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EX-31.1 - EXHIBIT 31.1 - NET TALK.COM, INC.v354596_ex31-1.htm
EX-32.2 - EXHIBIT 32.2 - NET TALK.COM, INC.v354596_ex32-2.htm
EX-32.1 - EXHIBIT 32.1 - NET TALK.COM, INC.v354596_ex32-1.htm
EX-31.2 - EXHIBIT 31.2 - NET TALK.COM, INC.v354596_ex31-2.htm

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-K

 

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
OR
¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

 

For the fiscal year ended: December 31, 2012

 

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   (I.R.S. Employer
incorporation or organization)   Identification No.)
     
1080 NW 163rd Drive, Miami Gardens, FL   33169 – 5816
(Address of principal executive offices)   (Zip Code)

 

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

 

Securities registered pursuant to Section 12(b) of the Act: None

 

Securities registered pursuant to Section 12(g) of the Act: Common Stock, $0.001 par value

 

Title of each class   Name of each exchange on which registered
Common stock, $0.001 par value per share   OTCBB
Redeemable preferred stock, $0.001 par value per share  

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

Yes ¨ No x

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.

Yes ¨ No x

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes ¨ No x

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x

 

Check whether the registrant 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 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, an 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.

 

Large accelerated filer ¨ Accelerated filer ¨
Non-accelerated filer ¨ (Do not check if a smaller reporting company) Smaller reporting company x

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes ¨ No x

 

The aggregate market value of the registrant’s common stock held by non-affiliates of the registrant as of September 4 , 2013 was $349,634.1 The Registrant had 60,251,355 shares of Common Stock, $0.001 par value, outstanding as of September 4, 2013.

 

 

1 The aggregate market value of common equity held-by non-affiliates is computed based upon sale price of $0.07 occurring on September 4, 2013. The calculation does not account for common shares issuable upon conversion of convertible preferred stock or exercise of common stock purchase warrants.

 

 
 

 

Net Talk.com, Inc.

 

Form 10-K

 

For year ended December 31, 2012

 

Table of contents Page
     
Part I    
     
Item 1. Business 4
Item 1A. Risk factors 9
Item 2. Properties 11
Item 3. Legal proceedings 11
Item 4. Mine safety disclosures 12
     
Part II    
     
Item 5. Market for registrant’s common equity, related stockholders matters and issuer purchases of equity securities 12
     
Item 6. Selected financial data 15
   
Item 7. Management discussion and analysis of financial condition and operation 15
Item 7A. Quantitative and qualitative disclosure about market risk 25
Item 8. Financial statements and supplementary data 25
Item 9. Changes in and disagreements with accountants on accounting and financial disclosure 25
Item 9A. Controls and procedures 25
Item 9B. Other information 27
     
Part III    
     
Item 10. Directors, executive officers and corporate governance 27
Item 11. Executive compensation 30
Item 12. Security ownership of certain owners and management and related stockholder matter 31
Item 13. Certain relationships and related transactions, and directors independence 32
Item 14. Principal accountant fees and services 33
     
Part IV    
     
Item 15. Exhibits, financial statement schedules 33
  Signatures 34
  Financial statements 35

 

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Forward Looking Statements

 

Certain statements contained in this annual report on Form 10-K (including the section regarding Management's Discussion and Analysis of Financial Condition and Results of Operations) 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 other sections of this report.

 

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.

 

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Part I

 

Item 1. Business

 

Company and Business

 

We are a telephone company, which manufactures, 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, and other similar type technologies. Our main products are the “DUO”, DUO II” and the “DUO WIFI”. All 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.

 

Our DUO, DUO II 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, DUOII 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, DUOII and DUO WIFI are able to use advanced calling features such as call forwarding, caller ID, 3-way calling, call holding, call retrieval, SMS, international call plans, local number portability and call transfer.

 

History and Overview

 

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

 

On September 10, 2008, we changed our name from Discover Screens, Inc. to NetTalk.com, Inc. and acquired certain tangible and intangible assets, formerly owned by Interlink Global Corporation (“Interlink”), related to our VOIP products.

 

Our Strategy

 

We continue to improve and enhance the following factors in building and expanding our customer base:

 

·Deployment and distribution of our main products the DUO, DUO II and DUO WIFI, NetTalk TV devices, IPhone and Androids applications for smartphones and tablets .

 

·We offer our customers an attractive and innovative value proposition: a portable telephone replacement with multiple and unique features that differentiates our services from the competition.

 

·Innovative, high technology and low cost technology platform. We believe our innovative software and network technology platform provides us with a competitive advantage over our competition and allows us to maintain a low cost infrastructure relative to our competitors.

 

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.

 

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Our Products

 

At this time, our main products are the DUO, DUOII and DUO WIFI. Our DUO, DUOII 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, DUOII and DUO WIFI have interface components so that the customer can purchase multiple units that can communicate with each other allowing simultaneous ringing from multiple locations.

 

Our DUO 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 product is under US patent number 8,243,722 as well as International patent pending in over 123 countries.

 

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 netTalk DUO, DUO II and DUO WIFI. 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 retail, 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.

 

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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 retail marketing co-ops with retail customers.

 

Geographic Markets

 

Our primary geographic market is North America. Our target audiences are 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 coop marketing with retail stores.

 

We have been granted and or are applying for Competitive Local Exchange Carrier (“CLEC”) Licenses in multiple 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  

 

It is our intent to focus our expansion on the geographic markets in which we have been granted CLEC Licenses. We also intend to expand our market place to reach customers worldwide.

 

The Industry

 

In the past decade, the use of the internet for all purposes has exploded. VoIP is a technology that enables communications over the internet through the compression of voice, video and/or other media into data packets that can be efficiently transmitted over data networks and then converted back into the original media at the other end of the transmission. Since the introduction of the first VoIP technology in the mid 1990s, the quality and clarity of VoIP connections have continued to evolve and improve. Perhaps the biggest jump in VoIP quality came with the introduction of SIP, or Session Initiation Protocol. SIP is a text-based protocol suitable for integrated voice-data applications. Today SIP is the predominant industry standard for establishing multimedia communications over the Internet. As the clarity and quality of VoIP services have increased, so has the acceptance of VoIP by consumers.

 

As a result of the potential cost savings and added feature availability of VoIP, consumers, industry leaders and traditional telecommunication service providers see VoIP as the future of telecommunications. Factors that have been contributing to the boom in VoIP use include: (a) increased consumer demand for lower cost telephone services; (b) increased demand for long distance services as the market place becomes increasingly global; (c) improved reliability and quality of VoIP due to technological advances; and (d) innovations that allow services for VoIP users that are not available in traditional telephone services. These factor, and others, have resulted in various service providers and consumers exploring VoIP alternatives to traditional analog phone services.

 

Our Competition

 

The communications industry is highly competitive and significantly affected by regulatory changes, technology evolution, marketing strategies, and pricing decisions of the larger industry participants. The market for our services is evolving rapidly and is subject to shifting customer demands and the introduction of new products and services. Our current and potential competitors come from different market sectors and vary in size and scope with respect to the products and services that they offer or intend to offer in the future.

 

One of our competitors in the domestic market is traditional telephone service providers that are increasingly adding advanced service features to traditional telephone services. Domestic telephone providers have the advantage of having strong name recognition, large research and development budgets and existing service and market networks.

 

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In addition, numerous vendors sell products and services using VoIP technology. Our competitors use innovations such as Analogue Terminal Adapters, or ATAs, to connect an analogue telephone to a VoIP network. Sometimes referred to as VoIP Gateways, these devices are widely advertised and sold. Sales are conducted by many different methods, including internet and infomercial sales, and barriers to entry into the business are low.

 

We also face competition from alternative communication methods such as internet, fax providers and voice mail service providers.

 

Many of our competitors may be better established, larger and better financed than us, and are able to use their visibility and substantial marketing resources to attract customers. In particular, many of our competitors are large, established network service providers that are able to market and distribute enhanced communication services within their already large base of subscribers.

 

As a result, these competitors may be able to adapt more quickly to new or emerging technologies and changes in customer requirements. They may also be able to devote greater resources to the promotion and sale of their products. Moreover, we may not have sufficient resources to undertake the continuing research and development necessary to remain competitive.

 

We differentiate our services from those offered by our competitors by offering exceptional customer service and lower cost alternatives. We have worked hard to control the development costs associated with the DUO, DUO II and DUOWIFI.                          We have done this by choosing phone components and component vendors that are economical but do not compromise on quality.        We have developed and marketed our own products and services, rather than simply reselling another manufacturer’s innovations. Finally, our DUO, DUO II and DUO WIFI products are standalone phone products that do not require the user to first invest in a computer. For these reasons, we believe that our DUO DUOII and DUO WIFI product is a lower cost alternative to similar telephone products currently being marketed (because we are engaged in the same cost saving measures for the services we offer).                            We are able to offer those services at a competitive price.

 

Our products and services are user friendly and convenient for our customers; for example, our packaging includes detailed, user friendly instructions and diagrams to allow for easy installation and activation. We have distinguished ourselves from our main competitors through the level of customer service offered to our consumers following their purchase or our products or services. Many of our competitors only offer customer service through an email query program. This does not allow the customer to receive rapid, real-time problem solving assistance in the event our competitor’s product or service fails. We have established a customer service online forum where our users can post their questions and read other users’ responses. The forum has key word or key phrase search option so that our customers can easily find a solution to the problem they are experiencing. Our forum is moderated by one of our development engineers to ensure that all questions are being properly addressed and issues resolved. We also offer a live customer support hotline. This allows us to provide superior customer service, while still keeping our costs low.

 

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.

 

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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 identifying 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. 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.

 

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 multiple 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.

 

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Employees

 

We employ 26 full time employees, none of our employees are subject to collective bargaining agreement, and we consider our employee relations to be satisfactory.

 

Intellectual Property

 

We regard our domain names, patents, trademarks, copyrights, trade dress, trade secrets, proprietary technologies and similar intellectual property as critical to our success, and we rely on patent, trademark and copyright law, trade-secret protection, and confidentiality and/or license agreements with our employees, customers, partners, and others to protect our proprietary rights.

 

We have filed multiple patent applications with the United States Patent and Trademark Office for the technology associated with our products. We also have software under development by our employees, subcontractors and consultants.

 

The status of any patent involves complex legal and factual questions, and the breadth of claims allowed is uncertain. Accordingly, we cannot assure you that any patent application filed by us will result in a patent being issued or that our issued patents, and any patents that may be issued in the future, will afford adequate protection against competitors with similar technology. We similarly face the risk that any patents issued to us might be infringed or designed around by others.

 

Patents – Domestic and International

 

Our DUO product is under US patent number 8,243,722 as well as International patent pending in over 123 countries.

 

Research and Development

 

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 which 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 the DUO, DUO II and DUO WIFI is being sold in the market place. Therefore, research and development cost reported in our financial statements relates to development of upcoming new products.

 

On July 14, 2010 we revealed our product the netTALK DUO (“DUO”).

 

Our DUO offers our customers free nationwide calls to any landline or mobile phone in the U.S. and Canada from anywhere in the world, as well as low-cost international rates. It’s also a versatile digital phone service with no monthly fees, no contracts and no computer required.

 

Our DUO is flexible enough to connect directly to your Internet connection through the router/modem, there is also a convenient option with our DUO to connect to your computer. The sleek design is small enough to fit in the palm of your hand, making it a portable device.

 

Our DUO reduces the wear and tear on your home or office computer and reduces energy costs, resulting in money savings. Our fax-friendly DUO, offers fax (incoming and outgoing), a unique feature not offered, to our knowledge, by similar digital phone services.

 

The portability of this small device is also great for international travelers who want to place free nationwide calls to the U.S. and Canada, or who are looking for a low-cost solution for international rates. Calls to other netTALK customers are always free.

 

We are presently working on other new products and anticipate future deployment the later part of this year and over the next year, including Nettalk “APP” for IPhone and Android and Nettalk TV.

 

Item 1 A. Risk factors

 

This Annual Report on Form 10-K contains forward-looking statements within the meaning of the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. Reference is made in particular to the description of our plans and objectives for future operations, assumptions underlying such plans and objectives and other forward-looking statements included in this section, “Item 1 Business,” “Item 7 Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and in other places in this Annual Report. Such statements may be identified by the use of forward-looking terminology such as “may”, “will”, “expect”, “believe”, “estimate”, “anticipate”, “intend”, “continue”, or similar terms, variations of such terms or the negative of such terms. Such statements are based on management’s current expectations and are subject to a number of factors and uncertainties that could cause actual results to differ materially from those described in the forward-looking statements. We expressly disclaim any obligation or undertaking to release publicly any updates or revisions to any forward-looking statements contained herein to reflect any change in our expectations with regard thereto or any change in events, conditions or circumstances on which any such statement is based. Factors that could cause such results to differ materially from those described in the forward-looking statements include, but are not limited to, those set forth below.

 

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Our business faces many risks. We believe the risks described below are the material risks we face. However, the risks described below are not the only risks we face. Additional unknown risks or risks that we currently consider immaterial may also impair our business operations. If any of the events or circumstances described below actually occurs, our business, financial condition or results of operations could suffer, and the trading price of our shares of common stock could decline significantly. Investors should consider the specific risk factors discussed below, together with the “Special Note Regarding Forward-Looking Information” and the other information contained in this Annual Report on Form 10-K and the other documents that we will file from time to time with the SEC.

