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EX-10.5 - EXHIBIT 10.5 - NET TALK.COM, INC.v377116_ex10-5.htm
EX-32.2 - EXHIBIT 32.2 - NET TALK.COM, INC.v377116_ex32-2.htm
EX-32.1 - EXHIBIT 32.1 - NET TALK.COM, INC.v377116_ex32-1.htm
EX-31.2 - EXHIBIT 31.2 - NET TALK.COM, INC.v377116_ex31-2.htm
EX-31.1 - EXHIBIT 31.1 - NET TALK.COM, INC.v377116_ex31-1.htm
EX-10.4 - EXHIBIT 10.4 - NET TALK.COM, INC.v377116_ex10-4.htm
EX-10.3 - EXHIBIT 10.3 - NET TALK.COM, INC.v377116_ex10-3.htm
EX-10.2 - EXHIBIT 10.2 - NET TALK.COM, INC.v377116_ex10-2.htm
EX-10.1 - EXHIBIT 10.1 - NET TALK.COM, INC.v377116_ex10-1.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-K

 

   

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

 

   

For the fiscal year ended: December 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 of incorporation)   (I.R.S. Employer Identification No.)
     
1080 NW 163rd Drive, Miami Gardens, FL   33169 – 5816
(Address of principal executive offices)   (Zip Code)

 

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

 

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

 

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

 

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

 

Check whether the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act. Yes ¨           No x

 

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

 

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

 

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

 

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

 

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

 

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

 

The aggregate market value of the registrant’s common stock held by non-affiliates as of June 30, 2013 was $1,577,716.1 The Registrant had 41,324,221 shares of Common Stock, $0.001 par value, outstanding as of April 30, 2014.

 

 

1 Aggregate market value of common equity held-by non-affiliates is computed based upon sale price of [$0.09] occurring on June 30, 2013.

 

 
 

 

Net Talk.com, Inc.

 

Form 10-K

 

For year ended December 31, 2013

 

Table of contents Page
     
Part I    
     
Item 1. Business 4
Item 1A. Risk factors 9
Item 2. Properties 10
Item 3. Legal proceedings 11
Item 4. Mine safety disclosures 12
     
Part II    
     
Item 5. Market for registrant’s common equity, related stockholders matters and  issuer purchases of equity securities 13
     
Item 6. Selected financial data 16
Item 7. Management discussion and analysis of financial condition and operation 16
Item 7A. Quantitative and qualitative disclosure about market risk 24
Item 8. Financial statements and supplementary data 24
Item 9. Changes in and disagreements with accountants on accounting and financial disclosure 24
Item 9A. Controls and procedures 24
Item 9B. Other information 25
     
Part III    
     
Item 10. Directors, executive officers and corporate governance 26
Item 11. Executive compensation 29
Item 12. Security ownership of certain owners and management and related stockholder matter 30
Item 13. Certain relationships and related transactions, and directors independence 30
Item 14. Principal accountant fees and services 31
     
Part IV    
     
Item 15. Exhibits, financial statement schedules 32
  Signatures 32
  Financial statements 34

 

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Forward Looking Statements

 

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

 

our ability to develop sales and marketing capabilities;

 

the accuracy of our estimates and projections;

 

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

 

changes in our business plan and corporate strategies; and other risks and uncertainties discussed in greater detail in other sections of this report.

 

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

 

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Part I

 

Item 1.  Business

 

Company and Business

 

We are a telephone company, which manufactures, provides, sells and supplies commercial and residential telecommunication services, including services utilizing voice over internet protocol (“VoIP”) technology, session initiation protocol (“SIP”) technology, wireless fidelity technology, wireless maximum technology, and other similar type technologies. Our main products are the “DUO”, DUO II” and the “DUO WIFI”. All of these products are analog telephone adapters that provide connectivity for analog telephones and faxes to home, home office or corporate local area networks (“LAN”). The DUO WIFI allows users to use these services without an Ethernet cable plugged into the device.

 

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

 

History and Overview

 

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

 

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

 

Our Strategy

 

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

 

·Deployment and distribution of our main products the DUO, DUO II and DUO WIFI, NetTalk TV devices in Beta testing, IPhone and Androids applications for smartphones, tablets and apps.
·We offer our customers an attractive and innovative value proposition: a portable telephone replacement with multiple and unique features that differentiates our services from the competition.
·Innovative, high technology and low cost technology platform.  We believe our innovative software and network technology platform provides us with a competitive advantage over our competition and allows us to maintain a low cost infrastructure relative to our competitors.

  

Plan of Operation

 

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

 

Our Products

 

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

 

·A Universal Serial Bus (“USB”) patented 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 pateneted both have standalone features allowing them to be plugged directly into a standard internet connection with out needing to plug into a computer.

 

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

 

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

 

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

 

Our Services

 

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

 

Patents – Domestic and International

 

Our product is under US patent number 8,243,722 as well as International patent pending in over 123 countries. Five additional Telecom and TV related patents are pending.

 

Marketing

 

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

 

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

 

Advertising

 

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

 

Customers

 

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

 

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 expect that consumers will find our websites by doing an internet search for VoIP service providers. We also use other means of advertising such as direct to consumer sales, ecommerce and retail marketing co-ops with retail customers.

 

Geographic Markets

 

Our primary geographic market is North America.

 

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

 

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

 

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

  

The Industry

 

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

 

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

 

Our Competition

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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Government Regulation

 

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

 

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

 

Federal Communications Commission (“FCC”) regulation

 

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

 

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

 

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

 

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

 

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

  

Federal CALEA

 

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

 

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

 

State Telecommunication Regulation

 

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

 

In Florida, a “competitive local exchange carrier” is defined as any company, other than an incumbent local exchange company, certified 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 certified 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.

 

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

 

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

 

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

 

Employees

 

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

 

Intellectual Property

 

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

 

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

 

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

 

Patents – Domestic and International

 

Our DUO product is under US patent number 8,243,722 as well as International patent pending in over 123 countries. Five additional Telecom and TV related patents are pending.

 

Research and Development

 

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

 

On July 14, 2010 we revealed our product the netTALK DUO (“DUO”) which was the first of its kind.

 

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

 

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

 

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

 

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

 

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

 

Item 1A. Risk factors

 

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

 

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

 

RISKS RELATED TO OUR BUSINESS:

  

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

 

We have experienced significant losses in the past and never sustained profits. For the years ended December 31, 2013 and 2012, we recorded net losses of $4.6 and $14.7 million, respectively.

 

At December 31, 2013 and 2012, we had $5.9 and $23.0 million in long term debt and preferred stock, respectively.

 

We are not certain if our current cash resources, together with anticipated cash flows from operating activities, will be sufficient to fund our operations in 2014 or repay indebtedness that becomes due in 2014. Further, we do not anticipate having sufficient cash and cash equivalents to repay the debt should our lenders 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.

 

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Equity financing would likely be substantially dilutive to our stockholders, particularly in light of the prices at which our common stock has been recently trading. In addition, if we raise additional funds through the sale of equity securities, new investors could have rights senior to our existing stockholders. The terms of any future financings may restrict our ability to raise additional capital, which could delay or prevent the further development or marketing of our products and services. Our need to raise capital before the repayment of our debt becomes due may require us to accept terms that may harm our business or be disadvantageous to our current stockholders, particularly in light of the current illiquidity and instability in the global financial markets.

 

Our business may be affected by factors outside our control

 

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

 

The Company may experience delays in the deployment of new products. If it is not successful in the continued development, introduction or timely manufacture of new products, demand for its products could decrease.

 

While the Company has new products currently in development or beta versions, its continued ability to adapt to such changes will be a significant factor in maintaining or improving its competitive position and its prospects for growth. Factors resulting in delays in product development include:

 

·rapid technological changes in the broadband communications industry;

 

·federal, state and local regulations governing our products and services;

 

·relationships with manufacturers, other carriers and service providers; and

 

·the availability of third party technology for the development of new products.

 

There can be no assurance that the Company will successfully introduce new products on a timely basis or achieve sales of new products in the future. In addition, there can be no assurance that the Company will have the financial and product design resources necessary to continue to successfully develop new products or to otherwise successfully respond to changing technology standards and service provider service offerings. If the Company fails to deploy new products on a timely basis, then its product sales will decrease, its quarterly operating results could fluctuate, and its competitive position and financial condition would be materially and adversely affected.

 

In addition, the Company’s pursuit of necessary technology may require substantial time and expense. It may need to license new technologies to respond to technological change. These licenses may not be available to the Company on terms that it can accept or may materially change the gross profits that it is able to obtain on its products. The Company may not succeed in adapting its products to new technologies as they emerge. Development and manufacturing schedules for technology products are difficult to predict, and there can be no assurance that the Company will achieve timely initial customer shipments of new products. The timely availability of these products in volume and their acceptance by customers are important to the Company’s future success. Any future delays, whether due to product development delays, manufacturing delays, lack of market acceptance, delays in regulatory approval, or otherwise, could have a material adverse effect on the Company’s results of operations.

 

Item 2. Properties

 

Description of properties

 

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

 

Interconnection Leasing Agreements

 

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

 

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

 

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

 

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

 

Item 3.  Legal Proceedings

 

On April 4, 2012, MagicJack Vocaltec Ltd. filed a complaint in United States District Court for the Southern District of Florida, Civil Action No.: 9:12-cv-80360-DMM, against the Company, alleging patent infringement, seeking injunctive relief and damages as a result of the alleged patent infringement. The Company answered the complaint, denying all of its material allegations, asserting a number of affirmative defenses, and seeking counterclaims for declaratory relief. The Company’s patent counsel has provided an opinion that the NetTalk DUO does not infringe their patent. MagicJack Vocaltec Ltd. and NetTalk filed a Joint Stipulation and motion for the dismissal. Effective November 2012, the federal court has dismissed the entire case with prejudice, including all claims, counterclaims, defenses and causes of action.

 

On September 21, 2012, NetTalk.com, Inc. filed a complaint in United States District Court For the Southern District of Florida, Civil Action No.: 9:12-cv-81022-CIV-MIDDLEBROOK/BRANNON, against MAGICJACK VOCALTECLTD, MAGIJACK HOLDINGS CORPORATION f/k/a YMAX HOLDINGS CORPORATION and DANIEL BORISLOW. In the complaint, we allege patent infringement by the defendants, seeking injunctive relief and damages of two hundred million dollars ($200,000,000.00) as a result of the alleged patent infringement by defendants.

 

As a result of this action, MAGICJACK/ VOCALTEC LTC filed a document with the United States Patent Office (“USPTO”) requesting reexamination of netTALK patent 8,243,722. The USPTO granted the reexamination petition and the claim against MAGICJACK/VOVALTEC LTD was stayed pending the outcome of the USPTO reexamination.

 

In December 2013 netTALK received a USPTO Notice of Intent to Issue Ex Parte Reexamination Certificate (“NIRC”) for netTALK’s U.S. Patent Number 8,243,722. 

 

In January 2014, netTALK petitioned the courts to restart the aforementioned lawsuit against MAGICJACK VOCALTECLTD, MAGIJACK HOLDINGS CORPORATION f/k/a YMAX HOLDINGS CORPORATION and DANIEL BORISLOW.

 

On February 27, 2014, netTALK received the reexamination certificate which restated that all three claims of the ‘722 Patent are deemed allowable by the USPTO.  The three claims of the ‘722 Patent were minimally amended during the proceeding.

 

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 December 31, 2013, the Company owes Arrow approximately $73,790 which is recorded in accounts payable. and The Company will continue making installment 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. The settlement was paid in full as of October 29, 2013.

