginning December 17, 2004.
On December 13, 2004, the Company issued two secured convertible
promissory notes in the amounts of $822,763 and $514,950. These notes were
issued in conjunction with an investment relating to the Company's emergence
from bankruptcy. The notes convert into 5,143,795 shares of Company common
stock. Unless converted, the notes automatically mature and principal is due and
payable on December 13, 2007. Interest on the notes accrues at a rate of 3% per
annum, increasing to a rate of 8% in the event of default. Accrued interest on
the notes is payable quarterly on the last day of each three-month period
beginning on December 13, 2004.
15
Avalon Digital Marketing Systems, Inc.
Notes to Unaudited Consolidated Financial Statements
--------------------------------------------------------------------------------
Debt Subject to Compromise
Pre-petition debt subject to compromise as of December 31, 2004
consisted of the following:
Notes payable $1,298,000
Convertible notes payable 889,289
----------------
Total debt subject to compromise $2,187,289
================
Morrison & Foerster Note Payable
On March 18, 2003, the Company issued a promissory note in the
principal amount of $715,000 to Morrison & Foerster LLP and entered into a
related security agreement in payment for legal services previously provided and
recorded by the Company in accounts payable and accrued liabilities. The note
bore interest at 10% per annum and was due upon the receipt of gross proceeds
from a debt or equity financing of $100,000 or greater, in the amount of 15% of
net proceeds from the financing, and on the tenth calendar day of each month in
the amount of ten percent of the Company's cash and short term investments. This
note payable was secured by substantially all of the assets of the Company.
In June 2003, the note and security agreement were amended to release
the security interest in the assets of the Company. The amendment required a
cash payment of $150,000 and the issuance of 1,000,000 shares of newly-created
series of preferred stock of the Company.
According to the Plan, which was confirmed by the Bankruptcy Court on
November 3, 2004, each share of the preferred stock was converted into one share
of common stock on December 9, 2004, and all obligations related to the
indebtedness to Morrison & Foerster LLP were settled and discharged under the
Plan.
Convertible Note Payable
In November 2001, the Company issued convertible notes in the aggregate
principal amount of $820,000 to sixteen investors (the "Convertible Notes"). The
Convertible Notes bore interest at 8% per annum, were due on November 21, 2002,
and were convertible into shares of common stock at the option of the holders.
In December 2002, the holders of the Convertible Notes agreed to amend
the repayment terms to increase the interest rate to 14%, lower the conversion
price and establish payment terms calling for six equal monthly principal
payments from January 2003 through June 2003. The note holders also received
additional warrants to purchase common stock and an amendment to their original
warrants to reduce the exercise price.
The grant of additional warrants and repricing of old warrants,
combined with the resulting beneficial conversion feature resulted in a discount
to the note of $820,000, thus yielding an effective interest rate of 114%. The
discount was amortized over the term of the Convertible Notes, therefore
$820,000 of the discount was amortized as interest expense as of June 30, 2003.
In January 2003, $130,667 of the notes were converted into 43,570
shares of common stock. The balance of the January payment that was not
converted into common stock amounted to $50,107.
All obligations under the Convertible Notes and the related warrants to
purchase common stock of the Company were settled and discharged under the Plan.
Radical Communications, Inc.
In September 2001, MindArrow issued an unsecured subordinated note
payable in the principal amount of $1 million to Radical Communication, Inc.
("Radical"), in connection with MindArrow's acquisition of substantially all of
the assets of Radical. In August 2002, $250,000 of the principal balance was
converted into 62,500 shares of common stock and warrants to purchase 71,875
shares of common stock.
16
Avalon Digital Marketing Systems, Inc.
Notes to Unaudited Consolidated Financial Statements
--------------------------------------------------------------------------------
The note bore interest at 5% per annum and was due in two principal
installments; $250,000 on October 1, 2002 and $500,000 on October 1, 2003. The
initial payment was not made when due, and in February 2003, $150,000 of this
note was converted into 37,500 shares of common stock and warrants to purchase
43,125 shares of common stock at $2 per share.
All obligations under this notes and the related warrants to purchase
common stock of the Company were settled and discharged under the Plan.
OTR Promissory Note
In May 2003, the Company settled a dispute with MindArrow's former
landlord over amounts due under a lease for MindArrow's former facilities. In
the settlement, the Company issued a promissory note in a principal amount of
$830,000 that called for payments of $5,000 per month from July 2003 until
February 2004 and $10,000 per month beginning in March 2004 until full payment.
In January 2005, the payments were scheduled to increase to $100,000 per quarter
until the balance was paid. In June 2003, a judgment lien covering all of the
assets of the Company was filed in connection with this settlement. As a
consequence of the bankruptcy filing, the above judgment lien did not perfect.
As of June 30, 2003, the Company had paid $105,000 of the outstanding promissory
note.
All obligations under the note were settled and discharged under the
Plan.
AGEA Convertible Promissory Note
In September 2003, the Company agreed to amend an asset purchase
agreement dated December 20, 2002 and issue an additional 825,000 shares of
common stock and a convertible promissory note in the principle amount of
$200,000 to the original investors and shareholders of the AGEA Corporation
("AGEA Parties"). The AGEA Parties agreed to release the Company from all
liability under the original asset purchase agreement dated December 20, 2002.
The Company recognized settlement expense of $249,000 as of June 30, 2004
related to the agreement.
All obligations under the convertible promissory note were settled and
discharged under the Plan.
7. COMMITMENTS AND CONTINGENCIES
Operating leases
The Company leases office space in Provo, Utah from a related party
under a non-cancelable lease agreement. The original term of the lease was
thirty-six months commencing on September 1, 2001 and terminating on August 31,
2004. On November 15, 2004, the Company exercised it Renewal Option under the
original lease. The Renewal Option requires monthly lease payments ranging from
$6,100 to $6,415 over the lease term expiring on November 30, 2007.
Legal claims
From time to time the Company is subject to legal proceedings and
claims in the ordinary course of business, including claims of alleged
infringement of trademarks, copyrights and other intellectual property rights.
The Company's liquidity position has resulted in it becoming party to
lawsuits for non-payment of liabilities. These amounts are included in
"Liabilities subject to compromise" and "Accounts payable and accrued
liabilities" in the accompanying consolidated balance sheet at December 31, 2004
and June 30, 2004. The Company is working with the creditors to reach
settlements and payment terms that are acceptable. As a consequence of the
bankruptcy filing, most litigation regarding non-payment of liabilities against
the Company has been stayed.
In July, 2004, the Company received a notice from the Utah Department
of Consumer Protection (the "Department") indicating that a former subsidiary of
the Company (which had subsequently been merged into the Company) had incurred a
fine in the amount of $44,000, which resulted in the Company being placed on the
Consumer Watch List. The Department has asserted that this fine may not be
discharged by the Plan or the Company's bankruptcy proceedings. The Company is
in discussions with the Department and the State of Utah regarding the
dischargability of this fine.
17
Avalon Digital Marketing Systems, Inc.