 

RISKS RELATED TO OUR BUSINESS:

 

We have not sustained profits and our losses could continue. Without sufficient additional capital to apply to repay our indebtedness, we may be required to significantly scale back our operations, significantly reduce our headcount, seek protection under the provisions of the U.S. Bankruptcy Code, and/or discontinue many of our activities which could negatively affect our business and prospects. Our current capital raising efforts may not be successful in raising additional capital on favorable terms, or at all.

 

We have experienced significant losses in the past and never sustained profits. For the years ended December 31, 2012 and 2011, we recorded net losses of $14.7 and $29.8 million, respectively. For the three month ended December 31, 2011 and 2010, we recorded net losses of $3.4 and $1.2 million, respectively. For the fiscal years ended September 30, 2011 and 2010 we recorded net losses of $27.7 and $6.4 million, respectively.

 

As of December 31, 2012, we had $15.6 million in current senior debentures, demand notes and $1.4 million in long term mortgage debt.

 

While we believe that our current cash resources, together with anticipated cash flows from operating activities, will be sufficient to fund our operations, including interest payments, in 2013, they will not be sufficient to fund repayment of principal on our outstanding indebtedness in 2013. Further, we do not anticipate having sufficient cash and cash equivalents to repay the debt should the senior debentures or mortgage debt lenders accelerate the maturity date of outstanding debt, and we would be forced to seek alternative sources of financing. In light of these circumstances, we will need to seek additional capital through public or private debt or equity financings.

 

However, there are no assurances that those efforts will be successful or that additional capital will be available on terms that do not adversely affect our existing stockholders or restrict our operations, if it is available at all. If we raise additional funds through the issuance of debt securities, these securities could have rights that are senior to holders of our common stock and could include different financial covenants, restrictions and financial ratios. The conversion of the convertible notes resulted in substantial dilution to our stockholders and any additional equity financing would also likely be substantially dilutive to our stockholders, particularly in light of the prices at which our common stock has been recently trading. In addition, if we raise additional funds through the sale of equity securities, new investors could have rights senior to our existing stockholders. The terms of any future financings may restrict our ability to raise additional capital, which could delay or prevent the further development or marketing of our products and services. Our need to raise capital before the repayment of our debt becomes due may require us to accept terms that may harm our business or be disadvantageous to our current stockholders, particularly in light of the current illiquidity and instability in the global financial markets.

 

Our business may be affected by factors outside our control .

 

Our ability to increase sales and to profitably distribute and sell our products and services is subject to a number of risks, including changes in our business relationships with our principal distributors, competitive risks such as the entrance of additional competitors into our markets, pricing and technological competition, risks associated with the development and marketing of new products and services in order to remain competitive and risks associated with changing economic conditions and government regulation. Our inability to overcome these risks could materially and adversely affect our operations.

 

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Item 2. Properties

 

Description of properties

 

On August 8, 2011 we purchased an existing building located in Miami Gardens, Florida, currently 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.

 

Interconnection Leasing Agreements

 

The Company will be entering into lease arrangements to provide interconnection services in multiple states. “Interconnection services” is defined in the Telecommunications Act of 1996 (the “Telecommunications Act”) as the linking of two telecommunication systems so that users of either system may utilize the system components of the other. Pursuant to the FCC rules implementing the

 

Telecommunications Act, we negotiate interconnection agreements with incumbent local exchange carriers to obtain access to facilities. Facilities leasing occurs where one network service provider leases the facilities of another network service provider to provide services to end users. We currently have executed two interconnection leasing agreements and are negotiating an interconnection leasing agreement with other major hosting/bandwidth companies. Our current interconnection leasing agreements are with multiple carriers. The agreements relate to facilities located or to be located in the following states:

 

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 agreements will grant us interconnection leasing rights in all forty-three states in which we have obtained or are pursuing a CLEC license. If we enter new markets, we expect to establish interconnection agreements with incumbent local exchange carriers on an individual state basis, as the need arises.

 

Item 3. Legal Proceedings

 

On April 4, 2012, MagicJack Vocaltec Ltd. filed a complaint in 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 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. MagicJack Vocaltec Ltd. and NetTalk filed a Joint Stipulation and motion for the dismissal. Effective November 2012, the federal court has dismissed the entire case with prejudice, including all claims, counterclaims, defenses and causes of action.

 

On September 21, 2012, NetTalk.com, Inc. filed a complaint in United States District Court For the Southern District of Florida, Civil Action No.: 9:12-cv-81022-CIV-MIDDLEBROOK/BRANNON, against MAGICJACK VOCALTECLTD, MAGIJACK HOLDINGS CORPORATION f/k/a YMAX HOLDINGS CORPORATION and DANIEL BORISLOW, In the complaint, we allege patent infringement by the defendants, seeking injunctive relief and damages as a result of the alleged patent infringement by defendants.

 

11
 

 

On September 14, 2012, a supplier filed a complaint in the United States District Court for the Southern District of Florida, Case No.: 1:12-cv-23366-FAM, alleging breach of contract by the Company and seeking damages of not less than $473,319 due to such alleged breach. The supplier alleges in the complaint that Net Talk failed to pay for component parts manufactured for the Company’s products. The Company filed an answer to the complaint denying the supplier’s allegations and asserting affirmative defenses.

 

NetTalk reached a settlement with the supplier and as of December 31, 2012 we are in full compliance with said settlement.

 

On November 26, 2012, a supplier to the Client, Broadvox, LLC (“Broadvox”), filed a complaint in the Court of Common Pleas, Cuyahoga County, Ohio, Case No.: CV-12-796095, alleging breach of contract by the Company and seeking damages of not less than $111,701 due to such alleged breach. The Company and Broadvox entered into a settlement agreement providing for the payment of all past due amounts.

 

A Statement of Claim was served by DACS Marketing & Sponsorship Inc. on NetTalk.com Inc. on June 20, 2012. The claim is for $125,834.21 for amounts DACS claims is owing to it pursuant to its agreement as well as $126,000 for general damages for breach of contract.

 

A Statement of Defence was delivered on your behalf on August 31, 2012, denying all claims.

 

The following offers to settle have been made by the parties but to date, the parties have not accepted any proposed offers:

 

1.November 7, 2012, NetTalk offered to settle the action by payment to DACS of $5,000.
2.December 18, 2012, DACS offered to settle the action by NetTalk paying to DACS the sum of $85,000.
3.December 27, 2012, NetTalk offered to settle the action by payment to DACS of $10,000.

 

To date, we have heard nothing further from the lawyer for DACS.

 

ITEM 4. Mine safety disclosures None

 

Part II

 

Item 5. Market for registrant’s common equity, related stockholder matters and issuer purchases of equity

 

Our common stock has been quoted on the OTC Bulletin Board under the symbol “NTLK” since September 15, 2009.

 

Market Information

 

The figures set forth below reflect the quarterly high and low bid information for shares of our common stock during the last two fiscal years, as reported by the OTC Bulletin Board. These quotations reflect inter-dealer prices without retail markup, markdown, or commission, and may not represent actual transactions.

 

  High   Low 
2011 Quarter Ended          
March 31, 2011  $2.50   $0.29 
June 30, 2011  $1.19   $0.51 
September 30, 2011  $0.70   $0.26 
December 31, 2011  $0.58   $0.15 
2012 Quarter Ended          
March 31, 2012  $1.67   $0.10 
June 30, 2012  $0.48   $0.10 
September 30, 2012  $0.20   $0.10 
December 31, 2012  $0.19   $0.08 

 

RULES GOVERNING LOW-PRICE STOCKS THAT MAY AFFECT ABILITY TO RESELL SHARES. Our common stock is subject to certain rules adopted by the SEC that regulate broker-dealer practices in connection with transactions in "penny stocks". Penny stocks generally are securities with a price of less than $ 5.00 other than securities registered on certain national exchanges or quoted on the NASDAQ system, provided that the exchange or system provides current price and volume information with respect to transaction in such securities. The additional sales practice and disclosure requirements imposed upon broker-dealers may discourage broker-dealers from effecting transactions in our shares which could limit the market liquidity of the shares and impede the sale of our shares in the secondary market.

 

12
 

 

The penny stock rules require broker-dealers, prior to a transaction in a penny stock not otherwise exempt from the rules, to make a special suitability determination for the purchaser to receive the purchaser's written consent to the transaction prior to sale, to deliver standardized risk disclosure documents prepared by the SEC that provides information about penny stocks and the nature and level of risks in the penny stock market. In addition, the penny stock regulations require the broker-dealer to deliver prior to any transaction involving the penny stock, a disclosure schedule prepared by the SEC relating to the penny stock market, unless the broker-dealer or the transaction is otherwise exempt. A broker-dealer is also required to disclose commissions payable to the broker-dealer and the registered representative and current quotations for the securities. Finally, a broker-dealer is required to send monthly statements disclosing recent price information with the respect to the penny stock held in a customer's account and information with respect to the limited market in penny stocks.

 

Holders

 

As of December 31, 2012, there were 170 registered holders or persons otherwise entitled to hold our common stock. The number of record holders was determined from the records of our transfer agent and does not include beneficial owners of common stock whose shares are held in the names of various security brokers, dealers, and registered clearing agencies. The transfer agent of our common stock is Fidelity Transfer.

 

Dividends

 

We have not declared or paid any cash dividends on our common stock since our inception, and our Board of Directors currently intends to retain all earnings for use in the business for the foreseeable future. Any future payment of dividends to holder of common stock will depend upon our results of operations, financial condition, cash requirements, and other factors deemed relevant by our Board of Directors.

 

Securities Authorized for Issuance Under Equity Compensation Plans

 

The following table sets forth certain information about the common stock that may be issued upon the exercise of options under the equity compensation plans as of December 31, 2012.

 

Plan category  Number of securities
to be issued upon
exercise of
outstanding options,
warrants and rights
   Weighted average
exercise price of
outstanding options,
warrants and rights
   Number of securities
remaining available for
future issuance under equity
compensation plans
(excluding securities
reflected in column (a)
 
   (a)   (b)   (c) 
Equity compensation plans approved by security holders   -0-    -0-    -0- 
                
Equity compensation plans not approved by security holders   -0-    -0-    19,528,500 
                
Total   -0-    -0-    19,528,500 

 

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.

 

13
 

 

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, 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 provide 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 issuable under the Plan was 10,000,000 shares of the Company’s common stock.

 

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 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 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 adjusted for ownership restrictions.

 

Summary of 2010 Stock Option Plan (issuances):

 

July 26, 2010   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, 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 provide 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 issuable under the Plan was 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 adjusted for ownership restrictions.

 

On May 28, 2012, we issued 15,488,000 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 adjusted for ownership restrictions.

 

On July 25, 2012, we issued 1,028,500 shares of common stock to our employees and vendors 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 adjusted for ownership restrictions.

 

Summary of 2011 Stock Option Plan (issuances):

 

January 6, 2012   3,483,500   Common shares
May 28, 2012   15,488,000   Common shares
July 25, 2012   1,028,500   Common shares
Total   20,000,000   Common shares

 

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2012 Stock Option Plan

 

On July 25, 2012, Nettalk adopted the 2012 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, 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 provide 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 July 25, 2012, we issued 471,500 shares of common stock to our employees and vendors as part of our 2012 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.

 

Recent Sales of Unregistered Securities

 

Unless otherwise noted below, we have previously included information concerning sales of unregistered securities in our Quarterly Reports on Form 10-Q or in a Current Report on Form 8-K.

 

Item 6. Selected financial data.

 

As a smaller reporting company, we are not required to include disclosure, pursuant to this item.

 

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

This discussion and analysis of our financial condition and results of operations contains forward-looking statements that involve risks and uncertainties. We have based these forward-looking statements on our current expectations and projections of future events. However, our actual results could differ materially from those discussed herein as a result of the risks that we face, including but not limited to those risks stated in ”Risk Factors," or faulty assumptions on our part. In addition, the following discussion should be read in conjunction with the audited financial statements and the related notes thereto included elsewhere in this Annual Report.

 

Liquidity and Capital Resources

 

During the years ended December 31, 2012 and 2011, we generated net losses of $14,715,006 and $28,389,302, respectively. We used cash in our operations in the amount of $5,248,675 during the year ended December 31, 2012.

 

As of December 31, 2012, we had cash and cash equivalents on hand of $96,347.

 

Statement of cash flow data:  12/31/2012   12/31/2011 
Net cash provided (used) in operating activities  $(5,248,675)  $(7,577,533)
Net cash provided (used) in investing activities  $(317,395)  $(2,564,888)
Net cash provided (used) in financing activities  $4,123,154   $10,660,000 

 

Our largest operating expenditures currently consist of compensation and benefits.

 

Borrowing Arrangements

 

Long-term and short term debt

 

Securities Option Agreement:

 

On June 30, 2012, we executed Securities Option Agreement with Vicis Capital Master Fund (“Vicis”) whereby Vicis grants us an option to purchase and redeem all securities and debentures held by Vicis. The option becomes exercisable on the date that all principal and accrued interest on all debentures have been paid in full, and may be exercised at any time after initial exercise date through and including December 31, 2013 (expiration date). Upon exercise of the “option” the redemption price for the securities shall be an amount equal to $16,000,000 minus the sum of principal and accrued interest paid on all debentures held by Vicis. Upon exercise of the option, any and all unpaid dividends on the securities shall be surrendered and cancelled without payment of additional consideration.

