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EXCEL - IDEA: XBRL DOCUMENT - Applied Visual Sciences, Inc.Financial_Report.xls
EX-23 - EX 23.1 AUDITOR CONSENT - Applied Visual Sciences, Inc.kblconsent10kexh231.htm
EX-32 - EX 32.1 CEO CERTIFICATION - Applied Visual Sciences, Inc.f201110kceocertex321.htm
EX-32 - EX 32.2 CFO CERTIFICATION - Applied Visual Sciences, Inc.f201110kcfocertex322.htm
EX-31 - EX 31.2 CFO CERTIFICATION - Applied Visual Sciences, Inc.f201110kcfocertex312.htm
EX-21 - EX 21 LIST OF SUBSIDIARIES - Applied Visual Sciences, Inc.subsidiariesex21123111.htm
EX-10 - EX 10.31 AMEND LOAN AGREEMENT WITH OFFICER 12-31-11 - Applied Visual Sciences, Inc.wtrudnakloanamend123111ex103.htm
EX-31 - EX 31.1 CEO CERTIFICATION - Applied Visual Sciences, Inc.f201110kceocertex311.htm


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC  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, 2011


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 number: 000-28238


APPLIED VISUAL SCIENCES, INC.

(Exact name of registrant as specified in its charter)


Delaware

 

54-1521616

(State or other jurisdiction of
incorporation or organization)

 

(I.R.S. Employer Identification No.)


250 Exchange Place, Suite H, Herndon, Virginia  20170

(Address of principal executive offices and zip code)


(703) 464-5495

(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, $0.001 par value per share


Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.   Yes __ No  ü 


Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act.   Yes __ No  ü 


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  ü   No __


Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).   Yes  ü   No __


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 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.   [   ]




Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company.  See definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.   Large accelerated filer [  ] Accelerated filer [  ] Non-accelerated filer [  ] Smaller reporting company [ü]


Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).   Yes __ No  ü

      

The aggregate market value of the registrant’s voting common equity held by non-affiliates of the registrant was approximately $12,508,308 (the last business day of the registrant’s most recently completed second fiscal quarter), as quoted on the OTC Bulletin Board for the registrant’s Common Stock, $0.001 par value, on June 30, 2011.


At April 10, 2012, 91,198,230 shares of the registrant’s Common Stock, $0.001 par value, were outstanding.

 


DOCUMENTS INCORPORATED BY REFERENCE

None.  








2


NOTE REGARDING FORWARD-LOOKING STATEMENTS


Our disclosure and analysis in this Report contains forward-looking statements which provide our current expectations or forecasts of future events.  Forward-looking statements in this Report include, without limitation:


·

information concerning possible or assumed future results of operations, trends in financial results and business plans, including those related to earnings, earnings growth, revenue and revenue growth;

·

statements about the level of our costs and operating expenses relative to our revenues, and about the expected composition of our revenues;

·

statements about expected future sales trends for our products;

·

statements about our future capital requirements and the sufficiency of our cash, cash equivalents, and available bank borrowings to meet these requirements;

·

information about the anticipated release dates of new products;

·

other statements about our plans, objectives, expectations and intentions;

·

and other statements that are not historical fact.


Forward-looking statements generally can be identified by the use of forward-looking terminology such as “believes,” “expects,” “may,” “will,” “intends, “plans,” “should,” “seeks,” “pro forma,” “anticipates,” “estimates,” “continues,” or other variations thereof (including their use in the negative), or by discussions of strategies, plans or intentions.  Such statements include but are not limited to statements under Part I, Item 1A - Risk Factors, Part II, Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations, Part I, Item 1 – Business and elsewhere in this Report.  A number of factors could cause results to differ materially from those anticipated by such forward-looking statements, including those discussed under Part I, Item 1A - Risk Factors, and Part I, Item 1 – Business of this Report.  The absence of these words does not necessarily mean that a statement is not forward-looking.  Forward-looking statements are subject to known and unknown risks and uncertainties and are based on potentially inaccurate assumptions that could cause actual results to differ materially from those expected or implied by the forward-looking statements.  Our actual results could differ materially from those anticipated in the forward-looking statements for many reasons, including factors described in Part I, Item 1A - Risk Factors of this Report.  You should carefully consider the factors described in Part I, Item 1A - Risk Factors of this Report in evaluating our forward-looking statements.


You should not unduly rely on these forward-looking statements, which speak only as of the date of this Report.  We undertake no obligation to publicly revise any forward-looking statement to reflect circumstances or events after the date of this Report, or to reflect the occurrence of unanticipated events.  You should, however, review the factors and risks we describe in the reports we file from time to time with the Securities and Exchange Commission (“SEC”).





3


     APPLIED VISUAL SCIENCES, INC.

TABLE OF CONTENTS

PART I

6

ITEM 1.     BUSINESS

6

ITEM 1A.  RISK FACTORS

26

ITEM 1B.  UNRESOLVED STAFF COMMENTS

40

ITEM 2.     PROPERTIES

40

ITEM 3.     LEGAL PROCEEDINGS

40

PART II

40

ITEM 5.     MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES  40

ITEM 6.     SELECTED FINANCIAL DATA

41

ITEM 7.     MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

42

ITEM 7A.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

62

ITEM 8.     FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

62

ITEM 9.     CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

62

ITEM 9A.  CONTROLS AND PROCEDURES

62

ITEM 9B.  OTHER INFORMATION

63

PART III

64

ITEM 10.   DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

64

ITEM 11.   EXECUTIVE COMPENSATION

69

ITEM 13.   CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE

84

ITEM 14.   PRINCIPAL ACCOUNTiNG FEES AND SERVICES

85

PART IV

86

ITEM 15.   EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

86

SIGNATURES

90

CONSOLIDATED FINANCIAL STATEMENTS

91

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

92




4


CONSOLIDATED BALANCE SHEETS

93

CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)

94

CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY (DEFICIT) AND COMPREHENSIVE INCOME (LOSS)

95

CONSOLIDATED STATEMENTS OF CASH FLOWS

97

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

99

NOTE 1.    Basis of Presentation and Going Concern Considerations

99

NOTE 2.    Significant Accounting Policies

101

NOTE 3.    Accrued Liabilities

108

NOTE 4.    Financing Arrangements

108

NOTE 5.    Fair Value Measurement

114

NOTE 6.    Stockholders’ Equity (Deficit)

115

NOTE 7.    Acquisitions

129

NOTE 8.    Goodwill and Intangible Assets

130

NOTE 9.    Income Taxes

130

NOTE 10.  Commitments and Contingencies

131

NOTE 11.  Employment Agreements With Executive officers

132

NOTE 12.  Related Party Transactions

134

NOTE 13.  Operating Leases

135

NOTE 14.  Subsequent Events

135




5


PART I

ITEM 1.     BUSINESS

Overview


Applied Visual Sciences, Inc. was incorporated under the name Guardian Technologies International, Inc., in the Commonwealth of Virginia in 1989 and reincorporated in State of Delaware in February 1996.  We changed our name to Applied Visual Sciences, Inc., on July 9, 2010.  Applied Visual Sciences, Inc. and its subsidiaries are collectively referred to herein as the “Company,” “Applied Visual Sciences, Inc.,” “Applied Visual,” “us,” “we,” or “our.”


Applied Visual Sciences is a software technology company that designs and develops imaging informatics solutions for delivery to its target markets, aviation/homeland security and healthcare.  Our two product lines are offered through our two operating subsidiaries as follows: Guardian Technologies International, Inc. for aviation/homeland security products and Signature Mapping Medical Sciences, Inc., for healthcare. On March 23, 2012, the Company established a new entity; Instasis Imaging, Inc., for the development, marketing, and sales of a suite of imaging analytic applications for the automated detection of breast cancer. We may engage in one or more acquisitions of businesses that are complementary, and may form wholly-owned subsidiaries to operate within defined vertical markets products.


The Company utilizes imaging technologies and analytics to create integrated information management technology products and services that address critical problems experienced by corporations and governmental agencies in healthcare and homeland security.  Each product and service can improve the quality and response time of decision-making, organizational productivity, and efficiency within the enterprise.  Our product suite integrates, streamlines, and distributes business and clinical information and images across the enterprise.


Our Business Strategy


Our strategic vision is to position our core technology as the de facto standard for digital image analysis, knowledge extraction, and detection.  Our strategy is based upon the following principal objectives:


·

Maintain product development and sales/marketing focus on large, underserved, and rapidly growing markets with a demonstrated need for intelligent imaging informatics.

·

Leverage Applied Visual Sciences, Inc.’s technology, experienced management team, research and development infrastructure.

·

Focus our talents on solving highly challenging information problems associated with digital imaging analysis.

·

Establish an international market presence through the development of a significant OEM/Reseller network.

·

Build and maintain a strong balance sheet to ensure the availability of capital for product development, acquisitions, and growth.

·

Seek to broaden our investment appeal to large institutions.


To achieve our strategic vision, we are aware of the need to exercise the financial and operational discipline necessary to achieve the proper blend of resources, products and strategic partnerships.  These efforts can accelerate our ability to develop, deploy and service a broad range of intelligent imaging informatics solutions directly to our target markets and indirectly through OEM/value added reseller (“VAR”) partners.  During 2011, we continued implementing changes across the spectrum of our business. We refined our marketing strategy for PinPoint™ and Signature Mapping™, and enhanced our Signature Mapping™ product offerings.   


We may engage in one or more acquisitions of businesses that are complementary, and may form wholly-owned subsidiaries to operate within defined vertical markets.


Our Core Technology


Our core technology is an “intelligent imaging informatics” (“3i™”) engine that is capable of extracting embedded knowledge from digital images, and has the capacity to analyze and detect image anomalies.  The technology is not limited by type of digital format. It can be deployed across divergent digital sources such as still images, x-ray images, video and hyper-spectral imagery.  To date, the technology has been tested in the area of threat detection for baggage scanning at airports, for bomb squad applications and the detection of tuberculosis by analyzing digital images of stained sputum slides captured through a photo microscopy system.  Varying degrees of research and development have been conducted in the areas of detection for cargo scanning, people scanning, military target acquisition in a hyper-spectral environment, satellite remote sensing ground surveys and mammography CAD products and radiologists’ diagnostic imaging tools, and while product development in these areas is ongoing, there can be no assurance that we will successfully develop product offerings in these areas.




6


  

We are currently focused on providing software technology solutions and services in two primary markets - aviation/homeland security with PinPoint™ and healthcare technology with Signature Mapping™ solutions.  However, as new or enhanced solutions are developed, we expect to expand into other markets such as military and defense utilizing hyper-spectral technology, and imaging diagnostics for the medical industry.


Financing Activities


2011 Short-Term Promissory Notes


During October and November 2011, the Company issued twelve-month promissory notes to accredited investors in the aggregate principal amount of $400,000.  The twelve-month notes accrue interest at a rate of 12% per annum.  The Company also issued to the two note holders an aggregate of 400,000 shares of common stock.  The relative fair value of the common stock of $34,700 will be amortized over the term of the notes.  The Company also issued 250,000 shares of common stock as compensation in connection with the financing for a fair value of $25,000.


2011 Securities Purchase Agreement


On February 23, 2011, the Company entered into a Securities Purchase Agreement (the “SPA”) with an institutional accredited investor for an investment up to $1,000,000, subject to certain stock price and volume conditions.  Subsequently on February 24, 2011, we sold to the institutional investor at the first closing of the private placement of securities, an aggregate of 600,000 shares of common stock, and 600,000 common stock purchase warrants to purchase an aggregate of 600,000 shares of common stock, for gross proceeds of $150,000 ($136,000 net of certain expenses and sales commissions in the amount of $14,000). The warrants are exercisable at a price of $0.25 per share for a period of five years after the date of issuance, contain a cashless exercise provision and other customary provisions. Also, we issued to a broker an aggregate of 72,000 placement agent’s warrants as compensation in connection with the offering. The placement agent’s warrants are under the same terms and conditions as those issued to the institutional investor.


In addition, under the SPA, the investor has agreed to provide additional financing to us by purchasing shares of our common stock at seven subsequent closings and subject to certain share price and volume requirements.  However, the subsequent closings scheduled during March through September 2011, did not take place since the stock price and volume conditions were not met.


We granted to the investor piggy back registration rights with regard to the shares issued in the financing, including the shares underlying the Warrants. The SPA contains representations and warranties of the Company and investor, certain indemnification provisions and customary conditions to each closing.  We may terminate the SPA on ten days prior written notice to the investor, and the investor may terminate the SPA at any time prior to a subsequent financing upon written notice to us if we consummate a reverse stock split or a subsequent financing to which the investor is not a party.


We agreed to pay the investor’s counsel with regard to the first closing in the amount of $25,000, $5,000 of which was paid at the first closing and $5,000 was to be paid at each of the first four subsequent closings.  As mentioned above, the subsequent closings did not take place and the Company did not pay the four additional $5,000 payments to the investor’s counsel. We also agreed to pay additional fees for their counsel for each subsequent closing in the amount of $2,500. A broker acted as placement agent for the offering.  Under the terms of a Non-Circumvention and Compensation Agreement, dated January 12, 2011, between the Company and the broker, in connection with the offering, we agreed to pay or issue the broker at each subsequent closing a placement fee equal to 6% of the proceeds received by us at each closing and placement agent’s warrants equal to 6% of the shares sold at the closing (including the shares underlying the Warrants).  


2006 through 2011 Short-Term Promissory Notes, Related Party


On April 21, 2006, the Company entered into a Loan Agreement with Mr. Michael W. Trudnak, our Chairman and Chief Executive Officer pursuant to which Mr. Trudnak loaned the Company $200,000. The Company issued a non-negotiable promissory note, dated effective April 21, 2006, to Mr. Trudnak in the principal amount of $200,000. The note is unsecured, non-negotiable and non-interest bearing. The note is repayable on the earlier of (i) six months after the date of issuance, (ii) the date the Company receives aggregate proceeds from the sale of its securities after the date of the issuance of the Note in an amount exceeding $2,000,000, or (iii) the occurrence of an event of default. The following constitute an event of default under the note: (a) the failure to pay when due any principal or interest or other liability under the loan agreement or under the note; (b) the material violation by us of any representation, warranty, covenant or agreement contained in the loan agreement, the note or any other loan document or any other document or agreement to which the Company is a party to or by which the Company or any of our properties, assets or outstanding securities are bound; (c) any event or circumstance shall occur that, in the reasonable opinion of the lender, has had or could reasonably be expected to have a material adverse effect; (d) an assignment for the benefit of our creditors; (e) the application for the appointment of a receiver or




7


liquidator for us or our property; (f) the issuance of an attachment or the entry of a judgment against us in excess of $100,000; (g) a default with respect to any other obligation due to the lender; or (h) any voluntary or involuntary petition in bankruptcy or any petition for relief under the federal bankruptcy code or any other state or federal law for the relief of debtors by or with respect to us, provided however with respect to an involuntary petition in bankruptcy, such petition has not been dismissed within 30 days of the date of such petition.  In the event of the occurrence of an event of default, the loan agreement and note shall be in default immediately and without notice, and the unpaid principal amount of the loan shall, at the option of the lender, become immediately due and payable in full.  The Company agreed to pay the reasonable costs of collection and enforcement, including reasonable attorneys’ fees and interest from the date of default at the rate of 18% per annum. The note is not assignable by Mr. Trudnak without our prior consent. The Company may prepay the note in whole or in part upon ten days notice. On October 21, 2006, Mr. Trudnak extended the due date of the loan to December 31, 2006. Subsequently, on October 3 and October 18, 2006, Mr. Trudnak loaned the Company $102,000 and $100,000, respectively, on substantially the same terms as the April 21, 2006 loan, except that each loan is due six months after the date thereof. Accordingly, following such additional loans, the Company owed an aggregate of approximately $402,000 to Mr. Trudnak. On November 10, 2006, Mr. Trudnak extended the due dates of such loans to May 31, 2007, except that $100,000 of the April 21, 2006, loan becomes due upon the Company raising $2,500,000 in financing after November 6, 2006, and the remaining amount of $202,000 of such loans become due upon the Company raising an aggregate of $5,000,000 in financing after November 6, 2006, and prior to May 31, 2007. Following the first closing of our Debenture and Series D Warrant financing on November 8, 2006, the Company repaid $100,000 on November 20, 2006, in principal amount of the April 1, 2006 loan, and paid an additional $100,000 to Mr. Trudnak on April 17, 2007 upon the second closing of our Debenture and Series D Warrant financing. On May 31, 2007, Mr. Trudnak extended the due dates of the remaining loans to May 31, 2008. Although, the anticipated payment of $202,000 had not been made, and Mr. Trudnak made an additional $24,000 loan to the company on June 25, 2008, and $5,000 on September 14, 2011, for cumulative loans of $231,000.  The maturity date of the outstanding loans was extended to May 31, 2009, then to May 31, 2010 and June 30, 2011, and subsequently to December 31, 2011. On December 31, 2011, the outstanding loans were extended to June 30, 2012. The Company repaid an aggregate of $108,900 of the notes during 2010, and repaid an aggregate $33,100 during 2011, resulting in an outstanding balance at December 31, 2011 of $89,000. The terms of the above transaction were reviewed and approved by the Company’s audit committee and by the independent members of our Board of Directors.


2009 Convertible Promissory Notes


During the period of June through August 2009, at a series of closings, The Company issued six-month convertible promissory notes to a total of 12 accredited investors’ in the aggregate principal amount of $725,000. The six-month notes accrued interest at a rate of 10% per annum. The notes were convertible, at the holder’s option, into shares of common stock at a conversion price of $0.25 per share. If converted, each holder is entitled to receive Class M common stock purchase warrants for the right to purchase an equal number of shares and they are exercisable at a price of $0.25 per share, contain certain anti-dilution and other customary provisions, and expire sixty (60) months from the date the warrants were issued. On December 31, 2009, the Company had an aggregate principal amount outstanding of $675,000 from eleven (11) note holders.  During fiscal 2010, all note holders converted an aggregate principal amount of $675,000 and $71,999 of accrued interest into an aggregate of 2,987,995 shares of common stock, and 2,987,995 Class M Warrants. The Warrants issued are exercisable at a price of $0.25 per share; contain a conditional call provision if the market price of each share exceeds $3.00, and customary anti-dilution provisions. The warrants expire in sixty (60) months from the date of issuance.


2006 and 2007 Series A Debentures (as Amended on October 15, 2010)


On October 15, 2010, we entered into an Amendment and Waiver Agreement (“Amendment and Waiver Agreement”) with the two holders of the Company’s outstanding Series A 10% Senior Convertible Debentures due November 8, 2008 (the “Debentures”) in the aggregate principal amount of $1,688,205, which were issued in a private placement that closed in November 2006 and April 2007 to amend certain terms of the Debentures, related securities purchase agreement and other agreements pursuant to which the Debentures and Series D Common Stock Purchase Warrants of the Company were sold to certain purchasers (the “Debenture transaction documents”). The principal amount of our outstanding Series A Debentures of $1,688,205 became due on July 1, 2011, and such amount was not paid.  Therefore, the Company may be considered in default.


Under the terms of the Amendment and Waiver Agreement: (i) the Holders agreed to extend the maturity date of the Debentures to June 30, 2011; (ii) the Holders agreed that, in lieu of, and in exchange for, the payment in cash of accrued interest, late fees, liquidated damages, certain penalty interest and the payment of certain mandatory default amounts in excess of the principal amount due to the Holders as of the date of the Amendment and Waiver Agreement (“Interest and Default Amounts”), the Company would issue to the Holders an aggregate of 2,552,653 shares of the Company’s common stock; (iii) the Holders agreed that the Debentures, as amended, will not bear interest during the period from July 1, 2010 through the maturity date; (iv) the Holders agreed to waive all claims with regard to the payment of the Interest and Default Amounts, to waive prior events of default under the Debentures and breaches of any covenant, agreement, term or condition (“Defaults”) in the Debenture transaction documents and to release the Company from any claims with respect to the Interest and Default Amounts and prior Defaults; (v) he conversion price of the Debentures was set at $0.25 to reflect adjustments that had previously occurred to the conversion price pursuant to the price reset and anti-dilution provisions of the Debentures;




8


(vi) each Holder agreed to terminate the Holder’s registration rights agreement with the Company pursuant to which the Company had undertaken to register and maintain the registration for resale under the Securities Act of 1933, as amended (the “Securities Act”), of the shares underlying the Debentures and Series D Common Stock Warrants held by the Holder.  In addition, the Holders agreed to certain conforming amendments to the default provisions of the Debentures, including to: (a) provide that only a default in the payment of principal or liquidated damages when due under the particular Debenture (and not any outstanding Debenture) will trigger an event of default, and (b) delete the default provision for a failure to maintain a registration statement to cover the resale of the shares underlying the Debentures and Series D Warrants.


The Holders agreed, commencing March 3, 2011, that we may force a conversion of the Debentures in accordance with the following: (i) if the variable weighted average price for our common stock (“VWAP”) for any five consecutive trading days exceeds $0.50 and the average daily dollar trading volume for our common stock during such period equals or exceeds $50,000, we may require a Holder to convert up to 25% of the outstanding principal amount of its Debenture on September 3, 2010, plus any liquidated damages or other amounts owing under the Debenture; (ii) if the VWAP for any five consecutive trading days exceeds $0.75 and the average daily dollar trading volume for the common stock during such period equals or exceeds $75,000, we  may require a Holder to convert up to an additional 25% of the outstanding principal amount of its Debenture on September 3, 2010, plus any liquidated damages or other amounts owing under the Debenture; (iii) if the VWAP for any five consecutive trading days exceeds $1.00 and the average daily dollar trading volume for the common stock during such period equals or exceeds $100,000, we may require a Holder to convert up to 100% of the outstanding principal amount of its Debenture on September 3, 2010, plus any liquidated damages or other amounts owing under the Debenture.  A forced conversion may only be effected once every 90 days and our ability to force any such conversion is subject to certain equity conditions which, as amended by the Amendment and Waiver Agreement, include that: (i) the registration statement covering the resale of the shares underlying the Debentures and Series D Warrants is effective permitting a Holder to utilize the registration statement to resell its shares or the shares issuable upon conversion may then be resold pursuant to Rule 144 without restriction or limitation and the Company has delivered an opinion of its outside counsel that such resale may legally be made, (ii) we have honored all conversions and redemptions of a Debenture by the Holder, (iii) we have paid all liquidated damages and other amounts due to the Holder, (iv) our stock is traded on the OTC Bulletin Board or other securities exchange and all of the shares upon conversion or exercise of the Debentures and Series D Warrants are listed for trading, (v) we have sufficient authorized but unreserved shares of common stock to cover the issuance of the shares upon conversion or exercise of the Debentures and Series D Warrants, (vi) there is no event of default under the Debentures, (vii) the issuance of the shares would not violate a holder’s 4.99% or 9.99% ownership restriction cap under the Debentures, (viii) we have not made a public announcement of a pending merger, sale of all of our assets or similar transaction or a transaction in which a greater than 50% change in control may occur and the transaction has not been consummated, and (ix) the Holder is not in possession of material non-public information regarding us. The Amendment Agreement contained certain representations and warranties of the parties and certain conditions to closing. There were no conversions of our debentures during the year ended December 31, 2011.


The debentures provide that any default in the payment of principal, which default is not cured within the five trading days of the receipt of notice of such default or ten trading days after the Company becomes aware of such default, will be deemed an event of default and may result in enforcement of the debenture holders’ rights and remedies under the debentures and applicable law.  We are in discussions with the debenture holders to re-negotiate the terms of the debentures, including the repayment or repurchase of the debentures and/or seek to extend their maturity date, although we have not reached any agreement with the debenture holders with regard to any such repayment, repurchase or extension.  Our ability to repay or repurchase the debentures is contingent upon our ability to raise additional financing, of which there can be no assurance.  Also, as a condition to any such extension, debenture holders may seek to amend or modify certain other terms of the debentures.  If an event of default occurs under the debentures, the debenture holders may elect to require us to make immediate repayment of the mandatory default amount, which equals the sum of (i) the greater of either (a) 120% of the outstanding principal amount of the debentures, or (b) the outstanding principal amount unpaid divided by the conversion price on the date the mandatory default amount is either (1) demanded or otherwise due or (2) paid in full, whichever has the lower conversion price, multiplied by the variable weighted average price of the common stock on the date the mandatory default amount is either demanded or otherwise due, whichever has the higher variable weighted average price, and (ii) all other amounts, costs, expenses, and liquidated damages due under the debentures.  In anticipation of such election by the debenture holders, due to the nonpayment of principal amount on the due date of July 1, 2011, we measured the mandatory default at approximately $337,641 and subsequently on each balance sheet date, which is reflected in the carrying value of the debentures and also recognized as interest expense.  We remeasured the mandatory default amount as of December 31, 2011 at approximately $337,641. As of the date of this report, the debenture holders have not made an election requiring immediate repayment of the mandatory amount, although there can be no assurance they will not do so.  The Company currently has insufficient funds to repay the outstanding amount in the event the debenture holders make a demand for payment.


Financial Condition, Going Concern Uncertainties and Events of Default


During the year ended December 31, 2011, Applied Visual Sciences’ revenue generating activities have not produced sufficient funds for profitable operations and we have incurred operating losses since inception. In view of these matters, realization of certain of the




9


assets in the accompanying consolidated balance sheet is dependent upon continued operations, which in turn is dependent upon our ability to meet our financial requirements, raise additional financing on acceptable terms, and the success of future operations. Our independent registered public accounting firm’s report on the consolidated financial statements included herein, and in our annual report on Form 10-K for the year ended December 31, 2010, contains an explanatory paragraph wherein they expressed an opinion that there is substantial doubt about our ability to continue as a going concern. Accordingly, careful consideration of such opinions should be given in determining whether to continue or become our stockholder.


As of December 31, 2011, we have outstanding trade and accrued payables of $1,356,404, other accrued liabilities of $486,560, and accrued salaries due to our employees and management of $5,833,216. Also, the Company has an outstanding noninterest-bearing loan from its Chief Executive Officer of $89,000, and $400,000 short-tern notes from two investors.


The principal amount of our outstanding Series A Debentures of $1,688,205 became due on July 1, 2011, and such amount was not paid.  Therefore, the Company may be considered in default.  The debentures provide that any default in the payment of principal, which default is not cured within the five trading days of the receipt of notice of such default or ten trading days after the Company becomes aware of such default, will be deemed an event of default and may result in enforcement of the debenture holders’ rights and remedies under the debentures and applicable law.  We are in discussions with the debenture holders to re-negotiate the terms of the debentures, including the repayment or repurchase of the debentures and/or seek to extend their maturity date, although we have not reached any agreement with the debenture holders with regard to any such repayment, repurchase or extension.  Our ability to repay or repurchase the debentures is contingent upon our ability to raise additional financing, of which there can be no assurance.  Also, as a condition to any such extension, debenture holders may seek to amend or modify certain other terms of the debentures.  If an event of default occurs under the debentures, the debenture holders may elect to require us to make immediate repayment of the mandatory default amount, which equals the sum of (i) the greater of either (a) 120% of the outstanding principal amount of the debentures, or (b) the outstanding principal amount unpaid divided by the conversion price on the date the mandatory default amount is either (1) demanded or otherwise due or (2) paid in full, whichever has the lower conversion price, multiplied by the variable weighted average price of the common stock on the date the mandatory default amount is either demanded or otherwise due, whichever has the higher variable weighted average price, and (ii) all other amounts, costs, expenses, and liquidated damages due under the debentures.  In anticipation of such election by the debenture holders, due to the nonpayment of principal amount on the due date of July 1, 2011, we measured the mandatory default at approximately $337,641 and subsequently on each balance sheet date, which is reflected in the carrying value of the debentures and also recognized as interest expense.  We remeasured the mandatory default amount as of December 31, 2011 at approximately $337,641. As of the date of this report, the debenture holders have not made an election requiring immediate repayment of the mandatory amount, although there can be no assurance they will not do so.  The Company currently has insufficient funds to repay the outstanding amount in the event the debenture holders make a demand for payment.


During 2011, the Company sold securities for gross proceeds of $211,000 (or $208,000, net of commission and expenses of $3,000) to certain accredited investors at a series of closings, and issued an aggregate of 844,000 shares of common stock, and 888,000 Class Q Warrants.  The Class Q Warrants are exercisable at a price of $0.25 per share; contain a conditional call provision if the market price of each share exceeds $3.00, certain anti-dilution and other customary provisions.  The warrants expire three years after the date of issuance. Also, on February 23, 2011, the Company entered into a Securities Purchase Agreement (the “SPA”) with an institutional accredited investor for an investment up to $1,000,000. Subsequently on February 24, 2011, the Company sold to the institutional investor at the first closing of the private placement of securities, an aggregate of 600,000 shares of common stock, and 600,000 common stock purchase warrants to purchase an aggregate of 600,000 shares of common stock, for gross proceeds of $150,000 ($136,000 net of certain expenses and sales commissions in the amount of $14,000).  The warrants are exercisable at a price of $0.25 per share for a period of five years after the date of issuance; contain piggyback registration rights, a cashless exercise provision, and certain anti-dilution and other customary provisions.  Also, we issued to a broker an aggregate of 72,000 placement agent’s warrants as compensation in connection with the offering.  The placement agent’s warrants are under the same terms and conditions as those issued to the institutional investor.  The institutional investor agreed to purchase additional shares if pre-established stock price and volume conditions were met during the seven months following the closing, although no such closing took place as the stock price and volume conditions were not met.


 During the period of October through November 16, 2011, the Company issued twelve-month promissory notes to a total of two accredited investors’ in the aggregate principal amount of $400,000.  The twelve-month notes accrue interest at a rate of 12% per annum. The Company also issued to the note holders an aggregate of 400,000 shares of common stock.


As of December 31, 2011, we had a cash balance of $6,490.  Subsequently and through April 16, 2012, we received $25,000 from an accredited investor, and issued an aggregate of 100,000 shares of common stock and 300,000 Class Q Warrants.  We also issued promissory notes to five accredited investors in the aggregate principal amount of $135,000 ($131,400, net of accrued commissions and expenses in the amount of $3,600); the notes accrue interest at a rate of 12% per annum, and the Company issued an aggregate of 210,000 shares of common stock to the note holders.  Management believes these funds to be insufficient to fund our operations for the next twelve months absent any cash flow from operations or funds from the sale of our equity or debt securities.  Currently, we are spending or incurring (and accruing) expenses of approximately $220,000 per month on operations and the continued research and development of our




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3i technologies and products, including with regard to salaries and consulting fees.  Management believes that we will require an aggregate of approximately $2,640,000 to fund our operations for the next 12 months and to repay certain outstanding trade payables and accrued expenses.  This assumes that holders of our outstanding debentures convert such debt into shares of our common stock or that we are able to extend the term of the debentures, of which there can be no assurance.  In the event we are unable to extend the term of the debentures beyond their new maturity date, the debenture holders do not convert such debt or require payment of principal, partially convert such debt, or effect the buy-in provision related to the warrants and the debentures, we shall be required to raise additional financing.  Also, this assumes that we are able to continue to defer the amounts due to our employees for accrued and unpaid salaries and that we are able to continue to extend or defer payment of certain amounts due to our trade creditors, of which there can be no assurance.


In view of our limited revenues to date, the Company has relied and continues to rely substantially upon equity and debt financing to fund its ongoing operations, including the research and development conducted in connection with its products and conversion of accounts payable for stock. The proceeds from our financings have been and continue to be insufficient to fund our operations, pay our trade payables, repay our unconverted debentures, or accrued and unpaid wages to our employees.  Therefore, the debentures holders, our employees, or trade creditors may seek to enforce payment of amounts due to them, and our results of operations and financial condition could be materially and adversely affected and we may be unable to continue our operations.  Also, in the event we continue to be unable to pay our employees, we may suffer further employee attrition.  There can be no assurances that we will be successful in our efforts to raise any additional financing, any bank borrowing, and research or grant funding.  Moreover, in view of the current market price of our stock, we may have limited or no access to the capital markets.  Furthermore, under the terms of our agreements with the debenture holders, we are subject to restrictions on our ability to engage in any transactions in our securities in which the conversion, exercise or exchange rate or other price of such securities is below the current conversion price or is based upon the trading price of our securities after initial issuance or otherwise subject to re-set.  In view of the foregoing, we may be required to curtail operations significantly, or obtain funds through entering into arrangements with collaborative partners or others that may require us to relinquish rights to certain of our technologies or products.


During Fiscal 2011, although our total stockholders’ deficit decreased by $338,708 to $9,825,807, our consolidated net loss for the period was $1,154,376, or a $2,495,855 decrease in net loss from 2010, and the decrease is mainly due to the change in the fair value of the derivative liability that reduced the net loss by $1,958,318. Notwithstanding the foregoing discussion of management’s expectations regarding future cash flows, Applied Visual Sciences’ insolvency continues to increase the uncertainties related to its continued existence.  Both management and the Board of Directors are carefully monitoring the Company’s cash flows and financial position in consideration of these increasing uncertainties and the needs of both creditors and stockholders.


Acquisition of Certain Assets of Difference Engines


On October 23, 2003, the Company entered into an agreement with Difference Engines Corporation (Difference Engines), a Maryland corporation, pursuant to which Applied Visual Sciences agreed to purchase certain intellectual property (IP) owned by Difference Engines, including but not limited to certain compression software technology, described as Difference Engine’s Visual Internet Applications or DEVision, as well as title and interest in the use of the name and the copyright of Difference Engines.


Under the terms of an Asset Purchase Agreement, Applied Visual Sciences issued 587,000 shares of its common stock as consideration for the purchase of the IP from Difference Engines Corporation. The 587,000 shares of common stock were subject to a two (2) year lock up.  Upon expiration of the two (2) year lock up period, in the event that the shares are not eligible for resale under “Rule 144” and have not been registered under the Securities Act, the holder of the shares may demand redemption of the shares. The redemption price is to be calculated on the basis of the average of the closing bid and asked prices of Applied Visual Sciences’ common stock for the twenty (20) consecutive business days ending on the day prior to the date of the exercise of the holder’s right of redemption. Under SEC Accounting Series Release (“ASR”) 268, “Presentation in Financial Statements of ‘Preferred Redeemable Stock’,” such freestanding financial instruments are to be classified as temporary equity and measured at the value of the redemption right. The initial redemption value of the common stock issued in the Difference Engines asset purchase was calculated at $2,044,228 and classified as temporary equity. As shares of common stock are sold by the holders and/or the Company registers its outstanding shares of common stock, the then current fair value of those shares, based on the redemption value, shall be reclassified from temporary equity to permanent equity.


Since the acquisition of the intellectual property, the cumulative effect on the temporary equity account for the change in the estimated redemption value of the outstanding shares held by the shareholders of Difference Engines Corporation was reduced by $1,309,496, and further reduced by $635,786 due to the sale of the Company’s stock previously held by the shareholders of Difference Engines Corporation. On March 31, 2011, prior to remeasurement, the balance of the temporary equity account for the purchase of the intellectual property owned by Difference Engines was $98,946.  The lock up period expired and the shares are eligible for resale under Rule 144.  The Company therefore considered ASU 2009-04 “Accounting for Redeemable Equity Instruments” and on March 31, 2011, reclassified the carrying value of the redemption, or $98,946, from temporary equity to permanent equity.





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Our Business


Applied Visual Sciences is a software technology company that designs and develops imaging informatics solutions for delivery to its target markets through its two operating subsidiaries: Guardian Technologies International, Inc. for aviation/homeland security and Signature Mapping Medical Sciences, Inc., for healthcare.


The Company utilizes imaging technologies and analytics to create integrated information management technology products and services that address critical problems experienced by corporations and governmental agencies in healthcare and homeland security.  Each product and service can improve the quality and response time of decision-making, organizational productivity, and efficiency within the enterprise.  Our product suite integrates, streamlines, and distributes business and clinical information and images across the enterprise.


Our Business Strategy


Our strategic vision is to position our core technology as the de facto standard for digital image analysis, knowledge extraction, and detection.  Our strategy is based upon the following principal objectives:


·

Maintain product development and sales/marketing focus on large, underserved, and rapidly growing markets with a demonstrated need for intelligent imaging informatics.

·

Leverage Applied Visual Sciences, Inc.’s technology, experienced management team, research and development infrastructure.

·

Focus our talents on solving highly challenging information problems associated with digital imaging analysis.

·

Establish an international market presence through the development of a significant OEM/Reseller network.

·

Build and maintain a strong balance sheet to ensure the availability of capital for product development, acquisitions, and growth.

·

Seek to broaden our investment appeal to large institutions.


To achieve our strategic vision, we are aware of the need to exercise the financial and operational discipline necessary to achieve the proper blend of resources, products and strategic partnerships.  These efforts can accelerate our ability to develop, deploy and service a broad range of intelligent imaging informatics solutions directly to our target markets and indirectly through OEM/value added reseller (“VAR”) partners.  During 2011, we continued implementing changes across the spectrum of our business. We refined our marketing strategy for PinPoint™ and Signature Mapping™, and enhanced our Signature Mapping™ product offerings.   


We may engage in one or more acquisitions of businesses that are complementary, and may form wholly-owned subsidiaries to operate within defined vertical markets.


Our Core Technology


Our core technology is an “intelligent imaging informatics” (“3i™”) engine that is capable of extracting embedded knowledge from digital images, and has the capacity to analyze and detect image anomalies.  The technology is not limited by type of digital format. It can be deployed across divergent digital sources such as still images, x-ray images, video and hyper-spectral imagery.  To date, the technology has been tested in the area of threat detection for baggage scanning at airports, for bomb squad applications and the detection of tuberculosis by analyzing digital images of stained sputum slides captured through a photo microscopy system.  Varying degrees of research and development have been conducted in the areas of detection for cargo scanning, people scanning, military target acquisition in a hyper-spectral environment, satellite remote sensing ground surveys and mammography CAD products and radiologists’ diagnostic imaging tools, and while product development in these areas is ongoing, there can be no assurance that we will successfully develop product offerings in these areas.

  

We are currently focused on providing software technology solutions and services in two primary markets - aviation/homeland security with PinPoint™ and healthcare technology with Signature Mapping™ solutions.  However, as new or enhanced solutions are developed, we expect to expand into other markets such as military and defense utilizing hyper-spectral technology, and imaging diagnostics for the medical industry.


Aviation/Homeland Security Technology Solution - PinPoint™


Through our wholly-owned subsidiary, Guardian Technologies, we market our PinPoint™ product, which is an “intelligent imaging informatics” (3i™) technology for the detection of guns, explosives, and other threat items contained in baggage in the airport environment or for building security applications.  PinPoint™ can identify threat items, notify screeners of the existence of threat items, and speed the security process by eliminating unnecessary baggage checks, provide the screener with an instantaneous second opinion,




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and reduce processing time spent on false positives (baggage selected for security review that contains no threat items).  We market and seek to license the PinPoint™ product primarily to the United States Transportation Services Administration (TSA) for use in airports, the Federal Protection Services for use in federal buildings and to foreign governments and airport authorities.  We compete with manufacturers of baggage screening, luggage and large parcel screening, people screening for weapons and explosive detection, container and vehicle screening, and cargo screening equipment and certain software companies and academic institutions that are developing solutions to detect threat items.  It is also our intent to distribute the product through various distribution methods.


The market for contraband detection systems has become intensely competitive and many of our competitors are better capitalized and have greater marketing and other resources than Applied Visual Sciences, Inc.  PinPoint™ continues to be developed to address the market for contraband detection.  The extended alpha version of PinPoint™ has been tested successfully at live carry-on baggage checkpoints in three international airports.  Integration within currently deployed manufacturers’ scanning equipment is a requisite to anticipated sales, and is considered a significant development risk.  PinPoint™ is available for sale to customers; however no sales are anticipated until we are able to seamlessly integrate with the manufacturers’ scanning equipment.


To date the marketplace has placed a premium on the newest innovations in hardware technology and has failed to grasp how a threat detection software solution can succeed.  It was expected that a major joint initiative between the Department of Homeland Security (DHS) and the National Electrical Manufacturers Association (NEMA) would open a path to both increase the interoperability of security equipment as well as provide a mechanism to use third party threat detection software as part of the screening solution.  This enabling initiative is the Digital Imaging and Communications in Security (DICOS) standard, similar to the Digital Imaging and Communications in Medicine (DICOM) standard.  With a defined standard for the output of each screening device, complimentary automated threat detection software can be appended to any x-ray equipment.  Applied Visual Sciences, Inc co-chaired one of the three NEMA working groups drafting the DICOS standard, and the DICOS standard was published in October 2010.  To date DHS has not made this standard a mandatory requirement for proposals or procurements which, as a result, has not enabled third party detection software providers the ability to enter the marketplace which has given an undue advantage to the existing security equipment providers.  


As highlighted below in the NEMA article, “DICOS - Homeland Security Spending Keeps on Growing” - Published by HYPE, expenditures for security solutions are increasing.  Management believes Applied Visual Sciences, Inc. is well positioned to be a third party solution provider leveraging the standard output of all future security equipment procured by the US Government. “Global homeland security spending has received a major boost in light of recent international terrorist events, as countries look at new ways to thwart terrorists and secure borders.  Spending in the industry is expected to triple to $178 billion by 2015.  Security-related spending will include more sophisticated information technology and the protection of other vulnerable terrorist targets.  With the initial focus on airport security, NEMA has stepped up its outreach to DHS and TSA.  Currently developing DICOS, the new NEMA standard will capture scans of checked baggage so that scans can be read by threat detection software.  The new standard will facilitate interoperability of security-imaging equipment.  With DHS/TSA expected to purchase new equipment for over 400 U.S. airports, NEMA members have joined with DHS to develop the standard.  Phase II of DICOS, for the testing of the new NEMA standards, began in April 2011, and NEMA has begun looking at other modalities.  The security industry is looking at border, rail, seaport, industrial and nuclear plant security.  


We have been involved in three wide ranging U.S. Government proposals during 2011.  We have teamed on two of the proposals with large, well-known defense contractors and a federally funded research laboratory.  The teamed proposals were submitted to the Department of Defense and the U.S. Navy, while the third project was a direct submission to the Department of Homeland Security, Science and Technology Directorate.  Unfortunately, all three projects were deferred due to the ongoing federal budget discussions in Congress and operational uncertainties within the funding agencies.  At this point in time, we have no indication that any of these projects will be funded this fiscal year or the next budget cycle.  We will continue to pursue opportunities for the deployment of our PinPoint™ product as opportunities develop, however, as discussed above, we believe our ability to successfully market our PinPoint™ product is contingent upon our ability to enter into a strategic arrangement with a scanner manufacturer to install our software on scanners offered by such manufacturers, of which there can be no assurance.  With these uncertainties and our ability to manage with limited cash resources during 2011, we have focused on the marketing and sale of our healthcare products, as discussed below.


Healthcare Technology Solutions - Signature Mapping™


In an effort to expand upon the use of our core technology 3i™ “intelligent imaging informatics,” we are adopting our threat detection algorithms and quantitative imaging capabilities for use in the imaging field of diagnostic radiology and pathology.  The technology is called Signature Mapping™.  Our Signature Mapping™ platform technology represents the technological basis upon which our diagnostic radiology and pathology applications will be developed.  Any Signature Mapping™ product introduced in the United States may be subject to Food and Drug Administration (“FDA”) review and approval, including with regard to its safety and effectiveness before we may begin marketing and selling any such product in the U.S. Such approval may require us to obtain extensive data from clinical studies to demonstrate such safety or effectiveness.  Within the international markets the regulatory requirements differ, specifically in South Africa, where we have been testing our TBDx™ application for the detection of tuberculosis by analyzing digital




13


images of auramine stained sputum slides captured through a photo microscopy system.  There may be similar regulatory requirements in foreign countries in which we seek to market and sell our healthcare CAD products.  As of the date of this report, we have developed and continue to develop two TB diagnostic products, TBDx™ and TBDxV™ and our SMDS™ product, an automated hardware-software laboratory solution.


Laboratory Pathology:  SMDS™


Signature Mapping Detection System (“SMDS™”) is an automated hardware-software laboratory solution designed to operate one or multiple infectious disease applications via multi-threaded detection algorithms.  SMDS™ automation software controls every movement of the integrated hardware components from slide management to image capture.  Where SMDS™ is integrated with a specific infectious disease detection application; the solution is capable of automatically analyzing each field-of-view for the presence of specific characteristics of the targeted disease.  The detection algorithms will perform with high sensitivity without sacrificing specificity.  The end product is a flexible; user defined diagnostic patient report that can be integrated to a laboratory information system.  Standard information includes patient information, processing date, field-of-view diagnostic findings and overall case severity or diagnostic finding.


In laboratory environments that use the image capture and visualization capabilities of Signature Mapping™ without specific infectious disease algorithms or in situations where the interface of the laboratory technician with the computer-aided identification software is a desired procedure, the SMDS™ laboratory platform includes the Decision Support Quick View (“DSQV”) module.  DSQV has been designed for rapid review of captured images and increased speed in diagnostic decision-making.  DSQV includes post-processing image tools to magnify, zoom or review images in alternative formats.  Using a high-resolution touch-screen monitor and an icon-driven menu system facilitates ease of use for even the most computer challenged individuals.  Signature Mapping SMDS™ includes built-in networking support to allow DICOM images to be transmitted for remote diagnosis or to be interfaced with an enterprise network.


