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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
(Mark one)
[X] Annual Report pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934 for the fiscal year ended December 31, 1998, or
[ ] Transition Report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934 for the transition period from ______________ to
_____________.
Commission File No. 0-23862
Fonix Corporation
(Exact name of registrant as specified in its charter)
Delaware 87-0380088
(State or other jurisdiction (I.R.S. Employer Identification No.)
of incorporation or organization)
60 East South Temple, Suite 1225
Salt Lake City, Utah 84111
(Address of principal executive offices with zip code)
(801) 328-8700
(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock ($0.0001 par value per share)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days: Yes [X] No [ ].
The aggregate market value of the voting stock held by non-affiliates of the
registrant is approximately $35,828,186.25 calculated using a closing price of
$0.75 per share on April 9, 1999. For purposes of this calculation, the
registrant has included only the number of shares held by its officers and
directors directly of record as of April 9, 1999, (and not counting shares
beneficially owned on that date) in determining the shares held by
non-affiliates. As of April 9, 1999, there were issued and outstanding
70,064,495 shares of the Company's common stock.
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [ ]
Fonix Corporation
1998 FORM 10-K ANNUAL REPORT
TABLE OF CONTENTS
Part I
Item 1. Business..............................................................3
Item 2. Properties...........................................................22
Item 3. Legal Proceedings....................................................23
Item 4. Submission of Matters to a Vote of Security Holders..................24
Part II
Item 5. Market for Registrant's Common Equity and Related
Stockholder Matters..................................................24
Item 6. Selected Financial Data..............................................27
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations................................................28
Item 8. Financial Statements and Supplementary Data..........................39
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure.................................................40
Part III
Item 10. Directors and Executive Officers of the Registrant...................40
Item 11. Executive Compensation...............................................42
Item 12. Security Ownership of Certain Beneficial Owners and Management.......50
Item 13. Certain Relationships and Related Transactions.......................52
Part IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K......54
Page 2 of 60
PART I
ITEM 1. BUSINESS
Overview
Fonix Corporation ("Fonix" or the "Company") is a development-stage company that
aims to make commercially available a comprehensive package of products and
technologies that allow humans to interact with computer and other electronic
products in a more efficient, intuitive and natural way than traditional methods
such as the keyboard. Specifically, Fonix has developed proprietary automated
speech recognition and related technologies such as text-to-speech (speech
synthesis), handwriting recognition and speech compression. These technologies,
as developed to date, use speech recognition techniques that include the use of
a proprietary neural network method. Neural networks are computer-based methods
which simulate the way the human brain processes information. Fonix licenses its
technologies to and has entered into co-development relationships and strategic
alliances with third parties including producers of application software,
operating systems, computers and microprocessor chips.
In March 1998, the Company acquired AcuVoice, Inc., a California corporation and
award winning developer of text-to-speech technologies ("AcuVoice"). AcuVoice
had developed and marketed its text-to-speech or speech synthesis technologies
and products directly to end-users, systems integrators and original equipment
manufacturers ("OEMs") for use in the telecommunications, multi-media, education
and assistive technology markets. The acquisition of AcuVoice by the Company
resulted in the introduction of Fonix-branded products to the market for the
first time in the Company's history. The transaction by which Fonix acquired
AcuVoice is referred to in this report as the AcuVoice Acquisition.
In September 1998, the Company acquired Articulate Systems, Inc., a Delaware
corporation and leading developer of specialized speech recognition applications
used in the health care industry ("Articulate"). This transaction is referred to
in this report as the Articulate Acquisition. Articulate's market focus, prior
to and following the acquisition, is providing solutions for healthcare
organizations for cost effective and rapid capture, transcription and management
of dictated clinical information across a network. Specifically, Articulate
develops, markets and supports an integrated dictation/transcription solutions
process called PowerScribe(R) to healthcare organizations utilizing advanced
continuous speech recognition technology to significantly automate medical
reporting. The PowerScribe system is intended to be user friendly to physicians
and other medical professionals, to significantly reduce transcription costs and
report turnaround time, and to provide other key benefits without sacrificing
dictation accuracy or physician acceptance. Articulate entered into its first
sales contracts for its first product, PowerScribeRAD, a product designed
specifically for radiologists, in January 1998. Articulate's first contracts for
its second product, PowerScribe EM for emergency medicine physicians, were
signed in January 1999. Fonix is in the process of developing a suite of speech
recognition solutions for the healthcare and other markets.
In October 1998, the Company acquired Papyrus Associates, Inc., a Pennsylvania
corporation ("PAI"), and Papyrus Development Corporation, a Massachusetts
corporation ("PDC" and together with PAI, "Papyrus"). The acquisition of PDC and
PAI by Fonix is referred to in this report as the Papyrus Acquisition. PAI
develops and markets printing and cursive handwriting recognition software for
personal digital assistants ("PDAs"), pen tablets and mobile phones. Its
customers include Philips, Hitachi, Olivetti/Oracle Research Lab, NuovoMedia,
ARM, Amstrad, Purple Software and Digital Equipment. The Papyrus technology is
marketed under the trademark Allegro(TM). PAI's software and technology are an
integral part of the Psion PDA. PDC is a systems integration provider with
expertise and intellectual property in embedded systems and enhanced Internet
applications. PDC had a partnership with e-Travel which resulted in the first
corporate travel management Web-browser client software system. This product is
now shipped by e-Travel to customers such as Fidelity Investments, ADP, Travel
One, Coca Cola, Time Inc., and Unisys.
The Company markets speech recognition technologies it has developed, together
with text-to-speech technologies and products acquired from AcuVoice and
handwriting recognition products and applications acquired from Papyrus, through
its Interactive Technologies Solutions Group. The present marketing direction
for the Interactive Technologies Solutions Group is to form relationships with
third parties who can incorporate the Company's technologies into their own
products or product development efforts. Such relationships may be structured in
any of a variety of ways including traditional technology licenses,
co-development relationships through joint ventures or otherwise, and strategic
alliances. The third parties with whom the Company presently has such
relationships and with which it may have similar relationships in the
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future include participants in the application software, operating systems,
computer, microprocessor chips, consumer electronics, automobile, telephony and
health care technology industries. The Company received its first revenues from
its internally developed speech recognition technologies in 1998.
The Company markets its voice recognition and systems software for specialized
applications in the health care industry through its HealthCare Solutions Group.
The HealthCare Solutions Group presently markets large vocabulary voice
recognition software to major hospitals and medical centers for the rapid
capture, transcription and management of clinical information dictated by
radiologists and emergency medical physicians. The HealthCare Solutions Group
also supports and services the systems within the United States. In December
1998, the Company acquired the assets used in the marketing of the HealthCare
Solutions Group's products from The MRC Group, Inc. ("MRC").
The executive offices of the Company are located at 60 East South Temple Street,
Suite 1225, Salt Lake City, Utah 84111, and its telephone number is (801)
328-8700. The principal executive offices of the HealthCare Solutions Group are
located at 600 West Cummings Park, Suite 4500, Woburn, Massachusetts 01801. The
executive offices of the Interactive Technologies Solutions Group are located at
180 West Election Drive, Draper, Utah 84020. The Company also maintains a
facility in Cupertino, California.
Technology and Product Overview
Automated Speech Recognition
Presently available traditional voice recognition technologies have been used in
a variety of products for industrial, telecommunications, business and personal
applications. Speech recognition algorithms in software have been developed and
refined over the past several years. However, the increase in processing speed
and memory capacity of personal computers has accounted for much of the
improvement in traditional speech recognition systems during that period. This
improvement includes vocabulary size, recognition accuracy and continuous speech
recognition ability. Currently available speech recognition systems for personal
computers include speech command systems for navigating the Windows(R) interface
and inexpensive, discrete word dictation systems offered by Dragon Systems, IBM,
Lernout & Hauspie and others. Recently, general and specific vocabulary
continuous speech dictation systems also have been introduced by Philips, IBM,
Dragon Systems and others. In addition, telephony applications with menu choice
systems and small vocabulary dialogue systems have been demonstrated by Nuance,
Nortel and others.
Despite the nominal advances in performance of such presently available systems,
there are significant limitations inherent in all of these systems, each of
which continues to use traditional approaches generally based on Hidden Markov
Models ("HMM") technology. These traditional approaches have not advanced
appreciably since the late 1980s. Applications based on such traditional speech
recognition systems for personal computers all require close-talking microphones
in relatively low noise environments and a formal speaking style to achieve
acceptable accuracy. In so-called continuous dictation systems, significant
adaptation to user speech, speaking style, and content area also are required.
These traditional systems are generally restricted to speech recognition for a
single individual dictating in a quiet environment; presently available
telephony-based systems are even more limited in general functionality.
The present industry standard methodology, the HMM, uses a general template or
pattern matching technique based on statistical language models. Massachusetts
Institute of Technology researcher Dr. Victor Zue has noted that speech-
recognition systems based on such technology
"utilize little or no specific-speech knowledge, but rely instead primarily
on general-purpose pattern- recognition algorithms. While such techniques
are adequate for a small class of well-constrained speech recognition
problems, their extendibility to multiple speakers, large vocabularies,
and/or continuous speech is highly questionable. In fact, even for the
applications that these devices are designed to serve, their performance
typically falls far short of human performance."
HMM's widely recognized weaknesses are many: (i) it does not meet the needs for
many mass market implementations, (ii) it has limited input feature types, (iii)
it accounts for only limited context, (iv) it has limited ability to generalize
acoustic and language structure, (v) it requires training data from the end-user
for acceptable performance, (vi) models
Page 4 of 60
become extremely large and complex as vocabulary grows, and (vii) there is a
lack of hardware parallel processing capability.
In contrast to HMM, Fonix researchers have developed what the Company believes
to be a fundamentally new approach to the analysis of human speech sounds and
the contextual recognition of speech. The core Fonix automated speech
recognition technologies (the "ASRT" or "Core Technologies") attempt to
approximate the techniques employed by the human auditory system and language
understanding centers in the human brain. The ASRT use information in speech
sounds perceptible to humans but not discernible by current automated speech
recognition systems. They also employ neural net technologies (artificial
intelligence techniques) for identifying speech components and word sequences
contextually, similar to the way in which scientists believe information is
processed by the human brain. As presently developed, the ASRT are comprised of
several components including a phonetic sound representation recognition engine,
audio signal processing, a feature extraction process, a phoneme estimation
process, and a linguistic process consisting of two components, one of which is
expert- or rule-based and one of which is based on proprietary neural net
technologies, that are designed to interpret human speech contextually.
Fonix believes the reliable recognition of natural, spontaneous speech spoken by
one or more individuals in a variety of common environments by means of a
conveniently placed microphone, all based on its ASRT, will significantly
improve the performance, utility and convenience of applications currently based
on traditional HMM technology such as computer interface navigation, data input,
text generation, telephony transactions, continuous dictation and other
applications. Additionally, the Company believes that its ASRT will make
possible major new speech recognition applications such as the transcription of
business meetings and conversations, real-time speech-to-speech language
translation, natural dialogues with computers for information access and
consumer electronic devices controlled by natural language.