 

15
 

 

Extension of Maturity Dates of Outstanding Non-Convertible Debentures:

 

On June 30, 2012, we entered into an agreement to modify our outstanding debentures solely to extend their maturity dates that originally ranged from June 30, 2012 to July 1, 2013 to December 31, 2013. There were no other material modifications to the debentures and the holders received no additional consideration to effect the modification. As a result of these modifications, we evaluated each debenture to determine whether the maturity extension constituted a substantial modification. Under current accounting standards, from a debtor’s perspective, a modification of a debt instrument is deemed equivalent to the exchange of debt instruments if the present value of the cash flows under the terms of the modified arrangement are at least 10 percent different from the present value of the remaining cash flows under the terms of the original debt instrument. In cases where the difference in cash flows exceeds this level, extinguishment accounting is prescribed. As a result of our calculations, we concluded that the present values, using the effective interest rates on the issuance dates, of our face value $5,266,130, $2,000,000, and $3,500,000 debentures exceeded the substantive threshold. Accordingly, the debentures were adjusted to their respective fair values of $6,150,160, $2,313,888, and $3,852,748 and a corresponding charge to income in the amount of $3,135,235 representing the extinguishment loss.

 

The fair values of the debentures were determined based upon their future cash flows, discounted at a credit-risk adjusted market interest rate of 7.4%.

 

2012 Issuance of Non-Convertible Debentures

 

On March 29, 2012, we issued a face value $500,000, 10% senior secured debenture, due June 30, 2012, extended to December 31, 2013

 

On April 20, 2012, we issued a face value $500,000, 10% senior secured debenture, due June 30, 2012, extended to December 31, 2013.

 

On June 26, 2012, we issued a face value $450,000, 10% senior secured debenture, due June 30, 2012, extended to December 31, 2013.

 

During the year ended December 31, 2012, we received advances in the total amount of $1,150,000, as part of a series of 10% senior secured debentures, due December 31, 2013, issued to our largest investor.

 

During the year ended December 31, 2012, we received advances in the total amount of $275,000, represented by Demand Notes, issued to our largest investor.

 

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

 

   December 31,   December 31, 
   2012   2011 
$2,000,000 face value 12% debenture, due December 31, 2013  $2,398,153   $941,762 
$3,500,000 face value 12% debenture, due December 31, 2013   3,993,053    2,211,483 
$5,266,130 face value 12% debenture, due December 31, 2013   6,374,130    2,841,930 
$ 500,000 face value 10% debenture, due December 31, 2013   500,000    - 
$ 500,000 face value 10% debenture, due December 31, 2013   500,000    - 
$ 450,000 face value 10% debenture, due December 31, 2013   450,000    - 
$1,150,000 advances on 10% debenture, due December 31, 2013   1,150,000    - 
$ 275,000 demand notes, due on demand   275,000    - 
Total  $15,640,336   $5,995,175 

 

16
 

 

Long-term debt:

 

On January 11, 2013, we received an additional advance of $400,000 pursuant to its existing lending facility with 1080 NW 163rd Drive, LLC. The additional advance of $400,000 was endorsed by a mortgage promissory note, which was consolidated with the initial advance of $1,000,000 from the mortgage on 1080 NW 163rd Drive, LLC. The consolidated promissory mortgage note has an aggregate principal balance of $1,400,000, accrues interest at 12% per year, is payable in full on November 29, 2014 and is secured by our corporate office building, located at 1080 NW 163rd Drive, Miami Gardens, FL 33169.

 

On February 15, 2013 and April 10, 2013 we received additional advances of $100,000 and $75,000 from 1080 NW 163rd Drive, LLC. These advances are not evidenced by a formal promissory note. The additional advances of $100,000 and $75,000 accrue interest at 8% per year, and were payable in full on June 9, 2013. These notes are now in default.

 

On February 19, 2013, August 9, 2013, August 14, 2013 and September 3, 2013the Company’s CEO advanced the Company $25,000, $5,000, $20,000 and $25,000, respectively. These advances are not evidenced by a formal promissory note. These advances were for working capital and bear no interest and are due on demand.

 

On April 22, 2013 and May 3, 2013 we received advances from Vicis in the amount of $50,000 and $25,000, respectively, both due on demand. These advances are not evidenced by a formal promissory note.

 

On May 31, 2013, we issued a $300,000 face value, 5% Secured Convertible Promissory Note, due December 1, 2013. This note is convertible into shares of the Company’s common stock at a rate of $0.08 per share, for a total of 3,750,000 common shares. This note has a second priority security interest, junior in priority only to the holder of the first priority interest, to all real property of the Company and any and all cash proceeds and/or noncash proceeds of any of the foregoing, including, without limitation, insurance proceeds, and all supporting obligations and the security therefore or for any right to payment.

 

On July 15, 2013, we issued a $200,000 face value, 5% Secured Convertible Promissory Note, due January 15, 2014. This note is convertible into shares of the Company’s common stock at a rate of $0.08 per share, for a total of 2,500,000 common shares. This note has a second priority security interest, junior in priority only to the holder of the first priority interest, to all real property of the Company and any and all cash proceeds and/or noncash proceeds of any of the foregoing, including, without limitation, insurance proceeds, and all supporting obligations and the security therefor or for any right to payment.

 

On July 7, 2013, August 9, 2013, August 9, 2013, August 15, 2013 and August 22, 2013 we received $111,000, $111,000, $55,000, $75,000 and $125,000 respectively, for working capital from an outside party. These notes are due on demand and carry a 0% interest rate. Interest will be imputed on these notes at current market rates.

 

17
 

 

Results of Operations

 

Year ended December 31, 2012 and 2011

 

Revenues: Our operating revenue amounted to $5,790,983 for the year ended December 31, 2012, compared to $3,548,714 at December 31, 2011. The increase in revenues relates to increases in sales to large retail customers and increases sales volume during the period ended December 31, 2012. We have historically benefitted from a high degree of revenue retention from both subscription based renewals and on demand customers. This high degree of customer retention means that our customers provide a stable and reliable cash flow retention model. Our customers typically pay us upfront and then use their downloads in a predictable pattern over time, which results in favorable cash flow and is adding predictability and stability to our financial performances.

 

Cost of sales: Our cost of sales amounted to $6,184,787 for the year ended December 31, 2012, compared to $3,631,360 at December 31, 2011. The increase in cost of sales relates to increased sales to large retail customers and increasing sales volume during the year ended December 31, 2012.

 

Advertising: Our advertising expenses amounted to $1,019,882 the year ended December 31, 2012, compared to $2,391,898 at December 31, 2011. The breakdown of our advertising expense is as follows:

 

   12/31/2012   12/31/2011 
Media and others  $914,427   $2,130,823 
Smartphone   105,455    261,075 
Total  $1,019,882   $2,391,898 

 

Compensation and Benefits: Our compensation and benefits expense amounted to $1,692,237 for the year ended December 31, 2012, compared to $1,036,201 at December 31, 2011. This amount represents normal salaries and wages paid to management members and employees. The increase is due to the addition of employees in our development, engineering and operations departments.

 

Professional Fees: Our professional fees amounted to $884,580 for the year ended December 31, 2012, compared to $379,929 at December 31, 2011. This amount includes normal payments and accruals for legal, accounting and other professional services related to general business and being a public company. The increase also relates to legal fees incurred in defending and securing our intellectual property rights and patents.

 

Depreciation and Amortization: Depreciation and amortization amounted to $262,842 for the year ended December 31, 2012, compared to $327,421 at December 31, 2011. These amounts represent amortization of our long-lived tangible and intangible assets using the straight-line method 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 years ended December 31, 2012 and 2011, 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.

 

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 which 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 products, the DUO, DUO II and DUO-WIFI are being sold in the market place.

 

Components of Research and development:  12/31/2012   12/31/2011 
Product development and engineering  $88,917   $295,424 
Payroll and benefits   1,122,794    825,061 
Total  $1,211,711   $1,120,485 

 

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General, Selling and Administrative Expenses: General, selling and administrative expenses amounted to $2,614,408 for the year ended December 31, 2012, compared to $2,337,965 at December 31, 2011. General corporate expenses, are as follows:

 

Items  12/31/2012   12/31/2011 
         
Shipping outbound  $437,126   $744,935 
Insurance   272,240    137,669 
Rent and occupancy   134,393    300,948 
Taxes and licenses   148,619    66,814 
Travel   168,599    188,067 
Commissions   667,176    521,851 
Other   786,255    377,681 
Total  $2,614,408   $2,337,965 

 

Loss from operations: Loss from operations amounted to $8,079,464 for the year ended December 31, 2012, compared to $7,676,545 at December 31, 2011. The increase in net loss resulted primarily from increase in payroll and legal fees.

 

Interest Expense: Interest expense amounted to $3,500,512 for the year ended December 31, 2012, compared to $2,035,257 at December 31, 2011. This amount represents interest on our mortgage debt and also includes, (i) stipulated interest under our convertible debentures that were converted to common stock during the year and our secured debentures issued on August 8, 2011, (ii) the related amortization of premiums and discounts (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 expenses: Derivative expense amounted to $0 for the year ended December 31, 2012, compared to $17,174,242 at December 31, 2011. Derivative expenses are extraordinary and non-recurring.

 

Debt extinguished: Debt extinguished amounted to $3,135,235 for the year ended December 31, 2012, compared to $1,293,539 at December 31, 2011.

 

Net Loss: Net loss amounted to $14,715,006 for the year ended December 31, 2012, compared to $28,389,302 at December 31, 2011.

 

Results of Operations

 

Three months ended December 31, 2011 and 2010

 

Revenues: Our operating revenue amounted to $1,298,623 for the three months ended December 31, 2011, compared to $470,378 at December 31, 2010. The increase in revenues relates to increase in sales to large retail customers and increase sales volume during the three month period. We have historically benefitted from a high degree of revenue retention from both subscription based renewals and on demand customers. This high degree of customer retention means that our customers provide a stable and reliable cash flow retention model. Our customers typically pay us upfront and then use their downloads in a predictable pattern over time, which results in favorable cash flow and is adding predictability and stability to our financial performances.

 

Cost of sales: Our cost of sales amounted to $1,787,815 for the three months ended December 31, 2011, compare to $724,988 at December 31, 2010. The increase in cost of sales relates to increased sales to large retail customers and increasing sales volume during the period.

 

Advertising: Our advertising expenses amounted to $606,209 for the three months ended December 31, 2011, compared to $109,996 at December 31, 2010. The breakdown of our advertising expense is as follows:

 

   12/31/2011   12/31/2010 
Media and others  $531,633   $109,996 
Smartphone   74,576    - 
Total  $606,209   $109,996 

 

Compensation and Benefits: Our compensation and benefits expense amounted to $289,652 for the three months ended December 31, 2011, compared to $104,750 at December 31, 2010. This amount represents normal salaries and wages paid to management members and employees. The increase is due to the addition of employees in our development, engineering and operations departments.

 

19
 

 

Professional Fees: Our professional fees amounted to $136,118 for the three months ended December 31, 2011, compared to $68,094 at December 31, 2010. This amount includes normal payments and accruals for legal, accounting and other professional services related to general business and being a public company.

 

Depreciation and Amortization: Depreciation and amortization amounted to $60,765 for the three months ended December 31, 2011, compared to $90,033 at December 31, 2010. These amounts represent amortization of our long-lived tangible and intangible assets using the straight-line method 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 December 31, 2011 and 2010, 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.

 

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 products, the DUO are 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.

 

Components of Research and development:  12/31/2011   12/31/2010 
Product development and engineering  $8,650   $90,147 
Payroll and benefits   262,132    95,411 
Total  $270,782   $185,558 

 

General, Selling and Administrative Expenses: General, selling and administrative expenses amounted to $497,986 for the three months ended December 31, 2011, compared to $184,282 at December 31, 2011 and consisted of general corporate expenses, as follows:

 

Items  12/31/2011   12/31/2010 
Bad debt  $-   $990 
Insurance   41,126    20,380 
Software   1,600    11,225 
Rent and occupancy   78,438    54,215 
Taxes and licenses   34,254    - 
Travel   51,434    52,150 
Commissions   149,203    - 
Other   141,931    45,322 
Total  $497,986   $184,282 

 

Loss from operations: Loss from operations amounted to $2,350,704 for the three months ended December 31, 2011, compared to $997,323 at December 31, 2010. The increase in net loss resulted primarily from an increase in payroll and advertising expense to sustain our growth in the retail segment and support awareness of the Company’s products. .

 

Interest Expense: Interest expense amounted to $1,090,735 for the three months ended December 31, 2011, compared to $126,000 at December 31, 2010. Such amount represented (i) stipulated interest under our aggregate $4,998,773 face value convertible debentures that were converted to common stock during the year and our secured debentures issued on August 8, 2011, (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 expense: Derivative expense amounted to $0 for the three months ended December 31, 2011, compared to $105,778 at December 31, 2010.

 

Net Loss: Net loss amounted to $3,440,286 for the three months ended December 31, 2011, compared to $1,227,545 at December 31, 2010.

 

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Results of Operations

 

Comparison - fiscal years ended September 30, 2011 and 2010

 

Revenues: Our operating income amounted to $2,720,465 and $737,498 for the fiscal years ended September 30, 2011 and 2010, respectively. The increase in revenues relates to establishing several brick and mortar retail customers and increasing sales volume during the fiscal year ended September 30, 2011.

 

Cost of sales: Our cost of sales amounted to $3,098,366 and $1,453,332 for the fiscal years ended September 30, 2011 and 2010, respectively. The increase in cost of sales relates to increased sales primarily driven by sales to our newly acquired retail customers and increasing sales volume during the fiscal year ended September 30, 2011.

