UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-QSB
[X] Quarterly Report Under Section 13 or 15(d) of the Securities Exchange Act
of 1934 For the quarterly period ended September 30, 2003
[ ] Transition Report Under Section 13 or 15(d) of the Exchange Act For the
transition period from to
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Commission file number 0-25675
PATRON SYSTEMS, INC.
(Exact name of small business issuer as specified in its charter)
DELAWARE 74-3055158
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(State or other jurisdiction (IRS Employer
of incorporation Identification No.)
or organization)
311 BELLE FORET DRIVE, SUITE 150, LAKE BLUFF, IL 60044
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(Address of principal executive offices)
(847) 295-7338
---------------------------------
(Issuer's telephone number)
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(Former name, former address and former fiscal year, if changed since
last report)
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 [ ]
APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCY PROCEEDINGS DURING THE
PRECEDING FIVE YEARS. Check whether the registrant filed all documents and
reports required to be filed by Section 12, 13 or 15(d) of the Exchange Act
after the distribution of securities under a plan confirmed by a court. Yes [ ]
No [ ]
As of December 29, 2003, there were 34,931,388 shares of the issuer's common
stock, par value $0.01 per share, outstanding.
Transitional Small Business Disclosure Format (Check one): Yes [ ] No [X]
PATRON SYSTEMS, INC.
INDEX
Page
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
Consolidated Balance Sheets at September 30, 2003 (Unaudited) and December 31, 2002 1
Unaudited Consolidated Statements of Operations for the Three-Months Ended September 30, 2003, 2
the Nine-Months Ended September 30, 2003 and the Three-Months ended September 30, 2002 and
from inception (April 30, 2002) to September 30, 2003
Unaudited Consolidated Statement of Stockholders' Deficit for the period from inception (April 3
30, 2002) to September 30, 2003
Unaudited Consolidated Statements of Cash Flows for the Nine-Months Ended September 30, 2003 4
and the period from inception (April 30, 2002) to September 30, 2003
Notes to Unaudited Consolidated Financial Statements 5
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION 12
ITEM 3. CONTROLS AND PROCEDURES 21
PART II. OTHER INFORMATION
ITEMS 6. EXHIBITS AND REPORTS ON FORM 8-K 21
SIGNATURES 23
CERTIFICATIONS 24
CONSOLIDATED BALANCE SHEETS
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SEPTEMBER 30, DECEMBER 31,
2003 2002
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(UNAUDITED)
ASSETS
CURRENT ASSETS
Cash and cash equivalents $ 117 $ 362
Loans to TrustWave Corp. and Entelagent Software Corp., net of reserves of
$2,345,639 at September 30, 2003 825,367 1,188,654
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TOTAL CURRENT ASSETS 825,484 1,189,016
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DEFERRED COSTS ASSOCIATED WITH PENDING ACQUISITIONS 48,128 212,509
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TOTAL ASSETS $ 873,612 $ 1,401,525
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LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
CURRENT LIABILITIES
Notes Payable $ 212,401 $ 229,900
Accounts payable 1,624,237 1,200,274
Expense reimbursement due to officers and shareholders 492,697 453,127
Accrued payroll and payroll related expenses 1,304,443 659,858
Advances from Shareholders 1,243,500 628,500
Accrued Costs associated with operation in the United Kingdom 215,000 --
------------ ------------
TOTAL CURRENT LIABILITIES 5,092,278 3,171,659
OBLIGATION UNDER FINANCING ARRANGEMENT -- 1,497,728
STOCKHOLDERS' DEFICIT
Common stock, par value $.01 per share, 150,000,000
shares authorized, 34,931,388 and 41,137,417 shares issued and outstanding
as of June 30, 2003 and December 31, 2002, respectively 349,314 41,137
Additional paid in capital 19,752,985 26,254,632
Shares issued and held in escrow (14,592,760 shares) -- (13,235,293)
Accumulated Deficit during Developmental Stage (24,320,965) (16,328,338)
TOTAL STOCKHOLDERS' DEFICIT (4,218,666) (3,267,862)
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TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 873,612 $ 1,401,525
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The accompanying notes are an integral part of this statement.
2
CONSOLIDATED STATEMENT OF OPERATIONS (UNAUDITED)
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PERIOD FROM INCEPTION PERIOD FROM INCEPTION
THREE-MONTHS ENDED NINE-MONTHS ENDED (APRIL 30, 2002) TO (APRIL 30, 2002) TO
SEPTEMBER 30, 2003 SEPTEMBER 30, 2003 SEPTEMBER 30, 2002 SEPTEMBER 30, 2003
------------------ ------------------ --------------------- ---------------------
REVENUE $ -- $ -- $ -- $ --
------------ ------------ ------------ ------------
GENERAL AND ADMINISTRATIVE EXPENSES (350,900) (3,310,713) (1,061,213) (5,809,153)
CHARGE ASSOCIATED WITH ALLOWANCE FOR
TRUSTWAVE LOANS -- (2,345,639) -- (2,345,639)
CHARGE ASSOCIATED WITH ISSUANCE OF STOCK
IN REVERSE MERGER TRANSACTION -- -- -- (3,965,726)
COMMON STOCK ISSUED FOR BUSINESS
DEVELOPMENT CONSULTING SERVICES -- -- -- (4,168,750)
STOCK OPTIONS GRANTED FOR SERVICES -- -- -- (4,676,000)
------------ ------------ ------------ ------------
LOSS FROM OPERATIONS (350,900) (5,656,352) (1,061,213) (20,965,268)
OTHER INCOME (EXPENSE)
Loss on financing arrangement -- (2,210,272) -- (3,258,000)
Write-down of deferred acquisition costs (248,735) (248,735) -- (248,753)
Other Income -- -- 20 --
Interest Income 15,500 122,732 -- 151,056
------------ ------------ ------------ ------------
LOSS BEFORE INCOME TAXES (584,135) (7,992,627) (1,061,193) (24,320,965)
INCOME TAX BENEFIT -- -- -- --
------------ ------------ ------------ ------------
NET LOSS $ (584,135) $ (7,992,627) $ (1,061,193) $(24,320,965)
------------ ------------ ------------ ------------
NET LOSS PER SHARE-BASIC AND DILUTED $ (0.02) $ (0.23) $ (0.04) $ (0.79)
------------ ------------ ------------ ------------
WEIGHTED AVERAGE NUMBER OF SHARES
OUTSTANDING-BASIC AND DILUTED 34,931,388 34,070,373 25,000,000 30,938,342
------------ ------------ ------------ ------------
The accompanying notes are an integral part of this statement.
3
CONSOLIDATED STATEMENT OF STOCKHOLDERS' DEFICIT (UNAUDITED)
For the period from inception (April 30, 2003) to September 30, 2003
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SHARES OF PAR VALUE ADDITIONAL
COMMON STOCK COMMON STOCK PAID IN CAPITAL
------------ ------------ ------------
BALANCE AT INCEPTION (APRIL 30, 2002) -- $ -- $ --
Issuance of founders shares 25,000,000 25,000 225,000
Shares issued to predecessor in exchange transaction 2,687,200 2,687 --
Issuance of common stock in share exchange transaction 2,201,688 2,202 3,960,836
Common stock issued in lieu of cash for services 2,425,000 2,425 4,166,325
Stock options issued in lieu for cash for services -- -- 4,676,000
Issuance of common stock as collateral to anticipated financing 8,823,529 8,823 13,226,471
BALANCE AT DECEMBER 31, 2002
Issuance of common stock in private placement transactions 1,162,500 7,125 2,640,027
Common stock issued under Accommodation Agreement 1,200,000 1,200 3,706,673
Issuance of common stock as collateral to anticipated financing 5,769,231 5,769 7,551,923
Adjustment to Par Value for Redomestication to Delaware -- 437,461 (437,461)
Common stock retired from due to non-delivery of financing (14,592,760) (145,928) (20,647,059)
Common stock issued in lieu of cash for services 2,250,000 22,500 7,537,500
Common stock retired due to services contract termination (2,120,000) (21,200) (7,102,000)
Common stock issued in private placement transaction 125,000 1,250 248,750
Net loss
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BALANCE, SEPTEMBER 30, 2003 34,931,388 $ 349,314 $ 19,752,985
------------ ------------ ------------
DEFICIT ACCUMULATED
SHARES HELD DURING THE
IN ESCROW DEVELOPMENT STAGE TOTAL
------------ ------------------- ------------
BALANCE AT INCEPTION (APRIL 30, 2002) -- $ -- $ --
Issuance of founders shares -- -- 250,000
Shares issued to predecessor in exchange transaction -- -- 2,687
Issuance of common stock in share exchange transaction -- -- 3,963,038
Common stock issued in lieu of cash for services -- -- 4,168,750
Stock options issued in lieu for cash for services -- -- 4,676,000
Issuance of common stock as collateral to anticipated financing (13,235,294) -- --
BALANCE AT DECEMBER 31, 2002
Issuance of common stock in private placement transactions -- -- 2,647,152
Common stock issued under Accommodation Agreement -- -- 3,707,872
Issuance of common stock as collateral to anticipated financing (7,557,693) -- --
Adjustment to Par Value for Redomestication to Delaware -- -- --
Common stock retired from due to non-delivery of financing 20,792,987 -- --
Common stock issued in lieu of cash for services -- -- 7,560,000
Common stock retired due to services contract termination -- -- (7,123,200)
Common stock issued in private placement transaction -- -- 250,000
Net loss (24,320,965) (24,320,965)
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BALANCE, SEPTEMBER 30, 2003 0 $(24,320,965) $ (4,218,666)
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The accompanying notes are an integral part of this statement.
