10-Q 1 imsc130331_10q.htm 130331 IMSC FORM 10-Q Form 10-Q - Q1 - 2012  (M0342807.DOC;2)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

(Mark One)

 

 

x

 

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

 

For the quarterly period ended March 31, 2013

 

o

 

TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934


For the transition period from:

 

to

 


Commission File No. 001-14949

 

Implant Sciences Corporation

(Name of small business issuer in its charter)

 

Massachusetts

 

04-2837126

(State or other jurisdiction of incorporation or organization)

 

(I.R.S. Employer Identification No.)

 

 

 

600 Research Drive, Wilmington, Massachusetts

 

01887

(Address of principal executive offices)

 

(Zip Code)

 

 

 

(978) 752-1700

(Issuer’s telephone number, including area code)

 

 

(Former name, former address and former fiscal year, if changed since last report)

 

 

 


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

Yes x  No q

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

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

q  Large Accelerated Filer

q  Accelerated Filer

q  Non-accelerated Filer

x  Smaller reporting company

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

As of May 6, 2013, there were 55,036,965 shares of the registrant’s Common Stock outstanding.

 







IMPLANT SCIENCES CORPORATION

TABLE OF CONTENTS


 

 

 

 

Page

PART I

 

FINANCIAL INFORMATION

 

 

Item 1.

 

Condensed Consolidated Financial Statements

 

 

 

 

Condensed Consolidated Balance Sheets as of March 31, 2013 (unaudited) and June 30, 2012

 

3

 

 

Condensed Consolidated Statements of Operations for the three and nine months ended March 31, 2013 and 2012 (unaudited)

 

4

 

 

Condensed Consolidated Statements of Cash Flows for the nine months ended March 31, 2013 and 2012 (unaudited)

 

5

 

 

Notes to Condensed Consolidated Financial Statements

 

6-26

Item 2.

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

27-32

Item 3.

 

Quantitative and Qualitative Disclosures About Market Risk

 

32

Item 4.

 

Controls and Procedures

 

33

PART II

 

OTHER INFORMATION

 

 

Item 1.

 

Legal Proceedings

 

34

Item 1A.

 

Risk Factors

 

34

Item 2.

 

Unregistered Sales of Equity Securities and Use of Proceeds

 

35

Item 3.

 

Defaults Upon Senior Securities

 

35

Item 4.

 

Mine Safety Disclosures

 

35

Item 5.

 

Other Information

 

35

Item 6.

 

Exhibits

 

36

 

 

Signatures

 

37





- 2 -




Implant Sciences Corporation

Condensed Consolidated Balance Sheets

(In thousands, except share and per share amounts)

 

 

 

 

 

 

 

 

 

 

March 31, 2013

 

 

 

June 30, 2012

 

 

 

(Unaudited)

 

 

 

(Audited)

 

ASSETS

 

 

 

 

 

 

 

Current assets:

 

 

 

 

 

 

 

Cash and cash equivalents

$

-

 

 

$

84

 

Restricted cash and investments

 

1,295

 

 

 

1,274

 

Accounts receivable-trade, net of allowances of $3 and $20, respectively

 

746

 

 

 

182

 

Inventories, net

 

2,218

 

 

 

3,193

 

Prepaid expenses and other current assets

 

333

 

 

 

809

 

Total current assets

 

4,592

 

 

 

5,542

 

Property and equipment, net

 

363

 

 

 

220

 

Restricted cash and investments

 

312

 

 

 

312

 

Other non-current assets

 

126

 

 

 

162

 

Total assets

$

5,393

 

 

$

6,236

 

LIABILITIES AND STOCKHOLDERS' DEFICIT

 

 

 

 

 

 

 

Current liabilities:

 

 

 

 

 

 

 

Senior secured convertible promissory note

$

3,184

 

 

$

3,224

 

Second senior secured convertible promissory note

 

12,000

 

 

 

-

 

Third senior secured convertible promissory note

 

12,000

 

 

 

-

 

Senior secured promissory note

 

1,000

 

 

 

1,000

 

Line of credit

 

9,586

 

 

 

26,231

 

Current maturities of obligations under capital lease

 

57

 

 

 

24

 

Payable to Med-Tec

 

20

 

 

 

30

 

Accrued expenses

 

5,741

 

 

 

4,360

 

Accounts payable

 

2,541

 

 

 

2,654

 

Deferred revenue

 

304

 

 

 

1,081

 

Total current liabilities

 

46,433

 

 

 

38,604

 

Long-term liabilities:

 

 

 

 

 

 

 

Long-term obligations under capital lease, net of current maturities

 

73

 

 

 

33

 

Total long-term liabilities

 

73

 

 

 

33

 

Total liabilities

 

46,506

 

 

 

38,637

 

 

 

 

 

 

 

 

 

Commitments and contingencies  (Note 18)

 

   

 

 

   

   

 

 

 

 

 

 

 

 

 

Stockholders' deficit:

 

 

 

 

 

 

 

Common stock; $0.001 par value; 200,000,000 shares authorized; 55,047,510 and 55,036,965 at March 31, 2013 and $0.10 par value: 50,000,000 shares authorized; 39,163,540 and 39,152,995 at June 30, 2012 shares issued and outstanding, respectively

 

55

 

 

 

3,916

 

Preferred stock; $0.10 par value; 5,000,000 shares authorized

 

-

 

 

 

-

 

Series G Convertible Preferred Stock, $0.10 par value; 650,000 shares authorized, 36,167 shares issued and outstanding at March 31, 2013 and 164,667 shares issued and outstanding at June 30, 2012 , respectively (liquidation value of $289,000 and $1,317,000, respectively)

 

60

 

 

 

