10KSB 1 d85728e10ksb.txt FORM 10KSB FOR FISCAL YEAR END DECEMBER 31, 2000 1 U.S. SECURITIES AND EXCHANGE COMMISSION Washington, DC 20549 FORM 10-KSB [X] ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended: DECEMBER 31, 2000 [ ] TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to -------------- ------------- Commission file number: 0-28484 QUALMARK CORPORATION (Name of small business issuer in its charter) COLORADO 84-1232688 (State or other jurisdiction (IRS Employer of incorporation or organization) Identification No.) 1329 WEST 121ST AVENUE, DENVER, COLORADO 80234 (Address of principal executive offices, including zip code) (303) 254-8800 (Registrant's Telephone Number, including area code) SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE EXCHANGE ACT: None SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE EXCHANGE ACT: COMMON STOCK (NO PAR VALUE) (Title of Class) Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act during the past 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 ----- ---- Check if there is no disclosure of delinquent filers in response to Item 405 of Regulation S-B contained in this form, and no disclosure will 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-KSB or any amendment to this Form 10-KSB. [ ] Issuer's revenues for its most recent fiscal year. $12,505,000 The aggregate market value of the voting stock held by nonaffiliates computed by reference to the average bid and asked prices of such stock as of March 16, 2001 was $7,107,369. The number of shares outstanding of the issuer's Common Stock as of March 16, 2001 was 3,610,092. DOCUMENTS INCORPORATED BY REFERENCE Registrant's definitive Proxy Statement to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934 is incorporated by reference in Part III of this report. Transitional Small Business Disclosure Format (Check One): Yes No X --- --- 2 PART I ITEM 1. DESCRIPTION OF BUSINESS. QualMark Corporation ("QualMark" or "the Company") designs, manufactures, and markets proprietary equipment that rapidly and efficiently expose product design and manufacturing-related defects for the purpose of improving product quality and reliability. The Company's high performance physical stress equipment supports significant improvements in the process of Design Verification Testing ("DVT") and Environmental Stress Screening ("ESS"). DVT is the process by which electronic product manufacturers ensure their products perform within the previously determined operating ranges (commonly known as "specifications"). ESS is the testing process used by these same manufacturers to expose production-related defects. The Company's equipment allow manufacturers to determine the true operating limits of their products. This gives manufacturers the necessary information to reduce design costs, improve product reliability, shorten time to market, reduce warranty costs, and extend warranty periods. The Company's equipment is used by manufacturers in a wide range of industries to perform highly accelerated stress testing on products such as circuit boards, personal computers, monitors, flight navigation systems, cellular telephones, LAN/WAN equipment and consumer electronics. The Company evolved from a business manufacturing and marketing its proprietary OVS (Omni-axial Vibration System) equipment to a full service organization offering HALT (Highly Accelerated Life Test) and HASS (Highly Accelerated Stress Screen) test services as well. The Company operates a network of test centers, known as Accelerated Reliability Test Centers ("ARTC"), which provide comprehensive HALT and HASS test and support services to industry. These services include accelerated reliability improvement test services (HALT and HASS) using QualMark's OVS physical stress equipment performed either in the ARTC test centers or at the customer's site. QualMark currently has six test centers located in the metropolitan areas of Denver, Colorado, Huntington Beach, California, Santa Clara, California, Boston, Massachusetts, Detroit, Michigan, and Orlando, Florida. The Company also has two strategic alliances with testing companies in the U.S. In addition, the Company has established strategic alliances with TUV Product Service Ltd. and Anecto Ltd., Maser Engineering, IMQ Instituto del marchia di Qualita, Institutet For Verkstadsteknisk Forskning/The Swedish Institute of Production Engineering, and Emitech, to operate testing centers in London, England, Galway, Ireland, Mannheim, Germany, Enschede, the Netherlands, Milan, Italy, Molndal, Sweden and Paris, France. As international demand for its products and services grows, the Company may further expand its domestic and international presence by expanding strategic alliance arrangements with other test lab organizations. The Company was organized in July 1991 as a Colorado limited liability company and was later incorporated in Colorado in March 1992. The Company completed its initial public offering in April 1996. PRODUCTS AND SERVICES THE OVS COMBINED STRESS SYSTEM The Company's OVS Combined Stress Systems for HALT and HASS are comprised of two main subassemblies: the LF Vibration Assembly, which applies vibrational stresses, and the UltraRate Thermal Chamber Assembly, which applies thermal stresses and houses the vibration assembly. During 2000, the Company released the newest advancement in the OVS Combined Stress System, the Typhoon ("Typhoon"). The Typhoon technology optimizes the operating efficiencies of the standard OVS test chambers. The lower costs are made possible by a unique design that significantly reduces both the consumption of liquid nitrogen used to cool the chambers and the amount of electricity used to heat the chambers. The LF Vibration Assembly The LF (low frequency) Vibration Assembly is a new generation vibration system, which the Company introduced in 1999. This system has increased low frequency compared to the Omniaxial vibration system previously produced and sold by the Company. The LF system is a multi-axis vibration system comprised of a table, actuators and unique attachment system and is the heart of the Company's technology. The vibration table moves simultaneously in three linear axes and three angular rotations. Each axis has broad-band random vibration, with all frequencies present, all of the time. While the traditional frequency range used for Design Verification Testing (DVT) and Environmental Stress Screening (ESS) is from 2Hz to 2,000 3 Hz, the Company's system creates vibrational forces between 2Hz and 10,000 Hz. The new LF table has significantly increased low frequency energy available resulting in more effective testing and screening for larger sub-systems. It also provides extremely complex motion across a broad frequency range, which is desirable for many current electronic technologies. Thus, the system creates virtually any vibration that could occur naturally during product use. This is important in testing and screening applications to expose most flaws, whether it is design or process related, before the product is placed into service. THE LF VIBRATION SYSTEM CONSISTS OF TWO MAJOR COMPONENTS: VIBRATION TABLE The new patent pending table is constructed out of a top plate, thermal insulation layer and supporting under structure. This new design is significantly lighter and stiffer than the previous design, resulting in higher low frequency energy and improved energy distribution over the active frequency range. This table has proved particularly effective in the testing of assemblies with larger components. The Company while continuing to supply a range of standard table sizes has also produced custom sizes to meet customer requirements. The Company uses an outside source to produce its vibration tables, however the Company is not dependent on a single source of supply and controls all design and documentation. ASX AND LF2 ACTUATORS Attached to the bottom surface of the under structure are a set of pneumatic piston driven actuators. The method of attachment is also the subject of a patent application, as the unique method shapes the frequency distribution. There are two types of actuator used, the patent pending ASX and the licensed LF2. The ASX actuator is an evolution of the patented Autosmear actuator. The Company is the sole licensee of the LF2 actuator from Storage Technology Corporation. The combination of actuators provides excitation in both the low and high frequency areas of the energy spectrum. Compressed air is used to drive the pistons in the actuators to impact the top of the actuators, translating the energy through the attachment system to vibration energy in the table. The unique design of these actuators when used in conjunction with the new table generates an even distribution of vibratory energy in the frequency spectrum. This provides for more effective fault detection and screening. The Company has released this technology in all the OVS system sizes. The UltraRate Thermal Chamber Assembly The UltraRate Thermal Chamber, which houses the OmniAxial Vibration Assembly, changes temperature at rates up to 600 Centigrade per minute as measured on the product being tested. This high rate of change results in highly effective design verification during HALT and extremely short production screens during HASS, requiring less equipment and personnel to perform a given series of thermal cycles. The Company believes that its UltraRate Thermal Chambers, comprised of patented and patent pending features, have one of the highest rate of thermal change available in the environmental stress screening industry. This capability significantly reduces test time, with resulting cost reductions in equipment and personnel. In spite of rapid temperature change and complex vibration spectra, the system is extremely quiet, allowing it to be used in standard lab and manufacturing environments without the necessity of building costly special stress screening rooms. TYPHOON TECHNOLOGY: The Typhoon technology represents the newest development in UltraRate Thermal technology. The technology lowers operating costs by reducing thermal mass of the chamber and optimizing the efficiency of the air flow system, which consequently reduces operating costs. The OVS Combined Stress System Product Line The Company's OVS Combined Stress Systems for HALT and HASS are presently available in four sizes. The number after the "OVS" in the Company's product models represents the linear footage of the vibration table as explained below. Therefore, an OVS-1.5 contains a one and one half foot by one and one half foot table, an OVS-2.5 contains a two and a half foot by two and a half foot table, and so on. In addition to these standard systems, the Company has also designed and manufactured custom systems to meet unique customer requirements. Through this product spectrum, the Company provides systems capable of meeting virtually every accelerated design ruggedization and production screening requirement. The variety of chamber sizes allows customers to purchase equipment that meets their requirements and to consume only the energy necessary to meet their requirements. The OVS-4 and Typhoon systems have a unique patented feature which allows the user 4 to raise the shaker table, thus decreasing the internal volume of the chambers to the minimum size required. By cooling and heating a smaller volume, the customer can save considerably on power and liquid nitrogen requirements. OVS-1.5: The OVS-1.5 is the smallest version of the OVS product line. The OVS-1.5 is a truly portable, multi-axis vibration and high performance thermal chamber. Equipped with all the same operating features of the larger OVS systems, including PC controller, the OVS-1.5 is primarily used by manufacturers of small products (such as "palm size" circuit boards, modem cards for notebook computers, disk drives, etc.) and usually in the product development (HALT) area. The OVS-1.5 can generate random vibration forces in excess of 90 Grms (2Hz-10,000 Hz) on the 18"x18" vibration table and up to 60(degrees) Centigrade per minute change on the product under test within the 18"x17"x13" internal dimension (ID) thermal chamber. The domestic price of the OVS-1.5 is approximately $77,900. OVS-2.5: The OVS-2.5 is the most popular system in the OVS product line. A mid-size system, the PC-controlled OVS-2.5 is equipped with four actuators mounted to the vibration table. The OVS-2.5 LF vibration system can generate 50 Grms from 2Hz to 10,000 Hz. The vibration table is 30"x30", and is enclosed within a thermal chamber that is 36"x36x37" (ID). The thermal chamber is capable of up to 60(degrees) Centigrade per minute change on the product under test. Typical uses of the OVS-2.5 include mid-size product HALT applications (disk drives, small computers, power supplies, monitors, etc.) and small volume HASS applications (multiple disk drives, multiple modem cards for notebook computers, etc.) The domestic price for a standard OVS-2.5 is approximately $128,500. OVS-4: The OVS-4 is the largest system in the OVS product line. By far, the most common application for the OVS-4 is for large volume production screening (HASS) on