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EX-10.1 - EXHIBIT 10.1 - NET TALK.COM, INC.v312375_ex10-1.htm
EX-32.1 - EXHIBIT 32.1 - NET TALK.COM, INC.v312375_ex32-1.htm
EX-32.2 - EXHIBIT 32.2 - NET TALK.COM, INC.v312375_ex32-2.htm
EX-31.1 - EXHIBIT 31.1 - NET TALK.COM, INC.v312375_ex31-1.htm
EX-31.2 - EXHIBIT 31.2 - NET TALK.COM, INC.v312375_ex31-2.htm

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

(Mark One)

 

þQUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarter ended March 31, 2012

 

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: 000-53668

 

NET TALK.COM, INC.

(Exact name of Registrant as specified in its charter)

 

Florida 20-4830633
(State or other jurisdiction of incorporation or organization) (I.R.S. employer identification no.)

 

1100 NW 163 Drive, Miami, FL 33169
(Address of principal executive offices) (Zip code)

 

Registrant's telephone number, including area code: (305) 621-1200

 

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 þ No ¨

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, 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 x No ¨

 

Indicate by check mark whether the registrant is a large accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer ¨      Accelerated Filer ¨      Non-accelerated filer ¨      Smaller reporting company þ

 

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

 

The Registrant had 42,948,392 shares of Common Stock, par value $0.001 per share, outstanding as of May 15, 2012.

 

 
 

 

Net Talk.com, Inc

 

INDEX

 

        Page No.  
Part I   Financial Information      
           
Item 1   Financial Statements      
           
    Balance Sheets at March 31, 2012 (Unaudited) and December 31, 2011   3  
           
    Statements of Operations for the Three Months Ended March 31, 2012 and 2011 (Unaudited)   4  
           
    Statements of Cash Flows for the Three Months Ended March 31, 2012 and 2011 (Unaudited)   5  
           
    Notes to Financial Statements   6 – 21  
           
Item 2   Management’s Discussion and Analysis of Financial Conditions and Results of Operations   22 – 29  
           
Item 3   Quantitative and Qualitative Disclosures About Market Risks   29  
           
Item 4   Controls and Procedures   30  
           
Part II   Other Information      
           
Item 1   Legal Proceedings   31  
           
Item 1A   Risk Factors   31  
           
Item 2   Unregistered Sales of Equity Securities and Use of Proceeds   31  
           
Item 3   Defaults Upon Senior Securities   31  
           
Item 4   Submission of Matters to a Vote of Security Holders   31  
           
Item 5   Other information   31  
           
Item 6   Exhibits   32  
           
Signatures       33  

 

2
 

 

Net Talk.com, Inc.

Balance Sheets

 

   (unaudited)     
   March 31,   December 31, 
   2012   2011 
Assets          
Current assets:          
Cash and cash equivalents  $511,345   $1,539,263 
Restricted cash   118,256    98,877 
Accounts receivable, net of allowance for bad debts of $0 and $0, respectively   802,520    576,160 
Inventory   2,013,181    2,205,255 
Prepaid expenses   4,131    3,511 
Note receivable   34,000    43,000 
Total current assets   3,483,433    4,466,066 
           
Building, telecommunications equipment, land and other property, net   3,010,764    3,000,039 
Intangible assets, net   115,591    132,364 
Other assets   39,754    39,754 
Total assets  $6,649,542   $7,638,223 
           
Liabilities, redeemable preferred stock and stockholders' deficit          
Current liabilities:          
Accounts payable  $1,112,833   $888,993 
Accrued dividends   851,116    701,116 
Accrued expenses   755,459    532,159 
Deferred revenue   1,952,311    1,683,948 
Demand note   150,010    - 
Current portion of senior debentures   3,384,655    2,211,483 
Total current liabilities   8,206,384    6,017,699 
           
Senior debentures   4,254,505    3,783,692 
Total liabilities   12,460,889    9,801,391 
           
Redeemable preferred stock, $.001 par value, 10,000,000 shares authrorized, 500   9,192,406    10,382,957 
and 300 issued and outstanding as of March 31, 2012 and December 31, 2011,          
respectively.          
           
Stockholders' deficit:          
Common stock, $.001 par value, 300,000,000 authorized, 42,948,392 and 39,464,892   42,948    39,465 
issued and outstanding as of March 31, 2012 and 2011, respectively          
Additional paid in capital   30,525,022    29,453,120 
Accumulated deficit   (45,571,723)   (42,038,710)
Total stockholders' deficit   (15,003,753)   (12,546,125)
           
Total liabilities, redeemable preferred stock and stockholders' deficit  $6,649,542   $7,638,223 

 

The accompanying notes are an integral part of the financial statements

 

3
 

 

Net Talk.com, Inc.

Statements of Operations

 

   Three months ended 
   March 31, 
   (unaudited)   (unaudited) 
   2012   2011 
         
Revenues  $1,056,321   $611,779 
           
Cost of sales   1,412,297    972,577 
           
Gross margin   (355,976)   (360,798)
           
Advertising and marketing   429,243    373,701 
Compensation and benefits   321,996    104,917 
Professional fees   141,635    77,642 
Depreciation and amortization   62,559    90,914 
Research and development   337,393    149,119 
General and administrative expenses   582,490    232,686 
           
Total operating expenses   1,875,316    1,028,979 
           
Loss from operations   (2,231,292)   (1,389,777)
           
Other income (expenses):          
Interest expense   (1,301,969)   (149,964)
Derivative (expense)   -    (22,260,451)
Settlement (expense)        (367,500)
Interest income   248    615 
    (1,301,721)   (22,777,300)
           
Loss applicable to common stockholders  $(3,533,013)  $(24,167,077)
           
Loss per common shares:          
Basic and diluted earnings per common share  $(0.08)  $(1.83)
           
Weighted average shares:          
Basic and diluted   42,948,392    13,179,300 

 

The accompanying notes are an integral part of the financial statements

 

4
 

 

Net Talk.com, Inc.

Statements of Cash Flows

 

   Three months ended 
   March 31, 
   (unaudited)   (unaudited) 
   2012   2011 
Cash flow from operating activities:          
Net loss  $(3,533,013)  $(24,167,077)
Adjustments to reconcile net loss to net cash (used) in operations:          
Depreciation   45,786    33,196 
Amortization   16,773    57,718 
Amortization of debt discount   993,985    - 
Bad debt expense   -    (23,739)
Derivative fair value adjustments   -    21,973,784 
Changes in assets and liabilities:          
Accounts receivables   (226,360)   (65,256)
Prepaid expenses and other assets   8,380    204 
Inventories   192,074    (650,952)
Deferred revenues   268,363    81,164 
Accounts payable   223,840    376,652 
Accrued expenses   373,300    57,381 
Net cash (used) in operating activities   (1,636,872)   (2,326,925)
Cash flow used in investing activities:          
Restricted cash   (19,379)   (73,674)
Acquisition of corporate offices and operations center and  fixed assets   (56,511)   (38,355)
Decrease in deposits   -    2,500 
Net cash (used) in investing activities:   (75,890)   (109,529)
Cash flow from financing activities:          
Notes payables - Demand notes   650,010    2,500,000 
Issuance of common stock (net)   34,834    367,500 
Net cash provided from financing activities   684,844    2,867,500 
Net decrease in cash   (1,027,918)   431,046 
Cash and equivalents, beginning   1,539,263    1,438,090 
Cash and equivalents, ending  $511,345   $1,869,136 
           
Supplemental disclosures:          
Cash paid for interest  $-   $149,953 
Cash paid for income taxes  $-   $- 
Cash paid for preferred stock dividends  $-   $289,667 

 

The accompanying notes are an integral part of the financial statements

 

5
 

 

NET TALK.COM, INC.

Notes to Unaudited Financial Statements

 

Note 1 – Nature of Operations and Basis of Presentation

 

Basis of presentation:

 

The accompanying unaudited financial statements as of and for the three months ended March 31, 2012 have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and pursuant to the rules and regulations of the Securities and Exchange Commission for Form 10-Q. Accordingly, they do not include all the information and footnotes required for complete financial statements. However, the unaudited condensed financial information includes all adjustments which are, in the opinion of management, necessary to fairly present the financial position and the results of operations for the interim periods presented. The operations for the three months ended March 31, 2012 are not necessarily indicative of the results for the year ending December 31, 2012.

 

The unaudited financial statements included in this report should be read in conjunction with the financial statements and notes thereto included in the Company’s Annual Report on Form 10-KT for the year ended December 31, 2011, filed with the Securities and Exchange Commission.

 

Nature of operations:

 

Net Talk.com, Inc. (“NetTalk” or the “Company”) was incorporated on May 1, 2006 under the laws of the State of Florida. We are a telephone company, who provides, sells and supplies commercial and residential telecommunication services, including services utilizing voice over internet protocol (“VoIP”) technology, session initiation protocol (“SIP”) technology, wireless fidelity technology, wireless maximum technology, marine satellite services technology and other similar type technologies. Our main products are the DUO and DUOWIFI, analog telephone adapters that provide connectivity for analog telephones and faxes to home, home office or corporate local area networks (“LAN”). Our DUO products and their related services are a cost effective solution for individuals, small businesses and telecommuters connecting to any analog telephone, fax or private branch exchange (“PBX”). Our DUO products provides one USB port, one Ethernet port and one analog telephone port. A full suite of internet protocol features is available to maximize universal connectivity. In addition, analog telephones attached to our DUO products are able to use advanced calling features such as call forwarding, caller ID, 3-way calling, call holding, call retrieval and call transfer.

 

Note 2 - Summary of Significant Accounting Policies

 

Use of Estimates

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires our management to make estimates and assumptions that affect the amounts reported in the financial statements and footnotes. Significant estimates inherent in the preparation of our financial statements include developing fair value measurements upon which to base our accounting for acquisitions of intangible assets and issuances of financial instruments, including our common stock. Our estimates also include developing useful lives for our tangible and intangible assets and cash flow projections upon which we determine the existence of, or the measurements for, impairments. In all instances, estimates are made by competent employees under the supervision of management, based upon the current circumstances and the best information available.

 

Risk and Uncertainties

 

Our future results of operations and financial condition will be impacted by the following factors, among others: dependence on the worldwide telecommunication markets characterized by intense competition and rapidly changing technology, on third-party manufacturers and subcontractors, on third-party distributors in certain markets and on the successful development and marketing of new products in new and existing markets. Generally, we are unable to predict the future status of these areas of risk and uncertainty.

 

6
 

 

Revenue Recognition

 

We derive revenue from (i) product sales and (ii) telecom services. All revenues are recognized in accordance with ASC 605, Revenue Recognition and SAB 104 as follows: when evidence of an arrangement exists, in the case of products, when the product is shipped to a customer, or in the case of telecom services, when the service is used by the consumer, when the fee is fixed or determinable and finally when we have concluded that amounts are collectible from the customers. Shipping costs billed to customers are included as a component of product sales. The associated cost of shipping is included as a component of cost of product sales.

 

Operating revenue consist of customer equipment sales of our products the NetTalk DUO (“DUO”) and DUO WIFI, telecommunication service revenues and shipping and handling revenues.

  

Our DUO products provides for revenue recognition from the sale of the device and from the sale of telephone service. The initial year of telephone service is included on the sale price at time of sale and billed subsequently thereafter. Therefore, revenue recognition on our DUO products are fully recognized at the time of our customer equipment sale, the one year telephone service is amortized over 12 month cycle.  Subsequent renewals of the annual telephone service are amortized over the corresponding 12 months cycle.