Thus, the Company believes that its ASRT offers unique speech processing
techniques that will complement and significantly enhance currently available
speech recognition systems. Through its Interactive Technologies Solutions
Group, Fonix intends to continue to license its ASRT, to continue to co-develop
the ASRT with research and development groups in industry and academia and
ultimately to market a suite of Fonix-branded technologies and products. In the
long term, the Company anticipates that automated speech recognition systems
employing the Company's unique ASRT will set the industry standard for all
automated speech recognition applications because of its anticipated capacities
to overcome the weaknesses of HMM. In addition, the Company expects that certain
elements of its Core Technologies will have industry-leading applications in
non-speech recognition industries, market segments and disciplines such as
artificial intelligence and data compression. Although these plans represent
management's beliefs and expectations based on its current understanding of the
market and its experience in the industry, there can be no assurance that actual
results will meet these expectations. See "Certain Significant Risk Factors." In
the last two fiscal years, the Company has expended $13,620,748 and $7,066,294
on research and development activities. Since its inception (October 1, 1993),
the Company has spent $31,558,041on research and development of the ASRT. The
Company expects that a substantial part of its capital resources will continue
to be devoted to research and development of the ASRT and other proprietary
technologies for the foreseeable future.
HealthCare Solutions Group Products
The three PowerScribe products now being sold by the HealthCare Solutions Group
are PowerScribeRAD, PowerScribeRAD Software Development Kit ("SDK")TM, and
PowerScribeEM. PowerScribe products use state-of-the- art continuous speech
recognition engines licensed from Dragon Systems, Inc., which enables a user to
dictate naturally and continuously without having to pause between words.
PowerScribe incorporates customized medical language models gleaned from
millions of words sampled from medical specialty departments across North
America.
PowerScribe products have been designed as mission-critical applications to
operate as an open and scalable continuous speech reporting and charting system.
PowerScribe products utilize core technologies from Microsoft's Back Office(R)
applications development suite and rely on Windows NT(R), Open Database
Connectivity (ODBC) and SQL Server(R) as the foundation operational elements.
Page 5 of 60
PowerScribeRAD for Radiology Reporting
PowerScribeRAD enables the full automation of the radiology reporting process
and replaces existing digital dictation and transcription systems.
PowerScribeRAD permits the dictation of radiology reports directly into text,
with edit, approve, and sign functions accomplished within a matter of minutes;
thereby significantly reducing transcription costs and report turnaround time.
Once reports are dictated, they may be automatically stored in the Radiology
Information System ("RIS"), the Hospital Information System ("HIS") or
PowerScribeRAD's own report repository.
PowerScribeEM for Emergency Medicine Reporting
PowerScribeEM is a completely integrated emergency medicine dictation and
transcription system which allows emergency department professionals to dictate
their reports directly into text in the first total solution for capturing and
documenting emergency medicine clinical encounters. PowerScribeEM minimizes
training and the need for healthcare professionals to modify their work styles.
PowerScribe includes post-processing of the text for organization into a typical
structured emergency medicine report. PowerScribeEM seamlessly handles the
overall workflow of an emergency department. Once reports are dictated, reports
are either automatically stored in the HIS or in PowerScribe's own report
repository for further analysis at a later date.
PowerScribe Radiology SDK for User Development Applications
The PowerScribe Radiology SDK allows users to integrate the full functionality
of the PowerScribeRAD system into the user's own radiology applications. For
radiology environments such as a RIS or Picture Archival Communication System
("PACS") the PowerScribe SDK allows users to develop a completely integrated
dictation and transcription system utilizing continuous speech recognition.
Using this SDK, the PowerScribeRAD client functionality can be embedded into the
user's application while also customizing the user interface and report workflow
to meet specific application needs. The PowerScribeRAD SDK supports multiple
development environments including Microsoft(R) Visual Basic, C++ and the
Microsoft(R) Internet Explorer environment. The SDK includes an Active-X
composite control along with sample code and developer documentation.
Interactive Solutions Group Products
The Interactive Technologies Solutions Group offers products and technologies
which include automated speech recognition, text-to-speech, and handwriting
recognition for a variety of hardware and software platforms. The marketing
direction for the Interactive Technologies Solutions Group is to form
relationships with third parties who can incorporate Fonix technologies into
their own products or product development efforts. Such relationships may be
structured in any of a variety of ways including traditional technology
licenses, co-development relationships through joint ventures or otherwise, and
strategic alliances. The third parties with whom Fonix presently has such
relationships and with which it may have similar relationships in the future
include participants in the application software, operating systems, computer,
microprocessor chips, consumer electronics, automobile, telephony and health
care technology market sectors. Interactive Technologies Group products include
AcuVoice AV 1700, AV 2001 text-to-speech systems, and Allegro handwriting
recognition.
Embedded Technologies
Fonix has developed an application development tool, the Fonix Advanced
Application Speech Toolkit (FAAST(TM)) which allows developers to simulate,
prototype and create code for embedded applications using Fonix' human computer
interaction technologies. This system currently supports Fonix speech
recognition for command and control applications and Fonix AcuVoice
text-to-speech engines for both very high quality limited vocabulary and high
quality unlimited vocabulary applications. The system is designed to support a
number of popular microprocessors and operating systems for embedded
applications. Currently, FAAST supports the Siemens TriCore micro-controller.
The beta version of the FAAST system will be available for developers in June
1999. An alpha version of the system is currently being used internally at Fonix
to support the development of embedded systems applications for several
companies including consumer electronic, automotive, and cell phone devices.
Page 6 of 60
Core Speech Recognition Technologies
Since 1994 Fonix has pursued the development of a "3rd Generation" automated
speech recognition technology to overcome the limitations of currently available
commercial speech recognition systems. This development has yielded a
proprietary ASR system utilizing a unique front-end analysis of the acoustic
speech signal, a neural net based phoneme identifier, and a completely novel
neural net architecture for back-end language modeling. The latter component is
the MULTCONS or multi-level constraint satisfaction network. These developments
have been the subject of two issued patents. In addition, the Company has
acquired a related patent covering portions of this technology. Portions of this
technology are currently being employed in Fonix embedded systems applications.
Text-to-Speech (Speech Synthesis)
In 1986 AcuVoice began to develop and market a new approach to synthesized
speech, a system using actual recordings of "units" of human speech (i.e., the
sound pulsation). Since the unit of speech consists of more than one phoneme
(sound), AcuVoice's approach has been called a "large segment concatenative
speech synthesis" approach. Other companies such as DEC and AT&T began in the
early 1960s and continue until the present to use a system called "parametric
speech synthesis." Parametric systems are plagued with problems of speech
quality, because their unit is not an actual recording, but a computer's version
of what a human voice sounds like. Poor speech quality also occurs because the
parametric unit consists, for the most part, of a single phoneme, such as the
"t" in the word "time."
Although as early as 1994 AcuVoice released versatile prototypes of its system,
it was not until early 1996 that the AcuVoice Speech Synthesizer was ready for
sale into the telecommunications, multi-media, educational and assistive
technology markets. AcuVoice won awards as "best text-to-speech" product at the
Computer Technology Expo '97 and '98 and the best of show award at AVIOS '97.
Presently AcuVoice products are sold to end-users, systems integrators and OEMs.
Fonix text-to-speech products include those developed by AcuVoice and those
developed by Fonix. All are sold under the AcuVoice brand name. The products
include the AcuVoice AV 1700 TTS system for end-user desktop and laptop system
use. The AcuVoice AV 2001 SDK is a software development kit for developers of
telephony applications. Run-time software licenses for the AV 2001 are offered
for applications developed with the SDK. The SDK supports major computer
telephony platforms.
Handwriting Recognition
Prior to the Papyrus Acquisition in October 1998, PAI developed and began
selling handwriting recognition software including the Allegro handwriting
recognition software. The Allegro handwriting recognition software is a single
letter recognition system like the popular Graffiti handwriting recognition
software for the PalmPilot PDA. However, Allegro's alphabet is all natural in
appearance as lower case letters. Because the letters are written in the
standard way in almost all instances, the Allegro system is easy to use and
requires practically no learning. Allegro is sold by Purple Software in England
for the Psion Series 5 hand-held PC. This software has also been licensed to
Philips for its popular smart cell phone. Allegro is also the subject of a sales
agreement with Lucent Technologies for use in its Inferno operating system.
Papyrus has also developed cursive handwriting recognition software which
recognizes naturally-written whole words. This cursive technology is only
available as a licensed product to OEM customers. Both the Allegro and the
cursive handwriting recognition software are user independent and require no
training of the software.
Employees
As of March 31, 1999, the Company employed 129 persons. Of this total, 74
persons are employed in the Interactive Technologies Solutions Group, 34 are
employed in the HealthCare Solutions Group and 21 are employed on the executive
and administrative staff.
Page 7 of 60
Recent Developments
Consistent with the objectives, vision and strategy of the Company outlined
above, Fonix entered into several key transactions in 1998 and the first quarter
of 1999. These are discussed briefly in the following section.
Acquisition of AcuVoice
The AcuVoice Acquisition was effected by an exchange of restricted shares of
Fonix common stock and cash for the issued and outstanding common stock of
AcuVoice. A total of 2,692,216 shares of Fonix common stock (having a market
value of $16,995,772) were issued in exchange for AcuVoice common stock and a
total of $8,000,232 was paid in cash (including amounts paid in lieu of
fractional shares). Of the 2,692,216 shares of Fonix stock issued, 80,000 shares
were placed in an escrow against which any claims for breach of warranty by the
Company against AcuVoice could be asserted. The closing was deemed to have
occurred on March 13, 1998, although certain acts such as the payment of
consideration to some AcuVoice stockholders and the filing of articles of merger
occurred after that date. After the AcuVoice Acquisition, the former
shareholders of AcuVoice, consisting of 52 persons, beneficially owned 5.25% of
the total of 51,303,739 shares of Fonix common stock then issued and
outstanding.
Before the acquisition, AcuVoice released the first versatile prototypes of its
system in 1994. By early 1996, the AcuVoice Speech Synthesizer was ready for
sale into the telecommunications, multi-media, educational and assistive
technology markets. Companies that have purchased developer kits from AcuVoice
and are now developing products for the market include IBM, General Motors,
Kurzweil Educational Systems, Pratt & Whitney, Octel Communications, Andersen
Consulting, NEC, Dialogic and Bell Atlantic. Companies that have developed
products using AcuVoice developer kits, and now are selling or using products
containing AcuVoice text-to-speech include AT&T, Motorola, Northern Telecom,
Lucky Goldstar (Korea), Aumtech Inc., Mail Call, Inc., IMG, Hurdman
Communications (Better Business Bureau), SmartDial, Signet, Concierge, Ultimate
Technology, FirstCall, XL Vision, Applied Future Technologies and Productivity
Works.
To the Company's knowledge, no other company has succeeded in developing a
versatile system of large segment concatenative synthesis. However, the AcuVoice
speech synthesis products compete with other concatenative and parametric speech
synthesis products. AcuVoice's main competitors are Lernout & Hauspie, Lucent
Technologies, Eloquent Technologies and Apple Computer.
AcuVoice's competitors offer a range of voices (male, female, child) and
languages. AcuVoice presently offers only a male voice which speaks American
English. However, AcuVoice is developing a female voice, and is working to
expand language capacity to major languages other than English.