computers, monitors, communications systems, etc. The PC-controlled OVS-4 is equipped with a 48"x48" vibration table housed within a 55"x54"x54" (internal dimension) (table in lower position) thermal chamber capable of producing temperature changes of up to 60(degrees) Centigrade per minute on the product under test. The OVS-4 LF vibration system is equipped with eight actuators that produce up to 50 Grms random vibration force. The domestic price for a standard OVS-4.0 is approximately $182,500. Typhoon: The Typhoon chamber compares in size with the OVS-4. The most common application for the Typhoon is large volume production screening (HASS) on computers, monitors, communications systems, etc. The PC-controlled Typhoon is equipped with a 48"x48" vibration table housed within a 55"x54"x54" (internal dimension) (table in lower position) thermal chamber capable of producing temperature changes of up to 70(degrees) Centigrade per minute on the product under test. The Typhoon vibration system is equipped with twelve actuators that produce up to 35 Grms random vibration force. The domestic price for a standard Typhoon is approximately $185,000. A one year limited warranty is included with each OVS system sold in 2000. Various options and accessories are available for each OVS model, including oxygen monitors, vacuum hold down apparatus (for product fixturing requirements), extended warranties, and on-site applications assistance. QUALMARK ENGINEERING SERVICES ("QES") The Company offers a range of engineering services tailored to help solve test process problems. The services that are offered under QES are: o HALT and HASS testing procedure development 5 o Precision production fixturing solutions o Automated electronic functional test equipment design and development o Software validation testing and life cycle analysis o Test and process data warehousing o Remote viewing and analysis of test data through Internet linking The Company reviews each project with experts in the various fields and compiles a proposal, which typically includes investigation, specification, and execution. After the system or process is installed, the Company continues to work with the client's staff to monitor and support the product and process. This approach gives customers access to experts in varying fields at a time when internal resources are often overburdened. The result is a better product delivered to the marketplace, faster. ACCELERATED RELIABILITY TEST CENTERS The Company has a network of ARTC test centers throughout the United States, which provide test services and on-site applications support services. The Company is uniquely positioned to offer comprehensive HALT/HASS test services to manufacturers. The QualMark test service business includes accelerated reliability test services performed in the Company's test centers and on-site applications support services. These services allow a broad range of customers convenient access to the Company's technology while also serving as valuable sales tools for gaining system orders. Each test center is equipped with the OVS-2.5, at least one applications engineer and ancillary testing equipment. Offering these services as an ISO-registered accelerated test lab significantly differentiates the Company from its equipment and lab competition. The Company opened its first ARTC facility in Denver in October 1993 and subsequently opened additional facilities in Marlborough (Boston), Massachusetts and Santa Clara, California in July 1994 and May 1995, respectively. Since opening these facilities, many test service clients have placed orders to purchase systems as a result of the data gathered and analyzed at the Company. The test center is a valuable tool for the Company sales people to stimulate system sales from those clients who are not willing to commit capital without being able to experience a demonstration of the benefits using their own product. Of strategic importance to the Company, the testing service business should help insulate the Company from external economic factors that affect capital spending and provide for more consistent revenues. In addition to its Boston, Denver and Santa Clara test centers, during 1996, the Company opened test centers in the metropolitan areas of Minneapolis-Saint Paul, Minnesota, Detroit, Michigan, and Raleigh, North Carolina. In 1997, the Company opened its seventh and eighth test centers in Huntington Beach, California and Orlando, Florida. During 1999 and 2000, the Company reevaluated its domestic test center market and closed the Minneapolis-Saint Paul, Minnesota and Raleigh, North Carolina labs. The Company established its first test center presence outside the U.S. via a strategic alliance with TUV Product Service Ltd. In Fareham, England. This lab began operations in February 1998. The second international alliance was established in Galway, Ireland with Anecto, Ltd. This lab commenced operations in August 1998. The Company established a third international alliance in Mannheim, Germany with TUV Product Service Ltd. as the partner. The Mannheim lab commenced operations in November 1998. In 1999 the Company further expanded its international network with its fourth additional alliance with Maser Engineering in Enschede, The Netherlands. This lab commenced operations in May of 1999. During 1999, agreements were put into place for the Company's fifth, sixth and seventh international strategic alliances. These alliances are with IMQ Institudo Italiano del Marchio di Qualita, located in Milan, Italy, Institutet for Verkstadsteknisk Forskning/the Swedish Institute of Production Engineering Research, located in Molndal, Sweden and with Emitech, located in Paris, France. Under all of these alliances, except for Maser Engineering, the Company contributed one OVS 2.5 system and the strategic partner provided the lab facility, personnel and sales management. Under the agreement with Maser Engineering, the Company contributed one OVS 1.5 system. In return for its contribution of these systems to these alliances, the Company receives a percentage of the revenues generated by the OVS systems. The Company may open additional test centers principally in metropolitan areas with a heavy concentration of potential client companies and in which the Company has a factory sales representative responsible for the target metro area. Management believes demand for its test services will continue to grow, allowing for controlled expansion into additional metro areas. Finally, the Company may expand its international presence via strategic alliance arrangements with other test lab organizations. Based on client demand, the Company offers on-site applications support services, principally through its ARTC network, to its clients as well as competitors' customers. Specifically, the Company advises customers how to apply HALT and HASS techniques to their products. 6 MARKETING During the last quarter of 2000, the Company reorganized it marketing group hiring a new Director of Marketing and support staff. This change is an effort to revitalize the Company's marketing philosophy and approach. Planning has been started to assess the company's market and to target potential areas of growth. The Company expanded it's offerings, entering the education field offering a range of seminars developed by an industry expert. These seminars along with open houses and technical presentations will continue to expand QualMark's presence in the marketplace. The following is planned for the next twelve months: 1) Continue to offer educational services and technical research and analysis through white papers. The Company will co-author to facility these white papers in an effort broadcast success with these techniques. 2) The Company will overhaul it's advertising and target the typical journals in the industry as well as a few in adjacent disciplines. 3) While the Company will attend a few focussed trade shows, the marketing plan is to expand it's presence on the web, positioning itself as a resource in accelerated testing. 4) The Company has shifted it's focus reducing it's direct sales force and recruiting a number of independent representatives. The Company is also developing its market presence through its relationship with Chart Industries. 5) The Company is focussing on expanding it's product offerings to existing chamber customers. The Company is developing a number of service plans to support the existing customer base. The Company is now offering a custom production fixturing business to help customers get the maximum benefit from their investment. Sales Strategy During the last quarter of 2000, the Company has revised its sales strategy, by shifting focus from direct to independent representatives. These representatives have been carefully chosen, each with many years selling similar types of equipment. These representatives will be support by the regional Vice Presidents as well as staff from head quarters. The Company will continue to do the telemarketing from headquarters and will continue to use independent sales/service agents in Europe, the Middle East and the Far East. The Company plans to further support these agents as well as investigate potential markets that have not yet been addressed. The regional vice presidents have been moved into more of a support role with each sales employee responsible for selling all of the Company's products. The Company believes that this will cause a relationship to be built as the customer is led through the Company's products and services. CUSTOMERS The Company's systems continue to be used by manufacturers in a wide variety of industries. From inception of the Company, through December 31, 2000, the Company has sold 377 systems to 135 different customers, in the following industries: Telecommunications and Computer, Defense and Aerospace, Medical Electronics, and others. The QualMark customer list includes major corporations such as Allied Signal (Honeywell), AT&T, Cessna, Dupont, Cummins Engine, Hewlett-Packard, Hughes (Raytheon), Intel, Lucent Technologies, Johnson & Johnson, Medtronic, Motorola, National Semiconductor, Magnavox, Nortel (formerly Northern Telecom), Sequent Computers (IBM), Tektronix, 3Com, United Technologies, Cisco, and Dell. During 2000, there were no customers that comprised 10% or more of the Company's revenue and the Company was not dependent on any single industry segment for its revenues. 7 The Company's customers continues to be varied and are as follows:
Aerospace and Defense Computer Related Products Other --------------------- ------------------------- ----- Aviation electronics Circuit boards Automotive circuitry Display switches Disk drives Electronic oil and gas flow meters Flight navigation systems Modems Global positioning systems Marine navigation systems Monitors Power supplies Printers Tape backup drives Telecommunications Medical Electronics ------------------ ------------------- Automated teller machines Electronic thermometers Air conditioning electronics Glucose monitors Cordless telephones Infusion pumps Fax machines IV pumps Laboratory centrifuges Medical imaging systems Patient monitors
RESEARCH AND PRODUCT DEVELOPMENT Research and development expenditures for the fiscal years ending December 31, 2000 and 1999 were $836,000 and $690,000, respectively. In 2000, the Company released the Typhoon chamber the culmination of two and a half years of research and development activity. It is the intent of the Company in 2001 to continue its commitment and effort to the development of new technologies and product offerings and expects its research and development expenditures to increase. This research and development effort is expected to be funded by cash flows from operations. Of great benefit to the Company is that its technology is extremely flexible in regard to the physical size of its OVS systems; consequently, product line extension opportunities normally do not require sizable expenditures on product development. The Company intends to continue taking advantage of design refinement opportunities specific to its OVS combined stress technology. As discussed in the following "Intellectual Property" section, the Company currently holds domestic and foreign patents on its products and continues to seek patent protection of current and new products. The Company is optimistic that the flexibility and scalability of its fundamental OVS combined stress technology will allow the Company to add to its product line as new opportunities develop. Through its association with the University of Maryland's CALCE EPRC (Computer Aided Life Cycle Enhancement, Electronic Packaging Research Center) research program, the Company has aligned itself with one of the premier electronic packaging research centers in the world. As a CALCE EPRC affiliate, the Company has ongoing access to leading-edge technology development in the areas of highly accelerated test methods and virtual verification. As the demand and viability of these new test methods and technologies are verified, the Company intends to add them to its ARTC service offering. The association with the University of Maryland allows the Company to better manage its