 

On June 30, 2012, a Statement of Claim was served by DACS Marketing & Sponsorship Inc. (“DACS”) on NetTalk.com Inc. The claim was 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. On November 28, 2013, the Company and DACS entered into a settlement agreement providing for $60,000 in 4 monthly equal installments beginning . As of December 31, 2013 the Company owes DACS $30,000 which is recorded in accounts payable. The obligation was paid in full as of the date of this filing.

 

11
 

 

On or about September 1, 2013, ADP Total Source filed a lawsuit against the Company.. The claim is for an amount not exceeding $90,776 for general damages for alleged breach of contract. The Company settled with ADP on December 23, 2013 and is making monthly payments of $15,000 until the obligation is satisfied. The balance at December 31, 2013 was $70,777 and is recorded in accounts payables.

 

On February 24, 2013, a Statement of Claim was served by Sears Canada Inc. on the Company. The claim is for $24,131.65 for amounts Sears claims is owed to it pursuant to its agreement under the “Universal Terms and Conditions for Sears Canada Suppliers”. We have settled with Sears Canada for $24,131.65 and are currently making monthly installment payments of $2,464.09 on the balance until the obligation is satisfied. The settlement amount is recorded in accounts payables at December 31, 2013.

 

On March 20, 2014 a claim was filed by Billsoft, Case No. 14CV01827. The claim states the Company indebted to Billsoft in the amount of $16,776.66 pursuant the terms of said Contract; the sum of $192.50 representing court costs incurred to date; and the sum of $1,000.00 as reasonable attorney’s fees incurred by Billsoft for a total of $17,969.16. The Company has reached a settlement agreement on April 24, 2014 to make $1,000 monthly payments until the debt is satisfied. The settlement amount was accrued as of December 31, 2013.

 

We are aggressively defending all of the lawsuits and claims described above. While we do not believe these aforementioned claims will have a material adverse effect on our financial position, given the uncertainty and unpredictability of litigation there can be no assurance of no material adverse effect. The Company is engaged in other legal actions and claims arising in the ordinary course of business, none of which are believed to be material to the Company.

 

ITEM 4. Mine safety disclosures

 

None

 

12
 

 

Part II

 

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

 

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

 

Market Information

 

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

 

2012 Quarter Ended  High   Low 
March 31, 2012  $1.67   $0.10 
June 30, 2012  $0.48   $0.10 
September 30, 2012  $0.20   $0.10 
December 31, 2012  $0.19   $0.08 
2013 Quarter Ended          
March 31, 2013  $0.36   $0.08 
June 30, 2013  $0.12   $0.07 
September 30, 2013  $0.12   $0.04 
December 31, 2013  $0.37   $0.02 

 

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

 

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

 

Holders

 

As of December 31, 2013, there were 166 registered holders or persons otherwise entitled to hold our common stock.  The number of record holders was determined from the records of our transfer agent and does not include beneficial owners of common stock whose shares are held in the names of various security brokers, dealers, and registered clearing agencies. The transfer agent of our common stock is VStock Transfer, LLC.

 

Dividends

 

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

 

Securities Authorized for Issuance Under Equity Compensation Plans

 

The following table sets forth certain information about the common stock that may be issued upon the exercise of options under the equity compensation plans as of December 31, 2013.

 

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Plan category  Number of securities
to be issued upon
exercise of
outstanding options,
warrants and rights
   Weighted average
exercise price of
outstanding options,
warrants and rights
   Number of securities
remaining available for
future issuance under equity
compensation plans
(excluding securities
reflected in column (a)
 
   (a)   (b)   (c) 
Equity compensation plans approved by security holders   -0-    -0-    -0- 
                
Equity compensation plans not approved by security holders   -0-    -0-    19,218,500 
                
Total   -0-    -0-    19,218,500 

 

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.

 

2010 Stock Option Plan

 

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

 

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

 

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

 

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

 

Summary of 2010 Stock Option Plan Issuances:

 

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

 

2011 Stock Option Plan

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

 

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

 

On May 28, 2012, we issued 15,488,000 shares of common stock to our employees as part of our 2011 Stock Option Plan. The shares are compensatory in nature and are fully vested. We have valued the shares consistent with fair value at the time of issuance adjusted for ownership restrictions.

 

On July 25, 2012, we issued 1,028,500 shares of common stock to our employees and vendors as part of our 2011 Stock Option Plan. The shares are compensatory in nature and are fully vested. We have valued the shares consistent with fair value at the time of issuance adjusted for ownership restrictions.

 

Summary of 2011 Stock Option Plan Issuances:

 

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

 

2012 Stock Option Plan

 

On July 25, 2012, Nettalk adopted the 2012 Stock Option Plan (the "Plan") which is intended to advance the interests of the Company’s shareholders by enhancing the Company’s ability to attract, retain and motivate persons who make (or are expected to make) important contributions to the Company by providing such persons with equity ownership opportunities and performance-based incentives, thereby better aligning the interests of such persons with those of the Company’s shareholders. All of the Company’s employees, officers, and directors, and those Company’s consultants and advisors (i) that are natural persons and (ii) who provide bona fide services to the Company not connected to a capital raising transaction or the promotion or creation of a market for the Company’s securities, are eligible to be granted options or restricted stock awards under the Plan. The maximum aggregate number of shares of the Company’s common stock that may be issued under the Plan is 20,000,000 shares of the Company’s common stock.

 

On July 25, 2012, we issued 471,500 shares of common stock to our employees and vendors as part of our 2012 Stock Option Plan. The shares are compensatory in nature and are fully vested. We have valued the shares consistent with fair value at the time of issuance including and adjusted for ownership restrictions.

 

On September 25, 2012, we issued 280,500 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.

 

On October 25, 2012, we issued 30,000 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.

 

July 25, 2012   471,500   Common shares
September 25, 2012   280,000   Common shares
October 25, 2012   30,500   Common shares
Total   781,500   Common shares

 

Recent Sales of Unregistered Securities

 

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

 

Purchase of Equity Securities by the Issuer and Affiliated Purchasers

 

Pursuant to the terms of the Redemption and Debt Restructuring Agreement effective December 31, 2013, Vicis Capital Master Fund (“Vicis”) shall return to netTALK for cancellation (i) 19,995,092 shares of the netTALK’s common stock, $0.001 par value (the “Common Stock”), (ii) 500 issued and outstanding shares of netTALK’s 12% Series A Convertible Redeemable Preferred Stock, par value $.001 per share, and (iii) common stock purchase warrants exercisable for 76,864,250 shares of common stock. Upon completion of the redemption and cancellation pursuant to the Redemption and Debt Restructuring Agreement, netTALK will have 41,324,221 shares of issued and outstanding common stock, $0.001 par value, of which 6,678,484 non-restricted and 34,645,737 restricted.

 

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Item 6. Selected financial data.

 

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

 

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

 

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

 

Critical Accounting Policies

 

The following is a summary of significant accounting policies used in preparing the Company’s financial statements and recent accounting pronouncements that may impact our financial statements.

 

Change in Fiscal Year

 

On May 26, 2011, the Company’s Board of Directors approved a change in the Company’s fiscal year end from September 30, to December 31, effective December 31, 2011. .

 

Use of Estimates

 

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

 

Risk and Uncertainties

 

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

 

Revenue recognition

 

Revenue is generated from product sales, telecom services, shipping, handling charges and leasing cell tower and co-location rack space in our operations center. 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 amounts are collectible from the customers.

 

Revenue is recognized for a device sale when the customer is invoiced for retail sales and when the customer completes the transaction for internet sales. Revenue for telecom service is recognized prorata monthly as the service is used and revenue for 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.

 

Cash and Cash Equivalents

 

We consider all highly liquid cash balances and debt instruments with an original maturity of three months or less to be cash equivalents. We maintain cash balances only in domestic bank accounts, which at times, may exceed FDIC limits. Our cash balances did not exceed the FDIC limits at December 31, 2013.

 

Inventory

 

Inventories are stated at the lower of cost or market. Cost is determined using the first-in first-out method. Obsolete inventory is reserve for as determined.

 

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Property and Equipment

 

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

 

Intangible Assets

 

Intangible assets are stated at cost with amortization calculated using the straight line method over the estimated useful lives of the assets, which range from three to five years.  

 

Impairments and Disposals

 

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

 

Research and Development and Software Costs

 

The Company accounts for its research and development costs in accordance with applicable accounting pronouncement which states that costs incurred for research and development be charged to expense until the product has reached technological feasibility. At this point, all costs should be capitalized until the product is available for general release to customers.

 

The Company has determined that technological feasibility for its products is reached after all high-risk development issues have been resolved through internal and customer base testing. Generally, new products offered to customers and improvements to the Company’s servers are placed in service on attainment of technological feasibility.

 

The Company has not capitalized any of its research and development costs. Research and development expenses were $953,370 and $1,211,711 for the years ended December 31, 2013 and 2012, respectively.

 

Reclassifications

 

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

 

Share-Based Payment Arrangements

 

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

 

NetTalk adopted a 2010 Stock Option Plan, a 2011 Stock Option Plan and a 2012 Stock Option Plan (the "Plans") which are intended to advance the interests of the Company’s shareholders by enhancing the Company’s ability to attract, retain and motivate key individuals by providing such persons with equity ownership opportunities and performance-based incentives, thereby better aligning the interests of such persons with those of the Company’s shareholders. All of the Company’s employees, officers, and directors, and those Company’s consultants and advisors (i) that are natural persons and (ii) who provide bona fide services to the Company not connected to a capital raising transaction or the promotion or creation of a market for the Company’s securities, are eligible to be granted options or restricted stock awards under the Plans.

 

Financial Instruments

 

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

 

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

 

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

 

Certain risks and concentration

 

Our primary manufacturer accounted for approximately 22% of our cost of goods sold and 2% of outstanding accounts payable at the year ended December 31, 2013 and our primary telecom provider, who as of March 11, 2014 is a related party, accounted for approximately 26% of our cost of sales and approximately 38% of accounts payable at the year ended December 31, 2013.

 

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

 

Redeemable Preferred Stock

 

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

  

Loss per common share

 

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

 

Recent accounting pronouncements

 

In February 2013, the Financial Accounting Standards Board issued ASU No. 2013-02, Reporting Amounts Reclassified Out of Accumulated Other Comprehensive Income ("ASU 2013-02"). ASU 2013-02 requires an entity to present, either on the face of the statement where net income is presented or in the notes to the financial statements, significant amounts reclassified out of accumulated other comprehensive income (loss) by the respective line items of net income but only if the amount reclassified is required under U.S. GAAP to be reclassified to net income in its entirety in the same reporting period. Amounts that are not required to be reclassified in their entirety to net income must be cross-referenced to other disclosures that provide additional detail. This guidance was effective on a prospective basis for the annual and interim reporting periods for the Company beginning January 1, 2013. The Company's adoption of this standard did not have a significant impact on its consolidated financial statements. The Company's accumulated other comprehensive loss is comprised of one item pertaining to the Company's unrealized gains and losses on marketable securities. Reclassification of the gains or losses occurs when the specific investments are sold.

 

General and Recent Developments

 

Effective December 31, 2013, the Company executed a Redemption and Debt Restructuring Agreement with Vicis Capital Master Fund ("Vicis") to, among other things, (1) extinguish $13,662,615 of debt, (2) extinguish $436,234 of accrued interest, (3) extinguish $5,000,000 of 12% Series A convertible redeemable preferred stock, (4) cancel 19,995,092 shares of the Company’s common stock and (5) cancel common stock purchase warrants exercisable for 76,864,250 shares of the Company’s common stock. Additionally, the remaining $3,000,000 promissory note matures June 1, 2014 and has two one-year extensions if the Company pays the current accrued interest prior to maturity.