 

Advertising: Our advertising expenses amounted to $1,701,490 and $357,413 for fiscal years ended September 30, 2011 and 2010. The breakdown of our advertising expense is as follows:

 

   September 30, 
   2011   2010 
         
Infomercial/production time  $-   $18,400 
Media and others   1,514,992    339,013 
Smartphone   186,498    - 
Total  $1,701,490   $357,413 

 

Compensation and Benefits: Our compensation and benefits expense amounted to $1,262,994 and $477,576 for fiscal years ended September 30, 2011 and 2010. This amount represents normal salaries and wages paid to management members and employees. The increase is due to the addition of employees in our development, engineering and operations departments.

 

Professional Fees: Our professional fees amounted to $235,756 and $255,471 for fiscal years ended September 30, 2011 and 2010, respectively. This amount includes normal payments and accruals for legal, accounting and other professional services related to general business and being a public company.

 

Depreciation and Amortization: Depreciation and amortization amounted to $356,688 and $363,335 for fiscal years ended September 30, 2011 and 2010. These amounts represent amortization of our long-lived tangible and intangible assets using the straight-line method 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 fiscal years ended September 30, 2011 and 2010, 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.

 

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 products, the DUO are 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.

 

Components of Research and development:  September 30, 2011   September 30, 2010 
         
Product development and engineering  $405,645   $119,933 
Payroll and benefits   497,724    255,264 
Total  $903,369   $375,197 

 

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General, Selling and Administrative Expenses: General, selling and administrative expenses amounted to $1,484,971 for the fiscal year ended September 30, 2011 as compared to $547,075 for the fiscal year ended September 30, 2010 and consisted of general corporate expenses.

 

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

 

Items  September 30, 2011   September 30, 2010 
         
Bad debt  $-   $21,707 
Insurance   116,023    73,801 
Software support   42,883    26,671 
Rent and occupancy   277,228    175,876 
Taxes and licenses   77,661    17,538 
Travel   176,031    85,088 
Distribution, processing and commissions   434,885    - 
Other   360,260    146,394 
Total  $1,484,971   $547,075 

 

Loss from operations: Loss from operations amounted to $6,323,169 and $3,091,901 for the fiscal year ended September 30, 2011 and 2010. The increase in net loss resulted primarily from an increase in payroll and advertising expense to sustain our growth in the retail segment and support awareness of the Company’s products. Research and development expenses increased as a result of the DUO WIFI and other products expected to roll out during 2012.

 

Interest Expense: Interest expense amounted to $1,070,522 for the fiscal year ended September 30, 2011 as compared to $1,058,363 for the fiscal year ended September 30, 2010. Such amount represented (i) stipulated interest under our aggregate $4,998,773 face value convertible debentures that were converted to common stock during the year and our secured debenture issued on August 8, 2011, (ii) the related amortization of premiums and discounts (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 income (expense) amounted to $(17,280,018) for the fiscal year ended September 30, 2011 as compared to derivative income of $1,445,632 for the year ended September 30, 2010. 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 had certain compound derivative financial instruments related to our $4,998,773 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.

 

Debt extinguished: Debt extinguished amounted to $1,293,538 for the fiscal year ended September 30, 2011 as compared to $3,617,983 for the fiscal year ended September 30, 2010. The amount represents loss recognized related to the June 30, 2011 transaction whereupon the investor converted debt into shares of our common stock and was granted inducement warrants to convert such debt; expense was also incurred to settle accrued interest as part of the transaction. The expense incurred during the fiscal year ended September 30, 2011 related to the issuance of new debentures on February 24, 2010.

 

Net Loss: Net loss amounted to $26,176,565 for the fiscal year ended September 30, 2011, as compared to a net loss of $6,306,963 for the fiscal year ended September 30, 2010.

 

Net Loss Per Common Share: Basic loss per common share represents our net loss 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. We computed the effects on diluted loss per common share arising from convertible securities using the if-converted method. The effects, are anti-dilutive and are excluded.

 

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Contractual obligations – Not Applicable

 

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.

 

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.

 

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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 product the NetTalk DUO (“DUO”), telecommunication service revenues, shipping and handling revenues.

 

Our DUO 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 is 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.

 

Inventory

 

Inventory consists of the cost of customer equipment and is stated at the lower of cost or market.

 

 At the present time we do not provide for inventory allowance. As we continue to sell our product we will evaluate the need for such an allowance.

 

   December 31,   December 31, 
Inventory  2012   2011 
Productive material and supplies  $869,740   $1,186,916 
Finished goods   598,034    1,018,339 
Total  $1,467,774   $2,205,255 

 

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

 

Of our $598,034 of finished goods inventory at December 31, 2012, $140,200 is held on consignment at one of our distributors.

 

Of our $1,018,339 of finished goods inventory at December 31, 2011, $170,402 was held on consignment at one of our distributors.

 

Income taxes

 

We recognize deferred taxes for the expected tax consequences of temporary differences between the tax bases of assets and liabilities and their reported amounts using tax rates in effect for the year. We have recorded a valuation allowance on the assumption that realization of the benefits is not more likely than not.

 

Net operating loss carry-forwards

 

As of December 31, 2012, we had net operating loss carry-forwards in the amount of $35,490,620 for US federal and state tax purposes expiring at various times thru 2031.

 

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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 became effective in the second quarter of fiscal 2012. The adoption of this update did not have a material impact on our financial statements.

 

Item 7A. 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.

 

Item 8. Financial Statement and Supplementary Data

 

The financial statements are part of this filings and are contained herein.

 

Item 9. Changes In and Disagreements With Accountants On Accounting and Financial Disclosure

 

None.

 

Item 9A. 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 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 December 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 December 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 and “one-person” office prohibits the segregation of duties and the timely review of accounts payable, expense reporting and inventory management and banking information.

 

25
 

 

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.

 

Management report on internal control over financial reporting

 

Our management is responsible for establishing and maintaining adequate internal control over financing reporting for our company. Internal control over financial reporting is defined in Rule 13a – 15(f) and 15d – 15(f) of the Securities and Exchange Act of 1934 as a process designed by or under the supervision of our principal executive and principal financial officer and effected by board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles and includes those policies and procedures that:

 

Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and disposition of assets of the company;

 

Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures are being made only in accordance with authorizations of our management and directors; and

 

Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of company’s assets that could have a material effect on the financial statements.

 

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

 

Our management assessed the effectiveness of our internal control over financial reporting as of December 31, 2012. In making this assessment, our management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in internal control – integrated framework. Based on our assessment, management concluded that as of December 31, 2012, our internal control over financial reporting is not effective based on those criteria.

 

In connection with the assessment described above, management identified the following control deficiencies that represent material weaknesses at December 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 and “one-person” office 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. Failure to develop adequate internal control and hiring of qualified accounting personnel may result in a “material weakness” in the Company’s internal control relating to the above activities.

 

26
 

 

This annual report does not include an attestation report of the company’s registered public accounting firm regarding internal control over financial reporting. As a smaller reporting company, the management’s report is not subject to attestation by the company’s registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission.

 

Changes in Internal Controls.

 

During the year ended December 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.

 

Item 9B. Other Information

 

On November 29, 2012, we borrowed $1,000,000 from a lender and in exchange, we issued a 12% promissory note and a mortgage and security agreement. The 12% promissory note, among other matters, accrues interest at 12% per annum, is payable in full on November 29, 2014, and is secured by our corporate office building, located at 1080 NW 163rd Drive, Miami Gardens, FL 33169. Proceeds from the 12% promissory note were used for operating expenses and working capital.

 

On January 11, 2013, we received an additional advance of $400,000 pursuant to its existing lending facility with 1080 NW 163rd Drive, LLC. The additional advance of $400,000 was memorialized by a future advance promissory note issued by us, which was consolidated with an initial advance of $1,000,000 from 1080 NW 163rd Drive, LLC. The consolidated promissory note has an aggregate principal balance of $1,400,000. The consolidated promissory note, among other matters, accrues interest at 12% per annum, is payable in full on November 29, 2014, and is secured by the Company’s corporate office building, located at 1080 NW 163rd Drive, Miami Gardens, FL 33169. Proceeds from the additional advance of $400,000 were used for operating expenses and working capital

 

Part III

 

Item 10. Directors, executive officers and corporate governance The following table sets forth certain information with respect to each of our directors, executive officers and key employees as of December 31, 2012. Their ages, positions, dates of initial election or appointment, and the expiration of their terms are as follows:

 

Name Age Position Period served
Anastasios Kyriakides 64 Director, Chief Executive Officer and Secretary May 2008 to present
Kenneth A. Hosfeld 61 Director, Vice President May 2008 to present
Guillermo Rodriguez (Retired) 64 Director, Chief Financial Officer May 2008 to April 30,2013
Shad Stastney (Resigned) 45 Director May 2012 to June 6, 2013
Dr. George Gabb 44 Director May 2011 to present

 

Unless expressly indicated in the above table, each director and officer will serve in these capacities until their successors are duly elected, qualified and seated in accordance with the Company’s Articles of Incorporation and Bylaws.

 

Background of Executive Officers and Directors

 

Anastasios Kyriakides, Director, Chief Executive Officer, Secretary. Mr. Kyriakides has served as a member of the Company’s board of directors and as the Company’s Chief Executive Officer and Secretary since September 2008. Mr. Kyriakides received a Bachelor of Science in business from Florida International University in 1975. In 1977, he received a degree in investment banking from the American Institute of Banking. From 1979 until present, Mr. Kyriakides has consulted for numerous companies in the areas of shipping, travel, banking and electronics. Mr. Kyriakides began his career in the electronics development field when, in 1979, he founded and served as Chairman of Lexicon Corporation, producer of the LK300, the first hand held electronic language translator which translated words and phrases into 12 different languages. Lexicon was publicly traded on the NASDAQ, under the symbol LEXI, until it was ultimately acquired by Nixdorf Computers of Germany. Mr. Kyriakides was also the founder of Delcor Industries, established in 1980 in Hollywood, Florida. Delcor was an electronics manufacturing facility employing over 150 employees to assemble OEM products for various electronics companies including IBM mainframe and Gable Division. In 1983, Mr. Kyriakides founded the Mylex Corporation to develop and produce the world’s first hand-held optical scanner and VGA card for personal computers. As the President and Chairman, Mr. Kyriakides guided Mylex from its beginning as a private company to its becoming a public company traded on the NASDAQ under the stock symbol MYLX until it was acquired as a wholly owned subsidiary of IBM (NYSE: IBM). In 1983, Mr. Kyriakides was the founder and Chairman of Tower Bank NA, a full service commercial bank, with three offices, headquartered in Dade County, Florida. Mr. Kyriakides also has extensive experience in the cruise line and travel industries. His cruise ship career started with Carnival Cruise line out of the Port of Miami, and continued to a successful startup with Tropicana Cruises; one of the first gaming ships out of the Port of Miami. Mr. Kyriakides founded Regency Cruise Line in 1984, as the world’s first publicly traded company in passenger shipping, and served as its Chairman and Secretary until 1987. Mr. Kyriakides also organized the successful start-up of Seawind Cruise Line. In his three years with Seawind Cruise Line, Mr. Kyriakides served as its founder, chairman, chief executive officer and secretary.

 

27
 

 

From 1994 to 1996, Mr. Kyriakides served as the Chairman of Montgomery Ward Travel, a company created to provide full travel services to eight million Montgomery Ward customers and credit card holders. Immediately prior to joining the Company, Mr. Kyriakides served as Chief Executive Officer of Interlink Global Corporation from 1994 until September, 2008. Interlink Global Corporation provided telecommunications applications utilizing hardware and software that enables its domestic and worldwide users to access the internet as a transmission medium for placing telephone calls.

 

Kenneth Hosfeld, Director, Vice President. Mr. Hosfeld was appointed to serve on the Company’s board of directors in September 2008. Mr. Hosfeld has over twenty-two years of international sales, marketing, and business management experience in the telecommunications industry. Most recently, Mr. Hosfeld served as a member of the board of directors and the executive vice president for Interlink Global Corporation (OTC: ILKG), a provider of private and public telecommunication network and internet services. Prior to joining Interlink, Mr. Hosfeld co-founded NetExpress. He has also served as the Regional Director of Brazil, the Andinos, and the Caribbean for Tellabs, Inc., a global supplier to the dynamic telecommunications industry that designs, manufactures, markets and services voice, data a video transportation tools and networks. While with Tellabs, Mr. Hosfeld secured that company’s first “turn-key” contract which involved a complete, fully managed network deployment including all products and services and project financing. He also opened Tellabs’ offices in Brazil and regularly exceeded revenue targets. Prior to that, Kenneth was Vice President of Nera Latin America, a subsidiary of Nera Telecommunications (formerly ABB), a telecommunications and IT solutions provider for microwave, satellite, wireless broadband access, networking and broadcasting. Mr. Hosfeld had full production and logistic responsibility for the Latin American region, including responsibilities for opening offices throughout Latin America including such countries as Brazil, Colombia, Mexico, and Venezuela, While with the company, Mr. Hosfeld was also able to penetrate the Mexican and Chilean markets. Prior to his work with Nera Latin America, Mr. Hosfeld was responsible for similar product sales in Africa and in China. Mr. Hosfeld speaks over six languages including fluent Spanish and Portuguese. Immediately prior to joining the Company, Mr. Hosfeld served as Executive Vice President of Interlink Global Corporation from 1994 until September, 2008. Interlink Global Corporation provided telecommunications applications utilizing hardware and software that enables its domestic and worldwide users to access the internet as a transmission medium for placing telephone calls.