investment in research and development, while enjoying the benefit of having an OVS system on site at CALCE EPRC for visiting prospective client representatives to observe its operation. INTELLECTUAL PROPERTY The Company has maintained the practice, where possible, to pursue patent protection on its products. The Company has been issued eleven United States patents (the "Patents") and one foreign patent issued in six countries. These patents protect certain features of the OmniAxial and LF Vibration Assemblies of the Company's OVS Combined Stress Systems or certain design features of the pneumatic, piston-driven actuators (vibrators) that help create random motion of the vibration table. The Company was issued U.S. Patent No. 5,365,788 on November 22, 1994, for certain design features of pneumatic, piston driven actuators that create motion for a vibration table. The Company was issued U.S. Patent No. 5,412,991 on May 9, 1995, for certain design features of the Company's vibration table. The Company was issued U.S. Patent No. 5,517,857 on May 21, 1996, for certain design features related to positioning of a vibration table within a stress screening chamber. The Company was issued U.S. Patent No. 5,540,109 on July 30, 1996, and U.S. Patent No. 5,675,098 on October 7, 1997, for certain design features related to use of multiple stress screening chambers. The Company was issued U.S. Patent No. 5,589,637 on December 31, 1996, for certain design features of mountings of actuators to a vibration table. The Company was issued U.S. Patent No. 5,744,724 on April 28, 1998 for certain design features related to honeycomb vibration table structures. The 8 Company was issued Patent No. 5,836,202 on November 17, 1998 for claims directed at the angle of attachment of the actuators to the vibration table. The Company was issued Patent No. 5,813,541 on September 29, 1998 for the configuration of the control system attachment to the chamber. The Company was issued Patent No. 6,062,086 on May 16, 2000 relating to interposer devices for adjusting and controlling the shock response of a shaker table assembly. The Company was issued Patent No. 6,105,433 on August 22, 2000 for low frequency shaker table technology. The remaining duration of each of the Patents is between ten and twenty years. The Patents provide barriers to competition in the equipment sales portion of its business. The loss of some or all of the protection of the Patents would make it easier for other companies to enter the Company's market, compete, by eroding the Company's ability to differentiate itself on the basis of technical superiority. In addition to the Patents, the Company tries to protect its proprietary technology and know-how through established security practices and confidentiality agreements with each of its employees, consultants, suppliers and technical advisors. There can be no assurance, however, that these agreements or procedures will provide meaningful protection for the Company's trade secrets in the event of unauthorized use or disclosure of such information. While the Company believes the protection afforded by the Patents is strong, there can be no assurance that other companies will not be able to design and build competing vibration tables in a manner that does not infringe the Patents. The Company has the following registered marks with the United States Patent and Trademark Office: QUALMARK, ACCELERATE THE FUTURE, ACCELERATED RELIABILITY TEST CENTER, ARTC, AUTOSMEAR and QHT. The Company has eleven U.S. trademarks pending and five foreign mark applications pending. The Company plans to make additional trademark, service mark, and certification mark applications as appropriate. COMPETITION Equipment The environment, which the Company competes, continues to get more competitive. With the growing acceptance of the HALT & HASS techniques, this market segment is being targeted as a growth area in an otherwise flat industry. However, with the release of the new Typhoon system and the market acceptance of the LF vibration system, the Company is confident that it will maintain it's leadership position and maintain it's market share. Screening Systems, Inc. ("SSI") (Laguna Hills, California) has been in the ESS and DVT business since the early 1980's. They operated for many of those years with technology licensed from Hughes Electronic ("Hughes"). On March 22, 1996, Screening Systems, Inc. filed a patent infringement suit against the Company in federal district court in Santa Ana, CA. This litigation was settled on August 30, 1999. See Item 3 - Legal Proceedings. Thermotron Industries (Holland, MI) announced their offering of a competitive product to the Company's OVS system in the first quarter of 1998. Thermotron is a broad line environmental chamber manufacturer and has also begun manufacturing and selling a chamber with an integrated vibration system that directly competes with QualMark's OVS product offering. ARTC and Applications Support Services As the test methods, HALT and HASS continue to gain market acceptance, the Company is starting to see competition for the ARTC's. Most of these competing facilities are traditional test labs that have been furnished with equipment by competing manufacturers. The Company is keeping a close eye on this development but is confident that the superior offering of the ARTC's will maintain market share. 9 MANUFACTURING The Company's manufacturing facility is located in Denver, Colorado. QualMark's assembly of the OVS systems follow a manufacturing line approach, in which drawings of all subassemblies used by the Company are maintained using computer aided design (CAD). The assembly of the Company's products is organized around three major elements that include vibration systems, chamber systems and control systems. To ensure that all subassemblies meet specifications when received, key suppliers remain actively involved throughout product design. Key suppliers perform source inspection at the point of manufacture. Most key suppliers are local companies. The Company intends to further develop local suppliers, with back-up suppliers as required. To date, the components and assemblies from these suppliers have met or exceeded all specifications. The Company is not dependent on any one or a few major suppliers for any of the key parts or components of its systems. However, the Company has developed relationships with what it considers critical vendors that manufacture three components of its OVS system. While the Company is not dependent on these suppliers, it would take as much as 60 days to locate, qualify and begin taking delivery of these components from new suppliers. While the Company maintains a small inventory of OVS systems in finished goods, the Company primarily uses a rolling-quarter sales forecast in determining the number of OVS-1.5, OVS 2.5, OVS-4, Typhoon systems to build during the quarter. Because of increased sales volume, the Company is producing certain common subassemblies that are integrated into the final systems when orders are booked. This helps provide a more even manufacturing flow and minimizes the "peaks and valleys" associated with small volume manufacturing. The Company has implemented Material Requirements Planning, a computer software driven inventory management process, to maximize the effectiveness in which an order can be filled while minimizing required inventory. Management uses fully-costed Bills of Materials (BOM) which ensure that all parts of an OVS system are identified and ordered in a timely manner. PRODUCT WARRANTIES AND SERVICE In 1999 and 2000, the Company offered a limited, two and one-year parts and labor warranty on all new OVS systems, respectively. OVS customers can purchase extended warranties on their OVS systems, which may include two preventive maintenance visits during the year by a qualified Company representative. In addition, the Company offers for sale a comprehensive spare parts kit for each OVS system, which further minimizes OVS system down time. Because of the efficient design of OVS systems, the Company occasionally sends its technicians into the field for warranty repairs. Most problems can be diagnosed over the phone and, if necessary, replacement parts are sent to the customer via overnight mail. During 2001, the Company will offer a standard, one-year parts and labor warranty on all new OVS systems, and a limited, two-year parts and labor warranty on specific negotiated contracts. GOVERNMENT REGULATION To its knowledge, the Company complies with all international, federal, state, and local regulations, including environmental regulations, governing the conduct of its business and the costs of such compliance are minimal. The Company has no significant environmental issues or impact in its manufacturing or service delivery and there are no significant costs or compliance issues with any government agencies or laws in this area. EMPLOYEES As of December 31, 2000, the Company had forty-five employees, forty-two of which are full-time. Thirty one of the Company's employees are employed at its principal offices and headquarters in Denver, Colorado, seven are employed at its facilities in Santa Clara, CA, two in Huntington Beach, CA , one in Farmington Hills, MI, one in Marlborough, MA, two in Winter Park, FL, and one in Huntsville, AL. No employees are represented by labor organizations and there are no collective bargaining agreements. Employee relations are believed to be good. ITEM 2. DESCRIPTION OF PROPERTY. The Company operates out of leased facilities located at 1329 West 121st Avenue, Denver, Colorado. The three-year lease for the property expires on May 31, 2003. The leased property consists of approximately 18,093 square feet. The lease calls for monthly payments over the term of the lease of $14,890. The Company also leases 2,400 square feet in a space in the same building, 1313 West 121st Avenue. This space has a separate lease agreement that expires on November 30, 2001. The lease calls for monthly payments over the term of the lease of $1,593. In addition to the two leases, the Company is responsible for certain expenses, including property taxes, insurance and maintenance. The Company's manufacturing, sales, administrative operations and regional ARTC services are conducted at this facility. 10 The suburban Boston ARTC facility is located at 98 South Street, Hopkinton, Massachusetts. The six-year lease expires April 30, 2005. The leased property consists of approximately 5,000 square feet. The lease calls for average monthly payments over the term of the lease of $3,252. In addition, The Company is responsible for certain expenses, including property taxes, insurance and maintenance. The Company's regional ARTC service business is conducted at this facility. The Silicon Valley ARTC facility is located at 2225 Martin Avenue, Suite K, Santa Clara, California. The three-year lease expires on February 28, 2001. The leased property consists of approximately 4,660 square feet. The lease calls for average monthly payments of $7,222. In addition, the Company is responsible for certain expenses, including property taxes, insurance and maintenance. The Company's regional ARTC service business is conducted at this facility. The suburban Minneapolis ARTC facility is located at Rush Lake Business Park, 1775 Old Highway 8, Suite 110, New Brighton, Minnesota. The Company ceased operations at this facility in April of 1999 but continues to lease the facility until a suitable sub-lessor can be located. The present value of the remaining lease cost was expensed during 1999. The five-year lease expires in February 2001. The leased property consists of 2,783 square feet. The lease calls for average monthly payments of $2,748. In addition, the Company is responsible for certain expenses, including property taxes, insurance and maintenance. The Company's regional ARTC service business was conducted at this facility. The suburban Raleigh ARTC facility is located at 215 Southport Drive, Suite 300, Morrisville, North Carolina. The five-year lease expires in July 2001. The Company ceased operations at this facility in November of 2000 but continues to lease the facility until a suitable sub-lessor can be located. The present value of the remaining lease cost was expensed during 2000. The leased property consists of approximately 4,692 square feet. The lease calls for average monthly payments of $3,175. In addition, The Company is responsible for certain expenses, including property taxes, insurance and maintenance. The Company's regional ARTC service business is conducted at this facility. The suburban Detroit ARTC facility is located at 39255 Country Club Drive, Suite B-8, Farmington Hills, Michigan. The five-year lease expires in September 2001. The leased property consists of approximately 4,491 square feet. The lease calls for average monthly payments of $5,427. In addition, the Company is responsible for certain expenses, including property taxes, insurance and maintenance. The Company's regional ARTC service business is conducted at this facility. The southern California ARTC facility is located at 15661 Producer Lane, Unit H, Huntington