274

 

   Series H Convertible Preferred Stock; $0.10 par value; 15,000 shares authorized

 

 

 

 

 

 

 

      no shares issued and outstanding

 

-

 

 

 

-

 

   Series I Convertible Preferred Stock; $0.10 par value; 15,000 shares authorized

 

 

 

 

 

 

 

      no shares issued and outstanding

 

-

 

 

 

-

 

   Series J Convertible Preferred Stock; $0.10 par value; 6,000 shares authorized

 

 

 

 

 

 

 

      no shares issued and outstanding

 

-

 

 

 

-

 

Additional paid-in capital

 

100,344

 

 

 

83,436

 

Accumulated deficit

 

(141,332

)

 

 

(119,522

)

Deferred compensation

 

(167

)

 

 

(432

)

Treasury stock, 10,545 common shares, at cost

 

(73

)

 

 

(73

)

Total stockholders' deficit

 

(41,113

)

 

 

(32,401

)

Total liabilities and stockholders' deficit

$

5,393

 

 

$

6,236

 


The accompanying notes are an integral part of these condensed consolidated financial statements.



- 3 -




Implant Sciences Corporation

Condensed Consolidated Statements of Operations

(In thousands, except share and per share amounts)

(Unaudited)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

For the Three Months Ended

March 31,

 

 

For the Nine Months Ended

March 31,

 

 

 

2013

 

 

 

2012

 

 

 

2013

 

 

 

2012

 

Revenues

$

1,262

 

 

$

686

 

 

$

9,615

 

 

$

2,854

 

Cost of revenues

 

959

 

 

 

504

 

 

 

6,883

 

 

 

1,908

 

Gross margin

 

303

 

 

 

182

 

 

 

2,732

 

 

 

946

 

Operating expenses:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Research and development

 

1,116

 

 

 

799

 

 

 

3,521

 

 

 

2,365

 

Selling, general and administrative

 

3,191

 

 

 

2,258

 

 

 

17,115

 

 

 

6,053

 

Total operating expenses

 

4,307

 

 

 

3,057

 

 

 

20,636

 

 

 

8,418

 

Loss from operations

 

(4,004

)

 

 

(2,875

)

 

 

(17,904

)

 

 

(7,472

)

Other income (expense), net:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest income

 

1

 

 

 

1

 

 

 

2

 

 

 

3

 

Interest expense

 

(1,336

)

 

 

(1,016

)

 

 

(3,908

)

 

 

(2,783

)

Total other income (expense), net

 

(1,335

)

 

 

(1,015

)

 

 

(3,906

)

 

 

(2,780

)

Net loss  

$

(5,339

)

 

$

(3,890

)

 

$

(21,810

)

 

$

(10,252

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net loss per share, basic and diluted

$

(0.10

)

 

$

(0.11

)

 

$

(0.47

)

 

$

(0.31

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Weighted average shares used in computing net loss per common share, basic and diluted

 

53,747,496

 

 

 

34,474,665

 

 

 

46,731,147

 

 

 

33,162,071

 




The accompanying notes are an integral part of these condensed consolidated financial statements.




- 4 -




Implant Sciences Corporation

Condensed Consolidated Statements of Cash Flows

(In thousands)

(Unaudited)

 

 

For the Nine Months Ended

March 31,

 

 

2013

 

 

2012

 

Cash flows from operating activities:

 

 

 

 

 

 

 

Net loss

$

(21,810

)

 

$

(10,252

)

Adjustments to reconcile net loss to net cash flows used in operating activities:

 

 

 

 

 

 

 

Depreciation and amortization

 

58

 

 

 

54

 

Stock-based compensation expense

 

12,325

 

 

 

200

 

Warrants issued to non-employees

 

482

 

 

 

325

 

Common stock issued to consultants

 

19

 

 

 

1,386

 

Litigation settlement

 

(295

)

 

 

-

 

Bad debt expense (recoveries)

 

2

 

 

 

(1

)

Changes in assets and liabilities:

 

 

 

 

 

 

 

Gain on sale of equipment

 

(20

)

 

 

-

 

Accounts receivable

 

(566

)

 

 

904

 

Inventories

 

975

 

 

 

(654

)

Prepaid expenses and other current assets

 

512

 

 

 

4

 

Accounts payable

 

211

 

 

 

40

 

Accrued expenses

 

1,548

 

 

 

565

 

Deferred revenue

 

(777

)

 

 

71

 

Net cash used in operating activities

 

(7,336

)

 

 

(7,358

)

 

 

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

 

 

Purchases of property and equipment

 

(103

)

 

 

(139

)

Proceeds from sale of equipment

 

20

 

 

 

 

-

Transfer to restricted funds, net

 

(21

)

 

 

(39

)

Net cash used in investing activities

 

(104

)

 

 

  (178

)

 

 

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

 

 

Proceeds from common stock issued in connection with exercise of stock options

 

26

 

 

 

-

 

Repayment of long-term capital lease obligations

 

(25

)

 

 

(20

)

Net borrowings on line of credit

 

7,355

 

 

 

7,294

 

Net cash provided by financing activities

 

7,356

 

 

 

7,274

 

Net change in cash and cash equivalents

 

(84

)

 

 

(262

)

Cash and cash equivalents at beginning of period

 

84

 

 

 

264

 

Cash and cash equivalents at end of period

$

-

 

 

$

2

 

 

 

 

 

 

 

 

 

Supplemental Disclosure of Cash Flow Information:

 

 

 

 

 

 

 

Interest paid

$

2,070

 

 

$

2,100

 

 

 

 

 

 

 

 

 

Non-cash Investing and Financing Activity:

 

 

 

 

 

 

 

Conversion of senior secured convertible promissory note to common shares

$

40

 

 

$

160

 

Conversion of line of credit to second senior secured convertible promissory note

 

12,000

 

 

 

-

 

Conversion of line of credit to third senior secured convertible promissory note

 

12,000

 

 

 

-

 

Exercise of stock options

 

200

 

 

 

-

 

Exercise of stock purchase warrants

 

109

 

 

 

-

 

   Purchases of property and equipment under capital lease

 

98

 

 

 

-

 



The accompanying notes are an integral part of these condensed consolidated financial statements.