When SMDS™ is integrated with a disease specific automated detection algorithm, such as Signature Mapping Tuberculosis Detection (“TBDx™”), the solution expands to a fully automated diagnostic system.  For high volume diagnostic laboratories, automation begins with a slide loader capable of processing up to 200 slides without human intervention.  At system initialization the slide loader automatically inventories every patient slide to be processed.  One-by-one the slides are moved from the holding cassettes onto the automated stage of the microscope.  A barcode reader collects information about the patient just prior to the slide being placed on the stage.  Information captured by the barcode reader can be automatically transferred to a laboratory information system along with the captured digital images and diagnostic case findings.


Once the slide has been positioned on the microscope stage, the automation software initiates the process of focusing the microscope system to maximize the quality of images to be captured.  Because the specimen on the slide may be topographical and/or the z-axis of the slide may require compensation, the automation software calculates the required adjustments to ensure high quality digital images are captured.  Further, the automation software is easily configured to capture fields-of-view in any quantity using a user established pattern of image capture.  The automation software can focus the microscope stage in approximately one minute and requires an additional minute per each one hundred high quality digital images to be captured.


TBDx™ and TBDxV™


The Company has developed two TB diagnostic products.


·

Signature Mapping Tuberculosis Detection (“TBDx™”) features automatic tuberculosis (“TB”) detection capabilities by analyzing digital images of Auramine-O stained sputum slides captured through a photo microscopy system.  We completed Phase II clinical trials in South Africa during 2011, which was a nested sub-study to the international Thibela TB Study trial at the Aurum Institute for Health Research.

·

Signature Mapping TBDx™ Visualization (“TBDxV™”), the precursor to TBDx™, is a fully automated tuberculosis visualization technology that has a 200-slide capacity auto-loader that delivers individual slides to a microscope and collects 100 fields of view from each stained tuberculosis sputum slide.  Fields of view will be presented to the microscopist on a workstation monitor thereby alleviating the tedious and error prone diagnosis using a microscope, and will assist microscopists in decision making on the most difficult cases through the visualization tools and digital imagery to improve diagnostic accuracy. The visualization tools are applicable to both Auramine-O and Ziehl-Neelsen staining processes.  


Both TBDx™ and TBDxV™ address the approximately 52 million diagnostic slides analyzed by clinical lab technicians each year, and are targeted to government and private institutions that screen tuberculosis patients.  India processes more TB diagnostic cases than anywhere in the world and the workload has overwhelmed the country's laboratory resources.  The Company is working closely with the Indian government and private organizations regarding our TBDx™ diagnostic system for




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the migration to the Ziehl-Neelsen staining process, with a belief that we can further enhance their TB diagnostics productivity after clinical trials are complete and other government clearances are received.


Radiology:  BCDx™


The Company is adding vision to breast cancer diagnosis by developing a radiological suite of products by developing a breast cancer detection solution to be known as Signature Mapping™ Breast Cancer Detection (“BCDx™”). Within the U.S. the annual estimates of breast cancer diagnostic activity are: 35 million mammograms performed; 1.5 million biopsies performed; 87% of biopsies return a negative finding (mammogram ‘false positive’); 200,000 confirmed cancer cases; and immeasurable emotional, mental, and physical pain for the individuals and families of biopsy patients.  The 1.3 million biopsies undertaken that resulted in negative findings can be directly attributed to an inability to resolve areas of concern due to the limited information provided in the mammography images.  In addition, approximately 10% of cancerous lesions are missed – partly due to dense tissue obscuring the cancer or the appearance of cancer having common characteristics with the appearance of normal tissue. The goal of BCDx™ is to deliver sophisticated image analysis processes that provide enhanced visualization capabilities and automated detection algorithms to help prevent unnecessary biopsies, while flagging previously unseen lesions for additional review.  


Similar to a person’s fingerprint, each tissue has a unique structure.  Each structure creates a unique pattern or “signature” that can be extracted from an image to differentiate, locate, identify, and classify by using our Signature Mapping™ technology, management expects BCDx to further help radiologists by visualizing the various structures within a particular tissue so they can be examined and quantified.  This capability is expected to provide a next-generation image analysis, clarification, visualization and Signature Mapped™ “tissue characterization” and detection.  Management believes that it will add significant clinical value to a wide range of difficult to detect diseases in diagnostic radiology by distinguishing and characterizing different tissue types in images regardless of the modality that generated the image.


Based on its unique properties, Signature Mapping™ is expected to be capable of being used to analyze images generated across all imaging modalities without the need for new image capture hardware costs.  It will serve as a software-based, multi-modality approach to image analysis when combined with Signature Mapping’s™ unique” tissue characterization” and detection. As a result, Signature Mapping™ is expected to differentiate the contrast resolution between different tissue types, even when the material or tissue in the image is very diffuse or obscured by other objects, such as is the case where diseased lung tissue is located behind a rib in an x-ray chest examination. It is capable of displaying these ‘signatures’ in a way that empowers radiologists to make a more informed and confident diagnosis, even for hard to distinguish structures such as masses in dense breast tissue.


Signature Mapping™ appears to provide advantages for providing the knowledge for automatic detection.  The development of a “tissue characterization” and detection model employs the use of supervised machine learning and contextual image analysis to analyze and classify the features associated with the newly created “signatures.”  The fusion of these three technologies is known as Applied Visual Sciences, Inc.’s Intelligent Imaging Informatics 3i™. Unlike other pattern recognition methodologies, the 3i™ solution can reveal and differentiate inherent structures for all materials in an image regardless of:  the imaging modality used to create the image, location within the image, shape or texture, and object orientation even if obscured by its relationship to other materials.


Clinical Experience and Medical Accomplishments


While Signature Mapping™ is expected to be capable of use in a wide range of medical image analysis applications, our initial application product development efforts are focused in four areas:


·

detection of tuberculosis by analyzing digital images of stained sputum slides captured through a photo microscopy system;

·

breast cancer detection using x-ray mammography, MRI and ultrasound;

·

neurological imaging analysis through the detection and quantification of acute intracranial hemorrhage using non-contrast CT, normal pressure hydrocephalus,

·

multiple sclerosis using MRI; and

·

chest radiography targeted at tuberculosis and silicosis detection using digital x-ray.


Laboratory Pathology:  TBDx™


First clinical evaluation of Signature Mapping™ Tuberculosis Detection (“TBDx™”) product, an automated tuberculosis detection sputum smear microscopy system, in cooperation with the South African National Health Laboratory Services (“NHLS”) and the Aurum Institute for Health Research.  The principal investigators included, James J. Lewis, Violet N. Chihota, Minty van der Meulen, Bernard Fourie, Gerrit Coetzee, Katherine L. Fielding, Alison D. Grant, Susan E. Dorman, and Gavin J. Churchyard.





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Background: Smear microscopy remains the most common method of diagnosing tuberculosis in many high-burden countries.  This is despite numerous limitations, including a lack of well-trained microscopists and reduced performance resulting from the substantial work load and poor ergonomics of the process.  An automated microscopy system TBDx™ has been developed that presents an innovative, multi-potential technology platform for automatically detecting TB from sputum slides.  The system loads slides onto a conventional microscope, automatically focuses and digitally captures images, and then uses Signature Mapping™, a set of specially developed image-analysis algorithms, to classify slides as TB positive or negative.


Objectives: To compare the diagnostic performance of TBDx™ in identifying tuberculosis from sputum smear microscopy slides stained with Auramine, using culture as the gold standard, to a human microscopist and to evaluate the effect of TBDx™ on the microscopist’s workload.


Methods: This study is nested within a cross-sectional study of South African gold miners with suspected pulmonary TB.  All TB suspects had one sputum sample collected for smear microscopy, MGIT culture and MPB64 organism identification.  All slides were read by a research and two routine microscopists, and then independently by TBDx™, each classifying slides based on the World Health Organization (“WHO”) classification standard of 100 fields of view (“FoV”) at 400x magnification.  For slides adjudged scanty by TBDx™, the digital FoV with suspected acid-fast bacilli (“AFB”) were reviewed by the research microscopist, using TBDx™ in decision support system mode (TBDx™-DSS), a mode presenting digital images of slides assisted by image enhancement tools.  The diagnostic performance of three algorithms was evaluated: TBDx™ alone; TBDx™ with review of scanty positive FoV images by the microscopist (TBDx™-DSS mode); TBDx™ with research microscopist’s readings substituted for slides judged by TBDx™ to be scanty positive.


Results: Of 981 participants, 269 were culture positive for Mycobacterium tuberculosis (27.4%) and 712 were culture negative (72.6%). TBDx™ alone had higher sensitivity (75.8%) than the research microscopist, but greatly reduced specificity (Table 1). TBDx™ classified 520/981 slides (53.0%) as scanty, with the majority of these slides having only 1-2 AFBs detected (371/520=71.3%). Of these, only 68/371 (18.3%) were culture positive, which was similar to TBDx™ negative slides (17.3%). Changing the algorithm to classify 0-2 AFBs on TBDx™ as negative gave improved specificity.  Combining this algorithm with an image review of positive FoV on TBDx™-DSS, scanty positive (3-9 AFBs) slides gave similar performance to that of the routine microscopists and reduced the number of FoV to be read by a microscopist by 99.7%.  Finally, an algorithm in which slides with 3-9 AFB on TBDx™ were replaced with the original research microscopist’s read gave sensitivity of 42.0%, specificity of 99.2% and resulted in an 84.8% reduction in the number of slides to be read by the research microscopist.  The negative predictive value (“NPV”) for all methods was similar.


Conclusion: The automated microscopy TBDx™ system has comparable performance to routine microscopy in this study and could greatly reduce the work load of microscopists in many high-burden settings as a Decision Support System (“DSS”). Further optimization of the TBDx™ system and training of microscopists in digital microscopy is required and is ongoing.  Opportunities for further research include the tuning of the present algorithms for LED-based light sources and the development of algorithms for Ziehl-Nielsen stained slides.


Table 1: performance characteristics of human microscopist versus the TBDx™ automated microscopy system, using culture as the gold standard.



Diagnostic method


Sensitivity


Specificity


PPV


NPV

FoV requiring human review

Protocol specified (0 AFB = negative; 1-9 AFB = scanty)

Research microscopist

52.8%

98.6%

93.4%

84.7%

98,100

Consensus of two routine microscopists

48.3%

95.8%

81.3%

83.1%

196,200

TBDx alone

75.8%

43.5%

33.7%

82.7%

0

Algorithm optimization (0-1 AFB = negative; 2-9 AFB = scanty)

TBDx alone

59.5%

71.8%

44.3%

82.4%

0

TBDx with research microscopist reviewing TBDx™ scanty positive FoV images (TBDx™-DSS)

56.1%

83.7%

56.6%

83.5%

847

TBDx with research microscopist’s readings for slides judged by TBDx™ to be scanty positive

45.0%

99.2%

95.3%

82.7%

27,500

Algorithm optimization (0-2 AFB = negative; 3-9 AFB = scanty)

TBDxalone

50.6%

86.1%

57.9%

82.2%

0

TBDx with research microscopist reviewing TBDx scanty positive FoV images (TBDx™-DSS)

48.0%

91.4%

67.9%

82.3%

597

TBDx with research microscopist’s readings for slides judged by TBDx™ to be scanty positive

42.0%

99.2%

95.0%

81.9%

14,900

AFB = acid-fast bacilli; PPV = positive predictive value; NPV = negative predictive value; FoV = fields of view.

Sensitivity = measures the proportion of actual positive which are correctly identified as having that condition,

Specificity = measures the proportion of negatives which are correctly identified




16



Breast Cancer Detection:  BCDx™


Our research to-date includes five programs and studies conducted under the direction of the Image Processing and Informatics Laboratory at the University of Southern California (“USC”) using clinical data and images provided by: the Image Processing and Informatics Laboratory at USC, Howard University, and the South Florida Clinical Mammography Data Base.  Competition is expected with existing computer-aided-detection (“CAD”) manufactures such as iCAD, Hologic, Medipatten, Confirma, Siemens, or Carestream Health.  We may partner with one or more of these existing CAD manufacturers, or with an emerging company with new technology for the CAD arena.  Once our products are commercially viable, we anticipate marketing and selling our products through original equipment manufacturers (“OEM”), or system integrators.


The Disease


Breast cancer is the most commonly diagnosed cancer and the second leading cause of cancer deaths among women in the US.  Although the overall morbidity rate of breast cancer is lower among African American Women (AAW) than Caucasian Women, the morbidity rate among AAW younger than 50 years old is higher than Caucasian Women and has resulted in substantially higher mortality rates (31/100,000 vs. 27/100,000). The table below shows annual demographics for breast cancer statistics in the U.S.

 

Breast imaging procedures

About 35 million screening exams

Biopsy procedures

About 1.5 million biopsies conducted

12% of biopsies are positive

168,000 detected cancers

Mortality rate

About 40,950 women

Biopsy per procedure cost

$1,000 - $3,000 dollars

Annual gross national biopsy cost

$1.5 -  $4.5 billion dollars

A 10% reduction in biopsies would save approximately

$150 - $500 million dollars

Source: Breast Cancer Fund, “The Demographics of Breast Cancer in the U.S. 2003.”

Detection


Early detection is a critical factor for controlling survival. Early detection provides increased therapeutic options and improved probability of survival. Mammography is a reliable and cost-effective screening technology. When properly conducted, mammography has been estimated to reduce breast cancer mortality by 20-30%.  Currently, ductal carcinoma-in-situ (DCIS) represents 25%-30% of all reported breast cancers.  Approximately 95% of all DCIS are diagnosed because radiologists identify them in mammograms. However, reading mammograms is difficult and prone to misinterpretation, subjectivity, and misreads.  Studies have found that screening x-ray exams are about 80% accurate at best and that lesions are simply not detected 10% to 15% of the time. The National Cancer Institute reported that 25% of breast tumors are missed in women in their forties. (See Liu B, Z. M., Document J (2005, "Utilizing data grid architecture for the backup and recovery of clinical image data." Comput Med Imaging Graph. 29(2-3): 95-102, and National Cancer Institute, "Cancer in African American Women.")


Dense breasts pose a greater challenge to cancer detection using mammograms, especially early-stage breast cancers. Approximately 25% of women have dense breasts; thus a large number of mammograms, especially in AAW, are more difficult to clinically interpret. The risk of breast cancer associated with the highest category of density is estimated to be two to six times greater than for women with the lowest category of breast density.


Clinical Value of Signature Mapping


On the basis of our initial studies, the signatures of malignant tumors in mammograms exhibit significant differences when compared with cysts, benign lesions, or dense breast tissue after being processed with Signature Mapping™.  Measurable differences exist among different breast structures in both the spatial and frequency domains.  Signatures of different tissues vary in their entropy, linearity, boundary gradients, and homogeneity. As a result, the internal structure of masses in dense breast tissue can be characterized and identified and displayed radiographically to the clinician. Signature Mapping™ is expected to visually display levels within the tumor and distortions in the breast geometry outside the tumor.


The effectiveness of these algorithms was evaluated through a pilot study conducted with the Norris Cancer Center at the University of Southern California. The study consisted of two sets of mammographic cases, a training set and a testing set.  Both sets contained 40 normal and 40 confirmed solid cancer masses and were matched for levels of interpretation difficulty and patient age,




17


variations in breast density, and types of tumors. Applied Visual used the training set for the development of its algorithms and for training the participating radiologists in the study.  The test set was used in the pilot study to gain clinical feedback and determine the effectiveness of the radiologist’s interpretations using Signature Mapping™. Preliminary clinical results based on the visual performance of five highly-skilled and experienced mammographers using the mammography-specific Signature Mapping™ process demonstrated improved accuracy and ease of use in the study.


Clustered micro-calcifications may be the only visually detectable manifestation of early breast cancer. Mammography is very responsive to the presence of micro-calcifications, however, the specificity of mammography remains low.  Benign calcifications cannot always be distinguished from those indicating malignancy resulting in a large population of women who do not have cancer, but are subjected to biopsy.  Using Signature Mapping™ we expect that the miniscule structures within micro-calcifications can be characterized and their potential for pathology identified by the radiologists.


While carcinomas are rarely found in cysts, they are difficult to accurately diagnose through the use of mammography because they cannot be distinguished from other well circumscribed solid masses unless they display several characteristic patterns of calcification. Applied Visual is optimizing Signature Mapping™ for the accurate characterization of cysts as part of ongoing development that includes an early-onset cancer detection model.


Recent Developments - Signature Mapping™


December 2011 - executives from Signature Mapping Medical Sciences traveled to India as part of an overall strategy to establish TBDxV™ in India.  The strategic objectives for the trip included: (1) demonstrating the TBDx™ fully automated hardware-software technology platform to as many TB stakeholders as possible; (2) meeting with key ministers in healthcare and technology; (3) exploring and establishing strategic business relationships with private Indian companies to accomplish important goals and needs including: (a) marketing and sales support; (b) installation, training and maintenance support; (c) joint project proposal efforts aimed at securing R&D project funding; and (d) seeking joint venture arrangements with an Indian company to deliver TB diagnostics via mobile vans; (4) meet with key government healthcare officials to develop governmental funding for R&D projects; and (5) meet with the Wellcome Trust Director of Operations in India to discuss our grant proposal, timing, and expectations. Management believes that it accomplished each of the aforementioned objectives.  Our goal was to develop interest in the technology and demonstrate that automated image capture of stained TB slides could be accomplished despite inherent image acquisition challenges, the vast variations in slide staining quality, and without using oil immersion.  From our efforts we have been invited to participate in several large clinical trials.  In addition, certain organizations have expressed an interest in submitting joint R&D grant proposals to various funding agencies.  We have also commenced the negotiations with certain private organizations to provide sales, marketing, support and joint venture business opportunities.


On October 25, 2011, the United States Patent & Trademark Office (“USPTO”) issued to the Company a sixth patent, Patent No. US 8,045,805, titled “Method for Determining Whether a Feature of Interest Anomaly is Present in an Image,” which is related to our underlying “intelligent imaging informatics” (3i™) technology for our healthcare products.


On October 17, 2011, the Company, through its Signature Mapping Medical Sciences, Inc. subsidiary, received its first sales order for three automated tuberculosis diagnostic systems (“TBDx™”) from Aurum Institute for Health Research in South Africa.  The total value of the order is $210,000.  The TBDx™ systems will be deployed in mobile laboratory environments as part of a project aimed at bringing diagnosis and treatment closer to the point-of-care.  The TBDx™ systems are being procured through funding by the U.S. President’s Emergency Plan for AIDS Relief (“PEPFAR”), and shipment is pending PEPFAR’s acceptance of the Company being the sole source provider for the TBDx™ systems.


August 2011 - The clinical research trials for TBDx™ were completed in South Africa.  They formally remained open until all of the analyses had been completed by the Principal Investigator.  The Principal Investigator and members of the Scientific Advisory Board have completed and submitted an abstract describing the performance results of the TBDx™ research trials.  Additionally the Principal Investigator drafted the paper that was submitted to the Public Library of Science (http://www.plos.org/) describing the clinical trial and the technology performance results. The protocol established for this clinical research requires all performance results to be embargoed until they can be publicly presented to the scientific community.  However, the results of TBDx™ are promising and are expected to have a substantial impact on the workload and screening for TB in the South Africa.


On June 3, 2011, the Company completed the clinical evaluation (processing and analysis of 981 tuberculosis sputum cases) of our fully automated Signature Mapping Tuberculosis Detection (“TBDx™”) product that was developed in cooperation with the Aurum Institute for Health Research and the South African National Health Laboratory Services (“NHLS”).


On April 25, 2011, the Company through its healthcare subsidiary, Signature Mapping Medical Sciences, began product sales and marketing initiatives for Signature Mapping TBDx™ Visualization (“TBDxV™”) through agents in India.  TBDxV™, the precursor




18


to TBDx™, a fully automated tuberculosis visualization technology that has a 200-slide capacity auto-loader that delivers individual slides to a microscope and collects 100 fields of view from each stained tuberculosis sputum slide.  Fields of view will be presented to the microscopist on a workstation monitor thereby alleviating the tedious and error prone diagnosis using a microscope, and will assist microscopists in decision making on the most difficult cases through the visualization tools and digital imagery to improve diagnostic accuracy.  The visualization tools are applicable to both Auramine-O and Ziehl-Neelsen staining. Though our agents, discussions with various healthcare institutions and engaging the Company, it has become apparent that the Indian healthcare regulatory body requires in-country clinical evaluation certification regardless of other country clinical evaluations. The Company and its agents are in discussions with various institutions to meet this requirement.


On March 15, 2011, the United States Patent & Trademark Office (“USPTO”) issued to the Company a fifth patent, Patent No. US 7,907,762, titled “Method of Creating a Divergence Transform for Identifying a Feature of Interest in Hyperspectral Data,” which is related to our underlying “intelligent imaging informatics” (3i™) technology for our healthcare product.


Markets and Competition


Aviation/Homeland Security Technology Solution - PinPoint™


Market


Initially, management has focused its principal development and marketing efforts for its PinPoint™ product on the market for airport baggage screening technology solutions. However, as discussed further below, and although there can be no assurance, management believes that its PinPoint™ solution is also capable of being adapted for use in the people portal and cargo screening markets.  The following discussion focuses on the market for baggage screening solutions; however, we have also provided an overview of the potential market for people portal and cargo screening technology solutions, potential future markets for our PinPoint™ product.


Baggage Screening Market


Security oversight of airports in the United States is overseen by the Transportation Safety Administration (“TSA”) with an annual operating budget in excess of $5 billion.  TSA has the responsibility for over 480 U.S. airports with a combined inventory of baggage scanning equipment (checked baggage area and the carry-on baggage area) in excess of 6,000 scanners.  While exact statistics on the number of scanners deployed in the rest of the world are not readily available, management estimates that the market is four times greater than the U.S.  In addition to baggage scanners, airports worldwide are faced with replacing or supplementing existing metal detectors for passenger processing.


Currently, there are limited standards within the aviation security marketplace for the testing and validation of software technology solutions.  To date the marketplace has placed a premium on the newest innovations in hardware technology and has failed to grasp how a threat detection software solution can succeed.


To date the marketplace has placed a premium on the newest innovations in hardware technology and has failed to grasp how a threat detection software solution can succeed.  It was expected that a major joint initiative between the Department of Homeland Security (DHS) and the National Electrical Manufacturers Association (NEMA) would open a path to both increase the interoperability of security equipment as well as provide a mechanism to use third party threat detection software as part of the screening solution.  This enabling initiative is the Digital Imaging and Communications in Security (DICOS) standard, similar to the Digital Imaging and Communications in Medicine (DICOM) standard.  With a defined standard for the output of each screening device, complimentary automated threat detection software can be appended to any x-ray equipment.  Applied Visual Sciences, Inc co-chaired one of the three NEMA working groups drafting the DICOS standard, and the DICOS standard was published in October 2010.  To date DHS has not made this standard a mandatory requirement for proposals or procurements which, as a result, has not enabled third party detection software providers the ability to enter the marketplace which has given an undue advantage to the existing security equipment providers.  


As highlighted below, in a recent NEMA article, “DICOS - Homeland Security Spending Keeps on Growing” - Published by, U.S. government expenditure for security solutions is expected to increase.  Management believes that Applied Visual Sciences, Inc. is positioned to be a third-party solution provider leveraging the standard output of all future security equipment procured by the US Government.  NEMA stated “Global homeland security spending has received a major boost in light of recent international terrorist events, as countries look at new ways to thwart terrorists and secure borders. Spending in the industry is expected to triple to $178 billion by 2015.  Security-related spending will include more sophisticated information technology and the protection of other vulnerable terrorist targets.  With the initial focus on airport security, NEMA has stepped up its outreach to DHS and TSA. Currently developing DICOS, the new NEMA standard will capture scans of checked baggage so that scans can be read by threat detection software. The new standard is expected to facilitate interoperability of security-imaging equipment. With DHS/TSA expected to purchase new equipment for over 400




19


U.S. airports, NEMA members have joined with DHS to develop the standard.  With Phase 1 of DICOS expected to be completed this year, NEMA has begun looking at other modalities. The security industry is looking at border, rail, seaport, industrial and nuclear plant security.”

 

Management believes that international market acceptance of PinPoint™ as a viable threat detection solution will not only enhance our ability to sell worldwide, but it will open additional opportunities for the development of PinPoint™ as the “intelligent image” analysis solution for areas such as military target acquisition, satellite remote sensing, and additional opportunities within aviation security such as people portals and cargo scanning.  Additionally, we will seek support of the U.S. Congress and the equipment manufacturers through lobbying and other efforts.  We continue the ongoing development of PinPoint™.  This focus must be even sharper when we enter the pilot test arena where the duration of the pilot test, the conditions under which the pilot test is conducted, and the definition of success and failure will vary country-by-country.

 

Information regarding the amount of the TSA’s annual budget allocated for the purchase of software solutions that are able to detect threat items at U.S. airports and other similar facilities, such as PinPoint™, is not readily discernible from publicly available information or independent research reports. However, management estimates, based upon information derived from the FY 2006 and requested FY 2007 United States Department of Homeland Security (DHS) budget, that the DHS budget allocation for FY 2006 for software solutions that are able to detect threat items at U.S. airports and other facilities, such as PinPoint™, was approximately .77% of the DHS’ $41.1B budget, and that the budget allocation for the proposed FY 2007 DHS budget will be approximately 2.25%.  In addition, management estimates that the worldwide market for solutions such as PinPoint™ is estimated to be approximately twice the United States’ Homeland Security budget.  These estimates have been prepared by Applied Visual’s management and reflect certain assumptions of such management.  There can be no assurance that these estimates are or will prove to be accurate or that budget allocations or these estimates may not change, based upon changes in government’s budget priorities and other factors.


In addition to the baggage screening market, management expects to target the following additional markets for PinPoint™.  Further evaluation and market studies are required in order for a business plan to be developed and the assessment of development efforts necessary before entering the “People Portal” (whole body imagers) and “Cargo Scanning” markets.


Whole Body Imagers


Almost every threat that requires people screening is currently monitored by a different system (explosives, weapons, biological, chemical, and nuclear/radiological).  Management believes that today's people screening systems deliver unacceptable performance (high ‘false alarm’ rates, slow processing throughput, continued dependence on human detection, and high transaction costs).  Over a period of 10 years (2001-2010) the total U.S. annual people screening outlay is expected to grow to over 15 times its current size.  Sales of $590 million in 2001 are forecasted to grow to $3.5 billion in 2006 and to $9.9 billion in 2010. The compound annual growth rate was expected to be over 50% for the 2003-2010 periods. Management believes that the market for people portals that utilize imaging as its detection methodology is a sub-set, and is estimated at 50% of the entire forecasted market of which management believes PinPoint™ can address.  See HSRC report, “2003-2010 People Screening Weapon & Explosives Detection Market Report.”  


It is management’s belief that the current people portal technology fails to meet the post-9/11 requirements. It is management’s belief that the technology will undergo dramatic technological changes when the multiple-threats "checkpoint of the future" is introduced.  The accumulated U.S. investment in people screening during the 2003-2010 period is expected to be over $50 billion.  During the 2006-2011 periods, over 80% of sales of people portal systems in the US are expected to be for technologies that were not in existence in 2003.  


Competition


The competition between the manufacturers of baggage (hand-held and small parcel) screening, luggage and large parcel screening, people screening for weapons and explosives detection, container and vehicle screening, and cargo screening is intense.  These same equipment manufacturers represent Applied Visual Sciences, Inc.’s major competition, and include: AS&E, Smiths-Detection, OSI Rapiscan and L3, each of which is better capitalized and has greater marketing and other resources than Applied Visual Sciences, Inc. The competition between manufacturers is intense in view of amounts appropriated by the U.S. Government for threat detection technologies. What is not so obvious is that the manufacturers that once held the largest share of installed base are at risk due to aging and inadequate technology.  Due to the agnostic nature of PinPoint™, we believe we can integrate PinPoint™ with any manufacturer’s scanning equipment.  We believe our technology improves the efficiency of the underperforming hardware and extends the obsolescence of the existing scanning equipment.  Funds previously appropriated for the upgrade or replacement of the in-place scanners could then be redeployed for the acquisition of required technologies such as body scanners or cargo scanners.


The equipment manufacturers in conjunction with software companies and academic institutions are attempting to develop sophisticated solutions to aid in the detection of contraband substances.  To date there has been no known solution developed.  We believe




20


that Applied Visual Sciences, Inc.’s approach is unique in that it is a non-intrusive adjunct to the current manufacturers’ products.  The enhancement identifies contraband at an accuracy level that is higher than the methodology used today by TSA.


The market for contraband detection systems software is anticipated to become intensely competitive and is characterized by continuously developing technology and frequent introductions of new products and features. We expect competition to increase as other companies introduce additional and more competitive products in the aviation security market and as we develop additional capabilities and enhancements for PinPoint™ and new applications for our technology. Historically, the principal competitors in the market for explosive detection systems have been GE-InVision, Vivid Technologies, Inc., EG&G Astrophysics, Smiths-Detection, Thermedics Detection Inc., and Barringer Technologies Inc. Each of these competitors provides aviation security solutions and products for use in the inspection of checked and carry-on luggage.  We expect certain major corporations competing in other markets to enter the aviation security market.


Applied Visual Sciences, Inc. believes that its ability to compete in the aviation security market is based upon such factors as: product performance, functionality, quality and features; quality of customer support services, documentation and training; and the capability of the technology to appeal to broader applications beyond the inspection of checked and carry-on baggage. Although we believe that PinPoint™ is superior to our competitors’ products in its detection capability and accuracy, PinPoint™ must also compete on the basis of price, throughput, and the ease of integration into existing baggage handling systems. Certain of our competitors may have an advantage over our existing technology with respect to these factors.


Healthcare Technology Solutions - Signature Mapping™


Market


CAD vendors today have developed and sold clinical products in three major applications segments; mammography as a second look for the screening and early detection of breast cancer; chest CT for the early detection of nodules and CT of the colon for the non-endoscope screening of polyps.


In 2006, an analyst at Frost & Sullivan stated "Early introduction of integrated CAD solutions is critical for gaining market share and may lead to higher profits…These new systems will enable workflow improvements while providing a smooth migration to the digital solution. This will increase the viability and broaden the appeal of these systems, and is likely to result in increased sales and revenues."  These are new markets with new applications. The market is shifting towards CAD as physicians’ confidence levels continue to grow. For example, the radiologist who uses CAD for Mammography (one of the most prevalent today) would most likely be very willing to trying new clinical applications.  This is true for general radiologists and specialty radiologists.  Frost and Sullivan studies published in 2006 estimated world wide radiology imaging procedures for all modalities at slightly a billion procedures per year and estimated that approximately 300 million to 350 million procedures were attributed to the USA.


Frost & Sullivan projected CAD sales to reach $600 million by 2009 with a Compound Annual Growth Rate (“CAGR”) of +18% by 2010. With replacement expected in full force in the two segments with the most demand by that point, namely, the breast MRI CAD segment and the mammography CAD segment, overall replacement in the total CAD market is expected to reach almost 50 percent of demand by 2012. With each new CAD technology introduced to the market, the potential size of this new market grows exponentially “Given the myriad of body parts and systems that CAD technology could be applied to in the future, as well as the different imaging modalities associated with each, growth in this market could be virtually unstoppable.” Such as, new technology introduced for CT would be applicable to the brain, chest, neck, abdominal and other areas of the body; and new technology for Ultrasound would be applicable for the breast, liver, prostate and abdominal.


Shalom S. Buchbinder, M.D., FACR, Chairman, Department of Radiology, Staten Island University Hospital, and Clinical Associate Professor of Radiology, Obstetrics, Gynecology and Women’s Health, Albert-Einstein College of Medicine of Yeshiva University, New York, U.S.A. (Changing the Way Healthcare is Delivered, RSNA 2004, p89) states “This relatively new technology improves the decision making compatibilities of clinicians…In my opinion mammography CAD has proven its clinical value and the future is about more robust and sophisticated tools that can, in addition to detection, help in the analysis of lesions. Innovative technologies can provide valuable information to support lesion classification.”


Financial support to fight TB comes from multiple sources world leaders, public health officials and international donors have taken action against TB and financial resources for control and research have increased dramatically in recent years.  Public-private partnerships like the Foundation for Innovative New Diagnostics (“FIND”) have emerged to bring together key players in these sectors to move research and development forward for the needs of patients.  Primarily, the government of each country is financially responsible for fighting TB with outside support of international organizations.


Market Conditions




21



Management’s review of current market conditions has identified the following trends:


·

TB is becoming a worldwide epidemic

·

Automatic differentiation of TB bacilli is a very challenging issue

·

Currently no such CAD product exists

·

Steady adoption of digital microscopy

·

Need for higher throughput and continued cost reduction without sacrificing quality

·

CAD is evolving as a clinical tool and physicians are adopting it

·

Current graphics cards and computational processing power are sufficient

·

Retiring workforce and  the current  prediction that there will be a shortage of pathologists

·

Economic pressures and increasing clinical demands

·

Facilitates productivity gains with inclusion of CAD

·

Pathologist can performs diagnosis on digital images and monitor

·

PMA FDA approvals of digital pathology tests is increasing

·

Facilitates improved workflow efficiency and enhances patient management practices

·

Pathology lab is poised for digital revolution

·

Pressures on the anatomical pathology sciences will drive change

·

STOP TB has stated they want “effective, efficient and validated clinical algorithms”


Potential Market For New TB Diagnostics


The persistent TB epidemic and expanding global population ensure that the total market for a range of TB diagnostic products is likely to increase yearly over the next decade by approximately 16%.  The current international policy on TB case detection recommends the examination of three sputum smears for the diagnosis of pulmonary tuberculosis (PTB). The present definition of a smear-positive case states "Tuberculosis in a patient with at least two initial sputum smear examinations (direct smear microscopy) positive for acid fast bacilli (AFB+)".


Worldwide, WHO estimates that the largest potential available market for a new TB diagnostic would be for a test that both detects latent infection and predicts progression to active disease (767 million patient evaluations/year). Such a test, if widely implemented and accompanied by successful treatment, has the potential to revolutionize TB control.  The infrastructure to achieve this globally is not available at this moment.  (See “Global Tuberculosis Control- surveillance, planning and financing,” WHO Reports: 2005 through 2008.)


The next largest total available market is for a point-of-care screening test, which is estimated to be 193 million patient’s evaluations/year, of which approximately 70%, or 137 million patient’s evaluations/year is concentrated in the 22 high-burden countries.  Substantial markets also exist for less revolutionary replacement technologies.  Specifically, the total available markets for smear, culture, and monitoring and DST replacement tests are 83 million, 57 million, 40 million, and 6 million patient evaluations, respectively in 2005.  We estimate that replacement technologies could capture a greater proportion of the market by 2020: smear 59% (49 million), culture 35% (20 million), monitoring 58% (23 million) and DST 45% (3 million).  Without exception, between 70%–90% of the potential available markets for these replacement technologies are in the 22 high-burden countries.  The continued emphasis on improving market conditions will encourage market growth in the high-burden countries and increase the accessibility to new products.  (See “Global Tuberculosis Control - surveillance, planning and financing,” WHO Report 2008.)


Competition


We expect to compete with existing CAD manufactures such as iCAD, Hologic, Medipatten, Confirma, Siemens, or Carestream Health and manufacturers of dipstick or biomarker manufacturers, including SPAN Diagnostics Ltd., India,  Yayasan Hati Sehat (YHS), Indonesia and Wiener Laboratorios, Argentina.  We may also partner with one or more of these existing CAD manufacturers, or an emerging company with new technology for the CAD arena.  Once our products are commercially viable, we anticipate marketing and selling our products through original equipment manufacturers (“OEM”), or system integrators.


While we are unaware of any computer-aided-detection for TB sputum microscopy analysis that can be identified that competes with our Signature Mapping™ products, there are substitute technologies that compete with sputum specimen analysis, such as the Cepheid Systems GeneXpert® System, a dip-stick or biomarker approach.  Management believes that competition will be driven by cost per procedure, ease-of-use, sensitivity and specificity, and the ability to be used by non-trained or lightly trained personnel in the point of care environment.  These emerging tests include: Polymerase Chain Reaction, TB Breathalyzer, Q-Beta Replicase Assay, Transcription-




22


Medicated Amplification, Ligase Chain Reaction, Strand Displacement Amplification, Nucleic Acid Sequence-Based Amplification and Branched DNA.

 

Sales, Marketing, and Distribution


Sales


Sales for products within our specific markets are conducted through both direct sales and indirect distribution channels worldwide.


Product Distribution and Marketing


We have entered into the following distributor, strategic partnership, development, and consulting agreements with regard to our products:


Preferred International Distributor Agreement with Rodash 136 (Pty) Ltd, of South Africa


On May 25, 2010, the Company and Rodash 136 (Pty) Ltd, of South Africa, entered into a Preferred International Distributor Agreement.  Under the agreement, Rodash has agreed to promote the licensing and distribution of Applied Visual Sciences’ PinPoint™ suite of software. Rodash will also provide support to licensees of the products. The three year agreement provides for automatic successive one year renewal periods, unless either party provides written notice to the other of its intention to terminate or to re-negotiate the agreement no less then one hundred and twenty days prior to the end of the then-current period. The Company appointed Rodash as the exclusive distributor for such products in Africa, Brazil, Argentina, Indonesia and Australia, although the agreement permits Applied Visual Sciences to enter into business relationships with original equipment manufactures for the licensing, distribution, or resale of PinPoint™ products.


Preferred International Distributor Agreement Romador 168 (Pty) Ltd, of South Africa


On May 25, 2010, the Company and Romador 168 (Pty) Ltd, of South Africa, entered into a Preferred International Distributor Agreement.  Under the agreement, Romador has agreed to promote the licensing and distribution of Applied Visual Sciences’ Signature Mapping™ suite of software. Romador will also provide support to licensees of the products. The three year agreement provides for automatic successive one year renewal periods, unless either party provides written notice to the other of its intention to terminate or to re-negotiate the agreement no less then one hundred and twenty days prior to the then-current period. The Company appointed Romador as the exclusive distributor for such products in Africa, Brazil, Argentina, Indonesia and Australia, although the agreement permits Applied Visual Sciences to enter into business relationships with original equipment manufactures for the licensing, distribution, or resale of Signature Mapping™ products.


Memorandum of Understanding with Aurum Innova (Pty) Limited and the National Health Laboratory Services of South Africa

  

On March 24, 2009, Applied Visual Sciences, Inc. signed a Memorandum of Understanding (“MOU”) with Aurum Innova (Pty) Limited (“Innova”) and the National Health Laboratory Services of South Africa (“NHLS”).  The purpose of the agreement is for the parties to jointly undertake activities for the completion of our Signature Mapping™ Tuberculosis (“TBDx™”) product for deployment in the NHLS laboratories.  The parties will collaborate to enhance TBDx™’s overall performance, customize its use for application in the National Health Laboratory Services tuberculosis diagnosis and quality management program, and clinically evaluate, measure, and test TBDx™ performance.  The collaboration includes conducting the clinical evaluation at selected NHLS laboratories that conduct sputum slide tuberculosis analysis and diagnosis.


Master Development Agreement with Aurum Innova (Pty), Ltd.


On February 4, 2009, Applied Visual Sciences, Inc. signed a Master Development Agreement Aurum Innova (Pty), Ltd., a company related to the Aurum Institute for Health Research, and installed in February 2009 an alpha product of Signature Mapping™ tuberculosis (“TBDx™”) software in a “retrofit configuration” for an evaluation by the National Health Laboratory Services (“NHLS”) in South Africa. This agreement extends the Company’s contractual relationship with Aurum that was first established with the signing of a Memorandum of Understanding on July 25, 2008.  The new agreement provides for the joint development of products and services aimed at the screening, early detection and staging of diseases including TB, silicosis, and malaria.  Each product will be the subject of a separate project specifications and the MDA included project specifications for our joint development of an automated TB sputum detection product.  Aurum has agreed to clinically evaluate the products, and the parties agreed to jointly market and sell, initially in South Africa but eventually in sub-Saharan Africa, the jointly developed products, including our Signature Mapping™ TBDx™ product, through third parties and/or through Aurum.  The Company agreed to pay Aurum a royalty on a product by products basis, based on the net revenue received by us through our distributors, and to be delineated by the parties.  Also, the Company agreed to pay Aurum a




23


commission with regard to sales of the products by Aurum.  Further, Aurum has agreed to use every reasonable effort to raise funding to complete the development of a product following completion of the initial proof of concept.  Any intellectual property jointly developed by us and Aurum will be jointly owned.  The agreement may be terminated on one year’s prior written notice by either party, automatically terminates upon completion of project specifications and if no products are being marketed under the agreement, or for cause.  The agreement also contains certain confidentiality and indemnification provisions.


Patents and Proprietary Rights


We rely on a combination of common law trademark, service mark, copyright and trade secret law and contractual restrictions to establish and protect our proprietary rights and promote our reputation and the growth of our business.  We do not own any patents that would prevent or inhibit our competitors from using our technology or entering our market, although we intend to seek such protection as appropriate.  It is our practice to require all of our employees, consultants and independent contractors to enter into agreements containing non-disclosure, non-competition and non-solicitation restrictions and covenants, and while our agreements with some of our customers and suppliers include provisions prohibiting or restricting the disclosure of proprietary information, we can not assure you that these contractual arrangements or the other steps taken by us to protect our proprietary rights will prove sufficient protection to prevent misappropriation of our proprietary rights or to deter independent, third-party development of similar proprietary assets.


The United States Patent & Trademark Office (“USPTO”) has granted the Company six patents, all of which are related to our underlying 3i™ technology.  We also have nine pending patents applications (U.S. and foreign) that further cover the implementation of our core 3i™ technology.   We cannot provide assurance that any or all of the remaining patent applications or the provisional application will be issued patents, or that they will not be challenged, or that rights granted to us would actually provide us with an advantage over our competitors.  Prior art searches have been conducted and, based on the results of these searches; we believe that we do not infringe any third party patents identified in the searches.


Date Granted

Patent No.

Patent Description

February 17, 2009

7,492,937

System and Method for Identifying Objects of Interest in Image Data

February 24, 2009

7,496,218

System and Method for Identifying Objects of Interest in Image Data

October 19, 2010

7,817,833

System and Method for Identifying Feature of Interest in Hyperspectral Data

November 23, 2010

7,840,048

System and Method for Determining Whether There is an Anomaly in Data

March 15, 2011

7,907,762

Method of Creating a Divergence Transform for Identifying a Feature of Interest in Hyperspectral Data

October 25, 2011

8,045,805

Method for Determining Whether a Feature of Interest Anomaly is Present in an Image


Due to the rapid pace of technological change in the software industry, we believe patent, trade secret and copyright protection are less significant to our competitive edge than factors such as the knowledge, ability and experience of our personnel, new product development, frequent product enhancements, name recognition and the ongoing reliability of our products.


Research and Development


Under United States’ generally accepted accounting principles, until technology is determined to be feasible, all related research and development expenditures must be expensed rather than capitalized. When a determination is made that software is feasible (commercially viable), then expenditures may be capitalized, as long as there are no high-risk development issues.  We determined that a high-risk development issue existed for integrating PinPoint™ into already existing scanning equipment.  Therefore, we have concluded that capitalizing such expenditures for PinPoint™ is currently inappropriate and have expensed all research and development costs to date. The PinPoint™ research and development costs for the years ended December 31, 2011, and 2010 were $0 and $4,669, respectively.  We also expense the research and development costs for our Signature Mapping™ (Medical Computer Aided Diagnosis) projects as these projects are not considered to be ready for commercial distribution as we need to complete the demonstration (workflow) phase of development in South Africa and certification requirement in India.  The Signature Mapping™ research and development costs for the years ended December 31, 2011, and 2010, were $233,330 and $152,686, respectively. Our research and development costs are comprised of staff and consultancy expenses on our core technology in intelligent imaging informatics (“3i™”) engine that is capable of extracting embedded knowledge from digital images, as well as the capacity to analyze and detect image anomalies for our development of our PinPoint™ and Signature Mapping™.


Governmental Regulation


Government authorities in the United States (including federal, state and local authorities) and in other countries, extensively regulate, among other things, the manufacturing, research and clinical development, marketing, labeling and packaging, distribution, post-approval monitoring and reporting, advertising and promotion, and export and import of security and healthcare products, such as those we are developing. The process of obtaining regulatory approvals and the subsequent compliance with appropriate federal, state, local and foreign statutes and regulations require the expenditure of substantial time and financial resources.




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Many of our prospective customers and the other entities with which we may develop a business relationship operate in the healthcare industry and, as a result, are also subject to governmental regulation.  Because our healthcare products and services are designed to function within the structure of the healthcare financing and reimbursement systems currently in place in the United States, and because we are pursuing a strategy of developing and marketing products and services that support our customers' regulatory and compliance efforts, we may become subject to the reach of, and liability under, these regulations.


