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EX-32.1 - CERTIFICATION - NET TALK.COM, INC.v356892_ex32-1.htm
EX-31.1 - CERTIFICATION - NET TALK.COM, INC.v356892_ex31-1.htm

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

(Mark One)

 

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

 

For the quarter ended March 31, 2013

 

OR

 

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

 

For the transition period from ______ to ______

 

Commission file number: 000-53668

 

NET TALK.COM, INC.

(Exact name of Registrant as specified in its charter)

 

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

 

1080 NW 163rd Drive, Miami Gardens, FL 33169
(Address of principal executive offices) (Zip code)

 

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

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes þ  No ¨

 

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

 

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

 

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

 

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

 

The Registrant had 61,309,313 shares of Common Stock, par value $0.001 per share, outstanding as of May 15, 2013.

 

 
 

 

NET TALK.COM, INC.

FORM 10-Q QUARTERLY REPORT

QUARTER ENDED MARCH 31, 2013

INDEX

 

        Page
         
Part I - FINANCIAL INFORMATION    
         
Item 1   Financial Statements   3
         
    Balance Sheets at March 31, 2013 (Unaudited) and December 31, 2012   3
         
    Statements of Operations and Comprehensive Income (Loss) for the Three Months Ended March 31, 2013 and 2012 (Unaudited)   4
         
    Statements of Cash Flows for the Three Months Ended March 31, 2013  and 2012 (Unaudited)   5
         
    Notes to Financial Statements   6
         
Item 2   MANAGEMENT'S DISCUSSION AND FINANCIAL ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS   21
         
Item 3   QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK   30
         
Item 4   CONTROLS AND PROCEDURES   30
         
Part II   OTHER INFORMATION    
         
Item 1   LEGAL PROCEEDINGS   31
         
Item 1A   RISK FACTORS   32
         
Item 2   UNREGISTERED SALES OF SECURITIES AND USE OF PROCEEDS   32
         
Item 3   DEFAULTS UPON SENIOR SECURITIES   32
         
Item 4   MINE SAFETY DISCLOSURES   32
         
Item 5   OTHER INFORMATION   32
         
Item 6   EXHIBITS   32
         
Item 9   CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE   32

 

2
 

 

NET TALK.COM, INC.

Balance Sheet

 

   March 31,   December 31, 
   2013   2012 
Assets          
Current assets:          
Cash and cash equivalents  $29,050   $96,347 
Restricted cash   115,530    115,259 
Accounts receivable, net   350,509    472,233 
Inventory   1,240,741    1,467,774 
Prepaid expenses and other current assets   200,785    284,908 
Total current assets   1,936,615    2,436,521 
           
Property and equipment, net   2,928,762    2,980,068 
Intangible assets, net   196,753    193,007 
Other assets   37,253    37,253 
Total assets  $5,099,383   $5,646,849 
           
Liabilities and Equity          
Current liabilities:          
Accounts payable  $2,258,240   $2,211,622 
Accrued dividends   1,451,116    1,301,116 
Accrued liabilities   691,043    477,743 
Deferred revenue   2,289,168    2,246,052 
Senior debentures   15,595,695    15,365,336 
Demand notes   400,000    275,000 
Total current liabilities   22,685,262    21,876,869 
Mortgage payable   1,400,000    1,000,000 
Total liabilities   24,085,262    22,876,869 
Redeemable preferred stock, $.001 par value, 10,000,000 shares authorized, 500 issued and outstanding as of March 31, 2013 and December 31, 2012.   5,647,573    6,379,016 
           
Stockholders’ Deficit          
Common stock, $.001 par value          
Authorized: 300,000,000 shares          
Issued:    60,251,355 shares at March 31, 2013          
60,251,355 shares at December 31, 2012   60,260    60,260 
           
Additional paid in capital   33,665,863    33,084,420 
           
Retained (deficit) earnings   (58,359,575)   (56,753,716)
           
Total stockholders' deficit   (24,633,452)   (23,609,036)
Total liabilities, redeemable preferred stock and stockholders' deficit  $5,099,383   $5,646,849 

 

See accompanying notes to financial statements.

 

3
 

 

NET TALK.COM, INC

Statements of Operations and Comprehensive Income (Loss)

 

For the three months ended March 31, 2013 and 2012

(Unaudited)

 

   Three months   Three months 
   ended   ended 
   March 31,   March 31, 
   2013   2012 
Revenues          
Sale of DUO products  $317,601   $347,908 
Renewals and access charges   1,137,295    640,987 
Other   98,369    67,426 
Total revenue   1,553,265    1,056,321 
           
Cost of sales          
Cost of DUO products   503,624    645,753 
Network and carrier charges   742,888    576,261 
Other   103,072    190,283 
Total cost of sales   1,349,584    1,412,297 
           
Gross margin   203,681    (355,976)
           
Expenses          
Advertising and marketing   93,112    429,243 
Compensation and benefits   374,423    321,996 
Professional fees   114,185    141,635 
Depreciation and amortization   77,463    62,559 
Research and development   296,003    337,393 
General and administrative expenses   482,415    582,490 
Total operating expenses   1,437,601    1,875,316 
Loss from operations   (1,233,920)   (2,231,292)
Other (expenses) income:          
Interest expense   (371,939)   (1,301,969)
Interest income   -    248 
Total other (expense)   (371,939)   (1,301,721)
Loss before income tax   (1,605,859)   (3,533,013)
Income tax (expense) benefit   -    - 
           
Net loss and comprehensive loss  $(1,605,859)  $(3,533,013)
           
Basic and diluted loss per common share  $(0.03)  $(0.08)

 

See accompanying notes to financial statements.