Notes to Unaudited Consolidated Financial Statements
--------------------------------------------------------------------------------
In 1999 and 2000, MindArrow was a victim of a fraud perpetrated by its
former transfer agent and her accomplice, who were convicted of felonies arising
from the scheme. At sentencing hearings in April and July 2002, the perpetrators
were ordered to pay to the Company $10.9 million in restitution in addition to
amounts already received. Any further recovery on these causes of action have
been assigned to the Creditors Trust.
8. RELATED PARTY TRANSACTIONS
Loans from Stockholders
Two stockholders of the Company have advanced amounts to the Company.
The advances do not bear interest and are non-secured. Both of the stockholders
who advanced the amounts were employees of the Company. At June 30, 2004, the
amount due to the shareholders was $208,868.
All obligations under this loans to the Company were settled and
discharged under the Plan.
Secured Promissory Notes
An investor affiliated with a significant shareholder and who is a
director provided to the Company a bridge loan on June 30, 2003 in the amount of
$300,000 (Note 6). All obligations under the secured promissory note were
settled and discharged under the Plan.
On November 30, 2004, in conjunction with the Plan of Reorganization,
the Company issued a secured promissory note in the amount of $29,760 to a
former secured creditor affiliated with two current employees of the Company.
Interest on the note accrues at a rate of 6% per annum. The entire balance is to
be repaid in three equal monthly installments beginning December 17, 2004.
Sales Commission
An investor affiliated with a significant shareholder and who is a
director provides sales lead generation services for the Company for which
commissions were paid. Commissions paid for the quarter and six months ended
December 31, 2004 totaled approximately $6,471 and $16,633, respectively.
Office Lease
The Company leases office space from a related party under a three year
lease agreement commencing September 1, 2001 (Note 7).
9. SHAREHOLDERS' EQUITY
Series D Preferred Stock Subject to Compromise
In June 2003, a note agreement (Note 6 - Morrison & Foerster Note
Payable) was amended to release the security interest in the assets of the
Company upon the earlier of the closing of the pending sale to Silverpop
Systems, Inc. (Note 10) or July 30, 2003. The amendment calls for a cash payment
of $150,000 and the issuance of 1,000,000 shares of newly-created Series D
preferred stock. Under the note agreement, if the payment is not made and
issuance of preferred stock not completed according to the terms of the
amendment, then the terms of the original note and security agreement will be
reinstated. Each share of Series D Preferred Stock, when issued, will be
convertible into one share of common stock and carry a liquidation preference of
$0.25.
According to the Company's Plan Reorganization, which was confirmed by
the Bankruptcy Court on November 03, 2004, each share of the Series D Preferred
Stock was converted into one share of common stock on December 09, 2004. All
further payment obligations under this note were settled and discharged under
the Plan.
18
Avalon Digital Marketing Systems, Inc.
Notes to Unaudited Consolidated Financial Statements
--------------------------------------------------------------------------------
Common Stock
Under the Plan, all equity securities of the Company were cancelled as
of November 18, 2004. Also under the Plan, approximately 1.1 million shares of
new Company common stock shares were authorized to be issued to settle the
claims of general unsecured creditors, 73,483 shares of new Company common stock
were authorized to be issued to the former shareholders of the Company.
Additionally, approximately 6.2 million shares of new Company common stock have
been authorized and reserved relating to convertible promissory notes and new
warrants issued by the Company on December 9, 2004 in connection with the
Company's emergence from bankruptcy.
Warrants
Under the Plan, all equity securities of the Company, including all
outstanding warrants, were cancelled as of November 18, 2004. In connection with
the consummation of the Plan, the Company issued 1,028,761 warrants to certain
former creditors of the Company and to investors in the Company's convertible
notes issued December 9, 2004. As of December 31, 2004, all of these warrants
were outstanding with exercise prices ranging from $.0001 to $.00011 per share,
and with expiration dates in 2011. The Company has reserved sufficient shares of
common stock to meet its stock option and warrant obligations.
10. SUBSEQUENT EVENTS
On January 14, 2005, the Board of Directors approved and reserved for
issuance 1 million shares of Company common stock to be issued upon exercise of
stock options. These options have an exercise price of $0.01 with one-fourth
vesting upon issuance and the remainder vesting equally in January 2006, 2007
and 2008. Additionally, the Board of Directors issued approximately 850,000
options to employees and members of the Board of Directors.
On February 14, 2005, the Company made a loan to Hubbard Acquisition
Corp. in the amount of $125,000. The Company's largest secured creditor is
affiliated with Hubbard Acquisition Corp. The loan was collateralized by a Note
and Warrant Purchase and Security Agreement previously executed by the Company.
Additionally, the loan was personally guaranteed by an individual affiliated
with the Company's largest secured creditor.
On March 8, 2005, the Company issued a promissory note to the Law
Debenture Trust Company of New York in the amount of $45,000 for services to be
rendered associated with the Plan of Reorganization and review and approval of
Company's unsecured claims. $15,000 remains outstanding under this note.
In April 2005, Hubbard Acquisition Corp., under a certain Settlement
Agreement with the Company, repaid the $125,000 loan made on February 14, 2005.
Additionally, the Company was compensated for legal fees and other costs
associated with reviewing a joint venture proposal made by Hubbard Acquisition
Corp. In addition to the repayment of the loan, Hubbard Acquisition Corp. issued
a promissory note to the Company for $33,500. This promissory note was to be
repaid on or before April 16, 2005. Currently the note is in default and has not
been repaid.
19
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
The following discussion should be read together with Company
consolidated financial statements and related notes included elsewhere in this
quarterly report on Form 10-QSB.
Overview
On September 5, 2003 (the "Petition Date"), Avalon Digital Marketing
Systems, Inc. (the "Company") filed a voluntary petition for reorganization
under Chapter 11 of the United States Bankruptcy Code (the "Bankruptcy Code") in
the United States Bankruptcy Court for the District of Utah, Central Division
(the "Bankruptcy Court"). The Company recently emerged from Chapter 11
Bankruptcy by obtaining confirmation of its Plan, which has become effective,
and received a concurrent debt infusion of approximately $1.3 million. The
Bankruptcy Court entered an order on November 3, 2004 confirming the Company's
First Amended Plan of Reorganization Pursuant to Chapter 11 of the United States
Bankruptcy Code (the "Plan"). The Plan became effective on November 18, 2004,
with the closing of the financing and related confirmation matters effective
December 9, 2004.
The Company was formed as a result of a merger between MindArrow
Systems, Inc. ("MindArrow") and Category 5 Technologies, Inc. ("Category 5") on
September 30, 2002.
The Company was founded in 1998 as Executive Credit Services LLC and
incorporated under the name ePenzio, Inc. in May 2000. On May 29, 2001, NWIC
acquired all of the outstanding shares of ePenzio, and effective July 23, 2001,
NWIC changed its name to Category 5 Technologies, Inc. For accounting purposes
the business combination with NWIC was treated as a reverse merger or a
recapitalization of ePenzio, with ePenzio being treated as the accounting
acquirer. On September 30, 2002, MindArrow Systems, Inc., a Delaware
corporation, acquired all of the outstanding shares of Category 5 and changed
its name to Avalon Digital Marketing Systems, Inc.