The federal Anti-Kickback Law, among other things, prohibits the direct or indirect payment or receipt of any remuneration for Medicare, Medicaid and certain other federal or state healthcare program patient referrals, or arranging for or recommending referrals or other business paid for in whole or in part by the federal health care programs.  Violations of the federal Anti-Kickback Law may result in civil and criminal sanction and liability, including the temporary or permanent exclusion of the violator from government health programs, treble damages and imprisonment for up to five years for each violation.  If the activities of a customer or other entity with which we have a business relationship were found to constitute a violation of the federal Anti-Kickback Law and we, as a result of the provision of products or services to such customer or entity, were found to have knowingly participated in such activities, we could be subject to sanction or liability under such laws, including exclusion from government health programs.  As a result of exclusion from government health programs, our customers would not be permitted to make any payments to us.


The federal Civil False Claims Act and the Medicare/Medicaid Civil Money Penalties regulations prohibit, among other things, the filing of claims for services that were not provided as claimed, which were for services that were not medically necessary, or which were otherwise false or fraudulent.  Violations of these laws may result in civil damages, including treble and civil penalties.  In addition the Medicare/Medicaid and other federal statutes provide for criminal penalties for such false claims. If, as a result of the provision by us of products or services to our customers or other entities with which we have a business relationship, we provide assistance with the provision of inaccurate financial reports to the government under these regulations, or we are found to have knowingly recorded or reported data relating to inappropriate payments made to a healthcare provider, we could be subject to liability under these laws.


The United States Food and Drug Administration (“FDA”) promulgated a draft policy for the regulation of computer software products as medical devices under the 1976 Medical Device Amendments to the Federal Food, Drug and Cosmetic Act.  To the extent that computer software is a medical device under the policy, we, as a manufacturer of such products, could be required, depending on the product, to:

·

register and list its products with the FDA;

·

notify the FDA and demonstrate substantial equivalence to other products on the market before marketing such products; or

·

obtain FDA approval by demonstrating safety and effectiveness before marketing a product.


Depending on the intended use of a device, the FDA could require us to obtain extensive data from clinical studies to demonstrate safety or effectiveness, or substantial equivalence.  If the FDA requires this data, we would be required to obtain approval of an investigational device exemption before undertaking clinical trials.  Clinical trials can take extended periods of time to complete.  We cannot provide assurances that the FDA will approve or clear a device after the completion of such trials. In addition, these products would be subject to the Federal Food, Drug and Cosmetic Act's general controls, including those relating to good manufacturing practices and adverse experience reporting.  Although it is not possible to anticipate the final form of the FDA's policy with regard to computer software, we expect that the FDA is likely to become increasingly active in regulating computer software intended for use in healthcare settings regardless of whether the draft is finalized or changed.  The FDA can impose extensive requirements governing pre- and post-market conditions like service investigation, approval, labeling and manufacturing. In addition, the FDA can impose extensive requirements governing development controls and quality assurance processes.


Employees


As of December 31, 2011, we employed six full-time employees and one part time employee.  Seven of our employees are on a temporary leave of absence. As of December 31, 2011, we had accrued and unpaid salaries due to our employees and management in the amount of $5,833,216. Due to our continued limited cash resource, we have not been able to pay our employees salaries and other compensation on a regular basis or at all, and there is substantial uncertainty that we will be able to do so in the foreseeable future unless we raise additional financing, or we are able to generate revenue from the sale of our products, of which there can be no assurance.  None of our employees is a party to a collective bargaining agreement and we believe our relationship with our current employees is good. We may also employ certain consultants and independent contractors from time to time to assist in the completion of projects. It is our practice to require all our employees, consultants, and independent contractors to enter into proprietary information and inventions agreements containing non-disclosure, non-compete, and non-solicitation restrictions or covenants.


Principal Offices




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We maintain our principal offices at 250 Exchange Place, Suite H, Herndon, Virginia  20170.  Our telephone number in the U.S. is (703) 464-5495.  Our Internet address is www.appliedvs.com.  Information on our website is not deemed to be part of this Annual Report on Form 10-K.


ITEM 1A.  RISK FACTORS


An investment in our common stock involves a high degree of risk.  You should carefully consider the risks described below and other information contained in this report before deciding to invest in our common stock.  The risks described below are not the only ones facing our company. Additional risks not presently known to us or which we currently consider immaterial may also adversely affect our company.  If any of the following risks actually occur, our business, financial condition and operating results could be materially adversely affected.  In such case, the trading price of our common stock could decline, and you could lose a part or all of your investment.


Risks Related to Our Company and Our Operations


We have insufficient cash resources to repay the amounts due to our debenture holders.


The principal amount of our outstanding Series A Debentures of $1,688,205 became due on July 1, 2011, and such amount was not paid.  Therefore, the Company may be considered in default.  The debentures provide that any default in the payment of principal, which default is not cured within the five trading days of the receipt of notice of such default or ten trading days after the Company becomes aware of such default, will be deemed an event of default and may result in enforcement of the debenture holders’ rights and remedies under the debentures and applicable law.  We are in discussions with the debenture holders to re-negotiate the terms of the debentures, including the repayment or repurchase of the debentures and/or seek to extend their maturity date, although we have not reached any agreement with the debenture holders with regard to any such repayment, repurchase or extension.  Our ability to repay or repurchase the debentures is contingent upon our ability to raise additional financing, of which there can be no assurance.  Also, as a condition to any such extension, debenture holders may seek to amend or modify certain other terms of the debentures.  If an event of default occurs under the debentures, the debenture holders may elect to require us to make immediate repayment of the mandatory default amount, which equals the sum of (i) the greater of either (a) 120% of the outstanding principal amount of the debentures, or (b) the outstanding principal amount unpaid divided by the conversion price on the date the mandatory default amount is either (1) demanded or otherwise due or (2) paid in full, whichever has the lower conversion price, multiplied by the variable weighted average price of the common stock on the date the mandatory default amount is either demanded or otherwise due, whichever has the higher variable weighted average price, and (ii) all other amounts, costs, expenses, and liquidated damages due under the debentures.  In anticipation of such election by the debenture holders, due to the nonpayment of principal amount on the due date of July 1, 2011, we measured the mandatory default at approximately $337,641 and subsequently on each balance sheet date, which is reflected in the carrying value of the debentures and also recognized as interest expense.  We remeasured the mandatory default amount as of December 31, 2011 at approximately $337,641. As of the date of this report, the debenture holders have not made an election requiring immediate repayment of the mandatory amount, although there can be no assurance they will not do so.  The Company currently has insufficient funds to repay the outstanding amount in the event the debenture holders make a demand for payment.


Our business plan and technologies are unproven. We have generated minimal revenues from our operation, and incurred substantial operating losses since our inception.  We have very limited cash resources and we are reliant on external sources of financing to fund our operations, including our ongoing product development.


As of December 31, 2011, our revenue generating activities have not produced sufficient funds for profitable operations and we have incurred operating losses since inception.  In view of these matters, realization of certain of the assets in the accompanying consolidated balance sheet is dependent upon continued operations, which in turn is dependent upon our ability to meet our financial requirements, raise additional financing on acceptable terms, and the success of future operations.  The principal amount due to our debenture holders as of December 31, 2011, was approximately $1,688,205, which matured on June 30, 2011, and was not paid. Also, we have outstanding trade and accrued payables of $7,676,180 including, accrued salaries due to our employees and management of $5,833,216. Also, our Chief Executive Officer’s net outstanding noninterest-bearing loans were $89,000.


As of December 31, 2011, we had a cash balance of $6,490.  Subsequently and through April 16, 2012, we received $25,000 from an accredited investor, and issued an aggregate of 100,000 shares of common stock and 300,000 Class Q Warrants.  We also issued promissory notes to five accredited investors’ in the aggregate principal amount of $135,000 ($131,400, net of accrued commissions and expenses in the amount of $3,600); the notes accrue interest at a rate of 12% per annum, and the Company issued an aggregate of 210,000 shares of common stock to the note holders.  Management believes these funds to be insufficient to fund our operations for the next twelve months absent any cash flow from operations or funds from the sale of our equity or debt securities.  Currently, we are spending or




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incurring (and accruing) expenses of approximately $220,000 per month on operations and the continued research and development of our 3i technologies and products, including with regard to salaries and consulting fees. Management believes that we will require an aggregate of approximately $2,640,000 to fund our operations for the next 12 months and to repay certain outstanding trade payables and accrued expenses.  This assumes that holders of our outstanding debentures convert such debt into shares of our common stock or that we are able to extend the term of the debentures, of which there can be no assurance.  In the event we are unable to extend the term of the debentures beyond their new maturity date, the debenture holders do not convert such debt or require payment of principal, partially convert such debt, or effect the buy-in provision related to the warrants and the debentures, we shall be required to raise additional financing.  Also, this assumes that we are able to continue to defer the amounts due to our employees for accrued and unpaid salaries and that we are able to continue to extend or defer payment of certain amounts due to our trade creditors, of which there can be no assurance.


In view of our limited revenues to date, the Company has relied and continues to rely substantially upon equity and debt financing to fund its ongoing operations, including the research and development conducted in connection with its products and conversion of accounts payable for stock. The proceeds from our financings have been and continue to be insufficient to fund our operations, pay our trade payables, repay our unconverted debentures, or accrued and unpaid wages to our employees.  Therefore, the debentures holders, our employees, or trade creditors may seek to enforce payment of amounts due to them, and our results of operations and financial condition could be materially and adversely affected and we may be unable to continue our operations.  Also, in the event we are unable to pay our employees, we may suffer further employee attrition.  There can be no assurances that we will be successful in our efforts to raise any additional financing, any bank borrowing, and research or grant funding.  Moreover, in view of the current market price of our stock, we may have limited or no access to the capital markets.  Furthermore, under the terms of our agreements with the debenture holders, we are subject to restrictions on our ability to engage in any transactions in our securities in which the conversion, exercise or exchange rate or other price of such securities is below the current conversion price or is based upon the trading price of our securities after initial issuance or otherwise subject to re-set.  In view of the foregoing, we may be required to curtail operations significantly, or obtain funds through entering into arrangements with collaborative partners or others that may require us to relinquish rights to certain of our technologies or products.


During Fiscal 2011, although our total stockholders’ deficit decreased by $338,708 to $9,825,807, our consolidated net loss for the period was $1,154,376, or a $2,495,855 decrease in net loss from 2010, and the decrease is mainly due to the change in the fair value of the derivative liability that reduced the net loss by $1,958,318. Notwithstanding the foregoing discussion of management’s expectations regarding future cash flows, Applied Visual Sciences’ insolvency continues to increase the uncertainties related to its continued existence.  Both management and the Board of Directors are carefully monitoring the Company’s cash flows and financial position in consideration of these increasing uncertainties and the needs of both creditors and stockholders.


Our independent registered public accounting firm has expressed uncertainty regarding our ability to continue as a going concern.


Our independent registered public accounting firm has expressed uncertainty regarding our ability to continue as a going concern.  The consolidated financial statements do not include any adjustments to reflect the possible future effects on recoverability and classification of assets or the amounts and classification of liabilities that might occur if we are unable to continue in business as a going concern.


We have generated limited revenue from our PinPoint and Signature Mapping products.


We have generated limited revenue from the sale of our aviation and healthcare products.  We anticipate launching our TBDx™ and TBDxV™ products during 2012; however, there can be no assurance we will be successful in such launches or that we will generate revenue from our products.  We expect to incur additional product development costs to complete our Signature Mapping™ Tuberculosis projects and other proof of concept projects as outside partners are solidified.  We completed a proof of concept project for the U.S. Department of Homeland Security (“DHS”) with regard to our PinPoint™ product in 2009, and we may incur additional product development cost for PinPoint™.  Although, there can be no assurance that we will be successful in launching the foregoing products in accordance with the timelines outlined, or that we will be successful in marketing and selling such products or generating significant revenue from such product.


We have a severe working capital deficit and, in addition to proceeds from financings, we continue to have outstanding loans from our chief executive officer and deferrals of salaries by our executive officer, employees and a consultant/director. In the event we are unable to pay our employees salaries, we may experience employee attrition which could materially and adversely affect our business and operations.


During Fiscal 2011, although our total stockholders’ deficit decreased by $338,708 to $9,825,807, our consolidated net loss for the period was $1,154,376, or a $2,495,855 decrease in net loss from 2010, and the decrease is mainly due to the change in the fair value of the derivative liability that reduced the net loss by $1,958,318. During 2011, our revenue generating activities had not produced sufficient funds for profitable operations and we have incurred operating losses since inception.  Although we have obtained cash from




27


certain financings, we continue to have outstanding loans from our chief executive officer of approximately $89,000, accrued and unpaid salaries of our executive officers in the amount of $2,697,976 and to other employees of $3,135,240, and outstanding accounts payable to a consultant/director of the Company in the amount of $493,926.  The Company’s insolvency continues to increase the uncertainties related to its continued existence.  Also, in the event we are unable to pay our employees, we may continue to experience further employee attrition which could materially adversely affect our business and operations, including our ongoing research and development activities.  As of December 31, 2011, we employed six full-time employees, and one part-time employee.  We also have seven employees that are on a temporary leave of absence, and their return is uncertain.


Dilutive effect of conversion of Series A Senior Convertible Debentures, exercise of Series D Warrants and Midtown placement agent’s warrants, and other warrants.


Under a securities purchase agreement, dated November 3, 2006, between the Company and certain institutional accredited investors, the Company sold an aggregate of $5,150,000 in principal amount of our Series A Debentures and Series D Common Stock Purchase Warrants to purchase an aggregate of 4,453,709 shares of our common stock.  On November 8, 2006, the Company issued to the institutional investors an aggregate of $2,575,000 in principal amount of Series A Debentures and 4,453,709 Series D Warrants.  On April 12, 2007, the Company issued at a second closing, an additional $2,575,000 in principal amount of the Series A Debentures, which followed the effectiveness of a registration statement registering the shares of our common stock underlying the Series A Debentures and Series D Warrants.  The Company allocated proceeds from each closing to the embedded conversion features of the Series A Debentures and Series D Warrants that were recognizable as a liability under generally accepted accounting principles.  We also issued during the first closing an aggregate of 623,520 common stock purchase warrants to the placement agent as compensation in the offering, which were upon terms substantially similar to the Series D Warrants. One-half of the Series D Warrants (2,226,854 warrants) and the placement agent warrants (311,760 warrants) became exercisable on November 8, 2006. The remaining one-half of the Series D Warrants (2,226,855 warrants) and the placement agent warrants (311,760 warrants) became exercisable on April 12, 2007 and expire on April 12, 2012. The Series D Warrants and the placement agent’s warrants may be exercised via a cashless exercise if certain conditions are met. Due to milestone-related adjustments, the initial exercise price of $1.15634 may be reset and the maximum number of shares to be issued under the debentures was indeterminable as of December 31, 2007. The Company considered ASC 815-40 (formerly EITF 00-19, relating to the provisions for Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock), and concluded that there were insufficient shares to share settle the contracts.  On April 1, 2007, due to the milestone-related provisions, the conversion price of the Series A Debentures and the exercise price of the Series D Warrants and Placement Agent’s Warrants were reset to a price $0.7453 per share, to $0.6948 effective October 1, 2007, and the final milestone reset of $0.4089 effective April 1, 2008.  As a result of a June 2009 financing in which the Company issued shares of common stock and warrants, the conversion price of our debentures and the exercise price of the Series D Warrants was adjusted under the anti-dilution provisions of such instruments to a price of $0.25 per share, and the number of shares underlying the Series D Warrants (including the warrants the Company issued to the placement agent in the financing) were increased by an aggregate of 2,677,417 Series D warrants.  On July 10, 2007, a debenture holder exercised 864,798 Series D Warrants for 864,798 shares of common stock, and 914,798 warrants were exercised during 2010 under the cashless provision for 420,166 shares of common stock. On November 8, 2011, an aggregate of 2,962,527 Series D Warrants expired.  Our outstanding Series A 10% Convertible Debentures originally became due on November 7, 2008. On October 15, 2010, we entered into an agreement with our two remaining Series A Convertible Debenture holders to extend the maturity date of the debentures to June 30, 2011, and the outstanding amount of $1,688,205 was not paid. As of December 31, 2011, an aggregate of $3,461,795 in principal amount of the Series A Debentures have been converted into 8,730,037 shares of common stock, an aggregate of $663,043 in interest amount have been converted into 2,675,576 shares of common stock, and an aggregate of 1,779,596 Series D Warrants have been exercised resulting in the issuance of 1,284,964 shares of common stock. Accordingly, as of December 31, 2011, an aggregate of $1,688,205 of principal amount of the debentures remain unconverted, and 3,012,523 Series D Warrants remain unexercised. Proceeds of the two offerings were used for the purpose of hiring new personnel, research and development, registration expenses, for general working capital purposes, and repaying $200,000 in loans made to us by Mr. Michael W. Trudnak, our Chairman and CEO.

  

As of December 31, 2011, approximately 15,246,929 warrants (including the warrants exercisable by the debenture holders) may be exercised pursuant to the cashless exercise provisions of such warrants, which may be subsequently resold as “restricted securities” under the provisions of Rule 144 under the Securities Act.  Increased sales volume of the Company’s common stock could cause the market price of the Company’s common stock to drop.


We have incurred substantial debt which could affect our ability to obtain additional financing and may increase our vulnerability to business downturns. We may be unable to repay our Series A Debentures that matured on June 30, 2011.


As of December 31, 2011, the aggregate principal under our outstanding Series A Debentures was $1,688,205, which matured on June 30, 2011. Also, we have outstanding trade and accrued payables of $1,356,404, other accrued liabilities of $486,560, and accrued salaries due to our employees and management of $5,833,216.  Also, the Company has an outstanding noninterest-bearing loan from its Chief Executive Officer of $89,000, and $400,000 short-tern notes from two investors.  Subsequently through the date of this report, we issued additional short-term notes in an aggregate of $135,000. We are subject to the risks associated with substantial indebtedness,




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including insufficient funds to repay the outstanding principal in the event the debenture holders make a demand for payment; it may be more expensive and difficult to obtain additional financing; and we are more vulnerable to economic downturns.


Our certifying officers evaluated the effectiveness of our disclosure controls and procedures, and concluded that our disclosure controls were effective for 2011 and 2010.  Although, management cannot assure you that measures taken will enable the Company to provide accurate and timely financial information.


Our Chief Executive Officer and Chief Financial Officer (the “Certifying Officers”) are responsible for establishing and maintaining our disclosure controls and procedures (as defined in Exchange Act Rule 13a-15(e) and 15d-15(e)).  The Certifying Officers designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under their supervision, to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified by the SEC’s rules and forms, and is made known to management (including the Certifying Officers) by others within the Company, including its subsidiaries. We regularly evaluate the effectiveness of our disclosure controls and procedures and report our conclusions about the effectiveness of the disclosure controls quarterly in our Forms 10-Q and annually in our Forms 10-K.  Although the Certifying Officers have determined that our disclosure controls and procedures were effective during 2011 and 2010, management continues to believe that refinement to our disclosure controls and procedures is an ongoing progress.  We cannot assure you that measures already taken, or any future measures, will enable us to provide accurate and timely financial reports, particularly if we are unable to hire additional personnel in our accounting and financial department, or if we lose personnel in this area.  Any failure to improve our internal controls or other problems with our financial systems or internal controls could result in delays or inaccuracies in reporting financial information, or non-compliance with SEC reporting and other regulatory requirements, any of which could adversely affect our business and stock price. The Audit Committee believes the Company should continue the following activities: (a) additional education and professional development for the Company’s accounting and other staff on new and existing applicable SEC filing requirements, certain applicable SEC disclosure requirements, and the timing of the filing thereof, and (b) reviewing disclosure requirements, including Form 8-K and Regulation S-K disclosure requirements, SEC staff guidance and interpretations related thereto. While management is responsible for establishing and maintaining our disclosure controls and procedures and has taken steps to ensure that the disclosure controls are effective and free of “significant deficiencies” and/or “material weaknesses,” the ability of management to implement the remediation of such weaknesses and deficiencies and the inherent nature of our business and rapidly changing environment may affect management’s ability to be successful with this initiative.


Current shareholdings may be diluted if we make future equity issuances or if outstanding debentures, warrants, and options are exercised for or converted into shares of common stock.


“Dilution” refers to the reduction in the voting effect and proportionate ownership interest of a given number of shares of common stock as the total number of shares increases.  Our issuance of additional stock, convertible preferred stock and convertible debt may result in dilution to the interests of shareholders and may also result in the reduction of your stock price.  The sale of a substantial number of shares into the market, or even the perception that sales could occur, could depress the price of the common stock.  Also, the exercise of warrants and options may result in additional dilution.


The holders of outstanding options, warrants and convertible securities have the opportunity to profit from a rise in the market price of the common stock, if any, without assuming the risk of ownership, with a resulting dilution in the interests of other shareholders.  We may find it more difficult to raise additional equity capital if it should be needed for our business while the options, warrants and convertible securities are outstanding.  At any time at which the holders of the options, warrants or convertible securities might be expected to exercise or convert them, we would probably be able to obtain additional capital on terms more favorable than those provided by those securities. Also, some holders of our warrants have piggy back registration rights requiring us to register their shares underlying such options and warrants in any registration statement we file under the Securities Act.  The cost to us for such required registration may be substantial.


We may undertake acquisitions which pose risks to our business.


As part of our growth strategy, we have and may in the future acquire or enter into joint venture arrangements with, or form strategic alliances with complimentary businesses. Any such acquisition, investment, strategic alliance or related effort will be accompanied by the risks commonly encountered in such transactions.  These risks may include:


·

Difficulty of identifying appropriate acquisition candidates;

·

Paying more than the acquired company is worth;

·

Difficulty in assimilating the operations of the new business;

·

Costs associated with the development and integration of the operations of the new entity;




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·

Existing business may be disrupted;

·

Entering markets in which we have little or no experience;

·

Accounting for acquisitions could require us to amortize substantial intangible assets (goodwill), adversely affecting our results of operations;

·

Inability to retain the management and key personnel of the acquired business;

·

Inability to maintain uniform standards, controls, policies and procedures; or

·

Customer attrition with respect to customers acquired through the acquisition.


We cannot assure you that we would successfully overcome these risks or any other problems associated with any acquisition, investment, strategic alliances, or related efforts.  Also, if we use our common stock in connection with an acquisition, your percentage ownership in us will be reduced and you may experience additional dilution.


Investor confidence in the price of our stock may be adversely affected if we are unable to comply with Section 404 of the Sarbanes-Oxley Act of 2002.


As an SEC registrant, we are subject to the rules adopted by the SEC pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, which require us to include in our annual report on Form 10-K our management’s report on, and assessment of the effectiveness of, our internal control over financial reporting (“management’s report”).  If we fail to achieve and maintain the adequacy of our internal control over financial reporting, there is a risk that we will not comply with all of the requirements imposed by Section 404.  Moreover, effective internal control over financial reporting, particularly that relating to revenue recognition, is necessary for us to produce reliable financial reports and is important in helping to prevent financial fraud.  Any of these possible outcomes could result in an adverse reaction in the financial marketplace due to a loss in investor confidence in the reliability of our financial statements, which ultimately could harm our business and could negatively impact the market price of our common stock.  Investor confidence and the price of our common stock may be adversely affected if we are unable to comply with Section 404 of the Sarbanes-Oxley Act of 2002.


In order to comply with public reporting requirements, we must continue to strengthen our financial systems and controls, and failure to do so could adversely affect our ability to provide timely and accurate financial statements.


Refinement of our internal controls and procedures will be required as we manage future growth successfully and operate effectively as a public company. Such refinement of our internal controls, as well as compliance with the Sarbanes-Oxley Act of 2002 and related requirements, will be costly and will place a significant burden on management.  We cannot assure you that measures already taken, or any future measures, will enable us to provide accurate and timely financial reports, particularly if we are unable to hire additional personnel in our accounting and financial department, or if we lose personnel in this area. Any failure to improve our internal controls or other problems with our financial systems or internal controls could result in delays or inaccuracies in reporting financial information, or non-compliance with SEC reporting and other regulatory requirements, any of which could adversely affect our business and stock price.


Our stock price is volatile.


The stock market from time to time experiences significant price and volume fluctuations that are unrelated to the operating performance of particular companies.  These broad market fluctuations may cause the market price of our common stock to drop.  In addition, the market price of our common stock is highly volatile.  Factors that may cause the market price of our common stock to drop include:


·

Fluctuations in our results of operations;

·

Timing and announcements of new customer orders, new products, or those of our competitors;

·

Any acquisitions that we make or joint venture arrangements we enter into with third parties;

·

Changes in stock market analyst recommendations regarding our common stock;

·

Failure of our results of operations to meet the expectations of stock market analysts and investors;

·

Increases in the number of outstanding shares of our common stock resulting from sales of new shares, or the exercise of warrants, stock options or convertible securities;

·

Reluctance of any market maker to make a market in our common stock;

·

Changes in investors’ perception of the transportation security scanning and healthcare information technology industries generally; and




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·

General stock market conditions.


There is a limited market for our common stock.


Our common stock is quoted on OTC Bulletin Board under the symbol “APVS.”  As a result, relatively small trades in our stock could have disproportionate effect on our stock prices.  No assurance can be made that an active market for our common stock will continue.


The OTC Bulletin Board is a regulated quotation service that displays real-time quotes, last-sale prices and volume information for shares of stock that are not designated for quotation on a national securities exchange.  Trades in OTC Bulletin Board quoted stocks will be displayed only if the trade is processed by an institution acting as a market maker for those shares. Although there are approximately 12 market makers for our stock, these institutions are not obligated to continue making a market for any specific period of time.  Thus, there can be no assurance that any institution will be acting as a market maker for our common stock at any time.  If there is no market maker for our stock and no trades in those shares are reported, it may be difficult for you to dispose of your shares or even to obtain accurate quotations as to the market price for your shares.  Moreover, because the order handling rules adopted by the SEC that apply to other listed stocks do not apply to OTC Bulletin Board quoted stock, no market maker is required to maintain an orderly market in our common stock.  Accordingly, an order to sell our stock placed with a market maker may not be processed until a buyer for the shares is readily available, if at all, which may further limit your ability to sell your shares at prevailing market prices.


Because we became public through a reverse acquisition, we may not be able to attract the attention of major brokerage firms or institutional investors.


We became a public company through a reverse acquisition in June 2003.  Accordingly, securities analysts and major brokerage firms and securities institutions may not cover our common stock since there is no incentive to recommend the purchase of our common stock.  No assurance can be given that established brokerage firms will want to conduct any financing for us in the future.


Our common stock is subject to the SEC’s Penny Stock Regulations.


Our common stock is subject to the SEC’s “penny stock” rules.  These regulations define a “penny stock” to be any equity security that has a market price (as defined) of less than $5.00 per share, subject to certain exceptions.  For any transaction involving a penny stock, unless exempt, these rules require the delivery, prior to the transaction, of a disclosure schedule prepared by the SEC relating to the penny stock market.  The broker-dealer also must disclose the commissions payable to the broker-dealer and the registered underwriter, current quotations for the securities, information on the limited market in penny stocks and, if the broker-dealer is the sole market-maker, the broker-dealer must disclose this fact and the broker-dealers’ presumed control over the market.  In addition, the broker-dealer must obtain a written statement from the customer that such disclosure information was provided and must retain such acknowledgment for at least three years.  Further, monthly statements must be sent disclosing current price information for the penny stock held in the account.  The penny stock rules also require that broker-dealers engaging in a transaction in a penny stock make a special suitability determination for the purchaser and receive the purchaser's written consent to the transaction prior to the purchase.  The foregoing rules may materially and adversely affect the liquidity for the market of our common stock.  Such rules may also affect the ability of broker-dealers to sell our common stock, the ability of holders of such securities to obtain accurate price quotations and may therefore impede the ability of holders of our common stock to sell such securities in the secondary market.


Certain provisions of our charter and bylaws may discourage mergers and other transactions.


Certain provisions of our certificate of incorporation and bylaws may make it more difficult for someone to acquire control of us.  These provisions may make it more difficult for stockholders to take certain corporate actions and could delay or prevent someone from acquiring our business.  These provisions could limit the price that certain investors might be willing to pay for shares of our common stock.  The use of a staggered board of directors and the ability to issue “blank check” preferred stock are traditional anti-takeover measures.  These provisions may be beneficial to our management and the board of directors in a hostile tender offer, and may have an adverse impact on stockholders who may want to participate in such tender offer, or who may want to replace some or all of the members of the board of directors.


Our board of directors may issue additional shares of preferred stock without stockholder approval.


Our certificate of incorporation authorizes the issuance of up to 1,000,000 shares of preferred stock of which 6,000 have been designated as Series A Convertible Preferred Stock, 6,000 shares as Series B Convertible Preferred Stock, and 1,000 shares as Class C Convertible Preferred Stock, none of which shares are outstanding on the date of the filing of this report.  Accordingly, our board of directors may, without shareholder approval, issue one or more new series of preferred stock with rights which could adversely affect the voting power or other rights of the holders of outstanding shares of common stock.  In addition, the issuance of additional shares of




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preferred stock may have the effect of rendering more difficult or discouraging, an acquisition or change of control of Applied Visual Sciences, Inc.  Although we do not have any current plans to issue any shares of preferred stock, we may do so in the future.


We depend on key personnel.


Our success depends of the contributions of our key management personnel, including Mr. Michael W. Trudnak, Chairman, Chief Executive Officer, and Secretary, Mr. William J. Donovan, President and Chief Operating Officer, and Mr. Gregory E. Hare, our Chief Financial Officer and Treasurer.  If we lose the services of any of such personnel we could be delayed in or precluded from achieving our business objectives.  We do not have key man life insurance on any of our officers.


In addition, the loss of key members of our sales and marketing teams or key technical service personnel could jeopardize our positive relations with our customers.  Any loss of key technical personnel would jeopardize the stability of our infrastructure and our ability to provide the service levels our customers expect.  The loss of any of our key officers or personnel could impair our ability to successfully execute our business strategy, because we substantially rely on their experience and management skills.


Our directors and named executive officers own a substantial percentage of our common stock.


As of April 10, 2012, our directors and executive officers beneficially owned approximately 23.6% of our shares of common stock. Accordingly, our directors, executive officers and a most highly compensated employee are entitled to cast an aggregate of 10,644,657 votes on matters submitted to our stockholders for a vote or approximately 11.7% of the total number of votes entitled to be cast at a meeting of our stockholders. These stockholders, if they acted together, could exert substantial control over matters requiring approval by our stockholders. These matters would include the election of directors and the approval of mergers or other business combination transactions. This concentration of ownership may discourage or prevent someone from acquiring our business.


Our ability to attract and retain additional skilled personnel may impact our ability to develop our technology and attract customers in growing our business. However, we have limited cash resources to hire additional personnel and have experienced employee attrition due to our inability to pay our employees.


We believe that our ability to attract, train, motivate and retain additional highly skilled technical, managerial and sales personnel, particularly in the areas of technology-based application development, business intelligence, knowledge extraction, management, product development, healthcare economics, radiology, integration and technical support, is essential to our future success.  Our business requires individuals with significant levels of expertise in knowledge extraction, business operations, mathematics, quantitative analysis, and machine learning.  Competition for such personnel is intense, and qualified technical personnel are likely to remain a limited resource for the foreseeable future.  Locating candidates with the appropriate qualifications, particularly in the desired geographic location, can be costly and difficult.  We may not be able to hire the necessary personnel to implement our business strategy, or we may need to provide higher compensation to such personnel than we currently anticipate.  Also, due to our limited cash resources, we have not been able to pay our employees and have accrued and unpaid wages and other perquisites due to our current and certain former employees of approximately $5,833,216.  Accordingly, we have experienced employee attrition and may not be able to attract new employees when we need to do so. If we fail to attract and retain sufficient numbers of highly skilled employees, our ability to provide the necessary products, technologies, and services may be limited, and as a result, we may be unable to attract customers and grow our business.


Our lease expires in January 2013 and we may not be able to extend our existing lease or obtain a lease for new office space because of our financial condition and limited cash resources.


The Company’s office lease for our principal executive offices expired on October 31, 2011, and the lease was extended during the period of negotiations to establish a new lease.  The Company entered into a new lease for our existing principal executive offices in February 2012, and negotiated with the landlord to lease 3,269 square feet of office space at a monthly lease payment of $5,764, and the lease expired on January 31, 2013.  The lease does not contain a renewal provision, and due to our financial condition and limited cash, the Company may be not be able to renew the lease or obtain a lease for office space or on terms that are acceptable to us.


We have never paid a cash dividend


We have not declared a cash dividend and we do not anticipate declaring or paying such dividends in the foreseeable future.


Risks Related to Our Industries


Changes may take place in funding for healthcare.





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We expect to derive a substantial portion of our revenues from sales of clinical healthcare information systems, and other related services within the healthcare industry. As a result, our success is dependent in part on political and economic conditions as they relate to the healthcare industry.


Virtually all of our prospective customers in the healthcare industry are subject to governmental regulation, including Medicare and Medicaid regulation.


Accordingly, our prospective customers and other entities with which we may develop a business relationship are affected by changes in such regulations and limitations in governmental spending for Medicare and Medicaid programs. Recent actions by Congress have limited governmental spending for the Medicare and Medicaid programs, limited payments to hospitals and other providers under such programs, and increased emphasis on competition and other programs that potentially could have an adverse effect on our customers and the other entities with which we have a business relationship. In addition, federal and state legislatures have considered proposals to reform the U.S. healthcare system at both the federal and state level. If enacted, these proposals could increase government involvement in healthcare, lower reimbursement rates and otherwise change the business environment of our prospective customers and other entities with which we may develop a business relationship. Our prospective customers and other entities with which we may develop a business relationship could react to these proposals and the uncertainty surrounding these proposals by curtailing or deferring investments, including those for our products and services.


In addition, many healthcare providers are consolidating to create integrated healthcare delivery systems with greater market power. These providers may try to use their market power to negotiate price reductions for our anticipated products and services, which would negatively impact our expected operating margins. As the healthcare industry consolidates, competition for customers will become more intense and the importance of acquiring each customer will become greater.


Product liability and other claims may occur.


Any failure by our products that provide applications relating to patient diagnostic procedures, and treatment plans could expose us to product liability claims for personal injury and wrongful death. Unsuccessful claims could be costly to defend and divert management time and resources.  In addition, we have not been able to maintain general liability, or directors and officers coverage, and cannot make assurances that we will have appropriate insurance available to us in the future at commercially reasonable and affordable rates. We expect to seek general liability and directors and officers coverage upon securing adequate financing, and product liability and other customary coverage upon the commercialization of our intelligent imaging informatics (“3i™”) technology.


Specific government regulations relating to Medicare and Medicaid may impinge on us.


Many of our prospective customers and the other entities with which we may develop a business relationship operate in the healthcare industry and, as a result, are subject to governmental regulation. Because our healthcare products and services are designed to function within the structure of the healthcare financing and reimbursement systems currently in place in the United States, and because we are pursuing a strategy of developing and marketing products and services that support our customers' regulatory and compliance efforts, we may become subject to the reach of, and liability under, these regulations.


The federal Anti-Kickback Law, among other things, prohibits the direct or indirect payment or receipt of any remuneration for Medicare, Medicaid and certain other federal or state healthcare program patient referrals, or arranging for or recommending referrals or other business paid for in whole or in part by the federal health care programs. Violations of the federal Anti-Kickback Law may result in civil and criminal sanction and liability, including the temporary or permanent exclusion of the violator from government health programs, treble damages and imprisonment for up to five years for each violation. If the activities of a customer or other entity with which we have a business relationship were found to constitute a violation of the federal Anti-Kickback Law and we, as a result of the provision of products or services to such customer or entity, were found to have knowingly participated in such activities, we could be subject to sanction or liability under such laws, including exclusion from government health programs. As a result of exclusion from government health programs, our customers would not be permitted to make any payments to us.


The federal Civil False Claims Act and the Medicare/Medicaid Civil Money Penalties regulations prohibit, among other things, the filing of claims for services that were not provided as claimed, which were for services that were not medically necessary, or which were otherwise false or fraudulent. Violations of these laws may result in civil damages, including treble and civil penalties. In addition the Medicare/Medicaid and other federal statutes provide for criminal penalties for such false claims. If, as a result of the provision by us of products or services to our customers or other entities with which we have a business relationship, we provide assistance with the provision of inaccurate financial reports to the government under these regulations, or we are found to have knowingly recorded or reported data relating to inappropriate payments made to a healthcare provider, we could be subject to liability under these laws.


Medical device regulation may require us to obtain approval for our products.




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The United States Food and Drug Administration (“FDA”) have promulgated a policy for the regulation of computer software products as medical devices under the 1976 Medical Device Amendments to the Federal Food, Drug and Cosmetic Act. To the extent that computer software is a medical device under the policy, we, as a manufacturer of such products, could be required, depending on the product, to:

·

register and list its products with the FDA;

·

notify the FDA and demonstrate substantial equivalence to other products on the market before marketing such products; or

·

obtain FDA approval by demonstrating safety and effectiveness before marketing a product.


Depending on the intended use of a device, the FDA could require us to obtain extensive data from clinical studies to demonstrate safety or effectiveness, or substantial equivalence. If the FDA requires this data, we would be required to obtain approval of an investigational device exemption before undertaking clinical trials. Clinical trials can take extended periods of time and substantial funds to complete. We cannot provide assurances that the FDA will approve or clear a device after the completion of such trials. In addition, these products would be subject to the Federal Food, Drug and Cosmetic Act's general controls, including those relating to good manufacturing practices and adverse experience reporting. Although it is not possible to anticipate the final form of the FDA's policy with regard to computer software, we expect that the FDA is likely to become increasingly active in regulating computer software intended for use in healthcare settings regardless of whether the draft is finalized or changed. The FDA can impose extensive requirements governing pre- and post-market conditions like service investigation, approval, labeling and manufacturing. In addition, the FDA can impose extensive requirements governing development controls and quality assurance processes.


System errors and warranties may subject us to liability.


Our technology is very complex. As is the case with all complex and new systems, our product may contain errors especially when first introduced. Our technology is intended to provide information to security agencies for threat detection, and to healthcare providers for use in medical diagnosis. Therefore, users of our products may have a greater sensitivity to system errors than the market for software products generally. Failure of a system to perform in accordance with its documentation could constitute a breach of warranty and require us to incur additional expenses in order to make the system comply with the documentation. If such failure is not timely remedied, it could constitute a material breach under a contract allowing the client to cancel the contract and subject us to liability.


We retain and transmit confidential information; including patient health information. A security breach could damage our reputation or result in liability. It is critical that these facilities and infrastructure remain secure and be perceived by the marketplace as secure. We may be required to expend significant capital and other resources to protect against security breaches and hackers or to alleviate problems caused by breaches. Despite the implementation of security measures, this infrastructure or other systems that we interface with, including the Internet and related systems, may be vulnerable to physical break-ins, hackers, improper employee or contractor access, computer viruses, programming errors, attacks by third parties or similar disruptive problems. Any compromise of our security, whether as a result of our own systems or systems that they interface with, could reduce demand for our services and products.


Customer satisfaction and our business could be harmed if our business experiences delays, failures or loss of data in its systems. The occurrence of a major catastrophic event or other system failure at any of our facilities, or at any third party facility, including telecommunications provider facilities, could interrupt data processing or result in the loss of stored data, which could harm our business.


We may infringe the proprietary rights of others.


If any of our products violate third party proprietary rights, we may be required to reengineer our products or seek to obtain licenses from third parties to continue offering our products without substantial reengineering. Any efforts to reengineer our products or obtain licenses from third parties may not be successful, in which case we may be forced to stop selling the infringing product or remove the infringing functionality or feature. We may also become subject to damage awards as a result of infringing the proprietary rights of others, which could cause us to incur additional losses and have an adverse impact on our financial position. We do not conduct comprehensive patent searches to determine whether the technologies used in our products infringe patents held by others. In addition, product development is inherently uncertain in a rapidly evolving technological environment in which there may be numerous patent applications pending; many of which are confidential when filed, with regard to similar technologies.


Unforeseeable disruption in the economy may take place consequent to terrorism or other international events.


The terrorist events of September 11, 2001, as well as new terrorists threats, the war in Iraq and Afghanistan, and the possibility of war in other areas of the Middle East, have sensitized us and many other businesses to the potential disruption that such activities can have on the economy, the business cycle and, ultimately on the financial performance of these organizations. It is impossible to know




34


whether such terrorist or military activities will continue, and whether, and to what extent, they may cause a disruption that may have a material adverse effect on our business and financial condition.


We may face competition from other developers or sellers of imaging and radiology technology and baggage screening technology.


While the market for imaging and radiology technology is highly fragmented, we face competition from other companies which are developing products that are expected to be competitive with our healthcare products.  We also face potential competition from other companies developing baggage screening technology and from baggage scanner manufacturers.  Business in general is highly competitive, and we compete with both large multinational solution providers and smaller companies. Some of our competitors have more capital, longer operating and market histories, and greater resources than we have, and may offer a broader range of products and at lower prices than we offer.


A number of factors that will affect our revenues will make our future results difficult to predict, and therefore we may not meet expectations for a particular period.


We believe that our future revenues when it occurs may have the potential to vary significantly from time to time. We believe that these variations may result from many factors, including:


·

the timing, size and mix of orders from our major customers including, in particular, the Department of Homeland Security and agencies of foreign governments;

·

legislative or other government actions driven, in part, by the public’s perception of the threats facing commercial aviation, leading to fluctuations in demand for transportation security scanning  products and services;

·

delays in product shipments caused by the inability of airports to install or integrate our products in a timely fashion;

·

the availability and cost of key components;

·

the timing of completion of acceptance testing for some of our products by various U.S. agencies and foreign governments;

·

the introduction and acceptance of new products or enhancements to existing products offered by us or our competitors;

·

changes in pricing policies by us, our competitors or our suppliers, including possible decreases in average selling prices of our products caused by customer volume orders or in response to competitive pressures; and

·

our sales mix to domestic and international customers.


We expect to depend on a small number of customers for a substantial portion of our future revenues.

A significant portion of our quarterly and annual operating expenses is expected to be relatively fixed in nature. This means that future revenue fluctuations will cause our quarterly and annual operating results to vary substantially. We also may choose to increase spending to pursue new market opportunities, which may negatively affect our financial results. We cannot assure investors that our PinPoint™ product will be selected by the U.S. DHS or other countries’ security departments or address their solutions needs for threat detection, or that our Signature Mapping™ product will be accepted in the healthcare arena.


Governmental agencies, the primary customers for our PinPoint™ products are subject to budget processes which could limit the demand for these products.


Substantially all of the potential customers for our PinPoint™ products under development to date have been public agencies or quasi-public agencies, such as the FAA, the TSA, airport authorities and manufactures of threat detection devices. Public agencies are subject to budgetary processes and expenditure constraints.


The funding of government programs is subject to legislative appropriation. Budgetary allocations for PinPoint™ depend, in part, upon governmental policies, which fluctuate from time to time in response to political and other factors, including the public’s perception of the threat of commercial airline bombings. For example, the terrorist attacks of September 11, 2001 resulted in the passage of the Aviation and Transportation Security Act of 2001, or Transportation Security Act, mandating a small surcharge on each airline ticket purchase to fund airline security. This surcharge was suspended from June 1, 2003 to September 30, 2003. We cannot assure investors that the surcharge will not again be suspended or that the funds generated by these surcharges will be used to purchase our PinPoint™ products. We cannot assure investors that funds will continue to be appropriated by Congress or allocated by the TSA or other agencies for the purchase of PinPoint™ product or any other such product we develop and market. Moreover, we expect that similar funding and appropriations issues will affect our ability to market and sell our PinPoint™ product outside the United States.


Legislative actions could lead to fluctuations in demand for transportation security scanning products and services.


In addition to the Congressional budgetary process, other legislation could be introduced that would impact demand for transportation security scanning products and services. In response to fluctuation in concern on the part of voters about transportation security scanning




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and competing homeland security demands, or for other reasons, the plans for deployment of our PinPoint™ product to screen baggage could be changed. Budgetary debates and delays could result in fewer PinPoint™ products being sold to the TSA.


Governmental agencies have special contracting requirements, which create additional risks.


In contracting with public agencies, we are subject to public agency contract requirements that vary from jurisdiction to jurisdiction. Future sales to public agencies will depend, in part, on our ability to meet public agency contract requirements, certain of which may be onerous or even impossible for us to satisfy.  Government contracts typically contain termination provisions unfavorable to us and are subject to audit and modification by the government at its sole discretion, which subject us to additional risks. These risks include the ability of the U.S. government to unilaterally:


·

suspend or prevent us for a set period of time from receiving new contracts or extending existing contracts based on violations or suspected violations of laws or regulations;

·

terminate of future contracts;

·

reduce the scope and value of our future contracts;

·

audit and object to our contract-related costs and fees, including allocated indirect costs;

·

control and potentially prohibit the export of our products, and

·

change certain terms and conditions in our contracts.