- 5 -



IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


1.

Description of Business, Liquidity and Going Concern

Implant Sciences Corporation provides systems and sensors for the homeland security market and related industries.  We have developed and acquired technologies using ion mobility spectrometry to develop a product line for use in trace explosives and narcotics detection.  We currently market and sell our existing trace explosives and narcotics detector products while continuing to make significant investments in developing the next generation of these products.

We are party to several loan and credit agreements with DMRJ Group LLC (“DMRJ”), an accredited institutional investor (see Note 13).  As of March 31, 2013, our obligation to DMRJ under a senior secured convertible promissory note, as amended, a second senior secured convertible promissory note, a third senior secured convertible promissory note, a senior secured promissory note and under a revolving line of credit approximated $3,184,000, $12,000,000, $12,000,000, $1,000,000 and $9,586,000, respectively.  Further, as of March 31, 2013, our obligation to DMRJ for accrued interest under these instruments approximated $4,390,000 and is included in current liabilities in the condensed consolidated financial statements.

As of May 6, 2013, our obligations to DMRJ under the amended and restated senior secured convertible promissory note, the second senior secured convertible promissory note, the senior secured promissory note and under the credit facility approximated $3,184,000, $12,000,000, $12,000,000, $1,000,000 and $10,862,000, respectively.  Further, as of May 6, 2013, our obligation to DMRJ for accrued interest under these instruments approximated $4,189,000.

Despite our current sales, expense and cash flow projections and $12,763,000 in cash available from our line of credit with DMRJ at March 31, 2013, we will require additional capital in the third quarter of fiscal 2014 to fund operations and continue the development, commercialization and marketing of our products. Our failure to achieve our projections and/or obtain sufficient additional capital on acceptable terms would have a material adverse effect on our liquidity and operations and could require us to file for protection under bankruptcy laws.

Our ability to comply with our debt covenants in the future depends on our ability to generate sufficient sales and to control expenses, and will require that we seek additional capital through private financing sources. There can be no assurances that our forecasted results will be achieved or that we will be able to raise additional capital necessary to operate our business.  These conditions raise substantial doubt about our ability to continue as a going concern.  The financial statements do not include any adjustments relating to the recoverability and classification of asset amounts or the amounts and classification of liabilities that might be necessary should we be unable to continue as a going concern.

Any such failure would have a material adverse impact on our liquidity and financial condition and could force us to curtail or discontinue operations entirely.  Further, upon the occurrence of an event of default under certain provisions of our agreements with DMRJ, we could be required to pay default rate interest equal to the lesser of 2.5% per month and the maximum applicable legal rate per annum on the outstanding principal balance outstanding. The failure to refinance or otherwise negotiate further extensions of our obligations to DMRJ would have a material adverse impact on our liquidity and financial condition and could force us to curtail or discontinue operations entirely and/or file for protection under bankruptcy laws.

We are currently expending significant resources to develop the next generation of our current products and to develop new products.  We will require additional funding in order to continue the advancement of the commercial development and manufacturing of our explosives and narcotics detection systems.  We will attempt to obtain such financing by: (i) government grants, (ii) private financing, or (iii) strategic partnerships.  However, there can be no assurance that we will be successful in our attempts to raise such additional financing.

We will require substantial funds for further research and development, regulatory approvals, and the marketing of our explosives detection products.  Our capital requirements depend on numerous factors, including but not limited to the progress of our research and development programs; the cost of filing, prosecuting, defending and enforcing any intellectual property rights; competing technological and market developments; changes in our development of commercialization activities and arrangements; and the hiring of additional personnel, and acquiring capital equipment. Our failure to achieve our projections and/or obtain sufficient additional capital on acceptable terms would have a material adverse effect on our liquidity and operations and could require us to file for protection under bankruptcy laws.



- 6 -



IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


2.

Interim Financial Statements and Basis of Presentation

Principles of Consolidation

The accompanying condensed consolidated financial statements include our operations in Massachusetts and California and those of our wholly-owned subsidiaries. All intercompany transactions and accounts have been eliminated in consolidation.

Accounting Principles

The accompanying condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”).  In the opinion of management, the accompanying condensed consolidated financial statements include all adjustments (consisting only of normal recurring adjustments), which we consider necessary for a fair presentation of the financial position at such date and of the operating results and cash flows for the periods presented.  The results of operations and cash flows for the nine months ended March 31, 2013 may not necessarily be indicative of results that may be expected for any succeeding quarter or for the entire fiscal year.  The balance sheet at June 30, 2012 has been derived from our audited consolidated financial statements at that date, but does not include all of the information and notes required by U.S. GAAP for complete financial statements.

The information contained in this Form 10-Q should be read in conjunction with our audited financial statements, included in our Form 10-K, as of and for the year ended June 30, 2012.

Use of Accounting Estimates

The preparation of these financial statements in conformity with U.S. GAAP 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 periods.  Some of the more significant estimates include allowance for doubtful accounts, allowance for sales returns, inventory valuation and warranty reserves.  Management's estimates are based on the facts and circumstances available at the time estimates are made, past historical experience, risk of loss, general economic conditions and trends and management's assessments of the probable future outcome of these matters.  Consequently, actual results could differ from such estimates.