Beach, California. The five-year lease expires in December 2002. The leased property consists of 3,420 square feet. The lease calls for average monthly payments of $2,154. In addition, the Company is responsible for certain expenses, including property taxes, insurance and maintenance. The Company's regional ARTC service business is conducted at this facility. The suburban Orlando facility is located at Crossroads Business Center, Suite 212, 931 Semoran Boulevard, Winter Park, Florida. The five-year lease expires April 30, 2002. The lease calls for average monthly payments of $2,969. In addition, the Company is responsible for certain expenses, including property taxes, insurance and maintenance. The Company's regional ARTC service business is conducted at this facility. The Company believes that its facilities are adequate for its current needs and that suitable additional space can be acquired if needed. All of the premises are of recent construction, are in good condition, are neat in their appearance and are located in business complexes with business of similar quality. ITEM 3. LEGAL PROCEEDINGS On March 22, 1996, the Company was served with a summons and complaint in the U.S. District Court in the Central District of California from Screening Systems, Inc. ("SSI"), a competitor. The complaint, as amended, alleged that the Company's vibration system infringed three patents owned by Hughes Electronics ("Hughes") and licensed to SSI, and sought injunctive relief, monetary damages and costs of litigation. On August 30, 1999, the Company entered into a settlement agreement ("The Agreement") with SSI. Both the Company and SSI denied any wrongdoing or liability in any of the claims asserted. The Company agreed to pay SSI $925,000 to settle the litigation. Of that amount, the Company agreed to pay $300,000 at the execution of the settlement agreement and to pay the remaining amounts by April 1, 2001. The Company also agreed to issue SSI warrants to purchase 620,000 shares of common stock of QualMark Corporation. The exercise price of these warrants is $4.85 per share and the warrants expire on August 30, 2004. Based on the fully diluted shares used in the Company's earnings per share calculation for the year ended 11 December 31, 2000, if SSI exercised this warrant at a cost of $3,007,000, it would own 14.8% of the Company's common stock. According to the terms of The Agreement, as long as SSI family members own more than 5% of QualMark Corporation common stock, their shares shall be non-voting. Both parties agreed to a Mutual Release of Claims and to a Mutual Covenant not to sue each other over any claim of patent infringement or alleged patent infringement with regard to the making, having made, selling, offering for sale, importing or using any products or services sold by either party in the ordinary course of business prior to August 1, 1999. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. There were no matters submitted to a vote of shareholders during the last quarter of the fiscal year ended December 31, 2000. PART II ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The common stock of the Company is traded on the NASDAQ (National Association of Securities Dealers Automated Quotations) Small-Cap Market. The following table sets forth the range of high and low closing bid prices of the Company's common stock as reported by NASDAQ during fiscal years 2000 and 1999:
Fiscal Year Ended December 31, 2000 High Close Low Close First Fiscal Quarter $ 4.875 $3.125 Second Fiscal Quarter 4.125 2.750 Third Fiscal Quarter 3.375 2.313 Fourth Fiscal Quarter 2.938 1.000
Fiscal Year Ended December 31, 1999 High Close Low Close First Fiscal Quarter $ 5.438 $4.000 Second Fiscal Quarter 4.875 2.250 Third Fiscal Quarter 3.375 2.250 Fourth Fiscal Quarter 3.000 2.000
The foregoing quotations represent quotations between dealers without adjustment for retail markups, markdowns or commissions and may not represent actual transactions. At December 31, 2000, the Company had approximately 1,081 beneficial shareholders and 31 shareholders of record. The Company has never paid a cash dividend and does not intend to do so in the future. The Company anticipates a dividend payment on the outstanding preferred stock, in kind, of additional preferred stock in future quarters (Refer to Note 8 of the Financial Statements). ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS The following table sets forth for the fiscal periods indicated the percentage of total revenues, unless otherwise indicated, represented by certain items reflected in the Company's consolidated statement of operations: 12
Fiscal Year Ended ------------------------------------------- December 31, 2000 December 31, 1999 Statement of Operations Data: Revenues 100.0% 100.0% Cost of Revenues 60.3 60.3 ----- ----- Gross Profit 39.7 39.7 Selling, general and administrative expenses 31.5 54.2 Research and development expenses 6.7 5.5 Severance Charges 2.2 -- ----- ----- Income (loss) from operations (0.7) (20.0) Other income (expense) (2.4) (1.4) ----- ----- Income (loss) before income taxes (3.1) (21.4) Income tax benefit 0.1 2.6 ----- ----- Net income (loss) (3.0)% (18.8)% ===== =====
RESULTS OF OPERATIONS The Company's annual and quarterly operating results could be subject to fluctuations for a variety of reasons. The Company operates with a small backlog relative to its revenue; thus most of its sales in each quarter result from orders received in the current or prior quarter. In addition, because prices for the Company's products are relatively substantial, a significant portion of net sales for each quarter is attributable to a relatively small number of units. Comparison of Years Ended December 31, 2000 and 1999 REVENUE Revenue decreased $54,000 or 0.4% to $12,505,000 in the year ended December 31, 2000 from 12,559,000 in the year ended December 31, 1999. OVS system revenue increased $409,000 or 4.6% from in $8,804,000 in the year ended December 31, 1999 to $9,213,000 in the year ending December 31, 2000. Sixty-three OVS units were sold in the year 2000 compared with the sixty OVS units sold in the year 1999. The Company attributes the increase in demand for OVS systems to the continuing development of strategic business relationships. In the third quarter of 2000, QualMark entered into a marketing agreement with Chart Industries. The agreement provides QualMark and Chart broad domestic distribution rights to each other's products. Chart's contract with three independent sales organizations and a staff of six sales personnel resell OVS units in the mid-west and mid-atlantic states. During 2000, 8 OVS units were sold to Chart, which were immediately sold by Chart to third parties, representing 10.2% of equipment revenue, under the agreement. Additionally, the Company continues to develop its already strong presence in the international market place. QualMark has established business relationships with Hielkema Test Equipment B.V. in the Netherland, Beatronic in Denmark, Emitech in France, Amitra Oy in Finland, Thermotec Weilburg GmbH & Co. KG in Germany, AB-AD Technology and Engineering Ltd. In Israel, Sumitomo in Japan, Namil Environ Company in Korea, Logicom in Singapore, Kendro Laboratory Products AB in Sweden, Chroma ATE Inc. in Taiwan, and Alphatech Limited in the UK. Of the units sold in the year ended December 31, 2000, 19 represented international sales for 29.7% of equipment revenue. The Company is continuing to expand its customer base in 2001 by initiating contact with potential distributors in China, India, South Africa, and Jordan. QualMark is committed to focusing on domestic sales staff to build relationships with potential key customers and establishing new sales partnerships to expand the Company's customer base. Test center revenue decreased $463,000 or 12.3% from $3,755,000 the year ended December 31, 1999 to $3,292,000 in the year ending December 31, 2000. As of December 31, 2000, the Company operated six test centers containing ten systems. This compares to December 31, 1999 when the Company operated seven test centers containing eleven systems. The Company primarily attributes the decrease in ARTC lab revenue to a reduction in ARTC labs. During the year ended December 31, 2000, two of the Company's larger test center labs suffered losses in key sales and test engineer personnel. These factors directly affect the ARTC labs ability to maximize volume. During the fourth quarter 2000, QualMark took steps to optimize ARTC Labs by closing one lab in Morrisville, North Carolina. The Company believes that these changes will result in increased margins and utilization. During 1998 and continuing into 2000, the Company initiated its international ARTC expansion 13 program and is continuing to maintain its strategic alliances with operating test labs in five different countries: TUV Product Service in the U.K. and Germany, Anecto, ltd. in Ireland, IMQ in Italy, and Maser in the Netherlands. Revenue for these alliances increased $71,000 or 31.7% from $224,000 in the year ended December 31, 1999 to $295,000 for year ended December 31,2000. Under the strategic alliance agreements, QualMark provides an OVS 2.5 to each lab location, except Maser Engineering in the Netherlands which has an OVS 1.5, and the strategic partner provides the facility, labor, and sales management. QualMark receives a percentage of the revenue that the OVS system generates. GROSS MARGIN The gross margin in 1999 and 2000 was 39.7%. The margin remained constant as continuing price pressures exist in the accelerated test equipment market. Management expects margins to increase during future quarters as emphasis is placed on manufacturing utilization and overhead management. The Company further believes that additional opportunities exist to improve margins through further enhancements of relationships with its key vendors. OPERATING EXPENSE Total operating expenses decreased $2,449,000 or 32.7% from $7,499,000 in the year ended December 31, 1999 to $5,050,000 for the year ended December 31, 2000. Selling, general and administrative expenses declined $2,867,000 or 42.1% from $6,809,000 for the year ended December 31, 1999 to $3,942,000 for the year ended December 31, 2000. The decrease is attributed to substantial legal costs of $2,114,000 incurred in 1999, which were associated with the defense of a Company patent. All patent litigation was resolved in August 1999 (Refer to Item 3. Legal Proceedings). Also in 1999, the Company incurred additional costs for consulting and travel expenses related to the continual development of the international ARTC labs. Research and development costs increased $146,000 or 21.2% from $690,000 for the year ended December 31, 1999 to $836,000 for the year ended December 31, 2000. The increase is attributed to the Company's commitment to investing in research and development, with a focus on current product line improvements. On October 2, 2000, QualMark introduced a new product called Typhoon that the Company believes will enable users of combined stress and thermal-only test chambers to cut their consumable costs by up to 50% (Refer to Item 1, Description of Business). It is the intent of the Company in 2001 to continue its commitment and effort to the development of new technologies and product offerings and expects its research and development expenditures to increase to over $1,000,000. During June 2000, the Company initiated an organizational restructure plan and charged $272,000 in severance to operations. This reorganization resulted in the resignation of the Company's president and a reduction of six other personnel from the Sales and Marketing, Accounting and Administrative, and Manufacturing departments. Severance costs include salary payments, fringe benefits and taxes related to these seven employees. Cash payments to settle the salary payments, fringe benefits and taxes will continue through May of 2001. Cash payments made during 2000 totaled $190,000 and as of December 31, 2000, the severance liability balance remaining is $82,000. INCOME TAX BENEFIT The Company experienced an unexpected business downturn during 2000 and 1999 that resulted in operating losses. Management concluded that it was more likely than not that some portion of the deferred tax assets would not be realizable and determined that a valuation allowance was required for a portion of the deferred tax assets. Accordingly, a valuation allowance was established, which, as of December 31, 2000 totaled $712,000 or 36% of total existing deferred tax asset. The Company needs to generate approximately $4,700,000 in taxable income to fully utilize its deferred tax assets in the future. LIQUIDITY AND CAPITAL RESOURCES During 2000, the Company generated $188,000 of cash from operating activities, invested $371,000 for equipment and sold equipment for $15,000, invested $28,000 for patents, made $3,000 in capital lease payments, borrowed $950,000 from banks and repaid $575,000 of those borrowings. Employees and investors exercised options and warrants to purchase 104,223 shares of common stock for proceeds of $235,000. Together, these activities resulted in a cash increase