The U.S. government or foreign governments can terminate any of its contracts with us either for its convenience or if we default by failing to perform in accordance with the contract schedule and terms.  Termination for convenience provisions generally enable us to recover only our costs incurred or committed, and settlement expenses and profit on the work completed prior to termination.  Termination for default provisions do not permit these recoveries and make us liable for excess costs incurred by the U.S. government in procuring undelivered items from another source.  Our contracts with foreign governments may contain similar provisions.  In the event we enter into one or more government contracts for PinPoint™, the government’s termination of any such contracts for our PinPoint™ product under development would harm our business.


In addition, U.S. government contracts are conditioned upon the continuing availability of Congressional appropriations. Congress usually appropriates funds annually for a given program on a September 30 fiscal year-end basis, even though contract performance may take years. Consequently, our future contracts with the Department of Homeland Security (“DHS”) may only be partially funded at the outset, and additional monies are normally committed to the contract by DHS only as appropriations are made by Congress for future periods. The government’s failure to fully fund one or more of the contracts for our PinPoint™ product under development would harm our business.


Because we expect to contract with the U.S. government, we will be subject to periodic audits and reviews. Based on the results of its audits, the U.S. government may adjust our contract-related costs and fees, including allocated indirect costs.  In the future, government audits and reviews could result in adjustments to our revenues and cause other adverse effects, particularly to our relationship with the TSA.  In addition, under U.S. government purchasing regulations, some of our costs, including most financing costs, amortization of intangible assets, portions of our research and development costs, and some marketing expenses may not be reimbursable or allowed in our negotiation of fixed-price contracts.  Further, because we expect to contract with the U.S. government, we will be subject to an increased risk of investigations, criminal prosecution, civil fraud, whistleblower lawsuits and other legal actions and liabilities to which purely private sector companies are not.


In addition, public agency contracts are frequently awarded only after formal competitive bidding processes, which are often protracted and typically contain provisions that permit cancellation in the event that funds are unavailable to the public agency. We may not be awarded any of the contracts for which we submit a bid. Even if we are awarded contracts, substantial delays or cancellations of purchases could result from protests initiated by losing bidders.


Our growth depends on our introduction of new products and services, which may be costly to develop and may not achieve market acceptance.


As part of our strategy for growth, we intend to develop products to address additional transportation security scanning opportunities, such as passenger, carry-on baggage and air cargo screening.  We also intend to address homeland security requirements beyond aviation, such as screening at border checkpoints, government offices and transportation terminals and ports.  We will be required to spend funds to develop or acquire technologies and products for these initiatives and these initiatives may divert our development and management resources away from our core PinPoint™ product.  In addition, we have acquired, rather than developed internally, some of our technologies in connection with our acquisitions of companies and businesses, and these technologies may not perform as we expect.  




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The development of new products may require greater time and financial resources than we currently anticipate and, despite significant investments in research and development, may not yield commercially successful products.


The development of our products for explosives and weapons detection is highly complex. Successful product development and market acceptance of any new products and services that we develop depends on a number of factors, including:


·

our timely completion and introduction of new products;

·

our accurate prediction of the demand for homeland security products and the changing requirements of the homeland security industry, including certification or other required performance standards;

·

the availability of key components of our products;

·

the quality, price and operating performance of our products and those of our competitors;

·

our customer service capabilities and responsiveness; and

·

the success of our relationships with potential customers.


Our PinPoint™ product may fail to obtain certification by the Transportation Safety Administration.


New products for transportation security scanning applications may require certification or approval by the Transportation Safety Administration (“TSA”), and we believe that the TSA does not currently have standards for the certification of transportation security scanning products other than bulk explosives detection systems and explosives trace detectors, or ETD.  Other products, such as metal detectors, are subject to TSA testing prior to approval. Market acceptance of new products may be limited if the TSA has not developed standards for certification or approval of such products, and even if it does develop such standards, we may be unable to obtain any such certification or approval, which could materially limit market acceptance of such products.  If we fail to timely introduce new products or if these products fail to gain market acceptance, our results of operations would be harmed.


In addition, even if successful in the United States, new products that we develop may not achieve market acceptance outside of the United States.  Foreign governments may be unwilling to commit financial resources to purchase our new products, which would reduce our potential revenues and harm our business.


Our existing PinPoint™ product may fail to obtain re-certification by the TSA for changes in the PinPoint™ system.


Our existing PinPoint™ product can be required to be re-certified by the TSA.  This can happen when a critical component is changed, or we wish to make other changes to the PinPoint™ systems.  When this happens, the affected PinPoint™ model requires re-certification by the TSA.  The failure or delay in gaining re-certification for an existing PinPoint™ product could harm our ability to continue to sell the product and recognize associated revenues.


Our major potential customer, the TSA, is a part of the Department of Homeland Security, an agency that has experienced, and may continue to experience, delays in its operations, which may cause delays in our receiving orders for our products from the TSA.


The TSA has experienced, and may continue to experience, delays in fulfilling its mandate as a result of ongoing restructuring and establishing necessary infrastructure to operate in an efficient manner.  This may result in delays in our receiving orders for our PinPoint™ product.  Further, the TSA, being an agency under the Department of Homeland Security, may experience changes in direction from DHS in performing their responsibilities or changes in responsibilities, which may further create delays in doing business with the TSA or DHS.


Future sales of our PinPoint™ products will depend on the ability of airports to secure funding to build baggage handling systems and to integrate our PinPoint™ product into such systems, which they may not be able to do.


Future sales will depend on integrating PinPoint™ into existing baggage and luggage handling systems within airports.  If an airport is not configured for these systems, deployment of our PinPoint™ products may require changes in the airport infrastructure.  If our PinPoint™ product cannot easily be integrated into existing baggage handling systems, we may experience reduced sales of our PinPoint™ products or these sales may be delayed.  There can be no assurance that the government will continue to fund installations, integrations and reimbursements at the current level or at all.  If there is a reduction in funding, we may experience reduced sales of our PinPoint™ products or these sales may be delayed.


We believe that a substantial opportunity exists for our PinPoint™ system to be integrated into baggage handling systems.  If airports determine, in conjunction with governmental authorities, that they will be unable or unwilling to modify or finance baggage handling systems, this opportunity may be limited.





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If our PinPoint™ product fails to detect explosives, we could be exposed to product liability and related claims for which we may not have adequate insurance coverage, and we may lose current and potential customers.


Our transportation security scanning business exposes us to potential product liability risks, which are inherent in the development, sale and maintenance of transportation security scanning products.  Our software is not designed to detect, and FAA/TSA certification does not require, 100% detection of any and all explosives contained in scanned baggage.  For this reason, or if our products malfunction, it is possible that explosive material could pass undetected utilizing our product, which could lead to product liability claims.  There are also many other factors beyond our control that could lead to liability claims, such as the reliability and competence of the customer’s operators and the training of the operators.  Such liability claims are likely to exceed any product liability insurance that we may have obtained.


In addition, the failure of any PinPoint™ product to detect explosives, even if due to operator error and not to the mechanical failure of a PinPoint™ product, could result in public and customer perception that our products do not work effectively, which may cause potential customers to not place orders and current customers to cancel orders already placed or to not place additional orders, any of which would harm our business and financial results.


We expect to substantially depend on large orders from a limited number of customers.  As a result, order cancellations from any of our customers or the failure of these customers to continue to purchase PinPoint™ products could have a material negative impact on our business and financial results.


In any given fiscal quarter or year, our revenues may be derived from orders of multiple units of our PinPoint™ product from a limited number of customers.  The failure of these customers, particularly the U.S. government, to purchase our PinPoint™ products or the cancellation of future orders would harm our business.


The sales cycle for our PinPoint™ product is lengthy and we may expend a significant amount of effort in obtaining sales orders and not receive them.


The sales cycle of our PinPoint™ product is expected to be lengthy due to the protracted approval process that typically accompanies large capital expenditures and the time required to install our PinPoint™ product.  In addition, in the United States, the creation of the TSA and formation of a Department of Homeland Security, as well as budgetary debates in Congress, may result in additional delays in the purchase of our PinPoint™ products.  During the sales cycle we may expend substantial funds and management resources but recognize no associated revenue.


Our future international sales subject us to risks that could materially harm our business.


It is part of our growth strategy to establish international sales. A number of factors related to our international sales and operations could adversely affect our business, including:


·

changes in domestic and foreign regulatory requirements;

·

political instability in the countries where we sell products;

·

possible foreign currency controls;

·

fluctuations in currency exchange rates;

·

our ability to protect and utilize our intellectual property in foreign jurisdictions;

·

tariffs, embargoes or other barriers;

·

difficulties in staffing and managing foreign operations;

·

difficulties in obtaining and managing distributors; and

·

potentially negative tax consequences.


Our failure to obtain the requisite licenses, meet registration standards or comply with other government export regulations, may affect our ability to generate revenues from the sale of our products outside the United States, which could harm our business.  In particular, our PinPoint™ product may be deemed regulated and subject to export restrictions under the U.S. Department of State regulations.  Consequently, these regulations may make the product more difficult to sell to a number of countries.  Compliance with government regulations may also subject us to additional fees and costs.  The absence of comparable restrictions on competitors in other countries may adversely affect our competitive position.


Exchange rate fluctuations could cause a decline in our financial condition and results of operations.





38


In 2011, the cost of certain international currencies has decreased, yet such costs may later increase, due to fluctuations in the exchange rate of the U.S. dollar against the Euro or other currencies.  Future fluctuations in this exchange rate or other currencies could adversely affect our results in the event we make foreign sales of our products.  From time to time, as and when we determine it is appropriate and advisable to do so, we will seek to mitigate the effect of exchange rate fluctuations through the use of derivative financial instruments. We cannot assure you, however, that we will continue this practice or be successful in these efforts.


Our inability to adapt to rapid technological change could impair our ability to remain competitive.


The transportation security scanning industry may undergo significant technological development in response to increased demand for transportation security scanning products. A fundamental shift in technology in our product markets could harm our ability to generate revenues from sales of PinPoint™ product and services.


We anticipate that we will incur expenses in the design and initial development and marketing of new products and services. Our competitors may implement new technologies before we are able to, allowing them to provide more effective products at more competitive prices. Future technological developments could:


·

adversely impact our competitive position;

·

require write-downs of obsolete technology;

·

require us to discontinue production of obsolete products before we can recover any or all of our related research, development and commercialization expenses; or

·

require significant capital expenditures beyond those currently contemplated.


We cannot assure investors that we will be able to achieve the technological advances to remain competitive and profitable, that new products and services will be developed and developed on schedule or on a cost-effective basis that anticipated markets will exist or develop for new products or services, or that our existing product and services will not become technologically obsolete.


The transportation security scanning industry is highly competitive. Given the anticipated continuing demand for airport security products, competition may increase.


The transportation security scanning industry is intensely competitive and we may not compete successfully.  As a result of increased demand for security systems, additional companies may enter the industry. Some of our competitors, and many of the potential new entrants into the transportation security scanning  industry, have financial, technical, production and other resources substantially greater than ours.  We believe that some of our competitors have products undergoing TSA certification.  Our failure to compete successfully could result in lost sales and could hamper our financial results.


We expect to become reliant upon third party distributors for the distribution and licensing of our PinPoint™ and Signature Mapping products in several domestic or foreign jurisdictions, and have reduced our reliance upon our own internal sales force.


We have established and continue to seek to establish a network of distributors, sales representatives and consultants to assist us in the distribution and licensing of our products domestically and in certain foreign countries, including those business relationships established prior to 2011.  Such distributors, sales representatives and consultants have not effected any sales of our PinPoint™, or Signature Mapping™ products to date and we have no assurance they will be able to effect any such sales in the future.  We continue to review sales activities under certain of such arrangements and, as our agreements with such third parties expire, we may determine not to renew or we may terminate such agreements, or establish new relationships.


Litigation may be necessary to enforce or defend against claims of intellectual property infringement, which could be expensive and, if we lose, could prevent us from selling our products.


Litigation may be necessary in the future to enforce our intellectual property rights, to protect our trade secrets or to determine the validity and scope of the proprietary rights of others. Any litigation, regardless of the outcome, could be costly and require significant time and attention of key members of our management and technical personnel.


Our domestic and international competitors, many of whom have substantially greater resources and have made substantial investments in competing technologies, may have patents that will prevent, limit or interfere with our ability to manufacture and sell our products. We have not conducted an independent review of patents issued to third parties. Because of the perceived market opportunity we face, companies possessing technology rights that they believe we might be infringing will now be much more motivated to assert infringement of their rights. These third parties may assert infringement or invalidity claims against us and litigation may be necessary to defend against these claims. An adverse outcome in the defense of a patent suit could subject us to significant liabilities to third parties,




39


require disputed rights to be licensed from third parties or require us to cease selling our products. Even successful defenses of patent suits can be costly and time-consuming.


ITEM 1B.  UNRESOLVED STAFF COMMENTS


Not applicable to Registrant as Registrant is not an “accelerated filer” or “large accelerated filer” as such terms are defined in Rule 12b-2 under the Exchange Act.


ITEM 2.     PROPERTIES

The Company previously leased 15,253 square feet for its headquarters building in Herndon, Virginia, pursuant to a 5 year commercial lease that expired on April 30, 2010. The annual base rental rate during the last year of the lease was approximately $24,557.  The Company elected not to exercise the renewal option provision of the lease, and negotiated with the landlord to lease 3,269 square feet of office space in the same business park. The new lease, for a monthly lease payment of $5,585 was entered into on April 13, 2010, and initially expired on April 30, 2011, was extended to October 31, 2011, and subsequently to January 1, 2012.  Although the extension did not contain a renewal option, the landlord agreed to a one year lease effective February 1, 2012, for a monthly lease payment of $5,764, and expires on January 31, 2013. The security deposit for the lease remains at $11,122. The Company’s principal offices are located at 250 Exchange Place, Suite H, Herndon, Virginia 20170. Our telephone number at such address is (703) 464-5495.


ITEM 3.     LEGAL PROCEEDINGS


None.


PART II


ITEM 5.     MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES


Our common stock is quoted on the OTC Bulletin Board.  Since, July 9, 2010, our stock has been quoted under the symbol “APVS,” and prior to such time our stock was quoted under the symbol “GDTI.”  The following table sets forth the high and low bid prices for each quarter during 2011 and 2010.


Fiscal Year Ended December 31, 2011:

High

Low

   First Quarter

$0.38

$0.17

   Second Quarter

$0.25

$0.13

   Third Quarter

$0.19

$0.08

   Fourth Quarter

$0.12

$0.03

 

 

 

Fiscal Year Ended December 31, 2010:

 

 

   First Quarter

$0.23

$0.11

   Second Quarter

$0.48

$0.13

   Third Quarter

$0.69

$0.25

   Fourth Quarter

$0.38

$0.25


These quotations reflect interdealer prices, without retail markup, markdown, or commission and may not represent actual transactions.  As of April 10, 2012, there were approximately 291 holders of record of our common stock.  This amount does not include beneficial owners of our common stock held in “street name.”  Our stock and warrant transfer agent is Signature Stock Transfer, Inc., 2632 Coachlight Court, Plano, Texas. Signature’s telephone number in the U.S. is (972) 612-4120, and their Internet address is www.signaturestocktransfer@msn.com.

Dividends

We have never declared or paid cash dividends on our common stock.  Currently, we intend to retain earnings, if any, to support our growth strategies and do not anticipate paying cash dividends in the foreseeable future. Payment of future dividends, if any, will be at the discretion of our Board of Directors after taking into account various factors, including our financial condition, operating results, current and anticipated cash needs and plans for expansion.




40



SECURITIES AUTHORIZED FOR ISSUANCE UNDER EQUITY COMPENSATION PLANS


The following table sets forth, as of December 31, 2011, information with regard to equity compensation plans (including individual compensation arrangements) under which our securities are authorized for issuance.


Plan Category

Number of Securities to be issued upon exercise of outstanding options and rights

Weighted-average exercise price of outstanding options and rights

Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in column (a))

Equity compensation plans approved by stockholders

14,788,489 

$0.32 

12,907,211 

Equity compensation plans not approved by stockholders

13,334,507 

Total

14,788,489 

$0.32 

26,241,718 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 


RECENT SALES OF UNREGISTERED SECURITIES

On April 12, 2012, the Company issued promissory notes to accredited investors in the aggregate principal amount of $35,000. $25,000 matures on August 12, 2012 and $10,000 matures on April 12, 2013.  The short-term notes accrue interest at a rate of 12% per annum.  The Company also issued to the note holders an aggregate of 60,000 shares of common stock. The common stock was issued in reliance upon the exemption from the registration requirements set forth in Section 4(2) of the Securities Act and/or Rule 506 of Regulation D promulgated thereunder.


On March 15, 2012, the Company sold to an accredited investor an aggregate of 100,000 shares of common stock and 300,000 Class Q Warrants for gross proceeds of $25,000.  The warrants are exercisable at a price of $0.25 per shares; contain a conditional call provision if the market price of each share exceeds $3.00, and customary anti-dilution provisions.  The warrants expire thirty-six (36) months from the date of issuance. The common stock and Class Q warrants were issued in reliance upon the exemption from the registration requirements set forth in Section 4(2) of the Securities Act and/or Rule 506 of Regulation D promulgated thereunder.


In January 2012, the Company issued promissory notes to accredited investors in the aggregate principal amount of $100,000. $50,000 matures on November 10, 2012 and $50,000 matures on January 25, 2013.  The short-term notes accrue interest at a rate of 12% per annum.  The Company also issued to the note holders an aggregate of 150,000 shares of common stock. The notes and common stock were issued in reliance upon the exemption from the registration requirements set forth in Section 4(2) of the Securities Act and/or Rule 506 of Regulation D promulgated thereunder.


During the period of October through November 16, 2011, the Company issued twelve-month promissory notes to a total of two accredited investors’ in the aggregate principal amount of $400,000.  The twelve-month notes accrue interest at a rate of 12% per annum. The Company also issued to the note holders an aggregate of 400,000 shares of common stock.  The notes and common stock were issued in reliance upon the exemption from the registration requirements set forth in Section 4(2) of the Securities Act and/or Rule 506 of Regulation D promulgated thereunder.


On October 11, 2011, the Company sold to an accredited investor an aggregate of 44,000 shares of common stock and 88,000 Class Q Warrants for gross proceeds of $11,000. The warrants are exercisable at a price of $0.25 per shares; contain a conditional call provision if the market price of each share exceeds $3.00, and customary anti-dilution provisions. The warrants expire thirty-six (36) months from the date of issuance. The common stock and Class Q warrants were issued in reliance upon the exemption from the registration requirements set forth in Section 4(2) of the Securities Act and/or Rule 506 of Regulation D promulgated thereunder.


On October 19, 2011, the Company issued to a consultant 150,000 shares of common stock as compensation for financial advisory services. The Common Stock was issued in reliance upon the exemption from the registration requirements set forth in Section 4(2) of the Securities Act and Rule 506 of Regulation D promulgated thereunder.


ITEM 6.     SELECTED FINANCIAL DATA





41


The selected financial data set forth below for Applied Visual Sciences, Inc. for the years ended December 31, 2011, and 2010, are derived from the audited consolidated financial statements and related notes included in this report. Historical results are not necessarily indicative of the results of operations for future periods.  The data set forth below is qualified in its entirety by and should be read in conjunction with Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations and our consolidated financial statements set forth in full elsewhere in this report.


Selected Financial Date

Year Ended December 31

 

2011

2010

Statement of Earnings Data:

 

 

Revenue

 $ 6,589 

 $ 110,499 

Operating loss

  (2,735,189)

  (4,643,400)

Net loss

  (1,154,376)

  (3,650,231)

Adjustments to reconcile net loss to net cash used in operating activities:

 

 

  Depreciation and amortization

  93,419 

  110,084 

  Amortization of debt discounts

  6,113 

  - 

  Stock-based compensation expense (1)

  451,613 

  1,559,215 

  Fair value of warrants issued - derivative instruments (2)

  - 

  38,550 

  Revaluation of derivative instruments expense (income) (3)

  (1,958,318)

  1,139,980 

  Revaluation of debenture default provision expense (income) (4)

  337,641 

  (2,587,216)

  Gain on settlement of debt (5)

  - 

  (265,600)

  Noncash broker compensation expense

  25,000 

  - 

  Other noncash - stock issued in lieu of interest paid

  - 

  681,117 

Per Share Data:

 

 

Basic and Diluted Loss Per Share

 $ (0.01)

 $ (0.05)

Cash Flow Data:

 

 

Net cash provided (used) in operating activities

 $ (686,287)

 $ (1,230,527)

Net cash provided (used) in investing activities

  (27,997)

  (79,926)

Net cash provided by financing activities

  715,900 

  1,306,230 

Effect of exchange rates on cash and cash equivalents

  - 

  390 

Balance Sheet Data:

 

 

Cash and Cash Equivalents

 $ 6,490 

 $ 4,874 

Total Assets

  606,745 

  756,749 

Total Liabilities

  10,432,552 

  10,822,318 

Common Shares Subject to Repurchase

  - 

  98,946 

Stockholders' Equity (Deficit)

  (9,825,807)

  (10,164,515)

 

 

 

(1) Stock-based compensation expense represents the estimated fair value of stock-based compensation to employees and consultants in lieu of cash compensation.

(2) Represents non-cash expense for issuance of warrants measured at fair value in consideration of ASC 815-40 (formerly EITF 00-19) relating to provisions for Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company*s Own Stock.

(3) Represents non-cash expense (income) from the revaluation of embedded derivative feature of the outstanding convertible debentures issued in November 2006 and April 2007. This reflects the conclusion that convertible note contracts should be analyzed under the provisions of ASC 815-10 (formerly SFAS 133) relating to  *Accounting for Derivative Instruments and Hedging Activities,* and the embedded derivative features should be bifurcated and separately measured at fair value.  We also considered ASC 815-40 (formerly EITF 00-19) relating to the provisions for Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company*s Own Stock.

(4) Represents non-cash expense (income) from the revaluation of a default provisions for a contingency due to an event of default on the convertible debentures and in considering FASB No. 5, "Accounting for Contingencies"

(5) Represents non-cash income from the elimination of the beneficial conversion feature upon conversion of the debt related to the convertible debentures issued in November 2006 and April 2007.  We considered ASC 815-40 (formerly EITF 00-19) relating to the provisions for Accounting for Derivative Financial Instruments Indexed to, and Potentially settled in, a Company's own Stock.

 

 

 

 

 

 



ITEM 7.     MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS


GENERAL





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You should read the following summary together with the more detailed information and consolidated financial statements and notes thereto and schedules appearing elsewhere in this report.  Throughout this report when we refer to the “Company,” “Applied Visual Sciences,” “we,” “our” or “us,” we mean Applied Visual Sciences, Inc., and its subsidiaries.


This discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities.  On an on-going basis, we evaluate our critical accounting policies and estimates, including those related to revenue recognition, intangible assets, and contingencies.  We base our estimates on historical experience, where available, and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources.  Actual results may differ from these estimates under different assumptions and conditions.


Except for historical information, the statements and other information contained in this Management’s Discussion and Analysis is forward-looking.  Our actual results could differ materially from the results discussed in the forward-looking statements, which include certain risks and uncertainties.  These risks and uncertainties include the rate of market development and acceptance of our “intelligent imaging informatics” (“3i™”) technology (particularly for our PinPoint™ and Signature Mapping™ products), the unpredictability of our sales cycle, the limited revenues and significant operating losses generated to date, and the possibility of significant ongoing capital requirements.


Our independent registered public accounting firm’s report on the consolidated financial statements included herein for the years ended December 31, 2011 and 2010 contains an explanatory paragraph wherein they expressed an opinion that there is substantial doubt about our ability to continue as a going concern. Accordingly, careful consideration of such opinions should be given in determining whether to continue or become our stockholder.


OVERVIEW


Applied Visual Sciences, Inc. was incorporated under the name Guardian Technologies International, Inc., in the Commonwealth of Virginia in 1989 and reincorporated in State of Delaware in February 1996.  We changed our name to Applied Visual Sciences, Inc., on July 9, 2010.  Applied Visual Sciences, Inc. and its subsidiaries are collectively referred to herein as the “Company,” “Applied Visual Sciences, Inc.,” “Applied Visual,” “us,” “we,” or “our.”


Applied Visual Sciences is a software technology company that designs and develops imaging informatics solutions for delivery to its target markets through its two operating subsidiaries: Guardian Technologies International, Inc. for aviation/homeland security and Signature Mapping Medical Sciences, Inc., for healthcare. On March 23, 2012, the Company established a new entity; Instasis Imaging, Inc., for the development, marketing, and sales of a suite of imaging analytic applications for the automated detection of breast cancer. We may engage in one or more acquisitions of businesses that are complementary, and may form wholly-owned subsidiaries to operate within defined vertical markets.


The Company utilizes imaging technologies and analytics to create integrated information management technology products and services that address critical problems experienced by corporations and governmental agencies in healthcare and homeland security.  Each product and service can improve the quality and response time of decision-making, organizational productivity, and efficiency within the enterprise.  Our product suite integrates, streamlines, and distributes business and clinical information and images across the enterprise.


Please refer to Item 1A – Risk Factors, above for certain risks related to us and our business.


Our Business Strategy


Our strategic vision is to position our core technology as the de facto standard for digital image analysis, knowledge extraction, and detection.  Our strategy is based upon the following principal objectives:


·

Maintain product development and sales/marketing focus on large, underserved, and rapidly growing markets with a demonstrated need for intelligent imaging informatics.

·

Leverage Applied Visual Sciences, Inc.’s technology, experienced management team, research and development infrastructure.

·

Focus our talents on solving highly challenging information problems associated with digital imaging analysis.

·

Establish an international market presence through the development of a significant OEM/Reseller network.

·

Build and maintain a strong balance sheet to ensure the availability of capital for product development, acquisitions, and growth.




43


·

Seek to broaden our investment appeal to large institutions.


To achieve our strategic vision, we are aware of the need to exercise the financial and operational discipline necessary to achieve the proper blend of resources, products and strategic partnerships.  These efforts can accelerate our ability to develop, deploy and service a broad range of intelligent imaging informatics solutions directly to our target markets and indirectly through OEM/value added reseller (“VAR”) partners.  During 2011, we continued implementing changes across the spectrum of our business. We refined our marketing strategy for PinPoint™ and Signature Mapping™, and enhanced our Signature Mapping™ product offerings.


We may engage in one or more acquisitions of businesses that are complementary, and may form wholly-owned subsidiaries to operate within defined vertical markets


Our Core Technology


Our core technology is an “intelligent imaging informatics” (“3i™”) engine that is capable of extracting embedded knowledge from digital images, and has the capacity to analyze and detect image anomalies.  The technology is not limited by type of digital format. It can be deployed across divergent digital sources such as still images, x-ray images, video and hyper-spectral imagery.  To date, the technology has been tested in the area of threat detection for baggage scanning at airports, for bomb squad applications and the detection of tuberculosis by analyzing digital images of stained sputum slides captured through a photo microscopy system.  Varying degrees of research and development have been conducted in the areas of detection for cargo scanning, people scanning, military target acquisition in a hyper-spectral environment, satellite remote sensing ground surveys and mammography CAD products and radiologists’ diagnostic imaging tools, and while product development in these areas is ongoing, there can be no assurance that we will successfully develop product offerings in these areas.

  

We are currently focused on providing software technology solutions and services in two primary markets - aviation/homeland security with PinPoint™ and healthcare technology with Signature Mapping™ solutions.  However, as new or enhanced solutions are developed, we expect to expand into other markets such as military and defense utilizing hyper-spectral technology, and imaging diagnostics for the medical industry.


Patents and Proprietary Rights


We rely on a combination of common law trademark, service mark, copyright and trade secret law and contractual restrictions to establish and protect our proprietary rights and promote our reputation and the growth of our business.  We do not own any patents that would prevent or inhibit our competitors from using our technology or entering our market, although we intend to seek such protection as appropriate.  It is our practice to require all of our employees, consultants and independent contractors to enter into agreements containing non-disclosure, non-competition and non-solicitation restrictions and covenants, and while our agreements with some of our customers and suppliers include provisions prohibiting or restricting the disclosure of proprietary information, we can not assure you that these contractual arrangements or the other steps taken by us to protect our proprietary rights will prove sufficient protection to prevent misappropriation of our proprietary rights or to deter independent, third-party development of similar proprietary assets.


The United States Patent & Trademark Office (“USPTO”) has granted the Company six patents, all of which are related to our underlying 3i™ technology.  We also have nine pending patents applications (U.S. and foreign) that further cover the implementation of our core 3i™ technology.   We cannot provide assurance that any or all of the remaining patent applications or the provisional application will be issued patents, or that they will not be challenged, or that rights granted to us would actually provide us with an advantage over our competitors.  Prior art searches have been conducted and, based on the results of these searches; we believe that we do not infringe any third party patents identified in the searches.


Date Granted

Patent No.

Patent Description

February 17, 2009

7,492,937

System and Method for Identifying Objects of Interest in Image Data

February 24, 2009

7,496,218

System and Method for Identifying Objects of Interest in Image Data

October 19, 2010

7,817,833

System and Method for Identifying Feature of Interest in Hyperspectral Data

November 23, 2010

7,840,048

System and Method for Determining Whether There is an Anomaly in Data

March 15, 2011

7,907,762

Method of Creating a Divergence Transform for Identifying a Feature of Interest in Hyperspectral Data

October 25, 2011

8,045,805

Method for Determining Whether a Feature of Interest Anomaly is Present in an Image


Due to the rapid pace of technological change in the software industry, we believe patent, trade secret and copyright protection are less significant to our competitive edge than factors such as the knowledge, ability and experience of our personnel, new product development, frequent product enhancements, name recognition and the ongoing reliability of our products.


Aviation/Homeland Security Technology Solution - PinPoint™




44



Through our wholly-owned subsidiary, Guardian Technologies, we market our PinPoint™ product, which is an “intelligent imaging informatics” (3i™) technology for the detection of guns, explosives, and other threat items contained in baggage in the airport environment or for building security applications.  PinPoint™ can identify threat items, notify screeners of the existence of threat items, and speed the security process by eliminating unnecessary baggage checks, provide the screener with an instantaneous second opinion, and reduce processing time spent on false positives (baggage selected for security review that contains no threat items).  We market and seek to license the PinPoint™ product primarily to the United States Transportation Services Administration (TSA) for use in airports, the Federal Protection Services for use in federal buildings and to foreign governments and airport authorities.  We compete with manufacturers of baggage screening, luggage and large parcel screening, people screening for weapons and explosive detection, container and vehicle screening, and cargo screening equipment and certain software companies and academic institutions that are developing solutions to detect threat items.  It is also our intent to distribute the product through various distribution methods.


The market for contraband detection systems has become intensely competitive and many of our competitors are better capitalized and have greater marketing and other resources than Applied Visual Sciences, Inc.  PinPoint™ continues to be developed to address the market for contraband detection.  The extended alpha version of PinPoint™ has been tested successfully at live carry-on baggage checkpoints in three international airports.  Integration within currently deployed manufacturers’ scanning equipment is a requisite to anticipated sales, and is considered a significant development risk.  PinPoint™ is available for sale to customers; however no sales are anticipated until we are able to seamlessly integrate with the manufacturers’ scanning equipment.


To date the marketplace has placed a premium on the newest innovations in hardware technology and has failed to grasp how a threat detection software solution can succeed.  It was expected that a major joint initiative between the Department of Homeland Security (DHS) and the National Electrical Manufacturers Association (NEMA) would open a path to both increase the interoperability of security equipment as well as provide a mechanism to use third party threat detection software as part of the screening solution.  This enabling initiative is the Digital Imaging and Communications in Security (DICOS) standard, similar to the Digital Imaging and Communications in Medicine (DICOM) standard.  With a defined standard for the output of each screening device, complimentary automated threat detection software can be appended to any x-ray equipment.  Applied Visual Sciences, Inc co-chaired one of the three NEMA working groups drafting the DICOS standard, and the DICOS standard was published in October 2010.  To date DHS has not made this standard a mandatory requirement for proposals or procurements which, as a result, has not enabled third party detection software providers the ability to enter the marketplace which has given an undue advantage to the existing security equipment providers.  


As highlighted below in the NEMA article, “DICOS - Homeland Security Spending Keeps on Growing” - Published by HYPE, expenditures for security solutions are increasing.  Management believes Applied Visual Sciences, Inc. is well positioned to be a third party solution provider leveraging the standard output of all future security equipment procured by the US Government. “Global homeland security spending has received a major boost in light of recent international terrorist events, as countries look at new ways to thwart terrorists and secure borders.  Spending in the industry is expected to triple to $178 billion by 2015.  Security-related spending will include more sophisticated information technology and the protection of other vulnerable terrorist targets.  With the initial focus on airport security, NEMA has stepped up its outreach to DHS and TSA.  Currently developing DICOS, the new NEMA standard will capture scans of checked baggage so that scans can be read by threat detection software.  The new standard will facilitate interoperability of security-imaging equipment.  With DHS/TSA expected to purchase new equipment for over 400 U.S. airports, NEMA members have joined with DHS to develop the standard.  Phase II of DICOS, for the testing of the new NEMA standards, began in April 2011, and NEMA has begun looking at other modalities.  The security industry is looking at border, rail, seaport, industrial and nuclear plant security.  


We have been involved in three wide ranging U.S. Government proposals during 2011.  We have teamed on two of the proposals with large, well-known defense contractors and a federally funded research laboratory.  The teamed proposals were submitted to the Department of Defense and the U.S. Navy, while the third project was a direct submission to the Department of Homeland Security, Science and Technology Directorate.  Unfortunately, all three projects were deferred due to the ongoing federal budget discussions in Congress and operational uncertainties within the funding agencies.  At this point in time, we have no indication that any of these projects will be funded this fiscal year or the next budget cycle.  We will continue to pursue opportunities for the deployment of our PinPoint™ product as opportunities develop, however, as discussed above, we believe our ability to successfully market our PinPoint™ product is contingent upon our ability to enter into a strategic arrangement with a scanner manufacturer to install our software on scanners offered by such manufacturers, of which there can be no assurance.  With these uncertainties and our ability to manage with limited cash resources during 2011, we have focused on the marketing and sale of our healthcare products, as discussed below.


Healthcare Technology Solutions - Signature Mapping™


In an effort to expand upon the use of our core technology 3i™ “intelligent imaging informatics,” we are adopting our threat detection algorithms and quantitative imaging capabilities for use in the imaging field of diagnostic radiology and pathology.  The technology is called Signature Mapping™.  Our Signature Mapping™ platform technology represents the technological basis upon which




45


our diagnostic radiology and pathology applications will be developed.  Any Signature Mapping™ product introduced in the United States may be subject to Food and Drug Administration (“FDA”) review and approval, including with regard to its safety and effectiveness before we may begin marketing and selling any such product in the U.S. Such approval may require us to obtain extensive data from clinical studies to demonstrate such safety or effectiveness.  Within the international markets the regulatory requirements differ, specifically in South Africa, where we have been testing our TBDx™ application for the detection of tuberculosis by analyzing digital images of auramine stained sputum slides captured through a photo microscopy system.  There may be similar regulatory requirements in foreign countries in which we seek to market and sell our healthcare CAD products.  As of the date of this report, we have developed and continue to develop two TB diagnostic products, TBDx™ and TBDxV™ and our SMDS™ product, an automated hardware-software laboratory solution.


Laboratory Pathology:  SMDS™


Signature Mapping Detection System (“SMDS™”) is an automated hardware-software laboratory solution designed to operate one or multiple infectious disease applications via multi-threaded detection algorithms.  SMDS™ automation software controls every movement of the integrated hardware components from slide management to image capture.  Where SMDS™ is integrated with a specific infectious disease detection application; the solution is capable of automatically analyzing each field-of-view for the presence of specific characteristics of the targeted disease.  The detection algorithms will perform with high sensitivity without sacrificing specificity.  The end product is a flexible; user defined diagnostic patient report that can be integrated to a laboratory information system.  Standard information includes patient information, processing date, field-of-view diagnostic findings and overall case severity or diagnostic finding.


In laboratory environments that use the image capture and visualization capabilities of Signature Mapping™ without specific infectious disease algorithms or in situations where the interface of the laboratory technician with the computer-aided identification software is a desired procedure, the SMDS™ laboratory platform includes the Decision Support Quick View (“DSQV”) module.  DSQV has been designed for rapid review of captured images and increased speed in diagnostic decision-making.  DSQV includes post-processing image tools to magnify, zoom or review images in alternative formats.  Using a high-resolution touch-screen monitor and an icon-driven menu system facilitates ease of use for even the most computer challenged individuals.  Signature Mapping SMDS™ includes built-in networking support to allow DICOM images to be transmitted for remote diagnosis or to be interfaced with an enterprise network.


When SMDS™ is integrated with a disease specific automated detection algorithm, such as Signature Mapping Tuberculosis Detection (“TBDx™”), the solution expands to a fully automated diagnostic system.  For high volume diagnostic laboratories, automation begins with a slide loader capable of processing up to 200 slides without human intervention.  At system initialization the slide loader automatically inventories every patient slide to be processed.  One-by-one the slides are moved from the holding cassettes onto the automated stage of the microscope.  A barcode reader collects information about the patient just prior to the slide being placed on the stage.  Information captured by the barcode reader can be automatically transferred to a laboratory information system along with the captured digital images and diagnostic case findings.


Once the slide has been positioned on the microscope stage, the automation software initiates the process of focusing the microscope system to maximize the quality of images to be captured.  Because the specimen on the slide may be topographical and/or the z-axis of the slide may require compensation, the automation software calculates the required adjustments to ensure high quality digital images are captured.  Further, the automation software is easily configured to capture fields-of-view in any quantity using a user established pattern of image capture.  The automation software can focus the microscope stage in approximately one minute and requires an additional minute per each one hundred high quality digital images to be captured.


TBDx™ - TBDxV™


The Company has developed two products for tuberculosis.


·

Signature Mapping Tuberculosis Detection (“TBDx™”) features automatic tuberculosis (“TB”) detection capabilities by analyzing digital images of Auramine-O stained sputum slides captured through a photo microscopy system.  We completed Phase II clinical trials in South Africa during 2011, which was a nested sub-study to the international Thibela TB Study trial at the Aurum Institute for Health Research.

·

Signature Mapping TBDx™ Visualization (“TBDxV™”), the precursor to TBDx™, is a fully automated tuberculosis visualization technology that has a 200-slide capacity auto-loader that delivers individual slides to a microscope and collects 100 fields of view from each stained tuberculosis sputum slide.  Fields of view will be presented to the microscopist on a workstation monitor thereby alleviating the tedious and error prone diagnosis using a microscope, and will assist microscopists in decision making on the most difficult cases through the visualization tools and digital imagery to improve diagnostic accuracy. The visualization tools are applicable to both Auramine-O and Ziehl-Neelsen staining processes.  





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Both TBDx™ and TBDxV™ address the approximately 52 million diagnostic slides analyzed by clinical lab technicians each year, and are targeted to government and private institutions that screen tuberculosis patients.  India processes more TB diagnostic cases than anywhere in the world and the workload has overwhelmed the country's laboratory resources.  The Company is working closely with the Indian government and private organizations regarding our TBDx™ diagnostic system for the migration to the Ziehl-Neelsen staining process, with a belief that we can further enhance their TB diagnostics productivity after clinical trials are complete and other government clearances are received.


Radiology:  BCDx™


The Company is adding vision to breast cancer diagnosis by developing a radiological suite of products.  by developing a breast cancer detection solution to be known as Signature Mapping™ Breast Cancer Detection (“BCDx™”). Within the U.S. the annual estimates of breast cancer diagnostic activity are: 35 million mammograms performed; 1.5 million biopsies performed; 87% of biopsies return a negative finding (mammogram ‘false positive’); 200,000 confirmed cancer cases; and immeasurable emotional, mental, and physical pain for the individuals and families of biopsy patients.  The 1.3 million biopsies undertaken that resulted in negative findings can be directly attributed to an inability to resolve areas of concern due to the limited information provided in the mammography images.  In addition, approximately 10% of cancerous lesions are missed – partly due to dense tissue obscuring the cancer or the appearance of cancer having common characteristics with the appearance of normal tissue.  The goal of BCDx™ is to deliver sophisticated image analysis processes that provide enhanced visualization capabilities and automated detection algorithms to help prevent unnecessary biopsies, while flagging previously unseen lesions for additional review.


Similar to a person’s fingerprint, each tissue has a unique structure.  Each structure creates a unique pattern or “signature” that can be extracted from an image to differentiate, locate, identify, and classify by using our Signature Mapping™ technology, management expects BCDx™ to further help radiologists by visualizing the various structures within a particular tissue so they can be examined and quantified.  This capability is expected to provide a next-generation image analysis, clarification, visualization and Signature Mapped™ “tissue characterization” and detection.  Management believes that it will add significant clinical value to a wide range of difficult to detect diseases in diagnostic radiology by distinguishing and characterizing different tissue types in images regardless of the modality that generated the image.


Based on its unique properties, Signature Mapping™ is expected to be capable of being used to analyze images generated across all imaging modalities without the need for new image capture hardware costs.  It will serve as a software-based, multi-modality approach to image analysis when combined with Signature Mapping’s™ unique” tissue characterization” and detection. As a result, Signature Mapping™ is expected to differentiate the contrast resolution between different tissue types, even when the material or tissue in the image is very diffuse or obscured by other objects, such as is the case where diseased lung tissue is located behind a rib in an x-ray chest examination. It is capable of displaying these ‘signatures’ in a way that empowers radiologists to make a more informed and confident diagnosis, even for hard to distinguish structures such as masses in dense breast tissue.


Signature Mapping™ appears to provide advantages for providing the knowledge for automatic detection.  The development of a “tissue characterization” and detection model employs the use of supervised machine learning and contextual image analysis to analyze and classify the features associated with the newly created “signatures.”  The fusion of these three technologies is known as Applied Visual Sciences, Inc.’s Intelligent Imaging Informatics 3i™. Unlike other pattern recognition methodologies, the 3i™ solution can reveal and differentiate inherent structures for all materials in an image regardless of:  the imaging modality used to create the image, location within the image, shape or texture, and object orientation even if obscured by its relationship to other materials.


Clinical Experience and Medical Accomplishments


While Signature Mapping™ is expected to be capable of use in a wide range of medical image analysis applications, our initial application product development efforts are focused in four areas:


·

detection of tuberculosis by analyzing digital images of stained sputum slides captured through a photo microscopy system;

·

breast cancer detection using x-ray mammography, MRI and ultrasound;

·

neurological imaging analysis through the detection and quantification of acute intracranial hemorrhage using non-contrast CT, normal pressure hydrocephalus,

·

multiple sclerosis using MRI; and

·

chest radiography targeted at tuberculosis and silicosis detection using digital x-ray.


Laboratory Pathology:  TBDx™


First clinical evaluation of Signature Mapping™ Tuberculosis Detection (“TBDx™”) product - an automated tuberculosis detection sputum smear microscopy system, in cooperation with the South African National Health Laboratory Services (“NHLS”) and




47


the Aurum Institute for Health Research.  Principal investigators included, James J. Lewis, Violet N. Chihota, Minty van der Meulen, Bernard Fourie, Gerrit Coetzee, Katherine L. Fielding, Alison D. Grant, Susan E. Dorman, and Gavin J. Churchyard.


Background: Smear microscopy remains the most common method of diagnosing tuberculosis in many high-burden countries.  This is despite numerous limitations, including a lack of well-trained microscopists and reduced performance resulting from the substantial work load and poor ergonomics of the process.  An automated microscopy system TBDx™ has been developed that presents an innovative, multi-potential technology platform for automatically detecting TB from sputum slides.  The system loads slides onto a conventional microscope, automatically focuses and digitally captures images, and then uses Signature Mapping™, a set of specially developed image-analysis algorithms, to classify slides as TB positive or negative.


Objectives: To compare the diagnostic performance of TBDx™ in identifying tuberculosis from sputum smear microscopy slides stained with Auramine, using culture as the gold standard, to a human microscopist and to evaluate the effect of TBDx™ on the microscopist’s workload.


Methods: This study is nested within a cross-sectional study of South African gold miners with suspected pulmonary TB.  All TB suspects had one sputum sample collected for smear microscopy, MGIT culture and MPB64 organism identification.  All slides were read by a research and two routine microscopists, and then independently by TBDx™, each classifying slides based on the World Health Organization (“WHO”) classification standard of 100 fields of view (“FoV”) at 400x magnification.  For slides adjudged scanty by TBDx™, the digital FoV with suspected acid-fast bacilli (“AFB”) were reviewed by the research microscopist, using TBDx™ in decision support system mode (TBDx™-DSS), a mode presenting digital images of slides assisted by image enhancement tools.  The diagnostic performance of three algorithms was evaluated: TBDx™ alone; TBDx™ with review of scanty positive FoV images by the microscopist (TBDx™-DSS mode); TBDx™ with research microscopist’s readings substituted for slides judged by TBDx™ to be scanty positive.