 

Effective March 11, 2014, netTALK and Telestrata LLC (“Telestrata”), a Colorado limited liability company executed a restricted stock and warrant purchase agreement, pursuant to which, in part, Telestrata purchased: (a) 25,441,170 shares of the Company’s common stock and (b) a common stock purchase warrant entitling Telestrata to purchase share of common stock of the Company equal to 20% of the then outstanding shares of common stock of netTALK.

 

The purchase price for the shares and warrant was $4,571,939, payable as follows: (a) $500,000 in the form of the conversion and cancellation of two promissory notes issued to Samer Bishay in May and July 2013, (b) $837,373 in loans to the Company received in the third and fourth quarters of 2013 and (c) the satisfaction by Telestrata of $2,734,566 of liabilities of the Company.

 

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The Company executed a secured promissory note dated February 27, 2014 in favor of Telestrata for $4,071,940. Interest accrues at 5% and is due at maturity date which is March 1, 2016. Advanced payments, as defined, were received in cash on March 3 and April 16, 2014, of $200,000 and $50,000, respectively, from an affiliate of Telestrata. And during the first quarter of 2014, the Company received $250,000 of indirect cash payments for support of its telecommunications traffic network from an affiliate of Telestrata. These payments will be added to the promissory note increasing the note to $4,571,940.

 

Our Ability to Continue as a Going Concern

 

The accompanying financial statements have been prepared and are presented assuming the Company’s ability to continue as a going concern. The Company has incurred significant recurring losses from operations and is dependent on outside sources of funding for continuation of its operations. Our independent registered public accounting firm issued its report dated May 7, 2014, in connection with the audit of our financial statements as of December 31, 2013, that included an explanatory paragraph describing the existence of conditions that raise substantial doubt about our ability to continue as a going concern.

 

The accompanying financial statements do not include any adjustments relating to the recoverability and classification of asset carrying amounts or the amount and classification of liabilities that might result from the outcome of this uncertainty.

 

In order to address the need to satisfy its continuing obligations and realize its long term strategy, management has been reviewing various strategic alternatives and has taken several steps and is considering additional actions to improve its operating and financial results, which we hope will be sufficient to provide the Company with the ability to continue as a going concern, including the following:

 

·As a result of the Redemption Agreement, we restructured the Company’s debt resulting in the extinguishment of $13,662,615 of debt, $436,234 of accrued interest and $1,301,116 accrued dividends, effective December 31, 2013.
·We identified key vendors and developed strategic alliances whereby the Company has reduced its cost of providing telecom service and extended the due dates of certain promissory notes to March 1, 2016.
·We have implemented more stringent credit and collection procedures and controls in an attempt to reduce days outstanding of trade accounts receivable and improve working capital.
·We eliminated 26 employees and reduced costs during 2013 by $1,164,000.
 ·We have executed an agreement with a New York based investment banker to obtain equity and or debt financing.

 

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In addition, we are seeking financing from other sources, including the possibility of an infusion of equity, to generate additional funds for operations, including the retention of an investment banker to seek funding and evaluate other strategic alternatives. There is no assurance that the above actions will allow the Company to continue as a going concern.

 

Based upon the steps outlined above being successful, we hope our cash on hand and the maintenance of our strategic alliances with a key vendor, who as of March 11, 2014 is a related party, will provide sufficient cash to meet current obligations for our operations to allow the Company to continue as a going concern.

 

There can be no assurance that the actions will be successful and any such new financing or equity infusion will be available or that we could obtain any such arrangements on terms suitable to us.

 

 Liquidity and Capital Resources

 

At December 31, 2013, we had negative working capital of $3,313,436 compared to negative working capital of $19,440,348 at December 31, 2012. The increase in working capital was due primarily to the effects of the Redemption Agreement which resulted in the (1) extinguishment of $13,662,615 of debt, (2) extinguishment of $436,234 of accrued interest and (3) extinguishment of $1,601,116 of accrued dividends as discussed above, and offset by a reduction in accounts receivable and inventories. At December 31, 2013, we had cash and cash equivalents and restricted cash of $260,720 compared to cash and cash equivalents and restricted cash of $211,606 at December 31, 2012.

 

Net cash used in operations for the year ended December 31, 2013 was $3,783,103 compared to net cash used in operations of $5,248,675 for the same period of 2012. The decrease in net cash used in operations was primarily due to the reduction in net loss of $4,601,441 for the year ended December 31, 2013 compared to $14,715,006 for the same period in 2012.

 

Net cash used in investing activities for the year ended December 31, 2013 was $105,035 compared to net cash used in investing activities of $317,395 for the same period of 2012. The decrease in net cash used in investing activities was due primarily to the reduction in fixed asset acquisitions for the year ended 2012 compared to 2013.

 

Net cash provided by financing activities in the year ended December 31, 2013 was $3,868,582 compared to net cash provided by financing activities of $4,123,154 for the same period of 2012. The decrease in cash provided by investing activities was due primarily to the reduction in proceeds from the mortgage payable offset by an increase in promissory and demand notes.

 

Future Commitments and Funding Sources

 

Our primary sources of cash are proceeds from sales to customers and funds raised from investors.

 

The accompanying financial statements have been prepared and are presented assuming the Company’s ability to continue as a going concern. The Company has incurred significant recurring losses from operations and is dependent on outside sources of funding for continuation of its operations. Our independent registered public accounting firm issued its report dated May 7, 2014, in connection with the audit of our financial statements as of December 31, 2013, that included an explanatory paragraph describing the existence of conditions that raise substantial doubt about our ability to continue as a going concern.

 

The accompanying financial statements do not include any adjustments relating to the recoverability and classification of asset carrying amounts or the amount and classification of liabilities that might result from the outcome of this uncertainty.

 

In order to address the need to satisfy its continuing obligations and realize its long term strategy, management has been reviewing various strategic alternatives and has taken several steps and is considering additional actions to improve its operating and financial results, which we hope will be sufficient to provide the Company with the ability to continue as a going concern, including the following:

 

·As a result of the Redemption Agreement, we restructured the Company’s debt resulting in the extinguishment of $13,662,615 of debt, $436,234 of accrued interest and $1,301,116 accrued dividends, effective December 31, 2013.
·We identified one of our key vendors and developed a strategic alliance whereby the Company has reduced its cost of providing telecom service and extended the due dates of certain promissory notes to March 1, 2016.
·We have implemented more stringent credit and collection procedures and controls in an attempt to reduce days outstanding of trade accounts receivable and improve working capital.
·We eliminated 26 employees and reduced costs during 2013 by $1,164,000
 ·We have executed an agreement with a New York based investment banker to obtain equity and or debt financing

 

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In addition, we are seeking financing from other sources, including the possibility of an infusion of equity, to generate additional funds for operations and to take advantage of lower interest rates, including the retention of an investment banker to seek funding and evaluate other strategic alternatives.

 

There is no assurance that the above actions will allow the Company to continue as a going concern.

 

Based upon the steps outlined above being successful, we hope our cash on hand and the maintenance of our strategic alliance with a key vendor will provide sufficient cash to meet current obligations for our operations to allow the Company to continue as a going concern. Our ability to maintain and improve our long-term liquidity is primarily dependent on our ability

 

There can be no assurance that the actions will be successful and any such new financing will be available or that we could obtain any such financing on terms suitable to us.

 

Debt

 

netTALK executed a Redemption and Debt Restructuring Agreement with Vicis Capital Master Fund effective December 31, 2013 (“Vicis”) to, among other things, extend the term of our loans to June 30, 2014, with two additional one year extensions, and reduce the overall loan amount from approximately seventeen million dollars ($17,000,000) to three million dollars ($3,000,000). The restated loan accrues interest at six (6%) percent per annum. In addition, pursuant to the Redemption and Debt Restructuring Agreement, all shares and derivative securities including the Series A Convertible Preferred Stock, Series B Convertible Preferred Stock, Common Stock, and warrants to purchase shares of Series A Convertible Preferred Stock and Series B Convertible Preferred Stock held by Vicis have been returned to netTALK and will be cancelled. The holders received no additional consideration to effect the modification.

 

During the third and fourth quarters of 2013, the Company received advances of $854,278 from a previously third party and now a related party. These advances were rolled into secured promissory to Telestrata LLC.On March 11, 2014, netTALK issued its Secured Promissory Note to Telestrata LLC, a Colorado limited liability, which provides: (a) an original principal balance of $4,071,939.84, (b) an increase in principal upon advances by the lender up to an aggregate of $500,000 at the request of the Company, (c) interest accruing at a rate per annum of five percent (5%), and (d) a maturity date of March 1, 2016.

 

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 memorialized by a future advance promissory note issued by us, which was consolidated with an initial advance of $1,000,000 from 1080 NW 163rd Drive, LLC. The consolidated promissory note has an aggregate principal balance of $1,400,000. The consolidated promissory note, among other matters, accrues interest at 12% per annum, is payable in full on November 29, 2014, and is secured by the Company’s corporate office building, located at 1080 NW 163rd Drive, Miami Gardens, FL 33169.

 

On February 13, 2013 and April 10, 2013 netTALK received advances of $100,000 and $75,000 from a third partyA formal promissory note was issued in March 2014 effective December 31, 2013. The advances of $100,000 and $75,000 accrue interest at 6% per year and the note matures June 30, 2015.

 

On February 19, 2013, August 9, 2013, August 14, 2013 and September 3, 2013the Company’s CEO advanced the Company $25,000, $5,000, $20,000 and $25,000, respectively. These advances are not evidenced by a formal promissory note. These advances were for working capital and these advances were repaid by the Company as of December 31, 2013.

 

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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. The majority of this debt was extinguished in December 2013 as a result of the Redemption Agreement as discussed thoughout this Form 10-K 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, of our face value $5,266,130, $2,000,000, and $3,500,000 debentures, using the effective interest rates on the issuance dates, 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 for the year ended December 31, 2012.

 

Results of Operations

 

Year Ended December 31, 2013 Compared To Same Period 2012

 

Revenues: Net revenues were $6,024,150 for the year ended December 31, 2013, compared to $5,790,983 for the year ended December 31, 2012. The increase in revenues is due primarily to the increase in sales from our telecommunication services offset by the decrease in sales of netTALK devices. We have historically benefitted from a high degree of revenue retention from both subscription based renewals. This high degree of customer retention means that our customers provide a stable and reliable cash flow retention model. Our customers typically pay fees in advance which are deferred and recognized ratably over the service period.

 

Cost of sales: Cost of sales were $4,678,863 for the year ended December 31, 2013, compared to $6,184,787 for the year ended December 31, 2012. The decrease in cost of sales is due primarily to the reduction in sales of our devices and a reduction in the cost of servicing our telecommunication customers.

 

Operating Expenses: Operating expenses were $4,953,388 for the year ended December 31, 2013 compared to $7,685,660 for the year ended December 31, 2012. The decrease in operating expenses was part of management’s cost cutting plan necessary to conserve working capital in order to maintain liquidity.