of $411,000, for the year, for a balance of $936,000 at December 31, 2000. During 1999, the Company generated $839,000 of cash from operating activities, invested $769,000 for equipment, invested $72,000 for patents, made $2,000 in capital lease payments, borrowed 14 $1,050,000 from banks and repaid $600,000 of those borrowings. Employees and investors exercised options and warrants to purchase 54,000 shares of common stock for proceeds of $115,000. In addition, the Company issued 465,116 Shares of preferred stock for net proceeds of $974,000. Together, these activities resulted in a cash decrease of $143,000, for a year-end balance of $525,000 at December 31, 1999. During 1999, the Company renegotiated its Revolving Credit and Term Loan Agreement ("Credit Agreement") with a commercial bank. Among other changes, this amendment to the existing Credit Agreement reduced the amount the Company may borrow on its revolving credit from $3,000,000 to $2,000,000. In addition, the Company will make no further borrowings on the term loan portion of the Credit Agreement. The revolving loan reflects five draws against it, with interest rates ranging from 9.71% to 10.08%. As of December 31, 2000, the balance of the revolving credit is $2,000,000. The term loan agreement, bears interest at the reserve adjusted LIBOR rate plus the applicable margin (as defined), which was 9.71% and 9.26% at December 31, 2000 and 1999, respectively. As of December 31, 2000, the Company had an outstanding balance of $886,000 under the term loan agreement. Both the line of credit arrangement and term loan agreement are collateralized by substantially all the assets of the Company. The Credit Agreement was due on December 22, 2001. The Company must maintain certain financial and other covenants in order to draw amounts available under the line of credit. Provisions under this agreement are not considered restricted to normal operations. Although the Company is not now, nor has it ever been in arrears on any payment pursuant to the Credit Agreement, as of December 31, 2000, the Company was in default of certain financial covenants contained in the Credit Agreement. The Company has, however, received waivers from its lender regarding such noncompliance. On February 1, 2001, the Company again renegotiated its Credit Agreement with the commercial bank. Among other changes, this amendment to the Credit Agreement reduces the revolving credit line to $1,000,000 (the outstanding balance at February 1, 2001 was $811,000). In addition, the term loan available was increased to $2,000,000 (the outstanding balance at February 1, 2001 was $2,000,000). Both the revolving credit line and term loan under the Credit Agreement become due on March 15, 2002. The Company expects to meet long term liquidity requirements through cash flows generated by operations and the existing cash balance. The Company does not anticipate any additional term loan borrowing, or draws against the revolving credit line in 2001. Management has derived a short and long-term plan to repay the existing Credit Agreement. As defined by the amended Credit Agreement on February 1, 2001, the Company will make monthly principal payments, beginning March 31, 2001, of $35,000 on the term loan. In addition, the Company has also determined during 2001, quarterly payments on the revolving line of credit will be made, based on cash flows generated from operations. At the close of each quarter, the Company has made arrangements to meet and review results of the Company with the commercial bank. During 2001, the Company expects to renegotiate with the commercial bank for an extension to the Credit Agreement. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company's exposure to interest rate changes are primarily related to its variable rate debt issued under its $2,886,000 Credit Agreement (Refer to Note 5 of the Financial Statements). Because the interest rates on these facilities are variable, based upon the bank's prime rate or LIBOR, the Company's interest expense and net income are affected by interest rate fluctuations. If interest rates were to increase or decrease by 100 basis points, the result, based upon the existing outstanding debt as of December 31, 2000 would be an annual increase or decrease of approximately $29,000 in interest expense and a corresponding decrease or increase of approximately $17,000 in the Company's net income after taxes. Revenue generated from foreign sales are payable in United States funds, thus no foreign exchange rate risk exists. FORWARD-LOOKING STATEMENTS The statements contained in this report which are not historical facts are forward-looking statements that are subject to risks and uncertainties that could cause actual results to differ materially from those set forth or implied by forward-looking statements, including but not limited to variability in order flow and operating results, the ability of the Company to find and retain qualified personnel to staff its manufacturing and marketing operations and existing and anticipated test centers, and the risk that the demand for the Company's systems will not continue to grow. 15 ITEM 7. FINANCIAL STATEMENTS. Index to Financial Statements:
Page Number ----------- Report of Independent Accountants F-1 Statement of Operations F-2 Balance Sheet F-3 Statement of Shareholders' Equity F-4 Statement of Cash Flows F-5 Notes to Financial Statements F-6
All schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore have been omitted. ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III ITEM 9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS; COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT. The Company's definitive Proxy Statement to be filed pursuant to Schedule 14A under the Securities Exchange Act of 1934 is incorporated herein by reference. ITEM 10. EXECUTIVE COMPENSATION. The Company's definitive Proxy Statement to be filed pursuant to Schedule 14A under the Securities Exchange Act of 1934 is incorporated herein by reference. ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The Company's definitive Proxy Statement to be filed pursuant to Schedule 14A under the Securities Exchange Act of 1934 is incorporated herein by reference. ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The Company's definitive Proxy Statement to be filed pursuant to Schedule 14A under the Securities Exchange Act of 1934 is incorporated herein by reference. ITEM 13. EXHIBITS AND REPORTS ON FORM 8-K. (a) Exhibits - See Index to Exhibits (b) Reports on Form 8-K during the last quarter of the Company's fiscal year ended December 31, 2000. - None 16 SIGNATURES In accordance with Section 13 or 15(d) of the Exchange Act, the registrant caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. Dated: April 11, 2001 QUALMARK CORPORATION By: /s/ CHARLES D. JOHNSTON ----------------------------------------- Charles D. Johnston, President and Chief Executive Officer In accordance with the Exchange Act, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Signature Title Date --------- ----- ---- /s/ Charles D. Johnston President, Chief Executive Officer April 11, 2001 --------------------------- and Director Charles D. Johnston /s/ Anthony A. Scalese Principal Accounting Officer April 11, 2001 --------------------------- Anthony A. Scalese /s/ H. Robert Gill Director April 11, 2001 --------------------------- H. Robert Gill /s/ Philip A. Gordon Director April 11, 2001 --------------------------- Philip A. Gordon /s/ James L.D. Roser Director April 11, 2001 --------------------------- James L.D. Roser /s/ William J. Sanko Director April 11, 2001 --------------------------- William J. Sanko /s/ Richard Jennewine Director April 11, 2001 --------------------------- Richard Jennewine
17 REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Shareholders of QualMark Corporation In our opinion, the accompanying balance sheet and the related statements of operations, of shareholders' equity and of cash flows present fairly, in all material respects, the financial position of QualMark Corporation at December 31, 2000 and 1999, and the results of its operations and its cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America. 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 audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit 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, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As discussed in Note 1, the Company restated its 1999 net loss per share calculations for the effect of a beneficial conversion feature associated with redeemable preferred stock. PricewaterhouseCoopers LLP Denver, Colorado April 2, 2001 F - 1 18 QUALMARK CORPORATION STATEMENT OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) --------------------------------------------------------------------------------
YEARS ENDED DECEMBER 31, 2000 1999 Revenues $ 12,505 $ 12,559 Cost of revenues 7,538 7,570 ---------- ---------- Gross profit 4,967 4,989 Selling, general and administrative expenses 3,942 6,809 Research and development expenses 836 690 Severance charges 272 -- ---------- ---------- Total operating expenses 5,050 7,499 ---------- ---------- Loss from operations (83) (2,510) Other income (expense): Interest expense (307) (200) Interest income 1 33 Other income (expense), net 2 (9) ---------- ---------- Loss before income taxes (387) (2,686) Income tax benefit 12 322 ---------- ---------- Net loss $ (375) $ (2,364) ========== ========== Net loss per basic and diluted common share $ (0.13) $ (0.80) ========== ========== Weighted average shares outstanding 3,571 3,532 ========== ==========
The accompanying notes are an integral part of these financial statements. F - 2 19 QUALMARK CORPORATION BALANCE SHEET (IN THOUSANDS, EXCEPT FOR NUMBER OF SHARES) --------------------------------------------------------------------------------
DECEMBER 31, 2000 1999 ASSETS Current assets: Cash and cash equivalents $ 936 $ 525 Trade accounts receivable, net of allowance for doubtful accounts of $187 and $192, respectively 3,968 4,089 Inventories, net 1,297 1,725 Deferred tax asset 1,194 1,089 Other current assets 122 125 ---------- ---------- Total current assets 7,517 7,553 Property and equipment, net 1,290 1,508 Note receivable from former officer -- 104 Deferred tax asset -- 88 Other assets 132 155 ---------- ---------- $ 8,939 $ 9,408 ========== ========== LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Accounts payable $ 1,032 $ 1,179 Accrued expenses 745 1,272 Customer deposits and deferred revenue 82 58 Current portion of long-term debt 700 1,700 Current portion of capital lease obligations -- 3 ---------- ---------- Total current liabilities 2,559 4,212 Long-term debt 2,461 1,086 Deferred tax liability 17 -- ---------- ---------- Total liabilities 5,037 5,298 Commitments and contingencies (Notes 6 and 13) Redeemable preferred stock (Note 8); no par value; 2,000,000 shares authorized; 502,326 designated as Series A, 465,116 shares issued and outstanding, liquidation preference $1,107; 99,619 designated as Series B, none issued or outstanding 1,016 919 Shareholders' equity: Common stock; no par value; 15,000,000 shares authorized; 3,643,238 and 3,539,015 shares issued 7,403 7,210 Treasury stock, at cost, 35,546 and zero shares held (123) -- Accumulated deficit (4,394) (4,019) ---------- ---------- Total shareholders' equity 2,886 3,191 ---------- ---------- $ 8,939 $ 9,408 ========== ==========
The accompanying notes are an integral part of these financial statements. F - 3 20 QUALMARK CORPORATION STATEMENT OF SHAREHOLDERS' EQUITY (IN THOUSANDS, EXCEPT FOR NUMBER OF SHARES) --------------------------------------------------------------------------------
COMMON STOCK TREASURY STOCK ACCUMULATED SHARES AMOUNT SHARES AMOUNT DEFICIT TOTAL Balance December 31, 1998 3,485,015 $ 6,396 -- $ -- $ (1,655) $ 4,741 Exercise of warrants for common stock 54,000 115 115 Amortization of deferred compensation related to issuance of warrants and option 23 23 Warrants issued in connection with redeemable preferred stock 87 87 Warrants issued for common stock in litigation settlement 621 621 Accretion of redeemable preferred stock, dividends and beneficial conversion feature (32) (32) Net loss (2,364) (2,364) ---------- ---------- ---------- -------- ------------ ---------- Balance December 31, 1999 3,539,015 7,210 -- -- (4,019) 3,191 Exercise of warrants for common stock 19,079 38 38 Exercise of options for common stock 85,144 197 197 Compensation related to issuance of options for services 55 55 Common stock received in settlement of note receivable and interest from former officer 35,546 (123) (123) Accretion of redeemable preferred stock and dividends (97) (97) Net loss (375) (375) ---------- ---------- ---------- -------- ------------ ---------- Balance December 31, 2000 3,643,238 $ 7,403 35,546 $ (123) $ (4,394) $ 2,886 ========== ========== ========== ======== ============ ==========
The accompanying notes are an integral part of these financial statements. F - 4 21 QUALMARK CORPORATION STATEMENT OF SHAREHOLDERS' EQUITY (IN THOUSANDS, EXCEPT FOR NUMBER OF SHARES) --------------------------------------------------------------------------------