The Company develops and provides software and services that enable its
clients to communicate and sell more effectively and efficiently over the web,
via email, and through other digital channels.
The Predecessor Company's business was divided between the small
business and large enterprise sales channels.
The small business channel was the primary source of historical
revenues, and provided small businesses with merchant services and digital
marketing software, primarily marketed through workshops.
Small business operations consisted primarily of the Category 5
subsidiary. In March 2003, the Company stopped selling its products through
seminars, and refocused on selling software and services through alternative
distribution methods. The large enterprise operations consisted primarily of the
former MindArrow clientele. In June 2003, the Company sold certain of the assets
from its large enterprise operations to Silverpop Systems, Inc. After the sale,
the Company changed its focus to software-based solutions for its small business
customers.
Company revenues were derived from the production and delivery of rich
media messages and software license fees. Production services include theme
development, design and layout, special effects, hyperlink recommendations,
hyperlink page design and creation, custom programming, reporting and sales
cycle consultation.
The Company currently sells its products and services through a direct
sales force and a small network of sales affiliates.
Critical accounting policies
Fresh-start reporting
For the period subsequent to the Petition Date, the accompanying
consolidated financial statements have been prepared in accordance with the
American Institute of Public Accountant's Statement of Position 90-7, "Financial
Reporting by Entities in Reorganization Under the Bankruptcy Code" ("SOP 90-7").
Accordingly, all pre-petition liabilities subject to compromise have been
segregated in the consolidated balance sheet and classified as liabilities
subject to compromise at the estimated amounts of allowable claims. Liabilities
20
not subject to compromise are separately classified as current and non-current.
Interest has not been accrued on debt subject to compromise subsequent to the
Petition Date. Reorganization items include the expenses, realized gains and
losses, and provisions for losses resulting from the reorganization under the
Bankruptcy Code, and are reported separately as reorganization items in the
Company's consolidated statement of operations. Cash used for reorganization
items is disclosed separately in the consolidated statement of cash flows.
Estimated receivable repurchase obligation
In the normal course of business the Company sells its receivables to
financing companies. The Company's sales of receivables to financing companies
include limited recourse provisions, which are deemed non-hedging derivatives
pursuant to the provisions of Statement of Financial Accounting Standards No.
133 ("SFAS No. 133"), "Accounting for Derivative Instruments and Hedging." The
purpose of the limited recourse provisions are normal in the course of business
and are meant to facilitate the sale of receivables to financing companies. The
fair value of the recourse liability has been determined using a best estimate
method, and the fair value estimate was based on historical recourse rates
experienced by the Company. The fair value of the recourse obligation at
December 31, 2004 and June 30, 2004 is $116,815 and $138,741, respectively.
Increases and decreases in the recourse liability are recorded as reductions and
increases of revenue, respectively.
Revenue recognition
Revenue from the sale of products is recognized when the following four
criteria are met: persuasive evidence of an arrangement exists; products are
shipped and the customer takes ownership and assumes the risk of loss; the
selling price is fixed or determinable; and collectibility is reasonably
assured.
Revenue from lead generation or email delivery consulting is recognized
when the consulting or production services are rendered and messages are
delivered. Revenue from media sales is recognized upon placing advertisements.
Revenue from other consulting is recognized as the services are rendered.
The Company records cash receipts from clients and billed amounts due
from clients in excess of revenue recognized as deferred revenue. The timing and
amount of cash receipts from clients can vary significantly depending on
specific contract terms and can therefore have a significant impact on the
amount of deferred revenue in any given period.
Stock-based compensation
The Company measures compensation expense for its equity incentive plan
using the intrinsic value method prescribed by Accounting Principles Board
Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25"), and
provides pro forma disclosures of net income as if the fair value based method
prescribed by Statement of Financial Accounting Standards No. 123, "Accounting
for Stock-Based Compensation" ("SFAS 123"), had been applied. Stock-based awards
to non-employees are accounted for under the provisions of SFAS No. 123 and
related pronouncements.
The Company has not provided pro forma disclosures as defined by SFAS
No. 148 for 2004 and 2003 as there were no stock option issuances and proforma
impact.
Recent accounting pronouncements
In December 2004, the FASB issued SFAS No. 153, Exchanges of
Nonmonetary Assets, which amends Accounting Principles Board (APB) Opinion No.
29, Accounting for Nonmonetary Transactions. The guidance in APB Opinion 29 is
based on the principle that exchanges of nonmonetary assets should be measured
based on the fair value of the assets exchanged. The guidance in APB Opinion 29,
however, included certain exceptions to that principle. SFAS 153 amends APB
Opinion 29 to eliminate the exception for nonmonetary exchanges of similar
productive assets and replaces it with a general exception for exchanges of
nonmonetary assets that do not have commercial substance. A nonmonetary exchange
has commercial substance if the future cash flows of the entity are expected to
change significantly as a result of the exchange. SFAS 153 is effective for
fiscal periods beginning after June 15, 2005. We do not expect that the adoption
of SFAS 153 will have a material impact on our financial position or results of
operations.
On December 16, 2004, the Financial Accounting Standards Board ("FASB")
published Statement of Financial Accounting Standards No.123 (Revised 2004),
Share Based Payment ("SFAS 123R"). SFAS 123R requires that compensation cost
21
related to share-based payment transactions be recognized in the financial
statements. Share-based payment transactions within the scope of SFAS 123R
include stock options, restricted stock plans, performance-based awards, stock
appreciation rights, and employee share purchase plans. The provisions of SFAS
123R are effective as of the first interim period that begins after December 15,
2005. Accordingly, the Company will implement the revised standard in the first
quarter of fiscal year 2006. Currently, the Company accounts for its share-based
payment transactions under the provisions of APB 25, which does not necessarily
require the recognition of compensation cost in the financial statements.
Management is assessing the implications of this revised standard and the effect
of the adoption of SFAS 123R will have on our financial position, results of
operations, or cash flow.
The Company needs additional financing
The Company is in the process of emerging from bankruptcy protection
under Chapter 11 of the Bankruptcy Code. The Company has paid, and will continue
to incur costs associated with the recent bankruptcy process. As a result of the
use of many of the Company's resources to settle debts as part of its bankruptcy
proceedings and the related costs associated with emerging from bankruptcy
protection, the Company has a significant need for addition capital.
Pursuant to the terms of the Plan, on December 9, 2004, the Company
issued Secured Convertible Promissory Notes (the "Secured Notes") payable in the
aggregate principal amount of $1,337,813. The Secured Notes are payable upon
maturity and mature on December 13, 2007. The Company also issued warrants to
purchase 734,828 shares of the Company's common stock in connection with the
issuance of the Secured Notes.
In addition, the Company's liquidity is significantly impacted by
credit and collection issues. Prior to its bankruptcy, the Company generated
large balances of receivables and, depending on the quality of the credit and
cash needs, certain of the receivables were sold, at a discount, to financing
sources. Receivables that were not sold were retained and billing and collecting
administration were outsourced. A large portion of the Company's customers prior
to its bankruptcy had sub-prime credit. Accordingly, many of the receivables
generated by these customers had high credit risk.