4
CONSOLIDATED STATEMENT OF CASH FLOWS (UNAUDITED)
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PERIOD FROM INCEPTION
NINE-MONTHS ENDED (APRIL 30, 2002) TO
SEPTEMBER 30, 2003 SEPTEMBER 30, 2003
------------------ ---------------------
CASH FLOWS FROM OPERATING ACTIVITIES
Net loss $ (7,992,627) $(24,320,965)
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Adjustments to reconcile net loss to net cash provided in operating
activities:
Charge associated with liabilities and loans 2,345,639 2,345,639
Non-cash charge associated with share exchange transaction -- 3,965,726
Common stock issued in lieu of cash for services 436,800 4,605,550
Stock options issued in lieu of cash for services -- 4,676,000
Non-cash loss on financing arrangement 2,210,272 3,258,000
Write-down of deferred acquisition costs 248,735 248,735
Changes in assets and liabilities:
Accounts payable 638,963 1,624,237
Expense reimbursement due to officers and shareholders 39,570 492,697
Accrued payroll and payroll related expenses 644,585 1,304,443
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Total adjustments 6,564,564 22,521,027
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NET CASH USED IN OPERATING ACTIVITIES (1,428,063) (1,799,938)
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CASH FLOWS USED IN INVESTING ACTIVITIES
Loans to TrustWave Corp. and Entelagent Software Corp. (2,066,834) (3,252,997)
NET CASH USED IN INVESTING ACTIVITIES (2,066,834) (3,252,997)
CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from issuance of notes payable (17,499) 212,401
Proceeds from issuance of common stock 2,897,151 3,147,151
Advances from shareholders 615,000 1,243,500
Proceeds received under financing arrangement -- 450,000
NET CASH PROVIDED BY FINANCING ACTIVITIES 3,494,652 5,053,052
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NET CASH INCREASE (DECREASE) (245) 117
CASH AND CASH EQUIVALENTS, beginning of period 362 --
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CASH AND CASH EQUIVALENTS, end of period $ 117 $ 117
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The accompanying notes are an integral part of this statement.
5
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE A - GENERAL
In the opinion of management, the accompanying unaudited consolidated financial
statements contain all adjustments (consisting of normal recurring accruals and
adjustments to reserve certain loans receivable at September 30, 2003 (see Note
D)) necessary to present fairly the financial position of Patron Systems, Inc.,
and, its subsidiaries at September 30, 2003 and December 31, 2002, the results
of its operations for the three- and nine-month periods ended September 30, 2003
and the periods from inception (April 30, 2002) to September 30, 2002 and 2003,
and its cash flows for the nine-month period ended September 30, 2003.
The results of operations presented are not necessarily indicative of the
results that may be expected for the fiscal year ending December 31, 2003. The
significant accounting principals and practices followed by Patron Systems, Inc.
are set forth in the Notes to Consolidated Financial Statements in Patron
System's Annual Report on Form 10-KSB for the year ended December 31, 2002.
NOTE B - ORGANIZATION AND BUSINESS
Patron Systems, Inc. (herein referred to as "Systems" or the "Company") is a
successor entity to Combined Professional Services, Inc., a Nevada corporation
originally formed in October 1995 (CPS), which later changed its name in a share
exchange to Patron Holdings, Inc. (Holdings). Holdings (as CPS) was originally
formed to provide corporate financial services to other business entities, but
abandoned that business plan shortly after formation. Holdings, therefore, has
never had business operations or revenue.
On October 11, 2002, Holdings (as CPS), Systems and the stockholders of Systems
consummated a share exchange (Share Exchange) pursuant to an Amended and
Restated Share Exchange Agreement, whereby Holdings (as CPS) issued to each
Systems stockholder, on a one-for-one basis and in exchange for all of the
outstanding shares of Systems capital stock, an aggregate of 25,400,000 shares
of Holdings (as CPS) common stock. Upon the closing of the Share Exchange,
Systems' stockholders held approximately 85 percent of the outstanding capital
stock of Holdings (as CPS), and Systems became a wholly-owned subsidiary of
Holdings (as CPS). The share exchange was accounted for as a reverse merger
whereby Systems, as the surviving company, was treated as the acquirer for
financial statement purposes.
On March 26, 2003, Holdings merged with and into Systems, for the purpose of
changing its state of incorporation from Nevada to Delaware (Redomestication
Merger). Systems became the surviving corporation of the Redomestication Merger,
and its Second Amended and Restated Certificate of Incorporation, Amended and
Restated Bylaws are the governing documents of the surviving corporation.
Systems' Board of Directors are the governing body of the Surviving Corporation.
Patron Systems, Inc., a Delaware corporation, was formed in April 2002 to
provide comprehensive, end-to-end information security solutions to global
corporations and government institutions by acquiring organizations with
characteristics fitting its strategic framework. Systems' founders intended to
raise capital on a private equity basis, but determined that there was a need
for public currency to achieve their growth path. Systems identified CPS during
this process and determined that CPS was well-suited to provide Systems with its
public currency because of its lack of
5
operational history, affording Systems an open platform from which to grow,
without the necessity of divesting existing operations or incurring liabilities
as a result of existing operations.
The Company has yet to begin revenue-generating operations and, as such, is a
development stage company. Since its inception, the Company has reported a net
loss of approximately $24,300,000 principally associated with expenses related
to the formation of the Company, assembling its management team, and capital
formation and acquisition activities consistent with its business plan. A
significant portion of this net loss can be attributed to non-cash capital stock
transactions, such as the issuance of capital stock or stock options in lieu of
cash for services.
NOTE C - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION AND BASIS OF PRESENTATION
Effective with the reincorporation merger on March 26, 2003, Patron Holdings,
Inc., merged into its wholly owned Delaware subsidiary, Patron Systems, Inc. As
such, the accompanying financial statements represent the accounts of Patron
Systems, Inc., and its two subsidiaries, TWC Acquisition Inc. and ESC
Acquisition Inc. The accompanying financial statements are unaudited. However,
management believes they contain all necessary adjustments and disclosures to be
presented in accordance with generally accepted accounting principles.
ACQUISITION COSTS
The Company has incurred certain expenses, principally legal fees, in connection
with the pending acquisition of Entelagent Corp. described in Note D, which have
been capitalized and deferred pending the completion of the transaction. Upon
closing, such costs will be included in the purchase price of the target company
and allocated to the assets received and obligations assumed. In the event a
pending acquisition does not occur, such costs will be expensed at that time.
Expenses associated with the TrustWave acquisition were expensed in the
three-month period ending September 30, 2003, due to the receipt of a notice
from TrustWave of its intent to terminate this transaction. Costs associated
with the Entelegant acquisition remain capitalized as management believes that
consummation of this transaction is still probable.
START UP COSTS
All expenses incurred in connection with formation of the Company and related
start up activities have been expensed as incurred and are included in general
and administrative expenses in the accompanying consolidated financial
statements.
STOCK OPTION PLANS
The Company accounts for employee stock option grants using the intrinsic method
in accordance with Accounting Principles Board (APB) Opinion No. 25 "Accounting
for Stock Issued to Employees" and accordingly associated compensation expense,
if any, is measured as the excess of the underlying stock price over the
exercise price on the date of grant. The Company complies with the disclosure
option of Statement of Financial Accounting Standards (SFAS) No. 123 "Accounting
for Stock Based Compensation", as amended by SFAS No. 148 "Accounting for
Stock-Based Compensation--Transition and Disclosure" which requires pro-forma
disclosure of compensation expense associated with stock options under the fair
value method.
The following sets forth proforma information as if the Company were using the
fair value method under SFAS No. 123 for the three months ended September 30,
2003 and the period from inception to September 30, 2003:
6
Period from
Inception
Nine Months Ended (April 30, 2002) to
September 30, 2003 September 30, 2003
Net Loss, as reported $ (7,992,526) $ (24,320,965)
Stock-based compensation cost reflected in the financial
statements -- --
Stock-based employee compensation cost under the fair value
method of SFAS No. 123 117,000 130,000
Pro-Forma Net Loss $ (8,109,526) $ (24,450,965)
Pro-Forma Net Loss per Share-Basic and Diluted (.24) (.79)
NET LOSS PER SHARE
Basic net loss per common share is computed by dividing net loss by the
weighted-average number of common shares outstanding during the period. Diluted
net loss per common share also includes common stock equivalents outstanding
during the period if dilutive. Diluted net loss per common share has been
computed by dividing net loss by the weighted-average number of common shares
outstanding without an assumed increase in common shares outstanding for common
stock equivalents; as such common stock equivalents are anti-dilutive. Common
stock equivalents at September 30, 2003, consist primarily of 2,091,242 vested
stock options.