 

   12-31-13   12-31-12   $ Decrease   % Decrease 
Advertising   373,308    1,019,882    (646,574)   -63%
Compensation & Benefits   1,301,904    1,692,237    (390,333)   -23%
Professional fees   438,823    884,580    (445,757)   -50%
Depreciation & Amortization   298,647    262,842    35,805    14%
Research & Development   953,370    1,211,711    (258,341)   -21%
General & Administrative   1,587,337    2,614,408    (1,133,702)   -39%
Total   4,953,388    7,685,660    (2,838,903)   -36%

 

Research and development costs were reduced the least in order to maintain our competitiveness and continue to develop the most advanced products possible for our customers.

 

General and Administrative Expenses: General and administrative expenses were $1,587,337 for the year ended December 31, 2013, compared to $2,614,408 at year ended December 31, 2012. The decrease in general and administrative expenses was part of management’s cost cutting plan necessary to conserve working capital in order to maintain liquidity.

 

   12-31-13   12-31-12   $ Decrease   % Decrease 
Shipping outbound   61,101    437,126    (376,025)   -86%
Insurance   214,490    272,240    (57,750)   -21%
Rent & occupancy   -    134,393    (134,393)   -100%
Taxes and licenses   102,205    148,619    (46,414)   -31%
Travel   40,906    168,599    (127,693)   -76%
Commissions   399,393    667,176    (267,783)   -40%
Other   769,243    786,255    (17,012)   -2%
Total   1,587,337    2,614,408    (1,027,071)   -39%

 

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Rent and occupancy was decreased by 100% due to the Company purchasing and owning the building which houses the corporate office and operations center August 8, 2011 as discussed in Item 2. Properties. The building was renovated during 2011 and early 2012 resulting in rent & occupancy costs during the year ended December 31, 2012.

 

Loss from operations: The loss from operations was $3,608,101 for the year ended December 31, 2013, compared to $8,079,464 for the year ended December 31, 2012. The reduction in the loss is due primarily to the significant reduction in operating expenses, the reduction in cost of sales as a percent of sales, plus the increase in sales.

 

Interest Expense: Interest expense was $1,479,186 for the year ended December 31, 2013 compared to $3,500,512 for the year ended December 31, 2012. The reduction in interest expenses is primarily due to the reduction in amortization of debt discount and debt issue costs associated with debentures which were converted to common stock in August 2011 slightly offset by an increase in debt throughout 2013.

 

Loss From Debt extinguished: Loss from debt extinguished was zero for the year ended December 31, 2013, compared to $3,135,235 at December 31, 2012. There was no gain or loss from debt extinguishment in 2013. The Company did extinguish approximately $14 million of debt, as a result of the Redemption Agreement, which was recorded as an equity transaction. The result was a decrease to common stock of $19,995, and an increase to additional paid-in capital of $14,098,847.

 

Net Loss: Net loss for the year ended December 31, 2013 was $4,787,831 compared to $14,715,006 at December 31, 2012. The reduction in the net loss is due primarily to the significant reduction in operating expenses, the reduction in cost of sales as a percent of sales, no loss from debt extinguishment, offset by other income of $299,457.

 

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Contractual obligations – Not Applicable

 

Off-Balance Sheet Arrangements - NONE

 

Item 7A. Quantitative and Qualitative Disclosures About Market Risk

 

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

 

Item 8. Financial Statement and Supplementary Data

 

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

 

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

 

On September 23, 2013 netTALK changed independent registered accounting firms 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.

 

Item 9A(T). Controls and Procedures

 

Disclosure controls

 

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

 

As of December 31, 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 officer, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.

 

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

 

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

 

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

 

Our Chief Executive Officer and Chief Financial Officer are in the process of determining how best to change our current system and implement a more effective system to insure that information required to be disclosed in this annual report on Form 10-K has been recorded, processed, summarized and reported accurately.  Our management acknowledges the existence of this problem, and intends to develop 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.  

 

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Management report on internal control over financial reporting

 

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

 

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

 

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

 

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

 

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

 

Our management assessed the effectiveness of our internal control over financial reporting as of December 31, 2013. In making this assessment, our management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in internal control – integrated framework. Based on our assessment, management concluded that as of December 31, 2013, our internal controls over financial reporting are not effective based on those criteria.

 

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

 

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

 

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

 

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

 

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

 

Changes in Internal Controls.

 

During the year ended December 31, 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.

 

Item 9B.  Other Information

 

None

 

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Part III

 

Item 10. Directors, executive officers and corporate governance The following table sets forth certain information with respect to each of our directors, executive officers and key employees as of December 31, 2013. Their ages, positions, dates of initial election or appointment, and the expiration of their terms are as follows:

 

Name Age Position Period served
Anastasios Kyriakides 66 Director, Chairman of the Board, Chief Executive Officer and Secretary May 2008 to present
Kenneth A. Hosfeld 62 Director, Vice President May 2008 to present
Steven Healy 51 Chief Financial Officer December 2013 to present
Shad Stastney (Resigned) 46 Director May 2012 to June 6, 2013
Dr. George Gabb 45 Director May 2011 to present

 

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

 

Background of Executive Officers and Directors

 

Anastasios Kyriakides, Director, Chief Executive Officer, Secretary. Mr. Kyriakides has served as a member of the Company’s board of directors and as the Company’s Chief Executive Officer and Secretary since September 2008. Mr. Kyriakides received a Bachelor of Science in business from Florida International University in 1975. In 1977, he received a degree in investment banking from the American Institute of Banking. From 1979 until present, Mr. Kyriakides has consulted for numerous companies in the areas of shipping, travel, banking and electronics. Mr. Kyriakides began his career in the electronics development field when, in 1979, he founded and served as Chairman of Lexicon Corporation, producer of the LK300, the first hand held electronic language translator which translated words and phrases into 12 different languages. Lexicon was publicly traded on the NASDAQ, under the symbol LEXI, until it was ultimately acquired by Nixdorf Computers of Germany. Mr. Kyriakides was also the founder of Delcor Industries, established in 1980 in Hollywood, Florida. Delcor was an electronics manufacturing facility employing over 150 employees to assemble OEM products for various electronics companies including IBM mainframe and Gable Division. In 1983, Mr. Kyriakides founded the Mylex Corporation to develop and produce the world’s first hand-held optical scanner and VGA card for personal computers. As the President and Chairman, Mr. Kyriakides guided Mylex from its beginning as a private company to its becoming a public company traded on the NASDAQ under the stock symbol MYLX until it was acquired as a wholly owned subsidiary of IBM (NYSE: IBM). In 1983, Mr. Kyriakides was the founder and Chairman of Tower Bank NA, a full service commercial bank, with three offices, headquartered in Dade County, Florida. Mr. Kyriakides also has extensive experience in the cruise line and travel industries. His cruise ship career started with Carnival Cruise line out of the Port of Miami, and continued to a successful startup with Tropicana Cruises; one of the first gaming ships out of the Port of Miami. Mr. Kyriakides founded Regency Cruise Line in 1984, as the world’s first publicly traded company in passenger shipping, and served as its Chairman and Secretary until 1987. Mr. Kyriakides also organized the successful start-up of Seawind Cruise Line. In his three years with Seawind Cruise Line, Mr. Kyriakides served as its founder, chairman, chief executive officer and secretary. From 1994 to 1996, Mr. Kyriakides served as the Chairman of Montgomery Ward Travel, a company created to provide full travel services to eight million Montgomery Ward customers and credit card holders. Immediately prior to joining the Company, Mr. Kyriakides served as Chief Executive Officer of Interlink Global Corporation from 1994 until September, 2008. Interlink Global Corporation provided telecommunications applications utilizing hardware and software that enables its domestic and worldwide users to access the internet as a transmission medium for placing telephone calls.

 

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

 

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Steven Healy, CPA, Chief Financial Officer. Mr. Healy is a graduate of the University of Florida with a bachelor degree in accounting. Mr. Healy completed his fifth year CPA qualification requirement at the University of Central Florida and passed the CPA exam in 1989. Mr. Healy began his career with Touche Ross as an auditor. Touche Ross merged with Deloitte Haskin and Sells forming the new company Deloitte & Touche. After becoming a manager, Mr. Healy left Deloitte & Touche and join an audit client, United Leisure Industries, Inc., as the accounting manager. United Leisure is a vertically integrated company which manufactures portable spas, spa covers and billiard tables and distributes and sells such products and other leisure products including above ground swimming pools and accessories, throughout the Southeast United States with 35 retail stores. Mr. Healy was promoted to Controller and was with United Leisure from 1993 to 1998. Mr. Healy moved to South Florida and worked as the Chief Financial Officer for two public companies, SystemOne Technologies from 1999 to 2003, a manufacturer of a washing machine size parts washer utilizing proprietary technology supported by 7 patents and Imperial Industries, Inc., a manufacturer and distributor of building materials and accessories which had 2 manufacturing plants and 13 distribution centers prior to becoming a casualty of the Great Recession. Most recently, Mr. Healy began working for netTALK as the chief financial officer in December 2013.

 

Dr. George Gabb, Director.

 

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

 

Shad Stastney, Director (Resigned June 6, 2013)

 

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

 

Significant employees

 

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

 

Family relationship – NONE.

 

Involvement in legal proceedings

 

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

 

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

 

27
 

 

Committees

 

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

 

Employment Agreements

 

On January 2, 2014, the Company entered into employment agreements with the chief executive officer, executive vice President, chief financial officer, chief operating officer and chief technical officer according to the following terms. Stated salary for 2014 and 2015, a term of 2 to 5 years and a change of control payment, as defined in the agreement.

 

Currently, with the exception of the chief executive officer, executive vice president, chief financial officer, chief operating officer and chief technical officer, all other employment with the Company is at will and may be terminated by either the employee or the Company at any time.

 

Compliance with Section 16(a) of the Exchange Act

 

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

 

Section 16(a) Beneficial Ownership Reporting Compliance

 

Name of Filer  Title  # of Late
Reports
   # of
Transactions
not timely
reported
   # of Failure
to File
 
Vicis Capital Master Fund  10% beneficial owner   0    0    1 
Telestrata LLC  10% beneficial owner   0    0    1 

 

Code of Ethics

 

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

 

Material Changes to Nominations by Security Holders of Director Candidates

 

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

 

Audit Committee

 

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

 

Audit Committee Financial Expert

 

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

 

28
 

 

Item 11. Executive compensation

 

The following table contains compensation information for our executive officers for the period ended December 31, 2013 and December 31, 2012. No other officer received compensation greater than $100,000 for either fiscal year. All of the information included in this table reflects compensation earned by the individuals for services rendered to our Company and all references in the following tables to stock awards relate to awards of common stock granted by us.

 

Name and Position  Year
ended
Dec 31,
   Salary   Common Stock Awards   Total 
Anastasios Kyriakides, Director,   2013   $250,000(2)  $0(3)  $258,600 
Chief Executive Officer (1)   2012   $250,000(2)  $173,072(3)  $423,072 
Kenneth Hosfeld, Director,   2013   $96,000(8)  $0(9)  $96,000 
Vice President (7)   2012   $96,000(8)  $3,711(9)  $99,711 
Guillermo Rodriguez, Director,   2013   $21,267(5)  $0(6)  $21,267 
Chief Financial Officer (4)   2012   $65,000(5)  $3,711(6)  $68,711 
Steven Healy, CPA,   2013   $3,654(10)  $0()  $65,000 
Chief Financial Officer (10)   2012                

 

(1)Mr. Kyriakides was appointed to serve as our Chairman of the Board, Chief Executive Officer on September 10, 2008.
(2)Mr. Kyriakides annual salary increased to $250,000 at January 1, 2012 per his amended employment agreement dated May 16, 2011. July 1, 2013, the CEO’s cash salary was decreased to $175,000 per year while the remaining $75,000 per year was accrued.
(3)No stock grants given in 2013 and 13.2 million shares were given in 2012 valued at $173,072.
(4)Mr. Rodriguez retired as Chief Financial Officer April 30, 2013.
(5)Mr. Rodriguez annual salary was $65,000 during the fiscal year ended December 31, 2013.
(6)No stock grants given in 2013 and 283,000 shares were given in 2012 valued at $3,711.
(7)Mr. Hosfeld was appointed to serve as our Vice President on September 30, 2008.
(8)Mr. Hosfeld annual salary is $96,000.
(9)No stock grants given in 2013 and 283,000 shares were given in 2012 valued at $3,711.
(10)Mr. Healy was appointed Chief Financial Officer December 2013.
(11)No stock grants were given in 2013.