Fonix believes that the AcuVoice text-to-speech technologies are an important
and complementary addition to the ASRT the Company has developed to date and
will develop in the future. For example, because both voice synthesis and voice
recognition technologies are dependent upon the analysis of human speech
patterns, those technologies share many similar challenges, and a solution in
one arena often will be portable to the other. Additionally, the Company
believes that a state- of-the-art voice synthesis technology, coupled with the
ASRT, will substantially increase the marketability of both technologies by
broadening the potential product applications, thereby increasing the pool of
potential licensees of the technologies.
In connection with the AcuVoice Acquisition, AcuVoice and its founder, David
Barton, made certain representations and warranties to the Company. One of those
representations focused on the scope of a license agreement previously entered
into between AcuVoice and General Magic for the use of AcuVoice's text-to-speech
software in General Magic's Serengeti product. After the AcuVoice Acquisition
closed, the Company determined that AcuVoice and Barton had breached the
representation concerning the scope of the General Magic license agreement.
Under the terms of the AcuVoice Acquisition agreement, on March 12, 1999, the
Company submitted a claim for the 80,000 shares deposited into the escrow
account by the former stockholders of AcuVoice. Barton, as agent for the former
stockholders of AcuVoice, denied the claim. The Company is presently preparing a
response to Barton's denial of the claim. If Barton continues to deny the claim
after review of the Company's response, the Company will seek to arbitrate its
claim pursuant to the terms of the AcuVoice Acquisition agreement. The Company
is presently considering other possible remedies against Barton and the other
former directors of AcuVoice.
Page 8 of 60
Acquisition of Articulate and Certain Assets of MRC
The Articulate Acquisition was effected through a merger of Articulate into a
wholly owned subsidiary of the Company that closed on September 2, 1998. As
consideration for the Company's acquisition by merger of Articulate, the Company
tendered to the stockholders of Articulate, in the aggregate, (i) 5,140,751
shares of the Company's restricted common stock (having a market value of
$8,353,720) and (ii) a cash payment of $12,534,588 (the "Cash Payment"). Of the
5,140,751 shares of stock issued, 315,575 shares were placed in an escrow
against which claims by the Company for breach of warranty against Articulate
could be asserted and 1,985,000 shares were placed in a separate escrow to be
converted to a new class of non-voting common stock to be issued upon
authorization by the shareholders of the Company. The balance of 2,840,176
shares of restricted common stock was issued to the shareholders of Articulate.
At closing, 13 of the Articulate stockholders agreed to accept a portion of the
Cash Payment payable to them in the form of demand notes bearing interest at the
rate of 8.5% per annum, payable at any time after November 1, 1998. The
aggregate principal amount of such notes is $4,747,339. The Company made partial
payments of several of these notes and has agreed with all of the holders to
extend the due dates to between March 15, 1999 and April 30, 1999. The balance
due and owing the holders of these notes was $4,708,980 at March 31, 1999.
Additionally, the Company agreed to pay seven Articulate employees cash bonuses
in the aggregate amount of $857,000. At Closing, the Company delivered demand
notes representing $452,900 of that aggregate bonus amount. These notes bear
interest at 8.5% per annum. The balance was payable on or before January 31,
1999. None of the holders of these notes have made demand for payment of the
balance due and they have verbally agreed to extend the due date to April 30,
1999. After the merger, the former shareholders of Articulate, constituting 62
persons, beneficially owned 8.8% of the total 58,586,633 shares of Fonix common
stock then issued and outstanding.
At the time the Company acquired Articulate, MRC marketed Articulate's
PowerScribeRAD and PowerScribeEM products to hospitals and medical centers. The
Company intended to continue to use MRC to market its PowerScribe products after
the acquisition. However, shortly after the acquisition the Company learned that
MRC had agreed to be acquired by Medquist, Inc., which, the Company believes,
had little or no interest in marketing the PowerScribe products. Thereafter, the
Company commenced negotiations to acquire certain assets of MRC relating to
MRC's sales, marketing and service of the PowerScribe products. On December 31,
1998, the Company entered into an Asset Acquisition Agreement with MRC pursuant
to which it acquired certain fixed assets, license agreements, intellectual
property, advertising materials and other property used by MRC to market, sell
and service the PowerScribe products. In consideration of the assets described
above, the Company agreed to pay MRC at closing $219,833, less amounts then owed
to the Company, plus $133,333 per month for each of the three months immediately
following the closing, less certain credits. The unpaid balance due and owing
MRC was $190,144 as of March 31, 1999. In addition to acquiring certain assets
of MRC relating to PowerScribe products, the Company hired approximately 20
former employees of MRC who had been engaged in the marketing, sales and
servicing of PowerScribe products.
Acquisition of Papyrus
The Papyrus Acquisition which closed October 29, 1998, was effected by an
exchange of restricted shares of the Company's common stock and the Company's
promissory notes for all of the issued and outstanding common stock of PAI and
PDC as follows:
PAI
The Company issued 1,076,926 shares of its restricted common stock (having
a market value of $1,110,580 on the closing date) and promissory notes
aggregating $540,000 to the stockholders of PAI in exchange for all of the
outstanding shares of PAI common stock. The promissory notes were payable
as follows: $360,000 of notes were payable not later than February 28,
1999; and $180,000 of notes are payable on April 30, 1999. The notes bear
interest at the rate of 6% per annum after they become payable. The Company
has entered into agreements with four of the holders of these promissory
notes to pay approximately 88% of the balances due under the promissory
notes on or before May 15, 1999 in consideration for which the holders will
surrender to the Company 30%, or approximately 276,630 shares, of the
common stock issued to the note holders in the PAI Acquisition. The Company
is in default with respect to the remaining five promissory notes totaling
$51,750. However, the Company anticipates paying the balances of these
notes on or before May 15, 1999.
Page 9 of 60
PDC
The Company issued 2,034,188 shares of its restricted common stock (having
a market value of $2,097,756 on the closing date) and promissory notes
aggregating $1,170,000 to the stockholders of PDC in exchange for all of
the outstanding shares of PDC common stock. The promissory notes are
payable as follows: $490,000 of notes were payable not later than February
28, 1999; $340,000 of notes were payable on February 28, 1999; and $340,000
of the notes are due and payable on September 30, 1999. The notes bear
interest at the rate of 6% per annum after they become payable. The Company
has entered into an agreement with all of the holders of these promissory
notes to pay approximately 70% of the balances due under the notes on or
before May 15, 1999, in consideration for which the holders will surrender
to the Company 30%, or approximately 610,256 shares, of the common stock
issued to the note holders in the PDC Acquisition.
After the Papyrus Acquisition, the former shareholders of PAI and PDC,
constituting 10 persons, beneficially owned less than 1% of the total 61,697,747
shares of the Company's common stock then issued and outstanding. Of the
3,111,114 shares of the stock issued in the Papyrus Acquisition, 311,106 shares
were placed in an escrow against which any claims by the Company for breach of
warranty against Papyrus could be asserted. After the Papyrus Acquisition
closed, the Company investigated some of the representations and warranties made
by Papyrus to induce the Company to acquire Papyrus. The Company determined that
certain of the representations made by Papyrus and the executive officers of
Papyrus were not accurate. At about the same time, the Company began
negotiations with the former executive officers of Papyrus. On February 26,
1998, the Company filed an action against Papyrus in the United States District
Court for the District of Utah, Central Division (the "Utah Action"). In the
Utah Action, the Company alleged claims for misrepresentation, negligent
misrepresentation, breach of contract, breach of the implied covenant of good
faith and fair dealing and rescission. On March 11, 1999, three of the former
shareholders of Papyrus filed an action against the Company in the United States
District Court for the District of Massachusetts (the "First Massachusetts
Action"), alleging a default under the terms of the promissory notes issued to
them in connection with the Papyrus Acquisition. On April 8, 1999, a fourth
former Papyrus shareholder filed an action against the Company in the United
States District Court for the District of Massachusetts (the "Second
Massachusetts Action") alleging a default under the terms of the promissory
notes issued to him in connection with the Papyrus Acquisition and seeking
additional remedies including violation of Massachusetts unfair and deceptive
acts and practices statutes and copyright infringement. The Company has entered
into agreements with the four former Papyrus shareholders for dismissal of the
First and Second Massachusetts Actions and the Utah Action upon payment to the
former shareholders of $1,122,209 (the "Settlement Payment") an amount equal to
approximately 73% of the balance due them under the notes issued to them in the
Papyrus Acquisition, and return for cancellation by the Company of 970,586
shares of restricted common stock issued in the Papyrus Acquisition. This
represents approximately 30% of the total number of shares of the Company's
common stock originally issued to these shareholders in the Papyrus Acquisition.
The Company must pay the Settlement Payment before May 16, 1999. If it does not,
the Company and the four former Papyrus shareholders are free to pursue their
respective claims in the Utah Action and the First and Second Massachusetts
Actions.
Status of Acquisition Activities
In addition to the transactions involving AcuVoice, Articulate and Papyrus in
1998, the Company also was in negotiations to acquire several other speech
technology companies in 1998. The Company has now terminated all such
acquisition discussions. The Company advanced money during 1998 to some of those
acquisition candidates in anticipation of the completion of an acquisition
transaction. The Company presently is pursuing the return of such loaned funds
which amount, in the aggregate, is $245,000.
Financing Activities
Series D and Series E Preferred Stock
In March 1998, the Company completed a private placement (the "March 1998
Offering") of 6,666,666 shares of its restricted common stock to seven separate
investment funds. The total purchase price to be paid by the investors pursuant
to the March 1998 Offering was $30,000,000. Of that amount, $15,000,000 was paid
to the Company on March 12, 1998, in return for which the Company issued a total
of 3,333,333 shares of restricted stock, pro rata to the investors in proportion
to the total amount of the purchase price paid by them. Finders' fees of
$870,000 were paid in connection with
Page 10 of 60
the $15,000,000 received. The proceeds of that offering were used to fund the
AcuVoice Acquisition and for operating capital. The remainder of the purchase
price was to be paid by the investors on July 27, 1998 (60 days after the
effectiveness of a registration statement that the Company filed with the
Securities and Exchange Commission covering the common stock issued and issuable
to the investors (the "Second Funding Date")), provided that, as of such date,
certain conditions were satisfied. Additionally, the investors in the March 1998
Offering acquired certain "reset" rights pursuant to which the investors would
receive additional shares of restricted common stock if the average market price
of the Company's common stock for the 60-day periods following the initial
closing date and the Second Funding Date did not equal or exceed $5.40 per
share. On August 31, 1998, the Company and the investors in the March 1998
Offering restructured the reset provision whereby the Company issued 608,334
shares of Series D 4% Convertible Preferred Stock ("Series D") and 1,390,476
shares of common stock for (i) the relinquishment of the investors' contractual
right to receive reset shares in connection with the $15,000,000 received in
March 1998, and an additional $3,000,000 received in June and August 1998. On
that same date, the Company issued 500,000 additional shares of Series D in
consideration for the investment of $10,000,000 of additional funds by the
investors. These proceeds were used primarily to finance the Articulate
Acquisition.