 

4
 

 

Net Talk.Com, Inc

Statements of Cash Flows

(Unaudited)

 

   Three Months Ended 
   March 31, 2013   March 31, 2012 
CASH FLOWS FROM OPERATING ACTIVITIES          
Net loss  $(1,605,859)  $(3,533,013)
Adjustments to reconcile net (loss) to net cash used in operating activities:          
Depreciation and amortization   77,463    62,559 
Amortization of discount on debt   230,359    993,985 
Recognition of deferred revenue   (1,190,568)   (782,343)
Changes in operating assets and liabilities :          
Restricted cash   (271)   (19,379)
Accounts receivable   121,724    (226,360)
Inventories   227,033    192,074 
Prepaid expenses   84,123    8,380 
Deferred revenues   1,233,684    1,050,706 
Accounts payable   46,618    223,840 
Accrued liabilities   213,300    373,300 
Net cash used in operating activities   (562,394)   (1,656,251)
           
Cash Flows From Investing Activities          
Purchase of property and equipment   (8,446)   (56,511)
Investment in intangible assets   (21,457)   - 
Net cash used in investing activities   (29,903)   (56,511)
           
Cash Flows From Financing Activities          
Borrowings:          
Proceeds from demand notes   125,000    650,010 
Proceeds from mortgage note   400,000    - 
Issue of common stock   -    34,834 
Net cash provided by financing activities   525,000    684,844 
Net Decrease in Cash and Cash Equivalents   (67,297)   (1,027,918)
Cash and cash equivalents -  beginning of period   96,347    1,539,263 
           
Cash and cash equivalents -  end of period   29,050    511,345 

 

See accompanying notes to financial statements.

 

5
 

 

NET TALK.COM, INC.

Notes to Unaudited Financial Statements

 

Note 1 – Nature of Business Operations

 

NET TALK.COM, INC. (“NetTalk” or the “Company”) was incorporated on May 1, 2006 under the laws of the State of Florida, under the name Discover Screens Inc. On September 10, 2008 the Company changed its name to NetTalk.com Inc. 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 DUOWIFI, analog telephone adapters that provide connectivity for analog telephones and faxes to home, home office or corporate local area networks (“LAN”). Our DUO products and their related services are a cost effective solution for individuals, small businesses and telecommuters connecting to any analog telephone, fax or private branch exchange (“PBX”). Our DUO products provide one USB port, one Ethernet port and one analog telephone port. A full suite of internet protocol features is available to maximize universal connectivity. In addition, analog telephones attached to our DUO products are able to use advanced calling features such as call forwarding, caller ID, 3-way calling, call holding, call retrieval, and call transfer.

 

Note 2 - Summary of Significant Accounting Policies

 

Basis of presentation

 

The accompanying unaudited interim financial statements are presented in U.S. dollars in conformity with accounting principles generally accepted in the United States (“GAAP”) and have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (the SEC) for reporting of interim financial information. Pursuant to such rules and regulations, certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted. However, the unaudited condensed financial information includes all adjustments which are, in the opinion of management, necessary to fairly present the financial position and the results of operations for the interim periods presented. The operations for the three months ended March 31, 2013 are not necessarily indicative of the results for the year ending December 31, 2013.

 

The balance sheet as of December 31, 2012 was derived from audited financial statements included in our 2012 Annual Report on Form 10-K but does not include all disclosures required by GAAP. These consolidated financial statements should be read in conjunction with our December 31, 2012 consolidated financial statements included in our 2012 Annual Report on Form 10-K and the notes to the financial statements included therein, filed with the Securities and Exchange Commission.

 

Use of Estimates

 

The preparation of financial statements in conformity with GAAP 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. Actual results could differ significantly from these estimates and assumptions, and the differences could be material.

 

Risk factors

 

Our Form 10 Q 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 2 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.

 

6
 

 

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 Quarterly Report on Form 10-Q and the other documents that we will file from time to time with the SEC.

 

RISKS RELATED TO OUR BUSINESS

 

We have never sustained profits and our losses could continue. Without sufficient additional capital 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 recorded net losses of $1,605,859 and $3,533,013 for the three month ended March 31, 2013 and 2012, respectively; net losses of $14,715,006 and $28,249,635, for the years ended December 31, 2012 and 2011, respectively; net losses of $1,367,216 for the three months ended December 31, 2010 and for fiscal year ended September 30, 2010 we recorded net losses of $6,399,963. As of March 31, 2013, we were indebted for $15,595,695 in current senior debentures, $400,000 in demand notes and $1,400,000 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.

 

Going concern and management’s plans

 

The presentation of financial statements in accordance with GAAP contemplates that operations will be sustained for a reasonable period. However, we have incurred operating losses of $1,605,859 and $3,533,013 during the three months ended March 31, 2013 and 2012, respectively. The company is also highly leveraged with $15,995,695 in senior debentures and demand notes and $1,400,000 in mortgage debt. In addition, during these periods, we used cash of $562,394 and $1,656,251, 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, due 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.