 

Overview

 

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

 

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

 

Elements of executive compensation

 

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

 

Compensation of Directors

 

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

 

29
 

 

Director Independence

 

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

 

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

 

The following table sets forth certain information, as of December 31, 2013 with respect to the beneficial ownership of the outstanding common stock by (i) any holder of more than five (5%) percent; (ii) each of our executive officers and directors; and (iii) our directors and executive officers as a group. Except as otherwise indicated, each of the stockholders listed below has sole voting and investment power over the shares beneficially owned.

  

Type  Name of Beneficiary  Amount and
Nature of Owner
   Percent 
Common stock  Anastasios Kyriakides   18,985,539(3)   40%
Common stock  Kenneth A. Hosfeld   2,238,000    5%
Common stock  Guillermo Rodriguez   2,483,000    5%
Common stock  Dr. George Gabb    106,000    0.2%
Executive officers and directors      23,812,539    50%
   Shad Stastney   3,250,000(5)   7%
   Samer Bishay   6,250,000(4)   13%
Total Common stock of officers, directors and beneficial owners      33,312,539    70%

 

(1)Unless otherwise indicated, the address of each shareholder is 1080 NW 163rd Drive, Miami, Florida 33169. Shad Stastney is located in New York, NY and Samer Bishay is located in Canada

 

(2)Beneficial ownership of shares is determined under Rule 13d-3(d)(1) of the Exchange Act and generally includes any shares over which a person exercises sole or shared voting or investment power and the number of shares that can be acquired within sixty (60) days upon exercise of an option or conversion of warrants and debentures. Common stock subject to these convertible securities are deemed to be outstanding for the purpose of computing the ownership percentage of the person holding such convertible security, but are not deemed to be outstanding for the purpose of computing the ownership percentage of any other person. Applicable percentage of ownership is based on 47,574,221 of fully diluted shares of Net Talk.com, Inc. common stock being issued and outstanding as of December 31, 2013. Calculations do not include outstanding warrants or options, or other rights issued by the Company, unless the reporting person is the beneficial owner of the warrants, options, or other rights.

 

(3)Includes 18,985,539 shares of common stock owned by Kyriakides Investments, LLC.

 

(4)Includes 6,250,000 shares of common stock issuable upon conversion of 5% secured convertible promissory notes with a face value of $300,000 and $200,000. These notes are convertible into shares of the Company’s common stock at a rate of $0.08 per share.

 

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

 

Except as described below, there were no other transactions since the beginning of our last fiscal year, and there are no proposed transactions, that involve amounts in excess of the lesser of $50,000 or 1% of the average of our total assets during our two most recently completed fiscal years, to which we were or are to become a party in which any director, executive officer, beneficial owner of more than five (5%) percent of our common stock, or members of their immediate families had, or is to have, a direct or indirect material interest, except, during the period ended December 31, 2013 we incurred and paid certain consulting service fees to a related party. Effective December 31, 2013, the Company executed a Redemption and Debt Restructuring Agreement with Vicis Capital Master Fund ("Vicis") to, among other things, (1) extinguish $13,662,615 of debt, (2) extinguish $436,234 of accrued interest, (3) extinguish $5,000,000 of 12% Series A convertible redeemable preferred stock, (4) cancel 19,995,092 shares of the Company’s common stock and (5) cancel common stock purchase warrants exercisable for 76,864,250 shares of the Company’s common stock. Additionally, the remaining $3,000,000 promissory note matures June 1, 2014 and has two one-year extensions if the Company pays the current accrued interest prior to maturity.

 

These securities were returned to the Company on February 5, 2014, and will be cancelled. Accordingly, the Redemption Agreement has been accounted for as of December 31, 2013, its effective date, and the securities in process of being returned have been reflected as a reduction of the related shares of preferred and common stock and other securities as of December 31, 2013.

 

30
 

 

Samer Bishay is the beneficial owner of 6,250,000 shares of common stock issuable upon conversion of 5% secured convertible promissory notes with a face value of $300,000 and $200,000. These notes are convertible into shares of the Company’s common stock at a rate of $0.08 per share. Mr. Bishay was elected President of the Company in the first quarter of 2014. MR. Bishay is also the owner of Iristel, Inc. which is our primary provider of telecom services and the owner of Telestrata, LLC which is now a significant shareholder of the Company effective in the first quarter of 2014.

 

2012 Issuance of Non-Convertible Debentures

 

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

 

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

 

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

 

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

 

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

 

Item 14. Principal Accountant Fees and Services

 

Pre-Approval Policies and Procedures

 

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

 

Audit Fees

 

The aggregate fees billed by Thomas Howell Ferguson PA formerly known as Meeks International, LLC for professional services for the audit of the annual financial statements and Form 10-K and reviews of the financial statements on Form 10-Q for 2012 was $91,000 and for the 2013 reviews and audits, $65,000 was charged by Zachary Salum Auditors, P.A.

  

Audit-Related Fees

 

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

 

Tax Fees

 

There were no fees paid for tax or consulting services for the year ended December 31, 2013.

 

All Other Fees

 

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

 

31
 

 

Part IV

 

Item 15. Exhibits, financial statement schedules

 

Exhibit No.   Description
     
31.1   Certification of Principal Executive Officer pursuant to 13a-14(a) under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2   Certification of Principal Financial Officer pursuant to 13a-14(a) under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1   Certification of the Principal Executive Officer pursuant to U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 
32.2   Certification of the Principal Financial Officer pursuant to U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
10.1   Employment agreement, chief executive officer
10.2   Employment agreement, executive vice president
10.3   Employment agreement, chief financial officer
10.4   Employment agreement, chief operating officer
10.5   Employment agreement, chief technical officer

 

SIGNATURES

 

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

 

  NET TALK.COM, INC.
   
Date: May 7, 2014 By: /s/ Anastasios Kyriakides
  Anastasios Kyriakides
  Chief Executive Officer (Principal Executive Officer)
   
Date: May 7, 2014 By: /s/ Steven Healy, CPA
  Steven Healy, CPA
  Chief Financial Officer (Principal Financial Officer and
  Principal Accounting Officer)

  

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

 

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

 

32
 

 

Index to financial statements Page
   
Reports of Independent Registered Public Accountanting firm 34
Balance sheets as of December 31, 2013 and 2012 36
Statements of operations for the years ended December 31, 2013 and 2012 37
Statements of cash flows for the years ended December 31, 2013 and 2012 38
Statements of stockholders’ deficit for the year ended December 31, 2013 and 2012 39
Notes to financial statements 40

 

33
 

 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

To the Board of Directors and Stockholders of

NetTalk.com, Inc.

Miami Gardens, Florida

 

We have audited the accompanying balance sheet of NetTalk.com, Inc. as of December 31, 2013, and the related statement of operations, stockholders’ deficit, and cash flows for the year then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit.

 

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

 

In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of NetTalk.com, Inc. at December 31, 2013, and the results of its operations and its cash flows for the year then ended, in conformity with accounting principles generally accepted in the United States of America.

 

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

 

/s/ Zachary Salum Auditors P.A.

Miami, Florida

 

May 7, 2014

 

34
 

 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

To the Board of Directors and Stockholders of

 

NetTalk.com, Inc.

Miami Gardens, Florida

 

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

 

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

 

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

 

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

 

Thomas Howell Ferguson P. A.

Tampa, Florida

 

September 4, 2013

 

35
 

 

Nettalk.com Inc.

Balance Sheets

 

   December 31,   December 31, 
   2013   2012 
Assets          
Current assets:          
Cash and cash equivalents  $76,791   $96,347 
Restricted cash   183,930    115,259 
Accounts receivable, net   175,157    472,233 
Inventory   1,126,300    1,467,774 
Prepaid expenses   91,843    277,908 
Note receivable        7,000 
Total current assets   1,654,021    2,436,521 
           
Building, telecommunications equipment, land and other property, net   2,794,148    2,980,068 
Intangible assets, net   116,770    193,007 
Other assets   27,253    37,253 
Total assets  $4,592,192   $5,646,849 
           
Liabilities, redeemable preferred stock and stockholders' deficit          
Current liabilities:          
Accounts payable  $2,434,952   $2,211,622 
Accrued dividends   -    1,301,116 
Accrued expenses   773,905    477,743 
Due to Shareholder   87,583      
Deferred revenue   1,857,407    2,246,052 
Current portion of senior debentures and demand notes   1,400,000    15,640,336 
Total current liabilities   6,553,847    21,876,869 
           
Mortgage payable   -    1,000,000 
Long term debt   4,529,278      
Total liabilities   11,083,125    22,876,869 
           
Redeemable preferred stock, $.001 par value, 10,000,000 shares authorized, zero (Net of 500 shares in process of return under Redemption agreement) and 500 issued and outstanding as of December 31, 2013 and December 31, 2012.   -    6,379,016 
           
Stockholders' deficit:          
Common stock, $.001 par value, 300,000,000 shares authorized, 41,324,221 (Net of 19,995,092 shares in process of return under Redemption agreement) and 60,251,355 issued and outstanding as of December 31, 2013 and December 31, 2012.   41,333    60,260 
Additional paid in capital   55,009,280    33,084,420 
Accumulated deficit   (61,541,547)   (56,753,716)
Total stockholders' deficit   (6,490,934)   (23,609,036)
           
Total liabilities, redeemable preferred stock and stockholders' deficit  $4,592,192   $5,646,849 

 

The accompanying notes are an integral part of the financial statements

 

36
 

 

Nettalk.com, Inc

Statements of Operations

 

   Year ended   Year ended 
   December 31,   December 31, 
   2013   2012 
           
Net revenues  $6,024,150   $5,790,983 
           
Cost of revenues   4,678,863    6,184,787 
           
Gross profit   1,345,287    (393,804)
           
Operating expenses   4,953,388    7,685,660 
           
Operating (loss)   (3,608,101)   (8,079,464)
           
Other income (expenses):          
Interest expense   (1,479,186)   (3,500,512)
Debt extinguishment (loss)        (3,135,235)
Other income   299,457      
Interest income        205 
    (1,179,729)   (6,635,542)
Net loss  $(4,787,831)  $(14,715,006)
Loss per common shares:          
Basic and diluted earnings per common share  $(0.08)  $(0.28)
Weighted average shares:          
Basic and diluted   61,035,259    52,733,460 

 

The accompanying notes are an integral part of the financial statements

 

37
 

 

Nettalk.com, Inc.