Effective September 30, 1998, the Company entered into an agreement with two of
the investors in the March 1998 Offering whereby the Company issued 100,000
shares of the Company's Series E 4% Convertible Preferred Stock ("Series E") for
$2,000,000. Additionally, the Company issued to the purchasers of the Series E a
total of 150,000 additional shares of Series E in exchange for which those
purchasers surrendered a total of 150,000 shares of Series D.
Subsequently, on November 13, 1998, the Company sold 50,000 additional shares of
Series D on the same terms and conditions as the August 31, 1998 agreement.
Each share of Series D and Series E is convertible into that number of shares of
common stock as determined by dividing $20 by the lesser of any of the following
(at the option of the converting holder):
1. $3.50, or
2. the lesser of
* $2.3375 (for the Series D) or $1.4369 (for the Series E) which
amounts constitute 110% of the average per share closing bid
prices for the 15 trading days immediately preceding the dates of
the Series D and Series E Agreements, respectively; or
* 90% of the average of the three lowest per share closing bid
prices during the 22 trading days immediately preceding the
conversion date.
If the converting holder elects conversion option 1, in addition to the shares
of common stock issued upon the conversion, the converting holder will receive a
warrant to purchase 0.8 shares of common stock. Those warrants will have an
exercise price that will be 120% of the per share closing bid price of the
common stock on the date the warrants are issued and will have a three-year
term. Any shares of Series D or Series E not converted as of August 31, 2001
will automatically be converted to common stock according to whichever of the
conversion formulas described above yields the greatest number of shares of
common stock.
As part of the Series D and Series E transactions, the Company agreed that it
would register the shares of common stock issuable upon conversion of the Series
D and Series E or the exercise of any warrants issued upon conversion for public
resales by the converting or exercising holder. On November 19, 1998, the
Company filed a registration statement with the Securities and Exchange
Commission on Form S-3 to register the sale by the holders of the Series D and
Series E of up to 58,623,442 shares of the Company's common stock (File No.
333-67573). The shares covered by the registration statement are the shares of
common stock issued or issuable by the Company upon the conversion of the Series
D or Series E, or the exercise of the warrants, if any warrants are issued. That
registration statement has not yet been declared effective.
When the registration statement is declared effective, the selling stockholders
will be able to sell the Company's shares issued upon conversion of the Series D
and Series E preferred stock in public transactions or otherwise, on the Nasdaq
Page 11 of 60
SmallCap Market or in privately negotiated transactions. Those resales may be at
the then-prevailing market price or at any other price the selling stockholders
may negotiate.
December 1998 Private Placement of Common Stock
On December 22, 1998, the Company completed a private placement of 1,801,802
shares of common stock. Additionally, for each share of common stock issued, the
Company issued one "Repricing Right" that entitles the holder thereof to receive
upon exercise additional shares of the Company's common stock for no additional
consideration according to a formula that is related to the then-prevailing
market price of the Company's common stock. The Company also issued 200,000
common stock purchase warrants in connection with this transaction. The number
of additional shares of common stock issuable upon exercise of the Repricing
Rights is determined by multiplying the number of Repricing Rights exercised by
the following fraction:
(Repricing Price - Market Price)
--------------------------------
Market Price
"Market Price" means the lowest closing bid price of common stock, as quoted on
the Nasdaq Small Cap Market, during the 15 consecutive trading days immediately
preceding the exercise date. "Repricing Price" means:
$1.3875 from March 22, 1999 to and including April 21, 1999,
$1.3986 from April 22, 1999 to and including May 21, 1999,
$1.4097 from May 22, 1999 to and including June 20, 1999,
$1.4208 from June 21, 1999 to and including July 20, 1999, and
$1.4319 at any time after July 20, 1999 until the expiration of the
Repricing Rights.
The investor that purchased the common stock in the December 1998 private
placement has the right, upon the occurrence of a "Major Transaction" or
"Triggering Event" as those terms are defined in the transaction documents to
require the Company to repurchase all or a portion of such holder's common
shares or Repricing Rights at a price equal to (i) for each common share with an
associated Repricing Right, the greater of (A) 125% of the purchase price and
(B) the sum of (I) the purchase price and (II) the product of (x) the Repricing
Rate of the Repricing Right on the date of such holder's delivery of a notice of
repurchase and (y) the last reported sale price of the common stock on the date
of such holder's delivery of a notice of repurchase, (ii) for each Repricing
Right without the associated share of common stock, the product of (x) the
Repricing Rate of the Repricing Right on the date such holder's delivery of a
notice of repurchase and (y) the last reported sale price of the common stock on
the date of such holder's delivery of a notice of repurchase and (iii) for each
common share without an associated Repricing Right, 125% of the purchase price.
One of the several events described in the transaction documents as a
"Triggering Event"is the suspension from listing or delisting of the common
stock from The Nasdaq SmallCap Market for a period of three trading days. In
March 1999, trading in the Company's common stock was temporarily halted for
more than three days. Trading resumed within five trading days, and the Company
has not been notified that the holders of the common stock and Repricing Rights
desire to exercise any repurchase rights they may have.
Series C 5% Convertible Debentures
On January 29, 1999, the Company entered into a Securities Purchase Agreement
with four investors pursuant to which the Company sold its Series C 5%
Convertible Debentures (the "Debentures") in the aggregate principal amount of
$4,000,000. The outstanding principal amount of the Debentures is convertible at
any time at the option of the holder into shares of the Company's common stock
at a conversion price equal to the lesser of $1.25 or 80% of the average of the
closing bid price of the Company common stock for the five trading days
immediately preceding the conversion date. The Company also issued 400,000
warrants in connection with this financing. Each warrant entitles the holder to
purchase up to 400,00 shares of the Company common stock at an exercise price of
$1.1625 per share. On March 3, 1999, the Company executed a Supplemental
Agreement pursuant to which the Company agreed to sell an additional $2,500,000
principal amount of the Debentures on the same terms and conditions as the
January 29, 1999 agreement, except no additional warrants were issued. Gross
proceeds to the Company from these two transactions were $6,500,000. The
obligations of the Company for repayment of the Debentures, as well as its
obligation to register the common stock underlying the potential conversion of
the Debentures and the exercise of the warrants issued in these transactions,
were
Page 12 of 60
personally guaranteed by Thomas A. Murdock, Roger D. Dudley (each of whom are
executive officers and directors of the Company) and Stephen M. Studdert
(Chairman of the Board of Directors of the Company). The personal guarantees of
these three directors were secured by a pledge of 6,000,000 shares of Fonix
common stock beneficially owned by them and held in the name of Thomas A.
Murdock, Trustee. In connection with the Supplemental Agreement, the Company
agreed to pledge as collateral for repayment of the Debentures, a lien on the
patent covering the ASRT. At the present time the Company has not executed a
security agreement in favor of the investors describing the patent. In
connection with the guaranty and the pledge for that guaranty given by these
directors, the Company agreed to indemnify and hold them harmless in the event
of a default by the Company that results in any payment or other liability or
damage incurred by any of them. In consideration for the guaranty and pledge by
these directors, the Company agreed to grant each of them common stock purchase
warrants to purchase 666,666 shares of common stock at a price of $1.59 per
share. On or about April 6, 1999, the holders of the Debentures notified the
Company and the Guarantors that the Guarantors were in default under the terms
of the pledge, and that the holders intended to exercise their rights to sell
some or all of the pledged shares. At the present time, the Company has no
knowledge of sales of the Guarantors' shares by the holders. However, if the
holders proceed to sell some or all of the Guarantors' shares, the Company may
be obligated under its indemnity agreement in favor of the Guarantors to issue
shares to the Guarantors in replacement of all shares sold by the holders and
reimburse the Guarantors for any income tax liability incurred as a result of
the holders' sales of the Guarantors' shares.
Grants Of Stock Options
During the year ended December 31, 1998, the Company granted options to purchase
6,414,782 shares of common stock. Of such options, 450,000 (having an exercise
price of $5.16 per share) and 1,200,000 (having an exercise price of $1.18 per
share) were granted to three individuals who are executive officers and
directors of the Company; 1,600,000 (having an exercise price of $1.18 per
share) were granted to directors and 400,000 (having an exercise price of $1.18
per share) were granted to two officers of the Company, 360,000, 1,595,000, and
617,950 options were granted to a director and various employees at exercise
prices of $3.34, $1.00, and $6.50 per share, respectively, and 100,000 options
were granted to an unrelated party for services with an exercise price of $3.75
per share. The term of all of these stock options is ten years from the date of
grant. Additionally, the Company agreed to issue options to purchase 91,832
shares of common stock in exchange for stock options granted in connection with
the acquisition of Articulate. Of these options, 58,678 are exercisable at a
price of $0.83 per share and have expiration dates ranging from June 1, 2000 to
November 2, 2002. During the year ended December 31, 1998, 35,000 options
previously outstanding were exercised, and 1,067,000 options previously
outstanding were forfeited. As of December 31, 1998, the Company had a total of
15,877,782 options outstanding, of which 9,524,766 were exercisable on or before
December 31, 1998.
The Synergetics Transaction
Prior to March 1997, the Company's scientific research and development
activities were conducted solely by a third party, Synergetics, Inc.
("Synergetics"), pursuant to product development and assignment contracts
(collectively, the "Synergetics Agreement"). Under that arrangement, Synergetics
provided personnel and facilities, and the Company financed the scientific
research and development activities on an as-required basis. There was no
minimum requirement or maximum limit with respect to the amount of funding the
Company was obligated to provide to Synergetics and the Company was obligated to
use its best efforts in raising all of the necessary funding for the development
of the ASRT. Moreover, under the Synergetics Agreement, the Company was
obligated to pay to Synergetics a royalty of 10% (the "Royalty") of net revenues
from sales of products incorporating Synergetics' "VoiceBox" technology as well
as technologies derivatives thereof. Synergetics compensated its developers and
others contributing to the development effort by granting project shares to
share in royalty payments received by Synergetics ("Project Shares"). On March
13, 1997, the Company and Synergetics reached an agreement in principle to
modify the Synergetics Agreement (the "Modification Terms") with regard to the
development and assignment of the ASRT. On April 6, 1998, the Company and
Synergetics entered into a Royalty Modification Agreement to finalize the
Modification Terms. Under the terms of the Royalty Modification Agreement, the
Company agreed to offer an aggregate of 4,800,000 non-transferable common stock
purchase warrants to the holders of the Project Shares in consideration for
which Synergetics agreed to cancel any further obligation on the part of the
Company to pay the Royalty. The exercise price of the warrants is $10 per share.
The Company has agreed to register the shares of common stock underlying the
warrants. No warrants will be offered to the holders of the Project Shares until
such time as the registration statement relating to such shares has been
declared effective by the Securities and Exchange Commission. After issuance,
the warrants will not be exercisable until the first
Page 13 of 60
to occur of (i) the date that the per share closing bid price of the common
stock is equal to or greater than $37.50 per share for a period of 15
consecutive trading days, or (ii) September 30, 2000. In addition, the warrants
will become immediately exercisable in the event of a merger or similar
transaction in which the Company is not the surviving entity or the sale of
substantially all of the Company assets.