Results: Of 981 participants, 269 were culture positive for Mycobacterium tuberculosis (27.4%) and 712 were culture negative (72.6%). TBDx™ alone had higher sensitivity (75.8%) than the research microscopist, but greatly reduced specificity (Table 1). TBDx™ classified 520/981 slides (53.0%) as scanty, with the majority of these slides having only 1-2 AFBs detected (371/520=71.3%). Of these, only 68/371 (18.3%) were culture positive, which was similar to TBDx™ negative slides (17.3%). Changing the algorithm to classify 0-2 AFBs on TBDx™ as negative gave improved specificity.  Combining this algorithm with an image review of positive FoV on TBDx™-DSS, scanty positive (3-9 AFBs) slides gave similar performance to that of the routine microscopists and reduced the number of FoV to be read by a microscopist by 99.7%.  Finally, an algorithm in which slides with 3-9 AFB on TBDx™ were replaced with the original research microscopist’s read gave sensitivity of 42.0%, specificity of 99.2% and resulted in an 84.8% reduction in the number of slides to be read by the research microscopist.  The negative predictive value (“NPV”) for all methods was similar.


Conclusion: The automated microscopy TBDx™ system has comparable performance to routine microscopy in this study and could greatly reduce the work load of microscopists in many high-burden settings as a Decision Support System (“DSS”). Further optimization of the TBDx™ system and training of microscopists in digital microscopy is required and is ongoing.  Opportunities for further research include the tuning of the present algorithms for LED-based light sources and the development of algorithms for Ziehl-Nielsen stained slides.


Table 1: performance characteristics of human microscopist versus the TBDx™ automated microscopy system, using culture as the gold standard.



Diagnostic method


Sensitivity


Specificity


PPV


NPV

FoV requiring human review

Protocol specified (0 AFB = negative; 1-9 AFB = scanty)

Research microscopist

52.8%

98.6%

93.4%

84.7%

98,100

Consensus of two routine microscopists

48.3%

95.8%

81.3%

83.1%

196,200

TBDx alone

75.8%

43.5%

33.7%

82.7%

0

Algorithm optimization (0-1 AFB = negative; 2-9 AFB = scanty)

TBDx alone

59.5%

71.8%

44.3%

82.4%

0

TBDx with research microscopist reviewing TBDx™ scanty positive FoV images (TBDx™-DSS)

56.1%

83.7%

56.6%

83.5%

847

TBDx with research microscopist’s readings for slides judged by TBDx™ to be scanty positive

45.0%

99.2%

95.3%

82.7%

27,500

Algorithm optimization (0-2 AFB = negative; 3-9 AFB = scanty)

TBDx alone

50.6%

86.1%

57.9%

82.2%

0

TBDx with research microscopist reviewing TBDx scanty positive FoV images (TBDx™-DSS)

48.0%

91.4%

67.9%

82.3%

597

TBDx with research microscopist’s readings for

 

 

 

 

 




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slides judged by TBDx™ to be scanty positive

42.0%

99.2%

95.0%

81.9%

14,900

AFB = acid-fast bacilli; PPV = positive predictive value; NPV = negative predictive value; FoV = fields of view.

Sensitivity = measures the proportion of actual positive which are correctly identified as having that condition.

Specificity = measures the proportion of negatives which are correctly identified.


Competition: There is no current computer-aided-detection for TB sputum microscopy analysis that can be identified as competition to Signature Mapping™.  Although, there are substitute technologies that compete for sputum specimen analysis, such as the Cepheid Systems GeneXpert® System, a dip-stick or biomarker approach that is considered a competitor to Signature Mapping™.  Ultimately, competition to our approach will be driven by its cost per procedure, ease-of-use, sensitivity and specificity, and ability to be used by non-trained or lightly trained personnel in the point of care environment.  These emerging tests are Polymerase Chain Reaction, TB Breathalyzer, Q-Beta Replicase Assay, Transcription-Medicated Amplification, Ligase Chain Reaction, Strand Displacement Amplification, Nucleic Acid Sequence-Based Amplification and Branched DNA.


Breast Cancer Detection:  BCDx™


Our research to-date includes five programs and studies conducted under the direction of the Image Processing and Informatics Laboratory at the University of Southern California (“USC”) using clinical data and images provided by: the Image Processing and Informatics Laboratory at USC, Howard University, and the South Florida Clinical Mammography Data Base.  Competition is expected with existing computer-aided-detection (“CAD”) manufactures such as iCAD, Hologic, Medipatten, Confirma, Siemens, or Carestream Health.  We may partner with one or more of these existing CAD manufacturers, or with an emerging company with new technology for the CAD arena.  Once our products are commercially viable, we anticipate marketing and selling our products through original equipment manufacturers (“OEM”), or system integrators.


LIQUIDITY AND CAPITAL RESOURCES


The following table presents a summary of our net cash provided by (used in) operating, investing and financing activities:


 

 

Year Ended December 31

Category

 

2011

 

2010

 

 

 

 

 

Net cash provided (used) in operating activities

 

 $ (686,287)

 

 $ (1,230,527)

Net cash provided (used) in investing activities

 

  (27,997)

 

  (79,926)

Net cash provided by financing activities

 

  715,900 

 

  1,306,230 

Effect of exchange rates on cash and cash equivalents

 

  - 

 

  390 

 

 

 

 

 

Net increase (decrease) in cash

 

 $ 1,616 

 

 $ (3,833)

 

 

 

 

 



Net Cash Used in Operations


Net cash used in operating activities for the fiscal year ended December 31, 2011, was $686,287, compared with net cash used in operating activities of $1,230,527 during the same period for 2010, or a decrease in the use of cash for operating activities of $544,240 (44.2%). The decrease in the use of cash is due to: (i) lower operating costs of $821,143 (27.6%), including but not limited to a decrease in revenue of $103,910 (94.0%), a decrease in cost of sales of $45,104 (100.0%), decreases in selling, general and administrative costs (other than depreciation and amortization, and stock based compensation) of $888,700 (28.8%), and an increase in net non-operating expense (other than noncash items) of $8,751 (100.0%); and (ii) offset by a net decrease in components of operating assets and liabilities of $276,903 (15.9%).


Net Cash Used in Investing Activities


Net cash used in investing activities of $27,997 was for the net purchase of equipment and costs for patent applications for the year ended December 31, 2011. This compares with net cash used for the same activities of $79,926 for same period for 2010, or a decrease of $51,929, or 65.0%. The net decrease is comprised of lower equipment costs for the TBDx™ project of $39,179 (86.8%), and an decrease in patent costs of $12,750 (36.7%). The Company anticipates it will continue to incur equipment costs during the current fiscal year ending December 31, 2011, as we design add-on features that extend our current products into other areas, and ongoing patent costs related to further protection of our PinPoint™ and Signature Mapping™ products.


Net Cash Provided by Financing Activities




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Net proceeds from financing activities were $715,900 for the year ended December 31, 2011, compared with $1,306,230 for the same period in 2010, or a decrease of $590,330 (45.2%). Of the 2011 net proceeds from financing activities, $344,000 (48.0%) was from the issuance of a new equity financing, $400,000 (55.9%) from the issuance of short-term promissory note, and a reduction of cash provided by financing activities of $28,100 (3.9%) for the net reduction of short-term notes payable to an executive of the Company. The decrease in the net cash provided by financing activities is due to (i), a decrease of $771,280 (69.2%) from the issuance of new equity financings, (ii) a reduction of $262,500 (100.0%) from the exercise of warrants, (iii) a decrease of $37,350 (100.0%) from the exercise of employee stock options, (iv) an increase in funds of $400,000 (100.0%) from short-term notes payable, and (v) a decrease in use of funds of $80,800 to reduce short-term note payable to an executive of the Company.  Management is seeking, and expects to continue to seek to raise additional capital through equity or debt financings or bank borrowings, including through one or more equity or debt financings or bank borrowings to fund its operations, repay or repurchase its debentures, and pay amounts due to its creditors and employees. However, there can be no assurance that the Company will be able to raise such additional equity or debt financing or obtain such bank borrowings on terms satisfactory to the Company or at all.


Cash and Cash Equivalents


Our cash and cash equivalents increased during fiscal year ended December 31, 2011 by $1,616, compared to a decrease in cash and cash equivalents during the same period in 2010 of $3,833.  As outlined above, the increase in cash and cash equivalents for the current period was the result of; (i) cash used in operating activities of $686,287, (ii) cash used for the purchase of equipment and patent costs of $27,997, and (iii) an increase in cash by $715,900 from financing activities.  The net change in cash and cash equivalents for the twelve months ended December 31, 2011, as compared to the same period in 2010, was $5,449 (142.2%), and is the result of (i) a decrease in cash used in operating activities of $544,240 (44.2%), (ii) a decrease from the net purchase of equipment and patent costs of $51,929 (65.0%), (iii) a decrease of $390 (100.0%) from the positive effect of currency exchange rates, and (iv) an offset by a reduction of $590,330 (45.2%) from financing activities.


Working Capital Information - The following table presents a summary of our working capital at the end of each fiscal year:


 

 

As of December 31

Category

 

2011

 

2010

 

 

 

 

 

Cash and cash equivalents

 

 $ 6,490 

 

 $ 4,874 

 

 

 

 

 

Current assets

 

  9,100 

 

  93,682 

Current liabilities

 

  10,432,552 

 

  10,822,318 

Working capital (deficit)

 

 $ (10,423,452)

 

 $ (10,728,636)

 

 

 

 

 



As of December 31, 2011, the Company had cash and cash equivalents of $6,490, compared to $4,874 on December 31, 2010, or an increase in cash and cash equivalents of $1,616 (33.2%).  The increase in cash is the net result of our operating, investing and financing activities outlined above.  At December 31, 2011, we had a working capital deficit of $10,423,452, compared with a working capital deficit at December 31, 2010 of $10,728,636, or a decrease in working capital deficit of $305,184 (2.8%). For 2011, overall current assets decreased $84,582 (90.3%), including (i) an increase in cash and cash equivalents of $1,616 (33.2%), (ii) a decrease in prepaid expenses of $16,671 (86.5%), and (iii) a decrease in accounts receivable of $69,527 (100.0%).  Current liabilities decreased $389,766 (3.6%), with specific decreases in liabilities of $2,525,243, including: (i) $28,100 in notes payable, net of additional notes from a related party, (ii) $246,175 for conversion of accrued wages for stock, (iii) $292,650 for conversion of accounts payable for stock, (iv) $1,958,318 for the reduction of derivative liabilities due to the revaluation of the beneficial conversion feature of the outstanding debentures, (vii) and specific increases in current liabilities of $2,135,477, including: (i) $8,422 in accrued interest, (ii) $301,235 trade and accrued payables, (iii) $337,641 for default provision of the debentures, (iv) $371,413 short-term notes payable, and (v) $1,116,766 for the continued accrual of unpaid wages and related expenses for all employees.


Our revenue generating activities during the period, as in previous years, have not produced sufficient funds for profitable operations, and we have incurred operating losses since inception. Accordingly, we have continued to utilize the cash raised in our financing activities to fund our operations. In addition to raising cash through additional financing activities, we may supplement our future working capital needs through the extension of trade payables and increases in accrued expenses. In view of these matters, realization of certain of the assets in the accompanying balance sheet is dependent upon our continued operations, which in turn is dependent upon our ability to meet our financial requirements, raise additional financing, and the success of our future operations.


Other Liabilities




50



2011 Short-Term Promissory Notes


During the October and November 2011, the Company issued twelve-month promissory notes to accredited investors in the aggregate principal amount of $400,000.  The twelve-month notes accrue interest at a rate of 12% per annum.  The Company also issued to the two note holders an aggregate of 400,000 shares of common stock.  The relative fair value of the common stock of $34,700 will be amortized over the term of the notes.  The Company also issued 250,000 shares of common stock as compensation in connection with the financing for a fair value of $25,000.


2011 Securities Purchase Agreement


On February 23, 2011, the Company entered into a Securities Purchase Agreement (the “SPA”) with an institutional accredited investor for an investment up to $1,000,000, subject to certain stock price and volume conditions.  Subsequently on February 24, 2011, we sold to the institutional investor at the first closing of the private placement of securities, an aggregate of 600,000 shares of common stock, and 600,000 common stock purchase warrants to purchase an aggregate of 600,000 shares of common stock, for gross proceeds of $150,000 ($136,000 net of certain expenses and sales commissions in the amount of $14,000). The warrants are exercisable at a price of $0.25 per share for a period of five years after the date of issuance, contain a cashless exercise provision and other customary provisions. Also, we issued to a broker an aggregate of 72,000 placement agent’s warrants as compensation in connection with the offering. The placement agent’s warrants are under the same terms and conditions as those issued to the institutional investor.


In addition, under the SPA, the investor has agreed to provide additional financing to us by purchasing shares of our common stock at seven subsequent closings and subject to certain share price and volume requirements.  However, the seven subsequent closings scheduled during March through September 2011, did not take place since the stock price and volume conditions were not met.


We granted to the investor piggy back registration right with regard to the shares issued in the financing, including the shares underlying the Warrants. The SPA contains representations and warranties of the Company and investor, certain indemnification provisions and customary conditions to each closing.  We may terminate the SPA on ten days prior written notice to the investor, and the investor may terminate the SPA at any time prior to a subsequent financing upon written notice to us if we consummate a reverse stock split or a subsequent financing to which the investor is not a party.


We agreed to pay the investor’s counsel with regard to the first closing in the amount of $25,000, $5,000 of which was paid at the first closing and $5,000 was to be paid at each of the first four subsequent closings.  As mentioned above, the subsequent closings did not take place and the Company did not pay the four additional $5,000 payments to the investor’s counsel. We also agreed to pay additional fees for their counsel for each subsequent closing in the amount of $2,500. A broker acted as placement agent for the offering.  Under the terms of a Non-Circumvention and Compensation Agreement, dated January 12, 2011, between the Company and the broker, in connection with the offering, we agreed to pay or issue the broker at each subsequent closing a placement fee equal to 6% of the proceeds received by us at each closing and placement agent’s warrants equal to 6% of the shares sold at the closing (including the shares underlying the Warrants).  


2009 Convertible Promissory Notes


During the period of June through August 2009, at a series of closings, The Company issued six-month convertible promissory notes to a total of 12 accredited investors’ in the aggregate principal amount of $725,000. The six-month notes accrued interest at a rate of 10% per annum. The notes were convertible, at the holder’s option, into shares of common stock at a conversion price of $0.25 per share. If converted, each holder is entitled to receive Class M common stock purchase warrants for the right to purchase an equal number of shares and they are exercisable at a price of $0.25 per share, contain certain anti-dilution and other customary provisions, and expire sixty (60) months from the date the warrants were issued. On December 31, 2009, the Company had an aggregate principal amount outstanding of $675,000 from eleven (11) note holders.  During fiscal 2010, all note holders converted an aggregate principal amount of $675,000 and $71,999 of accrued interest into an aggregate of 2,987,995 shares of common stock, and 2,987,995 Class M Warrants. The Warrants issued are exercisable at a price of $0.25 per share; contain a conditional call provision if the market price of each share exceeds $3.00, and customary anti-dilution provisions. The warrants expire in sixty (60) months from the date of issuance.


2006 through 2011 Short-Term Promissory Notes, Related Party


On April 21, 2006, the Company entered into a Loan Agreement with Mr. Michael W. Trudnak, our Chairman and Chief Executive Officer pursuant to which Mr. Trudnak loaned the Company $200,000. The Company issued a non-negotiable promissory note, dated effective April 21, 2006, to Mr. Trudnak in the principal amount of $200,000. The note is unsecured, non-negotiable and non-interest bearing. The note is repayable on the earlier of (i) six months after the date of issuance, (ii) the date the Company receives aggregate proceeds from the sale of its securities after the date of the issuance of the Note in an amount exceeding $2,000,000, or (iii) the




51


occurrence of an event of default. The following constitute an event of default under the note: (a) the failure to pay when due any principal or interest or other liability under the loan agreement or under the note; (b) the material violation by us of any representation, warranty, covenant or agreement contained in the loan agreement, the note or any other loan document or any other document or agreement to which the Company is a party to or by which the Company or any of our properties, assets or outstanding securities are bound; (c) any event or circumstance shall occur that, in the reasonable opinion of the lender, has had or could reasonably be expected to have a material adverse effect; (d) an assignment for the benefit of our creditors; (e) the application for the appointment of a receiver or liquidator for us or our property; (f) the issuance of an attachment or the entry of a judgment against us in excess of $100,000; (g) a default with respect to any other obligation due to the lender; or (h) any voluntary or involuntary petition in bankruptcy or any petition for relief under the federal bankruptcy code or any other state or federal law for the relief of debtors by or with respect to us, provided however with respect to an involuntary petition in bankruptcy, such petition has not been dismissed within 30 days of the date of such petition.  In the event of the occurrence of an event of default, the loan agreement and note shall be in default immediately and without notice, and the unpaid principal amount of the loan shall, at the option of the lender, become immediately due and payable in full.  The Company agreed to pay the reasonable costs of collection and enforcement, including reasonable attorneys’ fees and interest from the date of default at the rate of 18% per annum. The note is not assignable by Mr. Trudnak without our prior consent. The Company may prepay the note in whole or in part upon ten days notice. On October 21, 2006, Mr. Trudnak extended the due date of the loan to December 31, 2006. Subsequently, on October 3 and October 18, 2006, Mr. Trudnak loaned the Company $102,000 and $100,000, respectively, on substantially the same terms as the April 21, 2006 loan, except that each loan is due six months after the date thereof. Accordingly, following such additional loans, the Company owed an aggregate of approximately $402,000 to Mr. Trudnak. On November 10, 2006, Mr. Trudnak extended the due dates of such loans to May 31, 2007, except that $100,000 of the April 21, 2006, loan becomes due upon the Company raising $2,500,000 in financing after November 6, 2006, and the remaining amount of $202,000 of such loans become due upon the Company raising an aggregate of $5,000,000 in financing after November 6, 2006, and prior to May 31, 2007. Following the first closing of our Debenture and Series D Warrant financing on November 8, 2006, the Company repaid $100,000 on November 20, 2006, in principal amount of the April 1, 2006 loan, and paid an additional $100,000 to Mr. Trudnak on April 17, 2007 upon the second closing of our Debenture and Series D Warrant financing. On May 31, 2007, Mr. Trudnak extended the due dates of the remaining loans to May 31, 2008. Although, the anticipated payment of $202,000 had not been made, and Mr. Trudnak made an additional $24,000 loan to the company on June 25, 2008, and $5,000 on September 14, 2011, for cumulative loans of $231,000.  The maturity date of the outstanding loans was extended to May 31, 2009, then to May 31, 2010 and June 30, 2011, and subsequently to December 31, 2011. On December 31, 2011, the outstanding loans were extended to June 30, 2012. The Company repaid an aggregate of $108,900 of the notes during 2010, and repaid an aggregate $33,100 during 2011, resulting in an outstanding balance at December 31, 2011 of $89,000. The terms of the above transaction were reviewed and approved by the Company’s audit committee and by the independent members of our Board of Directors.


2006 and 2007 Series A Debentures (as Amended on October 15, 2010) and Series D Common Stock Purchase Warrants


Under a securities purchase agreement, dated November 3, 2006, between the Company and certain institutional accredited investors, the Company sold an aggregate of $5,150,000 in principal amount of our Series A Debentures and Series D Common Stock Purchase Warrants to purchase an aggregate of 4,453,709 shares of our common stock.  On November 8, 2006, the Company issued to the institutional investors an aggregate of $2,575,000 in principal amount of Series A Debentures and 4,453,709 Series D Warrants.  On April 12, 2007, the Company issued at a second closing, an additional $2,575,000 in principal amount of the Series A Debentures, which followed the effectiveness of a registration statement registering the shares of our common stock underlying the Series A Debentures and Series D Warrants.  The Company allocated proceeds from each closing to the embedded conversion features of the Series A Debentures and Series D Warrants that were recognizable as a liability under generally accepted accounting principles.  We also issued during the first closing an aggregate of 623,520 common stock purchase warrants to the placement agent as compensation in the offering, which were upon terms substantially similar to the Series D Warrants. One-half of the Series D Warrants (2,226,854 warrants) and the placement agent warrants (311,760 warrants) became exercisable on November 8, 2006. The remaining one-half of the Series D Warrants (2,226,855 warrants) and the placement agent warrants (311,760 warrants) became exercisable on April 12, 2007 and expire on April 12, 2012. The Series D Warrants and the placement agent’s warrants may be exercised via a cashless exercise if certain conditions are met. Due to milestone-related adjustments, the initial exercise price of $1.15634 may be reset and the maximum number of shares to be issued under the debentures was indeterminable as of December 31, 2007. The Company considered ASC 815-40 (formerly EITF 00-19, relating to the provisions for Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock), and concluded that there were insufficient shares to share settle the contracts.  On April 1, 2007, due to the milestone-related provisions, the conversion price of the Series A Debentures and the exercise price of the Series D Warrants and Placement Agent’s Warrants were reset to a price $0.7453 per share, to $0.6948 effective October 1, 2007, and the final milestone reset of $0.4089 effective April 1, 2008.  As a result of a June 2009 financing in which the Company issued shares of common stock and warrants, the conversion price of our debentures and the exercise price of the Series D Warrants was adjusted under the anti-dilution provisions of such instruments to a price of $0.25 per share, and the number of shares underlying the Series D Warrants (including the warrants the Company issued to the placement agent in the financing) were increased by an aggregate of 2,677,417 Series D warrants.  On July 10, 2007, a debenture holder exercised 864,798 Series D Warrants for 864,798 shares of common stock, and 914,798 warrants were exercised during 2010 under the cashless provision for 420,166 shares of common stock. On November 8, 2011, an aggregate of 2,962,527 Series D Warrants expired.  




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Our outstanding Series A 10% Convertible Debentures originally became due on November 7, 2008. On October 15, 2010, we entered into an agreement with our two remaining Series A Convertible Debenture holders to extend the maturity date of the debentures to June 30, 2011, and the outstanding amount of $1,688,205 was not paid. As of December 31, 2011, an aggregate of $3,461,795 in principal amount of the Series A Debentures have been converted into 8,730,037 shares of common stock, an aggregate of $663,043 in interest amount have been converted into 2,675,576 shares of common stock, and an aggregate of 1,779,596 Series D Warrants have been exercised resulting in the issuance of 1,284,964 shares of common stock. Accordingly, as of December 31, 2011, an aggregate of $1,688,205 of principal amount of the debentures remain unconverted, and 3,012,523 Series D Warrants remain unexercised. Proceeds of the two offerings were used for the purpose of hiring new personnel, research and development, registration expenses, for general working capital purposes, and repaying $200,000 in loans made to us by Mr. Michael W. Trudnak, our Chairman and CEO.


October 15, 2010, we entered into an agreement with our two remaining Series A Debenture holders to amend and effect a restructuring of the debentures that originally became due on November 7, 2008.  Under the amendment agreement, the Company and two debenture holders agreed: (i) to an extension of the maturity date of the debentures to June 30, 2011, (ii) that the $1,688,205 of outstanding principal amount will not bear interest from July 1, 2010 through the new maturity date, (iii) that, in exchange for the payment in cash of amounts of accrued but unpaid regular interest of approximately $638,163, and waived all additional interest and late fees, liquidated damages and certain other amounts due under the debentures (“Interest and Default Amounts”) the Company issued an aggregate of 2,552,653 shares of common stock, (iv) that all claims with regard to the payment of the Interest and Default Amounts and all prior events of default under the Debentures and breaches of any covenant, agreement, term or condition (“Defaults”) debentures and debenture transaction documents would be waived and the Company was released from any claims with respect to the Additional Interest and Late Fees of approximately $773,314, and Default Amounts of approximately $2,541,739, and prior Defaults Events, (v) to terminate the registration rights agreements between the Company and each debenture holder, and (vi) that the Company may force a conversion of the debentures if our common stock equals or exceeds certain price and volume conditions.


Also under the Debenture amendment agreement, the Debenture holders agreed, commencing March 3, 2011, that the Company may force a conversion of the Debentures.  There were no conversions of our debentures during the year ended December 31, 2011.  Such a forced conversion may only be effected once every 90 days and the ability of the Company to force any such conversion is subject to certain equity conditions, which conditions were amended under the terms of the Debenture Amendment Agreement in accordance with the following:


·

if the variable weighted average price for the Company’s common stock (“VWAP”) for any five consecutive trading days exceeds $0.50 and the average daily dollar trading volume for the Company’s common stock during such period equals or exceeds $50,000, the Company may require a Holder to convert up to 25% of the outstanding principal amount of its Debenture on September 3, 2010, plus any liquidated damages or other amounts owing under the Debenture;

·

if the VWAP for any five consecutive trading days exceeds $0.75 and the average daily dollar trading volume for the common stock during such period equals or exceeds $75,000, the Company may require a Holder to convert up to an additional 25% of the outstanding principal amount of its Debenture on September 3, 2010, plus any liquidated damages or other amounts owing under the Debenture;  

·

if the VWAP for any five consecutive trading days exceeds $1.00 and the average daily dollar trading volume for the common stock during such period equals or exceeds $100,000, the Company may require a Holder to convert up to 100% of the outstanding principal amount of its Debenture on September 3, 2010, plus any liquidated damages or other amounts owing under the Debenture.  


The principal amount of our outstanding Series A Debentures of $1,688,205 became due on July 1, 2011, and such amount was not paid.  Therefore, the Company may be considered in default.  The debentures provide that any default in the payment of principal, which default is not cured within the five trading days of the receipt of notice of such default or ten trading days after the Company becomes aware of such default, will be deemed an event of default and may result in enforcement of the debenture holders’ rights and remedies under the debentures and applicable law.  We are in discussions with the debenture holders to re-negotiate the terms of the debentures, including the repayment or repurchase of the debentures and/or seek to extend their maturity date, although we have not reached any agreement with the debenture holders with regard to any such repayment, repurchase or extension.  Our ability to repay or repurchase the debentures is contingent upon our ability to raise additional financing, of which there can be no assurance.  Also, as a condition to any such extension, debenture holders may seek to amend or modify certain other terms of the debentures.  If an event of default occurs under the debentures, the debenture holders may elect to require us to make immediate repayment of the mandatory default amount, which equals the sum of (i) the greater of either (a) 120% of the outstanding principal amount of the debentures, or (b) the outstanding principal amount unpaid divided by the conversion price on the date the mandatory default amount is either (1) demanded or otherwise due or (2) paid in full, whichever has the lower conversion price, multiplied by the variable weighted average price of the common stock on the date the mandatory default amount is either demanded or otherwise due, whichever has the higher variable weighted average price, and (ii) all other amounts, costs, expenses, and liquidated damages due under the debentures.  In anticipation of such election by the debenture holders, due to the nonpayment of principal amount on the due date of July 1, 2011, we measured the mandatory default at approximately $337,641 and subsequently on each balance sheet date, which is reflected in the carrying value of the debentures




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and also recognized as interest expense.  We remeasured the mandatory default amount as of December 31, 2011 at approximately $337,641. As of the date of this report, the debenture holders have not made an election requiring immediate repayment of the mandatory amount, although there can be no assurance they will not do so.  The Company currently has insufficient funds to repay the outstanding amount in the event the debenture holders make a demand for payment.


Prior to the Debenture amendment agreement and absent a default, the Debentures bore interest at the rate of 10% per annum.  The Debenture agreement, as amended on October 15, 2010, continues to permit the payment of interest due under the Debentures in cash or registered shares of our common stock. If we elected to pay the interest due in shares of our common stock, the number of shares to be issued in payment of interest is determined on the basis of 85% of the lesser of the daily volume weighted average price of our common stock as reported by Bloomberg LP (“VWAP”) for the five trading days ending on the date that is immediately prior to (a) date the interest is due or (b) the date such shares are issued and delivered to the holder. We could pay interest in shares of our common stock only if the equity conditions, described below, have been met during the 20 consecutive trading days prior to the date the interest is due and through the date the shares are issued. The payment of interest in shares of our stock, the redemption of the Debentures and the occurrence of certain other events, was subject to a requirement that certain equity conditions (“equity conditions”) were met, as follows: (i) we have honored all conversions and redemptions of a Debenture by the holder, (ii) we have paid all liquidated damages and other amounts due to the holder, (iii) the registration statement covering the resale of the shares underlying the Debentures and Series D Warrants is effective permitting a holder to utilize the registration statement to resell its shares, (iv) our stock is traded on the OTC Bulletin Board or other securities exchange and all of the shares upon conversion or exercise of the Debentures and Series D Warrants are listed for trading, (v) we have sufficient authorized but unreserved shares of our common stock to cover the issuance of the shares upon conversion or exercise of the Debentures and Series D Warrants, (vi) there is no event of default under the Debentures, (vii) the issuance of the shares would not violate a holder’s 4.99% or 9.99% ownership restriction cap, (viii) we have not made a public announcement of a pending merger, sale of all of our assets or similar transaction or a transaction in which a greater than 50% change in control of the Company may occur and the transaction has not been consummated, (ix) the holder is not in possession of material public information regarding us, and (x) the daily trading volume of our shares for 20 consecutive trading days prior to the applicable date exceeds 100,000 shares. Under the terms of the Debenture Amendment Agreement, (A) the equity condition in (iii) above was amended to provide that such condition is met if, in the alternative, the shares issuable upon conversion of the Debentures may then be resold pursuant to Rule 144 without restriction or limitation and the Company has delivered to a holder an opinion of the Company’s counsel that such resale may legally be made and provided the holder has furnished a representation letter reasonable acceptable to the Company’s counsel that the holder is not an “affiliate” for purposes of Rule 144; (B) the equity condition in (vi) above was amended to except an event of default that has previously been waived; and (C) the equity condition in (x) above was amended to except circumstances where another volume condition is applicable.


The Debentures contain a limitation on the amount of Debenture that may be converted at any one time in the event the holder owns beneficially more than 4.99% of our common stock without regard to the number of shares underlying the unconverted portion of the Debenture. This limitation may be waived upon 61 days’ notice to us by the holder of the Debenture permitting the holder to change such limitation to 9.99%.


An event of default may occur under the Debentures if (a) the Company defaults in the payment of principal or, liquidated damages , (b) the Company fails to materially observe or perform a covenant or agreement in the Debentures, (c) a default or event of default occurs under any other transaction document related to the financing or in any other material agreement to which the Company is a party that results in a material adverse effect on the Company, (d) any representation or warranty the Company made to investors in the transaction documents related to the financing is materially untrue or incorrect, (e) a bankruptcy event occurs with regard to the Company, (f) the Company defaults on any other loan, mortgage, or credit arrangement that involves an amount greater than $150,000 and results in the obligation becoming declared due prior to the due date, (g) the Company’s common stock is not eligible for quotation on the OTC Bulletin Board or other exchange on which the Company’s shares are traded, (h) a transaction occurs in which the control of the Company changes, the Company effects a merger or consolidation, the Company sells substantially all of the assets, a tender offer is made for the Company’s shares, the Company reclassify their shares or a compulsory share exchange, or the Company agrees to sell more than 33% of the assets, unless the Company receives the consent of holders of 67% of then outstanding principal of the Company’s Debentures, (i) the Company fails to deliver certificates for shares to be issued on conversion within seven trading days, (j) the Company has a judgment against it for more than $150,000. We have agreed to compensate a holder of a Debenture in the event our transfer agent fails to deliver shares upon conversion of the Debentures within three trading days of the date of conversion, and the holder’s broker is required to purchase shares of our common stock in satisfaction of a sale by a holder.


As outlined above, the Series D Warrants and placement agent warrants are exercisable at the same price as the conversion price of the debentures. If certain milestones are not met, the exercise price of such warrants may be reset. Also, the exercise price may be adjusted under anti-dilution and other price reset provisions contained in the warrants. The warrants initial exercise price of $1.15634 was reset to $0.7453 on April 1, 2007, due to the milestone-related provisions, to $0.6948 effective October 1, 2007, and the final milestone reset of $0.4089 effective April 1, 2008. As a result of a June 2009 financing, in which the Company issued shares of common stock and warrants below the then current exercise price of the Series D Warrants, the exercise price of the outstanding Series D Warrants and




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placement agent warrants were adjusted under the anti-dilution provisions of such instruments to a price of $0.25 per share, and the number of shares underlying the outstanding Series D Warrants and the placement agent warrants, issued under the Debenture agreement, were increased to an aggregate of 6,889,848 shares.


The Series D Warrants contain a cashless exercise provision in the event (i) at any time after one year following the date the Series D Warrants are first exercisable there is no registration statement effective covering the resale of the shares underlying the Series D Warrants or (ii) at any time after four years following the date the Series D Warrants were issued.


The Series D Warrants contain a limitation on the amount of Series D Warrants that may be exercised at any one time in the event the holder owns beneficially more than 4.99% of our common stock without regard to the number of shares underlying the unconverted portion of the warrants. This limitation may be waived upon 61 days’ notice to us by the holder of the Series D Warrants permitting the holder to change such limitation to 9.99%.


The conversion price of the Debentures and the exercise price of the Series D Warrants or the number of shares to be issued upon conversion or exercise of the Debentures and Series D Warrants are subject to adjustment in the event of a stock dividend, stock split, subdivision or combination of our shares of common stock, reclassification, sales of our securities below their then conversion or exercise price (“subsequent equity sales anti-dilution adjustment provisions”), a subsequent rights offering, or a reclassification of our shares. Also, if we effect a merger or consolidation with another company, we sell all or substantially all of our assets, a tender offer or exchange offer is made for our shares, or we effect a reclassification of our shares or a compulsory share exchange, a holder that subsequently converts its Debenture will be entitled to receive the same kind and amount of securities, cash or property as if the shares it is entitled to receive on the conversion had been issued and outstanding on the date immediately prior to the date any such transaction occurred.  Except as discussed above, no such events have occurred through the date of this report.


We are not required to make an adjustment to the conversion or exercise price or the number of shares to be issued upon conversion or exercise of the Debentures and Series D Warrants pursuant to the subsequent equity sales anti-dilution adjustment provisions related to an “exempt issuance,” which is defined as: (A) any stock or options that are issued under our stock option plans or are approved by a majority of non-employee directors and issued (i) to employees, officers or directors or (ii) to consultants, but only if the amount issued to consultants does not exceed 400,000 shares in a 12 month period, (B) securities issued under the Debentures or Series D Warrants, (C) shares of common stock issued upon conversion or exercise of, or in exchange for, securities outstanding on the date we entered into the securities purchase agreement, (D) the issuance of the Midtown placement agent’s warrants or the shares underlying the placement agent’s warrants, or (E) the issuance of securities in an acquisition or strategic transaction approved by our disinterested directors. Under the Debenture Amendment Agreement, commencing October 15, 2010, Debenture holders agreed that an “exempt issuance” shall also include the issuance of stock or common stock equivalents authorized and approved in advance by the Company’s disinterested directors at a price per share or at a conversion or exercise price per share equal to or greater than $0.25.


In connection with our Series A Debenture financing, we entered into a registration rights agreement with purchaser of our debentures pursuant to which we agreed we would use our best efforts to file a registration statement under the Securities Act within 45 days of the first closing to permit the public resale by debenture holders of the shares that may be issued upon conversion of the Debentures and upon exercise of the Series D Warrants, including the shares of our common stock underlying the Debentures to be issued at the second closing. Pursuant to the amendments we entered into with the current debenture holders on October 15, 2010, the debenture holders agreed to terminate their registration rights agreements with us. Accordingly, we are not required to register or maintain the registration of the shares underlying the Series A Debentures and Series D warrants held be such debenture holders; however, the Company continues to be obligated under the terms of the Registration Rights Agreement that the Company entered into with each purchaser that has fully converted its Debenture but continues to hold Series D Warrants.


We also granted to each purchaser of the Debentures and Series D Warrants the right to participate in any offering by us of common stock or common stock equivalents until the later of (i) 12 months after the effective date of the registration statement and (ii) the date a purchaser holds less than 20% of the principal amount of the Debenture the purchaser originally agreed to purchase, except for an exempt issuance or an underwritten public offering of our common stock.  Purchasers may participate in such an offering up to the lesser of 100% of the future offering or the aggregate amount subscribed for under the securities purchase agreement by all purchasers. Although such common stock offerings have occurred, the Debenture holders have notified the Company that they do not want to participate in any future financings.


The securities purchase agreement also contained representations and warranties of both us and purchasers, conditions to closing, certain indemnification provisions, and other customary provisions.  Also the Debenture Amendment Agreement amended certain provisions covering events of default under the Debentures, contained certain representations and warranties of the Company, a reaffirmation of certain of the representations and warranties in the securities purchase agreement, contained certain conditions to closing, and certain other customary provisions.





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We were prohibited from effecting a reverse or forward stock split or reclassification of our common stock except as may be required to comply with the listing standards of any national securities exchange.


Midtown Partners & Co., LLC acted as placement agent for the financing pursuant to the terms of a Placement Agent Agreement, dated July 14, 2006, between us and Midtown. At the first closing, we paid or issued the following compensation to Midtown for its services as placement agent in connection with the offering: (i) sales commissions in the amount of $180,250; (ii) non-accountable expense reimbursement and legal fees of $30,000 of which $10,000 was paid prior to closing, (iii) placement agent’s warrants to purchase an aggregate of 623,520 shares (one half of the placement agent warrants were exercisable on November 6, 2006 and the remaining one-half became exercisable on April 12, 2007). The second closing took place on April 12, 2007, at which time we paid the following compensation to Midtown for its services as placement agent in connection with the offering: (i) sales commissions in the amount of $180,250; (ii) non-accountable expense reimbursement and legal fees equal to 1% of the second closing or $25,750, (iii) the placement agent’s warrants to purchase an aggregate of 311,760 shares (the remaining one-half of the placement agent’s warrants). The Midtown placement agent’s warrants were initially exercisable at a price of $1.15634 per share for a period of five years from the date they become exercisable, the exercise price was reset as disclosed above for the convertible debentures, contain a piggyback registration right, a cashless exercise provision and are substantially identical to the warrants issued to purchasers in the Debenture and Warrant offering.  As a result of the June 2009 financing, the exercise price of the placement agent’s warrants were adjusted under the anti-dilution provisions of such warrants to a price of $0.25 per share and the number of shares underlying the placement agent’s warrants would be increased to an aggregate of 1,019,828 shares.


The securities, including certain securities issued to Midtown, were not registered under the Securities Act of 1933 or any state laws and may not be offered or sold in the United States absent registration or an applicable exemption from registration requirements.


Additional Capital


To the extent that additional capital is raised through the sale of our equity or equity-related securities of our subsidiaries, the issuance of our securities could result in dilution to our stockholders.  No assurance can be given that we will have access to the capital markets in the future, or that financing will be available on terms acceptable to satisfy our cash requirements, implement our business strategies, and meet the restrictive requirements of the debenture financing described above.  If we are unable to access the capital markets or obtain acceptable financing, our results of operations and financial condition could be materially and adversely affected.  We may be required to raise substantial additional funds through other means. We have not begun to receive material revenues from our commercial operations associated with the software products.  Management may seek to raise additional capital through one or more equity or debt financings or have discussions with certain investors with regard thereto.  We cannot assure our stockholders that our technology and products will be commercially accepted or that revenues will be sufficient to fund our operations.  If adequate funds are not available to us, we may be required to curtail operations significantly or to obtain funds through entering into arrangements with collaborative partners or others that may require us to relinquish rights to certain of our technologies or products.


Financial Condition, Going Concern Uncertainties and Events of Default


During the year ended December 31, 2011, Applied Visual Sciences’ revenue generating activities have not produced sufficient funds for profitable operations and we have incurred operating losses since inception. In view of these matters, realization of certain of the assets in the accompanying consolidated balance sheet is dependent upon continued operations, which in turn is dependent upon our ability to meet our financial requirements, raise additional financing on acceptable terms, and the success of future operations. Our independent registered public accounting firm’s report on the consolidated financial statements included herein, and in our annual report on Form 10-K for the year ended December 31, 2010, contains an explanatory paragraph wherein they expressed an opinion that there is substantial doubt about our ability to continue as a going concern. Accordingly, careful consideration of such opinions should be given in determining whether to continue or become our stockholder.


As of December 31, 2011, we have outstanding trade and accrued payables of $1,356,404, other accrued liabilities of $486,560, and accrued salaries due to our employees and management of $5,833,216.  Also, the Company has an outstanding noninterest-bearing loan from its Chief Executive Officer of $89,000, and $400,000 short-tern notes from two investors.


The principal amount of our outstanding Series A Debentures of $1,688,205 became due on July 1, 2011, and such amount was not paid.  Therefore, the Company may be considered in default.  The debentures provide that any default in the payment of principal, which default is not cured within the five trading days of the receipt of notice of such default or ten trading days after the Company becomes aware of such default, will be deemed an event of default and may result in enforcement of the debenture holders’ rights and remedies under the debentures and applicable law.  We are in discussions with the debenture holders to re-negotiate the terms of the debentures, including the repayment or repurchase of the debentures and/or seek to extend their maturity date, although we have not reached any agreement with the debenture holders with regard to any such repayment, repurchase or extension.  Our ability to repay or repurchase the debentures is contingent upon our ability to raise additional financing, of which there can be no assurance.  Also, as a




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condition to any such extension, debenture holders may seek to amend or modify certain other terms of the debentures.  If an event of default occurs under the debentures, the debenture holders may elect to require us to make immediate repayment of the mandatory default amount, which equals the sum of (i) the greater of either (a) 120% of the outstanding principal amount of the debentures, or (b) the outstanding principal amount unpaid divided by the conversion price on the date the mandatory default amount is either (1) demanded or otherwise due or (2) paid in full, whichever has the lower conversion price, multiplied by the variable weighted average price of the common stock on the date the mandatory default amount is either demanded or otherwise due, whichever has the higher variable weighted average price, and (ii) all other amounts, costs, expenses, and liquidated damages due under the debentures.  In anticipation of such election by the debenture holders, due to the nonpayment of principal amount on the due date of July 1, 2011, we measured the mandatory default amount at approximately $337,641 and subsequently on each balance sheet date, which is reflected in the carrying value of the debentures and also recognized as interest expense.  We remeasured the mandatory default amount as of December 31, 2011 at approximately $337,641. As of the date of this report, the debenture holders have not made an election requiring immediate repayment of the mandatory amount, although there can be no assurance they will not do so.  The Company currently has insufficient funds to repay the outstanding amount in the event the debenture holders make a demand for payment.


During 2011, the Company sold securities for gross proceeds of $211,000 (or $208,000, net of commission and expenses of $3,000) to certain accredited investors at a series of closings, and issued an aggregate of 844,000 shares of common stock, and 888,000 Class Q Warrants.  The Class Q Warrants are exercisable at a price of $0.25 per share; contain a conditional call provision if the market price of each share exceeds $3.00, certain anti-dilution and other customary provisions.  The warrants expire three years after the date of issuance. Also, on February 23, 2011, the Company entered into a Securities Purchase Agreement (the “SPA”) with an institutional accredited investor for an investment up to $1,000,000. Subsequently on February 24, 2011, the Company sold to the institutional investor at the first closing of the private placement of securities, an aggregate of 600,000 shares of common stock, and 600,000 common stock purchase warrants to purchase an aggregate of 600,000 shares of common stock, for gross proceeds of $150,000 ($136,000 net of certain expenses and sales commissions in the amount of $14,000).  The warrants are exercisable at a price of $0.25 per share for a period of five years after the date of issuance; contain piggyback registration rights, a cashless exercise provision, and certain anti-dilution and other customary provisions. Also, we issued to a broker an aggregate of 72,000 placement agent’s warrants as compensation in connection with the offering.  The placement agent’s warrants are under the same terms and conditions as those issued to the institutional investor.  The institutional investor agreed to purchase additional shares if pre-established stock price and volume conditions were met during the seven months following the closing, although no such closing took place as the stock price and volume conditions were not met.


 During the period of October through November 16, 2011, the Company issued twelve-month promissory notes to a total of two accredited investors’ in the aggregate principal amount of $400,000.  The twelve-month notes accrue interest at a rate of 12% per annum. The Company also issued to the note holders an aggregate of 400,000 shares of common stock.


As of December 31, 2011, we had a cash balance of $6,490.  Subsequently and through April 16, 2012, we received $25,000 from an accredited investor, and issued an aggregate of 100,000 shares of common stock and 300,000 Class Q Warrants.  We also issued promissory notes to five accredited investors in the aggregate principal amount of $135,000 ($131,400, net of accrued commissions and expenses in the amount of $3,600); the notes accrue interest at a rate of 12% per annum, and the Company issued an aggregate of 210,000 shares of common stock to the note holders.  Management believes these funds to be insufficient to fund our operations for the next twelve months absent any cash flow from operations or funds from the sale of our equity or debt securities.  Currently, we are spending or incurring (and accruing) expenses of approximately $220,000 per month on operations and the continued research and development of our 3i technologies and products, including with regard to salaries and consulting fees.  Management believes that we will require an aggregate of approximately $2,640,000 to fund our operations for the next 12 months and to repay certain outstanding trade payables and accrued expenses.  This assumes that holders of our outstanding debentures convert such debt into shares of our common stock or that we are able to extend the term of the debentures, of which there can be no assurance.  In the event we are unable to extend the term of the debentures beyond their new maturity date, the debenture holders do not convert such debt or require payment of principal, partially convert such debt, or effect the buy-in provision related to the warrants and the debentures, we shall be required to raise additional financing.  Also, this assumes that we are able to continue to defer the amounts due to our employees for accrued and unpaid salaries and that we are able to continue to extend or defer payment of certain amounts due to our trade creditors, of which there can be no assurance.