 

International calls are billed as earned from our customers.  International calls are prepaid and customers account is debited as minutes are used and earned.

 

Cash and Cash Equivalents

 

We consider all highly liquid cash balances and debt instruments with an original maturity of three months or less to be cash equivalents. We maintain cash balances only in domestic bank accounts, which at times, may exceed FDIC limits. Our cash balances exceeded the FDIC limits by $293,863 and $1,289,263 at March 31, 2012 and December 31, 2011, respectively.

 

Accounts receivables

 

As of December 2011, we entered into an accounts receivable factoring arrangement with a financial institution (the “Factor”). Pursuant to the terms of this arrangement, from time to time we shall sell to the Factor certain of our accounts receivable balances on a non-recourse basis for credit approved accounts. The Factor shall then remit 80% of the accounts receivable balance, with the remaining balance, less fees to be forwarded once the Factor collects the full accounts receivable balance from the customer. Factoring fees range from 7.3% to 9% of the face value of the invoice factored, determined by the number of days required for collection of the invoice. We expect to use this factoring arrangement periodically to assist with general working capital requirements.

 

We also granted to Factor as security for all present and future obligations owing to Factor, a continuing priority security interest in all of our existing and later acquired assets.

 

Inventory

 

Inventories are recorded at cost or market, whichever is lower.

 

   March 31, 2012   December 31, 2011 
Productive material, work in process and supplies  $1,187,650   $1,186,916 
Finished products   825,531    1,018,339 
Total  $2,013,181   $2,205,255 

 

During the three months period ended March 31, 2012 and December 31, 2011 in accordance with our lower of cost or market analyses we did not recorded any lower of cost or market adjustments to our finished goods inventories.

 

Of our $825,531 of finished goods inventory, $80,708 of it is held on consignment at one of our distributors.

 

Telecommunications Equipment and Other Property

 

Property, equipment and telecommunication equipment includes acquired assets which consist of network equipment, computer hardware, furniture and software. All of our equipment is stated at cost with depreciation calculated using the straight line method over the estimated useful lives of related assets, which ranges from three to five years. The cost associated with major improvements are capitalized while the cost of maintenance and repairs is charged to operating expenses.

 

7
 

 

Intangible Assets

Our intangible assets were recorded at our acquisition cost, which encompassed estimates of their respective and their relative fair values, as well as estimates of the fair value of consideration that we issued. We amortize our intangible assets using the straight-line method over lives that are predicated on contractual terms or over periods we believe the assets will have utility.

 

Impairments and Disposals

 

We evaluate our tangible and definite-lived intangible assets for impairment annually or more frequently in the presence of circumstances or trends that may be indicators of impairment. Our evaluation is a two step process. The first step is to compare our undiscounted cash flows, as projected over the remaining useful lives of the assets, to their respective carrying values. In the event that the carrying values are not recovered by future undiscounted cash flows, as a second step, we compare the carrying values to the related fair values and, if lower, record an impairment adjustment. For purposes of fair value, we generally use replacement costs for tangible fixed assets and discounted cash flows, using risk-adjusted discount rates for intangible assets.

 

Research and Development and Software Costs

 

We expense research and development costs, as these costs are incurred. We account for our offering-related software development costs as costs incurred internally in creating a computer software product and are charged to expense when incurred as research and development until technological feasibility has been established for the product. Technological feasibility is established upon completion of a detail program design or, in its absence, completion of a working model. Thereafter, all software production costs shall be 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. At this time our main products, the DUO and DUO WIFI are being sold in the market place. Therefore, research and development cost reported in our financial statements relates to pre – marketing costs and are expensed accordingly.

 

   Three Months Ended
March 31,
 
Components of research and development:  2012   2011 
Product development and engineering  $37,282   $31,325 
Payroll and benefits   300,111    117,794 
Total  $337,393   $149,119 

 

Reclassification

 

Certain reclassifications have been made to prior years financial statements in order to conform to the current year’s presentation. The reclassification had no impact on net earnings previously reported.

 

Share-Based Payment Arrangements

 

In June 2008, the FASB issued authoritative guidance on the treatment of participating securities in the calculation of earnings per shares (“EPS”). This guidance addresses whether instruments granted in share – based payment transactions are participating securities prior to vesting and, therefore, need to be included in the earnings allocation in computing EPS under the two - class method. This guidance was effective for fiscal years beginning on or after December 15, 2008. Adoption of this guidance did not have a material impact on our results of operations and financial position, or on basic or diluted EPS.

 

We apply the grant date fair value method to our share – based payment arrangements with employees and consultants. Share – based compensation cost to employees is measured at the grant date fair value based on the value of the award and is recognized over the service period. Share – based payments to non – employees are recorded at fair value on the measurement date and reflected in expense over the service period.

 

2010 Stock Option Plan

 

On November 15, 2009, NetTalk adopted the 2010 Stock Option Plan (the "Plan") which is intended to advance the interests of the Company’s shareholders by enhancing the Company’s ability to attract, retain and motivate persons who make (or are expected to make) important contributions to the Company by providing such persons with equity ownership opportunities and performance-based incentives and thereby better aligning the interests of such persons with those of the Company’s shareholders. All of the Company’s employees, officers, and directors, and those Company’s consultants and advisors (i) that are natural persons and (ii) who provides bona fide services to the Company not connected to a capital raising transaction or the promotion or creation of a market for the Company’s securities, are eligible to be granted options or restricted stock awards under the Plan. The maximum aggregate number of shares of the Company’s common stock that may be issued under the Plan is 10,000,000 shares of the Company’s common stock.

 

8
 

 

On July 26, 2010, we issued 3,709,500 shares of common stock to our employees as part of our 2010 Stock Option Plan. The shares are compensatory in nature and are fully vested. We have valued the shares consistent with fair value at the time of issuance including and adjusted for ownership restrictions.

 

On May 23 2011, we issued 3,890,000 shares of common stock to our employees as part of our 2010 Stock Option Plan. The shares are compensatory in nature and are fully vested. We have valued the shares consistent with fair value at the time of issuance including and adjusted for ownership restrictions.

 

On July 26 2011, we issued 2,400,500 shares of common stock to our employees as part of our 2010 Stock Option Plan. The shares are compensatory in nature and are fully vested. We have valued the shares consistent with fair value at the time of issuance including and adjusted for ownership restrictions.

 

Summary of 2010 Stock Option Plan (issuances):

 

July 26, 2011   3,709,500  Common shares 
May 23, 2011   3,890,000  Common shares 
July 26, 2011   2,400,500  Common shares 
Total   10,000,000  Common shares 

 

2011 Stock Option Plan

 

On June 15, 2011, NetTalk adopted the 2011 Stock Option Plan (the "Plan") which is intended to advance the interests of the Company’s shareholders by enhancing the Company’s ability to attract, retain and motivate persons who make (or are expected to make) important contributions to the Company by providing such persons with equity ownership opportunities and performance-based incentives and thereby better aligning the interests of such persons with those of the Company’s shareholders. All of the Company’s employees, officers, and directors, and those Company’s consultants and advisors (i) that are natural persons and (ii) who provides bona fide services to the Company not connected to a capital raising transaction or the promotion or creation of a market for the Company’s securities, are eligible to be granted options or restricted stock awards under the Plan. The maximum aggregate number of shares of the Company’s common stock that may be issued under the Plan is 20,000,000 shares of the Company’s common stock.

 

On January 6, 2012, we issued 3,483,500 shares of common stock to our employees as part of our 2011 Stock Option Plan. The shares are compensatory in nature and are fully vested. We have valued the shares consistent with fair value at the time of issuance including and adjusted for ownership restrictions.

 

Financial Instruments

 

Financial instruments, as defined in the Accounting Standards Codification (“ASC”) 825 Financial Instruments, consist of cash, evidence of ownership in an entity, and contracts that both (i) impose on one entity a contractual obligation to deliver cash or another financial instrument to a second entity, or to exchange other financial instruments on potentially unfavorable terms with the second entity, and (ii) conveys to that second entity a contractual right (a) to receive cash or another financial instrument from the first entity, or (b) to exchange other financial instruments on potentially favorable terms with the first entity. Accordingly, our financial instruments consist of cash and cash equivalents, accounts receivable, accounts payable, accrued liabilities, secured convertible debentures, and derivative financial instruments.

 

We carry cash and cash equivalents, accounts receivable, accounts payable and accrued liabilities at historical costs since their respective estimated fair values approximate carrying values due to their current nature. We also carry convertible debentures and redeemable preferred stock at historical cost.

 

Derivative financial instruments, as defined in ASC 815-10-15-83 Derivatives and Hedging, consist of financial instruments or other contracts that contain a notional amount and one or more underlying (e.g. interest rate, security price or other variable), require no initial net investment and permit net settlement. Derivative financial instruments may be free-standing or embedded in other financial instruments. Further, derivative financial instruments are initially, and subsequently, measured at fair value and recorded as liabilities or, in rare instances, assets.

 

9
 

 

Certain risks and concentration

 

Our manufacturing partner accounted for approximately 45% of our cost of goods sold and 10% of outstanding accounts payable at period ended March 31, 2012 comparable amounts for period ended March 31, 2011 were 29% of cost of goods sold and 0% of outstanding accounts payables.

 

One of our customers presently operates under a “Consignment Agreement”, under the agreement we sell and ship merchandise to our customer and we collect payments upon final sale of our product to the ultimate (final) consumer.

 

Redeemable Preferred Stock

 

Redeemable preferred stock (and other redeemable financial instrument we may enter into) is initially evaluated for possible classification as liabilities under ASC 480 Distinguishing Liabilities from Equity. Redeemable preferred stock classified as liabilities is recorded and carried at fair value. Redeemable preferred stock that does not, in its entirety, require liability classification is evaluated for embedded features that may require bifurcation and separate classification as derivative liabilities under ASC 815. In all instances, the classification of the redeemable preferred stock host contract that does not require liability classification is evaluated for equity classification or mezzanine classification based upon the nature of the redemption features. Generally, any feature that could require cash redemption for matters not within our control, irrespective of probability of the event occurring, requires classification outside of stockholders’ equity. See Note 6 for further disclosures about our redeemable preferred stock.

 

Loss per common share

 

Basic loss per common share represents our loss applicable to common shareholders divided by the weighted average number of common shares outstanding during the period. Diluted loss per common share gives effect to all potentially dilutive securities. We compute the effects on diluted loss per common share arising from warrants and options using the treasury stock method or, in the case of liability classified warrants, the reverse treasury stock method. We compute the effects on diluted loss per common share arising from convertible securities using the if-converted method. The effects, if anti-dilutive are excluded.

 

Recent accounting pronouncements

 

In May 2011, the FASB issued an update that amends the guidance provided in ASC Topic 820, Fair Value Measurement, by clarifying some existing concepts, eliminating wording differences between GAAP and International Financial Reporting Standards (“IFRS”), and in some limited cases, changing some principles to achieve convergence between GAAP and IFRS. The update results in a consistent definition of fair value, establishes common requirements for the measurement of and disclosure about fair value between GAAP and IFRS, and expands the disclosures for fair value measurements that are estimated using significant unobservable (Level 3) inputs. This update becomes effective in the second quarter of fiscal 2012. We do not expect the adoption of this update to have a material impact on our consolidated financial statements.