Significant accounting policies are described in Note 2 to the financial statements included in Item 7 of our Form 10-K for the fiscal year ended June 30, 2012.  

We have evaluated subsequent events after the balance sheet date through the date of filing of these financial statements for appropriate accounting and disclosure.

3.

Fair Value Measurement

Accounting Standards Codification (“ASC”) ASC 820, “Fair Value Measurements and Disclosures,” establishes a three-level fair value hierarchy to classify the inputs used in measuring fair value, which are as follows:

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

Level 2 inputs to the valuation methodology are based on inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly; and

Level 3 inputs to the valuation methodology are based on unobservable inputs that reflect the company’s own assumptions about the assumptions market participants would use in pricing the asset or liability.

Financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.  

Our financial instruments at March 31, 2013 include cash equivalents, certificates of deposit, accounts receivable, accounts payable, a senior secured convertible promissory note, a second senior secured convertible promissory note and a senior secured promissory note. The carrying amounts of cash and cash equivalents, certificates of deposit, receivables and accounts payable are representative of their respective fair values because of the short-term maturities or expected settlement dates of these instruments. The fair value of debt, as included in Note 13, is based on the fair value of similar instruments. These instruments are short-term in nature and there is no known trading market for our debt.



- 7 -



IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


The following table provides the fair value measurements of assets and liabilities as of March 31, 2013:

 

 

 

 

 

Fair Value Measurements as of

March 31, 2013

Description (In thousands)

 

 

Carrying

Value at

March 31, 2013

 

 

Quoted Prices in Active Markets for Identical Asset

Level 1

 

 

Significant Other Observable Inputs

Level 2

 

 

Significant Unobservable Inputs

Level 3

Certificates of deposit

 

$

1,562

 

$

1,562

 

$

-   

 

$

-   

Senior secured convertible promissory note

 

 

3,184

 

 

-   

 

 

-   

 

 

3,184

Second senior secured convertible promissory note

 

 

12,000

 

 

-

 

 

-

 

 

12,000

Third senior secured convertible promissory note

 

 

12,000

 

 

-

 

 

-

 

 

12,000

Senior secured promissory note

 

 

1,000

 

 

-   

 

 

-   

 

 

1,000

The following table provides the fair value measurements of assets and liabilities as of June 30, 2012:

 

 

 

 

 

Fair Value Measurements as of

June 30, 2012

Description (In thousands)

 

 

Carrying

Value at

June 30, 2012

 

 

Quoted Prices in Active Markets for Identical Asset

Level 1

 

 

Significant Other Observable Inputs

Level 2

 

 

Significant Unobservable Inputs

Level 3

Certificates of deposit

 

$

1,562

 

$

1,562

 

$

-   

 

$

-   

Senior secured convertible promissory note

 

 

3,224

 

 

-   

 

 

-   

 

 

3,224

Senior secured promissory note

 

 

1,000

 

 

-   

 

 

-   

 

 

1,000

 

 

 

 

 

 

 

 

 

 

 

 

 


4.

Restricted Cash and Investments – Current and Long-Term

As of March 31, 2013 and June 30, 2012, we had restricted cash and investments, with maturities of less than one year, of $1,295,000 and $1,274,000, respectively, and restricted investments, with maturities of more than one year, of $312,000.  Restricted cash and investments consisted of the following:

 

 

 

March 31,

 

 

June 30,

(In thousands)

 

 

2013

 

 

2012

Current assets

 

 

 

 

 

 

Certificates of deposit

 

$

1,250

 

$

1,250

Blocked account deposit

 

 

45

 

 

24

 

 

$

1,295

 

$

1,274

 

 

 

 

 

 

 

 

 

 

 

 

 

 


Non-current assets

 

 

 

 

 

 

Certificates of deposit

 

$

312

 

$

312

 

 

$

312

 

$

312




- 8 -



IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


Pursuant to our September 2009 credit agreement with DMRJ, we agreed to cause all of our receivables and collections to be deposited in a bank deposit account pledged to DMRJ pursuant to a blocked account agreement. All funds deposited in the blocked collections account are applied towards the repayment of our obligations to DMRJ under the revolving line of credit. Until the line of credit and all of our obligations thereunder have been paid and satisfied in full, we will have no right to access or make withdrawals from the blocked account without DMRJ’s consent.   As of March 31, 2013 and June 30, 2012, the balance in the blocked collections account was $45,000 and $24,000, respectively.  

The restricted investments of $1,562,000 held in certificates of deposit collateralize our performance under three irrevocable letters of credit issued in April 2010, aggregating to $1,488,000, in connection with our contract with the India Ministry of Defence, plus the bank required collateralization deposit of $74,000.  These letters of credit (1) provide performance security equal to 5% of the amount of our contract with the India Ministry of Defence; (2) provide warranty performance security equal to 5% of the contract amount; and (3) provide security equal to 15% of the contract amount against an advance deposit under the terms of the contract.  We have amended each of the letters of credit, extending the expiration dates. As amended, the letters of credit expire between August 2, 2013 and May 4, 2015. On May 1, 2013, the letter of credit providing security for the advance deposit was cancelled, resulting in the release of $937,000 held in a certificate of deposit. The funds have been applied to reduce our obligation for accrued interest and borrowings under the credit facility with DMRJ.  

5.