In view of our limited revenues to date, the Company has relied and continues to rely substantially upon equity and debt financing to fund its ongoing operations, including the research and development conducted in connection with its products and conversion of accounts payable for stock. The proceeds from our financings have been and continue to be insufficient to fund our operations, pay our trade payables, repay our unconverted debentures, or accrued and unpaid wages to our employees.  Therefore, the debentures holders, our employees, or trade creditors may seek to enforce payment of amounts due to them, and our results of operations and financial condition could be materially and adversely affected and we may be unable to continue our operations.  Also, in the event we are unable to pay our employees, we may suffer further employee attrition.  There can be no assurances that we will be successful in our efforts to raise any additional financing, any bank borrowing, and research or grant funding.  Moreover, in view of the current market price of our stock, we may have limited or no access to the capital markets.  Furthermore, under the terms of our agreements with the debenture holders, we are subject to restrictions on our ability to engage in any transactions in our securities in which the conversion,




57


exercise or exchange rate or other price of such securities is below the current conversion price or is based upon the trading price of our securities after initial issuance or otherwise subject to re-set.  In view of the foregoing, we may be required to curtail operations significantly, or obtain funds through entering into arrangements with collaborative partners or others that may require us to relinquish rights to certain of our technologies or products.


During Fiscal 2011, although our total stockholders’ deficit decreased by $338,708 to $9,825,807, our consolidated net loss for the period was $1,154,376, or a $2,495,855 decrease in net loss from 2010, and the decrease is mainly due to the change in the fair value of the derivative liability that reduced the net loss by $1,958,318. Notwithstanding the foregoing discussion of management’s expectations regarding future cash flows, Applied Visual Sciences’ insolvency continues to increase the uncertainties related to its continued existence.  Both management and the Board of Directors are carefully monitoring the Company’s cash flows and financial position in consideration of these increasing uncertainties and the needs of both creditors and stockholders.


CONSOLIDATED RESULTS OF OPERATIONS


The following analysis reflects the consolidated results of operations of Applied Visual Sciences, Inc. and its subsidiaries.

Fiscal 2011 as Compared with Fiscal 2010

Net Revenues.  Net revenues for the fiscal 2011 of $6,589 was from the sale of hardware and related, specifically freight, duty and taxes reimbursed by the customer for the shipment of TBDx™.  Net revenue for the same period ended December 31, 2010, was $110,499 and includes, $90,226 from the sale of our first fully automated Signature Mapping TBDx™ system installed at the South African National Health Laboratory Services (NHLS) to complete the clinical evaluation of TBDx™, and $20,273 from research activities of our security product/services and consulting contract with the National Electrical Manufacturers Association (“NEMA”), which is a funded project by the Department of Homeland Security (DHS) for the establishment of the Digital Imaging and Communications in Security (DICOS).  The revenue from the Signature Mapping TBDx™ system installed at the NHLS of $90,226, includes, $67,670 for software license and $22,556 for equipment.  


Cost of Sales.  There was no cost of sales for fiscal 2011, compared to $45,104 during the same period in 2010, or a decrease of 45,104 (100.0%). The freight, duty and taxes billed during 2011 were expensed in December 2010.  Cost of sales for fiscal 2010 was 40.8% of net revenue and represents $23,729 for material, $14,000 for labor, and $7,375 for other related costs.


Selling, General and Administrative Expenses.  Selling, general and administrative expenses for fiscal 2011, decreased by $1,967,017 (41.8%) to $2,741,778 for 2011, as compared to $4,708,795 for the same period in 2010. The table below details the components of selling, general and administrative expense, as well as the dollar and percentage changes for the fiscal years ended December 31.


 

Twelve Months Ended December 31

 

2011

 

2010

 

$ Change

 

% Change

 

 

 

 

 

 

 

 

Payroll and related costs

 $ 1,073,527 

 

 $ 2,027,183 

 

 $ (953,656)

 

(47.0)

Professional fees

  630,953 

 

  496,140 

 

  134,813 

 

27.2 

Research and development costs

  233,330 

 

  157,355 

 

  75,975 

 

48.3 

Insurance costs

  69,756 

 

  86,029 

 

  (16,273)

 

(18.9)

Rent - building and equipment

  70,160 

 

  158,319 

 

  (88,159)

 

(55.7)

Travel and related

  62,811 

 

  61,092 

 

  1,719 

 

2.8 

Miscellaneous expenses

  56,209 

 

  99,328 

 

  (43,119)

 

(43.4)

Depreciation and amortization

  93,419 

 

  110,084 

 

  (16,665)

 

(15.1)

Stock-based compensation

  451,613 

 

  1,513,265 

 

  (1,061,652)

 

(70.2)

    Total

 $ 2,741,778 

 

 $ 4,708,795 

 

 $ (1,967,017)

 

(41.8)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



Payroll and related costs, which includes salaries, commissions, taxes and benefits, decreased $953,656 (47.0%), due to seven employees being on temporary leave of absence, although they continue to support the Company on an as needed basis.  The Company currently employs six full-time and one part-time employee, compared to 14 full-time employees for the same period in 2010.


Professional fees include legal, accounting, stock transfer agent, SEC filing, and general consulting fees. Professional fees increased in 2011 versus the same period last year by $134,813 (27.2%) due to: (i) a increase in legal fees of $205,194 for services related to financing activities, offset by lower fees for SEC compliance reporting, corporate structure and related name change in 2010, (ii) decrease in general consultants of $63,945, (iii) an increase in accounting services by $5,500 representing changes in rates, and (iv) a net decrease of $11,936 for various miscellaneous services and fees.





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Research and development (“R&D”) costs increased in fiscal 2011, compared to the same period last year by $75,975 (48.2%), due to: (i) no activities during the period for our PinPoint™ product, or a reduction of $4,669 (100.0%), (ii) increased R&D activities for Signature Mapping TBDx™ and TBDxV™ projects of $80,644 (52.8%) for development activities to increase the capabilities of the automated system and migrate the technology for Ziehl-Neelsen staining process.


Insurance costs in fiscal 2011 were $69,756 compared to $86,029 during fiscal 2010, a decrease of $16,273 (18.9%). The decrease is attributed to not renewing various business policies.


Rent decreased by $88,159 (55.7%) to $70,160 in fiscal 2011, as compared to $158,319 for the same period in 2010, due to the Company relocating its office, effective May 1, 2010, to a smaller facility of approximately 3,269 square feet of space, whereas our previous office lease was for approximately 15,253 square feet. The fixed monthly rent of $5,585 reduced monthly operating costs by approximately $22,648.


Travel and entertainment expense for fiscal 2011 were $62,811 compared to the same period for 2010 of $61,092, or an increase of $1,719 (2.8%).  The Company focused its travel on our Signature Mapping™ Tuberculosis activities including, business development activities in South Africa for TBDx™, and in India for our TBDxV™ visualization product.


Miscellaneous expense decreased by $43,119 (43.4%) to $56,209 during fiscal 2011, compared to $99,328 for the same period in 2010. The decrease during 2011  is related to: (i) lower mobile phone costs of $2,920, (ii) reduction of $3,388 for telephone costs as a result of a renegotiated contract with our service provider, (iii) decreased postage and overnight service of $4,457, (iv) reduced business taxes of $4,822, (v) reduced office supplies and equipment of $4,953 reflecting a reduction in the number of employees, (vi) a decrease in membership and publication fees of $14,121, (vii) a decrease of $14,599 for office relocation costs incurred during 2010 to a new facility under a one year lease, (viii) increased bad debt expense of $1,792 not incurred during the prior year, and (ix) an increase in various miscellaneous expenses of $4,349.


Depreciation and amortization expense in selling, general, and administrative for fiscal 2011, of $93,419, compared to the same period for 2010 of $110,084, or a decrease of $16,665 (15.1%). The decrease in depreciation expense is due to acquired assets that became fully depreciated during the 2010 and first quarter 2011.


Stock-based compensation, which represents a noncash expense category, is the amortization of the estimated fair value of stock-based compensation to employees, non-employee members of our Board of Directors, and consultants in lieu of cash compensation. During fiscal 2011, the Company recognized an expense associated with employee stock-based and director’s compensation of $164,241, and $287,372 of consulting expense. During the same period of 2010, the Company recognized stock-based compensation expense for employees and directors of $1,212,663 and consultants of $300,602. The decrease in stock-based compensation for employees and non-employee directors of $1,048,422 (86.5%) is due to no issuance of incentive stock options to: (i) employees in 2010 or 2011, whereas stock options were issued to employees during prior years and amortized over the two year vesting period, and (ii) non-employee directors during 2011, whereas such stock options were issued in 2010 and amortized over the one year vesting period no stock grants issued to employees during 2011. Fiscal 2010 included other stock compensation to executives, which was not issued in 2011.  Stock-based compensation expense for consultants decreased $13,230 (4.4%) during 2011.


Employee stock option expense in 2011 and 2010 represents the amortization of the Black-Scholes fair value as outlined above in accordance with ASC 718-10. ASC 718-10 requires the recognition of all share-based payments to employees or to non-employee directors, as compensation for service on the Board of Directors, as compensation expense in the consolidated financial statements. The amount of compensation is measured based on the estimated fair values of such stock-based payments on their grant dates, and is amortized over the estimated service period to vesting.  Consulting expense for stock-based payments to consultants is based on the fair value of the stock-based compensation at inception and amortized over the estimated service period but, in accordance with ASC 505-50, is remeasured on each reporting date until the performance commitment is complete.


Other Income (Expense).  Other income (expense) includes interest income, interest expense, and other non-operating income and expense. Other income for fiscal 2011 was $1,580,813, compared to $993,169 for the same period last year, for an increase of $587,644 (59.2%). There was no interest income from interest bearing accounts during 2011, or for the same period in 2010, due to low average daily cash balances in interest bearing accounts during the periods.  The activity for fiscal 2011 and the variances to the same period in 2010 include: (i) interest expense of $8,751, compared to $681,117 for the same period in 2010, or a decrease of $672,366 (98.7%) as a result of the October 15, 2010 Debenture Amendment Agreement, whereby the $1,688,205 of outstanding principal amount does not bear interest from July 1, 2010 through their maturity on June 30, 2011, nor provides for interest after the maturity date, (ii) financing costs in 2011 of $25,000 versus no expense in 2010 (iii) Debt discount amortization costs in 2011 of $6,113 versus no expense in 2010 (ii) an expense of $337,641 for the valuation of the default provision for the outstanding debenture, compared to income during 2010 of $2,587,216, or a decrease in income of $2,924,857 (113.1%), (iii) income of $1,958,318 from the revaluation of embedded conversion feature of the outstanding debentures, compared to an expense in 2010 of $1,139,980, or a decrease in other expense of $3,098,298




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(271.8%), (iv) no expense for the fair value of warrants as inducement to extend short-term notes or conversion for stock, or a decrease of $38,550 (100.0%), and (v) no gain on settlement of debt for the embedded conversion feature of debentures since there were no conversion during 2011, compared to income for the same period last year of $265,600 (100.0%). Non-cash non-operating income included above for 2011 was $1,589,564, and for 2010 of $993,169.


Net Income (Loss) and Net Income (Loss) per Common Share.  Net loss for fiscal 2011 was $1,154,376, compared to a net loss for the same period in 2010 of $3,650,231, for a decrease in net loss of $2,495,855 (68.4%). Net income (loss) for the Company per common share (“basic EPS”) is computed by dividing net income (loss) by the weighted average number of shares outstanding.  Net income (loss) per common share assuming dilution (“diluted EPS”) is computed by reflecting potential dilution from contingently issuable shares (i.e. common stock purchase warrants and stock options issued and outstanding).


Reconciliation between the numerators and denominators of the basic and diluted EPS computations is as follows:


 

Year Ended December 31

 

2011

 

2010

Numerator:

 

 

 

Net loss

 $ (1,154,376)

 

 $ (3,650,231)

 

 

 

 

Denominator:

 

 

 

Weighted average common shares outstanding - basic & diluted

  85,456,082 

 

  69,024,431 

Weighted average common shares outstanding - Diluted

  139,246,542 

 

  110,690,895 

 

 

 

 

Net loss per common share:

 

 

 

Basic & diluted

 $ (0.01)

 

 $ (0.05)

Diluted

  (0.01)

 

  (0.03)

 

 

 

 



CONTRACTUAL OBLIGATIONS AND COMMITMENTS


The following table summarizes scheduled maturities of our contractual obligations extending beyond one year for which cash flows are fixed and determinable as of December 31, 2011.


Category

Payments Due in Fiscal

Total

2012

2013

2014

2015

2016

Thereafter

 

 

 

 

 

 

 

 

Short-term convertible debentures (1)

 $ 1,688,205 

 $ 1,688,205 

 $ - 

 $ - 

 $ - 

 $ - 

 $ - 

Interest payments (2)

  - 

  - 

  - 

  - 

  - 

  - 

  - 

Operating lease commitments (3)

  74,757 

  68,993 

  5,764 

  - 

  - 

  - 

  - 

Unconditional purchase obligations (4)

  - 

  - 

  - 

  - 

  - 

  - 

  - 

  Total contractual obligations

 $ 1,762,962 

 $ 1,757,198 

 $ 5,764 

 $ - 

 $ - 

 $ - 

 $ - 

 

 

 

 

 

 

 

 

(1) Represents the outstanding Series A Convertible Debentures that originally matured November 8, 2008, and were amended October 15, 2010. Under terms of the amendment, the Company and the debenture holders agreed to an extension of the maturity date to June 30, 2011.  The Company is currently in default under the amendment agreement and is negotiating with the debenture holders to extend the maturity date.  Commencing March 3, 2011, the Company may force a conversion of the debentures if certain trading price and volume conditions are met.

(2) The outstanding Series A convertible debentures, under the October 15, 2010 amendment, did not bear interest through the new maturity date of June 30, 2011, and the amendment agreement does not require interest after the maturity date.  The Company is in negotiations with the debenture holders to extend the maturity date of the convertible debentures, and the holders may require interest to be paid for such extension.

(3) Represents projected rent cost for the existing office lease, which expires on January 31, 2012.  Total rental expense included in the accompanying consolidated statements of earnings was $70,160 in fiscal 2011, and $158,319 in fiscal 2010.

(4) The company currently does not have any outstanding unconditional purchase obligations.  They would though include inventory commitments, future royalty, consulting agreements, other than month-to-month arrangements or those that expire in less then one year, or commitments pursuant to executive compensation arrangements.



CRITICAL ACCOUNTING POLICIES


The discussion and analysis of our financial condition at December 31, 2011 and our results of operations for the two fiscal years ended December 31, 2011, are based upon our consolidated financial statements, which have been prepared in conformity with U.S. generally accepted accounting principles.  The preparation of these financial statements requires us to make estimates and assumptions that affect the amounts of assets, liabilities, revenues and expenses reported in those financial statements.  These estimates and assumptions can be subjective and complex and, consequently, actual results could differ from those estimates.  We believe the following




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critical accounting policies affect the more significant judgments and estimates used in the preparation of our consolidated financial statements.


Revenue Recognition.  Revenues are derived primarily from the sublicensing and licensing of computer software, installations, training, consulting, software maintenance and sales of PACS, RIS and RIS/PACS solutions.  Inherent in the revenue recognition process are significant management estimates and judgments, which influence the timing and amount of revenue recognized.


For software arrangements, we recognize revenue according to the ASC 985-605, “Software Revenue Recognition,” and related amendments.  ASC 985-605 generally requires revenue earned on software arrangements involving multiple elements to be allocated to each element based on the relative fair values of those elements.  Revenue from multiple-element software arrangements is recognized using the residual method.  Under the residual method, revenue is recognized in a multiple element arrangement when vendor-specific objective evidence of fair value exists for all of the undelivered elements in the arrangement, but does not exist for one or more of the delivered elements in the arrangement.  We allocate revenue to each undelivered element in a multiple element arrangement based on its respective fair value, with the fair value determined by the price charged when that element is sold separately.  Specifically, we determine the fair value of the maintenance portion of the arrangement based on the renewal price of the maintenance offered to customers, which is stated in the contract, and fair value of the installation based upon the price charged when the services are sold separately.  If evidence of the fair value cannot be established for undelivered elements of a software sale, the entire amount of revenue under the arrangement is deferred until these elements have been delivered or vendor-specific objective evidence of fair value can be established.


Revenue from sublicenses sold on an individual basis and computer software licenses is recognized upon shipment provided that evidence of an arrangement exists, delivery has occurred and risk of loss has passed to the customer, fees are fixed or determinable and collection of the related receivable is reasonably assured.


Revenue from software usage sublicenses sold through annual contracts and software maintenance is deferred and recognized ratably over the contract period.  Revenue from installation, training, and consulting services is recognized as services are performed.


Cost of goods sold incorporates our direct costs of raw materials, consumables, staff costs associated with installation and training services, and the amortization of the intangible assets (developed software) related to products sold.


Research and Development.  Costs incurred in connection with the development of software products that are intended for sale are accounted for in accordance with ASC 985-20, “Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed.”  Costs incurred prior to technological feasibility being established for the product are expensed as incurred.  Technological feasibility is established upon completion of a detail program design or, in the absence, completion of a working model.  Thereafter, as long as no high-risk development issues exist, all software production costs are capitalized and subsequently reported at the lower of unamortized cost or net realizable value.  Capitalized costs are amortized based on current and future revenue for each product with an annual minimum equal to the straight-line amortization over the remaining estimated economic life of the product.  Amortization commences when the product is available for general release to customers.


Stock-Based Compensation.  We adopted on January 1, 2006, the provisions of ASC 718-10, which requires recognition of stock-based compensation expense for all share-based payments based on fair value. ASC 718-10, “Share-Based Payment” defines fair value-based methods of accounting for stock options and other equity instruments.  This method measures compensation costs based on the estimated fair value of the award and recognizes that cost over the service period. We also consider ASC 505-50, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods, or Services” (“ASC 505-50”), establishes the measurement principles for transactions in which equity instruments are issued in exchange for the receipt of goods or services.  We relied upon the guidance provided under ASC 505-50 to determine the measurement date and the fair value re-measurement principles to be applied.  Based on these findings, we determined that the unamortized portion of the stock compensation should be re-measured on each interim reporting date and proportionately amortized to stock-based compensation expense for the succeeding interim reporting period until goods are received or services are performed. We recognize compensation costs, net of an estimated forfeiture rate, on a pro rata basis over the requisite service period of each vesting tranche of each award. We consider voluntary termination behavior as well as trends of actual option forfeitures when estimating the forfeiture rate.


Valuation of Long-Lived Assets Including Acquired Intangibles.  We evaluate the carrying value of long-lived assets for impairment, whenever events or changes in circumstances indicate that the carrying value of an asset within the scope of ASC 360-10, “Accounting of the Impairment or Disposal of Long-Lived Assets” may not be recoverable. Our assessment for impairment of assets involves estimating the undiscounted cash flows expected to result from use of the asset and its eventual disposition. An impairment loss recognized is measured as the amount by which the carrying amount of the asset exceeds the fair value of the asset, and considers year-end the date for its annual impairment testing.  The Company prepared this analysis as of the year ended December 31, 2011, and 2010, and concluded that the intangible assets are not impaired.  Therefore, there was no impairment expense during Fiscal 2011 and 2010.





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Impairment of Excess of Purchase Price Over Net Assets Acquired.  We follow the provisions of ASC 805-10, “Business Combinations” and ASC 350-10, “Goodwill and Other Intangible Assets.” These statements establish financial accounting and reporting standards for acquired goodwill.  Specifically, the standards address how acquired intangible assets should be accounted for both at the time of acquisition and after they have been recognized in the financial statements.  Effective January 1, 2002, with the adoption of ASC 350-10, goodwill must be evaluated for impairment and is no longer amortized.  Excess of purchase price over net assets acquired (“goodwill”) represents the excess of acquisition purchase price over the fair value of the net assets acquired.  To the extent possible, a portion of the excess purchase price is assigned to identifiable intangible assets.  We determine impairment by comparing the fair value of the goodwill, using the undiscounted cash flow method, with the carrying amount of that goodwill.  Impairment is tested annually or whenever indicators of impairment arise.  There was no goodwill on the consolidated balance sheet of the Company during Fiscal 2011 and 2010, as a net realizable value analysis was made for goodwill in prior years and such asset was considered fully impaired during those prior years. Therefore, there was no amortization expense of goodwill during Fiscal 2011 and 2010.


OFF-BALANCE SHEET ARRANGEMENTS


We do not maintain any off-balance sheet arrangements, transactions, obligations or other relationships with unconsolidated entities that would be expected to have a material current or future effect upon our financial condition or results of operations.


RECENTLY ISSUED ACCOUNTING STANDARDS


Refer to “Notes to Consolidated Financial Statements, Note 2 - Significant Accounting Policies” for discussion regarding the impact of Accounting Standards that were recently issued but not yet effective, on our Consolidated Financial Statements.


ITEM 7A.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK


Our market risk is confined to changes in foreign currency exchange rates and potentially adverse effects of differing tax structures.  There were no international revenues subject to such market risks during fiscal 2011.  International activities were mostly from our Signature Mapping™ revenue opportunities in South Africa and India.  Therefore, we may be exposed to foreign exchange rate fluctuations as the Company continues to pursue the revenue opportunities outside the United States.  As exchange rates vary, results when translated may vary from expectations and adversely impact overall expected profitability. As of December 31, 2011, the Company’s foreign currency exposure is related to accounts payable trade in the amount of $30,371.

ITEM 8.     FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA


The information required by this item appears beginning on page 91 of this Annual Report on Form 10-K and is incorporated herein by reference.


ITEM 9.     CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

The Audit Committee of the Board of Directors of the Company has appointed the firm of KBL, LLP, to serve as Applied Visual Sciences, Inc.'s independent registered public accountants and to be the principal registered public accountants to conduct the audit of Applied Visual Sciences, Inc.'s financial statements. KBL, LLP was first appointed on February 23, 2009 for the fiscal year ending December 31, 2008 audit. On March 29, 2012, KBL, LLP was reaffirmed by the Audit Committee as Applied Visual Sciences, Inc.'s independent registered public accountants and to be the principal registered public accountants to conduct the audit of Applied Visual Sciences, Inc.'s financial statements for the fiscal year ended December 31, 2011.

ITEM 9A.  CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures


As of the end of the period covered by this Report, the Chief Executive Officer and Chief Financial Officer of the Company (the “Certifying Officers”) conducted evaluations of the Company’s disclosure controls and procedures. As defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), the term “disclosure controls and procedures” means controls and other procedures of an issuer that are designed to ensure the information required to be disclosed by the issuer in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s (“SEC”) rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by an issuer in the reports that it files or submits under the Exchange Act is accumulated and communicated to the issuer’s management, including the Certifying Officers, to allow timely decisions regarding required disclosure.




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Based on this evaluation, the Certifying Officers determined that, as of the end of the period covered by this Report, the Company’s disclosure controls and procedures were effective to ensure that the information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms and to ensure that information required to be disclosed by the Company in the Reports that it files or submits under the Exchange Act is accumulated and communicated to the Company’s management, including the Company’s principal executive and principal financial officers, or persons performing similar functions, as appropriate, to allow timely decisions regarding disclosure.


Although the Certifying Officers have determined that our disclosure controls and procedures were effective, management continues to believe that a refinement to our disclosure controls is an ongoing process. The Audit Committee believes the Company should continue the following activities: (a) additional education and professional development for the Company’s accounting and other staff on new and existing applicable SEC filing requirements, certain applicable SEC disclosure requirements, and the timing of the filing thereof, and (b) reviewing disclosure requirements, including Form 8-K and Regulation S-K disclosure requirements, SEC staff guidance and interpretations related thereof, as well as Accounting Standards Codification (“ASCs”) and updates.


Management’s Annual Report on Internal Control Over Financial Reporting


Management of Applied Visual Sciences, Inc. (including its subsidiaries) (the “Company”) is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rules13a-15(f) of the Securities Exchange Act of 1934, as amended).


The Company’s internal control over financial reporting is a process designed by, and under the supervision of, its principal executive and principal financial officers, or person performing similar functions, and effected by the Company’s board of directors, management and other personnel,  to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles in the United States of America. The Company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the Company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets that could have a material effect on the financial statements.


Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements.  Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.


Under the supervision of and with the participation of the Chief Executive Officer and the Chief Financial Officer, the Company’s management conducted an assessment of the effectiveness of the Company’s internal control over financial reporting based on the framework in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Based on this assessment, the Company’s management has concluded that, as of December 31, 2011, the Company’s internal control over financial reporting was effective.


This annual report does not include an attestation report of the Company’s registered independent public accounting firm regarding internal control over financial reporting.  Management’s report was not subject to attestation by the Company’s registered independent public accounting firm pursuant to rules of the Securities and Exchange Commission that permit the Company to provide only management’s report in this Annual Report on Form 10-K.


Changes in Internal Controls


There were no changes in the Company’s internal controls over financial reporting during the period covered by the Report that have materially affected, or are reasonably likely to materially affect, the Company’s internal controls over financial reporting.


ITEM 9B.  OTHER INFORMATION


On October 26, 2010, in accordance with an outstanding capital raise, four executives and a consultant/director of the Company converted a portion of their accrued and unpaid wages, outstanding accounts payable, and other related compensation in an aggregate of $1,267,706, for a total of 5,070,825 shares of Common Stock, and an aggregate of 5,070,825 Class N Common Stock Purchase Warrants.




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The Warrants issued are exercisable at a price of $0.25 per share; contain a conditional call provision if the market price of each share exceeds $3.00, and customary anti-dilution provisions. The warrants expire in sixty (60) months from the date of issuance.


PART III


ITEM 10.   DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE


The following table sets forth the current directors and executive officers of Applied Visual Sciences, Inc.:


Name

Age

Title

Joseph C. Brothers

52

Director - Class I

William J. Donovan

60

President, Chief Operating Officer and Director - Class III

Gregory E. Hare

58

Chief Financial Officer, Treasurer

Keith S. Kelly

48

Director - Class I

Sean W. Kennedy

62

Director - Class II, Consultant to the Company

Charles T. Nash

61

Director - Class I

Michael W. Trudnak

59

Chairman of the Board, Chief Executive Officer, Secretary, Director - Class III

Under Applied Visual Sciences, Inc.’s Certificate of Incorporation, the board of directors is divided into three classes and, if the board consists of seven directors, the first class shall consist of three directors to hold office for a term of one year from the date of the ratification of their election by stockholders at the next meeting of stockholders held to consider such matter, the second class shall consist of two directors to hold office for a term of two years from the date of the ratification of his election by stockholders at the next meeting of stockholders held to consider such matter, and the third class shall consist of two directors to hold office for a term of three years from the date of the ratification of their election by stockholders at the next meeting of stockholders held to consider such matter.  At each succeeding annual meeting of stockholders, the successors to the class of directors whose terms shall then expire shall be elected to hold office for a term expiring at the third succeeding annual meeting.

Biographical information with respect to the present executive officers and directors of Applied Visual Sciences, Inc. are set forth below. There are no family relationships between any present executive officers or directors.


Joseph C. Brothers, Director.  Mr. Brothers became a Class I director of Applied Visual Sciences, Inc. on April 26, 2010. Since September 1997, Mr. Brothers has been President of The Joseph Brothers Company, Inc., a privately-held ERP (Enterprise Resource Planning) and SAP (Systems, Applications and Products) consulting services company.  Since October 2009, Mr. Brothers has been the Principal Research Scientist for University of Alabama Enterprise Resource Planning Advisor, supporting the Army Chief Information Office and Office of the Deputy Chief of Staff of the Army.  From December 2006 to October 2009, Mr. Brothers was U.S. Army ERP Functional Integration Advisor, Enterprise Integration Office, Business Transformation Agency, United States Department of Defense. From March 2003 to December 2006, Mr. Brothers was a SAP Implementation Functional Integration Lead with Northrop Grumman Mission Systems.  Mr. Brothers has over fifteen years of SAP project/program management, configuration, and functional architecture and business modernization experience for the United States Department of Defense, United States Army, commercial manufacturing, media, and state government environments.  Also, he has over twelve years of operational accounting and financial accounting experience in the commercial environment. As an ERP project leader, he has solid knowledge of U.S Army tactical logistical requirements as it relates to SAP functionality.  Mr. Brothers received a Bachelor of Science Degree in Business Administration from the University of Arizona, and a Master of Science Degree in Management from the Krannert Graduate School of Management at Purdue University.  Mr Brothers is a certified public accountant.


William J. Donovan, President, Chief Operating Officer and Director. Mr. Donovan became a Class III director in August 2006. Mr. Donovan has been President and Chief Operating Officer since November 21, 2005. Also, from August 18, 2003, until January 30, 2006, Mr. Donovan was Chief Financial Officer. From January 2003 until August 2003, Mr. Donovan was an independent consultant to an affiliate of American Express Small Business Services. From September 1999 through December 2002, Mr. Donovan was CFO of Streampipe.com, Inc., a privately held streaming communications media company.  From October 1996 to August 1999, Mr. Donovan was Chief Operating and Financial Officer for TDI, Inc., a privately held international wireless telecommunications services company.   From October 1986 to October 1996, Mr. Donovan was Chief Financial Officer, Secretary, Treasurer and a director at Riparius Corporation, a privately held holding company with operating subsidiaries in the areas of real estate development, property management, general contracting, government contracting, and telecommunications engineering.  From October 1980 to October 1986, Mr. Donovan was the Controller for McCormick Properties, Inc., a publicly held commercial real estate subsidiary of McCormick & Company.  From




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July 1973 to October 1980, Mr. Donovan was the Controller for AMF Head Sports Wear, Inc., a privately held international sporting goods manufacturer and a subsidiary of AMF, Inc., a publicly held company.  Mr. Donovan received a Bachelor of Arts in History in 1973 and a Certificate in Accounting in 1978 from the University of Maryland.  In 1982, he received an MBA from the Sellinger School of Business, Loyola University Maryland.  Mr. Donovan has been a Certified Public Accountant since 1982.  He is also a Certified Business Valuation & Transfer Agent, Business Brokers Network, 2002.  He has been on the Advisory Board for Nogika Corporation, a privately held software company, since 2001.


Henry A. Grandizio, Director.  Mr. Grandizio, who resigned from the Board on October 18, 2011, was appointed as a Class II director of Applied Visual Sciences, Inc. on September 17, 2007.  Since 2006 to present, Mr. Grandizio has been the managing partner at Grandizio, Wilkins, Little & Matthews, LLP, a certified public accounting firm.  From 1986 until 2006, Mr. Grandizio was shareholder and vice president of Scheiner, Mister, & Grandizio, P.A.  From 1978 to 1986, Mr. Grandizio was an audit and accounting manager for McGrow, Pridgeon and Company, P.A.  Mr. Grandizio received a Masters in Science, Taxation from the University of Baltimore and a Bachelor of Arts in Accounting from Loyola College.


Gregory E. Hare, Chief Financial Officer, and Treasurer.  Mr. Hare was appointed Chief Financial Officer on January 30, 2006. From May 2001 through January 2006, Mr. Hare served as a financial executive of Jane Cosmetics, a national mass market cosmetics manufacturing and distribution company headquartered in Baltimore, Maryland. There he served three years as Director of Finance for the wholly owned subsidiary of The Estee Lauder Companies, Inc. and the last two years as CFO/Controller of the privately held Jane & Company, LLC.  Prior to that, Mr. Hare held positions including CFO/Controller for a privately held hospitality company LFB Enterprises, with locations in and around Baltimore and Washington, DC; Manager, Pricing Group for the Industrial Division of McCormick & Company, a publicly held international spice company headquartered in Hunt Valley, Maryland; and CFO/Controller for Acordia Collegiate Benefits, Inc., a for-profit subsidiary of Anthem (formerly Blue Cross and Blue Shield of Indiana).  Mr. Hare received a Bachelor of Science in Accounting from the University of Baltimore, and an MBA from the Sellinger School of Business of Loyola University Maryland in 1984.  Mr. Hare has been a Certified Public Accountant since 1979.


Keith S. Kelly, Director.  Mr. Kelly became a Class I director of Applied Visual Sciences, Inc. on April 26, 2010. Since December 2008, has been Chairman and CEO of Mortgage Harmony Corporation (formerly, Lending Annuity Group), a privately-held financial engineering company, where he developed patented mortgage compensation systems and methods, including the introduction of the Harmony Loan, a closing-cost savings platform.  From August 2006 to December 2008, Mr. Kelly was President of Modified Lending, Inc., a privately-held marketing company. From May 1999 to August 2006, Mr. Kelly was Division Manager of National City Mortgage, a publicly-held mortgage company. During these periods, Mr. Kelly also held loan officer positions with MetLife Home Loans, SunTrust Mortgage, National City, and manager positions with Megastar Financial, Access National Bank and Flagstar Bank.  Mr. Kelly is an entrepreneur in the mortgage industry who has created and patented certain mortgage compensation systems and methods, including the platform that enabled the introduction of the Harmony Loan. As a seasoned retail mortgage banking executive, Mr. Kelly has been an advocate for proper homeowner education for nearly two decades, focusing on strategies to avoid paying closing costs and his closing-cost savings platform has been featured in Money, The Washington Post, Time, New York Times, Woman’s World, CNBC and a host of other national publications. He is also a host of MyMortgageWatchDog (a mortgage educational talk show) in Washington, D.C.  Mr. Kelly received a Bachelor of Science Degree from James Madison University in 1985.


Sean W. Kennedy, Director.  Mr. Kennedy became a Class II director in July 2003 and a consultant to the Company since May 27, 2008.  From January 2001 to the present, Mr. Kennedy has been President and Chief Executive Officer of BND Software, Inc. a privately held software development company.  On May 27, 2008, the Company entered into a consulting agreement with BND Software pursuant to which it agreed to provide certain consulting services to the Company including managing the research, development and information systems activities of the Company.  From October 1999 to December 2000, Mr. Kennedy was divisional Vice President of Votenet Solutions, a Web development and consultant for trade associations, political parties and related organizations.  From April 1994 to October 1999, Mr. Kennedy was President and CEO of Raintree Communications Corporation, a privately held telecommunications services company, focused on providing technology tools for legislative lobbying to Trade Associations and Fortune 500 companies.  From June 1989 to April 1994, Mr. Kennedy was President and CEO of Electronic Funds Transfer Association, a trade association for the electronic payments systems industry.  Mr. Kennedy is a graduate of Mount Saint Mary’s College in Emmitsburg, Maryland.


Charles T. Nash, Director.  Mr. Nash became a Class I director of Applied Visual Sciences, Inc. in June 2004.  Mr. Nash has over 25 years of military experience and more than 14 years of leadership experience in emerging technology in the private sector.   Since October 2000, Mr. Nash has been President of Emerging Technologies International, Inc. (“ETII”), a privately held consulting company. ETII works to get high level technologies developed by small commercial companies inserted quickly, efficiently and inexpensively into applications/tools for immediate military use. The company also works with government laboratories and acquisition agencies to facilitate speedy and effective “lab to fleet” technology interchanges and discussions.  From April 1998 to October 2000, Mr. Nash was vice president of Emerging Technology Group of Santa Barbara Applied Research, Inc., a privately held defense consulting and emerging technology marketing company.  Prior to that, Mr. Nash served in various military leadership positions, including: head of Strike/Anti-Surface Unit Warfare and Air to Air/Strike Support section on the staff of the Chief of Naval Operations, overseeing budget planning of




65


approximately $18 billion; executive assistant to the Deputy Commander in Chief, U.S. Naval Forces Europe; and executive and commanding officer, Strike Fighter Squadron 137.  Mr. Nash retired from the U.S. Navy in 1998 with the rank of Captain.  Mr. Nash is a frequent guest military and aviation analyst for Fox News Channel, and several regional radio stations.  Mr. Nash earned a BS Aeronautics degree in 1973 from the Parks College of Aeronautical Technology, Saint Louis University, Cahokia, Illinois, and is a graduate of the National War College.


Michael W. Trudnak, Chairman of the Board, Chief Executive Officer, Secretary, and Director.  Mr. Trudnak was appointed Chairman of the Board, Secretary, and Chief Executive Officer and became a Class III director in June 2003.  From March 2003 and until the present, Mr. Trudnak has been Chairman of the Board, Chief Executive Officer, Secretary, Treasurer and a director of RJL. From October 2002 to March 2003, Mr. Trudnak was a consultant to certain telecommunications services companies. From April 2002 to October 2002, Mr. Trudnak was Chief Operating Officer and subsequently President, Chief Executive Officer and a director of Advanced Data Centers, Inc., a privately held telecommunications services company. From July 2001 to March 2002, Mr. Trudnak served as Vice President of Mid-Atlantic Sales for Equant N.V, a leading provider of global IP and data services to multinational companies. Prior to Equant's acquisition of Global One, Inc., in July 2001, Mr. Trudnak served as an Executive Director for South East Region Sales for Global One from June 1998 to July 2001, and from January 1996 to June 1998, served as Managing Director of Global One's sales and operations in France and Germany. From November 1989 through December 1995, Mr. Trudnak served as director of facilities engineering and then Senior Group Manager for Sprint International, a global telecommunications services provider. Mr. Trudnak has over twenty-five years of diversified executive management, sales, business operations, technical and administrative experience in the telecommunications industry.  Mr. Trudnak served in the Marine Corps from April 1972 through January 1976.


Each officer is appointed by the board of directors and holds his office at the pleasure and discretion of the board of directors or until his earlier resignation, removal or death.


There are no material proceedings to which any director, officer or affiliate of Applied Visual Sciences, Inc., any owner of record or beneficially of more than five percent of any class of voting securities of Applied Visual Sciences, Inc., or any associate of any such director, officer, affiliate of Applied Visual Sciences, Inc. or security holder is a party adverse to Applied Visual Sciences, Inc. or any of its subsidiaries or has a material interest adverse to Applied Visual Sciences, Inc. or any of its subsidiaries.


Independent Directors

Our board of directors has adopted the definition of independence as defined in Section 803A of the NYSE Amex LLC Company Guide.  Based upon such definition, the board of directors has determined that the following directors are independent: Joseph C. Brothers, Charles T. Nash, and Keith S. Kelly, that a majority of our directors are “independent.”  The board of directors maintains an audit committee, compensation committee, and nominating committee.  We may also establish special or other committees from time to time to consider matters at the request of the Board.  The current members of such committees as of the date of the filing of this report are as follows:


Audit

-

Joseph C. Brothers, Chairman

Charles T. Nash

Keith S. Kelly


Compensation

-

Charles T. Nash, Chairman

Keith S. Kelly


Nominating

-

Joseph C. Brothers, Chairman

Charles T. Nash


The Board of Directors

The Board oversees the business affairs of Applied Visual Sciences, Inc. and monitors the performance of management. During the year ended December 31, 2011, the Board held twelve (12) meetings and handled certain other business through unanimous written consents of its board in accordance with its by-laws and applicable Delaware law.  Messrs. Brothers and Trudnak attended all of such meetings of the Board, Mr. Donovan attended eleven (11) of such meetings, Mr. Nash attended ten (10) of such meetings, Mr. Kennedy attended nine (9) of such meetings of the Board.  Mr. Henry A. Grandizio, who attended two of such board meetings, resigned from the Board on October 18, 2011. Applied Visual Sciences, Inc. has a policy of requesting all directors to attend annual meetings of stockholders. On April 24, 2010, the Company reduced the number of members required for the board of directors from nine to seven members. Currently, the Board has four committees, an Audit, Compensation, Nominating, and Special Committee. The membership and functions of such committees are described below.


Currently, Mr. Trudnak serves as our Chairman and Chief Executive Officer.  Mr. Donovan serves as our President and Chief Operating Officer. A majority of our directors are independent and each of our Board committees consists of independent directors,




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including each of the Chairs of such committees. We do not have a lead independent director to preside at our Board meetings, but may do so in the future.  For a company of our size, we believe that the CEO is in the best position to focus the independent directors’ attention on the issues of greatest importance to the company and its stockholders, and we believe that splitting such roles may have the consequence of making our management and governance processes less effective than they are today through duplication and a blurring of the lines of accountability and responsibility for matters.


Our senior management is responsible for overseeing, assessing and managing our exposures to risk on a day-to-day basis, including the creation of appropriate management programs and policies. We do not maintain a separate committee of our Board responsible for managing and overseeing our exposure to risk. Our Board is responsible for overseeing management in the execution of this responsibility and for assessing our approach to risk management. Our Board exercises this responsibility at its periodic Board meetings and at meetings of our Board committees, each of which has a defined area of responsibility. Our Board’s role in risk management is consistent with our leadership structure, with our CEO and President having responsibility for assessing and managing our risk exposure and the Board and its committees providing oversight in connection with those efforts.


Audit Committee

The Audit Committee consists of three members, Joseph C. Brothers, Keith S. Kelly, and Charles T. Nash.  Mr. Brothers was appointed as chairman of the committee on October 27, 2011, upon the resignation of Mr. Henry A. Grandizio.  Mr. Nash was also appointed to the committee on October 27, 2011,. The Audit Committee held four meetings during 2011, and Mr. Brothers attended all of such committee meetings, Messrs. Kelly and Grandizio attended three of such meetings, and Mr. Nash attended one meeting of the committee meetings. The board of directors determined that Messrs. Brothers, Kelly, and Nash are deemed independent within the definition of “independence” set forth in Section 803A of the NYSE Amex LLC Company Guide, as was Mr. Grandizio during his tenure on the committee.


The board of directors has adopted a written charter for the Audit Committee which provides that the Audit Committee's primary functions are to (a) oversee the integrity of Applied Visual Sciences, Inc.’s financial statements and Applied Visual Sciences, Inc.’s compliance with legal and regulatory reporting requirements, (b) appoint a firm of certified public accountants whose duty it is to audit Applied Visual Sciences, Inc.’s financial records for the fiscal year for which it is appointed, (c) evaluate the qualifications and independence of the independent auditors, (d) oversee the performance of Applied Visual Sciences, Inc.’s internal audit function and independent auditors, and (e) determine the compensation and oversee the work of the independent auditors. It is not the duty of the Audit Committee to plan or conduct audits or to determine that Applied Visual Sciences, Inc.’s financial statements are complete and accurate and are prepared in accordance with generally accepted accounting principles in the United States.  Management is responsible for preparing Applied Visual Sciences, Inc.’s financial statements, and the independent auditors are responsible for auditing those financial statements.


Compensation Committee

The Compensation Committee consists of two members, including Charles T. Nash, and Keith S. Kelly. Mr. Nash was appointed chairman of the committee on April 21, 2009.  Mr. Henry A. Grandizio was a member of the committee until his resignation on October 18, 2011.  The Compensation Committee held two meetings during 2011, and Messrs. Grandizio, Kelly, and attended all of such committee meetings.


The Compensation Committee's primary functions are to:


·

evaluate the performance of the CEO and determine the CEO’s total compensation and individual elements thereof;

·

determine the compensation level of the CEO and President and review and approve corporate goals and objectives relevant to senior executive compensation (including that of the CEO), evaluate senior management's performance in light of those goals and objectives, and determine and approve senior management's compensation levels based on their evaluation;

·

evaluate the performance of other executive officers and determine their total compensation and individual elements thereof;

·

make all grants of restricted stock or other equity based compensation to executive officers;

·

administer Applied Visual Sciences, Inc.'s compensation plans and programs;

·

recommend to the board for approval equity based plans and incentive compensation plans;

·

review management development and succession programs; and

·

review appropriate structure and amount of compensation for board members.


The board of directors has determined that all members of the Compensation Committee currently are independent within the meaning of “independence” set forth in Section 803A of the NYSE Amex LLC Company Guide.





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Nominating Committee

The Nominating Committee consists of two members, Joseph C. Brothers, and Charles T. Nash.  Mr. Brothers was elected chairman of the committee on April 24, 2010. The Nominating Committee did not hold committee meetings during 2011. The board has adopted a written charter for the Nominating Committee.


The Nominating Committee's primary functions are to:


·

consider, recommend and recruit candidates to serve on the board and to recommend the director nominees selected by the Committee for approval by the board and the stockholders of Applied Visual Sciences, Inc.;

·

recommend to the board when new members should be added to the board;

·

recommend to the board the director nominees for the next annual meeting;

·

when vacancies occur or otherwise at the direction of board, actively seek individuals whom the Committee determines meet the criteria and standards for recommendation to the board;

·

consider recommendations of director nominees by stockholders and establish procedures for shareholders to submit recommendations to the Committee in accordance with applicable SEC rules and applicable listing standards;

·

report, on a periodic basis, to the board regarding compliance with the Committee’s Charter, the activities of the Committee and any issues with respect to the duties and responsibilities of the Committee;

·

establish a process for interviewing and considering a director candidate for nomination to the board;

·

recommend to the board guidelines and criteria as to the desired qualifications of potential board members;

·

provide comments and suggestions to the board concerning board committee structure, committee operations, committee member qualifications, and committee member appointment;

·

review and update the Committee’s charter at least annually, or more frequently as may be necessary or appropriate; and

·

perform such other activities and functions related to the selection and nomination of directors as may be assigned from time to time by the board of directors including, but not limited to, preparing or causing to be prepared any reports or other disclosure required with respect to the Committee by any applicable proxy or other rules of the SEC or as required by the rules and regulations of any exchange or over-the-counter market on which our securities may then be listed or quoted.