YEARS ENDED DECEMBER 31, 2000 1999 CASH FLOWS FROM OPERATING ACTIVITIES Net loss $ (375) $ (2,364) Adjustments to reconcile net loss to net cash from operating activities: Inventory write off 111 50 (Gain) loss on disposal of equipment (2) 32 Depreciation and amortization 597 550 Warrant and stock option expense 55 23 Deferred income tax benefit -- (316) Issuance of warrants and note payable to settle litigation -- 1,546 Changes in assets and liabilities: Accounts receivable, net 121 (173) Inventories 317 (412) Other assets 14 59 Accounts payable (147) 310 Accrued expenses (527) (139) Customer deposits and deferred revenue 24 (5) ---------- ---------- Net cash provided by (used in) operating activities 188 (839) ---------- ---------- CASH FLOWS FROM INVESTING ACTIVITIES Acquisition of property and equipment (371) (769) Proceeds from disposal of property and equipment 15 -- Investment in patents (28) (72) ---------- ---------- Net cash used in investing activities (384) (841) ---------- ---------- CASH FLOWS FROM FINANCING ACTIVITIES Proceeds from borrowings 950 1,050 Repayments of borrowings (575) (600) Proceeds from issuance of common stock, net 235 115 Proceeds from issuance of preferred stock and warrants, net -- 974 Principal payments on capital lease obligations (3) (2) ---------- ---------- Net cash provided by financing activities 607 1,537 ---------- ---------- Net increase (decrease) in cash and cash equivalents 411 (143) Cash and cash equivalents at beginning of year 525 668 ---------- ---------- Cash and cash equivalents at end of year $ 936 $ 525 ========== ========== SUPPLEMENTAL DISCLOSURE Interest paid $ 299 $ 170 NON-CASH INVESTING AND FINANCING ACTIVITIES Issuance of note payable to settle litigation $ -- $ 925 Issuance of warrants to settle litigation $ -- $ 621 Common stock received in settlement of note receivable and interest from former officer $ 123 $ -- Redeemable preferred stock dividends declared but not paid $ 80 $ 27
F - 5 22 QUALMARK CORPORATION STATEMENT OF SHAREHOLDERS' EQUITY (IN THOUSANDS, EXCEPT FOR NUMBER OF SHARES) -------------------------------------------------------------------------------- 1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES ORGANIZATION QualMark Corporation (the "Company") was incorporated on March 11, 1992 in the State of Colorado. Its principal business activity is the manufacture and sale of vibration and thermal chambers for quality control testing of various electronic devices. The Company's sole manufacturing facility is located in Denver, Colorado. The Company also operates service centers, called Accelerated Reliability Test Centers ("ARTC"), where vibration and thermal chambers are available to customers for daily rental which are located in various cities across the United States. In addition, the Company has formed alliances for service centers in various cities in the United States and a number of foreign countries. CASH AND CASH EQUIVALENTS Cash on hand and in banks, together with marketable securities having original maturities of three months or less, are classified as cash and cash equivalents by the Company. CONCENTRATION OF CREDIT RISK Financial instruments that potentially subject the Company to concentrations of credit risk consist primarily of trade accounts receivable. Receivables arising from sales to customers are not collateralized and, as a result, management continually monitors the financial condition of its customers to reduce the risk of loss. INVENTORIES Inventories are stated at the lower of cost or market with cost determined by the first-in, first-out (FIFO) method. PROPERTY AND EQUIPMENT Property and equipment are recorded at cost. Depreciation is recorded using the straight-line method over estimated useful lives of three to ten years. Amortization of leasehold improvements and equipment under capital leases is provided over the shorter of the assets useful lives or the lives of the leases and is included in depreciation expense. Maintenance and repairs are expensed as incurred and improvements are capitalized. Upon sale or retirement of assets, the cost and related accumulated depreciation or amortization are eliminated from the respective accounts and any resulting gains or losses are reflected in operations. INTANGIBLES Costs related to patents are capitalized and amortized over their useful life. REVENUE RECOGNITION Revenues from product sales are recognized when persuasive evidence of an arrangement exists, delivery has occurred, sales price is fixed or determinable and collectibility is probable. Generally, the criteria is met upon shipment of products and transfer of title to customers. Provisions for discounts and allowance are recorded in the period of sale. Revenues from services are recognized when the services are performed and billable. Revenue from equipment service contracts is recognized ratably over the term of the contract. ADVERTISING EXPENSE The Company charges advertising, including production costs, to expense on the first date of the advertising period. Advertising and marketing expense for 2000 and 1999 was $68,000 and $65,000, respectively. PREOPENING COSTS The Company charges to selling, general and administrative expense the preopening costs of new service centers as incurred. These costs are primarily labor, supplies, preopening marketing and advertising and other expendable items. INCOME TAXES Deferred tax liabilities and assets are recognized for the expected future tax consequences of temporary differences between the carrying amounts for financial reporting purposes and the tax basis of individual assets and liabilities. F - 6 23 QUALMARK CORPORATION STATEMENT OF SHAREHOLDERS' EQUITY (IN THOUSANDS, EXCEPT FOR NUMBER OF SHARES) -------------------------------------------------------------------------------- PRODUCT WARRANTIES A provision has been recorded for expected costs to be incurred as a result of product warranties at the time the sale is recognized. In 1999, the Company offered a, two-year parts and labor warranty on all new OVS systems. In 2000, the Company offered a, one-year parts and labor warranty on all new OVS systems, and sells an equipment service contract for an additional one-year parts and labor warranty. FINANCIAL INSTRUMENTS The carrying amounts of cash and cash equivalents, accounts receivable, accounts payable, accrued expenses, and customer deposits approximate fair value. The carrying amount of long term debt approximates its fair value due to variable rates. EARNINGS (LOSS) PER SHARE Earnings (loss) per basic share of common stock is based on the weighted average number of shares of common stock outstanding during each respective period. Earnings (loss) per diluted share of common stock adds to basic weighted shares the weighted average number of shares of potential common shares (diluted stock options and warrants) outstanding during each respective period. Proceeds from the exercise of the potential common shares are assumed to be used to repurchase outstanding shares of the Company's common stock at the average fair market value during the period. In a period in which a loss is incurred, only the weighted average number of common shares is used to compute the diluted loss per share as the inclusion of potential common shares would be antidilutive. Net loss applicable to common shareholders and net loss per basic and diluted common share for 1999 have been restated to reflect the beneficial conversion feature associated with the redeemable preferred stock discussed in Note 8. The only effect on the previously issued December 31, 1999 financial statements is an increase in net loss applicable to common shareholders of $424,000 and an increase in net loss per basic and diluted common share of $0.13. There was no effect on previously reported revenues, expenses, net loss, assets, liabilities and cash flows as a result of the restatement. The calculation of basic and diluted earnings per share is as follows (in thousands, except per-share amounts):
DECEMBER 31, 2000 1999 Basic and diluted loss per share computation: Net loss $ (375) $ (2,364) Accretion of redeemable preferred stock and dividends (97) (32) Beneficial conversion feature on redeemable preferred stock -- (424) ---------- ---------- Net loss applicable to common shareholders $ (472) $ (2,820) ========== ========== Weighted average shares outstanding - basic 3,571 3,532 ========== ========== Net loss per share - basic $ (0.13) $ (0.80) ========== ========== Weighted average shares outstanding 3,571 3,532 Dilutive stock options and warrants -- -- ---------- ---------- 3,571 3,532 ========== ========== Net loss per share - diluted $ (0.13) $ (0.80) ========== ==========
Options and warrants to purchase 993,658 shares of common stock were excluded from dilutive stock option calculations for 2000, because their exercise prices were greater than the average fair market value of the Company's stock for the period, and as such they would be antidilutive. F - 7 24 QUALMARK CORPORATION STATEMENT OF SHAREHOLDERS' EQUITY (IN THOUSANDS, EXCEPT FOR NUMBER OF SHARES) -------------------------------------------------------------------------------- Options and warrants to purchase 1,729,991 shares of common stock were excluded from dilutive stock option calculations for 1999, because their exercise prices were greater than the average fair market value of the Company's stock for the period, and as such they would be antidilutive. USE OF ESTIMATES The preparation of the financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. RECLASSIFICATION Certain amounts have been reclassified in prior years to be consistent with the classification as of December 31, 2000. NEW ACCOUNTING PRONOUNCEMENTS In June 1998, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("FAS") No. 133, "Accounting for Derivative Instruments and Hedging Activities." This statement establishes accounting and reporting standards for derivative instruments and for hedging activities. It requires the recognition of all derivatives as either assets or liabilities in the statement of financial position at fair value. In June 1999, the FASB issued FAS No. 137, which defers the effective date of FAS No. 133 to fiscal years beginning after June 15, 2000. Currently, the Company does not engage in such activities and the adoption of this standard is not expected to have an effect on the Company's financial position or results of operations. 2. INVENTORIES Inventories consist of the following at (in thousands):
DECEMBER 31, 2000 1999 Raw materials $ 708 $ 905 Work in process 1 213 Finished goods 638 657 Less: Allowance for obsolescence (50) (50) ---------- ---------- $ 1,297 $ 1,725 ========== ==========
The Company monitors inventory for technological obsolescence and provides an allowance when necessary. During the year ended December 31, 2000 and 1999, $111,000 and $50,000, respectively is included in cost of sales as a write down of obsolescent raw materials. F - 8 25 QUALMARK CORPORATION STATEMENT OF SHAREHOLDERS' EQUITY (IN THOUSANDS, EXCEPT FOR NUMBER OF SHARES) -------------------------------------------------------------------------------- 3. PROPERTY AND EQUIPMENT Property and equipment consist of the following at (in thousands):
DECEMBER 31, 2000 1999 Machinery and equipment $ 2,686 $ 2,426 Furniture and fixtures 190 189 Leasehold improvements 466 458 Capitalized internal use software 189 128 Construction in process 101 87 Less: Accumulated depreciation and amortization (2,342) (1,780) ---------- ---------- $ 1,290 $ 1,508 ========== ==========
Depreciation expense was $575,000 and $544,000 for the years ended December 31, 2000 and 1999, respectively. 4. ACCRUED EXPENSES Accrued expenses consist of the following at (in thousands):
DECEMBER 31, 2000 1999 Accrued warranty $ 345 $ 661 Accrued employee related 200 226 Accrued royalties payable -- 78 Severance payable (Note 12) 82 -- Other 118 307 ---------- ---------- $ 745 $ 1,272 ========== ==========