 

7
 

 

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.

 

During the first quarter of 2013, the company received $400,000 of funding from an additional advance on a promissory note on 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.

 

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 May 31, 2013, the Company issued to Samer Bishay 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, the Company issued to Samer Bishay 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 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, are non-interest bearing and are due on demand. Interest will be imputed on these notes at current market rates.

 

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 formal promissory notes.

 

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 is non-interest bearing. Interest will be imputed on these notes at current market rates.

 

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.

 

8
 

 

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 in domestic and Canadian bank accounts; the balances in our domestic accounts may at times exceed the FDIC limits. Management believes cash and cash equivalent balances are not exposed to significant credit risk due to the financial position of the depository institutions in which these deposits are held.

 

Accounts receivables

 

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

 

We also grant to the factor, as security for all present and future obligations owing to factor, a continuing security interest in all of our existing and later acquired receivables.

 

Inventory

 

Inventories are recorded at the lower of cost or net realizable value.

 

   March 31,   December 31, 
   2013   2012 
         
Productive material, work in process and supplies  $654,250   $869,740 
Finished products   586,491    598,034 
Total  $1,240,741   $1,467,774 

 

During the three months ended March 31, 2013 and for the year ended December 31, 2012, we evaluated our inventory for impairments in accordance with our lower of cost or net realizable value analyses. Based on our analysis no impairments were deemed necessary to our finished goods inventories.

 

At March 31, 2013, $113,305 of our finished goods inventory is held on consignment at one of our distributors.

 

Fair Value of Financial Instruments

 

A financial instrument’s categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement. The three levels of valuation hierarchy are defined as follows:

 

Level 1 - inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets.

 

Level 2 - inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument.

 

Level 3 - inputs to the valuation methodology are unobservable and significant to the fair value measurement.

 

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. The carrying amounts of debt obligations approximate their fair values as the terms are comparable to terms currently offered by local lending institutions for arrangements with similar terms to industry peers with comparable credit characteristics.

 

9
 

 

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

 

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

 

Property and Equipment

 

Property, equipment and telecommunication equipment includes acquired assets which consist of buildings, network equipment, computer hardware, furniture, and software. All of our equipment is stated at cost with depreciation calculated using the straight line method over the estimated useful lives of related assets, which ranges from three to five years. The 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 acquisition cost, which encompassed estimates of their respective and their relative fair values, as well as estimates of the fair value of consideration that we issued. We amortize our intangible assets using the straight-line method over lives that are predicated on contractual terms or over periods we believe the assets will have utility.

 

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; with the associated cost of shipping included as a component in cost of product sales.

 

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

 

Our DUO products provides for revenue recognition from the sale of the device and from the sale of telephone service. The initial year of telephone service is included in the sale price at time of sale and billed subsequently thereafter. Therefore, revenue recognition on our DUO products are fully recognized at the time of our customer equipment sale, and the one year telephone service is amortized over a 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.

 

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.

 

10
 

 

Research and Development and Software Costs

 

We expense research and development costs, as these costs are incurred. We account for our offering-related software development costs as costs incurred internally in creating a computer software product and are charged to expense when incurred as research and development until technological feasibility has been established for the product. Technological feasibility is established upon completion of a detail program design or, in its absence, completion of a working model. Thereafter, all software development costs shall be capitalized and subsequently reported at the lower of unamortized cost or net realizable value. Development costs are amortized based on current and future revenue for each product with an annual minimum equal to the straight-line amortization over the remaining estimated economic life of the product. At this time our main products, the DUO, DUO II and DUOWIFI are being sold in the market place. Therefore, research and development cost reported in our financial statements relates to pre–marketing costs and are expensed accordingly.

 

   Three Months Ended 
   March 31,   March 31, 
   2013   2012 
Components of research and development:          
           
Product development and engineering  $7,528   $37,282 
Payroll and benefits   288,475    300,111 
   $296,003   $337,393 

 

Reclassification

 

Certain reclassifications have been made to prior years financial statements in order to conform to the current quarter’s presentation.

 

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 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.

 

Stock Option Plans

 

In 2009, 2011 and 2012, NetTalk adopted various Stock Option Plans which is intended to advance the interests of the Company’s shareholders by enhancing the Company’s ability to attract, retain and motivate personnel who make (or are expected to make) important contributions to the Company by providing such persons with equity ownership opportunities and performance-based incentives and thereby better aligning the interests of such persons with those of the Company’s shareholders. All of the Company’s employees, officers, and directors, and those Company’s consultants and advisors (i) that are natural persons and (ii) who provides bona fide services to the Company not connected to a capital raising transaction or the promotion or creation of a market for the Company’s securities, are eligible to be granted options or restricted stock awards under the Plan.

 

On November 15, 2009, NetTalk adopted the 2010 Stock Option 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. During 2010, we issued 10,000,000 shares of common stock to our employees. The shares are compensatory in nature and are fully vested. We have valued the shares consistent with fair value at the time of issuance including and adjusted for ownership restrictions.

 

On June 15, 2011, NetTalk adopted the 2011 Stock Option 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. During 2012, we issued 20,000,000 shares of common stock to our employees. 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.