 

In June 2009, the Financial Accounting Standards Board (“FASB”) issued the FASB Accounting Standards Codification (“Codification”). The Codification is the single source for all authoritative Generally Accepted Accounting Principles (“GAAP”) recognized by the FASB to be applied for financial statements issued for periods ending after September 15, 2009. The Codification does not change GAAP and did not have a material impact on the Company’s financial statements.

 

Income Taxes

 

We record our income taxes using the asset and liability method. Under this method, the future tax consequences attributed to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis are reflected as tax assets and liabilities using enacted tax rates expected to apply to taxable income in the years in which those temporary differences reverse. Changes in these deferred tax assets and liabilities are reflected in the provision for income taxes. However, we are required to evaluate the recoverability of net deferred tax assets. If it is more likely than not that some portion of a net deferred tax asset will not be realized, a valuation allowance is recognized with a charge to the provision for income taxes.

 

Our net loss reflects permanent tax differences which are not deductible for tax purposes. Therefore, our tax net operating loss would be reduced accordingly. Our major permanent differences for the three ended March 31, 2012 and 2011, are as follows:

 

10
 

 

Permanent differences:  Three Months Ended
March 31,
 
   2012   2011 
Derivative income (expense)  $-   $(22,260,451)
Debt extinguished   -    (367,500)
Total income (expense)  $-   $(22,627,951)

 

Note 3 - Telecommunications Equipment and Other Property

 

Telecommunications equipment and other property consist of the following:

 

   Life   March 31, 2012   December  31, 2011 
             
Telecommunication equipment   7   $350,246   $335,340 
Computer equipment   5    131,799    121,944 
Building   35    2,448,364    2,448,364 
Building improvements   10    23,390    - 
Office equipment and furnishing   7    29,914    29,914 
Purchased software   3    34,147    25,787 
Land        270,000    270,000 
Sub – total        3,287,860    3,231,349 
Less: accumulated depreciation        (277,096)   (231,310)
Total       $3,010,764   $3,000,039 

 

Our telecommunications equipment is deployed in our Network Operations Center (“NOC”) as is most of the computer equipment. Other computer and office equipment and furnishings are deployed at our corporate offices, which we lease under an operating lease.

 

Depreciation of the above assets was as follows: 

   Three Months Ended
March 31,
 
   2012   2011 
Depreciation expense  $45,786   $33,196 

 

Note 4 - Intangible Assets:

 

Intangible assets consist of following:

   Life   March 31, 2012   December 31, 2011 
             
Trademarks National and International   5   $332,708   $332,708 
Employment agreements   3    225,084    225,084 
Knowhow and specialty skills   3    212,254    212,254 
Workforce   3    54,000    54,000 
Telephony licenses   2    9,195    9,195 
Patents   20    11,024    11,024 
Domain names   2    7,723    7,723 
         851,988    851,988 
Less accumulated amortization        (736,397)   (719,624)
        $115,591   $132,364 

 

Amortization of the above assets was as follows:

   Three Months Ended
March 31,
 
   2012   2011 
           
Amortization expense  $16,773   $57,718 

 

The weighted average amortization period for the amortizable intangible assets is 2.4 years.

 

11
 

 

Estimated future amortization of intangible assets is for each of the following years as of December 31, 2012, as follows:

 

2013   67,092 
2014   48,499 
Total  $115,591 

 

Note 5 – Secured Convertible Debentures, Secured Long-Term Debentures and Short Term Debt

 

On March 29, 2012, we issued face value $500,000, 10% Senior secured debenture, due June 30, 2012.

 

On March 26, 2012, we received an advance of $150,010 from an unrelated source.

 

The carrying values our long-term and short term debt consisted of the following as of March 31, 2012 and December 31, 2011:

 

   March 31,
2012
   December 31,
2011
 
         
$2,000,000 face value 12% debenture, due July 1, 2013  $1,104,874   $941,762 
$3,500,000 face value 10% debenture, due June 30, 2012   2,884,655    2,211,483 
$5,266,130 face value 12% debenture, due July 1, 2013   3,149,631    2,841,930 
$   500,000 face value 10% debenture, due June 30, 2012   500,000    - 
$   150,010 face value demand note, due on demand   150,010    - 
Total  $7,789,170   $5,995,175 

 

Issuance of Non-Convertible Debentures

 

On August 8, 2011 and September 30, 2011, we issued face value $2,000,000 12% debentures, due July 1, 2013, and face value $3,500,000 10% debentures, due June 30, 2012, respectively, for aggregate cash of $5,500,000. Concurrent with these financing transactions we also issued the investor warrants to purchase an aggregate of 18,000,000 shares of our common stock for $0.50 for periods of five years.

 

We allocated the gross proceeds from the financing transactions to the debentures and the warrants based upon their relative fair values, as reflected in the following table:

 

August 8, 2011 Financing Arrangement  Fair Values   Relative
Fair Values
 
$2,000,000 face value of debentures  $2,127,063   $721,642 
Warrants to purchase 8,000,000 shares of common stock   3,768,000    1,278,358 
   $5,895,063   $2,000,000 

 

September 30, 2011 Financing Arrangement  Fair Values   Relative
Fair Values
 
$3,500,000 face value of debentures  $3,560,675   $1,695,404 
Warrants to purchase 10,000,000 shares of common stock   3,790,000    1,804,596 
   $7,350,675   $3,500,000 

 

The fair value of the debentures was computed based upon the present value of all future cash flows, using a credit risk adjusted discount rates ranging from 7.63% to 7.86%. This discount rate was developed based upon bond curves of companies with similar high risk credit ratings plus a range of 0.25% to 0.36% risk free rate based upon yields for zero coupon government securities with maturities consistent with those of the debentures. The fair value of the warrants was determined using the Binomial Lattice technique. The effective volatility and risk free rates resulting from the calculations were 55.15% — 129.86% and 0.07% — 1.11%, respectively.

 

On June 30, 2011, we issued face value $5,266,130, 12% debentures, due July 1, 2013 and warrants to purchase 21,064,520 shares of our common stock for $0.50 per share, which expire five years from the issuance date, for $2,500,000 cash, settlement of $2,500,000 in bridge financing and settlement of $266,130 in accrued interest on the former convertible debentures. See discussion on the conversion of the convertible debentures, below. The cash and advance settlement were accounted for as financing transactions. The settlement of the accrued interest was accounted for as an extinguishment of debt.

 

12
 

 

The debentures were allocated $5,000,000 face value and $266,130 to the financing and extinguishment, respectively. Applying that same relationship, we allocated 20,000,000 and 1,064,520 warrants to the financing and extinguishment, respectively.

 

We allocated the gross proceeds from the financing transaction to the debentures and the warrants based upon their relative fair values, as reflected in the following table:

 

   Fair Values   Relative
Fair Values
 
$5,000,000 face value of debentures  $5,340,195   $2,029,536 
Warrants to purchase 20,000,000 shares of common stock   7,816,000    2,970,464 
   $13,156,195   $5,000,000 

 

The fair value of the debentures was computed based upon the present value of all future cash flows, using a credit risk adjusted discount rate of $7.75%. This discount rate was developed based upon bond curves of companies with similar high risk credit ratings plus a 0.50% risk free rate based upon yields for zero coupon government securities with maturities consistent with those of the debentures. The fair value of the warrants was determined using the Binomial Lattice valuation technique. The effective volatility and risk free rate used in the calculation were 113.8% and 1.70%, respectively.

 

For purposes of the extinguished instrument, we recorded the allocated face value of the debentures and the allocated number of warrants at their fair values. The difference between these amounts and the carrying value of the settled obligation was recorded as an extinguishment loss in our income, as follows:

 

   Extinguishment
Calculation
 
$266,130 face value of debentures  $284,238 
Warrants to purchase 1,064,520 shares of common stock   416,014 
    700,252 
Carrying value of settled obligation   266,130 
Extinguishment loss  $434,122 

 

The fair value of the debentures and the warrants were determined in the same manner as those allocated to the financing and as described above.

 

The total carrying value of the debentures arising from the financing and the extinguishment transactions amounted to $2,313,774. This discounted balance is subject to amortization through charges to interest expense over the term to maturity using the effective interest method. Amortization will commence on July 1, 2011.

 

Conversion of Convertible Debentures:

 

On June 30, 2011, the holders of our secured convertible debentures converted the debentures for an aggregate of 19,995,092 shares of common stock, which was in accordance with the contractual conversion price. On the date of the conversion, the compound embedded derivatives associated with the secured convertible debentures were adjusted to fair value resulting in a credit to derivative income in the amount of $2,514,209. Following the derivative adjustment, the adjusted carrying value of the compound embedded derivative ($8,797,840) and carrying value of the secured convertible notes ($4,998,773) were combined in the amount of $13,776,613 and reclassified to stockholders equity to give effect to the issuance of the common shares.

 

Further, on the June 30, 2011 conversion date we issued the holders of the secured convertible debentures warrants to purchase 1,000,000 shares of our common stock as conversion inducement consideration. These warrants have a five year term and a strike price of $0.50 per common share. The warrants meet all conditions for equity classification. The fair value of the warrants, determined using the Noreen Wolfson dilution adjustment model for the Black Scholes Merton valuation technique, amounted to $390,800 which has been recorded in expense. The volatility and risk free rate used in the Black Scholes Merton calculation were 113.8% and 1.70%, respectively.

 

13
 

 

Issuance of Convertible Debentures:

 

By way of background, our convertible debentures were issued on February 24, 2010 in connection with an exchange agreement with our creditors that provided for, among other things, the consolidation of our previous secured convertible debt instruments, with maturities listed in the table above, and included the capitalization of $798,773 of accrued interest. The newly issued convertible debentures bear interest at 12%, which is payable at the earlier of the maturity date or the date that the debentures are converted, if ever. Such interest is payable at the Company’s option in cash or common stock at $0.25 per common share. The principal amount of the debentures is convertible into common stock at $0.25. Accordingly, the convertible debentures are indexed to 19,995,092 shares of our common stock. Each of the principal and debt conversion rates are subject to adjustment for recapitalization events or sales of equity or equity-linked contracts with a price or conversion price less than the contractual conversion price. The convertible debentures are secured by substantially all of our assets and are either callable or subject to a default interest rate, at the creditor’s option, if we default on the debentures. The significant events that could trigger a default include our failure to service the debentures, bankruptcy and the filing of significant judgments against us. The debentures also preclude merger and similar transactions, incurring additional debt, our payment of dividends on our equity securities and limit the compensation that we may pay to our officers.

 

Our accounting for the aforementioned exchange transaction required us to consider whether the exchange resulted in a substantial modification to the original convertible debentures based upon either cash flows or the fair value of the embedded conversion feature, wherein substantial is generally defined as a change greater than 10%. In all instances, our calculations indicated that the exchange of convertible debentures resulted in changes that were substantial to either cash flows, the embedded conversion option, or both. As a result, we were required to extinguish the prior debt instruments and reestablish the new convertible debentures at fair value, with the difference reflected in our expenses.