Stock Based Compensation

In December 2000, we adopted the 2000 Incentive and Non-Qualified Stock Option Plan (the “2000 Plan”). The 2000 Plan provides for the grant of incentive stock options and non-qualified stock options to employees and affiliates. The exercise price of the options equal 100% of the fair market value on the date of the grant or 110% of the fair market value for beneficial owners of more than 5% of our stock. Options expire between five and ten years from the date of the option grant and have various vesting periods. Options may be exercised by delivering to the company cash in an amount equal to such aggregate exercise price of the options exercised, or with the consent of the Committee, shares of our common stock having a fair market value equal to such aggregate exercise price, a personal recourse note issued to the company in a principal amount equal to such aggregate exercise price, other acceptable consideration including a cashless exercise/resale procedure, or any combination of the foregoing. The Committee may in its discretion provide upon the grant of any option that we may repurchase, upon terms and conditions determined by the Committee, all or any number of shares purchased upon exercise of such option. A total of 600,000 shares were originally reserved for issuance under the 2000 Plan. In December 2003, our stockholders approved an increase in the 2000 Plan from 600,000 shares to 1,000,000 shares. In December 2004, our stockholders approved an increase in the 2000 Plan from 1,000,000 shares to 1,500,000 shares. The 2000 Plan expired in October 2010, as such no further options grants may be issued under this plan.

In December 2004, we adopted the 2004 Stock Option Plan (the “2004 Plan”). The 2004 Plan provides for the grant of incentive stock options and non-qualified stock options to employees and affiliates. The exercise price of the options equa1 100% of the fair market value on the date of the grant or 110% of the fair market value for beneficial owners of more than 10% of our stock. Options expire between five and ten years from the date of the option grant and have various vesting periods. Options may be exercised by delivering to the company cash in an amount equal to such aggregate exercise price of the options exercised, or with the consent of the Committee, shares of our common stock having a fair market value equal to such aggregate exercise price, a personal recourse note issued to the company in a principal amount equal to such aggregate exercise price, other acceptable consideration including a cashless exercise/resale procedure, or any combination of the foregoing. A total of 500,000 shares were originally reserved for issuance under the 2004 Plan. In December 2005, our stockholders approved an increase in the 2004 Plan from 500,000 shares to 1,000,000 shares.  In December 2007, our stockholders approved an increase in the 2004 Plan from 1,000,000 shares to 2,000,000 shares. In March 2012, our stockholders approved an increase in the 2004 Plan from 2,000,000 shares to 4,000,000 shares.



- 9 -



IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


In September 2012, our Board of Directors adopted an amendment to our 2004 Stock Option increasing the total number of shares of our common stock issuable thereunder from 4,000,000 shares to 20,000,000 shares and approved the following grants of options under the amended plan:


Named Executives and Directors

 

Shares Granted

 

Glenn D. Bolduc

 

 5,442,490

 

William J. McGann

 

 1,498,972

 

Roger P. Deschenes

 

 1,058,498

 

Darryl K. Jones

 

 1,258,498

 

Michael C. Turmelle

 

 640,949

 

Howard Safir

 

 303,399

 

Robert P. Liscouski

 

 806,798

 

John A. Keating

 

 303,399

 

Todd A. Silvestri

 

 730,949

 

Brenda L. Baron

 

 730,949

 

Estate of Joseph E. Levangie

 

 525,099

 

 

 

 13,300,000

 


Each of the options has an exercise price of $1.40 per share. One-half of options granted to each of Messrs. Bolduc, Deschenes, Silvestri and Ms. Baron are immediately exercisable and the other one-half will become exercisable on September 7, 2013, subject to acceleration of vesting upon a “Change in Control,” as defined in the option plan. One-third of the new options granted to each of Dr. McGann and Dr. Jones are immediately exercisable, one-third will become exercisable on September 7, 2013, and the remaining one-third will become exercisable on September 7, 2014, subject to acceleration of vesting upon a “Change in Control.” Options granted to Messrs. Turmelle, Safir, Liscouski, Keating and the Estate of Mr. Levangie are immediately exercisable in full. All of the options will expire on September 6, 2022, subject to earlier expiration with respect to Messrs. Bolduc, McGann, Deschenes, Jones, Silvestri and Ms. Baron in connection with the termination or cessation of their respective employment with the company.

On September 7, 2012, the Board of Directors adopted the Implant Sciences Corporation Change of Control Payment Plan, the purpose of which is to reward management for the increases in shareholder value generated between January 2009 and the present.  

On January 2, 2009, the closing price of our common stock on the NYSE Amex LLC was $.18 per share. On the date the plan was adopted, the closing price of the common stock on the OTC Markets Group’s OTCPK tier was $1.40. Our Board of Directors believes that this increase in shareholder value is directly attributable to the dedication and hard work of our management team, employees and directors. The Board also believes, however, that our management and directors own significantly less equity in the company than do the officers and directors of most publicly traded early-stage (i.e., turn-around) businesses. Accordingly, our management and directors have not significantly benefitted from the increase in shareholder value between January 2009 and the present, and the plan is intended to provide value to our management and directors equivalent to the value they would have earned had they owned a more significant portion of our equity.  

Pursuant to the plan, the Board established a target level of stock ownership for each officer as a percentage of our fully diluted capitalization, and a corresponding ownership percentage for directors. To reflect the increase in shareholder value between January 2009 and the adoption of the plan, the Board determined that each officer and director should be allocated a “Change of Control Payment” equal to the product of (x) the closing price of our common stock on September 7, 2012 (i.e., $1.40) less a “floor price,” multiplied by (y) the number of additional stock options granted to each participant on the same date. The floor price applicable to directors and officers who served us at the beginning of the turn-around is $.20, i.e., slightly above the closing price of the common stock on January 2, 2009. The floor prices for Dr. McGann and Dr. Jones are $.51 and $.67, respectively, reflecting the closing prices of the common stock on the dates those officers joined us. The benefits under the plan are payable upon, and only upon, a “Change of Control,” as defined in the plan, involving the company.  Accordingly, the payment of the benefits allocated under the plan will be further deferred until such time that all shareholders receive payments for or in respect of their common stock in a transaction constituting a Change of Control.