 

11
 

 

On July 25, 2012, NetTalk adopted the 2012 Stock Option 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.

 

Certain risks and concentration

 

Our largest manufacturer accounted for approximately 52% and 36% of our cost of goods sold for the three months ended March 31, 2013 and 2012, respectively.

 

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

 

On September 26, 2013, the Company elected to terminate the “Consignment Agreement” based on the specified contractual terms.

 

Redeemable Preferred Stock

 

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

 

Loss per common share

 

Basic earnings (loss) per share is calculated by dividing net income (loss) attributable to the Company available to common stockholders by the weighted average number of common shares outstanding for the three months ended March 31, 2013 and 2012. Diluted earnings per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the Company. In accordance with ASC 260, the effect of potentially dilutive securities is not considered during periods of loss or if the effect is anti-dilutive. 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. If required, we compute the effects on diluted loss per common share arising from convertible securities using the if-converted method.

 

The following table represents a reconciliation of the net income and weighted average shares outstanding for the calculation of basic and diluted earnings per share for the three months ended March 31, 2013 and 2012:

 

   Three Months Ended 
   March 31,   March 31, 
   2013   2012 
Numerator:          
Basic and diluted - net loss  $(1,605,859)  $(3,533,013)
           
Denominator:          
Basic and diluted weighted average shares outstanding   60,251,355    42,948,392 

 

12
 

 

Recent accounting pronouncements

 

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

 

In December 2011, the FASB issued amended guidance requiring companies to disclose information about offsetting and related arrangements to enable users of its financial statements to understand the effect of those arrangements on its financial position. This guidance is required to be applied retrospectively for all prior periods presented and is effective for annual periods for fiscal years beginning on or after January 1, 2013, and interim periods within those annual fiscal years. The adoption of this standard did not have an impact on the results of operations and financial condition.

 

In July 2012, the FASB issued ASU 2012-02, “Intangibles – Goodwill and Other (Topic 350): Testing Indefinite-Lived Intangible Assets for Impairment” in Accounting Standards Update No. 2012-02. This update amends ASU 2011-08, Intangibles – Goodwill and Other (Topic 350): Testing Indefinite-Lived Intangible Assets for Impairment and permits an entity first to assess qualitative factors to determine whether it is more likely than not that an indefinite-lived intangible asset is impaired as a basis for determining whether it is necessary to perform the quantitative impairment test in accordance with Subtopic 350-30, Intangibles - Goodwill and Other - General Intangibles Other than Goodwill. The amendments are effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012. Early adoption is permitted, including for annual and interim impairment tests performed as of a date before July 27, 2012, if a public entity’s financial statements for the most recent annual or interim period have not yet been issued or, for nonpublic entities, have not yet been made available for issuance. As the Company does not currently have any indefinite-lived intangible assets, the adoption of ASU 2012-02 did not impact our financial position or results of operations.

 

Income Taxes

 

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

 

Note 3 – Property and equipment

 

Telecommunications equipment and other property consist of the following:

 

      March 31,   December 31, 
   Life  2013   2012 
            
Telecommunication equipment  7  $356,154   $356,154 
Computer equipment  5   169,754    166,408 
Building  35   2,448,364    2,448,364 
Building improvements  10   86,442    81,342 
Office equipment and furnishing  7   48,212    48,212 
Purchased software  3   34,147    34,147 
Land      270,000    270,000 
Sub – total      3,413,073    3,404,627 
Less: accumulated depreciation      (484,311)   (424,559)
Property and equipment, net     $2,928,762   $2,980,068 

 

13
 

 

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. Depreciation expense on the above assets was $59,752 and $45,786 for the three months ending March 31, 2013 and 2012, respectively.

 

Note 4 - Intangible Assets

 

Intangible assets consist of following:

 

      March 31,   December 31, 
   Life  2013   2012 
            
Trademarks National and International  5   332,708    332,708 
Employment agreements  3   225,084    225,084 
Knowhow and specialty skills  3   212,254    212,254 
Workforce  3   54,000    54,000 
Patents  20   102,942    102,942 
Finance cost  2   76,693    55,236 
       1,003,681    982,224 
Less accumulated amortization      (806,928)   (789,217)
Intangible assets, net     $196,753   $193,007 

 

Amortization on the above assets was $17,711 and $16,773 for the three months ending March 31, 2013 and 2012, respectively. The weighted average amortization period for the intangible assets is 18 years.

 

The estimated future amortization of intangible assets for each of the following years as of March 31, 2013, is as follows:

 

2013   53,133 
2014   70,844 
2015   3,750 
Future years   69,026 
Total  $196,753 

 

Note 5 – 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.

 

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.

 

14
 

 

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.

 

The carrying values our senior debentures and demand notes consisted of the following as of March 31, 2013 and December 31, 2012:

 

   March 31,   December 31, 
   2013   2012 
         
$2,000,000 face value 12% debenture, due December 31, 2013  $2,441,429   $2,398,153 
$3,500,000 face value 12% debenture, due December 31, 2013   4,065,111    3,993,053 
$5,266,130 face value 12% debenture, due December 31, 2013   6,489,155    6,374,130 
$   500,000 face value 10% debenture, due December 31, 2013   500,000    500,000 
$   500,000 face value 10% debenture, due December 31, 2013   500,000    500,000 
$   450,000 face value 10% debenture, due December 31, 2013   450,000    450,000 
$1,150,000 advances on 10% debenture, due December 31, 2013   1,150,000    1,150,000 
   $15,595,695   $15,365,336 
           
Demand notes  $400,000   $275,000 

 

Principal repayments on the senior debentures are due in full in December 2013.