At December 31, 2004, the Company had $370,388 in cash, which requires
that it seek immediate additional capital. As of December 31, 2004, total assets
were $2,697,571 and total liabilities were $1,766,162.
The accompanying consolidated financial statements have been prepared
in conformity with accounting principles generally accepted in the United States
of America, which contemplate continuation of the Company as a going concern.
In the Company's view, recoverability of a major portion of the
recorded asset amounts shown in the accompanying balance sheet is dependent upon
its continued operations, which in turn is dependent upon its ability to meet
obligations on a continuing basis. The consolidated financial statements do not
include any adjustments relating to the recoverability and classification of
recorded asset amounts or amounts and classification of liabilities that might
be necessary should it be unable to continue in existence.
Results of operations
In recent months, the Company has maintained Axis(TM), a software
product that enables small businesses to create, manage and host websites using
Macromedia, Inc.'s Flash(TM) technology, as well as Courier(TM), which is a
Flash-enabled email marketing tool designed for small business customers. These
products, together with professional services that will enable customers to make
the best use of them, should contribute to the Company's revenue going forward.
Throughout the bankruptcy process, The Company has been actively
engaged in the development of a new, enterprise level software application. This
application, Point Blank, is an enterprise email marketing system that manages
the entire life-cycle of strategic email marketing campaigns, from list
management to design and execution, to reporting. Combining robust creation and
delivery features with event-driven content and campaign logic, the software
delivers individually customized messaging to each recipient without sacrificing
the economic and marketing advantages of email. Point Blank is offered as an ASP
product, allowing global access via the Web, and providing full third-party data
and program access through a web services interface. These new products should
allow the Company to shift its reliance away from the sources of revenue
generated prior to its bankruptcy filing. Clients of the Company prior to its
bankruptcy generally entered into long-term installment contracts to pay for the
products and services they purchased, and the Company experienced high rates of
payment default in these contracts.
22
Quarterly revenues totaled $281,755, a 47% decrease from the same
quarter in the previous year. Revenues for the six months ended December 31,
2004 decreased to $538,727 from $1,114,339 for the six months ended December 31,
2003, a 52% decrease. The decreases are primarily the result of management's
plan to reduce its dependency on the lower quality revenues typically produced
prior to the Company's bankruptcy filing, and a shift in the overall direction
of the Company by developing its own, proprietary, digital marketing software
application.
Gross profit decreased from $485,834 for the three months ended
December 31, 2003 to $269,238 for the three months ended December 31, 2004.
Gross profit decreased from $991,748, or 89% of revenues, to $507,856, or 94% of
revenues, for the six months ended December 31, 2004.
Selling, general and administrative expenses decreased from $667,134,
or 126% of revenues, and $1,437,729, or 129% of revenues, for the quarter and
six months ended December 31, 2003, respectively, to $576,074, or 204% of
revenues, and $1,066,637, or 198% of revenues, for the quarter and six months
ended December 31, 2004, respectively. These decreases were associated with a
reduction in workforce and scaled back operations during bankruptcy. During the
quarter ended December 31, 2004, the Company completed cost reductions which
should reduce costs in subsequent quarters.
Bad debt expense decreased from $12,831 and $30,928 for the quarter and
six months ended December, 31, 2003, respectively, to $6,370 and $11,827 for the
quarter and six months ended December 31, 2004, respectively. The decrease
resulted primarily from a reduction in defaults on contracts receivable of the
Company pertaining to contracts receivable previously sold to financing
companies. The Company has decreased its dependence on long-term contracts
receivable for revenues generated prior to the Company's bankruptcy filing, and
therefore expects bad debt expense to decrease on both an absolute and relative
basis in future quarters.
The Company incurred a loss from operations of $313,206 and $570,608
for the quarter and six months ended December, 31, 2004, respectively, compared
to a loss from operations of $194,131 and $726,409 for the same periods from
2003. The loss resulted from a number of factors, including the factors
discussed in the foregoing paragraphs and the following factors:
o The decrease in lead-source revenues and bad debt expense;
o Reduction in new sales due to perceived instability during
bankruptcy; and
o Increases in costs related to the bankruptcy completed during the
year.
Certain of these costs are nonrecurring, such as the costs associated
with bankruptcy, and the curtailing of entering into installment contracts will
significantly reduce bad debt expense in future quarters.
Liquidity and sources of capital
In conjunction with its recent Plan of Reorganization and emergence
from Chapter 11 bankruptcy, on December 9, 2004, the Company issued Secured
Convertible Promissory Notes payable in the amount of $1,337,813 and due in
2007. Additionally, the Company has paid, and will continue to incur costs
associated with the recent bankruptcy process.
At December 31, 2004, the Company had $370,388 in cash, which requires
that it seek immediate additional capital. As of December 31, 2004, total assets
were $2,697,571 and total liabilities were $1,766,162.
The accompanying consolidated financial statements have been prepared
in conformity with accounting principles generally accepted in the United States
of America, which contemplate continuation of the Company as a going concern.
In the Company's view, recoverability of a major portion of the
recorded asset amounts shown in the accompanying balance sheet is dependent upon
its continued operations, which in turn is dependent upon its ability to meet
obligations on a continuing basis. The consolidated financial statements do not
include any adjustments relating to the recoverability and classification of
recorded asset amounts or amounts and classification of liabilities that might
be necessary should it be unable to continue in existence.
23
During the six months ended December 31, 2004, the Company used
$885,768 of cash from operating activities and generated $1,205,627 of cash in
financing activities. During the six months ended December 31, 2003, the Company
generated $281,788 of cash from operating activities, generated $2,545 of cash
in investing activities and used $193,278 of cash in financing activities.
Liquidity is significantly impacted by credit and collection issues and the
continued costs and fees associated with the recent bankruptcy process.
The Company needs additional capital to continue operations in the near
term. Additional capital may come from the sale of certain assets of the
Predecessor Company or other available means, which may include debt and/or
equity financings. Assurance cannot be given that any additional financing will
be available on acceptable terms, if at all. Any equity financing and debt
financing, if available, may include restrictive covenants. If unable to raise
additional capital and/or reach agreement with its creditors to convert
convertible debt into equity, Company operations will be severely harmed.
Certain of the matters and subject areas discussed in this quarterly
report on Form 10-QSB contain "forward-looking statements" that are subject to a
number of risks and uncertainties, many of which are beyond the Company's
control. All statements, other than statements of historical fact included in
this report regarding business strategy, future operations, financial position,
estimated revenues, projected costs, prospects, plans and objectives of
management as well as third parties are forward-looking statements. Generally,
when used in this report, the words "anticipate," "intend," "estimate,"
"expect," "project," and similar expressions are intended to identify
forward-looking statements, although not all forward-looking statements contain
such identifying words. All forward-looking statements speak only as of the date
of this report. Although the Company believes that the expectations reflected in
the forward-looking statements are reasonable, it can give no assurance that
such expectations will prove to be correct. Important factors that could cause
its actual results to differ materially from its expectations are described
below and in other Company filings with the SEC.