5. INDEBTEDNESS During 1999, the Company renegotiated its revolving credit and term loan agreement ("Credit Agreement") with a commercial bank. Among other changes, this amendment to the existing Credit Agreement reduced the amount the Company may borrow on its revolving credit from $3,000,000 to $2,000,000. In addition, the Company will make no further borrowings on the term loan portion of the Credit Agreement. The revolving credit reflects five draws against it, with interest rates ranging from 9.71% to 10.08%. As of December 31, 2000, the balance of the revolving credit is $2,000,000. The term loan agreement, bears interest at the reserve adjusted LIBOR rate plus the applicable margin (as defined), which was 9.71% and 9.26% at December 31, 2000 and 1999, respectively. As of December 31, 2000, the Company had an outstanding balance of $886,000 under the term loan agreement. Both the line of credit arrangement and term loan agreement are collateralized by substantially all the assets of the Company. The Credit Agreement was due on December 22, 2001. The Company must maintain certain financial and other covenants in order to draw amounts available under the line of credit. Provisions under this agreement are not considered restricted to normal operations. Although the Company is not now, nor has it ever been in arrears on any payment pursuant to the Credit Agreement, as of December 31, 2000, the Company was in default of certain financial covenants contained in the Credit Agreement. The Company has, however, received waivers from its lender regarding such noncompliance. On February 1, 2001, the Company again renegotiated its Credit Agreement with the commercial bank. Among other changes, this amendment to the Credit Agreement reduces the revolving credit line to $1,000,000 (the outstanding balance at February 1, 2001 was $811,000). In addition, the term loan available was increased to $2,000,000 (the outstanding balance at February 1, 2001 was $2,000,000). Both the revolving credit line and term loan under the Credit Agreement become due on March 15, 2002 F - 9 26 QUALMARK CORPORATION STATEMENT OF SHAREHOLDERS' EQUITY (IN THOUSANDS, EXCEPT FOR NUMBER OF SHARES) -------------------------------------------------------------------------------- The Company expects to meet long term liquidity requirements through cash flows generated by operations and existing cash balances. The Company does not anticipate any additional term borrowing, or draws against the revolving credit line in 2001. Management has derived a short and long term plan to repay the existing Credit Agreement. As defined by the renegotiated Credit Agreement on February 1, 2001, the Company will make monthly principal payments, beginning March 31, 2001, of $35,000 to the term loan. The Company has also determined that, during 2001, quarterly payments to the revolving line of credit will be made, based on cash flows generated from operations. At the close of each quarter, the Company has made arrangements to meet and review results of the Company with the commercial bank. At the end of 2001, the Company expects to negotiate with the commercial bank for an extension to the Credit Agreement. The following represents future amounts payable at December 31, 2000 (in thousands). Year ended December 31, 2001 $ 425 2002 2,461 --------- $ 2,886 =========
On August 31, 1999, the Company entered into a settlement agreement with Screening Systems, Inc. ("SSI") (See Note 13). Under the terms of the settlement, the Company issued a $925,000 note payable, which accrues interest at 9% per annum. As of December 31, 2000 the note had an outstanding balance of $275,000, which is payable in full on April 1, 2001. 6. LEASE COMMITMENTS The Company leases equipment, office space, and operating facilities under operating lease arrangements. Future minimum lease payments consist of the following at December 31, 2000 (in thousands):
OPERATING LEASES Year ended December 31, 2001 $ 396 2002 258 2003 113 2004 39 2005 13 --------- $ 819 =========
Rent expense for the years ended December 31, 2000 and 1999 was $576,000 and $560,000, respectively. F - 10 27 QUALMARK CORPORATION STATEMENT OF SHAREHOLDERS' EQUITY (IN THOUSANDS, EXCEPT FOR NUMBER OF SHARES) -------------------------------------------------------------------------------- 7. INCOME TAXES Income tax expense (benefit) consists of the following (in thousands):
YEARS ENDED DECEMBER 31, 2000 1999 Current tax expense (benefit) Federal $ (6) $ (9) State (6) 3 ---------- ---------- (12) (6) Deferred tax expense (benefit) Federal -- (271) State -- (45) ---------- ---------- -- (316) ---------- ---------- $ (12) $ (322) ========== ==========
A reconciliation of the statutory Federal income tax rate to the income tax benefit is as follows (in thousands):
YEARS ENDED DECEMBER 31, 2000 1999 AMOUNT % AMOUNT % Computed "expected" tax $ (132) (34.0)% $ (913) (34.0)% State income taxes, net of Federal income tax effect 2 0.5% (127) (4.8) Change in valuation allowance 96 24.8 616 23.0 Other 22 5.6 102 3.8 -------- ----- -------- ------ $ (12) (3.1)% $ (322) (12.0)% ======== ===== ======== ======
Deferred tax assets and liabilities represent the future impact of temporary differences between the financial statement and tax bases of assets and liabilities and are as follows (in thousands):
DECEMBER 31, 2000 1999 Deferred tax assets: NOL carryforwards $ 1,619 $ 1,331 Accrued liabilities 192 278 Allowance for doubtful accounts 74 76 Inventory 20 20 Depreciation and amortization -- 88 Other 5 5 Valuation allowance (712) (616) ---------- ---------- Total deferred tax assets 1,198 1,182 ---------- ---------- Deferred tax liabilities: Unicap 4 5 Depreciation and amortization 17 -- ---------- ---------- Total deferred tax liabilities 21 5 ---------- ---------- Net deferred tax asset $ 1,177 $ 1,177 ========== ==========
F - 11 28 QUALMARK CORPORATION STATEMENT OF SHAREHOLDERS' EQUITY (IN THOUSANDS, EXCEPT FOR NUMBER OF SHARES) -------------------------------------------------------------------------------- Financial Statements: Current deferred tax assets $ 1,194 $ 1,089 Non-current deferred tax assets -- 88 Non-current deferred tax liabilities (17) -- --------- --------- Net deferred tax asset $ 1,177 $ 1,177 ========= =========
As of December 31, 2000 and 1999, the Company had net operating loss ("NOL") carryforwards of approximately $4,114,000 and $3,372,000, respectively, which are available to offset future taxable income. The ultimate realizations of these assets are dependent upon the generation of future taxable income sufficient to offset the related deductions and loss carryforwards within the applicable carryforward period. The Company experienced an unexpected downturn it its business during 1999 and 2000, which resulted in operating losses. Management concluded that it was more likely than not that a portion of the deferred tax assets would not be realizable and determined a valuation allowance was required for that portion of the deferred tax assets. During 2000, the Company's valuation allowance was increased by $96,000. 8. REDEEMABLE PREFERRED STOCK In 1999, the Company authorized the issuance of 502,326 shares of Series A, redeemable, cumulative, participating, no par preferred stock ("Series A preferred stock"). Each share of the Series A preferred stock issued and outstanding shall have the right to vote on all matters presented to the holders of the common stock for vote, in the number of votes equal at any time to the number of shares of common stock into which each share of the Series A preferred stock would be convertible, and shall vote with the holders of the common stock as a single class. The Series A preferred shares accrue dividends at 8% per annum, and dividends may be paid in cash or additional preferred shares, in kind, at the option of the Company. In addition, in the event the Company declares, pays or sets apart a common stockholder dividend, each holder of shares of the Series A preferred stock shall be entitled to receive a per share dividend equal to the number of shares of common equity on which such common dividend is declared into which each share of Series A preferred stock is convertible on the record date, multiplied by the amount of cash or property paid, or by the number of shares of capital stock issued. During 1999, an existing common stock shareholder purchased 465,116 shares of the Series A preferred stock and warrants to purchase 139,535 shares of common stock at $2.50 per share, with a five-year expiration, in exchange for $1,000,000. The proceeds to the Company were $974,000, net of transaction costs. As of December 31, 2000 and 1999, the Series A preferred shares accumulated dividends in arrears of $107,000 and $27,000, respectively. Of the dividends in arrears at December 31, 2000, the Company anticipates a dividend payment of 37,210 in preferred shares at the conversion price of $2.15 per share, with the remaining $27,000 to be paid in cash. The Series A preferred stock rank senior to the common stock and have a liquidation preference of $2.15 per share plus all declared and unpaid dividends which total $1,107,000 at December 31, 2000. The Series A preferred stock is convertible to common shares at any time. On any date after September 1, 2004, at the option of the holders of the Series A preferred stock, the Company shall redeem the Series A preferred stock at $2.15 to the extent the Company has funds legally available for such payment. If the Company does not have funds available, at the option of the holders of the Series A preferred stock, be converted into a debt obligation of the Company in a form acceptable to the holders of the Series A preferred stock. As a result of the conversion price of the Series A preferred stock being less than the quoted market price on the date of issuance/commitment in 1999, a beneficial conversion feature existed in the amount of $424,000. This beneficial conversion feature would normally have resulted in a credit to common stock and a charge to retained earnings. As the Company has an accumulated deficit, both the credit and charge are reflected in common stock in the accompanying financial statements for 1999. The Company maintains a one-time option to repurchase the Series A preferred stock or require the holder to convert their preferred stock, under the following terms. At any time following a 45-day consecutive trading period during which the average closing price per share of the Company's common stock is at least $5.00 per F - 12 29 QUALMARK CORPORATION STATEMENT OF SHAREHOLDERS' EQUITY (IN THOUSANDS, EXCEPT FOR NUMBER OF SHARES) -------------------------------------------------------------------------------- share, the Company may give notice of its intention to repurchase all of the outstanding Series A preferred shares. The holder of the Series A preferred stock shall have 30 days from receipt of the Company's repurchase notice to elect to convert their Series A preferred shares to common stock. In the event that the holder of the Series A preferred stock does not elect to convert all of their Series A preferred stock, the Company may repurchase all, but not less than all, of the remaining Series A preferred stock at the price of $4.00 per share, or 90% of the fair market value of the common stock, whichever is greater, plus any accumulated dividends, by notice to the holder of the Series A preferred stock and tendering of funds within five business days of the expiration of the Series A preferred stock holder's conversion option. The fair market value of the commons stock shall be determined by the average closing price of the common stock for the five trading days prior to the date on which the Series A preferred stock holder's option to convert expires. 9. STOCK WARRANTS AND OPTIONS In 1995, warrants to purchase 72,000 shares of common stock at an exercise price of $2.13 per share were issued to a principal shareholder, in connection with the Company's sale of Hobbs Engineering Corporation ("Hobbs") to the shareholder (Note 11). The warrants vest and are exercisable in 25% increments on December 31, 1996, 1997, 1998 and 1999. All warrants expire five years from the grant date. Compensation expense relative to these warrants of $92,000 will be charged to expense over the four-year vesting period which began January 1, 1996. During 1999, Hobbs exercised 54,000 warrants to purchase 54,000 shares of common stock. During 2000, Hobbs exercised the remaining 18,000 warrants to purchase 18,000 shares of common stock. During 1996, the Company offered its stock for sale to the public. In connection therewith, the Company issued to the underwriter a five-year warrant to purchase up to 132,170 shares of common stock at $4.50 per share. During 2000, 5,001 warrants were converted into 1,079 shares of common stock. No warrants were exercised during 1999. During 1999, five-year warrants to purchase 139,535 shares of common stock at an exercise price of $2.50 per share were issued in connection with the Series A preferred stock, as described above. These warrants had a fair market value of $87,000 at the time of issuance. Also in 1999, the Company issued five-year warrants to purchase 620,000 shares of common stock at an exercise price of $4.85 per share in connection with the settlement of patent litigation with SSI. These warrants had a fair market value of $621,000 at issuance. (See Note 13). STOCK OPTIONS In 1993, the Company adopted an incentive stock option plan (the "1993 Plan") which provides employees and officers with an opportunity to purchase an aggregate of 159,746 shares of the Company's common stock. The 1993 Plan requires that incentive stock options be issued at exercise prices which are at least 100% of the fair value of the stock at the date of the grant. Options issued under the 1993 Plan vest at a rate of 25% per year over four years and generally expire up to ten years from the date of grant. Stock option transactions of the 1993 Plan are summarized below:
WEIGHTED AVERAGE SHARES EXERCISE PRICE Outstanding at December 31, 1998 100,497 $ 2.10 Forfeited (3,000) 2.13 --------- ------ Outstanding at December 31, 1999 97,497 2.09 Exercised (52,477) 2.08 Forfeited (1,500) 2.00 --------- ------ Outstanding at December 31, 2000 43,520 $ 2.12 ========= ======