Termination of Financing Relationship
For several years, the Company has maintained a relationship with a major
regional federally insured financial institution pursuant to which the Company
borrowed against its own funds on deposit with the institution. Borrowings under
this arrangement accrued interest at a rate approximately 1% greater than the
rate of interest earned by the Company on its funds on deposit with the
institution. In order to reduce interest expenses, on January 8, 1999, the
Company applied its deposit account in the amount of $20,024,109 against the
unpaid loan balance of $20,046,776, resulting in an unpaid loan balance of
$22,667, which amount subsequently was paid by the Company.
Resignation of Stephen M. Studdert as Chief Executive Officer
On January 26, 1999, Stephen M. Studdert resigned as the Company's Chief
Executive Officer. Mr. Studdert continues as the non-executive Chairman of the
Board of Directors of the Company. In connection with his resignation, the
Company entered into a separation agreement with Mr. Studdert pursuant to which
Mr. Studdert released the Company from all claims and obligations under his
employment agreement, and the Company agreed to pay Mr. Studdert $250,000 during
1999, $250,000 in 2000 and $100,000 in 2001.
Cost Reduction Plan
On January 28, 1999, the Company announced a plan to reduce overall monthly
operating expenses by approximately $8,000,000 for all of 1999. The Company has
taken steps to implement these reductions by terminating certain consulting
relationships, reducing personnel, realizing cost efficiencies from the
integration of acquired business units and the reduction of salary of all
officers and certain employees of the Company. The Company believes such cost
reductions were necessary and appropriate in light of ongoing operating
requirements and limited revenues to date to offset such expenses. The Company
is not able to predict whether such present cost reductions will be sufficient
to achieve its goal of $8,000,000 of overall reductions for 1999. Similarly, the
Company cannot give any assurance that its operations and financial condition
will not be adversely affected by these measures.
Certain Significant Risk Factors
The short- and long-term success of the Company is subject to certain risks,
many of which are substantial in nature and outside the control of the Company.
You should consider carefully the following risk factors, in addition to other
information contained herein. All forward-looking statements contained herein
are deemed by the Company to be covered by and to qualify for the safe harbor
protection provided by the Private Securities Litigation Reform Act of 1995 (the
"1995 Act"). You should understand that several factors govern whether any
forward-looking statement contained herein will or can be achieved. Any one of
those factors could cause actual results to differ materially from those
projected herein. These forward-looking statements include plans and objectives
of management for future operations, including the strategies, plans and
objectives relating to the products and the future economic performance of the
Company and its subsidiaries discussed above. In light of the significant
uncertainties inherent in the forward-looking statements included herein, the
inclusion of any such statement should not be regarded as a representation by
the Company or any other person that the objectives or plans of the Company will
be achieved.
FONIX'S SUBSTANTIAL AND CONTINUING LOSSES SINCE INCEPTION, COUPLED WITH
SIGNIFICANT ONGOING OPERATING COSTS, RAISE DOUBT ABOUT FONIX'S ABILITY TO
CONTINUE AS A GOING CONCERN.
Since its inception, Fonix has sustained ongoing losses. Such losses are
presently continuing at an accelerated rate due to recent acquisitions, ongoing
operating expenses and a lack of revenues sufficient to offset the increased
operating expenses. Because past and current expenses exceed revenues, Fonix has
negative working capital and has been forced to raise capital to fund ongoing
operations by private sales of its securities, the terms of which transactions
have been highly dilutive and involve considerable expense. Furthermore, in
recent months, the financial condition of the Company
Page 14 of 60
has required the Company to negotiate with its creditors to extend the due date
of certain obligations and has resulted in the Company's failure to make timely
payment of certain of its obligations. In its present circumstances, there is
substantial doubt about Fonix's ability to continue as a going concern absent
immediate and significant sales of its existing products, substantial revenues
from new licensing contracts or a relatively large sale of its securities in the
near term.
Fonix incurred a net loss of $43,118,782 for the year ended December 31, 1998
and a net loss of $22,453,948 for the year ended December 31, 1997. For the year
ended December 31, 1998, Fonix recorded revenues from the operations of AcuVoice
and Articulate businesses in the aggregate amount of $521,546. Other than these
revenues, Fonix's only revenues to date resulted from one-time non-refundable
license fees totaling $2,368,138 paid by Siemens Aktiengesellschaft for the use
of technologies in integrated circuits suitable for telecommunications
applications.
Fonix expects continuing losses fro operating activities until such time as:
o Fonix is able to complete additional licensing or
co-development arrangements with third parties that produce
revenues sufficient to offset Fonix's ongoing operating
expenses; or
o revenues from Fonix's HealthCare Solutions and Interactive
Technologies Solutions Groups increase to levels sufficient to
exceed Fonix's aggregate operating expenses.
RECENTLY INCURRED DEBT OBLIGATIONS COULD IMPAIR FONIX'S ABILITY TO CONTINUE AS A
GOING CONCERN.
During the last half of 1998, Fonix incurred substantial amounts of debt which,
coupled with Fonix's ongoing operating expenses, could hamper Fonix's ability to
continue as a going concern unless Fonix is immediately able to generate
significant revenues or to raise a substantial amount of capital to pay that
debt. Presently, Fonix is in default on notes in the aggregate principal amount
of $3,116,000. Much of Fonix's debt is payable on demand. Fonix does not
presently have sufficient operating capital or revenues to allow Fonix to
satisfy notes presently in default or additional demand obligations if demand
for payment is made and Fonix cannot renegotiate the terms of the debt or
otherwise persuade its creditors to withdraw their demand. In such event,
Fonix's financial condition and operations could be adversely affected. The
following discussion summarizes the extent and nature of such recently incurred
debt.
In connection with Fonix's acquisition of Articulate in September 1998, Fonix
incurred new debt obligations to 13 former shareholders of Articulate in the
aggregate amount of $4,747,339. These debt obligations are in the form of demand
notes payable at any time after November 1, 1998, and bear interest at the
annual rate of 8.5%. The due dates of these obligations subsequently were
extended to dates ranging from April 1999 to October 1999, and, in some cases,
Fonix has agreed to pay interest at rates exceeding 8.5% per annum. Fonix is
presently in default on $2,943,206 of these notes. After the acquisition, Fonix
agreed to pay several Articulate employees incentive compensation for continued
employment in the aggregate amount of $857,000, in connection with which Fonix
issued 8.5% demand notes for $452,900 and recorded an accrued liability of
$404,100 for the balance. The notes issued to the Articulate employees are
presently payable on demand, but, as of the date hereof, Fonix has not received
any demand for payment of the notes by the former Articulate employees. The
$404,100 accrued liability was payable on or before January 31, 1999. The payees
with respect to this obligation have orally agreed to an extension of the
payment date to June 30, 1999. In connection with Fonix's acquisition of Papyrus
in October 1998, Fonix also incurred new debt obligations to the former
shareholders of Papyrus in the aggregate amount of $1,710,000. These debt
obligations are in the form of promissory notes which bear interest at the
annual rate of 6.0% after they become due and were originally payable as
follows:
Amount Due Date
------ --------
$ 1,190,000 Presently payable
$ 180,000 April 30, 1999
$ 340,000 September 30, 1999
Page 15 of 60
With respect to the debt listed immediately above that is presently due and
payable, holders of $1,632,375 of the notes, including substantially all of the
debt which is presently due and payable, have agreed to accept an aggregate
payment of $1,632,375 in full satisfaction of the notes, if paid before May 15,
1999.
On December 2, 1998, Fonix borrowed $560,000 from an unaffiliated private
lender. The loan accrues interest at the rate of 18% per annum, is secured by
certain accounts receivable and was due January 2, 1999. Fonix has subsequently
extended the due date of this loan from month to month by paying the lender the
accrued interest plus a fee of $5,600. The loan balance is due May 28, 1999.
However, Fonix anticipates that it will request and pay for an extension of the
due date for one or more additional months beyond that date.
In addition to these notes, Fonix presently owes trade payables in the aggregate
amount of approximately $2,700,000, some of which are more than 120 days
overdue.
All of these debt obligations are in addition to Fonix's regularly recurring
operating expenses. At present, Fonix's revenues from existing licensing
arrangements and products are not sufficient to offset Fonix's ongoing operating
expenses or to pay substantial amounts of Fonix's presently due debt. There is
substantial risk, therefore, that the existence and extent of the debt
obligations described above could adversely affect Fonix, its operations and
financial condition.
IF FONIX DOES NOT RECEIVE ADDITIONAL CAPITAL WHEN AND IN THE AMOUNTS IT WILL
NEED IN THE NEAR FUTURE, ITS ABILITY TO CONTINUE AS A GOING CONCERN WILL BE
DOUBTFUL.
Fonix anticipates incurring substantial product development and research and
general operating expenses for the foreseeable future which will require
substantial amounts of additional cash on an ongoing basis. These capital needs
are in addition to the amounts required to repay the debt discussed above. Fonix
most likely will have to obtain such capital from sales of its equity,
convertible equity and debt securities. Obtaining future financing may be costly
and will be dilutive to existing stockholders. If Fonix is not able to obtain
financing when and in the amounts needed, and on terms that are acceptable to
it, Fonix's operations, financial condition and prospects could be materially
and adversely affected, and Fonix could be forced to curtail its operations or
sell part or all of its assets, including its technology.
HOLDERS OF FONIX COMMON STOCK ARE SUBJECT TO THE RISK OF ADDITIONAL AND
SUBSTANTIAL DILUTION TO THEIR INTERESTS AS A RESULT OF THE CONVERSION OF
PRESENTLY ISSUED PREFERRED STOCK AND OTHER SECURITIES CONVERTIBLE INTO COMMON
STOCK.
Introduction
Fonix's present outstanding Series D and Series E are convertible into shares of
Fonix common stock. The Series D and Series E are convertible into Fonix common
stock according to one of three separate conversion formulas, one of which is
based, in part, on the market price of Fonix common stock during the several
week period leading up to the conversion date. Such conversion formulas are
described above under the heading "Recent Developments - Series D and Series E
Preferred Stock." In addition to the Series D and Series E, Fonix has other
contractual obligations to issue additional shares of its common stock that are
dependent on the prevailing market price of Fonix common stock, including the
Repricing Rights issued in December 1998 and the $6,500,000 principal amount of
Debentures issued in January and March 1999. The market price conversion
features of the Repricing Rights and the Debentures are described above under
the headings "Recent Developments - December 1998 Private Placement" and "Recent
Developments - Series C 5% Convertible Debentures."
The following table identifies the total number of shares of all series of
preferred stock with floating conversion rates, the total number of Repricing
Rights outstanding and the total principal amount of the Debentures outstanding,
and the total number of shares of common stock issuable assuming the
hypothetical conversion or exercise of all such preferred stock, Repricing
Rights or Debentures as of February 25, 1999, and the percentage of common stock
that would be issued to the holders of such convertible securities assuming such
conversions or exercises. For purposes of this table, Fonix has assumed that the
holders of the Series D and Series E, Repricing Rights and Debentures would have
elected that conversion price that would yield the greatest number of shares of
common stock upon conversion. All calculations exclude the issuance of shares of
common stock as payment of dividends accrued on the Series D and Series E and
the Debentures at the date of conversion.