- 10 -



IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


Our condensed consolidated statements of operations for the three months ended March 31, 2013 and 2012 include $1,532,000 and $83,000, respectively, of compensation costs and no income tax benefit related to our stock-based compensation arrangements for employee and non-employee director awards.  For the nine months ended March 31, 2013 and 2012, compensation costs related to our stock-based compensation arrangements for employee and non-employee director awards, included in our consolidated statement of operations was $12,325,000 and $200,000, respectively, as follows:


(In thousands)

 

For the Three Months Ended March 31,

 

For the Nine Months Ended March 31,

 

 

2013

 

2012

 

2013

 

2012

Cost of revenues

 

$

104

 

$

4

 

$

682

 

$

10

Research and development

 

 

164

 

 

27

 

 

819

 

 

62

Selling, general and administrative

 

 

1,264

 

 

52

 

 

10,824

 

 

 128

Total

 

$

1,532

 

$

83

 

$

12,325

 

$

200


As of March 31, 2013, the total amount of unrecognized stock-based compensation expense was approximately $4,385,000, which will be recognized over a weighted average period of 1.0 year.

As of March 31, 2013, there were options outstanding to purchase 17,514,651 shares of our common stock at exercise prices ranging from $0.08 to $10.00.

6.

Related Party Transactions

We have entered into a fixed asset lease agreement with Ferran Scientific, Inc., a firm owned by the father of the former chairman of Ion Metrics.  The lease, assumed as part of our acquisition of Ion Metrics, Inc., expires on December 31, 2013.  Our annual lease payments under this lease are approximately $31,000 per year.

Robert Liscouski, a member of our Board of Directors, had served as a partner at Secure Strategy Group, a homeland security-focused banking and strategic advisory firm that has been retained by us to assist with our efforts to acquire additional capital.  During the three and nine months ended March 31, 2013, this advisory firm was paid $6,000 and $54,000, respectively.  During the three and nine months ended March 31, 2012, this advisory firm was paid $25,000 and $81,000, respectively. We also issued 500,000 shares of common stock to this advisory firm in fiscal 2010.  As of March 31, 2013 and June 30, 2012, our obligation to the advisory firm was $124,000 and $83,000, respectively. On March 31, 2013, we terminated our relationship with this advisory firm. In April 2011, we entered into an advisory and consulting agreement with Mr. Liscouski to assist our U.S. government sales and marketing team with our efforts to advance our interests with the U.S. government.  During the three months ended March 31, 2013 and 2012, Mr. Liscouski was paid $45,000. During the nine months ended March 31, 2013 and 2012, Mr. Liscouski was paid $135,000. As of March 31, 2013 and June 30, 2012, we had no obligation to Mr. Liscouski.

7.

Note Payable – Related Party

In June 2009, Michael Turmelle, a member of our Board of Directors, loaned $100,000 to us.  

As of March 31, 2013 and June 30, 2012, we had no obligation to Mr. Turmelle for borrowed funds.  As of March 31, 2013 and June 30, 2012, our obligation to Mr. Turmelle for accrued interest approximated $11,000.



- 11 -



IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


8.

Prepaid Expenses and Other Current Assets

Prepaid expenses and other current assets consist of the following:


(In thousands)

 

 

March 31,

2013

 

 

June 30,

2012

Inventory

 

$

3

 

$

450

Insurance

 

 

94

 

 

56

Bank fees

 

 

20

 

 

35

Other prepaid expenses

 

 

216

 

 

268

 

 

$

333

 

$

809


9.

Inventories, net

We value our inventories at lower of cost or market.  Cost is determined by the first-in, first-out (FIFO) method, including material, labor and factory overhead.  The components of inventories, net of reserves, consist of the following:


(In thousands)

 

 

March 31,

2013

 

 

June 30,

2012

Raw materials

 

$

1,790

 

$

1,363

Work in progress

 

 

187

 

 

280

Finished goods

 

 

241

 

 

1,550

Total inventories

 

$

2,218

 

$

3,193


As of March 31, 2013 and June 30, 2012, our reserves for excess and slow-moving inventories were $40,000.


10.

Property and Equipment, net

Property and equipment consist of the following:


(In thousands)

 

 

March 31,

2013

 

 

June 30,

2012

Machinery and equipment

 

$

351

 

$

493

Computers and software

 

 

481

 

 

409

Furniture and fixtures

 

 

24

 

 

12

Leasehold improvements

 

 

98

 

 

98

Equipment under capital lease

 

 

160

 

 

62

 

 

 

1,114

 

 

1,074

Less: accumulated depreciation and amortization

 

 

751

 

 

854

 

 

$

363

 

$

220


For the three months ended March 31, 2013 and 2012, depreciation expense was approximately $18,000 and $15,000, respectively.  For the nine months ended March 31, 2013 and 2012, depreciation expense was approximately $58,000 and $54,000, respectively.  During the three months ended March 31, 2013, we recognized a gain of $20,000 on the disposition of machinery and equipment with a cost of approximately $161,000 and no net book value.



- 12 -



IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


11.

Accrued Expenses

Accrued expenses consist of the following:

(In thousands)

 

 

March 31,

2013

 

 

June 30,

2012

Accrued interest

 

$

4,402

 

$

2,571

Accrued compensation and benefits

 

 

655

 

 

1,224

Accrued warranty costs

 

 

227

 

 

118

Accrued legal and accounting

 

 

80

 

 

230

Other accrued liabilities

 

 

377

 

 

217

 

 

$

5,741

 

$

4,360


12.