Risk Factors
The Company needs additional financing
At December 31, 2004, the Company had $370,388 in cash, which requires
that it seek immediate additional capital. As of December 31, 2004, total assets
were $2,697,571 and total liabilities were $1,766,162.
Implementation of the Company's business plan will require access to
additional capital. Failure to obtain sufficient financing will restrict the
Company's ability to implement its business plan and materially adversely affect
its business. The Company believes that its current cash and cash equivalents,
together with cash flows expected to be generated from the Company's future
operations, will not be sufficient to fund the Company's operating needs for the
next 12 months. Therefore, the Company requires additional financing in an
amount that cannot be determined at this time to enable it to finance
unanticipated working capital requirements and to develop or enhance existing
products or services, among others. In addition, if the Company is unable to
fund its operations at its current levels, and if customers and vendors become
concerned about its business prospects, they may decide not to conduct business
with it, or may conduct business with it on terms that are less favorable than
those customarily extended by them. In that event, Company revenues would
decrease and its business will suffer significantly.
THERE CAN BE NO ASSURANCE THAT ANY ADDITIONAL FINANCING WILL BE
AVAILABLE ON ACCEPTABLE TERMS, IF AT ALL. IF UNSUCCESSFUL IN RAISING ADDITIONAL
FUNDS, THE COMPANY'S LIQUIDITY POSITION WILL BE MATERIALLY AND ADVERSELY
AFFECTED AND IT COULD BE REQUIRED TO MAKE DRASTIC COST REDUCTIONS, WHICH WOULD
NEGATIVELY IMPACT ITS OPERATIONS.
Although the Company believes its assumptions underlying its operating
plan to be reasonable, it lacks the operating history of a more seasoned company
and there can be no assurance that its forecasts will prove accurate. In the
event that its plans change, its assumptions change or prove inaccurate, if
future financing falls through, or if future private placements, other capital
resources and projected cash flow otherwise prove to be insufficient to fund
operations, it could be required to seek additional financing sooner than
currently anticipated. To the extent that it is able to raise additional funds
and it involves the sale of its equity securities, the interests of our
shareholders could be substantially diluted.
24
Recent actions of the Company may negatively impact its ability to achieve its
business objectives
In order to manage liquidity and cash positions, over the past year the
Company has had to implement certain cost cutting measures, including
significant reductions in force. After these staff reductions, as of December
31, 2004, the Company had 15 full time employees. Although these cost cutting
measures improved its short-term cash requirements, they may negatively impact
its ability to grow its business and achieve its business objectives.
Limited operating history makes evaluation of its business difficult
The Company has a limited operating history on which to base its
evaluation of current business and prospects. The Company's current business
plan is significantly changed from its business plan prior to its bankruptcy
filing, with less reliance on long-term contracts and the Predecessor Company's
product offerings. The very limited operating history using its new business
plan makes it difficult to predict future results, and there are no assurances
that its revenues will increase, or that it will achieve or maintain
profitability or generate sufficient cash from operations in future periods.
Company's ability to achieve and sustain profitability would be
adversely affected if it:
o fails to effectively market and sell its services;
o fails to develop new and maintain existing relationships with
clients;
o fails to continue to develop and upgrade its technology and
network infrastructure;
o fails to respond to competitive developments;
o fails to introduce enhancements to its existing products and
services to address new technologies and standards; or
o fails to attract and retain qualified personnel.
Company operating results are also dependent on factors outside of its
control, such as strength of competition and the growth of the market for our
services. There is no assurance that it will be successful in addressing these
risks, and failure to do so could have a material adverse effect on its
financial performance.
The Company is not sure if the market will accept its product offerings
The Company is in the process of developing and marketing new software
products and related services. The Company's ability to succeed will depend on
the effectiveness of its marketing and sales efforts of these new products,
market acceptance of these current and future product offerings and the
reliability of its networks and the services it offers to its clients. The
Company operates in a market that is rapidly evolving, and is characterized by
an increasing number of competitors and risk surrounding market acceptance of
new technologies and services. Potential customers must view its technologies as
a viable alternative to traditional commercial advertising and brochure
distribution. Because this market is so new, it is difficult to predict its size
and growth rate. If the market fails to develop as the Company expects, its
growth will be slower than expected.
The Company may make acquisitions of complementary technologies or businesses,
which may disrupt its business and be dilutive to its existing stockholders
The Company intends to consider acquisitions of businesses and
technologies on an opportunistic basis. Acquisitions of businesses and
technologies involve numerous risks, including the diversion of management
attention, difficulties in assimilating the acquired operations, loss of key
employees from the acquired company, and difficulties in transitioning key
customer relationships. In addition, these acquisitions may result in dilutive
issuances of equity securities, the incurrence of additional debt, large
one-time expenses and the creation of goodwill or other intangible assets that
result in significant amortization expense and impairment charges. Any
acquisition may not provide the benefits originally anticipated, and there may
be difficulty in integrating the service offerings and customer and supplier
relationships gained through acquisitions with its own. Although it attempts to
minimize the risk of unexpected liabilities and contingencies associated with
acquired businesses through planning, investigation and negotiation, such
unexpected liabilities nevertheless may accompany such acquisitions. The Company
cannot guarantee that it will successfully identify attractive acquisition
candidates, complete and finance additional acquisitions on favorable terms, or
integrate the acquired businesses or assets into its own. Any of these factors
could materially harm its business or its operating results in a given period.
25
Network and system failures could adversely impact its business.
The performance, reliability and availability of the Company's websites
and network infrastructure is critical to its reputation and ability to attract
and retain clients. Its systems and operations are vulnerable to damage or
interruption from earthquake, fire, flood, power loss, telecommunications
failure, Internet breakdowns, break-ins, tornadoes and similar events. Services
based on sophisticated software and computer systems often encounter development
delays and the underlying software may contain errors that could cause system
failures. Any system failure that causes an interruption could result in a loss
of clients and could reduce the attractiveness of its services.
The Company is also dependent upon web browsers, Internet service
providers and online service providers to provide Internet user's access to its
clients, users and websites. Users may experience difficulties due to system
failures or delays unrelated to its systems. These difficulties may hurt audio
and video quality or result in intermittent interruptions in broadcasting and
thereby slow its growth.
Circumvention of Company security measures and viruses could disrupt its
business
Despite the implementation of security measures, Company networks may
be vulnerable to unauthorized access, computer viruses and other disruptive
problems. Anyone who is able to circumvent security measures could steal
proprietary information or cause interruptions in its operations. Service
providers have occasionally experienced interruptions in service as a result of
the accidental actions of users or intentional actions of hackers. The Company
may have to spend significant capital to protect against security breaches or to
fix problems caused by such breaches. Although it has implemented security
measures, there can be no assurance that such measures will not be circumvented
in the future. Eliminating computer viruses and alleviating other security
problems may require interruptions, delays or cessation of service to users,
which could hurt its business.