 

Guillermo Rodriguez, Director, Chief Financial Officer (Retired April 30,2013). Mr. Rodriguez was appointed to the Company’s board of directors in September 2008. Mr. Rodriguez was a certified public accountant. He earned his Bachelor’s Degree with a major in accounting and business administration from the University of Miami in Coral Gables, Florida. Mr. Rodriguez earned his Masters of Business Administration from Nova Southeastern University in Davie, Florida. He has extensive accounting and financial reporting experience in banking, real estate brokering, property management and the telecommunications industry. Prior to joining the Company in September 2008, Mr. Rodriguez worked for Interlink Global Corporation from 2005 until September 2008 and as controller and financial officer for Land Cellular Corporation from 2003 until 2005. Prior to that, Mr. Rodriguez served as controller and financial officer for Bremer Real Estate, CSW Associates and Consolidated Bank, N.A. Mr. Rodriguez also worked as an auditor and investigator for the Federal Deposit Insurance Corporation (FDIC). Mr. Rodriguez is fluent in Spanish. Effective April 30, 2013, Mr. Rodriguez retired as CFO of the Company. The Company is currently looking for a new CFO. The Company’s CEO, Anastasios Kyriakides has fulfilled that role for the time being.

 

Dr. George Gabb, Director.

 

Mr. Gabb has over 18 years of experience within the education field. Currently he oversees the Computer Information Systems department at Miami Dade College North Campus (“MDC”), covering a wide variety of programming languages. Mr. Gabb has been with MDC since 1998 and has a total of 18 years of experience within the education field. Prior to his stay at MDC, he held a variety of Director-level academic IT-related positions. In addition to his academic background, Mr. Gabb is a member of the Florida Bar. He holds a B.S. in Psychology, M.S. in Computer Information Systems, and a J.D. from Nova Southeastern University.

 

Shad Stastney, Director(Resigned June 6, 2013)

 

Mr. Shadron Lee Stastney is a founding partner of Vicis Capital LLC. He graduated from the University of North Dakota in 1990 with a B.A. in Political Theory and History, and from Yale Law School in 1994 with a J.D. focusing on corporate and tax law. From 1994 to 1997, he worked as an associate at Cravath, Swaine and Moore in New York, where he worked in the tax group and in the corporate group, focusing on derivatives. In 1997, he joined CSFB’s then-combined convertible/equity derivative origination desk. From 1998 through 2001, he worked in CSFB’s corporate equity derivatives origination group, eventually becoming a Director and Head of the Hedging and Monetization Group, a joint venture between derivatives and equity capital markets. In 2001, he jointly founded Victus Capital Management, LP, and in 2004, he jointly founded Vicis. Mr. Stastney also jointly founded Vicis Capital Management LLC in 2001. Mr. Stastney has been a director of QHP Financial Group, Inc. since February 2010, China Hydro since January 2010, Master Silicone Carbide since September 2008, Amacore Holdings, Inc. since August 2008, Care Media since April 2007, China New Energy since August 2008, Zurvita Holdings, Inc. since March 2010, Age of Learning since March 2010 and OptimizeRX Corporation since July 2010. Mr. Stastney was a director of Medical Solutions Management from October 2007 to January 2009 and MDWerks from May 2008 to August 2009. Mr. Stastney resigned as a Member of the Board of Directors effective June 6, 2013.

 

28
 

 

Significant employees

 

Other than the executive officers named above, the Company does not have any “significant employees.”

 

Family relationship – NONE.

 

Involvement in legal proceedings

 

No officer, director, promoter or significant employee has been involved in the last five years in any of the following:

 

Any bankruptcy petition filed by or against any business of which such person was a general partner or executive officer either at the time of the bankruptcy or within two years prior to that time;
Any conviction in a criminal proceeding or being subject to a pending criminal proceeding (excluding traffic violations and other minor offenses);
Being subject to any order, judgment, or decree, not subsequently reversed, suspended or vacated, of any court of competent jurisdiction, permanently or temporarily enjoying, barring, suspending or otherwise limiting his involvement in any type of business, securities or banking activities; and
Being found by a court of competent jurisdiction (in a civil action), the Commission or the Commodity Futures Trading Commission to have violated or state securities or commodities law, and the judgment has not been reversed, suspended or vacated.

 

Committees

 

Our business, property and affairs are managed by or under the direction of the board of directors. Members of the board are kept informed of our business through discussion with the chief executive and financial officers and other officers, by reviewing materials provided to them and by participating at meetings of the board and its committees. We presently do not have any committees of our board of directors, however, our board of directors intends to establish various committees at some point in the future.

 

Employment Agreements

 

On May 16, 2011, we executed an Amended Employment Agreement with Mr. Kyriakides our Chief Executive Officer and President as follows:

 

Salary set at $250,000 per year starting on January 1, 2012. Three year term with automatic renewal of two years.

 

Change of control cash payment set at $1,500,000

 

Currently, with the exception of Mr. Kyriakides Employment Agreement, all other employment with the Company is at will and may be terminated by either the employee or the Company at any time. We require each of our three executive officers to execute a Confidentiality and Non-Competition Agreement.

 

Compliance with Section 16(a) of the Exchange Act

 

Section 16(a) of the Securities Exchange Act of 1934 requires our directors and executive officers and persons who beneficially own more than ten percent of a registered class of our equity securities to file with the SEC initial reports of ownership and reports of change in ownership of common stock and other equity securities of our company. Officers, directors and greater than ten percent stockholders are required by SEC regulations to furnish us with copies of all Section 16(a) forms they file. Based solely upon a review of Forms 3 and 4 and amendments thereto furnished to us under Rule 16a-3(e) during the year ended December 31, 2012, and Forms 5 and amendments thereto furnished to us with respect to the year ended December 31, 2012, we believe that during the year ended December 31, 2012, our executive officers, directors and all persons who own more than ten percent of a registered class of our equity securities have complied with all Section 16(a) filing requirements.

 

29
 

 

Code of Ethics

 

We have adopted and previously filed a Code of Ethics for our officers, directors and employees.

 

Material Changes to Nominations by Security Holders of Director Candidates

 

In the past fiscal year, there has been no material change to the procedures by which security holders may recommend nominees to the small business issuer’s board of directors.

 

Audit Committee

 

We do not currently have a standing audit committee. The Company’s Chief Executive Officer is actively researching candidates for membership on the Board of Directors who would be “independent” and who, accordingly, could serve on an audit committee. The entire Board of Directors is currently performing the equivalent functions of an audit committee, none of whom have been determined to be an “audit committee financial expert.”

 

Audit Committee Financial Expert

 

We do not currently have an “audit committee financial expert” as defined under Item 407(e) of Regulation S-K. As discussed above, our Board of Directors plans to form an Audit Committee. In addition, the Board is actively seeking to appoint an individual to the Board of Directors and the Audit Committee who would be deemed an audit committee financial expert.

 

Item 11. Executive compensation

 

Compensation of our executive officers

 

The following table contains compensation information for our executive officers for the period ended December 31, 2012 and December 31, 2011. No other officer received compensation greater than $100,000 for either fiscal year. All of the information included in this table reflects compensation earned by the individuals for services rendered to our Company and all references in the following tables to stock awards relate to awards of common stock granted by us.

 

Name and Position  Year
ended
Dec
31,
   Salary   Common Stock Awards   Total 
Anastasios Kyriakides, Director,   2012   $258,600(2)  $0(3)  $258,600 
Chief Executive Officer (1)   2011   $190,000(2)  $0(3)  $190,000 
Kenneth Hosfeld, Director,   2012   $96,000(8)  $0(9)  $96,000 
Vice President (7)   2011   $96,000(8)  $0(9)  $96,000 
Guillermo Rodriguez, Director,   2012   $65,000(5)  $0(6)  $65,000 
Chief Financial Officer (4)(4b)   2011   $65,000(5)  $0(6)  $65,000 

 

(1)Mr. Kyriakides was appointed to serve as our Chief Executive Officer on September 10, 2008.

 

(2)Mr. Kyriakides annual salary increased to $250,000 at January 1, 2012 per his amended employment agreement dated May 16, 2011.

 

(3)No stock grants given for the years ended December 31, 2012 and 2011.

 

(4)Mr. Rodriguez was appointed to serve as Chief Financial Officer on September 30, 2008.
   
 (4b)Effective April 30, 2013, Mr. Rodriguez retired as CFO of the Company.

 

(5)Mr. Rodriguez annual salary is $65,000.

 

(6)No stock grants given for the years ended December 31, 2012 and 2011.

 

(7)Mr. Hosfeld was appointed to serve as our Vice President on September 30, 2008.

 

(8)Mr. Hosfeld annual salary is $96,000.

 

(9)No stock grants given for the years ended December 31, 2012 and 2011.

 

30
 

 

Overview

 

The following is a discussion of our program for compensating our named executive officers and directors. Currently, we do not have a compensation committee, and as such, our board of directors is responsible for determining the compensation of our named executive officers. The primary goal of our executive compensation policy is to attract and retain the most talented and loyal executives possible. Our intent is to ensure that our executives are compensated effectively in a manner consistent with our strategy and competitive practice and to align executive compensation with the achievement of our short and long term business objectives.

 

 Our board of directors considers a variety of factors in determining compensation of executives including the executive’s background, training and prior work experience.

 

Elements of executive compensation

 

Our compensation program for the named executive officers consists primarily of base salary. There is no bonus plan or retirement plan. Except for 2012 Stock Option Plan described in Item 4 above, we have no long-term incentive plan or other such plans. The base salary we provide is intended to equitably compensate the named executive officers based upon their level of responsibility, complexity and implementation of our business plan.

 

Compensation of Directors

 

None of the Company’s directors have received any additional cash or equity remuneration since inception for their services as Directors except for Dr. George Gabb, one of the Company’s Board of Directors, who received 75,000 shares of stock valued at $563 during the year ended December 31, 2011 and Shad Stastney, another Director, who received 3,250,000 shares of stock valued at $3,250.

 

Director Independence

 

Our board of directors has determined that currently none of it members qualify as “independent” as the term is used in Item 407 of Regulation S-K as promulgated by the SEC and in the listing standards of The Nasdaq Stock Market, Inc. - Marketplace Rule 4200, except for Dr. George Gabb.

 

Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

 

The following table sets forth certain information, as of December 31, 2012 with respect to the beneficial ownership of the outstanding common stock by (i) any holder of more than five (5%) percent; (ii) each of our executive officers and directors; and (iii) our directors and executive officers as a group. Except as otherwise indicated, each of the stockholders listed below has sole voting and investment power over the shares beneficially owned.

 

Title  Name of beneficiary  Amount and nature of owner   Percent 
Common stock  Anastasios Kyriakides   20,126,500(3)   13%
Common stock  Kenneth A. Hosfeld   2,238,000    1%
Common stock  Guillermo Rodriguez (Retired)   2,483,000    1%
Common stock  Dr. George Gabb   106,000    1%
Common stock  Shad Stastney (Resigned)   3,250,000    2%
Executive officers and directors (5 persons)     28,203,500   18%
Common stock  Vicis Capital Master Fund   116,859,612(4)   74%
Total Common stock of officers, directors and beneficial owners      145,063,112    92%

 

31
 

 

(1)Unless otherwise indicated, the address of each shareholder is 1080 NW 163rd Drive, Miami, Florida 33169. Vicis Capital Master Fund is located in New York, NY.

 

(2)Beneficial ownership of shares is determined under Rule 13d-3(d)(1) of the Exchange Act and generally includes any shares over which a person exercises sole or shared voting or investment power and the number of shares that can be acquired within sixty (60) days upon exercise of an option or conversion of warrants and debentures. Common stock subject to these convertible securities are deemed to be outstanding for the purpose of computing the ownership percentage of the person holding such convertible security, but are not deemed to be outstanding for the purpose of computing the ownership percentage of any other person. Applicable percentage of ownership is based on 158,173,834 of fully diluted shares of Net Talk.com, Inc. common stock being issued and outstanding as of December 31, 2012. Calculations do not include outstanding warrants or options, or other rights issued by the Company, unless the reporting person is the beneficial owner of the warrants, options, or other rights.

 

(3)Includes 20,126,500 shares of common stock owned by Kyriakides Investments, LLC.

 

(4)Includes: 19,995,092 shares of common stock, 20,000,000 shares of common stock issuable upon conversion of 12% Redeemable preferred stock. It also includes 76,864,520 shares of common stock issuable upon exercise of Common Stock Purchase Warrants, which may be exercised, at the option of the holder, at an exercise price of $0.50 per share. Vicis Capital LLC serves as the investment advisor to Vicis Capital Master Fund. For purposes of Rule 13d-3 under the Securities Exchange Act of 1934, as amended, Vicis Capital LLC may be deemed to beneficially own, but has disclaimed ownership of, all shares owned by Vicis Capital Master Fund. The voting and dispositive power granted to Vicis Capital LLC by Vicis Capital Master Fund may be revoked at any time. Shadron Stastney, a member of Vicis Capital LLC and its chief operating officer, together with John Succo and Sky Lucas, have voting and dispositive control over these securities. No single natural person can exercise voting or investment power with respect to the securities owned by Vicis Capital Master Fund, and investment decisions with respect to these securities are made by a majority of these persons. The address for Vicis Capital Master Fund and Mr. Stastney is 445 Park Avenue, Suite 1901, New York, New York 10022.