USE OF ESTIMATES IN PREPARING FINANCIAL STATEMENTS
In preparing financial statements in conformity with accounting principles
generally accepted in the United States of America, management is required to
make estimates and assumptions that affect the reported amounts of assets and
liabilities and the disclosure of contingent assets and liabilities at the date
of the financial statements and revenue and expenses during the reporting
period. Actual results could differ from those estimates.
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In April 2002, the FASB issued SFAS 145, "Rescission of FASB Statements No. 4,
44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections." SFAS
145 rescinds certain standards and modifies certain standards related to the
extinguishment of debt and sale-leaseback transactions. The provisions of SFAS
145 are generally effective after May 15, 2002. The adoption of this standard is
not expected to have a material effect on the financial statements of the
Company.
In January 2003, the FASB issued Interpretation Number 46, Consolidation of
Variable Interest Entities ("FIN 46"). This interpretation of Accounting
Research Bulletin No. 51, Consolidated Financial Statements, addresses
consolidation by business enterprises of variable interest entities. Under
current practice, two enterprises generally have been included in consolidated
financial statements because one enterprise controls the other through voting
interests. FIN 46 defines the concept of "variable interests" and requires
existing unconsolidated variable interest entities to be consolidated by their
primary beneficiaries if the entities do not effectively disperse risks among
the parties involved. This interpretation applies immediately to variable
interest entities created after January 31, 2003. It applies in the first fiscal
year or interim period beginning after June 15, 2003, to variable interest
entities
7
in which an enterprise holds a variable interest that it acquired before
February 1, 2003. The interpretation may be applied prospectively with a
cumulative-effect adjustment as of the date on which it is first applied or by
restating previously issued financial statements for one or more years with a
cumulative-effect adjustment as of the beginning of the first year restated.
Adoption of this standard is not expected to have a material effect on the
Company's financial statements.
In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on
Derivative Instruments and Hedging Activities." SFAS No. 149 amends and
clarifies accounting and reporting for derivative instruments and hedging
activities under SFAS No. 133, "Accounting for Derivative Instruments and
Hedging Activities." SFAS No. 149 is effective for derivative instruments and
hedging activities entered into or modified after June 30, 2003, except for
certain forward purchase and sale securities. For these forward purchase and
sale securities, SFAS No. 149 is effective for both new and existing securities
after June 30, 2003. Adoption is not expected to have a material impact on the
Company's financial statements.
In May 2003, the Financial Accounting Standards Board (FASB) issued SFAS No.
150, "Accounting for Certain Financial Instruments with Characteristics of both
Liabilities and Equity." SFAS No. 150 establishes standards for issuer
classification and measurement of certain financial instruments with
characteristics of both liabilities and equity. Instruments that fall within the
scope of SFAS No. 150 must be classified as a liability. SFAS No. 150 is
effective for financial instruments entered into or modified after May 31, 2003.
For financial instruments issued on or before May 31, 2003, SFAS No. 150 is
effective for the Company in the first quarter of fiscal year 2004. Adoption of
this standard is not expected to have a material effect on the Company's
financial statements.
NOTE D -- CERTAIN PROPOSED TRANSACTIONS
TRUSTWAVE CORP.
In late 2002, Patron entered into an agreement (the TrustWave Merger Agreements)
to purchase TrustWave, an information assurance and security services company
based in Maryland. The TrustWave Merger was approved by the Board of Directors
of both Patron and TrustWave and the shareholders of TrustWave. The transaction
was subject to a number of closing conditions.
Patron has received notification from TrustWave of its intent to terminate the
TrustWave Merger Agreements. The Company has rejected the termination of the
TrustWave Merger by TrustWave due to its failure to meet key provisions of the
Merger Agreement and Supplemental Agreements, as amended. The Company intends to
pursue binding arbitration as set forth in the agreements. However, it is still
the Company's wish to find a mutually agreeable set of terms to complete this
transaction.
In connection with this transaction, Patron provided working capital financing
to TrustWave. Advances under these notes, bearing interest at 10 percent per
annum, are repayable on demand. Total outstanding advances under such notes at
September 30, 2003 were $2,240,000 and approximately $161,000 in accrued
interest. The Company has demanded repayment of these notes. As of the date of
filing, TrustWave has yet to make any payments and is in default on these notes.
While the Company believes that these notes will ultimately be collected, it is
prudent to fully reserve for these notes at this time. Accordingly, the Company
has increased net loss by reserving against both the principal and interest of
the notes outstanding. Should the Company collect funds from TrustWave, we will
recognize the amounts collected in the future as income.
ENTELAGENT SOFTWARE CORP.
On November 24, 2002, Patron Systems, ESC Acquisition, Inc., a California
corporation and wholly-owned subsidiary of Patron Systems Inc. (Entelagent
Mergerco), and Entelagent Software Corp., a California corporation (Entelagent),
entered into an Agreement and Plan of Merger, as amended (the Entelagent Merger
Agreement) whereby Entelagent Mergerco will be merged with and into Entelagent
with Entelagent surviving as a wholly owned subsidiary of Patron Systems Inc.
(the Entelagent Merger). Patron, Entelagent Mergerco and Entelagent also
concurrently entered into a Supplemental Agreement, as amended (the Entelagent
Supplemental Agreement). Upon the consummation of the Entelagent Merger,
shareholders of Entelagent will receive, in the aggregate, 1,800,000 shares of
Patron and Patron will assume certain debts and obligations of Entelagent.
Despite the passage of time since the
8
Agreement and Plan of Merger was executed, management of the Company remains
committed to closing this transaction when conditions precedent are satisfied.
The Entelagent Merger has been approved by the Boards of Directors of Patron,
Entelagent Mergerco and Entelagent. The Entelagent Merger is intended to be a
tax-free reorganization under the Internal Revenue Code. In connection with the
consummation of the Entelagent Merger, certain executive officers of Entelagent
will execute employment agreements with Patron. The closing of the acquisition
is subject to certain closing conditions, including approval of the transaction
by Entelagent shareholders, the consummation of Patron's merger with TrustWave
and obtaining funding for the additional working capital needs of Entelagent.
Working capital advances under such notes bear interest at 10 percent per annum
and are repayable upon demand. Total outstanding advances under such notes at
September 30, 2003, were $780,000 plus accrued interest of approximately
$45,267. Management periodically assesses such loans for collectibility and as
of September 30, management believes the amounts loaned to Entelagent are fully
collectible. As such, an allowance has not been established. However, should
matters arise that indicate that the Company may not collect all or a portion
the balance of such loans, a charge to earnings may result.
Subsequent to the closing of this transaction, the Company will be obligated to
grant 440,000 common stock options to certain employees and non-employee
consultants of Entelagent.
Entelagent is an information technology products and services company founded in
1996. Entelagent's products and services are focused on e-mail management
solutions, including monitoring and data mining with a particular focus on
ensuring compliance with laws and regulations in the financial services and
brokerage industries.
NOTE E - RELATED PARTY TRANSACTIONS
ADVANCES FROM SHAREHOLDERS
Since its inception, the Company has obtained financing from certain
shareholders for working capital needs. At September 30, 2003, the face amount
of notes with these shareholders was approximately $1,243,500 and related
accrued interest of $120,577 has been included in accounts payable. These
advances bear interest at rates ranging from 8 percent to 10 percent per annum
and are due on demand. Three shareholders holding notes in the amount of
$200,000 have demanded repayment and commenced legal action. Patron has not yet
repaid these notes.
REIMBURSEMENTS OF EXPENSES INCURRED BY SHAREHOLDERS, OFFICERS AND DIRECTORS
Certain shareholders, officers and directors of the Company have incurred
operating expenses totaling $1,178,343 on the Company's behalf. Such expenses
have been recorded in the accompanying consolidated financial statements with a
corresponding obligation to reimburse the shareholders, officers and directors.
Included in such expenses is approximately $60,000 of expenses incurred by a
founder prior to incorporation of the Company for which the Company has agreed
to reimburse the founder. As of September 30, 2003, approximately $686,000 in
reimbursements has been paid to the shareholders, officers and directors,
leaving $492,697 outstanding.
A creditor has received a judgment against the Company to pay $125,000 plus
costs. This amount was accrued and expensed by the Company in January 2003.
Patron has not yet paid this claim.
NOTE F - NOTES PAYABLE
CONVERTIBLE NOTES PAYABLE
In 2002, the Company borrowed an aggregate amount of $145,000 from four
unrelated third parties and such amounts remain outstanding at September 30,
2003. The notes bear interest at 8 percent and are convertible into shares of
the Company's common stock with the conversion price based on the underlying
fair market value at the dates that the notes are settled.
DEMAND NOTES PAYABLE
In 2002, the Company borrowed an aggregate amount of $85,000 from two unrelated
third parties under demand notes payable, which bear interest at 10 percent. The
amount borrowed remains outstanding at September 30, 2003.