The Company may be unable to collect its receivables and retainages in amounts
previously estimated
In accordance with United States generally accepted accounting
principles, the Company has established reserves against its retainages and
receivables. It believes that the established reserves adequately allow for the
estimated uncollectible portion of the retainages and receivables. However, it
may experience collection rates below established reserves, which could reduce
the amount of available funds and require additional reserves. Reduced available
funds could adversely affect its ability to successfully implement the
objectives of its business plan. There can be no assurance that it will be able
to collect retainages and receivables in sufficient amounts. Failure to collect
adequate amounts of retainages and receivables could materially adversely affect
its business and results of operations.
The market for Internet-based services is relatively new, intensely
competitive and rapidly evolving. There are minimal barriers to entry, and
current and new competitors can launch new Internet products and services at a
relatively low cost within relatively short time periods. The Company expects
competition to persist and intensify and the number of competitors to increase
significantly in the future. Should it seek in the future to attempt to expand
the scope of its Internet services and product offerings, it will compete with a
greater number of Internet companies. Because the operations and strategic plans
of existing and future competitors are undergoing rapid change, it is difficult
for it to anticipate which companies are likely to offer competitive products
and services in the future.
If the Company does not respond to technological change, it could lose or fail
to develop customers
The development of its business entails significant technical and
business risks. To remain competitive, it must continue to enhance and improve
the functionality and features of its technology. The Internet and the ecommerce
industry are characterized by:
o rapid technological change;
o changes in client requirements and preferences;
o frequent new product and service introductions embodying new
technologies; and
o the emergence of new industry standards and practices.
The evolving nature of the Internet could render the Company's existing systems
obsolete
Company success will depend, in part, on its ability to:
o develop and enhance technologies useful in its business;
o develop new services and technology that address the increasingly
sophisticated and varied needs of its current and prospective
clients; and
26
o adapt to technological advances and emerging industry and
regulatory standards and practices in a cost-effective and timely
manner.
Future advances in technology may not be beneficial to, or compatible
with, the Company's business. Furthermore, it may not use new technologies
effectively or adapt its systems to client requirements or emerging industry
standards on a timely basis. Its ability to remain technologically competitive
may require substantial expenditures and lead time. If it is unable to adapt to
changing market conditions or user requirements in a timely manner, it will lose
clients.
The Company could face liability for Internet content
As a distributor of Internet content, the Company faces potential
liability for negligence, copyright, patent or trademark infringement,
defamation, indecency and other claims based on the content of its broadcasts.
Such claims have been brought, and sometimes successfully pressed, against
Internet content distributors. The Company's general liability insurance may not
be adequate to indemnify it for all liability that may be imposed. Although it
generally requires its clients to indemnify it for such liability, such
indemnification may be inadequate. Any imposition of liability that is not
covered by insurance or by an indemnification by a client could harm its
business.
The Company's stock price has been and may continue to be volatile
The trading price of the Company's common stock has been and is likely
to continue to be highly volatile. Its stock price could be subject to wide
fluctuations in response to factors such as:
o the average daily trading volume of its common stock;
o actual or anticipated variations in quarterly operating results
and its need for additional financing to fund its continuing
operations;
o announcements of technological innovations, new products or
services by it or its competitors;
o the addition or loss of strategic relationships or relationships
with its key customers;
o conditions or trends in the Internet, streaming media, media
delivery, and online commerce markets;
o changes in the market valuations of other Internet, online
service, or software companies;
o announcements by it or its competitors of significant
acquisitions, mergers, strategic partnerships, joint ventures, or
capital commitments;
o sales of its common stock and legal or regulatory developments;
o additions or departures of key personnel;
o its failure to obtain additional financing on satisfactory terms,
or at all; and
o general market conditions.
The historical volatility of the Company's stock price may make it more
difficult for investors in its securities to resell shares at prices they find
attractive.
In addition, the stock market in general, the Nasdaq SmallCap Market,
the market for Internet and technology companies in particular, has experienced
extreme price and volume fluctuations that have often been unrelated or
disproportionate to the operating performance of these companies. These broad
market and industry factors may reduce the Company's stock price, regardless of
its operating performance.
Failure to satisfy the Nasdaq SmallCap Market listing requirements may result in
the Company's common stock not being listed on the Nasdaq SmallCap Market, which
could have an adverse impact on its stock price.
In connection with its bankruptcy proceedings and related matters, the
Company's common stock was delisted from the NASDAQ SmallCap Market. The
Company's common stock is quoted on the Pink Sheets on an unsolicited trading
basis. As a result, there is currently no regular public trading market for the
Company's common stock. The Company is making every effort to comply with the
Nasdaq SmallCap Listing requirements, but the Company cannot ensure that it will
27
meet the requirements in a timely manner or that an active trading market will
exist for its common stock in the future. The Company's failure to obtain the
relisting of its common stock on the NASDAQ SmallCap Market could have an
ongoing material adverse effect on the liquidity of the Company's common stock
and result in a corresponding material reduction in the price of the common
stock.
Future sales of the Company's common stock may depress its stock price.
Sales of a substantial number of shares of Company common stock in the
public market, or the appearance that such shares are available for sale, could
adversely affect the market price for its common stock. As of December 31, 2004,
the Company had 1,175,725 shares of common stock outstanding. A significant
number of these shares are not publicly traded but may be available for
immediate resale to the public through private transactions. The Company also
has reserved shares of its common stock as follows:
o 1,028,761 shares are reserved for issuance upon the exercise of
warrants; and
o 5,143,795 shares are reserved for issuance upon the conversion of
convertible notes.
Shares underlying vested options are generally eligible for immediate
resale in the public market.
Company efforts to protect its intellectual property rights may not sufficiently
protect it and it may incur costly litigation to protect its rights
The Company marks its software with copyright notices, and intends to
file copyright registration applications where appropriate. It intends to file
several federal trademark registration applications for trademarks and service
marks it uses. There can, however, be no assurance that any patents, copyright
registrations, or trademark registrations applied for by the Company will be
issued, or if issued, will sufficiently protect its proprietary rights.
The Company also relies substantially on certain technologies that are
not patentable or proprietary and are therefore available to its competitors. In
addition, many of the processes and much of its technology is dependent upon its
technical personnel, whose skill, knowledge and experience are not patentable.
To protect its rights in these areas, the Company requires all employees,
significant consultants and advisors to enter into confidentiality agreements
under which they agree not to use or disclose Company confidential information
as long as that information remains proprietary. It also requires that its
employees agree to assign to it all rights to any inventions made during their
employment relating to its activities, and not engage in activities similar to
that of the Company during the term of their employment. There can be no
assurance, however, that these agreements will provide meaningful protection for
Company trade secrets, know-how or other proprietary information in the event of
any unauthorized use or disclosure of such trade secrets, know-how or
proprietary information. Further, in the absence of patent protection, the
Company may be exposed to competitors who independently develop substantially
equivalent technology or otherwise gain access to its trade secrets, knowledge
or other proprietary information.