The Committee will consider all stockholder recommendations for candidates for the Board, which should be sent to the Nominating Committee, c/o Michael W. Trudnak, Secretary, 250 Exchange Place, Suite H, Herndon, Virginia 20170. The information required to be included is set forth in Article III, Section 2 of our Bylaws.  We believe that directors should possess the highest personal and professional ethics, integrity and values, and be committed to representing the long-term interests of stockholders. We believe that the following attributes are important to board membership: experience as a leader of a business firm or institution; mature and practical judgment; the ability to comprehend and analyze complex matters; objectivity and perspective; effective communications skills; and strong character and integrity. The Committee’s evaluation of director nominees takes into account their ability to contribute to the diversity of background and experience represented on the Board, and the Committee reviews its effectiveness in balancing these considerations when assessing the composition of the Board. The Board also considers candidates recommended by current directors, company officers, employees and others.  The Committee evaluates all nominees for director in the same manner regardless of the source of the recommendation.


Director Communication Policy

We have established a policy whereby anyone who has a concern about our conduct or about our accounting, internal accounting controls, or auditing matters, may communicate that concern directly to the Board of Directors, the Chairman of our Audit Committee or any other non-employee director or the Audit Committee. All such concerns will be forwarded to the appropriate directors for their review, and all concerns related to audit or accounting matters will be forwarded to the Audit Committee. All reported concerns will be simultaneously reviewed and addressed by our CEO or his designee (unless he or she is alleged to be involved in the matter at issue). The status of all outstanding concerns addressed to the Board, the non-employee directors, or the Audit Committee will be reported to the Board or the Audit Committee (as applicable) on a quarterly basis. The Board or any Board committee may direct special treatment, including the retention of outside advisors or counsel, for any concern addressed to them. Our corporate policies prohibit retaliatory action against any employee who raises concerns or questions in good faith about these matters.


Stockholders wishing to communicate with the board of directors, any non-employee director, or the Audit Committee may do so by writing to the Company's Corporate Secretary at 250 Exchange Place, Suite H, Herndon, Virginia 20170. Our Secretary will forward any communications as directed by the stockholder.


 ADVISORY BOARD





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On November 7, 2007, we established an advisory board to advise and make non-binding recommendations to our board of directors and management regarding the strategic positioning of our new products, future product development, industry trends, and potential research collaborations with third parties.  Members serve for a term of one year.  The advisory board is currently inactive with no members, and the Company anticipates reestablishing the Advisory Board in 2012.


Each member of the Advisory Board of the Corporation (other than the Chairman of the Advisory Board) to be paid or provided as annual compensation an aggregate of 15,000 non-qualified stock options to purchase common stock, $.001 par value per share, of the Corporation pursuant to the Plan, each such option to be exercisable at a price equal to the fair market value of the Common Stock on the date of grant, such options to be exercisable immediately following the date of grant and for a term of ten (10) years thereafter (unless terminated earlier in accordance with the terms of the Plan).  Such compensation was recommended by the compensation committee, and approved by the board of directors of the Company.

AUDIT COMMITTEE EXPERT

We have designated Mr. Joseph C. Brothers as our “audit committee financial expert.”  Mr. Henry A. Grandizio was designated as our audit committee financial expert, until his resignation from the Board on October 18, 2011.  Mr. Brothers was so designated upon his appointment as chairman of the Audit Committee on October 27, 2011.

CODE OF ETHICS

On August 29, 2003, we adopted a Code of Ethics for our chief executive officer, chief financial officer, principal accounting officer or controller, and persons performing similar functions.  A copy of the Code of Ethics has been posted to our website.  Our website address is www.appliedvs.com.  


SECTION 16(a) COMPLIANCE AND REPORTING


Under the securities laws of the United States, the Company’s directors, executive officers, and certain securities holders of the Company’s common stock are required to report their initial ownership of the Company’s common stock and any subsequent changes in that ownership to the SEC.  Specific due dates for these reports have been established and the Company is required to disclose any failure to file by these dates.


Based on our review of Forms 3, 4 and 5 submitted to us pursuant to Rule 16a-3 under the Exchange Act by our executive officers and directors with respect to our most recent fiscal year ended December 31, 2011, there were no known (1) late reports, (2) transactions that were not reported, or (3) known failures to file a required report by such executives officers and directors.  


ITEM 11.   EXECUTIVE COMPENSATION


Compensation Discussion and Analysis

 

Overview

  

The material principles underlying our goals for executive compensation policies and decisions are intended to:


·

implement compensation packages, which are competitive with comparable organizations and allow us to attract and retain the best possible executive talent;

·

relate annual and long-term and stock incentives to achievement of measurable corporate and individual performance objectives;

·

appropriately balance mix of cash and noncash short and long-term compensation;

·

encourage integrity in business dealings through the discretionary portion of our compensation package; and

·

align executive’s incentives with long-term stockholder value creation.


We determine the appropriate levels of total executive compensation, including for our named executive officers, and each compensation element, based on several factors, such as an informal benchmarking of our compensation levels to those paid by comparable companies, our overall performance, each individual executive officer’s performance, the desire to maintain level equity and consistency among our executive officers, and other considerations that we deem to be relevant.  


In an effort to assist the Compensation Committee in the evaluation process, in August 2005, we engaged an independent compensation consultant to evaluate certain aspects of our compensation practices and to assist in developing our executive compensation




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program. To this end, the consultant developed a competitive peer group and performed benchmarking analyses of competitive compensation levels, and used the following companies as a source of the analysis: Merge eFilm, IDX Systems Corporation, DexCom, Inc, NeuStar Inc, Sybari Software, Inc, Technology Spectrum, Inc, Optio Software, Inc, and RadView Software, Ltd.  However, we have not implemented any formal or informal policy for allocating compensation between long-term and short-term, between cash and noncash or among the different forms of noncash compensation.   We did not engage a compensation consultant during fiscal years subsequent to 2005.


Our Compensation Committee reviews and approves all of our compensation policies.   Our Compensation Committee is responsible for evaluating the performance of all our named executive officers, their compensation levels, criteria for grants of stock options, and reviewing and evaluating the terms of their employment agreements.  Our Compensation Committee performs such tasks periodically and solicits the input of our executive officers.  The compensation levels for our named executive officers are based upon management recommendations, including the recommendations of our CEO.


Our executive compensation program during 2011 consisted of three principal elements: base salary, stock options, and severance and change in control benefits.  We also provided to two employees a car allowance.  Our ability to provide any cash incentive compensation, plan or non-plan has been constrained by our limited cash resources. Accordingly, our executive compensation arrangements have been relatively straight forward.


Moreover, due to our limited available cash, during 2006, a significant portion of the three named executive officers base salaries were and continue to be unpaid.  During 2007, three of our named executives had a small portion of their base salaries unpaid and the amount continued to be unpaid during 2011. Additionally, during 2009 through 2011, significant portions of our three named executive officers base salaries were unpaid.  As of December 31, 2011, the Company has an aggregate unpaid salary of its named executives of approximately $2,683,923. We continue to accrue the salaries for our Principal Executive Officers and named executive officers, however, there is substantial uncertainty that we will be able to pay such amounts to our officers.  On October 26, 2010, in accordance with an outstanding capital raise, four of our then named executives and a consultant/director of the Company converted a portion of their accrued and unpaid wages, outstanding accounts payable, and other related compensation in an aggregate of $1,267,706, for a total of 5,070,825 shares of Common Stock, and an aggregate of 5,070,825 Class N Common Stock Purchase Warrants. The Warrants issued are exercisable at a price of $0.25 per share; contain a conditional call provision if the market price of each share exceeds $3.00, and customary anti-dilution provisions. The warrants expire in sixty (60) months from the date of issuance. The Company also issued to such executives and consultant/director, an aggregate of 1,000,000 shares of common stock, and such issuance was previously authorized for all employees as compensation for the hardship of not regularly receiving their salaries, wages, or other compensation that was due during June 2008 through January 2009, and the continued or continuing nonpayment of such amounts by the Company. The issuance of the Common Stock was not in lieu of the payment of such compensation which remained accrued and unpaid.


 Elements of Compensation


The principal elements of our compensation package for our named executive officers, may include following, although we have not provided cash based compensation other than for base salary. We may consider in the future other cash based compensation once we become able to do so.


·

base salary;

·

annual cash incentive bonuses;

·

long-term incentive plan awards using stock options;

·

severance benefits;

·

change in control benefits;

·

401(k) savings plans;

·

retirement benefits; and

·

perquisites and other compensation.


Base Salary

 

The amount of base salary paid or payable to our named executive officers is used to recognize the experience, skills, knowledge and responsibilities required of all our employees, including our named executive officers. When establishing base salaries for the executives, the Compensation Committee and management consider a number of factors, including the seniority of the individual, the functional role of the position, the level of the individual’s responsibility, the ability to replace the individual, the base salary of the individual at his prior employment and various qualified candidates to assume the individual’s role. Generally, we believe our executive’s base salaries should be targeted near the median of the range of salaries for executives in similar positions at comparable companies.

 




70


The base salary of each of our named executive officers is determined on the basis of such officer’s employment agreement with us.  Our Compensation Committee is to review annually each executive officer’s base salary during our performance review. Base salaries may be adjusted from time to time to realign salaries with market levels after taking into account individual responsibilities, performance, experience and the our cash position.  During 2011, we did not increase the base salary of any of Messrs. Trudnak, Donovan, or Hare, and the Committee has not made a determination for 2012.


Also, as discussed above, and due to our limited available cash, during 2006, a significant portion of four of our then named executive officers base salaries were and continue to be unpaid.  During 2007, three of our named executives had a small portion of their base salaries unpaid and the amount continued to be unpaid during 2011.  Additionally, during 2009 through 2011, significant portions of our named executive officers base salaries were unpaid.  As of December 31, 2011, the Company had an aggregate accrued but unpaid salary due to its named executives of approximately $2,683,923.

 

Annual Cash Incentive Bonus

 

Due to the limited cash available to us, we currently do not have a bonus plan and, during 2011, we did not make any annual cash incentive award to our employees, including our named executive officers.

 

 Long-Term Incentive Plan Awards

 

We believe our long-term performance is fostered by a compensation methodology which compensates all employees, including our named executive officers, through the use of stock-based awards that foster a continuing stake of each employee in our long-term success.    We currently utilize stock options, restricted stock rights or other awards and other rights to receive compensation based on the value of our stock. Currently, we do not have a plan requiring us to make any grant or award of stock options or other equity based awards, except for certain annual awards to members of our board of directors who are also independent, discussed under “Director Compensation and Benefits,” below.


Amended and Restated 2003 Stock Incentive Plan


The Board of Directors adopted the 2003 Stock Incentive Plan on August 29, 2003. The Board of Directors amended and restated the plan on December 2, 2003. The Amended and Restated 2003 Stock Incentive Plan (“2003 Plan”) was approved by shareholders on February 13, 2004.  Under the 2003 Plan, we may grant stock-based compensation in the form of options.  The 2003 Plan authorizes the issuance of up to an aggregate of 30,000,000 shares of the Company’s common stock.  The 2003 Plan terminates on August 29, 2013. The plan may be modified or terminated at any time, and any such amendment or termination will not affect outstanding options without the consent of the optionee.  The aggregate number of shares and the number of shares in an award (as well as the option price) may be adjusted if our outstanding shares are increased, decreased or exchanged through merger or similar transaction. The Plan provides for options which qualify as Incentive Stock Options under Section 422 of the Internal Revenue Code of 1986, as well as the issuance of Non-Qualified Options, which do not so qualify. Pursuant to the terms of the 2003 Plan, the Company, as determined by the Board of Directors or a committee appointed by the Board, may grant Non-Qualified Stock Options (“NQSOs”) to its executive officers, non-employee directors, or consultants of the Company and its subsidiaries at any time, and from time to time.  The 2003 Plan also provides for Incentive Stock Options (“ISOs”) to be granted to any officer or other employee of the Company or its subsidi­aries at any time, and from time to time, as determined by the Board or selected by the committee appointed by the Board.  Such stock options granted allow a grantee to purchase a fixed number of shares of the Company’s common stock at a fixed exercise price provided that such price may not be less than the fair market value (or 110% thereof for Incentive Stock Options issued to a holder of 10% or greater beneficial ownership) of the shares on the date granted.  The options may vest on a single date or over a period of time, but normally they do not vest unless the grantee is still employed by, or a director of, the Company on the vesting date.  Generally for all employees, the options vest 50% after the first year from the date of grant and the remaining 50% after the second year from the date of grant.  Stock options granted to independent board of directors vest 100% after the service period, which generally is one year from the date of grant.


Factors considered in granting stock options included: (i) the general policy during the past five, and in the foreseeable future, of not increasing base salaries of all employees, (ii) the performance of employees, (iii) the employees’ increasing responsibilities in a dynamic, and shrinking organization, and (iv) the accomplishments achieved by the Company during the prior year.  The 2003 Plan has been the principal method for our employees and executive officers to acquire equity interests in the Company. We believe that the annual aggregate value of these awards should be set near competitive median levels for comparable companies.  We may provide a greater portion of total compensation to our executives and employees through stock options given the general policy of not increasing base salaries in the foreseeable future. Our Compensation Committee administers the 2003 Plan based on the above factors, and the Committee approved the grant of stock options to all current employees, including its named executives, during 2007 through 2009 as an incentive for continued contributions in moving our product development efforts forward. Also, the Compensation Committee, based on management’s recommendation and discussions with the Committee, may grant stock options to new employees.  New employees were




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granted stock options in prior years, but no such stock options were issued during 2010 since there were no new employees hired during the year.


Options granted under the Plan must be evidenced by a stock option agreement in a form consistent with the provisions of the 2003 Plan. Each option shall expire on the earliest of (a) ten (10) years from the date it is granted, (b) sixty (60) days after the optionee dies or becomes disabled, (c) immediately upon the optionee's termination of employment or service or cessation of Board service, whichever is applicable, or (d) such date as the Committee shall determine, as set forth in the relevant option agreement; provided, however, that no ISO which is granted to an optionee who, at the time such option is granted, owns stock possessing more than ten (10) percent of the total combined voting power of all classes of stock of the Company or any of its subsidiaries, shall be exercisable after the expiration of five (5) years from the date such option is granted.


To exercise an option, the 2003 Plan participant, in accordance with the relevant option agreement, must provide the Company a written notice setting forth the number of options being exercised and their underlying shares, and tender an amount equal to the total exercise value of the options being exercised.  The right to purchase shares is cumulative so that once the right to purchase any shares has vested; those shares or any portion of those shares may be purchased at any time thereafter until the expiration or termination of the option.  ISOs and NQSOs that are not exercised in accordance with the terms and provisions of the stock option agreement will expire as to any then unexercised portion.  Stock options that expire, are cancelled, or forfeited will again become available for issuance under the 2003 Plan as described below.  The aggregate number of shares and the number of shares in an award (as well as the option price) may be adjusted if the outstanding shares of Applied Visual Sciences, Inc. are increased, decreased or exchanged through merger or other stock transaction.  The shares issued by the Company under the 2003 Plan may be either treasury shares or authorized but unissued shares as the Company’s board of directors or the Compensation Committee may determine from time to time.  Except as specifically provided in an option agreement, options granted under the 2003 Plan may not be sold, pledged, transferred or assigned in any way, except by will or by the laws of descent and distribution, and during the lifetime of a participant to whom the ISOs is granted, and the ISOs may only be exercised by the participant.


During 2011, the Compensation Committee did not grant stock options under the 2003 Plan.  As of December 31, 2011, the Company has reserved under the 2003 Plan, 17,092,789 shares to be issued upon exercise of outstanding options, and 12,907,211 shares were available for future awards.  Compensation expense for stock options granted is recognized over the requisite service period, which is typically the period over which the stock-based compensation awards vest. In anticipation of implementation of SFAS 123R, we accelerated the vesting of the outstanding options in December 2005, prior to adopting SFAS 123R.  We applied the guidance of SAB 107 in conjunction with the adoption of SFAS 123R.  This acceleration was for all employees, including the named executive officers.


On April 24, 2010, the Company’s Compensation Committee approved the repricing of fully vested outstanding incentive and non-qualified stock options to purchase an aggregate of 10,552,921 shares of common stock, $.001 par value per share (“Common Stock”), of the Company previously granted to officers, directors, employees and consultants of the Company (the “Outstanding Options”) pursuant to the Company’s Amended and Restated 2003 Stock Incentive Plan. The Compensation Committee re-priced the Outstanding Options to a price equal to the mean between the closing bid and asked quotations for the Company’s Common Stock on April 26, 2010, as reported on the OTC Bulletin Board, the quotation service for the Company’s shares of Common Stock, namely, $0.30 per share. The Outstanding Options had been issued with exercise prices ranging from $0.43 to $5.27 per share, which prices represented the fair market value of a share of Common Stock on the date of each such grant. The Compensation Committee re-priced the Outstanding Options as compensation for the hardship of each optionee not regularly receiving his or her salary, wages, or other compensation due during the period April 6, 2006, through and including the present and ongoing, and the continued or continuing non-payment of such amounts by the Company.  The Compensation Committee determined that such action was in the best interest of the Company and its stockholders.


The following is a brief summary of the principal income tax consequences of awards under the 2003 Plan. This summary is based on current federal income tax laws and interpretations thereof, all of which are subject to change at any time, possibly with retroactive effect.  This summary is not intended to be exhaustive.


·

Non-Qualified Options.  A participant who receives Non-Qualified Stock Options does not recognize taxable income upon the grant of an option, and Applied Visual Sciences, Inc. is not entitled to a tax deduction.  Applied Visual Sciences, Inc. is generally entitled to tax a deduction in an amount equal to the amount taxable to the participant as ordinary income in the year the income is taxable to the participant (generally when the option is exercised).  Any appreciation in value after the time of exercise will be taxable to the participant as capital gain (assuming it is a capital asset) and will not result in a deduction by Applied Visual Sciences, Inc.


·

Incentive Options.  A participant who receives an Incentive Stock Option does not recognize taxable income upon the grant or exercise of the option and Applied Visual Sciences, Inc. is not entitled to a tax deduction.  The difference between the option price and the fair market value of the option shares on the date of exercise, however, will be




72


treated as an item of adjustment for purposes of determining the alternative minimum tax liability, if any, of the participant in the year of exercise.


·

A participant will recognize gain or loss upon the disposition of shares acquired from the exercise of ISOs.  The nature of the gain or loss depends on how long the option shares were held.  If the option shares are not disposed of pursuant to a “disqualifying disposition” (i.e., no disposition occurs within two years from the date the option was granted or one year from the date of exercise), the participant will recognize long-term capital gain or capital loss depending on the selling price of the shares.  If the option shares are sold or disposed of as part of a disqualifying disposition, the participant must recognize ordinary income in an amount equal to the lesser of the amount of gain recognized on the sale or the difference between the fair market value of the option shares on the date of exercise and the option price.  Any additional gain will be taxable to the participant as a long-term or short term capital gain, depending on how long the option shares were held.  Applied Visual Sciences, Inc. is generally entitled to a deduction in computing its federal income taxes for the year of disposition in an amount equal to any amount taxable to the participant as ordinary income.


2009 Stock Compensation Plan


On June 4, 2009, the Board of Directors adopted the 2009 Stock Compensation Plan (“2009 Plan) which provides for the grant or issuance of up to an aggregate of 20,000,000 shares of the Company’s common stock pursuant to non-qualified stock options (“NQSOs”), restricted stock awards (“RSAs”), restricted stock rights (“RSRs”), or common stock awards (“Common Stock Awards”) (a NQSO, RSA, RSR or Common Stock Award, individually, an “Award;” collectively, “Awards”). The exercise price of NQSOs may not be less than 100% of the fair market value of the stock on the date of the option grant, and may only be exercised at such times as may be specified by the Committee and provided for in an award agreement, but may not be exercised after ten years from the date on which it was granted.  RSAs and RSRs consist of a specified number of shares of the Company’s Common Stock that are, or may be, subject to restrictions on transfer, conditions of forfeiture, and any other terms and conditions for periods determined by the Committee. Generally, unless the Committee determines otherwise, once the restricted stock vests, the shares of Common Stock specified in the Award will be free of restriction, subject to any applicable lock up period. Prior to the termination of the restrictions, under a RSA (but not a RSR), a participant may vote and receive dividends on the restricted stock unless the Committee determines otherwise, but may not sell or otherwise transfer the shares. Common Stock Awards under the plan may be issued free of restriction and may vest immediately; however, the Committee may impose vesting and other restrictions related to the grant of such common stock Awards.  Compensation expense for these Awards is recognized over the period they vest, although generally Common Stock Awards vest immediately, while the RSAs, RSRs and NQSOs will have a vesting period.


During 2011, we issued 2,595,056 stock awards under the 2009 Stock Compensation Plan, of which 42,000 were issued to an employee upon exercise of stock options, 1,129,012 issued to employees upon conversion of accrued and unpaid wages, and 1,424,044 stock awards to consultants as compensation in lieu of cash payments for services rendered. As of December 31, 2011, there were 13,334,507 shares available for future awards under the 2009 Stock Compensation Plan.


The purpose of the 2009 Plan is to foster our success and the success of our subsidiaries and affiliates by providing incentives to employees, directors, officers and consultants to promote our long-term financial success.  The Plan complements our 2003 Amended and Restated Stock Incentive Plan (the “2003 Plan”) and provides greater flexibility to us in that it permits us to compensate and award employees, directors, officers and consultants through the issuance of certain options, RSAs, RSRs, and stock awards in addition, or as an alternative, to the incentive and non-qualified stock options that may be awarded under the 2003 Plan. The 2009 Plan terminates on June 4, 2019, and no award may be made after that date, however, awards made before that date may extend beyond that date. If an award under the 2009 Plan is cancelled, expires, forfeited, settled in cash or otherwise terminates without being exercised in full, the shares of common stock not acquired pursuant to the award will again become available for issuance under the 2009 Plan.


Our Board of Directors has delegated its authority to administer the 2009 Plan to the Compensation Committee.  Subject to the provisions of the 2009 Plan, the committee has the power to:


·

Prescribe, amend, and rescind rules and regulations relating to the 2009 Plan and to define terms not otherwise defined therein;

·

Determine which persons are eligible to participate, to which of such participants, if any, awards shall be granted, and the timing of any such awards;

·

Grant awards to participants and determine the terms and conditions thereof, including the number of shares subject to awards and the exercise or purchase price of such shares and the circumstances under which awards become exercisable or vested or are forfeited or expire;

·

Establish any performance goals or other conditions applicable to the grant, issuance, exercisability, vesting and/or ability to retain any award;




73


·

Prescribe and amend the terms of the agreements or other communications evidencing awards made under the 2009 Plan (which need not be identical) and the terms or form of any document or notice required to be delivered to us by participants under the 2009 Plan;

·

Determine the appropriate adjustment, if any, required as a result of any reorganization, reclassification, combination of shares, stock split, reverse stock split, spin-off or dividend (other than regular, quarterly cash dividends), or other changes in the number or kind of outstanding shares or any stock or other securities into which such shares shall have been exchanged;

·

Interpret and construe the 2009 Plan, any rules and regulations under the 2009 Plan and the terms and conditions of any award granted thereunder, and to make exceptions to any such provisions in good faith and for the benefit of the Company; and

·

Make all other determinations deemed necessary or advisable for the administration of the 2009 Plan.


Unless the Board expressly provides otherwise prior to a change of control or in an award agreement, in the event of a change of control of the Company, all outstanding options under the 2009 Plan vest and become exercisable on the date immediately before the change of control and all restrictions under RSAs and RSRs shall lapse or be deemed satisfied on the date immediately prior to the change of control.  A change of control is deemed to have occurred upon the occurrence of one of the following events: (i) any person or group of persons becomes the beneficial owner of shares of the Company to which 50% or more of the total number of votes for the election of directors may be cast; (ii) as a result of a cash tender offer, exchange offer, merger or other business combination, sale of assets or contested election, persons who were directors immediately prior to the event cease to constitute a majority of the board; (iii) stockholders approve an agreement providing either that the Company will cease to be an independent publicly owned corporation or for sale or other disposition of all or substantially all the assets of the Company; or (iv) a tender offer or exchange offer is made for shares of our common stock (other than one made by us) and shares of common stock are acquired.


The Compensation Committee determines all awards to non-employee directors and such awards are not subject to management’s discretion. From time to time, the committee will set the amount and the type of award that will be granted to non-employee directors on a periodic, nondiscriminatory basis, including pursuant to any plan adopted by the Compensation Committee or Board for the compensation of non-employee directors. The committee may set additional awards to be granted to non-employee directors also on a periodic, nondiscriminatory basis based on one or more of the following criteria: (i) service as the chair of a Board committee; (ii) service as chairman of the Board; (iii) the number or type of Board committees on which a director serves; or (iv) the first selection or appointment of an individual to the Board.


Non-qualified stock options may be granted pursuant to non-qualified stock option award agreements and certificates adopted by the Board, as amended by the Compensation Committee.  The Compensation Committee determines the terms of each stock option granted under the 2009 Plan, including the number of shares covered by an option, exercise price and means of payment, the vesting and exercisability of the option, and restrictions on transfer and the term.  The exercise price of an option granted under the Plan may not be less than the fair market value on the date of grant.  The options expire on the earliest of ten years after the date of grant, 90 days after the death or disability of the recipient, immediately upon termination of employment or service other than by death or disability, or such date as the Compensation Committee determines.  The Compensation Committee, in its sole discretion, may change by agreement the post-termination rights of a recipient, including accelerating the date or dates on which the option becomes vested and is exercisable following termination of employment or service, or extend the period.  Options granted under the plan may be exercised by delivering cash, a cashless exercise, or by delivering to us the proceeds of shares of our common stock issuable under an option.


An award of restricted stock consists of a specified number of shares of our common stock that are subject to restrictions on transfer, conditions of forfeiture, and any other terms and conditions for periods determined by the Compensation Committee. Prior to the termination of the restrictions, a participant may vote and receive dividends on the restricted stock unless the committee determines otherwise, but may not sell or otherwise transfer the shares.


An award of RSRs entitles a participant to receive a specified number of shares of our common stock upon the expiration of a stated vesting period. It may also include the right to dividend equivalents if and as so determined by the committee. Unless the committee determines otherwise, once a RSR vests, the shares of common stock specified in the award will be issued to the participant. A participant who has been awarded RSRs may not vote the shares of common stock subject to the rights until the shares are issued. Until the vesting period applicable to a RSRs award expires and the shares are issued, the participant also may not transfer or encumber any interest in the RSRs or in any related dividend equivalents.


The Compensation Committee may also make stock awards of common stock without restrictions, except that if the award is in lieu of salary, service fee, cash bonus or other cash compensation, the number of shares covered by an award shall be based on the fair market value of such shares on the date of grant.  The Compensation Committee has discretion to determine the terms of any award of restricted stock or RSRs, including the number of shares subject to the award, and the minimum period over which the award may vest, and the acceleration of any vesting in the event of death, disability or change of control, as discussed above with regard to options.  




74


Awards are not transferable or assignable unless provided otherwise by the Compensation Committee with respect to certain specified family-related transfers.


The Board may amend, terminate, or modify the 2009 Plan at any time, without shareholder approval, unless required by the Internal Revenue Code of 1986, pursuant to Section 16 under the Securities Exchange Act of 1934, as amended, or by any national securities exchange or system on which our common stock is then listed or reported, or by any regulatory body.


Severance and Change in Control Benefits


Three of our four named executive officers are covered by employment agreements which specify payments in the event the executive’s employment is terminated. The type and amount of payments vary by executive level and the nature of the termination. These termination benefits are payable if and only if the executive’s employment terminates as specified in the applicable employment agreement.  Also, two of our named executive officers, Mr. Donovan and Mr. Hare, have employment agreements that require us to make certain payments in the event of a change in control and upon the occurrence of certain other material events.


Our primary reason for including termination and change in control benefits in compensation packages is to attract and retain the best possible executive talent. We believe our termination benefits are competitive with general industry packages. For a further description of these severance benefits, see “Employment Agreements” and “Severance and Change in Control Benefits” below.


In addition, our 2003 Stock Incentive Plan provides that in the event of our “change in control,” the Compensation Committee may otherwise determine the status of unvested options or restricted stock, including, without limitation, whether the successor corporation will assume or substitute an equivalent award, or portion thereof, for each outstanding award under the plan or, if there is no assumption or substitution of unvested outstanding awards, such unvested awards may be canceled.


 401(k) Savings Plan


We maintain a tax-qualified retirement plan that provides eligible employees with an opportunity to save for retirement on a tax advantaged basis. Eligible employees are able to participate in the 401(k) plan as of the first day of the month following 90 days of employment. The 401(k) plan permits us to make profit sharing contributions to eligible participants, although we currently do not match contributions. Pre-tax contributions are allocated to each participant’s individual account and are then invested in selected investment alternatives according to the participants’ directions. All employee contributions are 100% vested. The 401(k) plan is intended to qualify under Sections 401(a) and 501(a) of the Internal Revenue Code. As a tax-qualified retirement plan, contributions to the 401(k) plan and earnings on those contributions are not taxable to the employees until distributed from the 401(k) plan. We believe that offering a 401(k) retirement plan fosters our ability to attract and retain the best possible executive talent.


Pension and Deferred Compensation Plans


Currently, we do not have a company sponsored pension or deferred compensation plans for any or all employees, including our named executive officers, or directors. 


Perquisites and Other Compensation


During the each of the two fiscal years ended December 31, 2011, two of our named executive officers received reimbursement of up to $6,000 annually for automobile expenses as required under the terms of their employment agreements. See below “Employment, Severance and Change in Control Arrangements.”  Currently, we do not provide short or long term disability or life insurance coverage for employees, including our named executive officers, as a result of our current cash position.  We do provide health care benefits to all employees including our named executive officers, and such benefits are contributory.


We intend to continue to maintain executive benefits and perquisites for officers, however, the Compensation Committee may in its discretion revise, amend or increase named executive officers’ perquisites as it deems advisable. We believe these benefits and perquisites are currently not above median competitive levels for comparable companies and are beneficial in attracting and retaining executive talent.


Equity Ownership Guidelines


Currently, we do not have any equity ownership guidelines for our executive officers or directors.


Role of Executive Officers in Executive Compensation





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The Compensation Committee considers management’s recommendation and other factors mentioned above in determining the compensation payable to each of the named executive officers as well as the compensation of the members of the board of directors.


Executive Officers Compensation:


Summary Compensation Table


The following Summary Compensation Table sets forth the compensation earned or awarded to our CEO, President and COO, CFO and other named executive officers during each of the two fiscal years ended December 31, 2011:


Name and principal position

 

Year

 

Compensation

Salary

 

Bonus

 

Stock awards (1)

 

Options awards (1)

 

All other compensation (2)

 

Total

Michael W. Trudnak (3)

 

2010

 

 $    275,000

 

                  -

 

 $      61,000

 

 $    488,229

 

 $        422,701

 

 $     1,246,930

  Chairman, CEO

 

2011

 

       275,000

 

                  -

 

                  -

 

                  -

 

               6,000

 

           281,000

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

William J. Donovan (4)

 

2010

 

       265,000

 

                  -

 

         61,000

 

       543,292

 

           273,098

 

        1,142,390

  President/COO

 

2011

 

       265,000

 

                  -

 

                  -

 

                  -

 

               6,000

 

           271,000

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Gregory E. Hare (5)

 

2010

 

       200,000

 

                  -

 

         61,000

 

       264,402

 

           210,322

 

           735,724

  Chief Financial Officer

 

2011

 

       200,000

 

                  -

 

                  -

 

                  -

 

                       -

 

           200,000

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Richard F. Borrelli (6)

 

2010

 

       160,000

 

                  -

 

         61,000

 

       110,490

 

             78,868

 

           410,358

  Vice President

 

2011

 

         36,922

 

                  -

 

                  -

 

                  -

 

                       -

 

             36,922

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(1) Reflects the grant date fair value on April 26, 2010 of stock and/or options estimated using option-pricing models calculated in accordance with ASC 718-10. See Note 2 "Significant Accounting Policies" to the Consolidated Financial Statements for a discussion of the relevant assumptions used in calculating the grant date fair value pursuant to ASC 718-10.  For 2010, the amount reflects the incremental fair value for repricing of previously issued options to $0.30, which was the maket price on the date repriced.  See Grants of Plan-Based Awards disclosure below for additional information related to the repricing of stock options.

(2) All Other Compensation consists of monthly automobile allowance expenses of $6,000 for Messrs Trudnak and Donovan.  2010 also includes interest on accrued and unpaid wages, which was converted to stock on October 26, 2010, under terms of the Company's then current private offering.  The purchase price of the stock and execrise price of the warrants issued in the offering were under the same terms and conditions to all investors participating in the offering of $0.25 per share, while the market price on the date of purchase was $0.305 per share.

(3) For Mr. Trudnak, includes accrued and unpaid salary of $281,047 in 2011, and $281,058 in 2010, for a cumulative deferral as of December 31, 2011 of $1,203,339.

(4) For Mr. Donovan, includes accrued and unpaid salary of $239,497 in 2011, and $207,496 in 2010, for a cumulative deferral as of December 31, 2011 $810,630.

(5) For Mr. Hare, includes accrued and unpaid salary of $174,499 in 2011, and $144,150 in 2010, for a cumulative deferral as of December 31, 2011 of $669,954.

(6) For Mr. Borrelli, includes accrued and unpaid salary of $32,922 in 2011, and $121,133 in 2010, for a cumulative deferral as of December 31, 2011 of $348,247.  Mr. Borrelli was an officer of the Company through January 10, 2011, and Vice President of Business Development, Healthcare until March 31, 2011, when Mr Borrelli took a leave of absence.

 


Grants of Plan-Based Awards Table

 

The following table sets forth information regarding stock option awards to our named executive officers under our 2003 Stock Incentive Plan during the fiscal year ended December 31, 2011:





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Name

Grant Date   (1)

 

Estimated future payouts under non-equity incentive plan awards

 

Estimated future payouts under equity incentive plan awards (#)

 

All other stock awards: Number of shares of stock or units (#)

 

All other option awards: Number of securities underlying options (#)

 

Exercise or base price of option awards ($/Share)

 

Grant date fair value of stock and option awards

Michael W. Trudnak

 

 

 $ - 

 

  - 

 

  - 

 

  - 

 

 $ - 

 

 $ - 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

William J. Donovan

 

 

  - 

 

  - 

 

  - 

 

  - 

 

  - 

 

  - 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Gregory E. Hare

 

 

  - 

 

  - 

 

  - 

 

  - 

 

  - 

 

  - 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Richard F. Borrelli

 

 

  - 

 

  - 

 

  - 

 

  - 

 

  - 

 

  - 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(1) No stock options or other awards were granted during 2011.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



Outstanding Equity Awards at Fiscal Year-End Table


The following table sets forth information for each named executive officer regarding the number of shares subject to exercisable and unexercisable stock options as of December 31, 2011.





77





Name

 

Option awards (1)

Stock awards

Number of securities underlying unexercised options (#)

 

Equity incentive plan awards: number of securities underlying unexercised unearned options (#)

 

Option exercise price (1)

 

Option Expiration Date

Number of shares or units of stock that have not vested (#)

Market value of shares or units of stock that have not vested (#)

Equity incentive plan awards: number of unearned shares, units or other rights that have not vested (#)

Equity incentive plan awards: market or payout value of unearned shares, units or other rights that have not vested

Exercisable

 

Unexercisable

Michael W. Trudnak

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

  450,000 

 

  - 

 

  - 

 

 $ 0.30 

(2)

2/18/2014

  - 

  - 

  - 

 $ - 

 

 

  10,000 

 

  - 

 

  - 

 

  0.30 

(2)

2/18/2014

  - 

  - 

  - 

  - 

 

 

  125,000 

 

  - 

 

  - 

 

  0.30 

(2)

1/14/2017

  - 

  - 

  - 

  - 

 

 

  707,530 

 

  - 

 

  - 

 

  0.30 

(2)

10/8/2017

  - 

  - 

  - 

  - 

 

 

  334,900 

 

  - 

 

  - 

 

  0.30 

(2)

1/8/2018

  - 

  - 

  - 

  - 

 

 

  357,900 

 

  - 

 

  - 

 

  0.30 

 

4/21/2019

  - 

  - 

  - 

  - 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

William J. Donovan

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

  200,000 

 

  - 

 

  - 

 

  0.30 

(2)

8/18/2013

  - 

  - 

  - 

  - 

 

 

  600,000 

 

  - 

 

  - 

 

  0.30 

(2)

2/18/2014

  - 

  - 

  - 

  - 

 

 

  10,000 

 

  - 

 

  - 

 

  0.30 

(2)

2/18/2014

  - 

  - 

  - 

  - 

 

 

  200,000 

 

  - 

 

  - 

 

  0.30 

(2)

11/21/2015

  - 

  - 

  - 

  - 

 

 

  125,000 

 

  - 

 

  - 

 

  0.30 

(2)

1/14/2017

  - 

  - 

  - 

  - 

 

 

  353,372 

 

  - 

 

  - 

 

  0.30 

(2)

10/8/2017

  - 

  - 

  - 

  - 

 

 

  322,600 

 

  - 

 

  - 

 

  0.30 

(2)

1/8/2018

  - 

  - 

  - 

  - 

 

 

  344,800 

 

  - 

 

  - 

 

  0.30 

 

4/21/2019

  - 

  - 

  - 

  - 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Gregory E. Hare

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

  200,000 

 

  - 

 

  - 

 

  0.30 

(2)

1/16/2016

  - 

  - 

  - 

  - 

 

 

  125,000 

 

  - 

 

  - 

 

  0.30 

(2)

1/14/2017

  - 

  - 

  - 

  - 

 

 

  312,840 

 

  - 

 

  - 

 

  0.30 

(2)

10/8/2017

  - 

  - 

  - 

  - 

 

 

  243,500 

 

  - 

 

  - 

 

  0.30 

(2)

1/08/2018

  - 

  - 

  - 

  - 

 

 

  260,200 

 

  - 

 

  - 

 

  0.30 

 

4/21/2019

  - 

  - 

  - 

  - 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Richard F. Borrelli

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

  100,000 

 

  - 

 

  - 

 

  0.30 

(2)

9/3/2014

  - 

  - 

  - 

  - 

 

 

  20,000 

 

  - 

 

  - 

 

  0.30 

(2)

10/3/2015

  - 

  - 

  - 

  - 

 

 

  112,000 

 

  - 

 

  - 

 

  0.30 

(2)

1/14/2017

  - 

  - 

  - 

  - 

 

 

  136,300 

 

  - 

 

  - 

 

  0.30 

(2)

1/8/2018

  - 

  - 

  - 

  - 

 

 

  208,100 

 

  - 

 

  - 

 

  0.30 

 

4/21/2019

  - 

  - 

  - 

  - 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(1) Two year vesting periods with 50% vested after year one, and 50% after year two.

(2) On April 24, 2010, the Company*s Compensation Committee approved the repricing of fully vested outstanding incentive and non-qualified stock options previously granted to officers, directors, employees and consultants of the Company, pursuant to the Company*s Amended and Restated 2003 Stock Incentive Plan. The Committee repriced the outstanding options to a price equal to the mean between the closing bid and asked quotations for the Company*s Common Stock on April 26, 2010, as reported on the OTC Bulletin Board, namely, $0.30 per share.  The outstanding options for the above named officers were issued with exercise prices ranging from $0.36 to $4.10 per share, which prices represented the fair market value of a share of Common Stock on the date of each such grant. The Compensation Committee repriced the outstanding options as compensation for the hardship of each optionee not regularly receiving his or her salary, wages, or other compensation due during the period April 6, 2006, through and including April 26, 2010, and the continued non-payment of such amounts by the Company.  The Committee determined that such action was in the best interest of the Company and its stockholders.

 



Option Exercises and Stock Vested Table


The following table sets forth information for each named executive officer regarding the number of shares acquired upon the exercise of stock options during the year ended December 31, 2011, and the aggregate dollar value realized upon the exercise of the




78


option. We have not issued stock appreciation rights (SAR’s) or restricted stock awards (RSA’s) under our 2009 Stock Compensation Plan.


Name

Option awards

 

Stock awards (2)

Number of shares acquired on exercise

 

Value realized on exercise (1)

Number of shares acquired on vesting

 

Value realized on vesting (1)

Michael W. Trudnak

  - 

 

 $ - 

 

  - 

 

 $ - 

 

 

 

 

 

 

 

 

William J. Donovan

  - 

 

  - 

 

  - 

 

  - 

 

 

 

 

 

 

 

 

Gregory E. Hare

  - 

 

  - 

 

  - 

 

  - 

 

 

 

 

 

 

 

 

Richard F. Borrelli

  - 

 

  - 

 

  - 

 

  - 

 

 

 

 

 

 

 

 

(1) Represents the difference between the market price on date of exercise and the exercise price.

(2) Includes stock awards, restricted stock, restricted stock rights and similar instruments.



Pension Benefits

 

None of our named executive officers participate in or have account balances in qualified or non-qualified defined benefit plans sponsored by us.


Nonqualified Deferred Compensation

 

None of our named executive officers participate in or have account balances in non-qualified defined contribution plans or other deferred compensation plans by us. The Compensation Committee may elect to provide our officers and other employees with non-qualified defined contribution or deferred compensation benefits if the Compensation Committee determines that doing so is in our best interests.


Employment, Severance and Change in Control Arrangements


 

The employment agreements for each named executive officer (except for Mr. Borrelli with whom we have not entered into any employment agreement) are multiple years in duration and automatically renew unless terminated by either party in accordance with its terms. Each of the named executive officers employment agreement provides for an annual base salary and a discretionary annual incentive cash bonus and/or equity awards.  In subsequent years, the amount of annual incentive cash and/or equity award bonus is subject to determination by our board of directors without limitation on the amount of the award. Each of the agreements provides for a severance payment over a prescribed term in the event the named executive is terminated without cause, including for Mr. Donovan and Mr. Hare, if their duties are materially changed in connection with a change in control. Each agreement also provides that no severance payment is due in the event of termination for cause, which includes termination for willful misconduct, conviction of a felony, dishonesty or fraud. Each agreement further contains an agreement by the named executive officer not to compete with us for a defined term equal in length to the applicable severance payment in the respective employment agreement, which we feel is reasonable and consistent with industry guidelines.


Michael W. Trudnak.   Mr. Trudnak serves as Chairman of the Board, Secretary, and Chief Executive Officer and a Class III director.  The Company entered into an employment agreement with Mr. Trudnak, which commenced on January 1, 2003.  The Company amended his agreement effective December 10, 2004. The amended agreement is for a three year term commencing June 26, 2003, and is renewable for one year terms.  The employment agreement provides for annual compensation to Mr. Trudnak of $275,000 and a monthly automobile allowance of $500.  The agreement provides for incentive compensation and/or bonuses as determined by Applied Visual Sciences, Inc., participation in the Company’s stock option plan, and participation in any of its employee benefit policies or plans.  The employment agreement may be terminated upon the death or disability of the employee or for cause, in which event Applied Visual Sciences, Inc.’s obligation to pay compensation shall terminate immediately.  In the event the agreement is terminated by us other than by reason of the death or disability of the employee or for cause, the employee is entitled to payment of his base salary for one year following termination.  The employee may terminate the agreement on 30 days’ prior notice to Applied Visual Sciences, Inc. The employee has entered into an employee proprietary information, invention assignment and non-competition agreement, pursuant to which the employee agrees not to disclose confidential information regarding Applied Visual Sciences, Inc., agrees that inventions conceived during his employment become the property of Applied Visual Sciences, Inc., agrees not to compete with the business of Applied Visual Sciences, Inc. for a period of one year following termination of employment, and agrees not to  solicit employees or customers of the Company following termination of employment.




79



William J. Donovan.   Mr. Donovan serves as President and Chief Operating Officer of Applied Visual Sciences, Inc., and previously served as Chief Financial Officer.  The Company entered into a new employment agreement with Mr. Donovan on November 18, 2005, which superseded his previous employment agreement with Applied Visual Sciences, Inc., dated effective August 18, 2003.  The new employment agreement is for a term of three years unless earlier terminated, and is automatically renewable for one year terms.  The employment agreement provides for an annual salary of $265,000.  The agreement provides for annual performance bonuses based on goals established by Applied Visual Sciences, Inc. and agreed to by Mr. Donovan, a monthly automobile allowance of $500, participation in our stock option and other award plans (which options or awards shall immediately vest upon a “change in control”), and participation in any benefit policies or plans adopted by us on the same basis as other employees at Mr. Donovan’s level.