Statements of Cash Flows

 

   Year ended   Year ended 
   December 31,   December 31, 
   2013   2012 
Cash flow (used) in operating activities:          
Net loss  $(4,787,831)  $(14,715,006)
Adjustments to reconcile net loss to net cash (used) in operations:          
Depreciation   194,366    193,249 
Amortization   104,281    69,593 
Debt and preferred stock extinguished        3,135,235 
Amortization of debt discount   947,279    - 
Derivative value adjustment        3,034,926 
Changes in assets and liabilities:          
Accounts receivables   297,076    103,927 
Prepaid expenses and other assets   186,065    (238,397)
Inventories   341,474    737,481 
Other assets   10,000      
Deferred revenues   (388,645)   562,104 
Accounts payable   223,330    1,322,629 
Accrued expenses   296,162    545,584 
Net cash (used) in operating activities   (2,576,443)   (5,248,675)
Cash flow used in investing activities:          
Restricted cash   (68,671)   (16,382)
Acquisition of corporate offices and operations center and fixed assets   (36,489)   (303,514)
Decrease in deposits        2,501 
Net cash (used) in investing activities:   (105,160)   (317,395)
Cash flow from financing activities:          
Proceeds from promissory and demand notes   2,040,509    2,875,000 
Proceeds from mortgage payable   400,000    1,000,000 
Note receivable   7,000      
Due to shareholder   87,583      
Issuance of common stock (net)   126,955    248,154 
Net cash provided from financing activities   2,662,047    4,123,154 
Net increase (decrease) in cash   (19,556)   (1,442,916)
Cash and cash equivalents, beginning   96,347    1,539,263 
Cash and cash equivalents, ending   76,791    96,347 
Supplemental disclosures:          
Cash paid for interest  $166,400   $10,000 
Cash paid for income taxes  $-   $- 
Cash paid for preferred stock dividends  $-   $- 
           
Non-cash transactions:          
As per redemption agreement          
Write-off of the accrued dividends   1,301,116      
Extinguishment of debt, preferred stock and accrued interest    1,187,653      

 

The accompanying notes are an integral part of the financial statements

 

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Nettalk.com, Inc.

Statement of Stockholders’ Deficit

 

   Common Stock   Additional Paid   Accumulated   Total 
   Shares   Amount   Capital   Deficit   Equity 
Balance at September 30, 2011   39,464,892    39,465    28,258,375    (38,598,424)   (10,300,584)
                          
Accretion of preferred stock   -    -    1,194,745    -    1,194,745 
Net loss   -    -    -    (3,440,286)   (3,440,286)
Balance at December 31, 2011   39,464,892   $39,465   $29,453,120   $(42,038,710)  $(12,546,125)
New common shares   20,786,463    20,795    227,359    -    248,154 
Accretion of preferred stock   -    -    3,403,941    -    3,403,941 
Net loss   -    -    -    (14,715,006)   (14,715,006)
Balance at December 31, 2012   60,251,355   $60,260   $33,084,420   $(56,753,716)  $(23,609,036)
New common shares   1,067,958    1,068    125,897         126,955 
Accretion of preferred stock             1,079,015         1,079,015 
Effects of Redemption Agreement:                         
Write off of preferred stock dividends             1,601,116         1,601,116 
Write off of preferred stock             5,000,000         5,000,000 
Extinguishment of debt             14,098,847        14,098,847 
Cancellation of common stock   (19,995,092)  (19,995)   19,995        
Net loss                  (4,787,831)   (4,787,831)
Balance at December 31, 2013   41,324,221   $41,333   $55,009,280   $(61,541,547)  $(6,490,934)

 

The accompanying notes are an integral part of the financial statements

39
 

 

NetTALK.COM, INC.

Notes to Financial Statements

 

Note 1 – Nature of operations and basis of presentation:

 

NET TALK.COM, INC. (“netTALK” or the “Company”) was incorporated on May 1, 2006 under the laws of the State of Florida. We are a telephone company, who provides, sells and supplies commercial and residential telecommunication services, including services utilizing voice over internet protocol (“VoIP”) technology, session initiation protocol (“SIP”) technology, wireless fidelity technology, wireless maximum technology, marine satellite services technology and other similar type technologies. Our main products are the DUO, DUO II and DUO WIFI, which 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 can connect to an internet hotspot without the use of an Ethernet cable. Our DUO, DUO II and DUO WIFI and their related services are a cost effective solution for individuals, small businesses and telecommuters connecting to any analog telephone, fax or private branch exchange (“PBX”). Our DUO, DUO II and DUO WIFI provide one USB port, one Ethernet port and one analog telephone port. The DUO WIFI offers an additional wireless chip that allows it to connect to internet hotspots without the use of an ethernet cable. A full suite of internet protocol features is available to maximize universal connectivity. In addition, analog telephones attached to our DUO. DUO II and DUO WIFI are able to use advanced calling features such as call forwarding, caller ID, 3-way calling, call holding, call retrieval and call transfer.

 

Note 2 – Going concern and management’s plans

 

The accompanying financial statements have been prepared and are presented assuming the Company’s ability to continue as a going concern. The Company has incurred significant recurring losses from operations and is dependent on outside sources of funding for continuation of its operations. Our independent registered public accounting firm issued its report dated May 7, 2014, in connection with the audit of our financial statements as of December 31, 2013, that included an explanatory paragraph describing the existence of conditions that raise substantial doubt about our ability to continue as a going concern.

 

The accompanying financial statements do not include any adjustments relating to the recoverability and classification of asset carrying amounts or the amount and classification of liabilities that might result from the outcome of this uncertainty.

 

In order to address the need to satisfy its continuing obligations and realize its long term strategy, management has been reviewing various strategic alternatives and has taken several steps and is considering additional actions to improve its operating and financial results, which we expect will be sufficient to provide the Company with the ability to continue as a going concern, including the following:

 

·As a result of the Redemption Agreement, we restructured the Company’s debt on December 31, 2013 resulting in the extinguishment of $13,662,615 of debt, $5,000,000 redeemable preferred stock, $436,234 of accrued interest and $1,301,116 accrued dividends, effective December 31, 2013.
·We identified key vendors and developed strategic alliances whereby the Company has reduced its cost of providing telecom service and extended the due dates of certain promissory notes to March 1, 2016.
·We have implemented more stringent credit and collection procedures and controls in an attempt to reduce days outstanding of trade accounts receivable and improve working capital.
·We eliminated 26 employees and reduced costs during 2013 by approximately $1,164,000 annually.
 · We have executed an agreement with a New York based investment banker to obtain equity and or debt financing.

 

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In addition, we are seeking financing from other sources, including the possibility of an infusion of equity, to generate additional funds for operations, including the retention of an investment banker to seek funding and evaluate other strategic alternatives. There is no assurance that the above actions will allow the Company to continue as a going concern.

 

Based upon the steps outlined above being successful, we expect our cash on hand and the maintenance of our strategic alliances with a key vendor will provide sufficient cash to meet current obligations for our operations to allow the Company to continue as a going concern. Our ability to maintain and improve our long-term liquidity is primarily dependent on our ability to increase sales and raise funds.

 

There can be no assurance that the actions will be successful and any such new financing or equity infusion will be available or that we could obtain any such arrangements on terms suitable to us. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.

 

Note 3 – Summary of Significant Accounting Policies:

 

The following is a summary of significant accounting policies used in preparing the Company’s financial statements and recent accounting pronouncements that may impact our financial statements.

 

Use of Estimates

 

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

 

Risk and Uncertainties

 

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

 

Revenue recognition

 

Revenue is generated from product sales, telecom services, shipping, handling charges and leasing cell tower and co-location rack space in our operations center. 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 amounts are collectible from the customers.

 

Revenue is recognized for a device sale when the customer is invoiced for retail sales and when the customer completes the transaction for internet sales. Revenue for telecom service is recognized prorata monthly as the service is used and revenue for 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.

 

Cash and Cash Equivalents

 

We consider all highly liquid cash balances and debt instruments with an original maturity of three months or less to be cash equivalents. We maintain cash balances only in domestic bank accounts, which at times, may exceed FDIC limits. Our cash balances did not exceed the FDIC limits at December 31, 2013 and 2012.

 

41
 

 

Inventory

 

Inventories are stated at the lower of cost or market. Cost is determined using the first-in first-out method. Obsolete inventory is reserved for as determined.

 

Property and Equipment

 

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

 

Intangible Assets

 

Intangible assets are stated at cost with amortization calculated using the straight line method over the estimated useful lives of the assets, which range from three to five years.

 

Impairments and Disposals

 

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

 

Research and Development and Software Costs

 

The Company accounts for its research and development costs in accordance with applicable accounting pronouncement which states that costs incurred for research and development be charged to expense until the product has reached technological feasibility. At this point, all costs should be capitalized until the product is available for general release to customers.

 

The Company has determined that technological feasibility for its products is reached after all high-risk development issues have been resolved through internal and customer base testing. Generally, new products offered to customers and improvements to the Company’s servers are placed in service on attainment of technological feasibility.

 

The Company has not capitalized any of its research and development costs. Research and development expenses were $953,370 and $1,211,711 for the years ended December 31, 2013 and 2012.

 

Reclassifications

 

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

 

Share-Based Payment Arrangements

 

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

 

NetTalk adopted a 2010 Stock Option Plan, a 2011 Stock Option Plan and a 2012 Stock Option Plan (the "Plans") which are intended to advance the interests of the Company’s shareholders by enhancing the Company’s ability to attract, retain and motivate key individuals by providing such persons with equity ownership opportunities and performance-based incentives, thereby better aligning the interests of such persons with those of the Company’s shareholders. All of the Company’s employees, officers, and directors, and those Company’s consultants and advisors (i) that are natural persons and (ii) who provide bona fide services to the Company not connected to a capital raising transaction or the promotion or creation of a market for the Company’s securities, are eligible to be granted options or restricted stock awards under the Plans.

 

Financial Instruments

 

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

 

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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 and corresponding carrying value.

 

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

 

Certain risks and concentration

 

Our primary manufacturer accounted for approximately 22% of our cost of goods sold and 2% of outstanding accounts payable at year ended December 31, 2013. Our primary telecom service provider who, as of March 11, 2014 is a related party accounted for approximately 26% of cost of goods sold and 38% of outstanding accounts payable at year ended December 31, 2013.

 

One of our customers presently operates under a consignment agreement. Under the agreement we sell and ship merchandise to our customer, and recognizes revenue as we collect payments upon the sale of our product to the ultimate (final) consumer, which assures our collectability.

 

Redeemable Preferred Stock

 

Redeemable preferred stock is initially evaluated for possible classification as liabilities under ASC 480 Distinguishing Liabilities from Equity. Redeemable preferred stock that does not, in its entirety, require liability classification is evaluated for embedded features that may require bifurcation and separate classification as derivative liabilities under ASC 815. In all instances, the classification of the redeemable preferred stock host contract that does not require liability classification is evaluated for equity classification or mezzanine classification based upon the nature of the redemption features. Generally, any feature that could require cash redemption for matters not within our control, irrespective of probability of the event occurring, requires classification outside of stockholders’ equity. See Note 10 for further disclosures about our redeemable preferred stock.

 

Loss per common share

 

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

 

Recent accounting pronouncements

 

In February 2013, the Financial Accounting Standards Board issued ASU No. 2013-02, Reporting Amounts Reclassified Out of Accumulated Other Comprehensive Income ("ASU 2013-02"). ASU 2013-02 requires an entity to present, either on the face of the statement where net income is presented or in the notes to the financial statements, significant amounts reclassified out of accumulated other comprehensive income (loss) by the respective line items of net income but only if the amount reclassified is required under U.S. GAAP to be reclassified to net income in its entirety in the same reporting period. Amounts that are not required to be reclassified in their entirety to net income must be cross-referenced to other disclosures that provide additional detail. This guidance was effective on a prospective basis for the annual and interim reporting periods for the Company beginning January 1, 2013. The Company's adoption of this standard did not have a significant impact on its consolidated financial statements. The Company's accumulated other comprehensive loss is comprised of one item pertaining to the Company's unrealized gains and losses on marketable securities. Reclassification of the gains or losses occurs when the specific investments are sold.