Despite Company efforts to protect its intellectual property, a third
party or a former employee could copy, reverse-engineer or otherwise obtain and
use its intellectual property or trade secrets without authorization or could
develop technology competitive to that of the Company.
The Company's intellectual property may be misappropriated or infringed
upon. Consequently, litigation may be necessary in the future to enforce its
intellectual property rights, to protect its confidential information or trade
secrets, or to determine the validity or scope of the rights of others.
Litigation could result in substantial costs and diversion of management and
other resources and may not successfully protect the Company's intellectual
property. Additionally, it may deem it advisable to enter into royalty or
licensing agreements to resolve such claims. Such agreements, if required, may
not be available on commercially reasonable or desirable terms or at all.
The Company's technology may infringe on the rights of others
Even if the patents, copyrights and trademarks the Company applies for
are granted, they do not confer on the Company the right to manufacture or
market products or services if such products or services infringe on
intellectual property rights held by others. If any third parties hold
conflicting rights, the Company may be required to stop making, using, or
marketing one or more of its products or to obtain licenses from and pay
royalties to others, which could have a significant and material adverse effect
on it. There can be no assurance that the Company will be able to obtain or
maintain any such license on acceptable terms or at all.
The Company may also be subject to litigation to defend against claims
of infringement of the rights of others or to determine the scope and validity
28
of the intellectual property rights of others. If third parties hold trademark,
copyright or patent rights that conflict with Company business, then the Company
may be forced to litigate infringement claims that could result in substantial
costs to it. In addition, if it were unsuccessful in defending such a claim, it
could have a negative financial impact. If third parties prepare and file
applications in the United States that claim trademarks used or registered by
the Company, it may oppose those applications and be required to participate in
proceedings before the United States Patent and Trademark Office to determine
priority of rights to the trademark, which could result in substantial costs to
it. An adverse outcome in litigation or privity proceedings could require it to
license disputed rights from third parties or to cease using such rights. Any
litigation regarding its proprietary rights could be costly, divert management's
attention, result in the loss of certain of its proprietary rights, require it
to seek licenses from third parties and prevent it from selling its services,
any one of which could have a negative financial impact. In addition, inasmuch
as the Company broadcasts content developed by third parties, its exposure to
copyright infringement actions may increase because it must rely upon such third
parties for information as to the origin and ownership of such licensed content.
The Company generally obtains representations as to the origin and ownership of
such licensed content and generally obtains indemnification to cover any breach
of such representations; however, there can be no assurance that such
representations will be accurate or given, or that such indemnification will
adequately protect it.
The length of the sales cycle increases Company costs
Many of the Company's potential customers conduct extensive and lengthy
evaluations before deciding whether to purchase or license its products. In the
Company's experience to date it has seen the sales cycle range from a few days
up to six months. While the potential customer is making this decision, it
continues to incur salary, travel and other similar costs of following up with
these accounts. Therefore, the risk associated with a lengthy sales cycle is
that the Company may expend substantial time and resources over the course of
the sales cycle only to realize no revenue from such efforts if the customer
decides not to purchase from it. Any significant change in customer buying
decisions or sales cycles for Company products could have a material adverse
effect on its business, results of operations, and financial conditions.
International markets for online marketing are in their very early stages of
development
The Company has distributed email messages globally. To date, the
Company has developed or modified into foreign language text and delivered rich
media content to recipients in the United Kingdom, France, Switzerland, Austria,
Norway, Sweden, Iceland, Finland, Denmark, Greece, Lebanon, Mexico, Panama,
Peru, Philippines, Australia, Singapore, Hong Kong, China, and Taiwan. The
markets for online advertising and direct marketing in these countries are
generally in earlier stages of development than in the United States, and the
Company cannot assure that the market for, and use of online advertising and
direct marketing in international markets such as these and others will be
significant in the future. Factors that may account for slower growth in the
online advertising and direct marketing markets include, but are not limited to:
o slower growth in the number of individuals using the Internet
internationally;
o privacy concerns;
o a lower rate of advertising spending internationally than in the
United States; and
o a greater reluctance to use the Internet for advertising and
direct marketing.
Any of the above-listed risks could have a material adverse effect on
future Company business, financial condition, or results of operations.
Company is subject to risks associated with governmental regulation and legal
uncertainties
The Company is subject to general business laws and regulations. These
laws and regulations, as well as new laws and regulations that may be adopted in
the United States and other countries with respect to the Internet, may impede
the growth of the Internet. These laws may relate to areas such as advertising,
taxation, personal privacy, content issues (such as obscenity, indecency, and
defamation), copyright and other intellectual property rights, encryption,
electronic contracts and "digital signatures," electronic commerce liability,
email, network and information security, and the convergence of traditional
communication services with Internet communications, including the future
availability of broadband transmission capability. Other countries and political
organizations are likely to impose or favor more and different regulation than
that which has been proposed in the United States, thus furthering the
complexity of regulation. In addition, state and local governments may impose
29
regulations in addition to, inconsistent with, or stricter than, federal
regulations. The adoption of such laws or regulations, and uncertainties
associated with their validity, applicability, and enforcement, may affect the
available distribution channels for and costs associated with Company products
and services, and may affect the growth of the Internet. Such laws or
regulations may therefore harm Company business.
The Company does not know for certain how existing laws governing
issues such as privacy, property ownership, copyright and other intellectual
property issues, taxation, illegal or obscene content, retransmission of media,
and data protection, apply to the Internet. The vast majority of such laws were
adopted before the advent of the Internet and related technologies and do not
address the unique issues associated with the Internet and related technologies.
Most of the laws that relate to the Internet have not yet been interpreted.
Changes to or the interpretation of these laws could:
o limit the growth of the Internet;
o create uncertainty in the marketplace that could reduce demand for
Company products and services;
o increase Company's cost of doing business;
o expose the Company to significant liabilities associated with
content distributed or accessed through its products or services,
and with its provision of products and services, and with the
features or performance of its products;
o lead to increased product development costs, or otherwise harm
Company business; or
o decrease the rate of growth of the Company user base and limit its
ability to effectively communicate with and market to its user
base.
Any of the above-listed consequences could have a material adverse
effect on the Company's future business, financial condition, or results of
operations.
Company may be subject to legal liability in connection with the data collection
capabilities of its products and services
Company products are interactive Internet applications that, by their
very nature, require communication between a client and server to operate. To
provide better consumer experiences and to operate effectively, Company products
occasionally send information to servers at the Company. Many of the services
the Company provides also require that users provide information to it. The
Company posts privacy policies concerning the use and disclosure of its user
data. Any failure by the Company to comply with its posted privacy policies
could impact the market for its products and services, subject it to litigation,
and harm its business.
In addition, the Child Online Privacy Protection Act ("COPPA") became
effective as of April 21, 2000. COPPA requires operators of commercial Web sites
and online services directed to children (under 13), and general audience sites
that know that they are collecting personal information from a child, to:
o provide parents notice of their information practices;
o obtain verifiable parental consent before collecting a child's
personal information, with certain limited exceptions;
o give parents a choice as to whether their child's information will
be disclosed to third parties;
o provide parents access to their child's personal information and
allow them to review it and/or have it deleted;
o give parents the opportunity to prevent further use or collection
of information; not require a child to provide more information
than is reasonably necessary to participate in an activity; and
o maintain the confidentiality, security, and integrity of
information collected from children.