The employment agreement may be terminated by Mr. Donovan on 30 days’ prior written notice.  The employment agreement may be terminated by us by reason of death, disability or for cause.  In the event the agreement is terminated for death or disability of the employee, our obligation to pay compensation to the employee shall terminate immediately; provided that if the Company does not maintain disability insurance for the employee, he is entitled to be paid his base salary for one year following his disability.  In the event that he is terminated other than by reason of his death, disability, for cause, or change in control, Mr. Donovan is entitled to payment of his base salary for one year following termination.  Further if Mr. Donovan terminates his employment for the following material reasons (each a “material reason”): written demand by us to change the principal workplace of the employee to a location outside of a 50-mile radius from the current principal address of Applied Visual Sciences, Inc.; a material reduction in the number or seniority of personnel reporting to employee or a material reduction in the frequency or in nature of matters with respect to which such personnel are to report to employee, other than as part of a company-wide reduction in staff; an adverse change in employee’s title; a material decrease in employee’s responsibilities; or a material demotion, Mr. Donovan is entitled to be paid the greater of the base salary remaining under the employment agreement or twelve months base salary.


In the event of a “change in control” of Applied Visual Sciences, Inc. and, within 12 months of such change of control, employee’s employment is terminated or one of the events in the immediately preceding sentence occurs, Mr. Donovan is entitled to be paid his base salary for 18 months following such termination or event.  A “change in control” would include the occurrence of one of the following events:

·

the approval of the stockholders for a complete liquidation or dissolution of Applied Visual Sciences, Inc.;

·

the acquisition of 20% or more of the outstanding common stock of Applied Visual Sciences, Inc. or of voting power by any person, except for purchases directly from Applied Visual Sciences, Inc., any acquisition by Applied Visual Sciences, Inc., any acquisition by a Applied Visual Sciences, Inc. employee benefit plan, or a permitted business combination;

·

if two-thirds of the incumbent board members as of the date of the agreement cease to be board members, unless the nomination of any such additional board member was approved by three-quarters of the incumbent board members;

·

upon the consummation of a reorganization, merger, consolidation, or sale or other disposition of all or substantially all of the assets of Applied Visual Sciences, Inc., except if (i) all of the beneficial owners of Applied Visual Sciences, Inc.’s outstanding common stock or voting securities who were beneficial owners before such transaction own more than 50% of the outstanding common stock or voting power entitled to vote in the election of directors resulting from such transaction in substantially the same proportions, (ii) no person owns more than 20% of the outstanding common stock of Applied Visual Sciences, Inc. or the combined voting power of voting securities except to the extent it existed before such transaction, and (iii) at least a majority of the members of the board before such transaction were members of the board at the time the employment agreement was executed or the action providing for the transaction.


Also, Mr. Donovan has entered into a proprietary information, invention assignment and non-competition agreement (“non-competition agreement”), pursuant to which he has agreed not to disclose confidential information regarding us, agrees that inventions conceived during his employment become our property, agrees not to compete with our business for a period of one year following termination or expiration of his employment, and agrees not to solicit our employees or customers following termination of his employment.  The employment agreement provides for arbitration in the event of any dispute arising out of the agreement or his employment, other than disputes arising under the non-competition agreement.


Gregory E. Hare.  Mr. Hare serves as our Chief Financial Officer, and Treasurer. The Company entered into an employment agreement with Mr. Hare commencing on January 30, 2006. The employment agreement is essentially the same as the agreement the Company entered into with Mr. Donovan, except that the agreement is for a term of two years unless earlier terminated and shall automatically renew for successive one year terms unless terminated prior thereto.  The employment agreement provides for a base salary of $200,000 per annum and no automobile allowances. The agreement provides for annual performance bonuses based on goals established by the Company and agreed to by Mr. Hare, participation in the Company’s stock option and other award plans, and participation in any company benefit policies or plans adopted by us on the same basis as other employees at Mr. Hare’s level.  The Company agreed to grant to Mr. Hare, subject to approval of our Compensation Committee, stock options to purchase 200,000 shares of our common stock pursuant to our 2003 Stock Incentive Plan, one-half of which options will vest on the one year anniversary of the commencement of his employment and the remaining options vesting on the two year anniversary of the commencement of his employment.




80



Also, Mr. Hare has entered into a proprietary information, invention assignment and non-competition agreement (“non-competition agreement”), pursuant to which he has agreed not to disclose confidential information regarding us, agrees that inventions conceived during his employment become our property, agrees not to compete with our business for a period of one year following termination or expiration of his employment, and agrees not to  solicit our employees or customers following termination of his employment.  The employment agreement provides for arbitration in the event of any dispute arising out of the agreement or his employment, other than disputes arising under the non-competition agreement.


Richard F. Borrelli. Mr. Borrelli’s employment as Vice President and Officer for the Company is at-will, and thus has not entered into employment agreements.  Therefore, there is no employment, severance or change of control arrangements.  Mr. Borrelli was an officer of the Company through January 10, 2011, and Vice President of Business Development, Healthcare until March 31, 2011, when Mr Borrelli took a leave of absence.


Potential Payments upon Termination or Change in Control


As described under “Employment, Severance and Change in Control,” above, we are required to make certain severance payments to all of our named executive officers and provide certain change in control benefits to Mr. Donovan and Mr. Hare.  In the event of the occurrence of such events, such named executive officer, as applicable, would be entitled to (a) cash payments of any unpaid base salary through the date of termination and any accrued vacation pay and severance pay and (b) in certain cases, the accelerated vesting of outstanding stock options and restricted stock.  Healthcare benefits would be continued at the individuals’ election and cost through the COBRA plan.  Perquisites would be discontinued upon termination.


Cash Severance and Change in Control Payments


The following table summarizes the potential payments and benefits payable to each of our named executive officer upon termination of employment or change in our control assuming our named executive officers were terminated on December 31, 2011:


 

Name

 

Other Than Death, Disability, or Cause (1)

 

 Disability (1)

 

Material Reason (1)

 

Change in Control (2)

Michael W. Trudnak

 

 $ 275,000 

 

 $ - 

 

 $ - 

 

 $ - 

William J. Donovan

 

265,000 

 

265,000 

 

265,000 

 

397,500 

Gregory E. Hare

 

200,000 

 

200,000 

 

200,000 

 

300,000 

 

 

 

 

 

 

 

 

 

(1) Represent 12 months salary, and does not include accrued and unpaid salary, nor earned and unused vacation.

(2) Represent 18 months salary, and does not include accrued and unpaid salary, nor earned and unused vacation.



Acceleration o f Vesting of Option Awards


If our named executive officers were terminated on December 31, 2011, the applicable officer is entitled to automatically and immediately vest in his or her outstanding stock options, as described in the table below:


 

Name/Circumstances

 

Description of Equity Awards

 

Michael W. Trudnak (Change of Control)

 

None. All outstanding options are exercisable.

 

William J. Donovan (Change of Control, Death, or Disability)

 

None. All outstanding options are exercisable.

 

Gregory E. Hare (Change of Control, Death, or Disability)

 

None. All outstanding options are exercisable.

 

 

 

 

 

 


  

Directors Compensation:


Compensation Discussion and Analysis





81


On December 6, 2007, based upon the recommendation of the Compensation Committee, the Board adopted an “Amended Policy Regarding Compensation of Independent Directors,” pursuant to which we will furnish the following compensation to our independent directors effective July 1, 2009.  The Board did not grant compensation to the independent directors during 2011.  Although, the Company generally furnishes compensation to our independent directors in accordance with the following policy:


·

At the beginning of each calendar year, each independent director will receive annual compensation in the form an award of non-qualified options to purchase 150,000 shares of common stock, an annual retainer for attending Board meetings of non-qualified options to purchase 24,000 shares of common stock, non-qualified options to purchase 3,000 shares of common stock for each board committee of which he or she is a member, and non-qualified options to purchase 2,000 shares of common stock for each board committee of which he or she is a chairperson of the Compensation, Nominating, and Special Committees, and non-qualified options to purchase 70,000 shares of common stock for the Audit Committee chairperson, or a pro rata portion of such number if a director is elected after the beginning of the year.

·

We reimburse our independent directors for out of pocket expenses in connection with travel to and attending board and committee meetings.


All of the options we issue to independent directors are pursuant to our 2003 Stock Incentive Plan.  The options are exercisable for a period of ten years and at a price equal to the fair market value of Applied Visual Sciences, Inc.’s common stock on the date of grant.  The board, at its discretion, may grant additional awards of options, restricted stock and/or cash compensation to its independent directors as it may determine from time to time.  


Our Policy may be amended, altered or terminated at the election of the board, provided no amendment, alteration or terminations shall have a retroactive effect or impair the rights of an independent director under any option grant theretofore granted.  Our directors who are also officers of or employed or engaged as consultants by Applied Visual Sciences, Inc. or any of its subsidiaries are not additionally compensated for their board activities.


Director Compensation Table


The following table sets forth compensation to our independent directors for the fiscal year ended December 31, 2011. Currently, our independent directors as a group only receive stock option awards as compensation for their services on the Board and do not receive any cash compensation other than reimbursement of expenses for such activities.


Name

 

Fiscal Year (1)

 

Fees Earned or Paid in Cash

 

Stock Awards Value

 

Option Awards Value (1)

 

Non-Equity Incentive Plan Compensation

 

Change in Pension Value and Nonqualified Deferred Compensation Earnings

 

All Other Compensation

 

Total

Joseph C. Brothers

 

2011

 

 $ - 

 

 $ - 

  - 

 $ - 

 

 $ - 

 

 $ - 

 

 $ - 

 

 $ - 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Keith S. Kelly

 

2011

 

  - 

 

  - 

 

  - 

 

  - 

 

  - 

 

  - 

 

  - 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Charles T. Nash

 

2011

 

  - 

 

  - 

 

  - 

 

  - 

 

  - 

 

  - 

 

  - 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Henry A. Grandizio

 

2011

 

  - 

 

  - 

 

  - 

 

  - 

 

  - 

 

  - 

 

  - 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(1) There were no options granted during 2011.  Options are generally issued in the same year as the Board activities, which is permitted by the current "Policy Regarding Compensation of Independent Directors" outlined above.  Such issuances would reflect the grant date fair value estimated using option-pricing models calculated in accordance with ASC 718-10. See Note 2 "Significant Accounting Policies" to the Consolidated Financial Statements for a discussion of the relevant assumptions used in calculating the grant date fair value pursuant to ASC 718-10.

 



Outstanding Equity Awards at Fiscal Year-End Table


The following table sets forth information for each of our independent directors regarding the number of shares subject to exercisable and unexercisable stock options as of December 31, 2011.




82



Name

 

Option awards (1)

Stock awards

Number of securities underlying unexercised options (#)

 

Equity incentive plan awards: number of securities underlying unexercised unearned options (#)

 

Option exercise price (1)

 

Option Expiration Date

Number of shares or units of stock that have not vested (#)

Market value of shares or units of stock that have not vested (#)

Equity incentive plan awards: number of unearned shares, units or other rights that have not vested (#)

Equity incentive plan awards: market or payout value of unearned shares, units or other rights that have not vested

Exercisable

 

Unexercisable

Josepg C. Brothers

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

  126,725 

 

  - 

 

  - 

 

  0.30 

 

5/24/20

  - 

  - 

  - 

 $ - 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Keith S. Kelly

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

  125,355 

 

  - 

 

  - 

 

  0.30 

 

5/24/20

  - 

  - 

  - 

  - 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Charles T. Nash

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

  6,000 

 

  - 

 

  - 

 

  0.30 

(2)

6/18/2014

  - 

  - 

  - 

  - 

 

 

  12,500 

 

  - 

 

  - 

 

  0.30 

(2)

9/21/2015

  - 

  - 

  - 

  - 

 

 

  12,500 

 

  - 

 

  - 

 

  0.30 

(2)

1/11/2017

  - 

  - 

  - 

  - 

 

 

  22,500 

 

  - 

 

  - 

 

  0.30 

(2)

1/14/2017

  - 

  - 

  - 

  - 

 

 

  60,000 

 

  - 

 

  - 

 

  0.30 

(2)

1/14/2018

  - 

  - 

  - 

  - 

 

 

  35,000 

 

  - 

 

  - 

 

  0.30 

 

4/21/2019

  - 

  - 

  - 

  - 

 

 

  150,000 

 

  - 

 

  - 

 

  0.22 

 

7/6/2019

  - 

  - 

  - 

  - 

 

 

  185,000 

 

  - 

 

  - 

 

  0.15 

 

2/1/2020

  - 

  - 

  - 

  - 

 

 

  3,425 

 

  - 

 

  - 

 

  0.30 

 

5/24/20

  - 

  - 

  - 

  - 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(1) One year vesting period.

(2) On April 24, 2010, the Company*s Compensation Committee approved the repricing of fully vested outstanding incentive and non-qualified stock options previously granted to officers, directors, employees and consultants of the Company, pursuant to the Company*s Amended and Restated 2003 Stock Incentive Plan. The Committee repriced the outstanding options to a price equal to the mean between the closing bid and asked quotations for the Company*s Common Stock on April 26, 2010, as reported on the OTC Bulletin Board, namely, $0.30 per share.  The outstanding options for the above named officers were issued with exercise prices ranging from $0.36 to $4.10 per share, which prices represented the fair market value of a share of Common Stock on the date of each such grant. The Compensation Committee repriced the outstanding options as compensation for the hardship of each optionee not regularly receiving his or her salary, wages, or other compensation due during the period April 6, 2006, through and including April 26, 2010, and the continued non-payment of such amounts by the Company.  The Committee determined that such action was in the best interest of the Company and its stockholders.

 



Other Arrangements


Our by-laws permit the Company to provide officers and directors liability insurance.  Such coverage was provided by the Company through October 19, 2011, with coverage limits of $5,000,000 and a maximum $200,000 deductible amount for each claim.  The Company anticipates providing such coverage upon approval of the Board.


ITEM 12.   SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS


The following table shows, as of February 29, 2012, the beneficial ownership of our common stock by (i) any person we know who is the beneficial owner of more than 5% of our common stock, (ii) each of our directors and executive officers, and (iii) all of our directors and executive officers as a group.  As of February 29, 2011 there were 90,474,230 shares of our common stock issued and outstanding.


Name of Beneficial Owner (1)

 

 Number of Shares Beneficially Owned (1)

 

 % of Common Stock Beneficial Ownership

 

 

 

 

 

 




83





Michael W. Trudnak

 

                    10,369,938

(2)

 

11.0%

William J. Donovan

 

                      4,665,972

(3)

 

5.0%

Gregory E. Hare

 

                      2,754,812

(4)

 

3.0%

Sean W. Kennedy

 

                      2,054,274

(5)

 

2.2%

Joseph C. Brothers

 

                      1,858,725

(6)

 

2.2%

Charles T. Nash

 

                         493,925

(7)

 

*

Keith S. Kelly

 

                         446,132

(8)

 

*

 

 

 

 

 

 

All executive officers and directors as a group (7 individuals)

 

                    22,643,778

(9)

 

22.0%

 

 

 

 

 

 

* Represents less than 1%


(1)

Beneficial ownership is determined in accordance with Rule 13d-3 under the Exchange Act, and is generally determined by voting powers and/or investment powers with respect to securities.  Unless otherwise noted, all shares of common stock listed above are owned of record by each individual named as beneficial owner and such individual has sole voting and dispositive power with respect to the shares of common stock owned by each of them.  Such person or entity’s percentage of ownership is determined by assuming that any options or convertible securities held by such person or entity which are exercisable within 60 days from the date hereof have been exercised or converted as the case may be.  All addresses, except as noted, are c/o Applied Visual Sciences, Inc., 250 Exchange Place, Suite H, Herndon, Virginia 20170.

(2)

Mr. Trudnak – includes 1,985,330 shares underlying options and 1,166,804 warrants to purchase shares of common stock which are exercisable.

(3)

Mr. Donovan - includes 2,155,772 shares underlying options and 1,600,000 warrants to purchase shares of common stock which are exercisable..

(4)

Mr. Hare – includes 1,141,540 shares underlying options and 900,136 warrants to purchase shares of common stock which are exercisable.

(5)

Mr. Kennedy - includes 638,850 shares underlying options and 588,412 warrants to purchase shares of common stock which are exercisable.  Includes 10,550 shares of common stock owned by Mr. Kennedy’s wife with respect to which Mr. Kennedy disclaims beneficial ownership.

(6)

Mr. Brother – includes 126,725 shares underlying options and 888,000 shares underlying warrants to purchase shares of common stock which are exercisable.

(7)

Mr. Nash - includes 486,925 shares underlying options to purchase shares of common stock which are exercisable.

(8)

Mr. Kelly – includes 125,355 shares underlying options to purchase shares of common stock which are exercisable.

(9)

All executive officers and directors as a group (8 individuals) - includes shares underlying options to purchase an aggregate of 1,985,330, 2,155,772, 1,141,540, 638,850, 126,725, 486,925, and 125,355 shares of common stock which are currently exercisable that have been granted to Messrs. Trudnak, Donovan, Hare, Kennedy, Brothers, Nash, and Kelly, respectively.  Also includes shares underlying warrants to purchase an aggregate of 1,666,804, 1,600,000, 900,136, 588,412, 888,000, 0, and 0 shares of common stock which are currently exercisable that have been issued to Messrs. Trudnak, Donovan, Hare, Kennedy, Brothers, Nash, and Kelly, respectively.


ITEM 13.   CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE


In addition to the executive and director compensation arrangements, including employment and change in control arrangements discussed above under Item 11 - Executive Compensation, the following is a description of transactions since January 1, 2008, to which we have been a party in which the amount involved in the transaction exceeded or will exceed the lesser of $120,000 or one percent of the average of our total assets as at the year end for the last two completed fiscal years, and in which any of our directors, executive officers or beneficial holders of more than 5% of our capital stock, or any immediate family member of, or person sharing the household with, any of these individuals, had or will have a direct or indirect material interest.


Loans from Our Chief Executive Officer


On April 21, 2006, the Company entered into a Loan Agreement with Mr. Michael W. Trudnak, our Chairman and Chief Executive Officer pursuant to which Mr. Trudnak loaned the Company $200,000. The Company issued a non-negotiable promissory note, dated effective April 21, 2006, to Mr. Trudnak in the principal amount of $200,000. The note is unsecured, non-negotiable and non-interest bearing. The note is repayable on the earlier of (i) six months after the date of issuance, (ii) the date the Company receives aggregate proceeds from the sale of its securities after the date of the issuance of the Note in an amount exceeding $2,000,000, or (iii) the occurrence of an event of default. The following constitute an event of default under the note: (a) the failure to pay when due any principal or interest or other liability under the loan agreement or under the note; (b) the material violation by us of any representation, warranty, covenant or agreement contained in the loan agreement, the note or any other loan document or any other document or agreement to which the Company is a party to or by which the Company or any of our properties, assets or outstanding securities are




84


bound; (c) any event or circumstance shall occur that, in the reasonable opinion of the lender, has had or could reasonably be expected to have a material adverse effect; (d) an assignment for the benefit of our creditors; (e) the application for the appointment of a receiver or liquidator for us or our property; (f) the issuance of an attachment or the entry of a judgment against us in excess of $100,000; (g) a default with respect to any other obligation due to the lender; or (h) any voluntary or involuntary petition in bankruptcy or any petition for relief under the federal bankruptcy code or any other state or federal law for the relief of debtors by or with respect to us, provided however with respect to an involuntary petition in bankruptcy, such petition has not been dismissed within 30 days of the date of such petition.  In the event of the occurrence of an event of default, the loan agreement and note shall be in default immediately and without notice, and the unpaid principal amount of the loan shall, at the option of the lender, become immediately due and payable in full.  The Company agreed to pay the reasonable costs of collection and enforcement, including reasonable attorneys’ fees and interest from the date of default at the rate of 18% per annum. The note is not assignable by Mr. Trudnak without our prior consent. The Company may prepay the note in whole or in part upon ten days notice. On October 21, 2006, Mr. Trudnak extended the due date of the loan to December 31, 2006. Subsequently, on October 3 and October 18, 2006, Mr. Trudnak loaned the Company $102,000 and $100,000, respectively, on substantially the same terms as the April 21, 2006 loan, except that each loan is due six months after the date thereof. Accordingly, following such additional loans, the Company owed an aggregate of approximately $402,000 to Mr. Trudnak. On November 10, 2006, Mr. Trudnak extended the due dates of such loans to May 31, 2007, except that $100,000 of the April 21, 2006, loan becomes due upon the Company raising $2,500,000 in financing after November 6, 2006, and the remaining amount of $202,000 of such loans become due upon the Company raising an aggregate of $5,000,000 in financing after November 6, 2006, and prior to May 31, 2007. Following the first closing of our Debenture and Series D Warrant financing on November 8, 2006, the Company repaid $100,000 on November 20, 2006, in principal amount of the April 1, 2006 loan, and paid an additional $100,000 to Mr. Trudnak on April 17, 2007 upon the second closing of our Debenture and Series D Warrant financing. On May 31, 2007, Mr. Trudnak extended the due dates of the remaining loans to May 31, 2008. Although, the anticipated payment of $202,000 had not been made, and Mr. Trudnak made an additional $24,000 loan to the company on June 25, 2008, and $5,000 on September 14, 2011, for cumulative loans of $231,000.  The maturity date of the outstanding loans was extended to May 31, 2009, then to May 31, 2010 and June 30, 2011, and subsequently to December 31, 2011. On December 31, 2011, the outstanding loans were extended to June 30, 2012. The Company repaid an aggregate of $108,900 of the notes during 2010, and repaid an aggregate $33,100 during 2011, resulting in an outstanding balance at December 31, 2011 of $89,000. The terms of the above transaction were reviewed and approved by the Company’s audit committee and by the independent members of our Board of Directors.


Consulting Agreement with BND Software, Principal Owner Sean Kennedy, a Director of the Company


On July 15, 2008, Applied Visual Sciences, Inc. entered into a consulting agreement with BND Software, Inc. (“BND”), a corporation that is owned and controlled by Mr. Sean W. Kennedy, a director of the Company. BND agreed to provide certain consulting services to the Applied Visual including managing the research, development and information systems activities of the Company. The agreement is for a term of one year commencing on May 27, 2008, and on May 31, 2009. The agreement provided for an extension of a twelve (12) month period upon mutual agreement by both parties. The agreement may be terminated upon 60 days prior written notice by one party to the other party. The agreement provided for an annual compensation of $216,000. The Company did not renew the agreement with BND, although Mr. Kennedy continues to provide management services for the research, development and information systems activities. We paid or agreed to pay BND an aggregate of $200,000 during 2011, and $208,000 during 2010.  As of December 31, 2011, the Company has accrued and unpaid fees payable to BND Software of $493,926.


ITEM 14.   PRINCIPAL ACCOUNTING FEES AND SERVICES


To ensure the independence of Applied Visual Sciences, Inc.’s independent auditor and to comply with applicable securities laws, the Audit Committee is responsible for reviewing, deliberating and, if appropriate, pre-approving all audit, audit-related, and non-audit services to be performed by Applied Visual Sciences, Inc.’s independent registered public accountants.  For that purpose, the Audit Committee has established a policy and related procedures regarding the pre-approval of all audits, audit-related, and non-audit services to be performed by Applied Visual Sciences, Inc.’s independent accountants (the "Policy").


The Policy provides that Applied Visual Sciences, Inc.’s independent accountant may not perform any audit, audit-related, or non-audit service for Applied Visual Sciences, Inc., subject to those exceptions that may be permitted by applicable law, unless (1) the service has been pre-approved by the Audit Committee, or (2) Applied Visual Sciences, Inc. engaged the independent registered public accountant to perform the service pursuant to the pre-approval provisions of the Policy. In addition, the Policy prohibits the Audit Committee from pre-approving certain non-audit services that are prohibited from being performed by Applied Visual Sciences, Inc.’s independent accountant by applicable securities laws. The Policy also provides that the Chief Financial Officer will periodically update the Audit Committee as to services provided by the independent auditor. With respect to each such service, the independent registered public accountant provides detailed back-up documentation to the board and the Chief Financial Officer.





85


Pursuant to its Policy, the Audit Committee has pre-approved certain categories of services to be performed by the independent registered public accountant and a maximum amount of fees for each category. The Board annually re-assesses these service categories and the associated fees. Individual projects within the approved service categories have been pre-approved only to the extent that the fees for each individual project do not exceed a specified dollar limit, which amount is re-assessed annually. Projects within a pre-approved service category with fees in excess of the specified fee limit for individual projects may not proceed without the specific prior approval of the Audit Committee. In addition, no project within a pre-approved service category will be considered to have been pre-approved by the Board if the project causes the maximum amount of fees for the service category to be exceeded, and the project may only proceed with the prior approval of the Audit Committee to increase the aggregate amount of fees for the service category.


The Audit Committee of the Board of Directors of the Company has appointed the firm of KBL, LLP, to serve as independent auditors of the Company for the fiscal year ending December 31, 2011.  KBL, LLP was first appointed on February 23, 2009 for the fiscal year ending December 31, 2008 audit.


For the fiscal years ended December 31, 2011, and 2010, the Company paid (or will pay) the following fees for services rendered during the year or for the audit in respect of those years:


Fee Type

 

2011

 

2010

 

 

 

 

 

Audit Fees (1)

 

 $ 63,500 

 

 $ 60,500 

Audit Related Fees (2)

 

  - 

 

  - 

Tax Fees (3)

 

  2,500 

 

  2,500 

All Other Fees (4)

 

  - 

 

  - 

   Total

 

 $ 66,000 

 

 $ 63,000 

 

(1) Represents fees for professional services rendered in connection with the audit of the annual financial statements, and review of the quarterly financial statements for each fiscal year.  Fees for fiscal 2011 and 2010 are for such services provided by KBL, LLP.

 

(2) Represents fees for professional services that principally include due diligence in connection with acquisitions or dispositions, accounting consultantations, and assistance with internal control documentation and information systems audits. The assurance and related services reasonably related to the performance of the audit or review of the Company's financial statements, such as SEC filings. No such services for Fiscal 2011 and 2010 were approved nor rendered.

 

(3) Represents fees for tax compliance services.  Fees for fiscal 2011 and 2010 represent amounts for service provided by KBL, LLP.

 

(4) Represents fees for professional services other than those described above.  No other such services for fiscal 2011 and 2010 were approved nor rendered pursuant to the de minimis exception provided in Rule 2-01 (7) (i)(C) of Regulation S-X.

 

 

 

 

 




PART IV


ITEM 15.   EXHIBITS AND FINANCIAL STATEMENT SCHEDULES


Financial statements:

The information required by this item appears beginning on page 91 of this Annual Report on Form 10-K. The following financial statements of the Company and those financial statement schedules required are incorporated herein by reference.


1.

Financial Statements


·

Report of Independent Registered Public Accounting Firm,

·

Consolidated Balance Sheets as of December 31, 2011 and 2010,

·

Consolidated Statements of Operations and Comprehensive Income (Loss) for the years ended December 31, 2011, and 2010,

·

Consolidated Statements of Stockholders’ Equity (Deficit) and Comprehensive Income (Loss) for the years ended December 31, 2011, and 2010,

·

Consolidated Statements of Cash Flows for the years ended December 31, 2011, and 2010,

·

Notes to Consolidated Financial Statements.


2. Financial Statement Schedules:





86


Exhibits:


The following exhibits are filed as part of this Annual Report on Form 10-K:


 

 

Incorporated by Reference From

 

Exhibit No.

                                                                                                                      Exhibit Description

     Form

          Filing Date

Filed Herewith

2.1

Amended and Restated Agreement and Plan of Reorganization dated effective June 12, 2003, by and among the Company, RJL Marketing Services, Inc., and the shareholders of RJL Marketing Services, Inc.

8-K

06/27/2003

 

3.1

Certificate of Incorporation

10-KSB

04/15/2004

 

3.2

Articles of Amendment to Certificate of Incorporation

10-KSB

04/15/2004

 

3.3

Certificate of Designation of Rights and Preferences of Series A Convertible Preferred Stock.

10-QSB

08/15/2003

 

3.4

Certificate of Designation, Preferences and Rights of Series B Convertible Preferred Stock.

10-QSB

08/15/2003

 

3.5

Certificate of Designations, Preferences and Rights of Series C Convertible Preferred Stock, dated September 24, 2003.   

10-QSB

11/14/2003

 

3.6

Certificate of Amendment to Certificate of Designation of Preferences and Rights of Series B Convertible Preferred Stock, dated October 27, 2003.

10-QSB

11/14/2003

 

3.7

Certificate of Amendment to Certificate of Designations of Rights and Preferences of Series A Convertible Preferred Stock, dated November 24, 2004

 

 

 

3.8

By-Laws

10-KSB

04/15/2004

 

4.1

Form of Common Stock Certificate, on file at company

 

 

 

10.1

Employment Agreement, dated August 18, 2003, between the Registrant and William J. Donovan.  

10-QSB

11/14/2003

 

10.2

Asset Purchase Agreement, dated October 23, 2003, between the Registrant, Difference Engines Corporation and Certain Stockholders.

10-QSB

11/14/2003

 

10.3

Amended And Restated 2003 Stock Incentive Plan.

10-KSB

04/15/2004

 

10.4

Amended Employment Agreement, dated December 10, 2004, between the Registrant and Michael W. Trudnak.

8-K

12/20/2004

 

10.5

Form of Incentive Stock Option Award Agreement.

10-Q

08/12/2005

 

10.6

Form of Non-Qualified Stock Option Award Agreement.

10-Q

08/12/2005

 

10.7

Form of Systems Implementation Agreement.

10-Q

11/14/2005

 

10.8

Employment Agreement, dated December 21, 2005, between the Registrant and Mr. Gregory E. Hare

8-K

01/31/2006

 

10.9

Loan Agreement, dated April 21, 2006, by and between the Registrant and Mr. Michael W. Trudnak.

8-K/A

5/25/06

 

10.10

Securities Purchase Agreement, dated November 3, 2006, by and among Registrant and Certain purchasers.

8-K

11/8/06

 

10.11

Form of Series A 10% Senior Convertible Debenture, due November 8, 2008.

8-K

11/8/06

 

10.12

Form of Registration Rights Agreement by and among Registrant and Certain Purchasers.

8-K

11/8/06

 

10.13

Form of Series D Common Stock Purchase Warrant Issued to Certain Purchasers.

8-K

11/8/06

 




87





10.14

Placement Agent Agreement, dated July 14, 2006, by and between Registrant and Midtown Partners & Co., LLC.

8-K

11/8/06

 

10.15

Form of Placement Agent’s Warrant issued to Midtown Partners & Co., LLC and its designees

8-K

11/8/06

 

10.16

Distribution Agreement, dated August 20, 2006, by and between Registrant and MTS Delft.

10-Q

11/14/06

 

10.17

Distribution Agreement, dated August 20, 2006, by and between Registrant and Calyx (UK) Limited.

10-Q

11/14/06

 

10.18

Securities Purchase Agreement, dated August 6, 2007, by and among Registrant and Certain purchasers.

8-K

8/7/07

 

10.19

Form of Series F and G Common Stock Purchase Warrant Issued to Certain Purchasers.

8-K

8/7/07

 

10.20

Form of Non-Qualified Stock Option Award Agreement Issued to Certain Executive Officers Related to Continued Deferral of Salary

10-Q

11/13/07

 

10.21

2009 Stock Compensation Plan, amended and effective on July 24, 2009

8-K

8/4/09

 

10.22

Form of Non-Qualified Stock Option Award Agreement, 2009 Stock Compensation Plan

8-K

6/22/09

 

10.23

Form of Restricted Stock Award Agreement, 2009 Stock Compensation Plan

8-K

6/22/09

 

10.24

Form of Restricted Stock Rights Agreement, 2009 Stock Compensation Plan

8-K

6/22/09

 

10.25

Amended Policy Independent Director Compensation, effective July 1, 2009

8-K

6/25/09

 

10.26

Form of Independent Director Non-Qualified Stock Option Award Agreement

8-K

6/25/09

 

10.27

2009 Stock Compensation Plan, amended and effective on July 24, 2009

8-K

8/4/09

 

10.28

Certificate of Ownership and Merger, and Name Change

8-K

7/15/10

 

10.29

Amendment and Waiver Agreement, dated October 15, 2010, by and between Registrant and Certain Purchasers

8-K

10/20/10

 

10.30

Securities Purchase Agreement, dated February 23, 2011, by and among Registrant and Seaside 88, L.P.

8-K

3/2/11

 

10.31

Amendment Agreement, dated December 31, 2011, by and between Registrant and Mr. Michael W. Trudnak.

 

 

X

14.1

Code of Ethics for Chief Executive Officer and Senior Financial Officers

10-KSB

4/15/04

 

21

List of Subsidiaries.

 

 

X

23.1

Consent of KBL, LLP

 

 

X

31.1

Certification Pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act of 1934, As Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (CEO)

 

 

X

31.2

Certification Pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act of 1934, As Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (CFO)

 

 

X

32.1

Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (CEO)

 

 

X

32.2

Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (CFO)

 

 

X

101.INS

XBRL Instance Document

 

 

X

101.SCH

XBRL Taxonomy Extension Schema Document

 

 

X

101.CAL

XBRL Taxonomy Extension Calculation Linkbase Document

 

 

X

101.DEF

XBRL Taxonomy Extension Definition Linkbase Document

 

 

X

101.LAB

XBRL Taxonomy Extension Label Linkbase Document

 

 

X




88





101.PRE

XBRL Taxonomy Extension Presentation Linkbase Document

 

 

X




89



SIGNATURES


Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.



 

APPLIED VISUAL SCIENCES, INC.

 

By:

/s/ Michael W. Trudnak

              Michael W. Trudnak

              Chief Executive Officer

              (Principal Executive Officer)

 

By:        /s/ Gregory E. Hare

              Gregory E. Hare

              Chief Financial Officer

              (Principal Financial and Accounting Officer)


Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.


Signature

Title

Date

/s/ Michael W. Trudnak

Michael W. Trudnak

Chairman of the Board, Chief Executive Officer and Secretary, Director

(Principal Executive Officer)

April 16, 2012

/s/ William J. Donovan

William J. Donovan

President and Chief Operating Officer, Director

April 16, 2012

/s/ Gregory E. Hare

Gregory E. Hare

Chief Financial Officer, Treasurer

(Principal Financial and Accounting Officer)

April 16, 2012

/s/ Joseph C. Brothers

Joseph C. Brothers

Director

April 16, 2012

/s/ Keith S. Kelly

Keith S. Kelly

Director

April 16, 2012

/s/ Sean W. Kennedy

Sean W. Kennedy

Director

April 16, 2012

/s/ Charles T. Nash

Charles T. Nash

Director

April 16, 2012



      




90





APPLIED VISUAL SCIENCES, INC. AND SUBSIDIARIES


CONSOLIDATED FINANCIAL STATEMENTS

TOGETHER WITH THE REPORT OF THE INDEPENDENT

REGISTERED PUBLIC ACCOUNTING FIRM







REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM


Board of Directors and Stockholders

Applied Visual Sciences, Inc.

Herndon, Virginia


We have audited the accompanying consolidated balance sheets of Applied Visual Sciences, Inc. (the “Company”) as of December 31, 2011 and 2010 and the related consolidated statements of operations, changes in stockholders’ equity (deficit), and cash flows for the years ended December 31, 2011 and 2010. These consolidated financial statements are the responsibility of the Company’s management.  Our responsibility is to express an opinion on these consolidated financial statements based on our audits.


We conducted our audits in accordance with standards of the Public Company Accounting Oversight Board (United States).  Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement.  The Company is not required to have, nor were we engaged to perform an audit of the Company’s internal control over financial reporting.  Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting.  Accordingly, we express no such opinion.  An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements.  An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation.  We believe that our audits provide a reasonable basis for our opinion.


In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Applied Visual Sciences, Inc. as of December 31, 2011 and 2010, and the results of its consolidated statements of operations, changes in stockholders’ equity (deficit), and cash flows for the years ended December 31, 2011 and 2010 in conformity with U.S. generally accepted accounting principles.


The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern.   As discussed in Note 1 to the consolidated financial statements, the Company has sustained significant operating losses and needs to obtain additional financing or restructure its current obligations. These conditions raise substantial doubt about the Company’s ability to continue as a going concern.  Management’s plans in regard to these matters are also described in Note 1.  The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.


/s/ KBL, LLP

New York, NY

April 16, 2012







CONSOLIDATED BALANCE SHEETS

APPLIED VISUAL SCIENCES, INC. AND SUBSIDIARIES

 CONSOLIDATED BALANCE SHEETS

 

 

 

December 31

 

 

2011

 

2010

 

 

 

 

 

ASSETS

 

 

 

Current Assets

 

 

 

 

Cash and cash equivalents

 $                6,490

 

 $                4,874

 

Accounts receivable

                         -

 

                 69,527

 

Prepaid expenses

                   2,610

 

                 19,281

 

     Total current assets

                   9,100

 

                 93,682

 

 

 

 

 

Equipment, net

               222,924

 

               286,772

 

 

 

 

 

Other Assets

 

 

 

 

Other noncurrent assets

                 11,122

 

                 11,122

 

Intangible assets, net

               363,599

 

               365,173

 

     Total assets

 $            606,745

 

 $            756,749

 

 

 

 

 

LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)

 

 

 

Current Liabilities

 

 

 

 

Accounts payable

 $          1,356,404

 

 $          1,347,819

 

Accrued wages and related

            6,311,354

 

            5,440,763

 

Other accrued liabilities

                   8,422

 

                         -

 

Notes payable and advances, related parties

                 89,000

 

               117,100

 

Notes payable, net of discount

               371,413

 

                         -

 

Convertible debentures

            2,025,846

 

            1,688,205

 

Derivative liabilities - embedded conversion feature of debentures

               270,113

 

            2,228,431

 

     Total current liabilities

           10,432,552

 

           10,822,318

 

 

 

 

 

Common shares subject to repurchase, stated at estimated redemption value; 282,704 shares outstanding at December 31, 2010

 

 

 

                         -

 

                 98,946

 

 

 

 

 

Stockholders' Equity (Deficit)

 

 

 

 

Convertible preferred stock, $0.20 par value; authorized 1,000,000 shares

 

 

 

 

   Shares issued and outstanding at December 31, 2011 - none

 

 

 

 

   Shares issued and outstanding at December 31, 2010 - none

                         -

 

                         -

 

Common stock, $0.001 par value; authorized 200,000,000 shares

 

 

 

 

   Shares issued and outstanding at December 31, 2011 - 88,506,305

 

 

 

 

   Shares issued and outstanding at December 31, 2010 - 82,212,233

                 88,506

 

                 82,212

 

Additional paid-in capital

           81,729,777

 

           80,242,987

 

Accumulated comprehensive income

                 63,354

 

                 63,354

 

Deficit accumulated

         (91,707,444)

 

         (90,553,068)

 

     Total stockholders' equity (deficit)

           (9,825,807)

 

         (10,164,515)

 

         Total liabilities and stockholders' equity (deficit)

 $            606,745

 

 $            756,749

 

 

 

 

 

See notes to condensed consolidated financial statements.

 

 

 








CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)

APPLIED VISUAL SCIENCES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)

 

 

 

 

Year Ended December 31

 

2011

 

2010

 

 

 

 

Net revenues

 $           6,589

 

 $       110,499

 

 

 

 

Cost of sales

                    -

 

            45,104

 

 

 

 

Gross profit

             6,589

 

            65,395

 

 

 

 

Selling, general and administrative expense

       2,741,778

 

       4,708,795

 

 

 

 

Operating loss

     (2,735,189)

 

     (4,643,400)

 

 

 

 

Other income

       1,580,813

 

          993,169

 

 

 

 

Net loss

 $  (1,154,376)

 

 $  (3,650,231)

 

 

 

 

 

 

 

 

 

 

 

 

Net loss per common share

 

 

 

     Basic and diluted

 $          (0.01)

 

 $          (0.05)

 

 

 

 

Weighted average common shares outstanding

 

 

 

     Basic and diluted

     85,456,082

 

     69,024,431

 

 

 

 

 

 

 

 

 

 

 

 

Other comprehensive income

 

 

 

     Comprehensive income - beginning of period

 $         63,354

 

 $         62,481

     Cumulative translation adjustments

                    -

 

                873

 

 

 

 

     Comprehensive income  - end of period

 $         63,354

 

 $         63,354

 

 

 

 

See notes to condensed consolidated financial statements.

 

 

 








CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY (DEFICIT) AND COMPREHENSIVE INCOME (LOSS)

APPLIED VISUAL SCIENSES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (DEFICIT) AND COMPREHENSIVE INCOME (LOSS)

 

 

 

 

 

 

 

 

 Total Accumulated Comprehensive Loss

 

 

 

 

 Deferred Stock Compensation

 Other Comprehensive Income (Loss)

 

 Total Stockholders' Equity (Deficit)

 

 Common Stock

 Additional

 Accumulated Deficit

 

 Shares

 Amount

 Paid-In Capital

Balance, December 31, 2009

     58,992,880

 $          58,993

 $     74,134,713

 $        (47,463)

 $             62,481

 $ (86,902,837)

 $ (12,694,113)

 $   (86,840,356)

Remeasurement of stock issued pursuant to consulting agreements

                    -

                    -

              4,100

            (4,100)

                      -

                    -

                    -

                     -

Proceeds from sale of common stock for cash, net

       4,824,000

             4,824

        1,110,456

                    -

                      -

                    -

       1,115,280

                     -

Common stock and warrants issued for consulting services

       1,121,108

             1,120

           306,557

        (185,070)

                      -

                    -

          122,607

                     -

Stock options issued for consulting services

                    -

                    -

             14,000

          (14,000)

                      -

                    -

                    -

                     -

Employee stock options exercised

          124,500

                124

             37,226

                    -

                      -

                    -

           37,350

                     -

Exercise of common stock purchase warrants

       1,092,000

             1,092

           261,408

                    -

                      -

                    -

          262,500

                     -

Cashless exercise of common stock purchase warrants

          420,166

                420

                (420)

                    -

                      -

                    -

                    -

                     -

Fair value of warrants in consideration extend/convert short-term note

                    -

                    -

             38,550

                    -

                      -

                    -

           38,550

                     -

Common stock issued to employees or consultant

       2,765,000

             2,765

           579,685

                    -

                      -

                    -

          582,450

                     -

Conversion of interest for common stock

       7,033,018

             7,033

        1,751,032

                    -

                      -

                    -

       1,758,065

                     -

Conversion of debentures to common stock

       1,710,000

             1,710

           425,790

                    -

                      -

                    -

          427,500

                     -

Conversion of convertible notes to common stock

       2,779,819

             2,780

           699,359

                    -

                      -

                    -

          702,139

                     -

Conversion of accounts payable to common stock

          759,287

                760

           218,731

                    -

                      -

                    -

          219,491

                     -

Conversion of accrued wages to common stock

          590,455

                591

           147,162

                    -

                      -

                    -

          147,753

                     -

Reclassification of common shares previously subject to repurchase

                    -

                    -

              2,733

                    -

                      -

                    -

             2,733

                     -

Gain on remeasurement of common shares subject to repurchase

                    -

                    -

           (59,368)

                    -

                      -

                    -

          (59,368)

                     -

Amortization of consultants deferred stock based compensation

                    -

                    -

                     -

          180,493

                      -

                    -

          180,493

                     -

Amortization of employee stock options

                    -

                    -

           641,413

                    -

                      -

                    -

          641,413

                     -

Foreign currency translation

                    -

                    -

                     -

                    -

                  873

                    -

                873

                 873

Net loss

                   -

                    -

                     -

                    -

                      -

     (3,650,231)

     (3,650,231)

       (3,650,231)

Total comprehensive loss

                    -

                    -

                     -

                    -

                      -

                    -

                    -

       (3,649,358)

Balance, December 31, 2010

     82,212,233

           82,212

      80,313,127

          (70,140)

              63,354

    (90,553,068)

    (10,164,515)

     (90,489,714)

Proceeds from sale of common stock for cash, net

       1,444,000

             1,444

           342,556

                    -

                      -

                    -

          344,000

                     -

Exchange commission for common stock

          250,000

                250

             24,750

                    -

                      -

                    -

           25,000

                     -

Common stock and/or warrants issued for consulting services

       1,549,044

             1,549

           233,186

          (17,500)

                      -

                    -

          217,235

                     -

Common stock issued to short-term note holders

          400,000

                400

             34,300

                    -

                      -

                    -

           34,700

                     -

Conversion of accounts payable to common stock

          968,216

                968

           291,682

                    -

                      -

                    -

          292,650

                     -

Conversion of accrued wages to common stock

       1,171,012

             1,171

             91,464

                    -

                      -

                    -

           92,635

                     -

Conversion of accrued wages for exercise of employee stock options

         511,800

                512

           153,028

                    -

                      -

                    -

          153,540

                     -

Reclassification of common stock previously subject to repurchase

                    -

                    -

             98,946

                    -

                      -

                    -

           98,946

                     -

Remeasurement of stock issued pursuant to consulting agreements

                    -

                    -

           (16,670)

            16,670

                      -

                    -

                    -

                     -

Amortization of consultants deferred stock based compensation

                    -

                    -

                     -

            70,137

                      -

                    -

           70,137

                     -

Amortization of employee stock options

                    -

                    -

           164,241

                    -

                      -

                    -

          164,241

                     -

Net loss

                    -