9
ACCOMMODATION AGREEMENTS
In November 2002, the Company entered into a financing arrangement with a third
party financial institution (the Lender), which called for the Company to borrow
$950,000 under a note to be collateralized by the pledge of 950,000 shares of
the Company's common stock from five different stockholders. In connection with
this arrangement, the Company executed a series of Accommodation Agreements with
the five stockholders wherein each stockholder pledged shares in return for the
right to receive on or before September 30, 2003 the return of the pledged
shares, or replacement shares in the event of foreclosure, and one additional
share of common stock for every four shares as compensation. The Company also
agreed to use "best efforts" to register these shares with the US Securities and
Exchange Commission 12 months from the date of issue.
In December 2002, the Company received approximately $450,000 of proceeds under
the note and provided the Lender the pledged shares. Since that date, no
additional proceeds have been provided by the Lender and repeated attempts have
been made by the Company to secure the additional proceeds. The Company plans to
take the necessary legal steps to either enforce the loan or secure the return
of the pledged shares.
In the accompanying financial statements as of September 30, 2003, the Company
has effectively accounted for these events as a foreclosure on the loan
collateral by the Lender. On March 13, 2003, the Company replaced the shares to
the five stockholders who pledged shares under the Accommodation Agreements for
a total of 1,200,000 shares of Patron common stock. The value of the replacement
shares issued totaled $3,708,000. As a result, the Company recorded a loss of
approximately $2,200,000 upon issuance of the replacement shares for difference
between the value of the shares issued and the amount of loss accrued in its
2002 financial statements.
SECURED PROMISSORY NOTE
In December 2002, the Company entered into a collateral loan agreement and
promissory note with Mercatus & Partners, Ltd. in the amount of $3 million. On
January 3, 2003, the Company entered into a second promissory note with Mercatus
& Partners, Ltd. in the amount of $1.5 million. As of April 29, 2003, the
Company has not borrowed any amounts under these arrangements. The $3 million
note was collateralized by 8,823,529 shares of restricted common stock, which
were placed in a custodial account for the benefit of the Lender as security for
the loan. The $1.5 million note was collateralized by 5,769,231 shares of
restricted common stock, which were also placed in a custodial account for the
benefit of the Lender to securitize the loan. Shares associated with the $3
million and the $1.5 million notes have been reflected as shares issued and
outstanding and held in escrow in the accompanying consolidated statement of
stockholders' deficit.
On June 30, 2003, the Company terminated the collateral loan agreements and
promissory notes for failure of Mercatus & Partners, Ltd. to deliver funds. The
Company has requested that all collateral shares be returned to the Company's
transfer agent for cancellation and retirement, which will reduce the number of
issued and outstanding shares of the Company by 14,592,760 shares. These shares
have since been removed from the number of issued and outstanding shares.
FUNDS RECEIVED FROM COMPANY OFFICER
In March 2003, an officer of the Company (the "officer") borrowed $635,000 from
third parties and used these funds to pay certain legitimate business expenses
of the Company, without the knowledge of the Board of Directors, the CEO and
CFO.
Pending determination by the Board as to whether the funds were obtained
personally by the officer and deposited in a Company account or whether this
officer obtained the funds on behalf of the Company, these transactions and the
related funds, as well as the subsequent disbursement of funds to pay
liabilities of the Company have been reflected in the financial statements as
they occurred inasmuch as the funds were received into and disbursed out of a
Company account. The Company recognizes its obligation to repay the principal
due either to the officer or to the third parties.
10
The funds in the amount of $635,000 received by the officer were used to
reimburse certain creditors and officers of the Company for expenses paid on the
Company's behalf, to fund certain expenses of its start up operation in the
United Kingdom, and to advance additional funds to Entelagent Software Corp.
Because these transactions were not known by or approved by the CEO, CFO or its
Board of Directors, a breach of the Company's internal controls occurred.
Management and legal counsel are evaluating actions necessary to prevent a
similar breach in the future.
NOTE G - PRIVATE PLACEMENTS
In March 2003, the Company completed three separate private placements of
restricted securities with unaffiliated third parties. A total of 1,162,500
shares were purchased in a range of $2.00 to $4.00 per share. Total proceeds
were approximately $2,600,000. These proceeds were used principally as working
capital advances to TrustWave Corp. and Entelagent Software Corp., including
$1,000,000 to TrustWave and $250,000 to Entelagent. The remainder of the
proceeds were used for partial repayment of accrued audit and legal fees, as
well as reimbursement of shareholder and officer expenses incurred on behalf of
the Company. On August 27, 2003, the Company received a letter from the
investor who purchased 1,000,000 shares for $2,000,000 demanding rescission of
his investment. It is the view of the Company that there are no grounds for
rescission.
On April 4, 2003, Patron completed a private placement of restricted securities
with an unaffiliated third party. 125,000 shares were purchased at a price of
$2.00 per share. Total proceeds under this private placement were $250,000 and
were used for partial repayment of accrued Company expenses, as well as
reimbursement of shareholder expenses incurred on behalf of the Company. $50,000
in proceeds were used as a working capital advance to Entelagent Software Corp.
The term sheet contains provisions for Patron to commit to file a registration
statement for these shares within two weeks of the closing of the TrustWave
Merger and to use best efforts to ensure that the registration statement is
declared effective within ninety days of the closing of the TrustWave Merger.
NOTE H - CONSULTING AGREEMENTS
Patron, in an attempt to generate merger and acquisition prospects quickly, has
issued shares of Common Stock which it has registered on registration statement
on Form S-8 to compensate consultants. On March 31, 2003, Patron entered into
consulting agreements with M. Rashid Qajar, who currently holds more than 5% of
our outstanding voting stock, and Paul Harary of Security Management Partners.
The term of each agreement is two years. The consulting services which were to
be provided by Mr. Qajar were to advise and consult with Patron regarding
general business matters including, but were not limited to, development of an
international business strategy, the evaluation and analysis of management needs
and identifying and introducing Patron to prospective merger, asset, business or
other acquisition candidates. The consulting services which were to be provided
by Mr. Harary were to include, but not limited to, the identification of
potential candidates in the enterprise security service and technology field for
acquisition by Patron.
For and as consideration for the services provided pursuant to the consulting
agreements, Patron has agreed to issue to Mr. Qajar 2,050,000 shares of Patron
Common Stock and Mr. Harary 200,000 shares of Patron Common Stock. On April 2,
2003, Patron registered 2,250,000 shares of Patron Common Stock on Form S-8. Mr.
Qajar has agreed to refrain from transferring 1,500,000 of his shares of Patron
common stock for a period of twelve months.
On June 16, 2003, the Company cancelled the consulting agreements with Mr. Qajar
and Mr. Harary. Accordingly, the Company filed an amendment to the registration
statement on Form S-8 to deregister 2,120,000 shares of common stock. The
Company has requested that Mr. Harary return 140,000 shares of common stock. The
Company is negotiating a reasonable compensatory arrangement for services
rendered with Mr. Qajar, which will include the return of 1,980,000 shares of
common stock. In connection with the termination of these consulting agreements
and subsequent deregistration of shares of common stock, the Company has
incurred a charge of approximately $437,000.
NOTE I - INTERCAP GROUP, LLC FUNDING
The Company has finalized the terms of a $50 million private placement of
securities with InterCap Group, LLC consisting of: (i) $15 million of common
stock at a price of $0.50 per share or 30 million shares, and (ii) $35 million
of convertible preferred stock. The preferred stock has a 5% dividend
payable-in-kind and is convertible into common stock at an effective conversion
price of $0.50 per common share. These shares do not have any special
registration rights and funding is not dependent on the closing of any specific
transaction. In addition, the Company granted to the investors an option until
June 30, 2004 to invest an additional $50 million by purchasing up to an
additional 100 million shares of common stock at a price of $0.50 per
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share. The option period can be extended by mutual agreement. The net proceeds
from the private placements, after deducting transactional costs, are expected
to be approximately $49 million (not assuming the optional shares). InterCap has
agreed to lock up all shares for a period of three years. We intend to use the
net proceeds for acquisitions and general corporate purposes.
In late December 2003, Patron requested an initial funding of $1 million from
InterCap Group, LLC. InterCap has confirmed this funding will be completed on
or before January 5, 2004. Additional funds are available in increments of $5
million with 10 days written notification.
As a condition of this funding process, the Company has agreed to a series of
changes, including a significant reduction in the number of founders' shares and
management options and reconstituting Patron's management team and Board of
Directors. To this end, Rich Linting, Brett Newbold and Marie Meisenbach Graul
have resigned from Patron. Separately, and prior thereto, Rich Beggs, Warren
Luke and Anthony Carbone left the board of directors. Patron is currently
in active discussions with replacement candidates for the board and management
team. InterCap has the right to nominate a number of Directors to constitute a
majority of the Board.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION.