Page 16 of 60
Number of Convertible Percent of Common
Securities Outstanding/ Shares of Common Stock Owned By
Principal Amount of Stock Issuable Upon Holders After
Convertible Security Debentures Conversion or Exercise Conversion
- ----------------------------- --------------------------- --------------------------- -----------------------
Series D Preferred Stock 990,834 24,465,037 26.5%
Series E Preferred Stock 90,000 2,222,222 3.2%
Repricing Rights 1,801,802 0 0.0%
Debentures $6,500,000 5,200,000 7.1%
-------------------
Total 31,887,259 32.0%
===================
The following table describes the number of shares of common stock that would be
issuable assuming all of the presently issued and outstanding shares of Series D
and Series E were converted, the Repricing Rights were exercised on the terms
most beneficial to the holder, and the Debentures were converted, and further
assuming that the applicable conversion or exercise prices at the time of such
conversion or exercise were the following amounts (the table excludes effect of
the issuance of shares of common stock upon payment of accrued dividends and
also excludes differences among the various methods of calculating the
applicable conversion or exercise price):
Shares of Common Stock Issuable Upon Conversion or Exercise of
- ------------------- ----------------------------------------------------------------------------------- --------------------
Hypothetical Series D Series E
Conversion/ Preferred Preferred Repricing Total Common
Exercise Price Stock Stock Rights Debentures Stock Issuable
- ------------------- ------------------- ------------------ ------------------- --------------------- --------------------
$0.75 26,422,240 2,400,000 1,531,531 8,666,667 39,020,438
$1.50 13,211,120 1,200,000 0 4,333,333 18,744,453
$2.25 8,807,413 800,000 0 2,888,889 12,496,302
$3.00 6,605,560 600,000 0 2,166,667 9,372,227
Given the structure of the conversion formulas applicable to the Series D and
Series E, and the other convertible securities described above, there
effectively is no limitation on the number of shares of Fonix common stock into
which such convertible securities may be converted or exercised. As the market
price of the Fonix common stock decreases, the number of shares of Fonix common
stock underlying the Series D and Series E and such other convertible securities
continues to increase. Following are specific risk factors relative to this
dilution.
Overall Dilution to Market Price and Relative Voting Power of Previously Issued
Common Stock
The conversion of the Series D and Series E, the exercise of the Repricing
Rights and the conversion of the Debentures may result in substantial dilution
to the equity interests of other holders of Fonix common stock. Specifically,
the issuance of a significant amount of additional Fonix common stock would
result in a decrease of the relative voting control of Fonix common stock issued
and outstanding prior to the conversion of the Series D and Series E, the
exercise of the Repricing Rights and the conversion of the Debentures.
Furthermore, public resales of Fonix common stock following the conversion of
the Series D and Series E, the exercise of the Repricing Rights or the
conversion of the Debentures likely would depress the prevailing market price of
Fonix common stock. Even prior to the time of actual conversions, exercises and
public resales, the market "overhang" resulting from the mere existence of
Fonix's obligation to honor such conversions or exercises could depress the
market price of Fonix common stock.
Increased Dilution With Decreases in Market Price of Common Stock
The outstanding shares of Series D and Series E are convertible, the Repricing
Rights are exercisable and the Debentures may be convertible, at a floating
price that may and likely will be below the market price of Fonix common stock
prevailing at the time of conversion or exercise. As a result, the lower the
market price of Fonix common stock at and
Page 17 of 60
around the time the holder converts or exercises, the more shares of Fonix
common stock the holder of such convertible securities receives. Any increase in
the number of shares of Fonix common stock issued upon conversion or exercise of
these securities as a result of decreases in the prevailing market price would
compound the risks of dilution described in the preceding paragraph of this risk
factor.
Increased Potential for Short Sales
Downward pressure on the market price of Fonix common stock that likely would
result from sales of Fonix common stock issued on conversion of the Series D and
Series E, the exercise of the Repricing Rights or the conversion of the
Debentures could encourage short sales of common stock by the holders of the
Series D and Series E, the Repricing Rights, the Debentures or others. Material
amounts of such short selling could place further downward pressure on the
market price of Fonix common stock.
Limited Effect of Restrictions on Extent of Conversions
The holders of the Series D and Series E, the Repricing Rights and the
Debentures are prohibited from converting their preferred stock or exercising
their Repricing Rights into more than 4.999% of the then outstanding Fonix
common stock. This restriction, however, does not prevent such holders from
either waiving such limitation or converting or exercising and selling some of
their convertible security position and thereafter converting or exercising the
rest or another significant portion of their holding. In this way, individual
holders of Series D and Series E, the Repricing Rights, and the Debentures could
sell more than 4.999% of the outstanding Fonix common stock in a relatively
short time frame while never holding more than 4.999% at a time.
IF FONIX HAS DIFFICULTY INTEGRATING INTO ITS BUSINESS AND CAPITALIZING ON RECENT
ACQUISITIONS, ITS OPERATIONS AND FINANCIAL PROSPECTS COULD BE ADVERSELY
AFFECTED.
Fonix recently completed the acquisitions of AcuVoice, Articulate, Papyrus and
MRC. Fonix's acquisitions of AcuVoice, Articulate, Papyrus and MRC, present
risks including at least the following:
o Fonix may have difficulty financing ongoing operations of the acquired
businesses to the extent such businesses are not generating positive
cash flows;
o Fonix may have difficulty combining or integrating the technology,
operations, management or work force of the acquired businesses with
Fonix's existing operations;
o Fonix may have difficulty retaining the key personnel of the acquired
businesses;
o Fonix may have difficulty expanding Fonix's financial and management
controls and reporting systems and procedures to the acquired
businesses;
o Fonix may have difficulty maintaining uniform standards, controls,
procedures, and policies across its entire organization, including the
acquired businesses;
o There may be impairment of relationships with employees, vendors and
customers as a result of the integration of new businesses and
management personnel; and
o There may be diversion of management attention during the pendency of
transactions, and increased commitment of management resources and
related expenses resulting from efforts to integrate and manage
acquired businesses located at a distance from Fonix's principal
executive offices and research facilities.
FONIX HAS ONLY A LIMITED PRODUCT OFFERING AND MANY OF ITS KEY TECHNOLOGIES ARE
STILL IN THE DEVELOPMENT STAGE.
There presently are only a limited number of commercially available applications
or products incorporating the Fonix technologies. Through its HealthCare
Solutions Group, Fonix offers PowerScribeRAD and PowerScribeEM, sophisticated
voice recognition products for radiologists and emergency medical doctors.
Through its Interactive Technologies
Page 18 of 60
Solutions Group, Fonix markets text-to-speech products acquired from AcuVoice
and the Allegro handwriting recognition software acquired from Papyrus. Fonix
has also licensed certain elements of its speech recognition technologies to
Siemens for incorporation into telecommunications equipment to be manufactured
by Siemens. Those products are not yet being manufactured. These product
offerings are still relatively limited and have not generated to date
significant revenues. An additional element of Fonix's business strategy is to
achieve revenues through appropriate strategic alliances, co-development
arrangements and license agreements with third parties. Other than the
arrangement with Siemens, a collaborative scientific agreement with the Oregon
Graduate Institute of Science and Technology, a similar agreement with Brigham
Young University and a license of its Allegro handwriting recognition
technology, Fonix presently has no licensing or co-development agreements with
any third party for the technologies which it has developed to date.
THE MARKET FOR MANY OF FONIX'S TECHNOLOGIES IS LARGELY UNPROVEN AND MAY NEVER
DEVELOP SUFFICIENTLY TO ALLOW FONIX TO CAPITALIZE ON ITS TECHNOLOGY AND
PRODUCTS.
The market for human-computer interaction technologies, including automated
speech recognition technologies, is relatively new. Fonix's technologies are new
and, in many instances, represent a significant departure from technologies
which already have found a degree of acceptance in the human-computer
interaction marketplace. The financial performance of Fonix will depend, in
part, on the future development, growth and ultimate size of the market for
human- computer interaction applications and products generally, and
applications and products incorporating Fonix's technologies and the
applications and products of its HealthCare Solutions and Interactive
Technologies Solutions Groups specifically. Applications and products
incorporating Fonix's technologies will compete with more conventional means of
information processing such as data entry, access by keyboard or touch-tone
phone or professional dictation services. Fonix believes that there is a
substantial potential market for applications and products incorporating
advanced human- computer interface technologies including speech recognition,
speech synthesis, speech compression, speaker identification and verification,
handwriting recognition, pen and touch screen input and natural language
understanding. Nevertheless, such a market for Fonix's technologies or for
products incorporating Fonix's technologies may never develop to the point that
profitable operations can be achieved or sustained.
COMPETITION FROM OTHER INDUSTRY PARTICIPANTS AND RAPID TECHNOLOGICAL CHANGE
COULD IMPEDE FONIX'S ABILITY TO ACHIEVE PROFITABLE OPERATIONS.
The computer hardware and software industries are highly and intensely
competitive. In particular, the human computer interaction market sector and
specifically the speech recognition, computer voice and communications
industries are characterized by rapid technological change. Competition in the
market sector of human-computer interaction technology is based largely on
marketing ability and resources, distribution channels, technology and product
superiority and product service and support. The development of new technology
or material improvements to existing technologies by Fonix's competitors may
render Fonix's technologies less attractive or even obsolete. Accordingly, the
success of Fonix will depend upon its ability to continually enhance its
technologies and interactive and health care solutions and products to keep pace
with or ahead of technological developments and to address the changing needs of
the marketplace. Some of Fonix's competitors have greater experience in
developing, manufacturing and marketing human computer interface technologies,
applications and products, and some have far greater financial and other
resources than Fonix, or its potential licensees and co-developers, as well as
broader name-recognition, more-established technology reputations, and mature
distribution channels for their products and technologies. Barriers to entry in
the software industry are low, and as the market for various human computer
interaction products expands and matures, Fonix expects more entrants into this
already competitive arena.
FONIX'S INDEPENDENT PUBLIC ACCOUNTANTS HAVE INCLUDED A "GOING CONCERN" PARAGRAPH
IN THEIR AUDIT REPORTS FOR 1998, 1997 AND 1996.
The auditors' reports for Fonix's financial statements for fiscal years 1998,
1997 and 1996 include an explanatory paragraph regarding substantial doubt about
Fonix's ability to continue as a going concern. This may have an adverse effect
on the Company's ability to obtain financing.
THE COMPANY'S SHARE PRICE AND FINANCIAL CONDITION MAY RESULT IN A FAILURE TO
CONTINUE TO MEET THE NASDAQ STOCK MARKET LISTING REQUIREMENTS.
Page 19 of 60
To maintain its stock listing on the Nasdaq SmallCap Market, Fonix is subject to
certain maintenance standards. One such maintenance standard is that Fonix
common stock must have a minimum bid price of $1 per share. Fonix will be deemed
to be in violation of this particular requirement if the bid price of Fonix
common stock is less than $1 for a period of 30 consecutive business days.