 

15
 

 

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 over a five year period.

 

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:

 

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 

 

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 

 

The fair value of the debentures was computed based upon the present value of all future cash flows, using credit risk adjusted discount rates ranging from 7.63% to 7.86%. The 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.

 

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.

 

16
 

 

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.

 

2013 Demand Notes and Convertible Debt

 

On February 15, 2013 we received an additional advance of $100,000 from 1080 NW 163rd Drive, LLC. This advance is not evidenced by a formal promissory note. This additional advance accrues interest at 8% per year, and was payable in full on June 9, 2013. This note is now in default.

 

On February 19, 2013, the Company’s CEO advanced the Company $25,000. This advance is not evidenced by a formal promissory note. The advance was for working capital, is non-interest bearing and is due on demand. Interest will be imputed on these notes at current market rates.

 

Subsequent to March 31, 2013, the Company issued convertible debt securities and entered into additional demand note agreements.

 

On April 22, 2013 and May 3, 2013 the Company 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, the Company issued to Samer Bishay 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 7, 2013, August 9, 2013, August 9, 2013, August 15, 2013 and August 22, 2013 the Company 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 are non-interest bearing. Interest will be imputed on these notes at current market rates.

 

On July 15, 2013, the Company issued to Samer Bishay 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 August 9, 2013, August 14, 2013 and September 3, 2013, the Company’s CEO advanced the Company $5,000, $20,000 and $25,000 respectively. These advances are not evidenced by a formal promissory note. These advances were for working capital, are non-interest bearing and are due on demand. Interest will be imputed on these notes at current market rates.

 

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Note 6 – 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.

 

Redeemable preferred stock consists of the following as of:  March 31, 2013   December 31, 2012 
Series A Convertible Preferred Stock, par value $0.001 per share, stated value $10,000 per share; 500 shares issued and outstanding at March 31, 2013; redemption value $5,000,000, and 500 shares issued and outstanding at December 31, 2012; redemption value $5,000,000.          
Initial carrying value  $13,246,609   $13,246,609 
Accumulated accretion   (7,599,036)   (6,867,593)
Carrying values  $5,647,573   $6,379,016 

 

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.

 

18
 

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Note 7 – 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

 

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On September 14, 2012, a supplier to the Company, Arrow Electronics, Inc. (“Arrow”), 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 Company and Arrow Electronics, Inc. entered into a settlement agreement providing for the payment of past due amounts. A final order was entered into on December 12, 2012 dismissing the litigation. As of September 30, 2013, the Company owes Arrow Electronics approximately $123,000 and will continue making frequent payments until the obligation is satisfied.

 

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 Defense was delivered on behalf of the Company 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.

 

On February 13, 2013, Rates Technology, Inc. (“RTI”) sent a letter alleging that the Company breached an agreement dated June 22, 2012; RTI has threatened litigation. RTI has alleged, among other matters, that the Company breached the agreement by failing to make a payment of $60,000, breached certain confidentiality provisions in the Agreement, and has failed to timely file its reports under the Exchange Act. The Company denies RTI’s allegations and intends to defend any lawsuit if brought.

 

ADP filed a lawsuit against the Company on or about September 1, 2013. The claim is for an amount not exceeding $89,000 for general damages for alleged breach of contract. Company is in the process of settling this action.

 

Note 8 - Related party

 

At March 31, 2013, there is $25,000 Due to Officers, the amount is non-interest bearing and is due on demand.

 

Note 9 – Subsequent events

 

On September 23, 2013 NetTalk.com, Inc. changed independent accountants from Thomas, Howell, Ferguson, CPA's to Zachary Salum Auditors P.A. Information regarding the change in independent accountants was reported in NetTalk.com, Inc.’s Current Report on Form 8-K dated September 23, 2013. There were no disagreements or any reportable events subject to Item 304(b) requiring disclosure.

 

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

 

Our Management’s discussion and analysis of our financial condition and results of operations should be read in conjunction with the financial statements included elsewhere in this Quarterly Report and the audited financial statements for the year ended December 31, 2012, included in our Annual Report on Form 10-K. This Quarterly Report contains, in addition to unaudited historical information, forward-looking statements, which involve risk and uncertainties. The words “believe,” “expect,” “estimate,” “may,” “will,” “could,” “plan,” or “continue” and similar expressions are intended to identify forward-looking statements. Our actual results could differ significantly from the results discussed in such forward-looking statements. Factors that could cause or contribute to such differences in results and outcomes include, without limitation, those discussed under the headings “Risk Factors” in our 2012 Annual Report on Form 10-K and this Quarterly Report on Form 10-Q, if any. Readers are urged not to place undue reliance on these forward-looking statements, which speak only as of the date of this Quarterly Report on Form 10-Q. We undertake no obligation to (and we expressly disclaim any obligation to) revise or update any forward-looking statement, whether as a result of new information, subsequent events, or otherwise (except as may be required by law), in order to reflect any event or circumstance which may arise after the date of this Quarterly Report on Form 10-Q.