 

Item 13. Certain relationships and related transactions, and director independence

 

There were no transactions since the beginning of our last fiscal year, and there are no proposed transactions, that involve amounts in excess of the lesser of $50,000 or 1% of the average of our total assets during our two most recently completed fiscal years, to which we were or are to become a party in which any director, executive officer, beneficial owner of more than five (5%) percent of our common stock, or members of their immediate families had, or is to have, a direct or indirect material interest, except, during the period ended December 31, 2012 we incurred and paid certain consulting service fees to a related party.

 

2012 Issuance of Non-Convertible Debentures

 

On March 29, 2012, we issued a face value $500,000, 10% senior secured debenture, due June 30, 2012, extended to December 31, 2013

 

On April 20, 2012, we issued a face value $500,000, 10% senior secured debenture, due June 30, 2012, extended to December 31, 2013.

 

On June 26, 2012, we issued a face value $450,000, 10% senior secured debenture, due June 30, 2012, extended to December 31, 2013.

 

During the year ended December 31, 2012, we received advances in the total amount of $1,150,000, as part of a series of 10% senior secured debentures, due December 31, 2013, issued to our largest investor.

 

During the year ended December 31, 2012, we received advances in the total amount of $275,000, represented by Demand Notes, issued to our largest investor.

  

32
 

 

Item 14. Principal Accountant Fees and Services

 

Pre-Approval Policies and Procedures

 

The Company's board of directors reviews and approves audit and permissible non-audit services performed by its independent accountants, as well as the fees charged for such services. In its review of non-audit service fees and its appointment of Thomas Howell Ferguson P. A., as the Company's independent accountants, the board of directors considered whether the provision of such services is compatible with maintaining independence. All of the services provided and fees charged by Thomas Howell Ferguson P. A., were approved by the board of directors.

 

Audit Fees

 

The aggregate fees billed by Meeks International, LLC for professional services for the audit of the annual financial statements of the Company and the reviews of the financial statements included in the Company's quarterly reports on Form 10-Q for 2012 was $30,000, of which $24,000 was paid to Meeks International, LLC and $6,000 to Thomas Howell Ferguson P. A.

 

Audit-Related Fees

 

There were no other fees billed during the last two fiscal years for assurance and related services that were reasonably related to the performance of the audit or review of the Company's financial statements and not reported under "Audit Fees" above.

 

Tax Fees

 

There were no fees paid for tax or consulting services for the year ended December 31, 2012.

 

All Other Fees

 

There were no other fees billed during the last three years for products and services provided.

 

Part IV

 

Item 15. Exhibits, financial statement schedules

 

Exhibit No.Description
10.1Form 8 K’s previously filed – Article of Incorporation, Amendment to Articles of Incorporation, Corporate By Laws, issuances of Senior debentures and material agreements , previously reported during last two years.
31.1Certification of Principal Executive Officer pursuant to 13a-14(a) under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2Certification of Principal Financial Officer pursuant to 13a-14(a) under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1Certification of the Principal Executive Officer pursuant to U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2Certification of the Principal Financial Officer pursuant to U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 

33
 

 

SIGNATURES

 

In accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

  NET TALK.COM, INC.
   
Date: September 4, 2013 By: /s/ Anastasios Kyriakides
  Anastasios Kyriakides
  Chief Executive Officer (Principal Executive Officer)
   
Date: September 4, 2013 By: /s/ Anastasios Kyriakides
  Anastasios Kyriakides
 

Chief Financial Officer (Principal Financial Officer and

Principal Accounting Officer)

 

POWER OF ATTORNEY

 

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Each person whose signature appears below hereby authorizes Anastasios Kyriakides or either of them acting in the absence of the other as his or her true and lawful attorney-in-fact and agent, with full power of substitution and re-substitution for him or her and in his or her name, place and stead, in any and all capacities to sign any and all amendments to this report, and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission.

 

Name   Position
     
/s/ Anastasios Kyriakides   Chief Executive Officer (Principal Executive Officer)
Anastasios Kyriakides   and Director
     
/s/ Anastasios Kyriakides   Chief Executive Officer (Principal Executive Officer)
Anastasios Kyriakides   and Director
     
/s/ Kenneth Hosfeld   Vice President and Director
Kenneth Hosfeld    

 

34
 

 

Index to financial statements Page
   
Reports of Independent Registered Public Accountant 36
Balance sheets as of December 31, 2012 and 2011 38
Statements of operations for the year ended December 31, 2012, three months ended December 31, 2011and fiscal years ended September 30, 2011 and 2010 39
Statements of cash flows for the year ended December 31, 2012, three months ended December 31, 2011 and fiscal years ended September 30, 2011 and 2010 40
Statements of stockholders’ deficit for the year ended December 31, 2012, three months ended December 31, 2011 and fiscal years ended September 30, 2011 and 2010. 41
Notes to financial statements 42

 

35
 

 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

To the Board of Directors and Stockholders of

 

NetTalk.com, Inc.

Miami Gardens, Florida

 

We have audited the accompanying balance sheet of NetTalk.com, Inc. as of December 31, 2012 and the related statement of operations, stockholders’ deficit, and cash flows for the year then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit.

 

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

 

In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of NetTalk.com, Inc. at December 31, 2012, and the results of its operations, and its cash flows for the year then ended, in conformity with U. S. generally accepted accounting principles .

 

The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 2 of the accompanying financial statements, the Company has incurred significant recurring losses from operations its total liabilities exceeds its total assets, and is dependent on outside sources of funding for continuation of its operations. These factors raise substantial doubt about the Company’s ability to continue as a going concern. Management’s plans in regard to these matters are also described in Note 2. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.

 

/s/ Thomas Howell Ferguson P. A.

Tallahassee, Florida

 

September 4, 2013

 

36
 

 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

To the Board of Directors and Stockholders of

 

NetTalk.com, Inc.

Miami Gardens, Florida

 

We have audited the accompanying balance sheet of NetTalk.com, Inc. as of December 31, 2011 and the related statement of operations, stockholders’ deficit, and cash flows for the three month period ended December 31, 2011 and each of the two years in the period ended September 30, 2011.These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit.

 

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

 

In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of NetTalk.com, Inc. at December 31, 2011, and the results of its operations, changes in its stockholder’s deficit and their cash flows for the three months period ended December 31, 2011, and each of the two years in the period ended September 30, 2011, in conformity with U. S. generally accepted accounting principles.

 

/s/ Meeks International, LLC.

Tampa, Florida

 

March 19, 2012

 

37
 

 

Nettalk.com Inc.

Balance Sheets

 

   December 31,   December 31, 
   2012   2011 
Assets          
Current assets:          
Cash and cash equivalents  $96,347   $1,539,263 
Restricted cash   115,259    98,877 
Accounts receivable, net   472,233    576,160 
Inventory   1,467,774    2,205,255 
Prepaid expenses   277,908    3,511 
Note receivable   7,000    43,000 
Total current assets   2,436,521    4,466,066 
           
Building, telecommunications equipment, land and other property, net   2,980,068    3,000,039 
Intangible assets, net   193,007    132,364 
Other assets   37,253    39,754 
Total assets  $5,646,849   $7,638,223 
           
Liabilities, redeemable preferred stock and stockholders' deficit          
Current liabilities:          
Accounts payable  $2,211,622   $888,993 
Accrued dividends   1,301,116    701,116 
Accrued expenses   477,743    532,159 
Deferred revenue   2,246,052    1,683,948 
Current portion of senior debentures and demand notes   15,640,336    2,211,483 
Total current liabilities   21,876,869    6,017,699 
           
Senior debentures   -    3,783,692 
Mortgage payable   1,000,000    - 
Total liabilities   22,876,869    9,801,391 
           
Redeemable preferred stock, $.001 par value, 10,000,000 shares authorized, 500 and 300 issued and outstanding as of December 31, 2012 and December 31, 2011.   6,379,016    10,382,957 
           
Stockholders' deficit:          
Common stock, $.001 par value, 300,000,000 authorized, 60,251,355 and 39,464,892 issued and outstanding as of December 31, 2012 and December 31, 2011.   60,260    39,465 
Additional paid in capital   33,084,420    29,453,120 
Accumulated deficit   56,753,716    (42,038,710)
Total stockholders' deficit   (23,609,036)   (12,546,125)
           
Total liabilities, redeemable preferred stock and stockholders' deficit  $5,646,849   $7,638,223 

 

The accompanying notes are an integral part of the financial statements

 

38
 

 

Nettalk.com, Inc

Statements of Operations

 

       Three months         
   Year ended   ended         
   December 31,   December 31,   Year ended September 30, 
   2012   2011   2011   2010 
Revenues                    
Sale of DUO products  $2,067,983   $756,675    1,676,436    641,837 
Renewals and access charges   3,509,282    482,093    729,333    19,289 
Other   213,718    59,855    314,696    76,372 
Total revenue   5,790,983    1,298,623    2,720,465    737,498 
Cost of sales                    
Cost of DUO products   2,698,971    931,322    1,620,605    797,916 
Network and carrier charges   2,924,180    446,110    692,793    401,324 
Other   561,637    410,383    784,968    254,092 
Total cost of sales   6,184,787    1,787,815    3,098,366    1,453,332 
Gross margin   (393,804)   (489,192)   (377,901)   (715,834)
Advertising and marketing   1,019,882    606,209    1,701,490    357,413 
Compensation and benefits   1,692,237    289,652    1,262,994    477,576 
Professional fees   884,580    136,118    235,756    255,471 
Depreciation and amortization   262,842    60,765    356,688    363,335 
Research and development   1,211,711    270,782    903,369    375,197 
General and administrative expenses   2,614,408    497,986    1,484,971    547,075 
Total operating expenses   7,685,660    1,861,512    5,945,268    2,376,067 
Loss from operations   (8,079,464)   (2,350,704)   (6,323,169)   (3,091,901)
Other income (expenses):                    
Interest expense   (3,500,512)   (1,090,735)   (1,070,522)   (1,058,363)
Derivative (expense)   -    -    (17,280,018)   1,445,632 
Debt extinguishment (loss)   (3,135,235)   -    (1,293,538)   (3,617,983)
Interest income   205    1,153    4,160    15,652 
Loss on sale of assets        -    (213,478)   - 
    (6,635,542)   (1,089,582)   (19,853,396)   (3,215,062)
Net loss   (14,715,006)   (3,440,286)   (26,176,565)   (6,306,963)
Reconciliation of net loss applicable to common stockholders:                    
Accretion of preferred stock   -    -    (923,778)   (93,000)
Preferred stock dividends   -    -    (586,667)   - 
Loss applicable to common stockholders  $(14,715,006)  $(3,440,286)  $(27,687,010)  $(6,399,963)
Loss per common shares:                    
Basic and diluted earnings per common share  $(0.28)  $(0.09)  $(1.40)  $(0.60)
Weighted average shares:                    
Basic and diluted   52,733,460    39,464,892    19,792,214    10,654,797 

 

The accompanying notes are an integral part of the financial statements

 

39
 

 

Nettalk.com, Inc.

Statements of Cash Flows

 

       Three months         
   Year ended   ended         
   December 31,   December 31,   Year ended September 30, 
   2012   2011   2011   2010 
Cash flow (used) in operating activities:                    
Net loss  $(14,715,006)  $(3,440,286)  $(26,176,565)  $(6,306,963)
Adjustments to reconcile net loss to net cash (used) in operations:                    
Depreciation   193,249    43,992    139,464    124,709 
Amortization   69,593    16,773    217,224    238,627 
Debt extinguished   3,135,235    -    1,293,538    3,617,983 
Amortization of debt discount   -    932,752    331,605    551,745 
Cancellation of shares for services   -    -    (223,361)   111,286 
Derivative value adjustment   3,034,926    -    17,280,018    (1,445,632)
Warranty expense        -    -    3,650 
Bad debt        -    -    21,708 
Changes in assets and liabilities:                    
Accounts receivables   103,927    120,180    (696,302)   25,610 
Prepaid expenses and other assets   (238,397)   10,309    233,831    (233,644)
Inventories   737,481    (293,607)   (1,343,088)   (450,848)
Deferred revenues   562,104    661,055    929,984    82,864 
Accounts payable   1,322,629    (312,334)   666,604    269,814 
Accrued expenses   545,584    224,245    246,399    510,547 
Net cash (used) in operating activities   (5,248,675)   (2,036,921)   (7,100,649)   (2,878,544)
Cash flow used in investing activities:                    
Restricted cash   (16,382)   41,543    1,877,235    (2,017,655)
Acquisition of corporate offices and operations center and  fixed assets   (303,514)   (48,808)   (2,608,069)   (38,012)
Decrease in deposits   2,501    -    (16,753)   1,497 
Net cash (used) in investing activities:   (317,395)   (7,265)   (747,587)   (2,054,170)
Cash flow from financing activities:                    
Notes payables - debentures   2,875,000    -    10,500,000    - 
Mortgage payable   1,000,000    -    -    - 
Payment on loans from officers             -    (56,300)
Cash paid for dividends on preferred stock        -    (90,000)   - 
Issuance of common stock (net)   248,154    -    -    5,000,000 
Net cash provided from financing activities   4,123,154    -    10,410,000    4,943,700 
Net increase (decrease) in cash   (1,442,916)   (2,044,186)   2,561,764    10,986 
Cash and cash equivalents, beginning   1,539,263    3,583,449    1,021,684    1,010,698 
Cash and cash equivalents, ending   96,347   $1,539,263    3,583,448    1,021,684 
Supplemental disclosures:                    
Cash paid for interest  $-   $-   $149,953   $- 
Cash paid for income taxes  $-   $-   $-   $- 
Cash paid for preferred stock dividends  $-   $-   $90,000   $125,000 

 

The accompanying notes are an integral part of the financial statements

 

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Nettalk.com, Inc.