 

The following table reflects the components of our extinguishment calculations on February 24, 2010:

 

   Convertible Debenture due     
   June 30,
2011
   July 20,
2011
   September 30
2011
   Total 
Fair value of new debenture  $7,767,450   $1,490,256   $3,196,102   $12,453,808 
Carrying value of old debentures:                    
Debentures   1,713,124    152,755    267,000    2,132,879 
Accrued Interest   546,000    87,166    165,607    798,773 
Compound embedded derivative   3,723,200    750,000    1,632,400    6,105,600 
Deferred finance costs   (85,372)   (23,933)   (92,122)   (201,427)
    5,896,952    965,988    1,972,885    8,835,825 
                     
Extinguishment loss  $1,870,498   $524,268   $1,223,217   $3,617,983 

 

The fair values of the Secured Convertible Debentures were determined based upon their respective discounted cash flow, using observable market rates, plus the fair value of the embedded conversion options. Observable market rates on the exchange date ranged from 7.91% for one-year and 8.47% for two years and were derived from publicly available surveys of corporate bond curves for issuers with similar risk characteristics as ours. The fair value of our compound embedded derivatives were determined using the Monte Carlo Simulations model. See Note 8. The compound embedded derivatives were adjusted to fair value on the exchange date, immediately before the exchange transaction, which amount is included in our derivative income (expense).

 

The fair value of the new convertible debentures was allocated to the debt balance, the compound embedded derivative and paid-in capital. Paid-in capital arises in this transaction, because the allocation resulted in premiums which, under accounting principles, are considered equity components. The following table summarizes the allocation on the exchange date:

 

   Convertible Debenture due     
   June 30,
2011
   July 20,
2011
   September 30
2011
   Total 
Convertible debentures  $3,146,000   $587,166   $1,265,607   $4,998,773 
Compound embedded derivative   4,505,072    880,749    1,878,161    7,263,982 
Paid-in capital   116,378    22,341    52,334    191,053 
   $7,767,450   $1,490,256   $3,196,102   $12,453,808 

 

14
 

 

Our accounting for the original debenture financings is as follows:

 

2008 Convertible Debenture Financing

 

On September 10, 2008, we issued a $1,000,000 face value, 12% secured convertible debenture (T-1), due September 10, 2010 and Series B warrants indexed to 4,000,000 shares of our common stock in exchange for the Interlink Asset Group, discussed in Note 3. Also on September 30, 2008, we issued a $500,000 face value 12% secured convertible debenture (T-2), due September 10, 2010 and Series B warrants indexed to 2,000,000 shares of our common stock for net cash proceeds of $472,800. The warrants have a term of five years. These financial instruments were issued to the same creditor under contracts that are substantially similar, unless otherwise mentioned in the following discussion.

 

The principal amount of the debentures was initially payable on September 10, 2010 and the interest is payable quarterly, on a calendar quarter basis. While the debenture is outstanding, the investor has the option to convert the principal balance, and not the interest, into shares of our common stock at a conversion price of $0.25 per common share. The terms of the conversion option provide for anti-dilution protections for traditional restructurings of our equity, such as stock-splits and reorganizations, if any, and for sales of our common stock, or issuances of common-indexed financial instruments, at amounts below the otherwise fixed conversion price. Further, the terms of the convertible debenture provide for certain redemption features. If, in the event of certain defaults on the terms of the debentures, some of which are indexed to equity risks, we are required at the investors option to pay the higher of (i) 110% of the principal balance, plus accrued interest or (ii) the if-converted value of the underlying common stock, using the 110% default amount, plus accrued interest. If this default redemption is not exercised by the investor, we would incur a default interest rate of 18% and the investor would have rights to our assets under the related Security Agreement. We may redeem the convertible debentures at anytime at 110% of the principal amount, plus accrued interest.

 

2009 Convertible Debenture Financings

 

We entered into several Securities Purchase Agreements with Debt Opportunity Fund, LLP (“DOF”) during the year ended September 30, 2009.

 

On January 30, 2009 we issued (a) 12% Senior Secured Convertible Debentures in the aggregate principal amount of $600,000 with a maturity date of January 30, 2011, convertible into shares of common stock at a conversion price of $0.25; and (b) Series C Warrants to purchase 2,400,000 shares of our common stock at an exercise price of $0.50 for net cash proceeds of $507,900. The warrants have a term of five years.

 

On February 6, 2009 we issued (a) 12% Senior Secured Convertible Debentures in the aggregate principal amount of $500,000 with a maturity date of January 30, 2011, convertible into shares of common stock at a conversion price of $0.25; and (b) Series C Warrants to purchase 2,000,000 shares of our common stock at an exercise price of $0.50 for net cash proceeds of $443,250. The warrants have a term of five years.

 

On July 20, 2009, we issued (a) 12% Senior Secured Convertible Debentures in the aggregate principal amount of $500,000 with a maturity date of July 20, 2011, convertible into shares of common stock at a conversion price of $0.25; and (b) Series C Warrants to purchase 2,000,000 shares of our common stock at an exercise price of $0.50 for net cash proceeds of $446,250. The warrants have a term of five years.

 

On September 25, 2009, we issued (a) 12% Senior Secured Convertible Debentures in the aggregate principal amount of $1,100,000 with a maturity date of July 20, 2011, convertible into shares of common stock at a conversion price of $0.25; and (b) Series C Warrants to purchase 4,400,000 shares of our common stock at an exercise price of $0.25 for net cash proceeds of $1,000,000. The warrants have a term of five years.

 

Each debenture bears interest at a rate of 12% per annum from the date of issuance until paid in full. Interest is calculated on the basis of a 360-day year and paid for the actual number of days elapsed, and accrues and is payable quarterly or upon conversion (as to the principal amount then being converted). The debentures convert into shares of our common stock at the option of the holder at $0.25 per share (which conversion price is subject to adjustment under certain circumstances). The debentures are secured by a lien in all of the assets of the Company. Further, the terms of the convertible debentures provide for default redemption features similar to those described above.

 

Midtown Partners & Co., LLC (“Midtown Partners”), an NASD registered broker dealer, acted as the placement agent for the Company in connection with the January 30, July 20, and September 25, 2009 Convertible Debt Offerings (“2009 Convertible Debt Offerings”). We paid Midtown Partners cash commissions equal to $198,000 and we issued Series BD Common Stock Purchase Warrants to Midtown Partners entitling Midtown Partners to purchase 1,720,000 shares of the Company’s common stock at an initial exercise price of $0.50 per share and 440,000 shares of the Company’s common stock at an initial exercise price $0.25 per share. Since the Series BD warrants offered full ratchet anti-dilution protection, any previously issued and outstanding warrants with a conversion price greater than $0.25 automatically had their conversion price ratchet down to $0.25 as subsequent issuances were made with a conversion price of $0.25.

 

15
 

 

 On September 22, 2009 we voided and reissued warrants in connection with our financing transactions. The cancellation and reissuance of warrants was treated as a modification under ASC 470-50 Modifications and Extinguishments although the change in cash flow was <10% so extinguishment accounting was not applicable.

 

Cancelled and re-issued warrants were as follows:

 

Original Warrants  Indexed
Shares
   Strike
Price
   Reissued
Warrants
   Indexed
Shares
   Strike
Price
 
C-1 warrants   2,400,000   $0.50    C-3 warrants    2,400,000   $0.50 
C-2 warrants   2,000,000   $0.50    C-4 warrants    2,000,000   $0.50 
BD-1 warrants   480,000   $0.50    BD-4 warrants    240,000   $0.25 
              BD-5 warrants    240,000   $0.50 
BD-2 warrants   400,000   $0.50    BD-6 warrants    200,000   $0.25 
              BD-7 warrants    200,000   $0.50 
BD-3 warrants   200,000   $0.50    BD-8 warrants    200,000   $0.25 
BD-4 warrants   200,000   $0.50    BD-9 warrants    200,000   $0.50 

 

Accounting for the Financing Arrangements:

 

We have evaluated the terms and conditions of the secured convertible debentures under the guidance of ASC 815, Derivatives and Hedging. We have determined that, while the anti-dilution protections preclude treatment of the embedded conversion option as conventional, the conversion option is exempt from classification as a derivative because it otherwise achieves the conditions for equity classification (if freestanding) provided in ASC 815. We have further determined that the default redemption features described above are not exempt for treatment as derivative financial instruments, because they are not clearly and closely related in terms of risk to the host debt agreement. On the inception date of the arrangements through June 30, 2010, we determined that the fair value of these compound derivatives is de minus. However, we are required to re-evaluate this value at each reporting date and record changes in its fair value, if any, in income. For purposes of determining the fair value of the compound derivative, we have evaluated multiple, probability-weighted cash flow scenarios. These cash flow scenarios include, and will continue to include fair value information about our common stock. Accordingly, fluctuations in our common stock value will significantly influence the future outcomes from applying this technique.

 

Since, as discussed above, the embedded conversion options did not require treatment as derivative financial instruments; however, we were required to evaluate the feature as embodying a beneficial conversion feature under ASC 470-20, Debt with Conversion and Other Options. A beneficial conversion feature (“BCF”) is present when the fair value of the underlying common share exceeds the effective conversion price of the conversion option. The effective conversion price is calculated as the basis in the financing arrangement allocated to the hybrid convertible debt agreement, divided by the number of shares into which the instrument is indexed. Because the two hybrid debt contracts dated September 10, 2008 were issued as compensation for the Interlink Asset Group and as further discussed in Note 3 we concluded that they should be combined for accounting purposes and the accounting resulted in no beneficial conversion feature. The financings issued in 2009 were found to have a BCF which gives effect to the (i) the trading market price on the contract dates and (ii) the effective conversion price of each issuance after allocation of proceeds to all financial instruments sold based upon their relative fair values. Notwithstanding, the BCF was limited to the value ascribed to the remaining hybrid contract (using the relative fair value approach). Accordingly, the BCF allocated to paid-in capital from the 2009 financings amounted to $872,320 for the year ended September 30, 2009.

 

We evaluated the terms and conditions of the Series B, Series C and Series BD warrants under the guidance of ASC 480, Distinguishing Liabilities from Equity (“ASC 480”). The warrants embody a fundamental change-in-control redemption privilege wherein the holder may redeem the warrants in the event of a change in control for a share of assets or consideration received in such a contingent event. This redemption feature places the warrants within the scope of ASC 480-10, as put warrants and, accordingly, they are classified in liabilities and measured at inception and on an ongoing basis at fair value. Fair value of the warrants was measured using the Black-Scholes-Merton valuation technique and in applying this technique we were required to develop certain subjective assumptions which are listed in more detail below.

 

Premiums on the secured convertible debentures arose from initial recognition at fair value, which is higher than face value. Discounts arose from initial recognition at fair value, which is lower than face value. Premiums and discounts are amortized through credits and debits to interest expense over the term of the debt agreement.

 

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Direct financing costs were allocated to the financial instruments issued (hybrid debt and warrants) based upon their relative fair values. Amounts related to the hybrid debt are recorded as deferred finance costs and amortized through charges to interest expense over the term of the arrangement using the effective interest method. Amounts related to the warrants were charged directly to income because the warrants were classified in liabilities, rather than equity, as described above. Direct financing costs are amortized through charges to interest expense over the term of the debt agreement.

 

On September 24, 2009, we obtained an extension of the interest payments due June 30, 2009 and September 30, 2009 to June 30, 2010 and September 30, 2010, respectively. The change in cash flow from this modification was analyzed to determine if it was greater than 10% which would give rise to extinguishment accounting. In each case, the change in cash flows was less than 10% so extinguishment accounting was not applicable.

 

On February 24, 2010, we exchanged the convertible debentures for newly issued convertible debentures as discussed in the beginning of this footnote.