 

Cautionary Statement about Forward Looking Statements

 

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

 

our ability to develop sales and marketing capabilities;

 

the accuracy of our estimates and projections;

 

our ability to fund our short-term and long-term financing needs;

 

changes in our business plan and corporate strategies; and other risks and uncertainties discussed in greater detail in the sections of this prospectus, including the section captioned “Plan of Operation”.

 

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

 

Background

 

Company and Business

 

We are a telephone company, which provides sells and supplies commercial and residential telecommunication services, including services utilizing voice over internet protocol (“VoIP”) technology, session initiation protocol (“SIP”) technology, wireless fidelity technology, wireless maximum technology, marine satellite services technology, and other similar type technologies. Our main products are the “DUO”; “DUO II” and the “DUO WIFI”. The DUO WIFI and DUO II are presently sold and distributed to our customers. 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.

 

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Our DUO, DOU 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, DUO II 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, 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.

 

History and Overview

 

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

 

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

 

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

 

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

 

Plan of Operation

 

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

 

Our Products

 

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

 

    A Universal Serial Bus (“USB”) connection allowing the interconnection of our DUO and DUO WIFI to any host computer.
    In addition to the USB power source option, our DUO and DUO WIFI have an external power supply allowing the phone to independently power itself when not connected to a host computer;

 

    Unlike most VoIP telephone systems, our DUO and DUO WIFI both have standalone feature allowing them to be plugged directly into a standard internet connection.

 

    Our DUO and DUO WIFI are compact, space-efficient products.

 

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

 

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

 

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Our Services

 

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

 

Patents – Domestic and International

 

Our products are currently under US Design Patent No. D674785 and US Patent No. 8,243,722 titled “VOIP Analogue System”. These patents have been issued. US Patent No. 8,243,722 is currently in the re-review process at the United States Patent and Trademark Office. NetTalk fully expects to prevail in the re-review process. The Company also has international patents pending in over 123 countries.

 

Government Regulation

 

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

 

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

 

Federal Communications Commission (“FCC”) regulation

 

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

 

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

 

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

 

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

 

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

 

Federal CALEA

 

On August 5, 2005, the 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. To date, we are fully compliant with CALEA.

 

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

 

Alabama Indiana Montana North Carolina Utah
Arkansas Kansas Nebraska Ohio Washington
California Kentucky Nevada Oregon Wisconsin
Connecticut Maryland New Jersey Pennsylvania  
Florida Massachusetts New Mexico South Dakota  
Georgia Missouri New York Texas  

 

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

 

Marketing

 

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

 

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

 

Advertising

 

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

 

Customers

 

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

 

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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 wholesale sales to retail stores.

 

Geographic Markets

 

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

 

Results of Operations

For the Three months ended March 31, 2013 compared to three months ended March 31, 2012

 

Revenues: Our revenues amounted to $1,553,265 and $1,056,321 for the three months ended March 31, 2013, and 2012, respectively. The increase in revenues relates to new products and increase in sales activities due to market penetration and sales to large retailers.

 

Cost of sales: Our cost of sales amounted to $1,349,584 and $1,412,297 for the three months ended March 31, 2013, and 2012, respectively. The decrease in cost of sales relates to production efficiencies quantities of scale.

 

Gross margin: Our gross margin (loss) amounted to $203,681 and ($355,976) for the three months ended March 31, 2013, and 2012, respectively. We expected our per unit manufacturing cost to decrease over time consistent with sales as we take advantages of economies of scale. Further, we are working with call terminating vendors to reduce our price per minute costs, which we expect to be much lower as we expand our subscriber base and take advantage of economies of scale and other opportunities.

 

Advertising and marketing: Our advertising and marketing expenses amounted to $93,112 and $429,243 for the three months ended March 31, 2013 and 2012, respectively.

 

Smartphone Application: We released our Smartphone application during December of 2010. The smart phone application continues to be one of the top downloaded apps in Canada. We had more than 1,000,000 users of our application at March 31, 2013.

 

Compensation and Benefits: Our compensation and benefits expense amounted to $374,423 and $321,996 for the three months ended March 31, 2013 and 2012, respectively. This amount represents normal salaries and wages paid to management members and employees including marketing and administrative functions. We continue to increase our technical staff by hiring IT engineers and software developers.

 

Professional Fees: Our professional fees amounted to $114,185 and $141,635 for the three months ended March 31, 2013 and 2012, respectively. This amount includes normal payments and accruals for legal, accounting and other professional services. Our costs associated with legal and accounting fees will remain higher than historical amounts because, as a publicly traded company, we will incur additional expenses associated with the services provided by our transfer agent and also with costs incurred for compliance with the reporting requirements of the Securities and Exchange Act of 1934, as amended (the “Exchange Act”). This involves the preparation and filing of quarterly and annual reports, as well as, other reporting requirements required under the Exchange Act.

 

Depreciation and Amortization: Depreciation and amortization amounted to $77,463 and $62,559 for the three months ended March 31, 2013 and 2012, respectively. These amounts represent amortization of our long-lived tangible and intangible assets using straight-line methods and lives commensurate with the assets’ remaining utility. Our long-lived assets, both tangible and intangible, are subject to annual impairment review, or more frequently if circumstances so warrant. During the three months ended March 31, 2013, 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.

