Note 2 – Debt Instruments
Secured Promissory Note
Timothy Looney, Barbara Looney and TWL Group, L.P. (collectively, “Looney”), on the one hand, and the Company and its then Chief Executive Officer, John C. Carson and its then Chief
Financial Officer, John J. Stuart, Jr., on the other hand, had been engaged in litigation since January 2008 regarding the Company’s acquisition of Optex Systems, Inc. (“Optex”) and related matters. In March 2010, the Company
and Messrs. Carson and Stuart entered into a Settlement and Release Agreement with Looney pursuant to which the Company and Messrs. Carson and Stuart, on the one hand, and Looney, on the other hand, settled and released all claims and agreed to
dismiss all litigation against each other relating to the Company’s acquisition of Optex in December 2005 and various transactions related thereto (the “Looney Settlement Agreement”).
Pursuant to the terms of the Looney Settlement Agreement, the Company issued to Mr. Looney a secured promissory note in the
principal amount of $2,500,000 (the “Secured Promissory Note”). The Secured Promissory Note bore simple interest at a rate per annum of 10% of the outstanding principal balance and was secured by substantially all of the assets of
the Company, but such security interests were subject to and subordinate to the existing perfected security interests and liens of the Company’s then senior creditor, Summit Financial Resources, L.P. (“Summit”). The Secured
Promissory Note required the Company to remit graduated monthly installment payments over a 27-month period to Mr. Looney beginning with a payment of $8,000 in May 2010 and ending with a payment of $300,000 in June 2012. All such payments were
applied first to unpaid interest and then to outstanding principal. Scheduled payments through April 2011 applied only to interest. A final payment of the remaining unpaid principal and interest under the Secured Promissory Note was due and payable
in July 2012.
In December 2011, the Company used approximately $1.9 million of the proceeds of a new $5,000,000 revolving
credit facility, described more fully below, to repay the total amount of principal, interest, fees and other amounts owed by the Company under the Secured Promissory Note, thereby satisfying all remaining obligations of the Company pursuant to the
Settlement and Release Agreement.
Senior Secured Revolving Credit Facility
In December 2011, the Company entered into a Loan and Security Agreement (the “Loan Agreement”) with Partners for Growth
III, L.P. (“PFG”) pursuant to which the Company obtained a two-year, $5,000,000 revolving credit facility from PFG (the “Revolving Credit Facility”). As additional consideration for entering into the Agreement, the
Company issued to PFG, and two of its affiliated entities, 7-year warrants to purchase an aggregate of 15,000,000 shares of the Company’s common stock at the exercise price of $0.11 per share (the “Warrants”). If the Company attains certain specified revenue and
EBITDA thresholds for calendar year 2012, the aggregate number of shares issuable upon exercise of the Warrants will be reduced to 10,000,000 shares. As a result of the potential adjustment of the Warrants, the Company considered such warrants to be
derivatives and recorded their fair value of approximately $250,000 at the date of issuance as a liability and as a discount to the underlying credit facility.
Upon execution of the Loan Agreement, the Company borrowed the entire $5,000,000 available thereunder (the “Initial Revolving Loan”) and used approximately $1.9 million of those funds to
repay the Secured Promissory Note. The Company expects to use the remaining proceeds of the Initial Revolving Loan, less expenses thereof and the repayment of the Secured Promissory Note, for general working capital purposes, but may repay some
portion of the Initial Revolving Loan to PFG prior to its maturity date. Any further borrowings by the Company under the Loan Agreement will be subject to the Company’s compliance with certain financial and other covenants in the Loan
Agreement, provided that no default or event of default (as defined in the Loan Agreement) has occurred and is continuing. At January 1, 2012, the principal balance outstanding under the Revolving Credit Facility was $5,000,000.
The maturity date for the Loans issued pursuant to the Revolving Credit Facility (the “Loans”) is December 14, 2013
(the “Maturity Date”). However, given our history of recurring losses, we cannot assure that we will be able to meet certain financial and other covenants in the Loan Agreement prior to Maturity Date. Interest on the Loans accrues
at the rate of 12% per annum. Interest only on the Loans is payable monthly on the third business day of each month for interest accrued during the prior month, and the remaining balance is payable on the Maturity Date. Each of Costa Brava
Partnership III L.P. (“Costa Brava”) and The Griffin Fund LP (“Griffin”), major stockholders and debt holders of the Company, individually and collectively, jointly and severally, have unconditionally guaranteed
repayment of $2,000,000 of the Company’s monetary obligations under the Loan Agreement to PFG.
To secure the payment of
all of the Company’s obligations under the Loans when due, the Company granted to PFG a first position, continuing security interest in substantially all of the Company’s assets, including substantially all of its intellectual property,
subject to the commitment by PFG to release any security interests in any assets sold by the Company to Vectronix Inc. pursuant to the APA. In addition, Costa Brava, Griffin and certain other existing creditors of the Company have agreed to
subordinate their security interests and liens that such creditor may have in any of the Company’s property and agreed that while any obligations remain outstanding by the Company to PFG, any and all liens of Creditor in respect of the Company
shall be junior to PFG’s security interests. In connection with the Loan Agreement, Summit cancelled its receivables line agreement with the Company and Summit’s related security interests in the Company’s assets were terminated.