 

Note 6 – Redeemable Preferred Stock

 

Redeemable preferred stock consists of the following as of:  March 31, 2012   December 31, 2011 
Series A Convertible Preferred Stock, par value $0.001 per share, stated value $10,000 per share; 500 shares issued and outstanding at June 30, 2011; redemption value $5,000,000, and 500 shares issued and outstanding at September 30, 2010; redemption value $5,000,000.          
Initial carrying value  $13,246,609   $13,246,609 
Accumulated accretion   (4,054,203)   (2,863,652)
Carrying values  $9,192,406   $10,382,957 

 

Our Series A Convertible Preferred Stock became mandatorily redeemable for cash of $5,000,000 on June 30, 2011. On that date, after negotiations with our preferred investors, we modified the underlying Certificate of Designation solely to extend the mandatory redemption date to July 1, 2013. In considering all facts and circumstances, including the changes in future cash flows and the fair value of the embedded conversion feature, we concluded that the modification to the Series A Convertible Preferred Stock was substantial, thus warranting accounting analogous to extinguishment accounting for debt wherein the fair value of the amended contracts replace the carrying value of the original contracts. The difference between those two amounts in the case of preferred stock is recorded in stockholders equity.

 

We first accreted the Series A Convertible to the June 30, 2011 redemption date with a charge to paid-in capital (in the absence of accumulated earning) in the amount of $2,442,686. The accretion adjustment resulted in a carrying value of our redeemable preferred stock in the amount of $5,000,000. We then adjusted the compound embedded derivative that had been carried in liabilities at fair value on the modification date, which resulted in a reduction credit of $2,500,000 and was recorded in income. The derivative fair value adjustment resulted in a carrying value of $8,800,000. Therefore, the combined carrying value of the Series A Convertible Preferred immediately preceding the modification amounted to $13,800,000. We computed the fair value using a combination of the forward cash flow, at risk adjusted discount rates, plus the fair value of the embedded conversion feature using Monte Carlo Simulation (“MCS”) techniques. The value of the preferred stock on this basis amounted to $13,246,609. As a result, our calculation of the extinguishment resulted in a credit to paid-in capital in the amount of $553,391.

 

The discount rate that we used to present value future cash flows from the modified preferred stock amounted to 7.75%. This rate was developed using bond curves for companies with similar high-risk credit ratings, plus a risk free rate of 0.50% representing the yield on zero coupon government securities with two year remaining terms. Material inputs into the MCS included volatilities ranging from 89.9% to 105.3%, a market interest rate equal to the contractual coupon of 12%, and credit adjusted yields ranging from 7.19% to 7.75%.

 

By way of background, on February 24, 2010, we designated 500 shares of our authorized preferred stock as Series A Convertible Preferred Stock; par value $0.001 per share, stated value $10,000 per share (“Preferred Stock”). The Preferred Stock is redeemable for cash on June 30, 2011 at the stated value, plus accrued and unpaid dividends. Dividends accrue, whether or not declared, at a rate of 12% of the stated value. The Preferred Stock is convertible into common stock at the holder’s option at $0.25 based upon the stated value (20,000,000 linked common shares). Such conversion rate is subject to adjustment for traditional reorganizations and recapitalization and in the event that we sell common stock or other equity-linked instruments below the conversion price. Holders of the Preferred Stock are entitled to a preference equal to the stated value, plus accrued and unpaid dividends. While the Preferred Stock is outstanding, holders vote the number of indexed common shares.

 

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We sold 300 shares of Series A Preferred on February 24, 2010, with warrants to purchase 12,000,000 shares of our common stock for proceeds of $3,000,000. We sold 200 shares of Series A Preferred on October 25, 2010, with warrants to purchase 8,000,000 shares of our common stock for proceeds of $2,000,000.

 

Our accounting for the Preferred Stock and warrant financing transaction required us to evaluate the classification of the embedded conversion feature and the warrants. As a prerequisite to establishing the classification of the embedded conversion option, we were required to determine the nature of the hybrid Preferred Stock contract based upon its risks as either a debt-type or equity-type contract. The presence of the mandatory cash redemption and the requirement to accrue dividends were persuasive evidence that the Preferred Stock was more akin to a debt than an equity contract, with insufficient evidence to the contrary (e.g. voting privilege). Given that the embedded conversion feature, when evaluated as embodied in a debt-type contract, did not meet the definition for an instrument indexed to a company’s own stock, the embedded conversion feature required bifurcation and classification in liabilities, at fair value. Similarly, the warrants did not meet the definition for an instrument indexed to a company’s own stock, resulting in their classification in liabilities, at fair value.

 

The following table reflects the allocation of the purchase price on the financing date:

 

Allocation:  October 25,
2010
   February 24,
2010
 
Redeemable preferred Stock  $624,000   $ 
Warrants   936,000    5,062,800 
Compound embedded derivative   440,000    4,260,000 
Derivative loss, included in derivative income (expense)       (6,322,800)
   $2,000,000   $3,000,000 

 

Warrants issued with the February 24, 2010 financing were valued on the financing date using the Black-Scholes-Merton valuation technique. Significant assumptions were as follows: Market value of underlying, using the trading market of $0.58; expected term, using the contractual term of 5.0 years; market volatility, using a peer group of 90.20%; and, risk free rate, using the yield on zero coupon government instruments of 2.40%. Warrants issued with the October 25, 2010 financing were valued on the financing date and subsequently using Binomial Lattice. Significant assumptions were as follows: Market value of the underlying, using the trading market of $0.26; market volatility, using a peer group ranged from 76.06% to 99.78% with an equivalent volatility of 89.40%; and risk free rate using the yield on zero coupon government instruments ranging from 0.12% to 2.01% with an equivalent rate of 0.66%. The implied expected life of the warrant is 4.7 years.

 

The compound embedded derivative was valued using the Monte Carlo Simulations (“MCS”) technique. The MSC technique is a generally accepted valuation technique for valuing embedded conversion features in hybrid convertible notes, because it is an open-ended valuation model that embodies all significant assumption types, and ranges of assumption inputs that management of the Company believe would likely be considered in connection with the arms-length negotiation related to the transference of the instrument by market participants. However, there may be other circumstances or considerations, other than those addressed herein, that relate to both internal and external factors that would be considered by market participants as it relates specifically to the Company and the subject financial instruments.

 

Given its redeemable nature, we are required to classify our Series A Preferred Stock outside of stockholders’ equity. Further, the inception date carrying value is subject to accretion to its ultimate redemption value over the term to redemption, using the effective method. During the period from its issuance to September 30, 2010, we accreted $224,969, which was reflected as a charge to paid-in capital in the absence of accumulated earnings.

 

Note 7 – Derivative Financial Instruments

 

On June 30, 2011, our investors agreed to modifications of our Series A Preferred Stock and our Series D Warrants that provided for reclassification of the derivatives to stockholders equity or, in the case of the preferred stock, redeemable preferred stock. The components of our derivative liabilities consisted of the following at June 29, 2011 (the last closing prices available prior to the modifications) and September 30, 2010:

 

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   June 29, 2011     
Derivative Financial Instrument  Indexed
Shares
   Fair
Value
   September 30
2010
 
Compound Derivative Financial Instruments:               
February 24, 2010 Secured Convertible Debentures   19,995,092   $8,797,840   $2,276,794 
February 24, 2010 Series A Convertible Preferred Stock   12,000,000    5,280,000    1,404,000 
October 24, 2010 Series A Convertible Preferred Stock   8,000,000    3,520,000     
                
Warrants (dates correspond to financing):               
February 24, 2010 Series D warrants, issued with the preferred financing (Note 7)   12,000,000    2,064,000    858,000 
February 24, 2010 Series D warrants, issued with the exchange (Note 8)   16,800,000    2,889,600    1,201,200 
October 25, 2010 Series D warrants, issued with the financing (Note 7)   8,000,000    1,736,000     
Financing warrants issued to brokers   2,160,000        165,628 
Total   78,955,092   $24,287,440   $5,905,622 

 

On January 11, 2011, certain warrants previously issued to brokers and that were linked to 2,160,000 shares of our common stock were modified to remove provisions that could result in adjustments to the exercise prices if we sold common shares or common share linked contracts at a per share price that was less than the exercise price of these warrants. As a result of this modification, these warrants no longer require liability classification and measurement at fair value. On the modification date we adjusted these warrants to their fair values with a charge to income and reclassified the balance, amounting to $274,200 to paid-in capital. On June 30, 2011, warrants linked to 36,800,000 shares of our common stock were modified to remove provisions that could result in adjustments to the exercise prices if we sold common shares or common share linked contracts at a per share price that was less than the exercise price of these warrants. As a result of this modification, these warrants no longer require liability classification and measurement at fair value. On the modification date we adjusted these warrants to their fair values with a charge to income and reclassified the balance, amounting to $6,689,600 to paid-in capital.

 

The following table reflects the activity in our derivative liability balances from October 1, 2010 to December 31, 2011:

 

   Compound   Warrants   Total 
Balances at October 1, 2010  $3,680,794   $2,224,828   $5,905,622 
Issuances   936,000    440,000    1,376,000 
Conversion and redemption            
Unrealized derivative (gains) losses   618,764    (512,988)   105,776 
Balances at December 31, 2010   5,235,558    2,151,840    7,387,398 
                
Reclassifications       (274,200)   (274,200)
Unrealized derivative (gains) losses   17,376,491    4,883,960    22,260,451 
Balances at March 31, 2011   22,612,049    6,761,600    29,373,649 
Conversion and redemption   (8,797,840)       (8,797,840)
Reclassifications   (8,800,000)   (6,689,600)   (15,489,600)
Unrealized derivative (gains) losses   (5,014,209)   (72,000)   (5,086,209)
Balances at December 31, 2011  $   $   $ 

 

Effective on January 1, 2011, we changed our method for valuing our derivative warrants from a Black-Scholes Merton Model, adjusted to give effect to the anti-dilution features (the Noreen Wolfson Model) to Binomial Lattice. Binomial Lattice was considered by our management to be more appropriate because it both provides for early exercise scenarios and incorporates the down-round anti-dilution protection possibilities that could arise in early exercise scenarios.

 

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 The following table reflects the activity in our derivative liability balances from October 1, 2009 to March 31, 2012:

 

   Compound   Warrants   Total 
Balances at October 1, 2009  $   $1,327,272   $1,327,272 
Accounting change   1,865,600        1,865,600 
Effect of exchange transaction   1,158,382        1,158,382 
Issuances   4,260,000    5,062,800    9,322,800 
Conversion and redemption            
Unrealized derivative (gains) losses   (3,603,188)   (4,165,244)   (7,768,432)
Balances at December 31, 2011  $3,680,794   $2,224,828   $5,905,622 

 

Effective on October 1, 2009, we adopted Emerging Issues Task Force Consensus No. 07-05 Determining Whether an Instrument (or Embedded Feature) is Indexed to an Entity’s Own Stock (“EITF 07-05”). EITF 07-05 amended previous guidance related to the determination of whether equity-linked contracts, such as our convertible debentures, meet the exclusion to bifurcation and derivative classification of the respective embedded conversion feature. Under EITF 07-05, the embedded conversion option was no longer exempt from bifurcation and derivative classification because the conversion option was subject to adjustments that are not allowable under the new standard. We have accounted for the change as a change in accounting principle where the derivative liability in the amount of $1,865,600 was established and the cumulative effect, which amounted to $872,319, was charged to our opening accumulated deficit on October 1, 2009.