 

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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 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.

 

   Three Months Ended 
   March 31,   March 31, 
   2013   2012 
Components of research and development:          
           
Product development and engineering  $7,528   $37,282 
Payroll and benefits   288,475    300,111 
   $296,003   $337,393 

 

General and Administrative Expenses: General and administrative expenses amounted to $482,416 and $582,490 for the three months ended March 31, 2013 and 2012, respectively, and consisted of general corporate expenses. Included in these expenses are occupancy costs of $0 and $81,105 for the three months ended March 31, 2013 and d March 31, 2012.

 

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

 

   March 31, 
   2013   2012 
Commission  $117,966   $179,774 
Rent and occupancy   -    81,105 
Insurance   84,164    48,319 
Taxes and licenses   25,270    20,757 
Travel   13,285    69,880 
Other   241,730    182,655 
Total  $482,415   $582,490 

 

Loss from operations: Loss from operations amounted to ($1,233,920) for the three months ended March 31, 2013 compared to ($2,231,292) for the three months ended March 31, 2012.

 

Interest Expense: Interest expense amounted to $371,939 and $1,301,969 for the three months ended March 31, 2013 and 2012 respectively. Included in these amounts are stipulated interest under our convertible debentures, the related amortization of premiums and discounts and 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.

 

Extended maturity dates on existing 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 $3,135,148 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%.

 

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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 the 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.

 

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.

 

Net loss applicable to common stockholders:

 

The net loss applicable to common stockholders amounted to ($1,605,859) and ($3,533,013) for the three months ended March 31, 2013 and 2012, respectively. Net loss applicable to common stockholders includes extraordinary items such as: derivative income or loss associated with the valuation of debentures, embedded conversion features and warrants and debt extinguishment expense. These items are non-cash, non-recurring and extraordinary.

 

Net loss Per Common Share:

 

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

 

Liquidity and Capital Resources

 

Our principal sources of liquidity are our cash and cash equivalents balances, cash flow from operations, our lines of credit, and access to financial markets. Our principal uses of cash are operating expenses, working capital requirements, capital expenditures, repayment of debt. We believe our sources of liquidity, including cash flow from operations, existing cash and cash equivalents, and borrowing capacity under our credit facilities will be sufficient to meet our projected cash requirements. We will monitor our capital requirements thereafter to ensure our needs are in line with available capital resources.

 

Cash Flows

 

As of March 31, 2013, our cash and cash equivalents totaled $29,050 and accounts receivable, net of allowance for doubtful accounts, totaled $350,509, compared to $96,347 and $472,233, respectively, on December 31, 2012. As of March 31, 2013, our accounts payable accrued dividends, and accrued liabilities were $2,258,240, $1,451,116, and $691,043, respectively, compared to $2,211,622, $1,301,116, and $477,743, respectively, on December 31, 2012. Also, as of March 31, 2013, we had senior debentures and demand notes payable of $15,595,695 and $400,000 respectively; compared to $15,365,336 and $275,000, respectively, on December 31, 2012. Our largest operating expenditure currently consists of payroll for approximately $300,000 per month.

 

Operating activities

For the three months ended March 31, 2013, net cash used in operating activities amounted to $562,394 primarily attributable to net losses of $1,605,859 partly offset by a decrease of $121,724 in accounts receivable, a net increase in deferred revenue and the related amortization of $43,116, and by non-cash charges of $307,822 related to depreciation and discount amortization. Operating expenses were affected by increased telecommunication expenses, research and development expenses related to new products, marketing expenses, travel expenses incurred to visit manufacturing facilities in China, and increases in wage and other general and administrative expenses, due to new hires.

 

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For the three months ended March 31, 2012 net cash used in operating activities amounted to $1,656,251 primarily attributable to net losses of $3,533,013 and an increase of $226,360 in accounts receivable, partially offset by non-cash charges of $62,559 from depreciation and amortization; and a net increase of $268,363 in deferred revenues and increases of $597,140 in accounts payable and accrued liabilities.

 

Investing activities

For the three months ended March 31, 2013, net cash used in investing activities amounted to $29,903 primarily resulting from cash used for expenditures on intangible assets.

 

For the three months ended March 31, 2012, net cash used in investing activities amounted to $56,511 primarily resulting from cash used for the purchase of property and equipment.

 

Financing activities

For the three months ended March 31, 2013, net cash provided by financing activities amounted to $525,000 primarily attributable to proceeds from additional financing activities on the 12% mortgage payable. On February 15, 2013 we received an additional advance of $100,000 from 1080 NW 163rd Drive, LLC. This advance is not evidenced by a formal promissory note, accrues interest at 8% per year, and was payable in full on June 9, 2013. This note is now in default. On February 19, 2013, the Company’s CEO advanced the Company $25,000. This advance is for working capital and is not evidenced by a formal promissory note, is non-interest bearing and is due on demand. Interest will be imputed on this note at current market rates. On March 31, 2013, we had restricted cash of $115,530.

 

For the three months ended March 31, 2012, net cash provided by financing activities amounted to $684,844 primarily attributable to financing activities from proceeds on a 12% mortgage payable.