FORWARD-LOOKING STATEMENTS
The following discussion and analysis of the financial condition and results of
operations for Patron Systems, Inc. should be read in conjunction with our
unaudited financial statements and related notes appearing elsewhere in this
report. This discussion contains forward-looking statements and information
relating to Patron Systems, Inc. our industry and planned business operations as
well as other information security businesses that involve risks and
uncertainties. The statements contained in this report that are not historical
statements of fact are forward-looking statements within the meaning of Section
27A of the Securities Act of 1933 (Securities Act) and Section 21E of the
Securities Exchange Act of 1934, as amended (Exchange Act). Forward-looking
statements include, among other things, statements regarding our expectations,
beliefs, intentions or strategies regarding the future. All forward-looking
statements included in this report are based on information available to us up
to and including the date of this document, and we expressly disclaim any
obligation to update or alter our forward-looking statements, whether as a
result of new information, future events or otherwise. Our actual results could
differ significantly from those anticipated in these forward-looking statements
as a result of certain factors, including those set forth below, under the
caption "Risk Factors" and elsewhere in this report.
GENERAL INFORMATION AND OVERVIEW
Patron Systems, Inc. is a successor entity to Combined Professional Services,
Inc., a Nevada corporation originally formed in October 1995 ("CPS"), which
later changed its name in a share exchange to Patron Holdings, Inc.
("Holdings"). Holdings (as CPS) was originally formed to provide corporate
financial services to other business entities, but abandoned that business plan
shortly after formation. Holdings, therefore, has never had business operations
or revenue.
Patron was formed as a Delaware corporation in April 2002 to provide
comprehensive, end-to-end information security solutions to global corporations
and government institutions. Patron's founders intended to raise capital on a
private equity basis, but determined that there was a need for a public company
currency to achieve their growth plan. Patron identified CPS during this process
and determined that CPS was well-suited to provide Patron with its public
currency because of its lack of operational history, affording Patron an open
platform from which to grow, without the necessity of divesting existing
operations or incurring liabilities as a result of existing operations.
On October 11, 2002, Holdings (as CPS), Patron and the stockholders of Patron
consummated a share exchange pursuant to an Amended and Restated Share Exchange
Agreement, whereby Holdings (as CPS) issued to each Patron stockholder, on a
one-for-one basis and in exchange for all of the outstanding shares of Patron
capital stock, an aggregate of 25,400,000 shares of Holdings (as CPS) common
stock. Upon the closing of the share exchange, Patron stockholders held
approximately 85 percent of the outstanding capital stock of Holdings (as CPS),
and Patron became a wholly owned subsidiary of Holdings (as CPS). The share
exchange was accounted for as a reverse merger whereby Patron, as the surviving
company, was treated as the acquirer for financial statement purposes.
On March 26, 2003, Holdings merged with and into Patron for the purpose of
changing its state of incorporation from Nevada to Delaware. Patron became the
surviving corporation of this redomestication merger, and its Second Amended and
Restated Certificate of Incorporation, Amended and Restated Bylaws are the
governing documents of the surviving corporation. Systems' Board of Directors
are the governing body of the surviving corporation. Prior to
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the date of the redomestication merger, Patron had no material assets or
business operations. Patron's principal activities since its formation in April
2002 consisted of the development of its business plan, capital raising and
evaluation and negotiation of potential acquisitions.
Prior to the date of the Redomestication merger, Patron had no material assets
or business operations. Patron's principal activities since its formation in
April 2002 consisted of the development of its business plan, capital raising,
and evaluation and negotiation of potential acquisitions.
PLAN OF OPERATION
During the third quarter ended September 30, 2003, the Company incurred a net
loss of $584,135. The Company had commenced operations upon incorporation on
April 30, 2002 and its operations through September 30, 2002 resulted in only
nominal activity incident to the start up of its business, making comparison to
the comparable period for 2003 not meaningful. A major element of the net loss
in the 2003 period was general administrative expenses of $599,635, comprised of
management salaries and associated expenses incidental to the development of its
business.
During the next 12 months, Patron intends to implement its business plan to
offer trusted security services and next generation integrated security products
through acquisitions and internal growth. Patron intends to work with
organizations to ensure that global enterprises implement information security
policies, procedures and products that result in "trusted" information
environments. Patron expects to offer information security and vulnerability
assessments, certification programs, remediation, implementation, training,
monitoring and management services.
In executing its current plans, Patron intends to identify and pursue potential
acquisition targets consistent with its business plan; seek additional financing
to fund ongoing business operations and to support its acquisitions strategies;
develop management and information systems and technology to support operations;
and attract and retain qualified personnel. Patron's ability to pursue this plan
and to carry out its proposed business activities is dependent upon its ability
to implement its acquisitions strategies, and to operate acquired companies
efficiently, and to obtain required financing.
Patron has yet to begin revenue generating operations and as such is a
development stage company. Since its inception, Patron has reported a net loss
of approximately $24,321,000, principally associated with expenses related to
its formation, assembling its management team, and capital formation and
acquisition activities consistent with its business plan. Patron has 2 corporate
employees as of the date of this report. Patron intends to hire additional
employees during the next 12 months as it completes pending acquisitions and
executes its business plan, which will be dependent upon Patron' ability to
raise necessary funding.
CERTAIN PROPOSED TRANSACTIONS
Previously, Patron had entered into an agreement (the TrustWave Merger
Agreements) to purchase TrustWave, an information assurance and security
services company based in Maryland. The TrustWave Merger was approved by the
Board of Directors of both Patron and TrustWave and the shareholders of
TrustWave. The transaction was subject to a number of closing conditions.
Recently, Patron received notification from TrustWave of its intent to terminate
the TrustWave Merger Agreements. The Company has rejected the termination of the
TrustWave Merger by TrustWave due to its failure to meet key provisions of the
Merger Agreement and Supplemental Agreements, as amended. The Company is
pursuing binding arbitration as set forth in the agreements. However, it is
still the Company's wish to find a mutually agreeable set of terms to complete
this transaction.
In connection with this transaction, Patron was required to provide working
capital financing to TrustWave. Advances under such notes bear interest at 10
percent per annum and are repayable on demand. Total outstanding advances under
such notes at September 30, 2003 were $2,240,000 and approximately $166,000 in
accrued interest. The Company has demanded repayment of these notes. As of the
date of filing, TrustWave has yet to make any payments
13
and is in default on these notes. While the Company believes that these notes
will ultimately be collected, it is prudent to fully provide for these notes at
this time. Accordingly, the Company has increased net loss by recognizing both
the principal and interest of the notes outstanding. Should the Company collect
funds from TrustWave, we will recognize the amounts collected in the future as
income.
On November 24, 2002, Patron, ESC Acquisition, Inc., a California corporation
and wholly-owned subsidiary of Patron, and Entelagent Software Corp., a
California corporation, entered into an Agreement and Plan of Merger whereby ESC
Acquisition will be merged with and into Entelagent with Entelagent surviving as
a wholly owned subsidiary of Patron. Patron, ESC Acquisition and Entelagent also
concurrently entered into a Supplemental Agreement. Upon the consummation of the
Entelagent Merger, shareholders of Entelagent will receive, in the aggregate,
1,800,000 shares of Patron's Common Stock and will assume certain debts and
obligations of Entelagent. The closing of the acquisition is subject to several
closing conditions, including approval of the transaction by Entelagent's
shareholders.
Subsequent to the closing of this transaction, Patron will be obligated to grant
440,000 common stock options to certain employees and non-employee consultants
of Entelagent.
In connection with this transaction, Patron agreed to provide working capital
financing to Entelagent. Advances under such notes bear interest at 10 percent
per annum and are repayable upon demand. Total outstanding advances under such
notes at September 30, 2003, were $780,000.
LIQUIDITY AND CAPITAL RESOURCES
The Company has received a commitment providing for a $50 million private
placement of securities with InterCap Group, LLC consisting of: (i) $15 million
of common stock at a price of $0.50 per share or 30 million shares, and (ii) $35
million of convertible preferred stock. The preferred stock has a 5% dividend
payable-in-kind and is convertible into common stock at an effective conversion
price of $0.50 per common share. These shares do not have any special
registration rights and funding is not dependent on the closing of any specific
transaction. In addition, the Company granted to the investors an option until
June 30, 2004 to invest an additional $50 million by purchasing up to an
additional 100 million shares of common stock at a price of $0.50 per share. The
option period can be extended by mutual agreement. The net proceeds from the
private placements, after deducting transactional costs, are expected to be
approximately $49 million (not assuming the optional shares). InterCap has
agreed to lock up all shares for a period of three years. We intend to use the
net proceeds for acquisitions and general corporate purposes.
Patron believes that the $50 million in financing, will be sufficient to fund
operations for the foreseeable future.
HISTORIC FINANCINGS
STOCKHOLDER ADVANCES
Patron has been financed to date by a group of stockholders and private
investors with "seed" capital. At September 30, 2003, the face amount of notes
with stockholders was $1,243,500 with related accrued interest of $120,577. Each
of these advances bears interest at rates ranging from 8 percent to 10 percent
per annum and is due on demand. In addition, certain of Patron's stockholders
and officers have incurred operating expenses totaling approximately $1,178,343.