 

As more fully discussed in Note 6, on February 24, 2010, we exchanged our convertible debentures for newly issued convertible debentures. This amount represents the change in the fair value of the compound embedded derivatives between the old and new debentures, which in part arose from the capitalization of accrued interest and in part arose from other changes to the debentures. As further noted in Note 6, the exchange transaction gave rise to the extinguishment of the old debentures, and therefore the compound derivative, due to the substantive nature of these changes. Since an extinguishment is recorded by replacing the carrying value of the old debentures with the fair value of the new debentures, with a charge to expense for the difference, this amount is included in the extinguishment loss that we recorded in connection with the exchange.

 

Fair Value Considerations

 

We adopted the provisions of ASC 820 Fair Value Measurements and Disclosures (“ASC 820”) with respect to our financial instruments. As required by of ASC 820, assets and liabilities measured at fair value are classified in their entirety based on the lowest level of input that is significant to their fair value measurement. Our derivative financial instruments which are required to be measured at fair value on a recurring basis under of ASC 815 are all measured at fair value using Level 3 inputs. Level 3 inputs are unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.

 

We selected the Monte Carlo Simulations valuation technique to fair value the compound embedded derivative because we believe that this technique is reflective of all significant assumption types, and ranges of assumption inputs, that market participants would likely consider in transactions involving such types of derivatives while the financial instruments were outstanding. Such assumptions include, among other inputs, interest risk assumptions, credit risk assumptions and redemption behaviors in addition to traditional inputs for option models such as market trading volatility and risk free rates. On June 29, 2011, we valued the compound embedded derivatives at intrinsic value since there was no or no material remaining time value associated with mature or near mature financial instruments.

 

   June 29,   September 30,   June 30, 
   2011   2010   2010 
Quoted market price of our common stock  $0.69   $0.25   $0.18 
Contractual conversion rate  $0.25   $0.25   $0.25 
Implied expected term (years)   NA    0.59—0.92    0.96—1.18 
Market volatility:               
Range of volatilities   NA    134%-160   113%-127
Equivalent volatility   NA    145%—152   118%-125
Market-risk adjusted interest rate:               
Range of rates   NA    12.0%   12.0%
Equivalent market-risk adjusted interest rate   NA    12.0%   12.0%
Credit-risk adjusted yield rate:               
Range of rates   NA    7.5%-8.0   8.0%-8.8
Equivalent credit-risk adjusted yield rate   NA    7.7%   8.4%
Risk-free rates using yields on zero coupon US Treasury Security rates:               
Range of rates   NA    0.27%-0.64   0.32%-1.00

 

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The warrants are valued using the Binomial Lattice Valuation technique on June 30, 2011 and Black-Scholes-Merton (“BSM”) valuation methodology on September 30, 2010, adjusted to give effect to the anti-dilution features, because that model embodies all of the relevant assumptions that address the features underlying these instruments. Significant assumptions were as follows as of June 30, 2011 and September 30, 2010:

 

June 29, 2011 (Assumptions for  Series D   BD   BD 
BD Warrants are January 11, 2011)  Warrants   Warrants   Warrants 
Contractual strike price  $0.50         
Adjusted strike price (for anti-dilution)  $0.69         
Term to expiration   3.6-4.3         
Implied expected life   3.6-4.3         
Volatility range   94%-114        
 Effective volatility   107%-107        
Risk-free rate ranges   0.02%-1.47        
 Effective risk free rates   0.42%-0.51        

 

   Series D   BD   BD 
September 30, 2010   Warrants   Warrants   Warrants 
Contractual strike price  $0.50   $0.25   $0.50 
Adjusted strike price  $0.43   $0.23   $0.43 
Volatility   107.9%   111.5%-116.7%    111.5%-116.7% 
Term to expiration   4.40    3.33—4.00    3.33—4.00 
Risk-free rate   1.27    0.64-1.27    0.64-1.27 
Dividends            

 

Note 8 - Commitment and Contingencies

 

Leases

 

Our principal executive offices are located at 1100 NW 163rd Drive, Miami, Florida 33169.  Our offices consist of approximately 3,500 square feet. Our lease was extended on June 1st, 2011 for a term of 1 year, terminating on May 31, 2012. The facility is suitable for our purposes and is expected to accommodate our needs until we move all company operations to our newly purchased building.

 

On August 8, 2011 we purchased an existing building located in Miami, Florida to be used as our corporate offices and operational center. The building, a 21,675 square foot free standing structure, was purchased for $2,700,000 from Core Development Holdings Corporation, which entity has no relationship to the Company.

 

Rent and associated occupancy expenses for three months ended March 31, 2012 and 2011 was $81,105 and $66,779 respectively.

 

Note 9 – Related Party Transactions – None.

 

Note 10 - Subsequent Events

 

New Financing

 

On April 20, 2012, we issued face value $500,000, 10% Senior secured debenture, due June 30, 2012.

 

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Item 2 – Management Discussion and Analysis of Financial Conditions and Results of Operations

 

Our Management’s Discussion and Analysis should be read in conjunction with our financial statements included in this report.

 

Forward Looking Statements

 

Certain statements contained in this Form 10-Q and other written material and oral statements made from time to time by us do not relate to historical or current facts.  As such, they are referred to as “forward-looking statements,” which are intended to convey our expectations or predictions regarding the occurrence of possible future events or the existence of trends and factors that may impact our future plans and operating results. These forward-looking statements are derived, in part, from various assumptions and analyses we have made in the context of our current business plan and information currently available to us and in light of our experience and perceptions of historical trends, current conditions and expected future developments and other factors we believe to be appropriate in the circumstances. You can generally identify forward-looking statements through words and phrases such as “ seek, ” “ anticipate, ” “ believe, ” “ estimate, ” “ expect, ” “ intend, ” “ plan, ” “ budget, ” “ project, ” “ may be, ” “ may continue, ” “ may likely result, ” and similar expressions. When reading any forward looking statement, you should remain mindful that actual results or developments may vary substantially from those expected as expressed in or implied by that statement for a number of reasons or factors, such as those relating to:

 

our ability to develop sales and marketing capabilities;
   
the accuracy of our estimates and projections;
   
our ability to fund our short-term and long-term financing needs;
   
changes in our business plan and corporate strategies; and other risks and uncertainties discussed in greater detail in the sections of this prospectus, including the section captioned “Plan of Operation”.

 

Each forward-looking statement should be read in context with, and with an understanding of, the various other disclosures concerning our Company and our business made elsewhere in this prospectus, as well as other public reports filed with the SEC. You should not place undue reliance on any forward-looking statement as a prediction of actual results or developments. We are not obligated to update or revise any forward-looking statement contained in this report to reflect new events or circumstances unless and to the extent required by applicable law.

 

Background

 

Company and Business

 

We are a telephone company, which provides, sells and supplies commercial and residential telecommunication services, including services utilizing voice over internet protocol (“VoIP”) technology, session initiation protocol (“SIP”) technology, wireless fidelity technology, wireless maximum technology, marine satellite services technology and other similar type technologies. Our main products are the “DUO” and the “DUO WIFI”. The DUO WIFI is expected to roll out to customers during March 2012. Both of these products are analog telephone adapters that provide connectivity for analog telephones and faxes to home, home office or corporate local area networks (“LAN”). The DUO WIFI allows users to use these services without an Ethernet cable plugged into the device. We no longer offer the TK 6000 for sale to customers.

 

Our DUO and DUO WIFI and their related services are cost effective solution for individuals, small businesses and telecommuters connecting to any analog telephone, fax or private branch exchange (“PBX”).  Our DUO and DUO WIFI provide a USB port, one Ethernet port and one analog telephone port. The DUO WIFI additionally provides a wireless chip so that users can connect to the device over WIFI hotspots. A full suite of internet protocol features is available to maximize universal connectivity. In addition, analog telephones attached to our DUO and DUO WIFI are able to use advanced calling features such as call forwarding, caller ID, 3-way calling, call holding, call retrieval and call transfer.

 

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History and Overview

 

We are a Florida corporation, incorporated on May 1, 2006 under the name Discover Screens, Inc. (“Discover Screens”).

 

Prior to September 10, 2008, we were known as Discover Screens, a company dedicated to providing advertising through interactive, audiovisual, information and advertising portals located in high-traffic indoor venues. Our name and business operations changed in a series of transactions beginning in December of 2007.

 

On September 10, 2008, we changed our name from Discover Screens, Inc. to Net Talk.com, Inc.

 

On September 10, 2008, we acquired certain tangible and intangible assets, formerly owned by Interlink Global Corporation (“Interlink”), directly from Interlink’s creditor who had seized the assets pursuant to a Security and Collateral Agreement.

 

Plan of Operation

 

We provide, sell and supply commercial and residential telecommunication services, including services utilizing voice over internet protocol (“VoIP”) technology, session initiation protocol (“SIP”) technology, wireless fidelity technology, wireless maximum technology, marine satellite services technology and other similar type technologies. We are developing our business infrastructure and new products and services.

 

Our Products

 

At this time, our main products are the DUO and DUO WIFI. Our DUO and DUO WIFI are designed to provide specifications unique to each customer’s existing equipment. They allow the customer full mobile flexibility by being able to take internet interface anywhere the customer has an internet connection. Our DUO and DUO WIFI both have the following features:

 

    A Universal Serial Bus (“USB”) connection allowing the interconnection of our DUO and DUO WIFI to any host computer.
     
    In addition to the USB power source option, our DUO and DUO WIFI have an external power supply allowing the phone to independently power itself when not connected to a host computer;
     
    Unlike most VoIP telephone systems, our DUO and DUO WIFI both have standalone feature allowing them to be plugged directly into a standard internet connection.
     
    Our DUO and DUO WIFI are compact, space-efficient products.

 

Our DUO and DUO WIFI both have interface components so that the customer can purchase multiple units that can communicate with each other allowing simultaneous ringing from multiple locations.

 

Our products are portable and allow our customers to make and receive phone calls with a telephone anywhere a broadband internet connection is available.  We transmit the calls using Voice over Internet Protocol “VOIP” technology, which converts voice signals into digital data transmissions over the internet.

 

Our Services

 

Our business is to provide products and services that utilize Voice Over Internet Protocol, which we refer to as “VoIP.” VoIP is a technology that allows the consumer to make telephone calls over a broadband internet connection instead of using a regular (or analog) telephone line. VoIP works by converting the user’s voice into a digital signal that travels over the internet until it reaches its destination. If the user is calling a regular telephone line number, the signal is converted back into a voice signal once it reaches the end user. Our business model is to develop and commercialize software technology solutions for cost effective, real-time communications over the internet and related services.

 

Patents – Domestic and International

 

Our products are currently under US patent pending as well as International patent pending in over 123 countries.

 

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Government Regulation

 

As a telecommunications supplier, we are subject to extensive government regulation. The majority of our government regulation comes from the Federal Communications Commission (the “FCC”).

 

Telecommunications is an area of rapid regulatory change. Changes in the laws and regulations and new interpretations of existing laws and regulations may affect permissible activities, the relative costs associated with doing business and amounts paid to us for our services. We cannot predict the future of federal, state and local regulations or legislation, including FCC regulations.

 

Federal Communications Commission (“FCC”) regulation

 

The FCC is an independent United States government agency. The FCC was established by the Communications Act of 1934 and is charged with regulating interstate and international communications by radio, television, wire, satellite and cable. The FCC’s jurisdiction covers all fifty states, the District of Columbia and U.S. possessions.