 

Note 4 – Accounts Receivable

 

Trade accounts receivable consisted of the following at:

 

   December 31, 
   2013   2012 
Accounts receivable, gross   $304,501    622,891 
Allowance for doubtful accounts   (129,344)   (150,658)
Total  $175,157   $472,233 

 

Note 5 – Inventory

 

Inventories, recorded at lower of cost or market, are as follows:

 

   December 31, 
   2013   2012 
Raw materials  $721,914    869,740 
Finished goods   404,386    598,034 
Total  $1,126,300   $1,467,774 

 

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Of our $404,386 of finished goods inventory at December 31, 2013, $105,658 is held on consignment at one of our distributors.

 

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

 

During the year ended December 31, 2013 and 2012, there were no write-downs of obsolete inventory.

 

Note 6 – Building, Telecommunications Equipment, Land and Other Property:

  

Telecommunications equipment and other property consist of the following:

 

   Estimated     
  Useful   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 improvement   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 
         3,413,073    3,404,627 
Less accumulated depreciation        (618,925)   (424,559)
Total       $2,794,148   $2,980,068 

 

Depreciation expenses was $194,366 and $193,249 for the years ended December 31, 2013 and 2012, respectively.

 

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

 

Note 7 - Intangible Assets:

 

   Estimated     
   Useful     
Intangible assets consist of following:  Life   December 31, 
       2013   2012 
Trademarks   5   $332,708   $332,708 
Employment agreements   3    225,084    225,084 
Knowhow and specialty skills   3    212,254    212,254 
Workforce   3    54,000    54,000 
Patents   20    93,747    102,942 
Finance Cost   2    83,280    55,236 
         1,001,073    982,224 
Less accumulated amortization        (884,303)   (789,217)
        $116,770   $193,007 

 

Amortization expenses amounted to $104,281 and $69,593 for the years ended December 31, 2013 and 2012, respectively. 


Note 8 – 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.

 

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2010 Stock Option Plan

 

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

 

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

 

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

 

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

 

Summary of 2010 Stock Option Plan Issuances

 

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

 

2011 Stock Option Plan

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

 

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

 

On May 28, 2012, we issued 15,488,000 shares of common stock to our employees as part of our 2011 Stock Option Plan. The shares are compensatory in nature and are fully vested. We have valued the shares consistent with fair value at the time of issuance adjusted for ownership restrictions.

 

On July 25, 2012, we issued 1,028,500 shares of common stock to our employees and vendors as part of our 2011 Stock Option Plan. The shares are compensatory in nature and are fully vested. We have valued the shares consistent with fair value at the time of issuance adjusted for ownership restrictions.

 

Summary of 2011 Stock Option Plan Issuances

 

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

 

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2012 Stock Option Plan

 

On July 25, 2012, Nettalk adopted the 2012 Stock Option Plan (the "Plan") which is intended to advance the interests of the Company’s shareholders by enhancing the Company’s ability to attract, retain and motivate persons who make (or are expected to make) important contributions to the Company by providing such persons with equity ownership opportunities and performance-based incentives, thereby better aligning the interests of such persons with those of the Company’s shareholders. All of the Company’s employees, officers, and directors, and those Company’s consultants and advisors (i) that are natural persons and (ii) who provide bona fide services to the Company not connected to a capital raising transaction or the promotion or creation of a market for the Company’s securities, are eligible to be granted options or restricted stock awards under the Plan. The maximum aggregate number of shares of the Company’s common stock that may be issued under the Plan is 20,000,000 shares of the Company’s common stock.

 

On July 25, 2012, we issued 471,500 shares of common stock to our employees and vendors as part of our 2012 Stock Option Plan. The shares are compensatory in nature and are fully vested. We have valued the shares consistent with fair value at the time of issuance including and adjusted for ownership restrictions.

 

On September 25, 2012, we issued 280,000 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.

 

On October 25, 2012, we issued 30,000 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.

 

July 25, 2012   471,500  Common shares
September 25, 2012   280,000  Common shares
October 25, 2012   30,000  Common shares
Total   781,500  Common shares

 

Note 9 – Securities Option Agreement and Debt:

 

Effective December 31, 2013, the Company executed a redemption and debt restructuring agreement with a major stockholder, Vicis Capital Master Fund ("Vicis") to, among other things, extinguish $13,662,615 of debentures and certain demand notes, $436,234 of accrued interest, $5,000,000 of series A convertible redeemable preferred stock (500 shares of issued and outstanding), cancel 19,995,092 shares of the Company’s common stock and cancel common stock purchase warrants exercisable for 76,864,250 shares of common stock. Additionally, the remaining $3,000,000 promissory note matures June 1, 2014 but has two additional one year extensions if the Company pays the current accrued interest.

 

These securities were returned to the Company on February 5, 2014, and will be cancelled. Accordingly, the Redemption Agreement has been accounted for as of December 31, 2013, its effective date, and the securities in process of being returned have been reflected as a reduction of the related shares of preferred and common stock and other securities as of December 31, 2013.

 

The Company did extinguish approximately $14 million of debt, as a result of the Redemption Agreement, which was recorded as an equity transaction. The result was a decrease to common stock of $19,995 and an increase to additional paid-in capital as follows: $14,098,847 from the extinguishment of debt, $5,000,000 from the write-off of preferred stock and $1,601,116 from the write-off of preferred stock dividends.

 

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

 

   December 31,   December 31, 
   2013   2012 
$2,000,000 face value 12% debenture, due December 31, 2013  $-   $2,398,153 
$3,500,000 face value 12% debenture, due December 31, 2013   -    3,993,053 
$5,266,130 face value 12% debenture, due December 31, 2013   -    6,374,130 
$ 500,000 face value 10% debenture, due December 31, 2013   -    500,000 
$ 500,000 face value 10% debenture, due December 31, 2013   -    500,000 
$ 450,000 face value 10% debenture, due December 31, 2013   -    450,000 
$1,150,000 advances on 10% debenture, due December 31, 2013   -    1,150,000 
$275,000 demand notes, due on demand        275,000 
$3,000,000 face value 5% promissory note, due June 1, 2014   3,000,000    - 
$300,000 5% secured convertible promissory note, due December 1, 2013 (1)   300,000    - 
$200,000 5% secured convertible promissory note, due January 15, 2014 (1)   200,000    - 
$1,029,278 demand notes, due on demand   1,029,278    - 
Total  $4,529,278   $15,640,336 

 

(1)On March 11, 2014, These notes were extinguished and replaced with new debt which matures March 1, 2016. See subsequent events for further discussion.

 

Mortgage payable

 

On January 11, 2013, we received an additional advance of $400,000 pursuant to our 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.

 

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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.

 

At December 31, 2013, principal repayments requirements on mortgage payable were as follows:

 

For the year ending December 31:

 

2013  $0 
2014  $1,400,000 
   $1,400,000 

 

Securities Option Agreement:

 

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

 

Extension of Maturity Dates of Outstanding Non-Convertible Debentures:

 

As discussed in footnote 9, all the debentures discussed in the following footnote have been extinguished as of December 31, 2013. The Company did extinguish approximately $14 million of debt, as a result of the Redemption agreement, which was recorded as an equity transaction. The result was a decrease to common stock of $19,995 and an increase to additional paid-in capital of $20,719,958. There was no gain recorded on the extinguishment, although there was an increase in equity recorded of $14,098,847. 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 of our face value $5,266,130, $2,000,000, and $3,500,000, using the effective interest rates on the issuance dates, 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%.

 

2013 Issuance of Demand and Convertible Notes

 

During the first and second quarters, we received advances of $175,000 from a third party. This advance is evidenced by a formal promissory note, accrues interest at 8% per year, and is due June 30, 2015.

 

On May 31, and July 15, 2013, the Company issued to Samer Bishay, a related party, 5% Secured Convertible Promissory Notes with a face value of $300,000 and $200,000, respectively. These notes were due on December 1, 2013 and January 15, 2014 but on March 11, 2014 these notes were extinguished and replaced with new debt which matures March 1, 2016. See subsequent events for further discussion. These notes are convertible into shares of the Company’s common stock at a rate of $0.08 per share, for a total of 3,750,000 and 2,500,000 common shares, respectively. These notes have 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. See Note 16, “Subsequent Events”, for further information.

 

During the third and fourth quarters of 2013 the Company received $854,278, for working capital from now a related party. These notes were due on demand and were non-interest bearing. Interest will be imputed on these notes at current market rates. On March 11, 2014, these notes were also extinguished and replaced with new debt which matures March 1, 2016. See subsequent events for further discussion.

 

During the three and nine months ended September 30, 2013, the Company’s CEO made advances to the Company totalling $45,000 and $136,272, respectively. These advances were not evidenced by a formal promissory note, were for working capital, were non-interest bearing and were due on demand. Interest was imputed on these notes at current market rates. As of December 31, 2013, these advances have been paid in full.

 

The Company did extinguish approximately $14 million of debt, as a result of the Redemption Agreement, which was recorded as an equity transaction. The result was a decrease to common stock of $19,995, and an increase to additional paid-in capital of $20,719,958.

 

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2012 Issuance of Non-Convertible Debentures and Demand Notes

 

As discussed in footnote 9, all the debentures discussed in the following footnote have been extinguished as of December 31, 2013 in connection with the Redemption Agreement.

 

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 and a major stockholder at the time.

 

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 and a major stockholder at the time.

 

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

 

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

 

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

 

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

 

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

 

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

 

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

  

Accounting for the Financing Arrangements:

 

We have evaluated the terms and conditions of the secured convertible debentures under the guidance of ASC 815, Derivatives and Hedging. We have determined that, while the anti-dilution protections preclude treatment of the embedded conversion option as conventional, the conversion option is exempt from classification as a derivative because it otherwise achieves the conditions for equity classification (if freestanding) provided in ASC 815. We have further determined that the default redemption features described above are not exempt for treatment as derivative financial instruments, because they are not clearly and closely related in terms of risk to the host debt agreement. On the inception date of the arrangements through June 30, 2010, we determined that the fair value of these compound derivatives is de minus. However, we are required to re-evaluate this value at each reporting date and record changes in its fair value, if any, in income. For purposes of determining the fair value of the compound derivative, we have evaluated multiple, probability-weighted cash flow scenarios. These cash flow scenarios include, and will continue to include fair value information about our common stock. Accordingly, fluctuations in our common stock value will significantly influence the future outcomes from applying this technique. As discussed above, the embedded conversion options did not require treatment as derivative financial instruments; however, we were required to evaluate the feature as embodying a beneficial conversion feature under ASC 470-20, Debt with Conversion and Other Options. A beneficial conversion feature (“BCF”) is present when the fair value of the underlying common share exceeds the effective conversion price of the conversion option. The effective conversion price is calculated as the basis in the financing arrangement allocated to the hybrid convertible debt agreement, divided by the number of shares into which the instrument is indexed. Because the two hybrid debt contracts dated September 10, 2008 were issued as compensation for the Interlink Asset Group and as further discussed in Note 3 we concluded that they should be combined for accounting purposes and the accounting resulted in no beneficial conversion feature. The financings issued in 2009 were found to have a BCF which gives effect to the (i) the trading market price on the contract dates and (ii) the effective conversion price of each issuance after allocation of proceeds to all financial instruments sold based upon their relative fair values. Notwithstanding, the BCF was limited to the value ascribed to the remaining hybrid contract (using the relative fair value approach). Accordingly, the BCF allocated to paid-in capital from the 2009 financings amounted to $872,320 for the year ended September 30, 2009.