Thereafter, upon receipt of a notice from the Nasdaq SmallCap Market regarding
such failure, Fonix would have a period of 90 calendar days from receipt of such
notification to achieve compliance with the listing requirement. Fonix would be
deemed to be in compliance with the standard if the bid price of the Fonix
common stock was $1 or more for a minimum of 10 consecutive business days during
such 90 day period. Fonix has not received any notification from the Nasdaq
SmallCap Market that the Fonix common stock will be delisted from the Nasdaq
SmallCap Market. During the last half of 1998, and continuing to the present
date, Fonix common stock has traded at levels that have periodically been less
than $1 per share. If the Fonix common stock were to be delisted from the Nasdaq
SmallCap Market, it would likely continue to be traded in the over-the-counter
market. Nevertheless, such delisting could adversely affect the prevailing
market price of the common stock or the general liquidity of an investment in
Fonix common stock. A delisting would be deemed an event of default under the
rights and preferences of its outstanding series of preferred stock, the terms
and conditions of the Debentures and the terms of its agreement for the sale of
common stock entered into in December 1998.
FONIX'S OPERATIONS AND FINANCIAL CONDITION COULD BE ADVERSELY AFFECTED BY
FONIX'S FAILURE OR INABILITY TO PROTECT ITS INTELLECTUAL PROPERTY OR IF FONIX'S
TECHNOLOGIES ARE FOUND TO INFRINGE THE INTELLECTUAL PROPERTY OF A THIRD PARTY.
Dependence on proprietary technology
Fonix's success is heavily dependent upon proprietary technology. On June 17,
1997, the United States Patent and Trademark Office issued U.S. Patent No.
5,640,490 entitled "A User Independent, Real-time Speech Recognition System and
Method." The patent has a 20-year life running from the November 4, 1994 filing
date, and has been assigned to Fonix. This patent covers certain elements of the
Fonix ASRT. Fonix has acquired other patents and has filed additional patent
applications. In addition to its patents, Fonix relies on a combination of
copyright and trademark laws, trade secrets, confidentiality procedures and
contractual provisions to protect its proprietary rights. Such means of
protecting Fonix's proprietary rights may not be adequate because such laws
provide only limited protection. Despite precautions that Fonix takes, it may be
possible for unauthorized third parties to duplicate aspects of the Fonix
technologies or the current or future products or technologies of its business
units or to obtain and use information that Fonix regards as proprietary.
Additionally, Fonix's competitors may independently develop similar or superior
technology. Policing unauthorized use of proprietary rights is difficult, and
some non-U.S. laws do not protect proprietary rights to the same extent as
United States laws. Litigation periodically may be necessary to enforce Fonix's
intellectual property rights, to protect its trade secrets or to determine the
validity and scope of the proprietary rights of others. Fonix presently is
prosecuting an infringement action brought by Articulate against Apple Computer,
which action is now pending in federal court in Boston, Massachusetts. Such
litigation often results in substantial costs and diversion of management
resources and could materially adversely affect Fonix's business, operating
results, and financial condition. The Company has agreed to pledge the ASRT
patent as additional security for the repayment of the Company's Debentures.
While the Company has not executed a pledge agreement in favor of the holders of
the Debentures, it may be required to do so in the future. A breach of the
Company's obligations under such Debentures could result in a loss of the
Company's control of or rights under the patent.
Risks of infringement
Fonix is not aware and does not believe that any of its technologies or products
infringe the proprietary rights of third parties. Nevertheless, third parties
may claim infringement with respect to its current or future technologies or
products or products manufactured by others and incorporating Fonix's
technologies. Fonix expects that participants in the human- computer interaction
industry increasingly will be subject to infringement claims as the number of
products and competitors in the industry grows and the functionality of products
in different industry segments overlaps. Any such claims, with or without merit,
could be time consuming, result in costly litigation, cause development delays,
or require Fonix to enter into royalty or licensing agreements. Royalty or
license agreements may not be available on acceptable
Page 20 of 60
terms or at all. As a result, infringement claims could have a material adverse
affect on Fonix's business, operating results, and financial condition.
SOME MATTERS AFFECTING FONIX EFFECTIVELY COULD BE DETERMINED BY A CONTROLLING
SHAREHOLDER.
Thomas A. Murdock, a director, the Chief Executive Officer and a founding
shareholder of Fonix, is the trustee of a voting trust into which is deposited
approximately 33% of Fonix's common stock, based on the number of shares
outstanding as of April 9, 1999. This concentration of voting power in a single
individual could allow Mr. Murdock to control certain matters as to which the
Fonix shareholders are asked to vote. Such concentrated share ownership also may
prevent or discourage potential bids to acquire Fonix unless the terms of the
acquisition are approved by Mr. Murdock.
FONIX IS SUBJECT TO THE RISK THAT CERTAIN KEY PERSONNEL, ON WHOM FONIX DEPENDS,
IN PART, FOR ITS OPERATIONS, WILL CEASE TO BE INVOLVED WITH FONIX.
Fonix is dependent on the knowledge, skill and expertise of several key
scientific employees and independent contractors, including John A. Oberteuffer,
Ph.D., Dale Lynn Shepherd, Ivan Mimica, R. Brian Moncur, Tony R. Martinez,
Ph.D., and Caroline Henton, Ph.D., and its executive officers, Thomas A. Murdock
and Roger D. Dudley. The loss of any of the key personnel listed above could
materially and adversely affect Fonix's future business efforts. Fonix has taken
reasonable steps to protect its intellectual property rights including obtaining
non-competition and non-disclosure agreements from all of its employees and
independent contractors. However, if one or more of Fonix's key scientific or
executive employees or independent contractors resigns from Fonix to join a
competitor, to the extent not prohibited by such person's non-competition and
non-disclosure agreement, the loss of such personnel and the employment of such
personnel by a competitor could have a material adverse effect on Fonix. Fonix
does not presently have any key man life insurance on any of its employees.
RISKS ASSOCIATED WITH PENDING LITIGATION COULD ADVERSELY AFFECT FONIX.
The Company is party to certain litigation as described more particularly in
Part I, Item 3 of this Report. An adverse ruling or judgment against the Company
in any of such actions may have a material adverse effect on the Company's
business, results of operations or financial condition.
YEAR 2000 PROBLEMS COULD ADVERSELY AFFECT FONIX.
Many computer systems and software products are coded to accept only two digit
entries in the date code field. These date code fields will need to accept four
digit entries to distinguish 21st century dates from 20th century dates. As a
result, many companies' software and computer systems will need to be upgraded
or replaced in order to comply with such Year 2000 requirements. Fonix is
subject to the risk that problems encountered with Year 2000 issues, either in
its internal systems, technologies and products, or in external systems could
adversely affect its operations and financial condition.
In the ordinary course of its business, Fonix tests and evaluates its
technologies and software and hardware products. Fonix believes that its
technologies and products generally are Year 2000 compliant, meaning that the
use or occurrence of dates on or after January 1, 2000 will not materially
affect the performance of such technologies or products with respect to four
digit date dependent data or the ability of such products to correctly create,
store, process, and output information related to such data. However, Fonix may
learn that certain of its technologies or products do not contain all necessary
software routines and codes necessary for the accurate calculation, display,
storage, and manipulation of data involving dates. In addition, Fonix has
warranted or expects to warrant that the use or occurrence of dates on or after
January 1, 2000 will not adversely affect the performance of its technologies or
products with respect to four digit date dependent data or the ability to
create, store, process, and output information related to such data. If the end
users of any of Fonix's technologies or products experience Year 2000 problems,
those persons could assert claims for damages.
Fonix uses third-party equipment and software that may not be Year 2000
compliant. Fonix is presently conducting a review of key products provided by
outside vendors to determine if their products are Year 2000 compliant. Although
that process is not yet completed, Fonix presently believes that all software
provided by third parties that is critical to its business is Year 2000
compliant. Fonix expects to complete its review of all internal systems for Year
2000 compliance by June 30, 1999. If this third-party equipment or software does
not operate properly with regard to the Year 2000 issue,
Page 21 of 60
Fonix may incur unexpected expenses to remedy any problems. Such costs may
materially adversely affect Fonix's business, operating results, and financial
condition. In addition, if Fonix's key systems, or a significant number of its
systems, fail as a result of Year 2000 problems Fonix could incur substantial
costs and disruption of its business. Fonix may also experience delays in
implementing Year 2000 compliant software products. Any of these problems may
materially adversely affect Fonix's business, operating results or financial
condition.
In addition, the purchasing patterns of Fonix's licensees, potential licensees,
customers and potential customers may be affected by Year 2000 issues. Many
companies are expending significant resources to correct their current software
systems for Year 2000 compliance. These expenditures may result in reduced funds
available to license Fonix technologies or to purchase other Fonix products.
This may adversely affect Fonix's business, operating results, and financial
condition.
OTHER DEMANDS ON MANAGEMENT COULD ADVERSELY AFFECT FONIX.
In addition to occupying positions as the Company's Chairman of the Board of
Directors, Chief Executive Officer and President, and Executive Vice President,
respectively, Messrs. Stephen M. Studdert, Thomas A. Murdock and Roger D. Dudley
are executive officers and owners of Studdert Companies Corp. ("SCC"), an
international investment, finance and management firm based in Salt Lake City,
Utah. SCC engages in a variety of commercial activities unrelated to the
Company. Mr. Studdert recently resigned his position as Chief Executive Officer,
and Mr. Murdock replaced Mr. Studdert as Chief Executive Officer of the Company.
Further, in addition to serving as Vice President, Technology for the Company,
Dr. John A. Oberteuffer is the sole shareholder and President of Voice
Information Associates, Inc. ("VIA"), a company which publishes ASRNews, and
provides marketing consulting and other related services to other ASR companies,
groups and associations. Under the terms of his employment agreement with Fonix,
executed in February 1998, Dr. Oberteuffer is not required to devote more than 4
days per week to the business of Fonix. Although the Company anticipates that
Dr. Oberteuffer can fully discharge all of his duties and responsibilities to
the Company by working 4 days per week, the Company has no comparable prior
experience with such an arrangement. There can be no assurance that the outside
activities of Messrs. Murdock, Dudley or Oberteuffer, in connection with SCC,
VIA or otherwise, will not materially impede their ability to perform as
executive officers of the Company, in which case the Company's operations and
financial condition could be adversely affected.
THE MARKET PRICE OF FONIX'S COMMON STOCK IS EXTREMELY VOLATILE.
The trading price of the Company's common stock has been characterized by wide
fluctuations and the common stock must be considered a speculative investment.
Persons should not invest in Fonix common stock unless they can bear the
economic risks thereof, including the possibility of losing their entire
investment. Fonix believes that factors such as announcements of developments
related to the Company's business, announcements by competitors, the issuance of
patents, financings, and other factors have caused the price of the Company's
stock and its trading volume to fluctuate, in some cases substantially, and
could continue to do so in the future. In addition, the stock market has
experienced extreme price and volume fluctuations that have particularly
affected the market price for many technology companies and that have often been
unrelated to the operating performance of these companies. These broad market
fluctuations may adversely affect the market price of the Company's common
stock. The trading prices of many technology companies' stocks are at or near
their historical highs, and reflect price/earnings ratios substantially above
historical norms. In the Company's case the absence of revenues from operations
before February 1998 indicates that the market price of the Company's common
stock fluctuates as a result of highly speculative factors. In addition, the
Company has issued debt and equity securities convertible to common stock. The
conversion features of these securities are adjusted based on the market price
of the Company's common stock and conversion is likely to occur at times when
the price for the common stock is low, resulting in the issuance of a greater
number of shares of common stock and increasing, sometimes significantly, the
dilution experienced by the Company's shareholders. Such conversions, or the
possibility of the significant dilution that may be experienced as a result of
such conversions, is also a factor contributing to the volatility of the market
price of the Company's common stock.