 

The FCC works to create an environment promoting competition and innovation to benefit communications customers. Where necessary, the FCC has acted to ensure VoIP providers comply with important public safety requirements and public policy goals.

 

Interconnected VoIP providers must comply with the Commission’s Telecommunications Relay Services (TRS) requirements, including contributing to the TRS Fund used to support the provision of telecommunications services to persons with speech or hearing disabilities, and offering 711 abbreviated dialing for access to relay services. Interconnected VoIP providers and equipment manufacturers also must ensure that, consistent with Section 255 of the Communication Act, their services are available to and usable by individuals with disabilities, if such access is readily achievable.

 

Finally, the FCC now requires interconnected VoIP providers and telephone companies that obtain numbers from them to comply with Local Number Portability (LNP) rules. These rules allow telephone, and now VoIP, subscribers that change providers to keep the subscribers telephone numbers provided that they stay in the same geographic area. VoIP providers must also contribute to funds established to share LNP and numbering administrative costs among all telecommunications providers benefiting from these services.

 

The FCC monitors and investigates complaints against VoIP providers and, if necessary, can bring enforcement actions against VoIP providers that do not comply with applicable regulations.

 

Federal CALEA

 

On August 5, 2005, the Federal Communication Commission (the FCC) released an Order extending the obligation of the Communication Assistance for Law Enforcement Act (“CALEA”) to interconnect VOIP providers. Under CALEA , telecommunication carriers must assist law enforcement in executing electronic surveillance, which includes the capability of providing call content and call indentifying information to local enforcement agencies, or LEA, pursuant to a court order or other lawful authorization.

 

The FCC required all interconnect VOIP providers to become CALEA compliant by May 14, 2007. To date, we are fully compliant with CALEA.

 

State Telecommunication Regulation

 

We are also registered with the Florida Public Utilities Commission as a Competitive Local Exchange Carrier (“CLEC”) and Interexchange (“IXC”) Carrier.

 

In Florida, a “competitive local exchange carrier” is defined as any company, other than an incumbent local exchange company, certificated by the Public Service Commission to provide local exchange telecommunication services in the state of Florida on or after July 1, 1995. CLEC companies providing services in Florida after July 1, 1995, must be certificated by the Florida Public Service Commission, and competitive local exchange companies are required to file a price list specifying their rates and charges for basic local telecommunication services.

 

24
 

 

Florida, as well as other states, also regulates providers of Interexchange Telecommunications (“IXC”). The Florida Public Service Commission includes the following as examples of IXC providers: (1) operator service providers; (2) resellers; (3) switchless re-billers; (4) multi-location discount aggregators; (5) prepaid debit card providers; and (5) facilities based interexchange carriers. Section 364.02(13) of the Florida Statutes requires IXCs to provide current contact information and a tariff to the Florida Public Service Commission.

 

We have been granted and or are applying for Competitive Local Exchange Carrier (“CLEC”) Licenses in forty three states, as follows:

 

Alabama Hawaii Massachusetts New York Utah
Arizona Idaho Michigan North Carolina Vermont
Arkansas Illinois Minnesota North Dakota Washington, D.C.
California Indiana Missouri Ohio Washington
Colorado Iowa Montana Oregon West Virginia
Connecticut Kansas Nebraska Pennsylvania Wisconsin
Delaware Kentucky Nevada South Carolina Wyoming
Florida Maine New Jersey South Dakota  
Georgia Maryland New Mexico Texas  

 

The law relating to regulation of VoIP technology is in a flux. In recent court cases, other VoIP providers have challenged whether state regulations can be applied to VoIP technology or whether such regulation has been preempted by the Telecommunications Act of 1996 and other Federal laws. At least one of our competitors has successfully fought the application of state laws to VoIP technology. However, to be cautious, we will continue to obtain a competitive local exchange carrier license from each state in which we conduct business. An added advantage of obtaining a CLEC license from each state is that we can obtain an operational carrier number from the North American Numbering Plan Administration. The operational carrier number will allow us to assign our customers telephone numbers in the area code in which they reside.

 

Marketing

 

We have developed direct sales channels, as represented by web sites and toll free numbers. Our direct sales channels are supported by highly integrated advertising campaigns across multiple media such as infomercials, television and other media channels. Our website is www.nettalk.com, our telephone number is (305) 621-1200 and our fax number is (305) 621-1201.

 

Our primary source of revenue is the sale and distribution of our DUO and TK 6000 products. We also generate revenue from the sale of accessories to our product and international long distance monthly charges that are billed to our customers.

 

Advertising

Our goal is to position ourselves as a premier supplier of choice for VoIP services. Our current business strategy is to focus our advertising dollars on our home market in South Florida. Our advertising will consist of mass marketing campaigns focusing on television infomercials for the South Florida market and other states including cable television channels.

 

Customers

Our customers are made up of residential and small businesses. We anticipate that future services will appeal to our existing customers and hope that our additional phone products and services will provide a complete phone package experience to our customers.

 

Our target audience is individual consumers and small businesses looking to lower their current cost of telecommunications. We are also reaching a large audience with our websites. We hope that consumers will find our websites by doing an internet search for VoIP service providers. We also use other means of advertising such as direct to consumer sales, eCommerce and wholesale sales to retail stores.

 

Geographic Markets

 

Our primary geographic market is our home market of South Florida. Our target audience is individual consumers and small businesses looking to lower their current cost of telecommunications. We also expect to reach a large audience with our websites. We hope that consumers will find our websites by doing an internet search for VoIP service providers. We will also use other means of advertising such as direct to consumer sales, ecommerce and wholesale sales to retail stores.

 

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Results of Operations

 

Three months ended March 31, 2012 compared to three months ended March 31, 2011

 

Revenues: Our revenues amounted to $1,056,321 and $611,779 for the three months ended March 31, 2012, and 2011, respectively. The increase in revenues relates to increase in sales activities due to market penetration, increase in advertising and marketing expenditures and new sales to large retailers.

 

Cost of sales: Our cost of sales amounted to $1,412,297 and $972,577 for the three months ended March 31, 2012, and 2011, respectively. The increase in cost of sales relates to increase in sales activities due to market penetration, increase advertising and marketing expenditures and new sales to large retailers.

 

Gross margin: Our gross margin amounted to $(355,976) and $(360,798) for the three months ended March 31, 2012 and 2011, respectively. Our gross margin remains negative due to economies of scale. We expect our build of material cost to reduce over time consistent with sales as we take advantages of economies of scale, Further, we are working with call terminating vendors to reduce our price per minute costs, which we expect to be much lower as we expand our subscriber base and take advantage of economies of scale and other opportunities.

 

Advertising and marketing: Our advertising and marketing expenses amounted to $429,243 and $373,701 for the three months ended March 31, 2012 and 2011, respectively. The breakdown of our advertising expense is as follows:

 

   March 31, 
   2012   2011 
Media and others  $383,922   $373,701 
Smartphone application costs (branding)   45,321    - 
Total  $429,243   $373,701 

 

Smartphone Application: We released our Smartphone application during December of 2010. The smart phone application continues to be one of the top downloaded apps in Canada. We had more than 600,000 users of our application at March 31, 2012.

 

Compensation and Benefits: Our compensation and benefits expense amounted to $321,996 and $104,917 for the three months ended March 31, 2012 and 2011, respectively. This amount represents normal salaries and wages paid to management members and employees including marketing and administrative functions. We continue to increase our technical staff by hiring IT engineers and software developers.

 

Professional Fees: Our professional fees amounted to $141,635 and $77,642 for the three months ended March 31, 2012 and 2011, respectively. This amount includes normal payments and accruals for legal, accounting and other professional services. Our costs associated with legal and accounting fees will remain higher than historical amounts because, as a reporting company, we are required to comply with the reporting requirements of the Securities and Exchange Act of 1934, as amended (the “Exchange Act”). This involves the preparation and filing of the quarterly and annual reports required under the Exchange Act as well as other reporting requirements under the Exchange Act.

 

We will also incur additional expenses associated with the services provided by our transfer agent. In addition, to the work we are presently doing, we will need to focus our time and energy to complying with the Exchange Act. This will detract from our ability and efforts to develop and market our products and services. We anticipate incurring these additional expenses related to being a public company without receiving a substantial increase in revenues associated with this undertaking.

 

Depreciation and Amortization: Depreciation and amortization amounted to $62,559 and $90,914 for the three months ended March 31, 2012 and 2011, respectively. These amounts represent amortization of our long-lived tangible and intangible assets using straight-line methods and lives commensurate with the assets’ remaining utility. Our long-lived assets, both tangible and intangible, are subject to annual impairment review, or more frequently if circumstances so warrant. During the three months ended March 31, 2012, we did not calculate or record impairment charges. However, negative trends in our business and our inability to meet our projected future results could give rise to impairment charges in future periods.

 

26
 

 

Research and Development and Software Costs: We expense research and development expenses, as these costs are incurred. We account for our offering-related software development costs as costs incurred internally in creating a computer software product and are charged to expense when incurred as research and development until technological feasibility has been established for the product. Technological feasibility is established upon completion of a detail program design or, in its absence, completion of a working model. At this time our main product TK6000 is being sold in the market place. Therefore, research and development cost reported in our financial statements relates to pre – marketing cost and are expensed accordingly.

 

   Three Months Ended 
   March 31, 
   2012   2011 
Components of research and development:        
Product development and engineering  $37,282   $31,325 
Payroll and benefits   300,111    117,794 
Total  $337,393   $149,119 

 

General and Administrative Expenses: General and administrative expenses amounted to $582,490 and $232,686 for the three months ended March 31, 2012 and 2011, respectively, and consisted of general corporate expenses. General corporate expenses included $81,105 in occupancy costs for the three months ended March 31, 2012 and $66,779 for the comparable period ended March 31, 2011.

 

Our general and administrative expenses are made up of the following accounts:

 

   Three Months Ended March 31, 
   2012   2011 
Bad debt expense  $-   $(582)
Commission   179,774    - 
Rent and occupancy   81,105    66,779 
Insurance   48,319    25,190 
Software   -    13,260 
Taxes and licenses   20,757    17,482 
Telephone   7,833    5,548 
Customer support cost   -    - 
Travel   69,880    36,813 
Other   174,822    68,196 
Total  $582,490   $232,686 

 

Interest Expense: Interest expense amounted to $1,301,969 and $149,964 for the three months ended March 31, 2012 and 2011 respectively. Such amount represented (i) stipulated interest under our aggregate $4,200,000 face value convertible debentures, (ii) the related amortization of premiums and discounts and (iii) the amortization of deferred finance costs. Aggregate premiums continue to be credited to interest expense over the term of the debentures using the effective interest method.

 

Derivative income (expense): Derivative expense amounted to $0.00 and $(22,260,451) for the three months ended March 31, 2012 and 2011, respectively. Such amount represents the change in fair value of liability-classified warrants. Derivative financial instruments are carried as liabilities, at fair value, in our financial statements with changes reflected in income. In addition to the liability-classified warrants, we also have certain compound derivative financial instruments related to our $4,200,000 face value convertible debentures that had de minimus values. We are required to adjust our warrant and compound derivatives to fair value at each reporting period. The fair value of our warrant derivative is largely based upon fluctuations in the fair value of our common stock. The fair value of our compound derivative is largely based upon estimates of cash flow arising from the derivative and credit-risk adjusted interest rates. Accordingly, the volatility in these underlying valuation assumptions will have future effects on our earnings.