 

49
 

 

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

 

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

 

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

 

Note 10 – Redeemable Preferred Stock and Securities Option Agreement:

 

Effective December 31, 2013, the Company executed a redemption and debt restructuring agreement with a major shareholder Vicis Capital Master Fund ("Vicis") to, among other things, extinguish $13,662,615 of debentures and certain demand notes, $436,234 of accrued interest, $5,000,000 of series A convertible redeemable preferred stock (500 shares of issued and outstanding), cancel 19,995,092 shares of the Company’s common stock and cancel common stock purchase warrants exercisable for 76,864,250 shares of common stock.

 

On June 30, 2012, we executed Securities Option Agreement with Vicis Capital Master Fund (“Vicis”) whereby Vicis granted 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).

 

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:  December 31, 2013   December 31, 2012 
Series A Convertible Preferred Stock, par value $0.001 per share, stated value $10,000 per share; 500 shares cancelled 12/31/13, issued and outstanding at December 31, 2012; redemption value $5,000,000          
           
Initial carrying value   -   $13,246,609 
Accumulated accretion   -    (6,867,593)
Carrying values  $-   $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.

 

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

 

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

 

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

 

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

 

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

 

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.

 

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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 11 – Conversion of Warrants to Common Shares

 

For the nine months ended September 30, 2013, 4,231,832 warrants were converted into 1,057,958 common shares of netTALK. The share price of netTALK common stock on the day of conversion was $0.12; resulting in a charge of $126,955 included within general and administrative expenses in the Statements of Operations and Comprehensive Income (Loss).

 

Note 12 – Commitment and Contingencies:

 

On May 16, 2011, Mr. Kyriakides our Chief Executive Officer and Chairman of the Board executed an Amended Employment Agreement 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.

 

Pending Litigation

 

On April 4, 2012, MagicJack Vocaltec Ltd. filed a complaint in United States District Court for the Southern District of Florida, Civil Action No.: 9:12-cv-80360-DMM, against the Company, alleging patent infringement, seeking injunctive relief and damages as a result of the alleged patent infringement. The Company answered the complaint, denying all of its material allegations, asserting a number of affirmative defenses, and seeking counterclaims for declaratory relief. The Company’s patent counsel has provided an opinion that the NetTalk DUO does not infringe their patent. MagicJack Vocaltec Ltd. and NetTalk filed a Joint Stipulation and motion for the dismissal. Effective November 2012, the federal court has dismissed the entire case with prejudice, including all claims, counterclaims, defenses and causes of action.

 

On September 21, 2012, NetTalk.com, Inc. filed a complaint in United States District Court For the Southern District of Florida, Civil Action No.: 9:12-cv-81022-CIV-MIDDLEBROOK/BRANNON, against MAGICJACK VOCALTECLTD, MAGIJACK HOLDINGS CORPORATION f/k/a YMAX HOLDINGS CORPORATION and DANIEL BORISLOW. In the complaint, we allege patent infringement by the defendants, seeking two hundred million dollars ($200,000,000.00) injunctive relief and damages as a result of the alleged patent infringement by defendants.

 

As a result of this action, MAGICJACK/ VOCALTEC LTC filed a document with the United States Patent Office (“USPTO”) requesting reexamination of netTALK patent 8,243,722. The USPTO granted the reexamination petition and the claim against MAGICJACK/VOVALTEC LTD was stayed pending the outcome of the USPTO reexamination.

 

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In December 2013 netTALK received a USPTO Notice of Intent to Issue Ex Parte Reexamination Certificate (“NIRC”) for netTALK’s U.S. Patent Number 8,243,722.

 

In January 2014, netTALK petitioned the courts to restart the aforementioned lawsuit against MAGICJACK VOCALTECLTD, MAGIJACK HOLDINGS CORPORATION f/k/a YMAX HOLDINGS CORPORATION and DANIEL BORISLOW.

 

On February 27, 2014, netTALK received the reexamination certificate which restated that all three claims of the ‘722 Patent are deemed allowable by the USPTO. The three claims of the ‘722 Patent were minimally amended during the proceeding.

 

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 December 31, 2013, the Company owes Arrow approximately $73,790 which is recorded in accounts payable. and The Company will continue making installment payments until the obligation is satisfied.

 

On November 26, 2012, a supplier to the Company, 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. The settlement was paid in full as of October 29, 2013.

 

On June 30, 2012, a Statement of Claim was served by DACS Marketing & Sponsorship Inc. (“DACS”) on NetTalk.com Inc. The claim was 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. On November 28, 2013, the Company and DACS entered into a settlement agreement providing for $60,000 in 4 monthly equal installments beginning . As of December 31, 2013 the Company owes DACS $30,000 which is recorded in accounts payable. The obligation was paid in full as of the date of this filing.

 

On or about September 1, 2013, ADP Total Source filed a lawsuit against the Company.. The claim is for an amount not exceeding $90,776 for general damages for alleged breach of contract. The Company settled with ADP on December 23, 2013 and is making monthly payments of $15,000 until the obligation is satisfied. The balance at December 31, 2013 was $70,777 and is recorded in accounts payable.

 

On February 24, 2013, a Statement of Claim was served by Sears Canada Inc. on the Company. The claim is for $24,131.65 for amounts Sears claims is owed to it pursuant to its agreement under the “Universal Terms and Conditions for Sears Canada Suppliers”. We have settled with Sears Canada for $24,131.65 and are currently making monthly installment payments of $2,464.09 on the balance until the obligation is satisfied. The settlement amount is recorded in accounts payable at December 31, 2013.

 

On March 20, 2014 a claim was filed by Billsoft, Case No. 14CV01827. The claim states the Company is indebted to Billsoft in the amount of $16,776.66 pursuant the terms of said Contract; the sum of $192.50 representing court costs incurred to date; and the sum of $1,000.00 as reasonable attorney’s fees incurred by Billsoft for a total of $17,969.16. The Company has reached a settlement agreement on April 24, 2014 to make $1,000 monthly payments until the debt is satisfied. The settlement amount was accrued as of December 31, 2013.

 

We are aggressively defending all of the lawsuits and claims described above. While we do not believe these aforementioned claims will have a material adverse effect on our financial position, given the uncertainty and unpredictability of litigation there can be no assurance of no material adverse effect. The Company is engaged in other legal actions and claims arising in the ordinary course of business, none of which are believed to be material to the Company.

 

Note 13 - Related Party Transactions:

 

During the first, second and third quarters of 2013, amounts totaling $137,185 was advanced to the Company as a short term loan from the CEO. As of December 31, 2013, all loans have been repaid by the Company. During the year ended December 31, 2012 the Company incurred and paid consulting service fees of $62,100 to a related party. The CEO’s son is VP of product and consumer operations. See also Note 9, Securities Option Agreement and Debt.

 

Note 14 – Income Taxes:

 

Our income tax provision (benefit) for the years ended December 31, 2013 and 2012, consisted of the following:

 

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

 

   12/31/2013   12/31/2012 
Federal statutory rate   34.0%   34.0%
State rate, net of federal benefit   3.6%   3.6%
Derivative income   0.0%   4.3%
Change in valuation allowance   (37.6)%   (41.9)%
Effective tax rate   0.0%   0.0%

 

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

 

   12/31/2013   12/31/2012 
Property and fixed assets  $(27,090)  $(58,032)
Reserves and accruals   8,554    8,554 
Net operating loss carry forwards   3,421,711    12,355,046 
    3,403,175    12,305,568 
Valuation allowance   (3,403,175)   (12,305,568)
Net deferred taxes, after valuation allowance  $-   $- 

 

Our valuation allowance decreased $8,902,393 and increased $1,286,506 during the period ended December 31, 2013 and December 31, 2012, respectively.

 

Based on our prior earnings and insufficiency of income to be utilized in carry back years and future taxable income, we have concluded that it is more likely than not that these net deferred tax assets will not be utilized. Therefore, a valuation allowance has been set up to reduce deferred tax assets to zero. As of December 31, 2013, we have net operating loss carry forwards amounting to $28,658,898 that are available to offset future taxable income through 2032. Utilization of the Company’s net operating loss may be subject to a substantial annual limitation if there is an ownership change as set forth in Internal Revenue Code Section 382. The company is also not taking any uncertain tax position in the calculation of current or deferred taxes.

 

The company files income tax returns for U. S. Federal and State of Florida purposes. The company is not currently under any tax examination, but the statute of limitations has not yet expired. The company generally remains subject to examination of its U. S. Federal income tax returns for 2010 and subsequent years as the Internal Revenue Service has a three year window to assess/collect taxes. In addition, the company also remains subject to examination of its State of Florida tax returns for 2010 and subsequent years.

 

Note 15 - Revenue

 

Revenues and cost of revenues consist of the following:

 

   Years Ended December 31: 
   2013   2012 
Revenues:          
Sale of devices  $1,667,456   $2,067,983 
Renewals and access charges   4,128,681    3,509,282 
Other   228,013    213,718 
Total revenue   6,024,150    5,790,983 
           
Cost of revenues:          
Cost of devices sold   1,885,102    2,698,971 
Network and carrier charges   2,767,955    2,924,180 
Other   25,806    561,636 
Total cost of revenue   4,678,863    6,184,787 
           
Gross profit (loss)  $1,345,287   $(393,804)

 

Note 16 – Subsequent Events:

 

Effective March 11, 2014, netTALK and Telestrata LLC (“Telestrata”), a Colorado limited liability company executed a restricted stock and warrant purchase agreement, pursuant to which, in part, Telestrata purchased: (a) 25,441,170 shares of the Company’s common stock and (b) a common stock purchase warrant entitling Telestrata to purchase share of common stock of the Company equal to 20% of the then outstanding shares of common stock of netTALK.

 

The purchase price for the shares and warrant was $4,571,939, payable as follows: (a) $500,000 in the form of the conversion and cancellation of two promissory notes issued to Samer Bishay in May and July 2013, (b) $837,373 in loans to the Company received in the third and fourth quarters of 2013 and (c) the satisfaction by Telestrata of $2,734,566 of liabilities of the Company. The Purchaser’s Investment is to help the Company achieve its financial, operational and patent litigation goals.

 

The Company then executed a secured promissory note dated February 27, 2014 in favor of Telestrata for $4,071,940. Interest accrues at 5% and is due at maturity on March 1, 2016. Advanced payments, as defined, were received in cash on March 3 and April 16, 2014, of $200,000 and $50,000, respectively, from an affiliate of Telestrata. And during the first quarter of 2014, the Company received $250,000 of indirect cash payments for support of its telecommunications traffic network from an affiliate of Telestrata. These payments will be added to the promissory note increasing the note to $4,571,940.

 

On February 18, 2014, the Company executed an agreement with a New York based investment banker to obtain equity and or debt financing.

 

In the first quarter of 2014, the CEO’s son was promoted to chief operating officer.

 

On January 2, 2014, the Company entered into employment agreements with the chief executive officer, executive vice president, chief financial officer, chief operating officer and chief technical officer according to the following terms. Stated salary for 2014 and 2015, a term of 2 to 5 years and a change of control payment, as defined in the agreement.

 

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