Earnings Per Share

Basic earnings per share is computed by dividing net income (loss) by the weighted average number of common shares outstanding during the period.  Diluted earnings per share are based upon the weighted average number of common shares outstanding during the period plus additional weighted average common equivalent shares outstanding during the period.  Common equivalent shares result from the assumed exercise of outstanding stock options and warrants, the proceeds of which are then assumed to have been used to repurchase outstanding common stock using the treasury stock method and assumed conversion of certain convertible promissory notes and convertible preferred stock.  In addition, the numerator is adjusted for any changes in income or loss that would result from the assumed conversion of potential shares. As of March 31, 2013 and 2012, potentially dilutive shares would have been excluded from the earnings per share calculation, because their effect would be antidilutive.  Shares deemed to be antidilutive include stock options, warrants, convertible debt and convertible preferred stock.


 

 

For the Three Months Ended March 31,

 

 

For the Nine Months Ended March 31,

 

(In thousands, except share and per share amounts)

 

2013

 

 

2012

 

 

2013

 

 

2012

 

Basis loss per share:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Numerator:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net loss

 

$

(5,339

)

 

$

(3,890

)

 

$

(21,810

)

 

$

(10,252

)

Denominator:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Weighted average shares

 

 

53,747,496

 

 

 

34,474,665

 

 

 

46,731,147

 

 

 

33,162,071

 

Basic loss per share

 

$

(0.10

)

 

$

(0.11

)

 

$

(0.47

)

 

$

(0.31

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Diluted loss per share:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Numerator:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net loss

 

$

(5,339

)

 

$

(3,890

)

 

$

(21,810

)

 

$

(10,252

)

Denominator:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Weighted average shares

 

 

53,747,496

 

 

 

34,474,665

 

 

 

46,731,147

 

 

 

33,162,071

 

Effect of dilutive securities:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

  Stock options

 

 

-

 

 

 

-

 

 

 

-

 

 

 

-

 

  Warrants

 

 

-

 

 

 

-

 

 

 

-

 

 

 

-

 

  Convertible debt

 

 

-

 

 

 

-

 

 

 

-

 

 

 

-

 

    Convertible preferred stock

 

 

-

 

 

 

-

 

 

 

-

 

 

 

-

 

 

 

 

-

 

 

 

-

 

 

 

-

 

 

 

-

 

Weighted average share and equivalents

 

 

53,747,496

 

 

 

34,474,665

 

 

 

46,731,147

 

 

 

33,162,071

 

Diluted loss per share

 

$

(0.10

)

 

$

(0.11

)

 

$

(0.47

)

 

$

(0.31

)




- 13 -



IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


Common stock equivalents excluded from the diluted earnings per share calculation for the three and nine months ended March 31, 2013 and 2012, were as follows:


 

 

 

For the Three Months Ended

March 31,

 

 

For the Nine Months Ended   March 31,

 

 

 

2013

 

 

2012

 

 

2013

 

 

2012

Common stock equivalents excluded

 

 

 

 

 

 

 

 

 

 

 

 

   Stock options

 

 

2,171,153

 

 

2,483,636

 

 

2,630,184

 

 

2,524,096

   Warrants

 

 

516,242

 

 

1,052,795

 

 

595,081

 

 

1,059,681

   Convertible debt

 

 

54,424,994

 

 

43,000,000

 

 

49,348,657

 

 

43,000,000

   Convertible preferred stock

 

 

5,608,900

 

 

16,466,700

 

 

11,160,100

 

 

16,466,700

 

 

 

62,721,289

 

 

63,003,131

 

 

63,734,022

 

 

63,050,477


13.

Long-Term Debt and Credit Arrangements

Med-Tec Payment Obligation

In July 2003, we entered into an asset purchase agreement with Med-Tec Iowa, Inc., our former exclusive distributor of prostate seeds, to purchase Med-Tec’s customer lists and further to release each other from further obligations under an earlier distribution agreement.  The purchase price of $1,250,000, which was payable in varying amounts over 28 months, with the final payment payable on December 1, 2005, was recorded at the present value of the future payment stream, using a rate of 10.24%, which equaled $1,007,000.  This amount was recorded as an intangible asset and was amortized over our estimated useful life of 29 months.  The outstanding and past due principal balance as of March 31, 2013 and June 30, 2012 was approximately $20,000 and $30,000, respectively.

Term Debt and Revolving Credit Facility with DMRJ

In December 2008, we entered into a note and warrant purchase agreement with DMRJ, an accredited institutional investor, pursuant to which we issued a senior secured convertible promissory note in the principal amount of $5,600,000 and a warrant to purchase 1,000,000 shares of our common stock.  The note, which is collateralized by all of our assets, originally bore interest at 11.0% per annum.  The effective interest rate on the note, at the time of issuance, was approximately 23.4%.  We prepaid interest in the amount of $616,000 upon the issuance of the note.  In lieu of paying any commitment fees, closing fees or other fees in connection with the purchase agreement, we transferred our entire interest in 1,500,000 shares of the common stock of CorNova, Inc., a privately-held development stage medical device company, to DMRJ.  The note, which has been amended and restated, as described below, was originally convertible in whole or in part at the option of DMRJ into shares of our common stock at a conversion price of $0.26 per share. The warrant, which has been amended and restated, as described below, was originally exercisable in whole or in part at the option of DMRJ into shares of our common stock at an exercise price of $0.26 per share.