 

Net loss: Net loss amounted to $3,533,013 and $24,167,077 for the three months ended March 31, 2012 and 2011, respectively. Net income includes derivative income associated with the valuation of debentures, embedded conversion features and warrants, extinguishment expense, negative gross margin and increase in rent expense, travel expenses and customer support costs.

 

Net loss applicable to common stockholders: The net loss applicable to common stockholders amounted to $3,533,013 and $24,167,077 for the three months ended March 31, 2012 and 2011, respectively.

 

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Net loss Per Common Share: Basic income (loss) per common share represents our income (loss) applicable to common shareholders divided by the weighted average number of common shares outstanding during the period. Diluted income (loss) per common share gives effect to all potentially dilutive securities. We compute the effects on diluted loss per common share arising from warrants and options using the treasury stock method or, in the case of liability classified warrants, the reverse treasury stock method. We compute the effects on diluted loss per common share arising from convertible securities using the if-converted method. The effects, if anti-dilutive are excluded.

 

Liquidity and Capital Resources

 

Statement of cash flow data:  March 31, 2012   March 31,2011 
Net cash provided (used) in operating activities  $(1,636,872)  $(3,667,470)
Net cash provided (used) in investing activities   (75,890)   (120,234)
Net cash provided (used) in financing activities   684,844    2,617,500 

 

Net cash used by operating activities of $(1,636,872) was primarily due to operating expenses including increases in telecommunication expenses, research and development expenses for anticipated new products, marketing expenses, travel expenses to set up facilities in China, increases in wages expenses due to new hires and increased general and administrative expenses,

 

Net cash used in investing activities of $(75,890) was due to purchase of telecommunication equipment and increased in restricted cash.

 

Net cash of $684,844 provided by financing activities was due to proceeds from 10% Senior debenture in the amount of $500,000 and proceeds from short term demand note in the amount of $ 150,010.

 

On March 31, 2012, we had cash on hand of $511,345 and restricted cash on hand of $118,256.

 

Our largest operating expenditures currently consist of the following items: $30,000 per month on leasing our corporate office space and network operational center (NOC) and includes our base rent and associated utility expenses and $150,000 per month on payroll. We do not anticipate that our leasing cost will change during the next 12 months.

 

Off-Balance Sheet Arrangements - NONE

 

Critical Accounting Policies and estimates

 

Our accounting policies are discussed and summarized in Note 1 to our financial statements.  The following describes our critical accounting policies and estimates.

 

Critical Accounting Policies

 

The financial information contained in our comparative results of operations and liquidity disclosures has been derived from our financial statements. The preparation of those financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and notes. The following significant estimates were made in the preparation of our financial statements and should be considered when reading our Management’s Discussion and Analysis:

 

Impairment of Long-lived Assets: Our telecommunications equipment, other property and intangible assets are material to our financial statements. Further, they are subject to the potential negative effects arising from technological obsolescence. We evaluate our tangible and definite-lived intangible assets for impairment annually or more frequently in the presence of circumstances or trends that may be indicators of impairment. Our evaluation is a two step process. The first step is to compare our undiscounted cash flows, as projected over the remaining useful lives of the assets, to their respective carrying values. In the event that the carrying values are not recovered by future undiscounted cash flows, as a second step, we compare the carrying values to the related fair values and, if lower, record an impairment adjustment. For purposes of fair value, we generally use replacement costs for tangible fixed assets and discounted cash flows, using risk-adjusted discount rates, for intangible assets. These estimates are made by competent employees, using the best available information, under the direct supervision of our management.

 

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  Intangible assets: Our intangible assets require us to make subjective estimates about our future operations and cash flows so that we can evaluate the recoverability of such assets. These estimates consider available information and market indicators including our operational history, our expected contract performance, and changes in the industries that we serve.
   
Share-based payment arrangements: We currently intend to issue share-indexed payments in future periods to employees and non-employees. There are many valuation techniques, such as Black-Scholes-Merton valuation model that we may use to value share-indexed contracts, such as warrants and options. All such techniques will require certain assumptions that require us to develop forward-looking information as well as historical trends. For purposes of historical trends, we may need to look to peer groups of companies and the selection of such groups of companies is highly subjective.

 

Common stock valuation: Estimating the fair value of our common stock is necessary in the preparation of computations related to acquisition, share-based payment and financing transactions. We believe that the most appropriate and reliable basis for common stock value is trading market prices in an active market.

 

Derivative Financial Instruments: We generally do not use derivative financial instruments to hedge exposures to cash-flow, market or foreign-currency risks. However, we have entered into certain other financial instruments and contracts, such as our secured convertible debenture and warrant financing arrangements that are either (i) not afforded equity classification, (ii) embody risks not clearly and closely related to host contracts, or (iii) may be net-cash settled by the counterparty. We are required to carried as derivative liabilities, at fair value, in our financial statements.  The fair value of share-indexed derivatives will be significantly influenced by the fair value of our common stock (see Common Stock Valuation, above). Certain other elements of forward-type derivatives are significantly influenced by credit-adjusted interest rates used in cash-flow analysis. Since we are required to carry derivative financial instruments at fair value and make adjustments through earnings, our future profitability will reflect the influences arising from changes in our stock price, changes in interest rates,  and changes in our credit standing.

 

Revenue Recognition

 

We derive revenue from (i) product sales and (ii) telecom services. All revenues are recognized in accordance with ASC 605, Revenue Recognition and SAB 104 as follows: when evidence of an arrangement exists, in the case of products, when the product is shipped to a customer, or in the case of telecom services, when the service is used by the consumer, when the fee is fixed or determinable and finally when we have concluded that amounts are collectible from the customers. Shipping costs billed to customers are included as a component of product sales. The associated cost of shipping is included as a component of cost of product sales.

 

Operating revenue consist of customer equipment sales of our main products the NetTalk DUO (“DUO”) and DUO WIFI, telecommunication service revenues, shipping and handling revenues.

  

Our DUO products provides for revenue recognition from the sale of the device and from the sale of telephone service. The initial year of telephone service is included on the sale price at time of sale and billed subsequently thereafter. Therefore, revenue recognition on our DUO products are fully recognized at the time of our customer equipment sale, the one year telephone service is amortized over 12 month cycle.  Subsequent renewals of the annual telephone service are amortized over the corresponding 12 months cycle.

 

International calls are billed as earned from our customers.  International calls are prepaid and customers account is debited as minutes are used and earned.

 

Item 3 Quantitative and Qualitative Disclosures About Market Risk

 

We are a smaller reporting company as defined by Rule 12b-2 of the Securities Exchange Act of 1934 and, as such, are not required to provide the information under this item.

 

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Item 4 Controls and Procedures

 

Disclosure Controls

 

We maintain “disclosure controls and procedures,” as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”), that are designed to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in Securities and Exchange Commission rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures, management recognized that disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the disclosure controls and procedures are met. Additionally, in designing disclosure controls and procedures, our management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible disclosure controls and procedures. The design of any disclosure controls and procedures also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.

 

As of March 31, 2012, we carried out an evaluation, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were not effective in ensuring that information required to be disclosed by us in our periodic reports is recorded, processed, summarized and reported, within the time periods specified for each report and that such information is accumulated and communicated to our management, including our principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.

 

In connection with the assessment described above, management identified the following control deficiencies that represent material weaknesses at March 31, 2012:

 

  ·

Due to the Company’s limited resources, the Company has insufficient personnel resources and technical accounting and reporting expertise to properly address all of the accounting matters inherent in the Company’s financial transactions.  The Company does not have a formal audit committee, and the Board does not have a financial expert, thus the Company lacks the board oversight role within the financial reporting process.

 

    The Company’s small size prohibits the segregation of duties and the timely review of accounts payable, expense reporting and inventory management and banking information.

 

Our Chief Executive Officer and Chief Financial Officer are in the process of determining how best to change our current system and implement a more effective system to insure that information required to be disclosed in this annual report on Form 10-K has been recorded, processed, summarized and reported accurately.  Our management acknowledges the existence of this problem, and intends to developed procedures to address them to the extent possible given limitations in financial and manpower resources.   While management is working on a plan, no assurance can be made at this point that the implementation of such controls and procedures will be completed in a timely manner or that they will be adequate once implemented.

 

Changes in Internal Controls.

 

During the three months ended March 31, 2012 , there were no changes in our internal control over financial reporting identified in connection with the evaluation required by paragraph (f) of Rule 13a-15 or Rule 15d-15 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

 

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PART II  OTHER INFORMATION

 

Item 1.  Legal Proceedings –

 

On April 4, 2012, MagicJack Vocaltec Ltd. filed a complaint United States District Court For the Southern District Of Florida, Civil Action No.: 9:12-cv-80360-DMM, against the Company, alleging patent infringement, seeking injunctive relief and damages as a result of the alleged patent infringement. The Company has answered the complaint, denying all of its material allegations, asserting a number of affirmative defenses, and seeking counterclaims for declaratory relief. The Company’s patent counsel has provided an opinion that the Nettalk DUO does not infringe their patent, and the Company’s management intends to vigorously defend this lawsuit.

 

Item 1A. Risk Factors

 

We are a smaller reporting company as defined by Rule 12b-2 of the Securities Exchange Act of 1934 and, as such, are not required to provide the information under this item.

 

Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds

 

None, except as previously included in a current report on Form 8 K previously filed.

 

Item 3.  Defaults Upon Senior Securities – NONE.

 

Item 4.  Submission of Matters to a Vote of Security Holders – NONE.

 

Item 5.  Other Information - NONE.

 

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Item 6. Exhibits
   
Exhibit No. Description

 

10.1  Employment agreement with Mr. Anastasios Kyriakides, as amended March 31, 2012. 
31.1 Certification of Chief Executive Officer pursuant to Rule 13a-14(a) and 15d-14(a) as adopted pursuant to 
  Section 302 of the Sarbanes-Oxley Act of 2002, dated May 15, 2012. 
31.2 Certification of Chief Financial Officer pursuant to Rule 13a-14(a) and 15d-14(a) as adopted pursuant to
  Section 302 of the Sarbanes-Oxley Act of 2002, dated May 15, 2012. 
32.1 Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to
  Section 906 of the Sarbanes-Oxley Act of 2002, dated May 15, 2012.
32.2 Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to
  Section 906 of the Sarbanes-Oxley Act of 2002, dated May 15, 2012.
101. The following materials from the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2012, formatted in XBRL (eXtensible Business Reporting Language): (i) Condensed Consolidated Balance Sheets as of March 31, 2012 and December 31, 2011, (ii) Condensed Consolidated Statement of Operations for the three months ended March 31, 2012 and 2011, (iii) Condensed Consolidated Statement of Cash Flows for the three months ended March 31, 2012 and 2011, and (iv) Notes to Condensed Consolidated Financial Statements*.
   
* Pursuant to Rule 406T of Regulation S-T, the Interactive Data Files submitted as Exhibit 101 hereto are deemed not filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933, are deemed not filed for purposes of Section 18 of the Securities and Exchange Act of 1934, and otherwise are not subject to liability under those sections. 

 

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SIGNATURE

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

  NET TALK.COM, INC.
     
Date:  May 15, 2012 By /s/ Anastasios Kyriakides
  Anastasios Kyriakides
  Chief Executive Officer (Principal Executive Officer)
     
Date:  May 15, 2012 By: /s/ Guillermo Rodriguez
  Guillermo Rodriguez
  Chief Financial Officer (Principal Financial Officer and Principal Accounting Officer)

 

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