Statement of Stockholders’ Deficit

  

   Preferred Stock   Common Stock   Additional Paid   Accumulated   Total 
   Shares   Amount   Shares   Amount   Capital   Deficit   Equity 
Balance at October 1, 2009   -   $-    9,719,800   $9,720   $3,458,825   $(5,242,577)  $(1,774,032)
Preferred stock to be issued at future date   4,000    2,000,000    -    -    -         2,000,000 
Issuance of preferred shares   -    -    -    -    (251,912)   (689,319)   (941,231)
Preferred stock dividends   -    -    -    -    -    (183,000)   (183,000)
Stock issuance from stock option plan   -    -    3,709,500    3,710    107,575    -    111,285 
Net loss   -    -    -    -    -    (6,306,963)   (6,306,963)
Balance at September 30, 2010   4,000    2,000,000    13,429,300    13,430    3,314,488    (12,421,859)   (7,093,941)
                                    
Cancellation of common shares for services   -    -    (1,000,000)   (1,000)   (249,000)   -    (250,000)
Accretion of preferred stock   -    -    -    -    (2,782,132)   -    (2,782,132)
Reclass of preferred stock to mezzanine and derivative liabilities   (4,000)   (2,000,000)                       (2,000,000)
Preferred stock dividends   -    -    -    -    (586,667)   -    (586,667)
Settlement shares             750,000    750    366,750         367,500 
Reclassification of warrants from liability to equity   -    -    -    -    6,963,800    -    6,963,800 
Conversion of convertible notes to common stock   -    -    19,995,092    19,995    13,776,618    -    13,796,613 
Inducement warrants to convert debt to equity   -    -    -    -    390,800    -    390,800 
Modification of Mezzanine preferred stock and compound embedded derivatives treated as an extinguishment   -    -    -    -    553,391    -    553,391 
Settlement of accrued interest   -    -    -    -    416,014    -    416,014 
Warrants issued with debt financings   -    -    -    -    6,053,418    -    6,053,418 
Stock issuance related to 2010 stock option plan   -    -    6,290,500    6,290    40,895    -    47,185 
Net loss   -    -    -    -    -    (26,176,565)   (26,176,565)
Balance at September 30, 2011   -    -    39,464,892    39,465    28,258,375    (38,598,424)   (10,300,584)
                                    
Accretion of preferred stock   -    -    -    -    1,194,745    -    1,194,745 
Net loss   -    -    -    -    -    (3,440,286)   (3,440,286)
Balance at December 31, 2011   -    -    39,464,892   $39,465   $29,453,120   $(42,038,710)  $(12,546,125)
New common shares   -    -    20,786,463    20,795    227,359    -    248,154 
Accretion of preferred stock   -    -    -    -    3,403,941    -    3,403,941 
Net loss   -    -    -    -    -    (14,715,006)   (14,715,006)
Balance at December 31, 2012   -    -    60,251,355   $60,260   $33,084,420   $(56,753,716)  $(23,609,036)

 

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NetTALK.COM, INC.

Notes to Financial Statements

 

Note 1 – Nature of operations and basis of presentation:

 

NetTalk.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, DUO II and DUO WIFI, they are analog telephone adapters that provides connectivity for analog telephones and faxes to home, home office or corporate local area networks (“LAN”). The DUO WIFI can connect to an internet hotspot without the use of an Ethernet cable. Our DUO, DUO II and DUO WIFI 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, DUO II and DUO WIFI provide one USB port, one Ethernet port and one analog telephone port. The DUO WIFI offers an additional wireless chip that allows it to connect to internet hotspots without the use of an ethernet cable. A full suite of internet protocol features is available to maximize universal connectivity. In addition, analog telephones attached to our DUO. DUO II 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.

 

Note 2 – Going concern and management’s plans:

 

The presentation of financial statements in accordance with generally accepted accounting principles contemplates that operations will be sustained for a reasonable period. However, we have incurred operating losses of $14,715,006 and $28,389,302 during the years ended December 31, 2012 and 2011, respectively. The company is also highly leverage with $15.6 million senior debentures and demand notes and $1.4 million in mortgage debt. In addition, during these periods, we used cash of $5,248,675 and $7,577,533, respectively, in support of our operations. As more fully discussed in Note 6, we have material redemption requirements associated with our senior debentures and demand notes, during the year ended December 31, 2013. Since our inception, we have been substantially dependent upon funds raised through the sale of preferred stock and warrants to sustain our operating and investing activities. These are conditions that raise substantial doubts about our ability to continue as a going concern for a reasonable period.

 

If future defaults occur under the senior debentures or mortgage agreement, the Company does not anticipate having sufficient cash and cash equivalents to repay the debt under these agreements should it be accelerated and would be forced to restructure these agreements and/or seek alternative sources of financing. There can be no assurances that restructuring of the debt or alternative financing will be available on acceptable terms or at all. In the event of an acceleration of the Company’s obligations under the senior debentures or mortgage agreement and the Company’s failure to pay the amounts that would then become due, the senior debenture lender and mortgage agreement lender could seek to foreclose on the Company’s assets.

 

In order for the Company to meet the debt repayment requirements under the senior debentures and mortgage agreement, the Company will need to raise additional capital by refinancing its debt, raising equity capital or selling assets. Uncertainty in future credit markets may negatively impact the Company’s ability to access debt financing or to refinance existing indebtedness in the future on favorable terms, or at all. If additional capital is raised through the issuance of debt securities or other debt financing, the terms of such debt may include different financial covenants, restrictions and financial ratios other than what the Company currently operates under. Any equity financing transaction could result in additional dilution to the Company’s existing stockholders.

 

In January 2013 the company received $400,000 of funding from an additional advance on a promissory note from the mortgage from 1080 NW 163 Drive, LLC. Notwithstanding the additional funding, our ability to continue as a going concern for a reasonable period is dependent upon achieving our management’s plan for the company generating profitable operations. We cannot give any assurances regarding the success of management’s plan. Our financial statements do not include any adjustments relating to recoverability of recorded assets or liabilities that may be necessary should we be unable to continue as a going concern.

 

Note 3 – Summary of Significant Accounting Policies:

 

Change in Fiscal Year

 

On May 26, 2011, the Company’s Board of Directors approved a change in the Company’s fiscal year end from September 30, to December 31, effective December 31, 2011. Unless otherwise noted, all references to “years” of “fiscal” refer to the twelve-month fiscal year, which prior to October 1, 2011 ended on September 30. As a result of this change, the financial statements include the Company’s financial results for the three month transition period of October 1, 2011 to December 31, 2011.

 

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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, 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.

 

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 product the NetTalk DUO (“DUO”), telecommunication service revenues and shipping and handling revenues.

 

Our DUO 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 is 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 did not exceed the FDIC limits at December 31, 2012 and 2011.

 

Inventory

 

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

 

   December 31, 
Inventory  2012   2011 
         
Productive material and supplies  $869,740    1,186,916 
Finished goods   598,034    1,018,339 
Total  $1,467,774   $2,205,255 

 

During the year ended December 31, 2012 and 2011, in accordance with our lower of cost or market analyses, we did not record lower of cost or market adjustment to our finished goods inventories.

 

Of our $598,034 of finished goods inventory at December 31, 2012, $140,200 is held on consignment at one of our distributors.

 

Of our $1,018,339 of finished goods inventory at December 31, 2011, $170,402 was held on consignment at one of our distributors.

 

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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 range from three to five years. The costs associated with major improvements are capitalized while the cost of maintenance and repairs is charged to operating expenses.

 

Intangible Assets

 

Our intangible assets were recorded at our acquisition cost, which encompassed estimates of 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 are incurred internally in creating a computer software product which 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. Research and development costs reported in our financial statements relate to pre–marketing costs of new upcoming products.

 

   Year ended   Period ended   Fiscal year ended 
   12/31/2012   12/31/2011   09/30/2011   09/30/2010 
Components of Research and development:                    
Product development and engineering  $88,917   $8,650   $405,645   $119,933 
Payroll and benefits   1,122,794    262,132    497,724    255,264 
Total  $1,211,711   $270,782   $903,369   $375,197 

 

Reclassifications

 

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

 

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 is 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, 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 provide 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.

 

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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 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 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 adjusted for ownership restrictions.

 

Summary of 2010 Stock Option Plan Issuances:

 

July 26, 2010   3,709,500 
May 23, 2011   3,890,000 
July 26, 2011   2,400,500 
Total   10,000,000 

 

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, 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 provide 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 adjusted for ownership restrictions.

 

On May 28, 2012, we issued 15,488,000 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 adjusted for ownership restrictions.

 

On July 25, 2012, we issued 1,028,500 shares of common stock to our employees and vendors 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.

 

Summary of 2011 Stock Option Plan Issuances:

 

January 6, 2012   3,483,500 
May 28, 2012   15,488,000 
July 25, 2012   1,028,500 
Total   20,000,000 

 

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2012 Stock Option Plan

 

On July 25, 2012, NetTalk adopted the 2012 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, 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 provide 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 July 25, 2012, we issued 471,500 shares of common stock to our employees and vendors as part of our 2012 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 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 fair values.

 

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.

 

Certain risks and concentration

 

Our manufacturing partner accounted for approximately 44% of our cost of goods sold and 0% of outstanding accounts payable at year ended December 31, 2012.

 

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

 

Redeemable Preferred Stock

 

Redeemable preferred stock is initially evaluated for possible classification as liabilities under ASC 480 Distinguishing Liabilities from Equity. 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 7 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, are all anti-dilutive and are excluded.

 

46
 

 

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 became effective in the second quarter of fiscal 2012. The adoption of this update did not have a material impact on our financial statements.

 

Note 4 – Building, Telecommunications Equipment, Land and Other Property:

 

Telecommunications equipment and other property consist of the following:     December 31, December 31, 
   Life  2012   2011 
            
Telecommunication equipment  7  $356,154   $335,340 
Computer equipment  5   166,408    121,944 
Building  35   2,448,364    2,448,364 
Building improvement  10   81,342    - 
Office equipment and furnishing  7   48,212    29,914 
Purchased software  3   34,147    25,787 
Land      270,000    270,000 
       3,404,627    3,231,349 
Less accumulated depreciation      (424,559)   (231,310)
Total     $2,980,068   $3,000,039 

 

Depreciation expenses amounted to $193,249 and $151,142 for the years ended December 31, 2012 and 2011, respectively.

 

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.

 

Note 5 - Intangible Assets:

 

Intangible assets consist of following:  Life  December 31, December 31, 
      2012   2011 
Trademarks  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 
Patents  20   102,942    27,942 
Finance Cost  2   55,236        
       982,224    851,988 
Less accumulated amortization      (789,217)   (719,624)
      $193,007   $132,364 

 

Amortization expenses amounted to $69,593 and $176,279 for the years ended December 31, 2012 and 2011, respectively.

 

Note 6 – Securities Option Agreement, Secured Convertible Debentures, Senior Debentures and Demand Notes :

 

Mortgage promissory note:

 

On November 29, 2012, we borrowed $1,000,000 from a lender and in exchange, the Company issued a 12% promissory note and a mortgage and security agreement. The 12% promissory note, among other matters, accrues interest at 12% per annum, is payable in full on November 29, 2014, and is secured by our corporate office building, located at 1080 NW 163rd Drive, Miami Gardens, FL 33169.

 

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At December 31, 2012, principal repayments requirements on mortgage payable were as follows:

 

For the year ended December 31,:    
     
2013  $0 
2014  $1,000,000 
   $1,000,000 

 

On January 11, 2013, we received an additional advance of $400,000 pursuant to its existing lending facility with 1080 NW 163rd Drive, LLC. The additional advance of $400,000 was endorsed by a promissory note which was consolidated with the initial advance of $1,000,000 from the mortgage on 1080 NW 163rd Drive, LLC. The consolidated promissory mortgage note has an aggregate principal balance of $1,400,000, accrues interest at 12% per annum, is payable in full on November 29, 2014, and is secured by our corporate office building, located at 1080 NW 163rd Drive, Miami Gardens, FL 33169.

 

Securities Option Agreement:

 

On June 30, 2012, we executed a Securities Option Agreement with Vicis Capital Master Fund (“Vicis”) whereby Vicis grants us an option to purchase and redeem all securities and debentures held by Vicis. The option becomes exercisable on the date that all principal and accrued interest on all debentures has been paid in full, and may be exercised at any time after initial exercise date through and including December 31, 2013 (expiration date). Upon exercise of the “option” the redemption price for the securities shall be an amount equal to $16,000,000 minus the sum of principal and accrued interest paid on all debentures held by Vicis. Upon exercise of the option, any and all unpaid dividends on the securities shall be surrendered and cancelled without payment of additional consideration.

 

Extension of Maturity Dates of Outstanding Non-Convertible Debentures:

 

On June 30, 2012, we entered into an agreement to modify our outstanding debentures solely to extend their maturity dates that originally ranged from June 30, 2012 to July 1, 2013 to December 31, 2013. There were no other material modifications to the debentures and the holders received no additional consideration to effect the modification. As a result of these modifications, we evaluated each debenture to determine whether the maturity extension constituted a substantial modification. Under current accounting standards, from a debtor’s perspective, a modification of a debt instrument is deemed equivalent to the exchange of debt instruments if the present value of the cash flows under the terms of the modified arrangement are at least 10 percent different from the present value of the remaining cash flows under the terms of the original debt instrument. In cases where the difference in cash flows exceeds this level, extinguishment accounting is prescribed. As a result of our calculations, we concluded that the present values, using the effective interest rates on the issuance dates, of our face value $5,266,130, $2,000,000, and $3,500,000 debentures exceeded the substantive threshold. Accordingly, the debentures were adjusted to their respective fair values of $6,150,160, $2,313,888, and $3,852,748 and a corresponding charge to income in the amount of $3,135,235 representing the extinguishment loss.