In addition, through September 30, 2003, Patron borrowed an aggregate amount of
$230,000 from six unrelated parties. Four of the notes representing this debt
bear interest at a rate of 8 percent per annum and are convertible into shares
of Patron Common Stock, with the conversion price based on the fair market value
of such shares on the date on which the notes are converted. Two of the notes
representing this debt are demand notes accruing interest at a rate of 10
percent per annum.
ACCOMMODATION ARRANGEMENTS
In November 2002, Patron (as successor to Holdings) entered into a financing
arrangement with a third party (subsequently amended), which called for Patron
to borrow $950,000 pursuant to a note secured by a pledge by five of
14
its stockholders of 950,000 shares of Patron common stock. In connection with
this arrangement, Patron executed a series of Accommodation Agreements with the
pledging stockholders, whereby each pledgor pledged shares in return for the
right to receive, on or before June 30, 2003, the return of the pledged shares
plus additional shares, for a total of 1,200,000 shares of Patron Common Stock.
In December 2002, Patron received $450,000 of proceeds under the note, and
provided the lender with all of the pledged shares. To date, Patron has not
received the remaining $500,000 commitment. Patron intends to take all necessary
actions to either enforce the loan or secure the return of the pledged shares.
Patron issued the replacement shares of Patron Common Stock to the pledging
stockholders on March 13, 2003, for a total non-cash charge of $3,258,000.
MERCATUS & PARTNERS, LTD.
In December 2002, Patron entered into a collateral loan agreement and promissory
note with Mercatus & Partners, Ltd. ("Mercatus"), a financing group, in the
amount of $3 million. On January 2, 2003, Patron entered into a second
promissory note with Mercatus in the amount of $1.5 million. As of the date
here, Patron has not borrowed any amounts under these arrangements. Borrowings
on the $3 million note are collateralized by 8,823,529 shares of common stock,
which have been placed in a custodial account with UBS Bank in Switzerland for
the benefit of the lender as security for the loan. Borrowings on the $1.5
million note are collateralized by 5,769,231 shares of common stock, which have
also been placed in a custodial account for the benefit of the lender as
security to the loan. Interest on amounts borrowed accrues at 5.5 percent per
annum. Patron has agreed to pay fees of 3% to the lender and two months
principal and interest in advance. The term of the loan is five years. Interest
only payments will be due in the first year after funding of the loan. Aggregate
monthly principal payments of $93,750 will be due beginning February 2004. There
is an early termination charge for prepayment. Mercatus also requires a "key
man" life insurance policy naming it as beneficiary and matching the principal
balance of the loan on a decreasing basis. Patron is also required within 90
days of a loan drawdown to enter into good faith negotiations to establish a
warrant or option position.
As of the date hereof, Mercatus had not provided funding under the terms of the
collateral loan agreement and promissory note and is in breach of contract.
Patron sent notification to Mercatus on June 30, 2003, terminating the agreement
and requesting Mercatus to return all shares placed in the custodial account
with UBS Bank in Switzerland. Upon receipt of the shares, Patron intends to
cancel such shares.
Outside counsel has sent a second demand letter dated May 5, 2003, as the shares
have not yet been received. As Mercatus has not returned these shares to the
Company's transfer agent by November 12, 2003, the Company intends to take all
necessary actions to ensure the prompt return of the shares.
COMPLETED PRIVATE PLACEMENTS
In March 2003, the Company completed three separate private placements of
restricted securities with unaffiliated third parties. A total of 1,162,500
shares were purchased in a range of $2.00 to $4.00 per share. Total proceeds
were approximately $2,600,000. These proceeds were used principally as working
capital advances to TrustWave Corp. and Entelagent Software Corp., including
$1,000,000 to TrustWave and $250,000 to Entelagent. The remainder of the
proceeds was used for partial repayment of accrued audit and legal fees, as well
as reimbursement of shareholder and officer expenses incurred on behalf of the
Company. On August 27, 2003, the Company received a letter from the
investor who purchased 1,000,000 shares for $2,000,000 demanding rescission of
his investment. It is the view of the Company that there are no grounds for
rescission.
On April 4, 2003, Patron completed one private placement of restricted
securities with an unaffiliated third party. 125,000 shares were purchased at a
price of $2.00 per share. Total proceeds under this private placement were
$250,000 and were used for partial repayment of accrued Company expenses, as
well as reimbursement of shareholder expenses incurred on behalf of the Company.
$50,000 in proceeds were used as a working capital advance to Entelagent
Software Corp. The term sheet contains provisions for Patron to commit to file a
registration statement for these shares within two weeks of the closing of the
TrustWave Merger and to use best efforts to ensure that the registration
statement is declared effective within ninety days of the closing of the
TrustWave Merger.
FUNDS RECEIVED FROM COMPANY OFFICER
In March 2003, an officer of the Company (the "officer") borrowed $635,000 from
third parties and used these funds to pay certain legitimate business expenses
of the Company. This was done without the knowledge of the Board of Directors,
the CEO and CFO.
15
Pending determination by the Board as to whether the funds were obtained
personally by the officer and deposited in a Company account or whether this
officer obtained the funds on behalf of the Company, these transactions and the
related funds, as well as the subsequent disbursement of funds to pay
liabilities of the Company have been reflected in the financial statements as
they occurred inasmuch as the funds were received into and disbursed out of a
Company account. The Company's recognizes its obligation to repay the principal
due either to the officer or to the third parties.
The funds in the amount of $635,000 received by the officer were used to
reimburse certain creditors and officers of the Company for expenses paid on the
Company's behalf, to fund certain expenses of its start up operation in the
United Kingdom, and to advance additional funds to Entelagent Software Corp.
Because these transactions were not known by or approved by the CEO, CFO or its
Board of Directors, a breach of the Company's internal controls occurred.
Management and legal counsel are evaluating actions necessary to prevent a
similar breach in the future.
RISK FACTORS
FACTORS THAT MAY AFFECT OUR BUSINESS AND FUTURE RESULTS OF OPERATIONS AND
FINANCIAL CONDITION
LACK OF PROFITABILITY.
We are at an early stage of executing our business plan and have no history of
offering information security capabilities. We have generated no revenue from
operations as of September 30, 2003. We have incurred operating and net losses
and negative cash flows from operations since our inception. As of September 30,
2003, we had an accumulated deficit of $24.3 million. We may continue to incur
operating and net losses, due in part to implementing our acquisitions strategy,
engaging in financing activities and expansion of our personnel and our business
development capabilities. We may not be able to achieve or maintain
profitability, and, even if we do achieve profitability, the level of any
profitability cannot be predicted and may vary significantly from quarter to
quarter.
LACK OF BUSINESS OPERATIONS.
Patron has generated no revenue from operations to date and relies on revenue
generated from our capital raising activities to fund the implementation of our
business plan. We will continue to seek financing for the acquisition of
Entelagent and other acquisition targets that we may identify in the future. We
continue to believe that we will secure financing in the near future, but there
can no assurance of our success. If we are unable to obtain the necessary
funding, it will materially adversely affect our ability to execute our business
plan and to continue our operations.
OUR LIMITED HISTORY MAKES IT DIFFICULT TO EVALUATE OUR BUSINESS AND PROSPECTS.
Holdings (as CPS) was incorporated in Nevada in 1995 and Patron was incorporated
in Delaware in 2002. We have not had any business operations since inception. As
a result of our limited history, it may be difficult to plan operating expenses
or forecast our revenues accurately. Our assumptions about customer or network
requirements may be wrong. The revenue and income potential of these products is
unproven, and the markets addressed by these products are volatile. If such
products are not successful, our actual operating results could be below our
expectations and the expectations of investors and market analysts, which would
likely cause the price of our common stock to decline.
LACK OF MARKET FOR PRODUCTS.
We do not have any current products or revenues. We intend to acquire products
through the acquisition of existing businesses. There is no guarantee, however,
that a market will develop for Internet security solutions of the type we intend
to offer. We cannot predict the size of the market for Internet security
solutions, the rate at which the market will grow, or whether our target
customers will accept our acquired products.
16
THE PRICE OF OUR COMMON STOCK IS LIKELY TO BE VOLATILE.
The market prices of the securities of technology-related companies have
historically been volatile and may continue to be volatile. Thus, the market
price of our common stock is likely to be subject to wide fluctuations. If our
revenues do not grow or grow more slowly than we anticipate, if operating or
capital expenditures exceed our expectations and cannot be reduced
appropriately, or if some other event adversely affects us, the market price of
our common stock could decline. Only a small public market currently exists for
our common stock and the number of shares eligible for sale in the public market
is currently very limited, but is expected to increase. Sales of substantial
shares in the future would depress the price of our common stock. In addition,
we currently do not receive any stock market research coverage by any recognized
stock market research or trading firm and our shares are not traded on any
national securities exchange. A larger and more active market for our common
stock may not develop.
Because of our limited operations history and lack of assets and revenues to
date, our common stock is believed to be currently trading on speculation that
we will be successful in implementing our acquisition and growth strategies.