Senior Subordinated Secured Promissory Notes
In March 2011, the Company issued and sold to two accredited investors, Costa Brava and Griffin, 12% Senior Subordinated Secured Promissory Notes due March 2013 (the “Senior Subordinated
Notes”) in the aggregate principal amount of $4,000,000. In July 2011, the Senior Subordinated Notes were amended to permit the holders to demand repayment any time on or after July 16, 2012, in partial consideration for permitting the
issuance of additional Subordinated Secured Convertible Promissory Notes as discussed below. Because of this demand, the Senior Subordinated Notes have been classified as current obligations in the Company’s Condensed Consolidated Balance
Sheets of January 1, 2012 and October 2, 2011.
The Senior Subordinated Notes bear interest at a rate of
12% per annum, due and payable quarterly in cash within 10 business days of the end of each calendar quarter, calculated on the simple interest basis of a 365-day year for the actual number of days elapsed. The foregoing notwithstanding, until
Loans issued pursuant to the Revolving Credit Facility are repaid in full and said Revolving Credit Facility is no longer in effect, interest on the Senior Subordinated Notes must be paid by adding the amount of such
interest to the outstanding principal amount of the Senior Subordinated Notes as “paid-in-kind” (“PIK”) interest. As a result of the addition of such interest, the outstanding principal amount of the Senior Subordinated
Notes at January 1, 2012 was approximately $4,384,900.
The Senior Subordinated Notes are secured by substantially all of
the assets of the Company, but the liens securing the Senior Subordinated Notes are subordinate to the liens securing the indebtedness of the Company to PFG under the Revolving Credit Facility.
Subordinated Secured Convertible Promissory Notes
In December 2010, the Company entered into a Securities Purchase Agreement (the “Purchase Agreement”) with Costa Brava and Griffin, pursuant to which the Company issued and sold to Costa
Brava and Griffin 12% Subordinated Secured Convertible Notes due December 23, 2015 (the “Subordinated Notes”) in the aggregate principal amount of $7,774,800 and sold in a subsequent closing in March 2011 additional
Subordinated Notes (the “Milestone Notes”) to Costa Brava and Griffin for an aggregate purchase price of $1,200,000 (collectively, the “Institutional Financing”). In July 2011, the Company sold additional
Subordinated Notes to five accredited investors, including Costa Brava and Griffin, in the aggregate principal amount of $5,000,000.
In addition, holders of certain 10% unsecured convertible promissory notes of the Company (the “Bridge Notes”) with a principal balance of $1,578,300 (including accrued interest of
$18,300) converted their Bridge Notes into Subordinated Notes during Fiscal 2011.
The Subordinated Notes bear interest at a
rate of 12% per annum, due and payable quarterly within 10 business days of the end of each calendar quarter, calculated on the simple interest basis of a 365-day year for the actual number of days elapsed. For the first two years of the term
of the Subordinated Notes, the Company has the option, subject to the satisfaction of certain customary equity conditions, to pay all or a portion of the interest due on each interest payment date in shares of common stock, with the price per share
calculated based on the weighted average price of the Company’s common stock over the last 20 trading days ending on the second trading day prior to the interest payment date. While the Revolving Credit Facility is outstanding, interest on the
Subordinated Notes that is not paid in shares of common stock must be paid by adding the amount of such interest to the outstanding principal amount of the Subordinated Notes as PIK interest. The principal and accrued but unpaid interest under the
Subordinated Notes is convertible at the option of the holder into shares of the Company’s common stock at an initial conversion price of $0.07 per share. The conversion price is subject to full price adjustment feature for certain price
dilutive issuances of securities by the Company and proportional adjustment for events such as stock splits, dividends, combinations and the like. Beginning after the first two years of the term of the Subordinated Notes, the Company can force the
Subordinated Notes to convert to common stock if certain customary equity conditions have been satisfied and the volume weighted average price of the common stock is $0.25 or greater for 30 consecutive trading days.
The Subordinated Notes are secured by substantially all of the assets of the Company pursuant to a Security Agreement dated
December 23, 2010 and July 1, 2011, as applicable, between the Company and Costa Brava as representative of the Subordinated Note holders, but the liens securing the Subordinated Notes are subordinate in right of payment to Loans issued
pursuant to the Revolving Credit Facility.
As a result of the issuances of Subordinated Notes discussed above, the conversion
of Bridge Notes to Subordinated Notes discussed above and the application of PIK interest, the aggregate principal balance of the Subordinated Notes at January 1, 2012, exclusive of the effect of debt discounts, was $16,122,400. The balance of
the Subordinated Notes, net of unamortized discounts comprised of derivative liability, at January 1, 2012 was $4,744,000. The debt discounts will be amortized over the term of the Subordinated Notes, unless such amortization is accelerated due
to earlier conversion of the Subordinated Notes pursuant to their terms.
Conversion Features of the
Bridge Notes and the Subordinated Notes.
The conversion features of the Bridge Notes and the Subordinated Notes contain
provisions that adjust the conversion price in the event of certain dilutive issuances of securities. Accordingly, the Company considered such conversion features to be derivatives and recorded their fair value of $6,867,100 at the date of issuance
as a liability and as a discount to the underlying notes. In Fiscal 2011, the derivative liability of the Bridge Notes was eliminated as a result of their conversion or repayment.
The Company re-measured the fair value of the derivative liability of the Subordinated Notes and the warrants issued in conjunction with
the Senior Secured Revolving Credit Facility to be $15,912,800 as of January 1, 2012.
The following outlines the
significant weighted average assumptions the Company used to estimate the fair value information presented, with respect to derivative liabilities utilizing the Binomial Lattice pricing model at the date of issuance and January 1, 2012:
Risk free interest rate