 

The fair values of the debentures were determined based upon their future cash flows, discounted at a credit-risk adjusted market interest rate of 7.4%.

 

2012 Issuance of Non-Convertible Debentures and Demand Notes

 

On March 29, 2012, we issued a face value $500,000, 10% senior secured debenture, due June 30, 2012, extended to December 31, 2013

 

On April 30, 2012, we issued a face value $500,000, 10% senior secured debenture, due June 30, 2012, extended to December 31, 2013.

 

On June 26, 2012, we issued a face value $450,000, 10% senior secured debenture, due June 30, 2012, extended to December 31, 2013.

 

During the year ended December 31, 2012, we received advances in the total amount of $1,150,000, as part of a series of 10% senior secured debentures, due December 31, 2013, issued to our largest investor.

 

During the year ended December 31, 2012, we received advances in the total amount of $275,000, represented by Demand Notes, issued to our largest investor.

 

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The carrying values our senior debentures and demand notes consisted of the following as of December 31, 2012 and December 31, 2011:

 

   December 31,   December 31, 
   2012   2011 
$2,000,000 face value 12% debenture, due December 31, 2013  $2,398,153   $941,762 
$3,500,000 face value 12% debenture, due December 31, 2013   3,993,053    2,211,483 
$5,266,130 face value 12% debenture, due December 31, 2013   6,374,130    2,841,930 
$ 500,000 face value 10% debenture, due December 31, 2013   500,000    - 
$ 500,000 face value 10% debenture, due December 31, 2013   500,000    - 
$ 450,000 face value 10% debenture, due December 31, 2013   450,000    - 
$1,150,000 advances on 10% debenture, due December 31, 2013   1,150,000    - 
$ 275,000 demand notes, due on demand   275,000    - 
Total  $15,640,336   $5,995,175 

 

At December 31, 2012, principal repayments requirements on senior debentures and demand notes were as follows:

 

For year ended December 31, 2013: senior debentures and demand notes  $15,640,336 

 

2011 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.

 

June 30, 2011 Financing, Debt Settlement, and Accrued Interest Settlement

 

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.

 

49
 

 

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 commenced on July 1, 2011.

 

2011 Conversion of All Outstanding Convertible Debentures:

 

On June 30, 2011, the holder of all of our secured convertible debentures issued in connection with 2010 Convertible Debenture Exchange (see discussion below) converted said 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 $13,796,613 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.

 

50
 

 

2010 Convertible Debenture Exchange:

 

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, originally issued in connection with our 2008 Convertible Debenture Financing and 2009 Convertible Debenture (see discussion below), and included the capitalization of $798,773 of accrued interest. The newly issued convertible debentures bore interest at 12%, which was payable at the earlier of the maturity date or the date that the debentures were converted, if ever. Such interest was payable at the Company’s option in cash or common stock at $0.25 per common share. The principal amount of the debentures was convertible into common stock at $0.25. Accordingly, the convertible debenture was indexed to 19,995,092 shares of our common stock.

 

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 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 

 

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.

 

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The principal amount of the debentures was initially payable on September 10, 2010 and the interest was payable quarterly, on a calendar quarter basis. While the debenture was outstanding, the investor had 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. Each such debenture was exchanged on February 24, 2010 for a new debenture issued by the Company.

 

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 bore interest at a rate of 12% per annum from the date of issuance until paid in full. Each such debenture was exchanged on February 24, 2010 for a new debenture issued by the Company. (see discussion above)

 

Midtown Partners & Co., LLC (“Midtown Partners”), a 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.

 

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 

 

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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. 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.

 

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.

 

Note 7 – Redeemable Preferred Stock and Stock Option Agreement:

 

Securities Option Agreement:

 

On June 30, 2012, we executed Securities Option Agreement with Vicis Capital Master Fund (“Vicis”) whereby Vicis grants us an option to purchase and redeem all securities and debentures then held by Vicis. The option becomes exercisable on the date that all principal and accrued interest on all debentures has been paid in full, and may be exercised at any time after initial exercise date through and including December 31, 2013 (expiration date).

 

Upon exercise of the “option” the redemption price for the securities shall be an amount equal to $16,000,000 minus the sum of principal and accrued interest paid on all debentures then outstanding.

 

In addition, upon exercise of the option, any and all unpaid dividends on the securities shall be surrendered and cancelled without payment of additional consideration.

 

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Redeemable preferred stock consists of the following as of:  December 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 December 31, 2012; redemption value $5,000,000, and 500 shares issued and outstanding at December 31, 2011; redemption value $5,000,000.          
Initial carrying value  $13,246,609   $13,246,609 
Accumulated accretion   (6,867,593)   (2,863,652)
Carrying values  $6,379,016   $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 (extended to December 31, 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%.

 

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.

 

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.

 

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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 8 – 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 stockholder’s 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:

 

   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     
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 7)   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 

 

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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.

 

The following table reflects the activity in our derivative liability balances from October 1, 2009 to December 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, 2012  $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.

 

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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 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%  

 

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%      

 

September 30, 2010  

Series D

Warrants

 

BD

Warrants

 

BD

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          

 

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Note 9 – Commitment and Contingencies:

 

On May 16, 2011, we executed an Amended Employment Agreement with Mr. Kyriakides our Chief Executive Officer and President as follows:

 

Salary set at $199,000 per year and $250,000 starting on January 1, 2012.

 

Three year term with automatic renewal of two years.

 

Change of control cash payment set at $1,500,000

 

On April 4, 2012, MagicJack Vocaltec Ltd. filed a complaint in 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 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. MagicJack Vocaltec Ltd. and NetTalk filed a Joint Stipulation and motion for the dismissal. Effective November 2012, the federal court has dismissed the entire case with prejudice, including all claims, counterclaims, defenses and causes of action.

 

On September 21, 2012, NetTalk.com, Inc. filed a complaint in United States District Court For the Southern District of Florida, Civil Action No.: 9:12-cv-81022-CIV-MIDDLEBROOK/BRANNON, against MAGICJACK VOCALTECLTD, MAGIJACK HOLDINGS CORPORATION f/k/a YMAX HOLDINGS CORPORATION and DANIEL BORISLOW, In the complaint, we allege patent infringement by the defendants, seeking injunctive relief and damages as a result of the alleged patent infringement by defendants.

 

On September 14, 2012, a supplier filed a complaint in the United States District Court for the Southern District of Florida, Case No.: 1:12-cv-23366-FAM, alleging breach of contract by the Company and seeking damages of not less than $473,319 due to such alleged breach. The supplier alleges in the complaint that Net Talk failed to pay for component parts manufactured for the Company’s products. The Company filed an answer to the complaint denying the supplier’s allegations and asserting affirmative defenses.

 

NetTalk reached a settlement with the supplier and as of December 31, 2012 we are in full compliance with said settlement.

 

On November 26, 2012, a supplier to the Client, Broadvox, LLC (“Broadvox”), filed a complaint in the Court of Common Pleas, Cuyahoga County, Ohio, Case No.: CV-12-796095, alleging breach of contract by the Company and seeking damages of not less than $111,701 due to such alleged breach. The Company and Broadvox entered into a settlement agreement providing for the payment of all past due amounts.

 

A Statement of Claim was served by DACS Marketing & Sponsorship Inc. on NetTalk.com Inc. on June 20, 2012. The claim is for $125,834.21 for amounts DACS claims is owing to it pursuant to its agreement as well as $126,000 for general damages for breach of contract.

 

A Statement of Defence was delivered on August 31, 2012, denying all claims.

 

The following offers to settle have been made by the parties but to date, the parties have not accepted any proposed offers:

 

1.November 7, 2012, NetTalk offered to settle the action by payment to DACS of $5,000.
2.December 18, 2012, DACS offered to settle the action by NetTalk paying to DACS the sum of $85,000.
3.December 27, 2012, NetTalk offered to settle the action by payment to DACS of $10,000.

 

To date, we have heard nothing further from the lawyer for DACS.

 

Note 10 - Related party:

 

During the year ended December 31, 2012 we incurred and paid consulting service fees of $62,100 to a related party.

 

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Note 11 – Income taxes:

 

Our income tax provision (benefit) for the year ended December 31, 2012, three months ended December 31, 2011 and fiscal years ended September 30, 2011 and 2011 consisted of the following:

 

Our effective tax rate differs from statutory rates, as follows:

 

   12/31/2012   12/31/2011   09/30/2011   09/30/2010 
Federal statutory rate   34.0%   34.0%   34.0%   34.0%
State rate, net of federal benefit   3.6%   3.6%   3.6%   3.6%
Derivative income   0.0%   4.3%   4.3%   4.3%
Change in valuation allowance   (37.6)%   (41.9)%   (41.9)%   (41.9)%
Effective tax rate   0.0%   0.0%   0.0%   0.0%

 

Deferred tax assets and (liabilities) reflects the net tax effect of temporary differences between the carrying amount of assets and liabilities for financial reporting purposes and amounts used for income tax purposes. Significant components of our deferred taxes are as follows:

 

   12/31/2012   12/31/2011   09/30/2011   09/30/2010 
Property and fixed assets  $(58,032)  $(34,102)  $(37,723)  $(62,704)
Reserves and accruals   8,554    8,554    8,554    8,554 
Net operating loss carry forwards   12,355,046    7,069,018    5,786,123    2,902,843 
    12,305,568    7,043,470    5,756,954    2,848,693 
Valuation allowance   (12,305,568)   (7,043,470)   (5,756,954)  $(2,848,693)
Net deferred taxes, after valuation allowance  $-   $-   $-   $- 

 

Our valuation allowance increased $5, 262,098 and $1,286,506 during the period ended December 31, 2012 and December 31, 2011, respectively.

 

Based on our prior earnings and insufficiency of income to be utilized in carry back years and future taxable income, we have concluded that it is more likely than not that these net deferred tax assets will not be utilized. Therefore, a valuation allowance has been set up to reduce deferred tax assets to zero. As of December 31, 2012, we have net operating loss carry forwards amounting to $35,490,620 that are available, subject to limitations, to offset future taxable income through 2031. The company is also not taking any uncertain tax position in the calculation of current or deferred taxes.

 

The Company files income tax returns for U. S. Federal and State of Florida purposes. The Company is not currently under any tax examination, but the statute of limitations has not yet expired. The company generally remains subject to examination of its U. S. Federal income tax returns for 2009 and subsequent years as the Internal Revenue Service has a three year window to assess/collect taxes. In addition, the company also remains subject to examination of its State of Florida tax returns for 2009 and subsequent years.

 

Note 12 – Subsequent Events:

 

On January 11, 2013, we received an additional advance of $400,000 pursuant to the existing lending facility with 1080 NW 163rd Drive, LLC. The additional advance of $400,000 was endorsed by a promissory note which was consolidated with the initial advance of $1,000,000 from the mortgage on 1080 NW 163rd Drive, LLC. The consolidated promissory mortgage note has an aggregate principal balance of $1,400,000, accrues interest at 12% per annum, is payable in full on November 29, 2014, and is secured by our corporate office building, located at 1080 NW 163rd Drive, Miami Gardens, FL 33169.

 

On February 15, 2013 and April 10, 2013 we received additional advances of $100,000 and $75,000 from 1080 NW 163rd Drive, LLC. These advances are not evidenced by a formal promissory note. The additional advances of $100,000 and $75,000 accrue interest at 8% per year, and were payable in full on June 9, 2013. These notes are now in default.

 

On February 19, 2013, August 9, 2013, August 14, 2013 and September 3, 2013, the Company’s CEO advanced the Company $25,000, $5,000, $20,000 and $25,000 respectively. These advances are not evidenced by a formal promissory note. These advances were for working capital and bear no interest and are due on demand.

 

On April 22, 2013 and May 3, 2013 we received advances from Vicis in the amount of $50,000 and $25,000, respectively, both due on demand. These advances are not evidenced by a formal promissory note.

 

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On May 31, 2013, we issued a $300,000 face value, 5% Secured Convertible Promissory Note, due December 1, 2013. This note is convertible into shares of the Company’s common stock at a rate of $0.08 per share, for a total of 3,750,000 common shares. This note has a second priority security interest, junior in priority only to the holder of the first priority interest, to all real property of the Company and any and all cash proceeds and/or noncash proceeds of any of the foregoing, including, without limitation, insurance proceeds, and all supporting obligations and the security therefore or for any right to payment.

 

On July 15, 2013, we issued a $200,000 face value, 5% Secured Convertible Promissory Note, due January 15, 2014. This note is convertible into shares of the Company’s common stock at a rate of $0.08 per share, for a total of 2,500,000 common shares. This note has a second priority security interest, junior in priority only to the holder of the first priority interest, to all real property of the Company and any and all cash proceeds and/or noncash proceeds of any of the foregoing, including, without limitation, insurance proceeds, and all supporting obligations and the security therefor or for any right to payment.

 

On July 7, 2013, August 9, 2013, August 9, 2013, August 15, 2013 and August 22, 2013 we received $111,000, $111,000, $55,000, $75,000 and $125,000 respectively, for working capital from an outside party. These notes are due on demand and carry a 0% interest rate. Interest will be imputed on these notes at current market rates.

 

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