There can be no assurance that such success will be achieved. The failure to
implement our acquisitions and growth strategies would likely adversely affect
the market price of our common stock. In addition, if the market for
technology-related stocks or the stock market in general experiences a continued
or greater loss in investor confidence or otherwise fails, the market price of
our common stock could decline for reasons unrelated to our business, results of
operations and financial condition. The market price of our common stock also
might decline in reaction to events that affect other companies in our industry
even if these events do not directly affect us. General political or economic
conditions, such as an outbreak of war, a recession or interest rate or currency
rate fluctuations, could also cause the market price of our common stock to
decline. Our common stock has experienced, and is likely to continue to
experience, these fluctuations in price, regardless of our performance.
THE CONCENTRATION OF OUR CAPITAL STOCK OWNERSHIP WITH INSIDERS IS LIKELY TO
LIMIT THE ABILITY OF OTHER STOCKHOLDERS TO INFLUENCE CORPORATE MATTERS.
The executive officers, directors and entities affiliated with any of them
together beneficially own approximately 69% of our outstanding common stock. As
a result, these stockholders may be able to exercise control over matters
requiring approval by our stockholders, including the election of directors and
approval of significant corporate transactions. This concentration of ownership
might also have the effect of delaying or preventing a change in our control
that might be viewed as beneficial by other stockholders.
FUTURE SALES OF SHARES BY EXISTING STOCKHOLDERS COULD CAUSE OUR STOCK PRICE TO
DECLINE.
If our existing or future stockholders sell, or are perceived to sell,
substantial amounts of our common stock in the public market, the market price
of our common stock could decline. As of September 30, 2003, there were
approximately 34,931,388 shares of common stock outstanding (which number does
not include the 14,592,760 shares of common stock pledged to Mercatus that have
been requested to be returned and cancelled, as more fully described in the
description of our Liquidity and Capital Resources under the caption
"Management's Discussion and Analysis or Plan of Operation"), of which all but
11,026,388 shares will be held by directors, executive officers and other
affiliates, the sale of which are subject to volume limitations under Rule 144,
various vesting agreements and quarterly and other "blackout" periods.
Furthermore, shares subject to outstanding options and warrants and shares
reserved for future issuance under our stock option plan will become eligible
for sale in the public market to the extent permitted by the provisions of
various vesting agreements, the lock-up agreements and Rule 144 under the
Securities Act.
WE MAY BE UNABLE TO SUCCESSFULLY INTEGRATE.
Our business plan is dependent upon the acquisition and integration of companies
that have previously operated independently. The process of integrating could
cause an interruption of, or loss of momentum in, the activities of our business
and the loss of key personnel. The diversion of management's attention and any
delays or difficulties encountered in connection with our integration of
acquired operations could have an adverse effect on our business, results of
operations, financial condition or prospects.
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AVAILABILITY OF FUTURE CAPITAL.
To achieve our intended growth, we will require substantial additional capital.
We have encountered difficulty and delays in raising capital to date and the
market environment for development stage companies, like Patron, remains
particularly challenging. There can be no assurance that funds will be available
when needed or on acceptable terms. Technology companies in general have
experienced difficulty in recent years in accessing capital. Inability to obtain
additional financing may require us to delay, scale back or eliminate certain of
our growth plans which could have a material and adverse effect on our business,
financial condition or results of operations or to cease operations. Even if we
are able to obtain additional financing, such financing could be structured as
equity financing that would dilute the ownership percentage of any investor in
our securities.
DOWNTURNS IN THE INTERNET INFRASTRUCTURE, NETWORK SECURITY AND RELATED MARKETS
MAY DECREASE OUR REVENUES AND MARGINS.
The market for products and other products we intend to offer depends on
economic conditions affecting the broader Internet infrastructure, network
security and related markets. Downturns in these markets may cause enterprises
and carriers to delay or cancel security projects, reduce their overall or
security-specific information technology budgets or reduce or cancel orders for
products and other products we intend to offer. In this environment, customers
such as distributors, value-added resellers and carriers may experience
financial difficulty, cease operations and fail to budget or reduce budgets for
the purchase of products we intend to offer. This, in turn, may lead to longer
sales cycles, delays in purchase decisions, payment and collection, and may also
result in price pressures, causing us to realize lower revenues, gross margins
and operating margins. In addition, general economic uncertainty caused by
potential hostilities involving the United States, terrorist activities, the
decline in specific markets such as the service provider market in the United
States, and the general decline in the capital spending in the information
technology sector make it difficult to predict changes in the purchase and
network requirements of our potential customers and the markets we intend to
serve. We believe that, in light of these events, some businesses may curtail or
eliminate capital spending on information technology. A decline in capital
spending in the markets we intend to serve may adversely affect our future
revenues, gross margins and operating margins and make it necessary for us to
gain significant market share from our future competitors in order to achieve
our financial goals and achieve profitability.
COMPETITION MAY DECREASE OUR PROJECTED REVENUES, MARKET SHARE AND MARGINS.
The market for network security products is highly competitive, and we expect
competition to intensify in the future. Competitors may gain market share and
introduce new competitive products for the same markets and customers we intend
to serve with our products. These products may have better performance, lower
prices and broader acceptance than the products we intend to offer.
Many of our potential competitors have longer operating histories, greater name
recognition, large customer bases and significantly greater financial,
technical, sales, marketing and other resources than we will have. In addition,
some of our potential competitors currently combine their products with other
companies' networking and security products. These potential competitors also
often combine their sales and marketing efforts. Such activities may result in
reduced prices, lower gross and operating margins and longer sales cycles for
the products we intend to offer. If any of our larger potential competitors were
to commit greater technical, sales, marketing and other resources to the markets
we intend to serve, or reduce prices for their products over a sustained period
of time, our ability to successfully sell the products we intend to offer,
increase revenue or meet our or market analysts' expectations could be adversely
affected.
FAILURE TO ADDRESS EVOLVING STANDARDS IN THE NETWORK SECURITY INDUSTRY AND
SUCCESSFULLY DEVELOP AND INTRODUCE NEW PRODUCTS OR PRODUCT ENHANCEMENTS WOULD
CAUSE OUR REVENUES TO DECLINE.
The market for network security products is characterized by rapid technological
change, frequent new product introductions, changes in customer requirements and
evolving industry standards. We expect to introduce our products and
enhancements to existing products to address current and evolving customer
requirements and broader networking trends and vulnerabilities. We also expect
to develop products with strategic partners and incorporate third-party advanced
security capabilities into our intended product offerings. Some of these
products and enhancements may require us to develop new hardware architectures
and ASICs that involve complex and time consuming processes. In developing and
introducing our intended product offerings, we have made, and will continue to
make, assumptions with respect to which features, security standards and
performance criteria will be required by our potential customers.
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If we implement features, security standards and performance criteria that are
different from those required by our potential customers, market acceptance of
our intended product offerings may be significantly reduced or delayed, which
would harm our ability to penetrate existing or new markets.
Furthermore, we may not be able to develop new products or product enhancements
in a timely manner, or at all. Any failure to develop or introduce these new
products and product enhancements may adversely affect our ability to sell
solutions to address large customer deployments and, as a consequence, our
revenues may be adversely affected. In addition, the introduction of products
embodying new technologies could render existing products we intend to offer
obsolete, which would have a direct, adverse effect on our market share and
revenues. Any failure of our future products or product enhancements to achieve
market acceptance could cause our revenues to decline and our operating results
to be below our expectations and the expectations of investors and market
analysts, which would likely cause the price of our common stock to decline.
THE UNPREDICTABILITY OF AN ACQUIRED COMPANY'S QUARTERLY RESULTS MAY CAUSE THE
TRADING PRICE OF OUR COMMON STOCK TO DECLINE.
The quarterly revenues and operating results of companies we may acquire will
likely continue to vary in the future due to a number of factors, many of which
are outside of our control. Any of these factors could cause the price of our
common stock to decline. The primary factors that may affect future revenues and
future operating results include the following:
- the demand for intended current product offerings and our
future products;
- the length of sales cycles;
- the timing of recognizing revenues;
- new product introductions by us or our competitors;
- changes in our pricing policies or the pricing policies of our
competitors;
- variations in sales channels, product costs or mix of products
sold;
- our ability to develop, introduce and ship in a timely manner
new products and product enhancements that meet customer
requirements;
- our ability to obtain sufficient supplies of sole or limited
source components, including ASICs, and power supplies, for
our products;
- variations in the prices of the components we purchase;
- our ability to attain and maintain production volumes and
quality levels for our products at reasonable prices at our
third-party manufacturers;
- our ability to manage our customer base and credit risk and to
collect accounts receivable; and
- the financial strength of our value-added resellers and
distributors.
Our operating expenses are largely based on anticipated revenues and a high
percentage of our expenses are, and will continue to be, fixed in the short
term. As a result, lower than anticipated revenues for any reason could cause
significant variations in our operating results from quarter to quarter and,
because of our rapidly growing operating expenses, could result in substantial
operating losses. In this event, the price of our common stock would likely
decline.