The Company does not knowingly collect and disclose personal
information from such minors, and therefore believes that it is fully compliant
with COPPA. However, the manner in which COPPA may be interpreted and enforced
cannot be fully determined, and thus COPPA and future legislation such as COPPA
could subject the Company to potential liability, which in turn would harm its
business.
30
Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company does not believe that it currently has material exposure to
interest rate, foreign currency exchange rate or other relevant market risks.
Interest Rate and Market Risk. Company exposure to market risk for
changes in interest rates relates primarily to the Company's investment profile.
As of December 31, 2004, the Company's investment portfolio consisted primarily
of cash and cash equivalents, substantially all of which were held at one
financial institution. The Company does not use derivative financial instruments
in its investment portfolio.
Foreign Currency Exchange Risk. The Company does not believe that it
currently has material exposure to foreign currency exchange risk because of the
relative insignificance of its foreign relationships. The Company intends to
assess the need to use financial instruments to hedge currency exposures on an
ongoing basis.
The Company does not use derivative financial instruments for
speculative trading purposes.
Item 4. CONTROLS AND PROCEDURES
(a) Evaluation of disclosure controls and procedures.
We maintain disclosure controls and procedures as defined in Rule
13a-15(e) of the Securities Exchange Act of 1934, as amended (the "Exchange
Act"). Our disclosure controls and procedures include controls and procedures
designed to ensure that information required to be disclosed in our reports
filed or submitted under the Exchange Act is accumulated and communicated to our
management, including our Chief Executive Officer and Chief Financial Officer,
as appropriate to allow timely decisions regarding required disclosures.
As required by Rule 13a-15(b) of the Exchange Act, we conducted an
evaluation, under the supervision of our Chief Executive Officer and Chief
Financial Officer, of the effectiveness of the design and operation of our
disclosure controls and procedures as of December 31, 2004. Based on this
evaluation, our Chief Executive Officer and Chief Financial Officer concluded
that our disclosure controls and procedures were effective as of December 31,
2004 in ensuring that information required to be disclosed in our reports filed
or submitted under the Exchange Act is recorded, processed, summarized, and
reported within the time periods specified in the SEC's rules and forms.
(b) Changes in internal controls
There were no significant changes in the Company's internal controls
over financial reporting or in other factors that could significantly affect
these internal controls subsequent to the date of their most recent evaluation,
including any corrective actions with regard to significant deficiencies and
material weaknesses.
31
PART II
OTHER INFORMATION
Item 1. Legal Proceedings
The Company recently emerged from Chapter 11 Bankruptcy with the
confirmation of its First Amended Plan of Reorganization Pursuant to Chapter 11
of the United States Bankruptcy Code (the "Plan") on November 3, 2004. The Plan
became effective on November 18, 2004, with the closing of the financing and
related confirmation matters effective December 9, 2004. However, under the
Plan, the Bankruptcy Court retained jurisdiction over certain matters, including
matters relating to claim objections and specific matters relating to the
implementation and consummation of the Plan. In management's opinion, the
matters over which the Bankruptcy Court has retained jurisdiction are not
expected to have a material adverse impact on the Company's financial position
or results of operations.
In July, 2004, the Company received a notice from the Utah Department
of Consumer Protection (the "Department") indicating that a former subsidiary of
the Company (which had subsequently been merged into the Company) and the
Company will be placed on the "Buyers Beware List" for the State of Utah until
such time that the Company has no complaints filed with the Division for a
period of 90 days and the Company pays the $44,000 assessed by the Department in
connection with an earlier judgment obtained by the Department. The Department
has asserted that this fine may not be discharged by the Plan or the Company's
bankruptcy proceedings. The Company is in discussions with the Department and
the State of Utah regarding the dischargability of this fine and the Company's
listing on the Buyer Beware List.
In 1999 and 2000, MindArrow was a victim of a fraud perpetrated by its
former transfer agent and her accomplice, who were convicted of felonies arising
from the scheme. At sentencing hearings in April and July 2002, the perpetrators
were ordered to pay to the Company $10.9 million in restitution in addition to
amounts already received. Any further recovery on these causes of action have
been assigned to the Creditors Trust..
Item 2. Changes in Securities and Use of Proceeds
During the quarter ended December 31, 2004, the Company authorized the
following equity securities in transactions not registered under the Securities
Act:
On December 9, 2004, the Company issued Secured Convertible Promissory
Notes in the aggregate principal amount of $1,337,713, which notes are
convertible into 5,143,795 shares of the Company's common stock.
Additionally, 1,028,761 shares of new Company common stock have been
authorized and reserved relating to new warrants issued by the Company on
December 9, 2004 in connection with the Company's emergence from bankruptcy;
Each of the foregoing issuances was without registration under the
Securities Act in reliance upon the exemption from the registration requirements
of the Securities Act set forth in Section 4(2) of the Securities Act and
Regulation D thereunder. The recipients of securities in each transaction
represented their intentions to acquire the securities for investment only and
not with a view to or for sale in connection with any distribution thereof.
These sales were made without general solicitation or advertising. Each
recipient was either an accredited or sophisticated investor and had adequate
access to relevant information about us.
Item 3. Defaults Upon Senior Securities
None
Item 4. Submission of Matters to a Vote of Security Holders
None.
Item 5. Other Information
None.
32
Item 6. Exhibits
31.1 Certification of Registrant's Chief Executive Officer
pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2 Certification of Registrant's Chief Financial Officer
pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1 Certification of Registrant's Chief Executive Officer
pursuant to 18 U.S.C. Section 1350, as created by Section
906 of the Sarbanes-Oxley Act of 2002. This certification is
being furnished solely to accompany this Quarterly Report on
Form 10-QSB and is not being filed for purposes of Section
18 of the Securities Exchange Act of 1934, as amended, and
is not to be incorporated by reference into any filing of
the Company.
32.2 Certification of Registrant's Chief Financial Officer
pursuant to 18 U.S.C. Section 1350, as created by Section
906 of the Sarbanes-Oxley Act of 2002. This certification is
being furnished solely to accompany this Quarterly Report on
Form 10-QSB and is not being filed for purposes of Section
18 of the Securities Exchange Act of 1934, as amended, and
is not to be incorporated by reference into any filing of
this Company.
33
SIGNATURES
Pursuant to the requirements 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.
Avalon Digital Marketing Systems, Inc.
Date: May 17, 2005 /s/ DANIEL D. WALTER
--------------------------
Daniel D. Walter
Chief Executive Officer
(Principal Executive Officer)
Date: May 17, 2005 /s/ MATTHEW A. GREENE
--------------------------
Matthew A. Greene
Chief Financial Officer, Secretary, and Treasurer
(Principal Financial and Accounting Officer)
34