F - 13 30 QUALMARK CORPORATION STATEMENT OF SHAREHOLDERS' EQUITY (IN THOUSANDS, EXCEPT FOR NUMBER OF SHARES) -------------------------------------------------------------------------------- At December 31, 2000 and 1999, options were exercisable with respect to 43,520 and 97,497 shares, respectively, with exercise prices ranging from $2.00 to $2.13 and a weighted average exercise price of $2.12 and $2.09 respectively. As of December 31, 2000 the weighted average contractual life was 4.00 years. During 2000, nonqualified options to purchase 116,000 common stock shares at a price of $2.64 per share were issued and 29,000 of these options were exercised, of which, 87,000 were forfeited. During 2000, nonqualified options to purchase 116,088 at a price of $2.00 per share expired. In 1995, the Company adopted the 1996 Stock Option Plan (the "1996 Plan"). Under the 1996 Plan, grants of both incentive stock options and non-qualified options are permitted. Incentive stock options may only be granted to employees of the Company, including officers and directors who are also employees. Non-qualified options may be issued to officers, directors, employees or consultants of the Company. The exercise price of incentive stock options granted under the 1996 Plan must be at least 100% (or 110% in the case of a holder of 10% or more of the voting power of all classes of stock of the Company) of the fair market value of the Company's stock at the grant date, while the exercise price of non-qualified options is at the discretion of the Board of Directors. Aggregate common shares of 722,000 are reserved for issuance under the 1996 Plan, as amended. Shares forfeited can be reissued under the 1996 Plan. Options issued under the 1996 Plan vest at a rate of 25% per year over four years and generally expire up to ten years from the date of grant. Stock option transactions of the 1996 Plan are summarized below:
WEIGHTED AVERAGE SHARES EXERCISE PRICE Outstanding at December 31, 1998 431,000 $ 4.63 Granted 302,750 2.95 Forfeited (138,000) 3.95 --------- ------ Outstanding at December 31, 1999 595,750 3.94 Granted 242,000 2.80 Exercised (3,667) 3.35 Forfeited (232,067) 3.83 --------- ------ Outstanding at December 31, 2000 602,016 $ 3.53 ========= ======
At December 31, 2000 and 1999, options were exercisable with respect to 265,526 and 186,562 shares, respectively, with exercise prices ranging from $2.03 to $7.88 and a weighted average exercise price of $3.87 and $4.37, respectively. As of December 31, 2000 the weighted average contractual life was 6.54 years. In October 2000, 25,000 options were granted to a Director of the Company for services provided beyond normal director duties. These options were 100% vested and exercisable on the date of grant, compensation expense of $55,000 was recorded at the time of issue. F - 14 31 QUALMARK CORPORATION STATEMENT OF SHAREHOLDERS' EQUITY (IN THOUSANDS, EXCEPT FOR NUMBER OF SHARES) -------------------------------------------------------------------------------- FAIR VALUE The Company applies Accounting Principles Board Opinion No. 25 and related Interpretations in accounting for its stock plans. Accordingly, no compensation expense has been recognized for options granted at fair market value. Had compensation cost for the Company's stock option plans been determined based on the fair values at the grant dates for awards under the plans consistent with the method of accounting prescribed by Financial Accounting Standard No. 123, the Company's results would have been changed to the pro forma amounts indicated below (in thousands):
YEARS ENDED DECEMBER 31, 2000 1999 Net loss applicable to common shareholders: As reported $ (472) $ (2,820) Pro forma $ (504) $ (3,059) Basic loss per share: As reported $ (0.13) $ (0.80) Pro forma $ (0.14) $ (0.87) Fully diluted loss per share: As reported $ (0.13) $ (0.80) Pro forma $ (0.14) $ (0.87)
The fair value of each option and warrant grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions used for grants in the years ended December 31, 2000 and 1999: dividend yield of zero; expected volatility ranging from 79% to 97% ; risk-free interest rates ranging from 5.39% to 6.75%; and an expected term of seven years. The risk-free interest rate used in the calculation is the yield on the grant date of a U.S. Treasury Strip with a maturity equal to the expected term of the option. 10. PROFIT SHARING PLAN The Company maintains an employee profit sharing plan under Section 401(k) of the Internal Revenue Code (the "Plan") covering personnel who have been employed at least three months. Employees may contribute up to the federal limit of their compensation to the Plan each year. The Company may make discretionary contributions, as determined by the Board of Directors each year, to employee participants who have more than one year of service. Participants vest in employer contributions at a rate of 20% per year over five years. During 2000 and 1999, no employer contributions were made. 11. SEGMENT INFORMATION The Company operates in two business segments, testing equipment and Accelerated Reliability Test Centers ("ARTC"). The equipment segment is engaged in the manufacture and sale of vibration and thermal chambers for quality control testing of various electronic devices. The ARTC segment operates service centers where vibration and thermal chambers are available to customers for daily rental. The accounting policies for these segments are the same as those described in Note 1 and there are no intersegment transactions. The Company evaluates the performances of its segments and allocates resources to them based primarily on gross profit. All operating revenues and expenses are allocated to business segments in determining their gross profit. All other expenses are not utilized in determining the allocation of resources on a segment basis. F - 15 32 QUALMARK CORPORATION STATEMENT OF SHAREHOLDERS' EQUITY (IN THOUSANDS, EXCEPT FOR NUMBER OF SHARES) -------------------------------------------------------------------------------- The table below summarizes information about reported segments (in thousands):
EQUIPMENT ARTC TOTAL YEAR ENDED DECEMBER 31, 2000 Sales $ 9,213 $ 3,292 $ 12,505 Gross profit 3,770 1,197 4,967 Property and equipment, net 322 968 1,290 YEAR ENDED DECEMBER 31, 1999 Sales $ 8,804 $ 3,755 $ 12,559 Gross profit 3,330 1,659 4,989 Property and equipment, net 385 1,123 1,508
The following is sales by geographic area (in thousands):
YEARS ENDED DECEMBER 31, 2000 1999 United States $ 9,471 $ 10,592 International 3,034 1,967 --------------- ---------------- Total $ 12,505 $ 12,559 =============== ===============
International sales are based on where the products were shipped and where ARTC services were rendered. 12. RELATED PARTY TRANSACTIONS In 1995, the Company sold the assets of Hobbs Engineering Corporation (HEC), excluding any patents or other intellectual property, to Dr. Hobbs, a principal shareholder of the Company. In connection with the sale, the Company agreed to make quarterly royalty payments to Dr. Hobbs equal to two percent of the Company's total revenues, increasing to a maximum of three percent if certain revenue levels are achieved, for the period January 1, 1996 through December 31, 1999, in exchange for Dr. Hobbs being available to actively promote the Company's products and services. During 1999, royalties of $251,000 were expensed relating to this agreement. As of December 31, 1999, the Company had fulfilled the agreement with Dr. Hobbs and, therefore, no future royalties are payable on sales. During 1998, the Company lent $104,000 to the Company's former president pursuant to a note collateralized by his primary residence with interest accruing at a rate equal to 10% annually. The note was payable over five years, with 5% of the principal due at each anniversary date and the remaining balance due at the end of the term. On January 13, 2000, the former president remitted 4,016 shares of the Company's common stock at a fair market value of $4.06 per share on that date to satisfy $16,000 of principal, interest and penalties related to the note. On May 19, 2000, the Company's president resigned from his position. Subsequently, on June 14, 2000, 31,530 common shares were remitted to the Company by the former president, at a fair market value of $3.39 per share on that date to satisfy the remaining principal and accrued interest balance of $106,000. 13. SEVERANCE CHARGE During June 2000, the Company initiated an organizational restructure plan and charged $272,000 in severance to operations. This reorganization resulted in the resignation of the Company's president and a reduction of six other personnel from the Sales and Marketing, Accounting and Administrative, and Manufacturing departments. Severance costs include salary payments, fringe benefits and taxes related to these seven employees. Cash payments to settle the salary payments, fringe benefits and taxes will continue through F - 16 33 QUALMARK CORPORATION STATEMENT OF SHAREHOLDERS' EQUITY (IN THOUSANDS, EXCEPT FOR NUMBER OF SHARES) -------------------------------------------------------------------------------- May of 2001. Cash payments made during 2000 totaled $190,000 and as of December 31, 2000, the severance liability balance remaining is $82,000. 14. LEGAL MATTERS On March 22, 1996, the Company was served with a summons and complaint from Screening Systems, Inc., a competitor. The complaint, as amended, alleges the Company's vibration system infringes three patents owned by Hughes Electronics ("Hughes") and licensed to SSI, and seeks injunctive relief, monetary damages and costs of litigation. Although the Company continues to maintain it engaged in no wrongful conduct, on August 31, 1999, it entered into a settlement agreement with SSI. Under the terms of the settlement, the Company will pay $925,000 to SSI in three unequal payments upon signing the agreement, July 2000, and April 2001. Interest will accrue at 9% per annum and is payable quarterly, on the settlement amount. In addition, the Company issued warrants to SSI for the purchase of 620,000 shares of its non-voting common stock. The warrants have a five-year term at an exercise price of $4.85 per share, and a fair market value of $621,000. F - 17 34 INDEX TO EXHIBITS
EXHIBIT NUMBER DESCRIPTION ------- ----------- 3.1 Amended and Restated Articles of Incorporation of the Company.(1) 3.2 Amended and Restated Bylaws of the Company.(1) 3.3 Certificate of Designation for Series A Preferred Stock.(5) 4.1 Form of Certificate for Shares of Common Stock.(1) 4.6 Form of Warrant issued to holders of 10% secured promissory notes.(1) 10.1 QualMark Corporation 1993 Incentive Stock Option Plan.(1) 10.2 QualMark Corporation 1996 Stock Option Plan.(3) 10.3 Employment Agreement dated March 1, 1993 by and between the Company and W. Preston Wilson.(1) 10.4 Employment Agreement dated August 15, 1994 by and between the Company and J. Wayne Farlow.(1) 10.5 Agreement dated September 30, 1995 by and between the Company and Gregg K. Hobbs.(1) 10.8 Addendum to Agreement dated as of December 21, 1995 by and between the Company and Gregg K. Hobbs.(1) 10.11 Loan and Security Agreement dated April 30, 1996, by and between QualMark Corporation and Silicon Valley Bank, as amended by Amendment to Loan and Security Agreement dated August 18, 1997.(2) 10.12 Loan and Security Agreement dated December 22, 1998, by and between QualMark Corporation and U.S. Bank National Association.(4) 10.13 Waiver and Amendment to Loan Agreement dated March 15, 1999 by and between QualMark and U.S. Bank National Association.(4) 10.14 Second Amendment to Loan Agreement dated August 23, 1999 by and between QualMark and U.S. Bank National Association.(5) 10.15 Settlement Agreement dated August 30, 1999 by and among QualMark Corporation and Screening Systems, Inc.(5) 10.16 Preferred Stock Purchase Agreement dated September 1, 1999, including Warrant to Purchase 139,535 Shares of Common Stock.(5) 10.17 Third Amendment to Loan Agreement dated March 31, 2000 by and between QualMark and U.S. Bank National Association.(6) 10.18 Employment Agreement dated July 17, 2000 by and between the Company and Charles D. Johnston.(7) 10.19 Second Amendment to Promissory Notes and Fifth Amendment to Loan Agreement dated February 1, 2001 by and between QualMark and U.S. Bank National Association.
---------- (1) Incorporated by reference from the Company's Registration Statement No. 333-1454-D on Form SB-2. (2) Incorporated by reference from the Company's Quarterly Report on Form 10-QSB for the quarter ended September 30, 1997. (3) Incorporated by reference from the Company's Proxy Statement for the 1996 Annual Meeting of Shareholders. (4) Incorporated by reference from the Company's Annual Report of Form 10-KSB for the year ended December 31, 1998. (5) Incorporated by reference from the Company's Quarterly Report on Form 10-QSB for the quarter ended September 30, 1999. (6) Incorporated by reference from the Company's Quarterly Report on Form 10-QSB for the quarter ended June 30, 2000. (7) Incorporated by reference from the Company's Quarterly Report on Form 10-QSB for the quarter ended September 30, 2000.