WE MAY EXPERIENCE ISSUES WITH OUR FINANCIAL SYSTEMS, CONTROLS AND OPERATIONS
THAT COULD HARM OUR FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
Our ability to sell our intended product offerings and implement our business
plan successfully in a volatile and growing market requires effective management
and financial systems and a system of financial processes and controls. We have
limited management resources today and are still establishing our management and
financial systems. Growth, to the extent it occurs, is likely to place a
considerable strain on our management resources, systems, processes and
controls. To address these issues, we will need to continue to improve our
financial and managerial controls, reporting systems and procedures, and will
need to continue to expand, train and manage our work force worldwide. If we are
unable to maintain an adequate level of financial processes and controls, we may
not be able to accurately report our financial performance on a timely basis and
our business and stock price would be harmed.
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IF OUR FUTURE PRODUCTS DO NOT INTEROPERATE WITH OUR END CUSTOMERS' NETWORKS,
INSTALLATIONS WOULD BE DELAYED OR CANCELLED, WHICH COULD SIGNIFICANTLY REDUCE
OUR ANTICIPATED REVENUES.
Future products will be designed to interface with our end customers' existing
networks, each of which have different specifications and utilize multiple
protocol standards. Many end customers' networks contain multiple generations of
products that have been added over time as these networks have grown and
evolved. Or future products must interoperate with all of the products within
these networks as well as with future products that might be added to these
networks in order to meet end customers' requirements. If we find errors in the
existing software used in our end customers' networks, we may elect to modify
our software to fix or overcome these errors so that our products will
interoperate and scale with their existing software and hardware. If our future
products do not interoperate with those within our end customers' networks,
installations could be delayed or orders for our products could be cancelled,
which could significantly reduce our anticipated revenues.
WE WILL DEPEND ON OUR KEY PERSONNEL TO MANAGE OUR BUSINESS EFFECTIVELY IN A
RAPIDLY CHANGING MARKET, AND IF WE ARE UNABLE TO HIRE ADDITIONAL PERSONNEL OR
RETAIN EXISTING PERSONNEL, OUR ABILITY TO EXECUTE OUR BUSINESS STRATEGY WOULD BE
IMPAIRED.
We currently have only two employees. Our future success depends upon the
continued services of our executive officer. The loss of the services of any of
our key employees, the inability to attract or retain qualified personnel in the
future, or delays in hiring required personnel, could delay the development and
introduction of, and negatively impact our ability to sell, our intended product
offerings.
WE MIGHT HAVE TO DEFEND LAWSUITS OR PAY DAMAGES IN CONNECTION WITH ANY ALLEGED
OR ACTUAL FAILURE OF OUR PRODUCTS AND SERVICES.
Because our intended product offerings and services provide and monitor network
security and may protect valuable information, we could face claims for product
liability, tort or breach of warranty. Anyone who circumvents our security
measures could misappropriate the confidential information or other property of
end customers using our products, or interrupt their operations. If that
happens, affected end customers or others may sue us. Defending a lawsuit,
regardless of its merit, could be costly and could divert management attention.
Our business liability insurance coverage may be inadequate or future coverage
may be unavailable on acceptable terms or at all.
WE COULD BECOME SUBJECT TO LITIGATION REGARDING INTELLECTUAL PROPERTY RIGHTS
THAT COULD BE COSTLY AND RESULT IN THE LOSS OF SIGNIFICANT RIGHTS.
In recent years, there has been significant litigation in the United States
involving patents and other intellectual property rights. We may become a party
to litigation in the future to protect our intellectual property or as a result
of an alleged infringement of another party's intellectual property. Claims for
alleged infringement and any resulting lawsuit, if successful, could subject us
to significant liability for damages and invalidation of our proprietary rights.
These lawsuits, regardless of their success, would likely be time-consuming and
expensive to resolve and would divert management time and attention. Any
potential intellectual property litigation could also force us to do one or more
of the following:
- stop or delay selling, incorporating or using products that
use the challenged intellectual property;
- obtain from the owner of the infringed intellectual property
right a license to sell or use the relevant technology, which
license might not be available on reasonable terms or at all;
or
- redesign the products that use that technology.
If we are forced to take any of these actions, our business might be seriously
harmed. Our insurance may not cover potential claims of this type or may not be
adequate to indemnify us for all liability that could be imposed.
THE INABILITY TO OBTAIN ANY THIRD-PARTY LICENSE REQUIRED TO DEVELOP NEW PRODUCTS
AND PRODUCT ENHANCEMENTS COULD REQUIRE US TO OBTAIN SUBSTITUTE TECHNOLOGY OF
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LOWER QUALITY OR PERFORMANCE STANDARDS OR AT GREATER COST, WHICH COULD SERIOUSLY
HARM OUR BUSINESS, FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
From time to time, we may be required to license technology from third parties
to develop new products or product enhancements. Third-party licenses may not be
available to us on commercially reasonable terms or at all. The inability to
obtain any third-party license required to develop new products or product
enhancements could require us to obtain substitute technology of lower quality
or performance standards or at greater cost, which could seriously harm our
business, financial condition and results of operations.
GOVERNMENTAL REGULATIONS AFFECTING THE IMPORT OR EXPORT OF PRODUCTS COULD
NEGATIVELY AFFECT OUR REVENUES.
Governmental regulation of imports or exports or failure to obtain required
export approval of encryption technologies we intend to acquire could harm our
international and domestic sales. The United States and various foreign
governments have imposed controls, export license requirements and restrictions
on the import or export of some technologies, especially encryption technology.
In addition, from time to time, governmental agencies have proposed additional
regulation of encryption technology, such as requiring the escrow and
governmental recovery of private encryption keys.
In particular, in light of recent terrorist activity, governments could enact
additional regulation or restrictions on the use, import or export of encryption
technology. Additional regulation of encryption technology could delay or
prevent the acceptance and use of encryption products and public networks for
secure communications. This might decrease demand for our intended product
offerings and services. In addition, some foreign competitors are subject to
less stringent controls on exporting their encryption technologies. As a result,
they may be able to compete more effectively than we can in the domestic and
international network security market.
MANAGEMENT COULD INVEST OR SPEND OUR CASH OR CASH EQUIVALENTS AND INVESTMENTS IN
WAYS THAT MIGHT NOT ENHANCE OUR RESULTS OF OPERATIONS OR MARKET SHARE.
We have made no specific allocations of our cash or cash equivalents and
investments. Consequently, management will retain a significant amount of
discretion over the application of our cash or cash equivalents and investments
and could spend the proceeds in ways that do not improve our operating results
or increase our market share. In addition, these proceeds may not be invested to
yield a favorable rate of return.
ITEM 3. CONTROLS AND PROCEDURES.
Under the supervision and with the participation of Patron's management,
including Patron's Chief Executive Officer and Acting Chief Financial Officer,
Patron has evaluated the effectiveness of the design and operation of its
disclosure controls and procedures pursuant to Exchange Act Rule 13a-14(c)
within 90 days of the filing date of this quarterly report. Based on that
evaluation, the Chief Executive Officer and Chief Financial Officer have
concluded that these disclosure controls and procedures are effective. There
were no significant changes in Patron's internal controls or in other factors
that could significantly affect internal controls subsequent to the date of
their evaluation.
PART II -- OTHER INFORMATION
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits.
31.1 Certification pursuant to Rule 13(a) -- 15(e) or Rule 15(d) -- 15(e),
as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
-- Chief Executive Officer and Acting Chief Financial Officer -
Patron Systems, Inc.
32.1 Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant
to Section 906 of the Sarbanes-Oxley Act of 2002 -- Chief Executive
Officer and Acting Chief Financial Officer - Patron Systems, Inc.
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(b) Reports on Form 8-K.
On January 16, 2003, we filed a current report on Form 8-K with the Securities
and Exchange Commission containing two press release issued on January 2, 2003
and January 15, 2003, announcing the appointment of Richard G. Beggs, Warren K.
Luke and Robert E. Yaw II to serve on the Board of Directors, and an increase in
the size of the Board to nine.
On January 16, 2003, we filed a current report on Form 8-K with the Securities
and Exchange Commission containing a press release issued on January 15, 2003
announcing the execution of a term sheet with a private group of international
investors for an investment facility to Patron.
On January 28, 2003, we filed a current report on Form 8-K with the Securities
and Exchange Commission containing a press release issued on January 22, 2003
announcing the execution of a memorandum of understanding with TELSECURE (UK)
LTD, for the development by Patron of an information security platform and
broad-based suite of security products to support TELSECURE's wireless business
application development project, and a press release issued on January 24, 2003
announcing the progress of business combinations with TrustWave Corp. and with
Entelagent Software Corp.
On March 27, 2003, we filed a current report on Form 8-K with the Securities and
Exchange Commission announcing the consummation of the merger of Patron
Holdings, Inc., a Nevada corporation, with and into Patron Systems, Inc.
ITEMS 1 THROUGH 5 ARE NOT APPLICABLE AND HAVE BEEN OMITTED.
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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.
PATRON SYSTEMS, INC.
Date: December 29, 2003 /s/ Patrick J. Allin
----------------------------------
Patrick J. Allin
Chief Executive Officer and
Acting Chief Financial Officer
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