ITEM 2. PROPERTIES
The Company owns no real property. Commencing in October 1996, the Company
leased a 25,600 square foot facility in Draper, Utah, from an unaffiliated third
party at which it conducts its principal scientific research and development
Page 22 of 60
activities and operates its Interactive Technologies Solutions Group. The
Company's lease of that facility is for a term of 8 years. Provided that the
Company is not in default under the lease, the Company has the option to extend
the lease for 5 additional years. The average base monthly lease payment over
the 8-year life of the lease for that facility is $28,389.
In addition to the Draper facility, the Company sub-leases office space on a
month-to-month basis at market rates for its corporate headquarters and
administrative operations in Salt Lake City, Utah, from SCC. SCC is owned and
controlled by three individuals who are executive officers and directors of the
Company. [See "Certain Relationships and Related Transactions," and "Security
Ownership of Certain Beneficial Owners and Management"]. The three executive
officers of the Company have personally guaranteed this lease in favor of SCC's
landlord. The base monthly rental for the sub-leased space during 1998 was
approximately $10,369, plus reimbursable direct expenses for the use of
telephone, facsimile, photocopy and other business equipment. The Company
anticipates continuing the month-to-month sublease agreement with SCC for 1999
whereby the Company will pay the actual monthly rental and common area fees
incurred by SCC.
The Company also leases approximately 10,000 square feet of office space in
Cupertino, California. The lease on this space is for 5 additional years, with
rent of $24,412 per month. The Company is presently seeking to sublease all or
part of this space. In the event the Company can sublease all of the space, it
will seek to relocate its operations in California to a smaller facility.
The Company leases approximately 16,810 square feet of office space in Woburn,
Massachusetts, at which it conducts the operations of its Health Care Solutions
Group. This lease extends through November 1999, and monthly rents are $22,343.
The Company intends to negotiate an extension of the term of this lease for at
least one year or locate comparable space in the greater Boston area.
The Company believes that the facilities described above are adequate for its
current needs.
ITEM 3. LEGAL PROCEEDINGS
The Polomba Action
On July 9, 1998, the Company settled a case brought by a shareholder of the
Company against certain directors of the Company and K.L.S. Enviro Resources,
Inc. ("KLSE"), a third party affiliated with certain of the director-defendants.
Pursuant to the settlement, the Company has received warrants to purchase
583,000 shares of KLSE common stock at a purchase price of $0.40 per share.
The J&L Action
On March 11, 1998 an action (the "J&L Action) was filed against the Company in
the Supreme Court of the State of New York for the County of New York by Jesup &
Lamont Securities Corporation ("J&L"). The J&L Action alleged that the Company
was obligated to pay a fee in excess of $1,200,000 plus 30,000 shares of the
Company's restricted common stock in connection with the March 1998 Offering. In
September 1998, the J & L Action was settled and dismissed with prejudice upon
payment of $385,000 by the Company to J&L.
The Clarke Action
On August 28, 1998, John R. Clarke ("Clarke") and Perpetual Growth Fund
("Perpetual Growth"), a company Clarke's spouse purportedly owns, commenced an
action against the Company in federal court for the Southern District of New
York. Clarke and Perpetual Growth assert claims for breach of contract relating
to certain financing the Company received during 1998. Specifically, Clarke and
Perpetual Growth allege that they entered into a contract with the Company under
which the Company agreed to pay them a commission of 5% of all financing
provided to the Company by Southridge Capital Management or its affiliates.
Clarke and Perpetual Growth claim that they are entitled to commissions with
respect to approximately $3,000,000 of equity financing to the Company in July
and August 1998, and the Company's offerings of Series D and Series E (totaling
together $12,000,000) in August and September 1998.
Page 23 of 60
The Company believes that the Clarke lawsuit is without merit. The Company filed
a motion to dismiss based upon the court's lack of personal jurisdiction over
the Company. The court granted the Company's motion to dismiss, but Clarke and
Perpetual have appealed the New York court's decision that it lacks jurisdiction
over the Company. On November 9, 1998, the Company filed an action in the United
States District Court for the Central District of Utah, against Clarke and
Perpetual seeking a declaratory judgment that the Company is not obligated to
Clarke or Perpetual. Clarke and Perpetual have sought to have this action
dismissed, but the Utah court has not yet ruled on their motion. However, Clarke
and Perpetual Growth could prevail in the lawsuit, in which case the Company may
be required to pay significant amounts of money damages or other amounts awarded
by the court. At a minimum, the ongoing nature of this action will result in
some diversion of management time and effort from the operation of the business,
as well as additional legal fees and related costs and expenses.
The Papyrus Actions
On February 26, 1998, the Company filed an action against Papyrus in the United
States District Court for the District of Utah, Central Division (the "Utah
Action"). In the Utah Action, the Company alleged claims for misrepresentation,
negligent misrepresentation, breach of contract, breach of the implied covenant
of good faith and fair dealing and rescission. On March 11, 1999, three of the
former shareholders of Papyrus filed an action against the Company in the United
States District Court for the District of Massachusetts (the "First
Massachusetts Action"), alleging a default under the terms of the promissory
notes issued to them in connection with the Papyrus Acquisition. On April 8,
1999, a fourth former Papyrus shareholder filed an action against the Company in
the United States District Court for the District of Massachusetts (the "Second
Massachusetts Action") alleging a default under the terms of the promissory
notes issued to him in connection with the Papyrus Acquisition and seeking
additional remedies including violation of Massachusetts unfair and deceptive
acts and practices statutes and copyright infringement. The Company has entered
into agreements with the four former Papyrus shareholders for dismissal of the
First and Second Massachusetts Actions and the Utah Action upon payment to the
former shareholders of $1,122,209 (the "Settlement Payment") an amount equal to
approximately 73% of the balance due them under the notes issued to them in the
Papyrus Acquisition, and return for cancellation by the Company of 970,586
shares of restricted common stock issued to them in the Papyrus Acquisition.
This represents approximately 30% of the total number of the Company's common
stock originally issued to these shareholders in the Papyrus Acquisition. The
Company must pay the Settlement Payment before May 16, 1999. If it does not, the
Company and the four former Papyrus shareholders are free to pursue their
respective claims in the Utah Action and the First and Second Massachusetts
Actions.
The Apple Litigation
In February 1995, Articulate received a patent (the "303 Patent") for a product
that would allow users of Apple Macintosh computers to use voice commands for
certain computer control commands. Soon after the 303 Patent issued, Articulate
notified Apple that its "PlainTalk" product infringed the 303 Patent. When Apple
ignored Articulate's notice, Articulate sued Apple in the United States District
Court for the District of Massachusetts. Apple responded to the suit by suing
Articulate and Dragon Systems, Inc. in California. The California suit against
Articulate and Dragon Systems has now been dismissed. The Company acquired
Articulate's claims against Apple in the Articulate acquisition. The Company has
completed discovery in the action pending in Massachusetts and is awaiting the
scheduling of trial.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of the security holders during the
fourth quarter of fiscal 1998.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Fonix common stock is listed on the Nasdaq SmallCap Market under the trading
symbol FONX. The following table shows the range of high and low sales price
information for the Company's common stock as quoted on Nasdaq for the four
quarters of calendar 1998 and 1997. The quotations reflect inter-dealer prices,
without retail mark-up, mark-down or commissions and may not represent actual
transactions.
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Calendar Year 1998 Calendar Year 1997
------------------ ------------------
High Low High Low
---- --- ---- ---
First Quarter $ 6.50 $ 3.50 $ 9.00 $7.13
Second Quarter $ 6.34 $ 3.00 $ 8.75 $6.50
Third Quarter $ 4.00 $ 1.12 $ 7.44 $6.50
Fourth Quarter $ 2.63 $ 0.94 $ 7.00 $2.88
As of April 9, 1999, there were 7,064,495 shares of Fonix common stock
outstanding, held by 239 holders of record and approximately 5,100 beneficial
holders. This number of beneficial holders represents an estimate of the number
of actual holders of the Company's stock, including beneficial owners of shares
held in "nominee" or "street" name. The actual number of beneficial owners is
not known to the Company.
The Company has never declared any dividends on its common stock and it is
expected that earnings, if any, in future periods will be retained to further
the development and sale of the Company's human-computer interaction
technologies and products. No dividends can be paid on the common stock of the
Company until such time as all accrued and unpaid dividends on the Company's
preferred stock have been paid.
Recent Sales of Unregistered Equity Securities
During fiscal year 1998, the Company issued a total of 59,814 restricted shares
of common stock to various third parties in payment for services rendered under
consulting and other agreements. The shares were issued pursuant to and in
reliance on exemptions from registration under the Securities Act of 1933, as
amended (the "1933 Act"), particularly pursuant to Section 4(2) of the 1933 Act
and the rules and regulations promulgated thereunder. The value of the shares
issued in these transactions, based on the fair market value of the shares on
the several dates of issuance was approximately $151,119 or an average of
approximately $2.53 per share. More detail concerning these transactions is
included below.
On February 24, 1998, the Company issued 24,814 shares of common stock to an
unaffiliated entity as payment for certain intellectual property. The Company
issued such shares without registration under the 1933 Act in reliance on
Section 4(2). Such shares of common stock were issued as restricted securities
and the certificates representing such shares were stamped with a restrictive
legend to prevent any resale without registration under the 1933 Act or pursuant
to an exemption.
On March 5, 1998, the Company issued 80,000 shares of common stock to
unaffiliated individuals upon the exercise of warrants at a per share price of
$2.00. The Company issued such shares without registration under the 1933 Act in
reliance on Section 4(2) or Regulation D. Such shares of common stock were
issued as restricted securities and the certificates representing such shares
were stamped with a restrictive legend to prevent any resale without
registration under the 1933 Act or pursuant to an exemption.
On March 12, 1998, the Company issued 3,333,333 shares of common stock to seven
institutional investors under the terms of the March 1998 Offering. The
consideration received by the Company for these shares was $15,000,000 ($4.50
per share). In connection with the sale of those shares, the investors acquired
"reset" rights obligating the Company to issue to them additional shares of
common stock (the "Reset Shares") for no additional consideration if the average
market price of the Company's common stock for the 60 day period preceding July
27, 1998, did not equal or exceed $5.40 per share. The Company issued such
shares without registration under the 1933 Act in reliance on Section 4(2) or
Regulation D. Such shares of common stock were issued as restricted securities
and the certificates representing such shares were stamped with a restrictive
legend to prevent any resale without registration under the 1933 Act or pursuant
to an exemption.
On March 13, 1998, the Company issued 100,000 shares of common stock to
unaffiliated individuals upon the exercise of warrants. The exercise price was
$0.50 per share. The Company issued such shares without registration under the
1933 Act in reliance on Section 4(2) or Regulation D. Such shares of common
stock were issued as restricted securities and
Page 25 of 60
the certificates