 

Subsequent to the end of the first quarter the Company entered into various financing agreements described below:

 

On April 10, 2013 we received an additional advance of $75,000 from 1080 NW 163rd Drive, LLC. This advance is not evidenced by a formal promissory note. This additional advance accrues interest at 8% per year, and was payable in full on June 9, 2013. This note is now in default.

 

On May 31, 2013, the Company issued to Samer Bishay 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, the Company issued to Samer Bishay 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 August 9, 2013, August 14, 2013 and September 3, 2013, the Company’s CEO advanced the Company $5,000, $20,000, and $25,000 respectively. These advances are for working capital and are not evidenced by a formal promissory note, are non-interest bearing and are due on demand. Interest will be imputed on these notes at current market rates.

 

On April 22, 2013 and May 3, 2013 the Company 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 July 7, 2013, August 9, 2013, August 9, 2013, August 15, 2013 and August 22, 2013 the Company 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 are non-interest bearing. Interest will be imputed on these notes at current market rates.

 

Off-Balance Sheet Arrangements

 

We did not have any off-balance sheet arrangements as of March 31, 2013.

 

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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 carry as derivative liabilities, at fair value, in our financial statements. The fair value of share-indexed derivatives will be significantly influenced by the fair value of our common stock (see Common Stock Valuation, above). Certain other elements of forward-type derivatives are significantly influenced by credit-adjusted interest rates used in cash-flow analysis. Since we are required to carry derivative financial instruments at fair value and make adjustments through earnings, our future profitability will reflect the influences arising from changes in our stock price, changes in interest rates, and changes in our credit standing.

 

Revenue Recognition

 

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

 

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

  

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

 

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

 

Item 3 Quantitative and Qualitative Disclosures About Market Risk

 

Not applicable. 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 4 Controls and Procedures

 

Disclosure Controls

 

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

 

As of March 31, 2013, we carried out an evaluation, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were not effective in ensuring that information required to be disclosed by us in our periodic reports is recorded, processed, summarized and reported, within the time periods specified for each report and that such information is accumulated and communicated to our management, including our principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.

 

In connection with the assessment described above, management identified the following control deficiencies that represent material weaknesses at March 31, 2013:

 

Due to the limited resources, we have insufficient personnel resources and technical accounting and reporting expertise to properly address all of the accounting matters inherent in our financial transactions. We do not have a formal audit committee and the Board of Directors does not have a financial expert, thus we lack the Board oversight role within the financial reporting process.

 

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

 

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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 will be recorded, processed, summarized and reported accurately.  Our management acknowledges the existence of this problem, and intends to developed procedures to address them to the extent possible given limitations in financial and manpower resources.   While management is working on a plan, no assurance can be made at this point that the implementation of such controls and procedures will be completed in a timely manner or that they will be adequate once implemented.

 

Changes in Internal Controls.

 

During the three months ended March 31, 2013, 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.

 

PART II         OTHER INFORMATION

 

Item 1.    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 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 NetTalk 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. The Company and Arrow Electronics, Inc. subsequently entered into a settlement agreement providing for the payment of past due amounts. A final order was entered into on December 12, 2012 dismissing the litigation.

 

NetTalk reached a settlement with the supplier and is in full compliance with said settlement.

 

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 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 Defense 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.

 

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Item 1A. Risk Factors

 

For the quarter ended March 31, 2013, there are no material changes to the risk factors set forth in “Item 1A, Risk Factors” of our Annual Report on Form 10-K.

 

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

 

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

 

Item 3.   Defaults Upon Senior Securities

 

None.

Item 4.   Mine Safety Disclosures

 

Not Applicable.

 

Item 5.   Other Information.

 

None.

 

Item 6.   Exhibits

 

Exhibit No. Description
31.1 Certification of Chief Executive Officer and Chief Financial Officer pursuant to Rule 13a-14(a) and 15d-14(a) as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, dated November 15, 2012.  
32.1 Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section # 906 of the Sarbanes-Oxley Act of 2002, dated November 15, 2012.
101. The following materials from the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2013, formatted in XBRL (eXtensible Business Reporting Language): (i) Condensed Balance Sheets as of March 31, 2013 and December 31, 2012, (ii) Condensed Statement of Operations for the three months ended March 31m 2013and 2012, (iii) Condensed Statement of Cash Flows for the three months ended March 31, 2013and 2012, and (iv) Notes to Condensed Financial Statements*.

 

  * Pursuant to Rule 406T of Regulation S-T, the Interactive Data Files submitted as Exhibit 101 hereto are deemed not filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933, are deemed not filed for purposes of Section 18 of the Securities and Exchange Act of 1934, and otherwise are not subject to liability under those sections.

 

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

DISCLOSURE

 

NetTalk.com, Inc. changed independent accountants in September 2013 from Thomas, Howell, Ferguson, CPA's to Zachary Salum Auditors P.A. Information regarding the change in independent accountants was reported in NetTalk.com, Inc. Current Report on Form 8-K dated September 23, 2013. There were no disagreements or any reportable events subject to Item 304(b) requiring disclosure.

 

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SIGNATURES

 

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

 

  NetTalk.com, Inc.
   
Date:  October 8, 2013 By /s/ Anastasios Kyriakides
  Anastasios Kyriakides
  Chief Executive Officer (Principal Executive Officer)

 

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