The note and warrant contained reset terms providing that, in the event that we issue additional shares of common stock (or securities convertible into or exercisable for additional shares of common stock) at a price below the note conversion price or warrant exercise price then in effect, the conversion price and exercise price would be automatically adjusted to equal the price per share at which such shares are issued or deemed to be issued.   Upon  the adoption of Accounting Standards Codification (“ASC”) 815-40-15 “Derivatives and Hedging”, ASC 815-40-15, the note conversion option liability and warrant derivative liability were required to be initially and subsequently be measured at fair value with changes in fair value recorded in earnings in each reporting period.  



- 14 -



IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


We valued the note upon issuance at its residual value of $4,341,000 based on the fair values of the financial instruments issued in connection with this convertible debt financing, including the warrant, the fair value of the note conversion option liability and the fair value of the CorNova common stock transferred to DMRJ.  The amounts recorded in the financial statements represents the amounts attributed to the senior secured convertible debt of $5,600,000, net of the fair value $153,000 allocated to the warrant, $638,000 allocated to the note conversion liability fair value and $468,000 representing the estimated fair value of the CorNova common stock transferred to DMRJ.  The note discount was calculated based upon the residual method. The discount on the note was amortized to interest expense over the initial term of the note.  The fair value of the warrant and note conversion liabilities were determined using a binomial option pricing model, which includes variables such as expected volatility of our share price, interest rates, and dividend yields.  

As required under the terms of the note, we made a principal payment of $1,000,000 on December 24, 2008.  The note required us to make a principal payment in an amount equal to any funds released from the escrow created in connection with the May 2007 sales of the assets of Accurel Systems International to Evans Analytical Group LLC, upon the release of such funds.  DMRJ waived that requirement in connection with the settlement of the subsequent litigation with Evans.

The note contains restrictions and financial covenants including: (i) restrictions against declaring or paying dividends or making any distributions; against creating, assuming or incurring  any liens; against creating, assuming or incurring any indebtedness; against merging or consolidating with any other company, provided, however, that a merger or consolidation is permitted if we are the surviving entity; against the sale, assignment, transfer or lease of our assets, other than in the ordinary course of business and excluding inventory and certain asset sales expressly permitted by the note purchase agreement; against making investments in any company, extending credit or loans, or purchasing stock or other ownership interest of any company; and (ii) covenants that we have authorized or reserved for the purpose of issuance, 150% of the aggregate number of shares of our common stock issuable upon exercise of  the warrant; that we maintain a minimum cash balance of at least $500,000; that the aggregate dollar amount of all accounts payable be no more than 100 days past due; and that we maintain a current ratio, defined as current assets divided by current liabilities, of no less than 0.60 to 1.00.

In March 2009, we entered into a letter agreement with DMRJ pursuant to which we were granted access to $250,000 of previously restricted cash out of funds held in a blocked account.  The effect of the letter agreement made $250,000 available to us until the close of business on April 14, 2009. In consideration of the letter agreement, in March 2009, we issued an amended and restated senior secured convertible promissory note and amended and restated warrant to DMRJ to purchase shares of common stock, which replaced the note and warrant issued in December 2008.  The terms of the amended and restated note and the amended and restated warrant are identical to the terms of the original note and warrant, except that the amended instruments reduced the initial conversion price of the original note from $0.26 to $0.18 and reduced the initial exercise price of the original warrant from $0.26 to $0.18.  

In July 2009, we entered into an amendment to the December 2008 note and warrant purchase agreement with DMRJ, pursuant to which we issued a senior secured promissory note to DMRJ in the principal amount of $1,000,000. We valued the note at its residual value of $726,000 based on the relative fair value of the Series F Convertible Preferred Stock issued in conjunction with the note (see Note 14).

The senior secured promissory note, which has been amended, as described below, originally bore interest at the rate of 2.5% per month. The principal balance of the note, together with all outstanding interest and all other amounts owed under the note, was originally due and payable on the earlier of (i) December 10, 2009 and (ii) the receipt by us of net proceeds of at least $3,000,000 from the issuance of debt and/or equity securities in one or more transactions. In addition, DMRJ may require us to prepay such amounts upon (i) certain consolidations, mergers and business combinations involving us; (ii) the sale or transfer of more than 50% of our assets, other than inventory sold in the ordinary course of business, in one or more related or unrelated transactions; or (iii) the issuance by us, in one or more related or unrelated transactions, of any equity securities or securities convertible into equity securities (other than options granted to employees and consultants pursuant to employee benefit plans approved by our Board of Directors), which results in net cash proceeds to us of more than $500,000; provided, however, that DMRJ could not require us to prepay more than the net cash proceeds of any transaction described in the preceding clause (iii) of this sentence. The note permitted us to prepay all or any portion of the principal amount, without penalty or premium, after prior notice to DMRJ.



- 15 -



IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


In connection with the additional note issued in July 2009, we also issued 1,646,663 shares of our Series F Convertible Preferred Stock to DMRJ. The Series F Preferred Stock was originally convertible into that number of shares of common stock which equaled the original issue price of the Series F Preferred Stock ($0.08 per share) divided by the “Series F Conversion Price.” All of the 1,646,663 shares of Series F Preferred Stock held by DMRJ were convertible into 16,466,630 shares of common stock, or 25% of our common stock, calculated on a fully diluted basis. The Series F Preferred Stock contained reset terms providing that, in the event that we issued additional shares of common stock (or securities convertible into or exercisable for additional shares of common stock) at a price below the Series F Conversion Price then in effect, the Series F Conversion Price would be automatically adjusted to equal the price per share at which such shares are issued. The reset provision did not apply, however, to issuances of stock and options to our employees, directors, consultants and advisors pursuant to any equity compensation plan approved by our stockholders. In April 2011, as further described below, DMRJ exchanged all of the shares of Series F Preferred Stock held by it for shares of a new Series G Convertible Preferred Stock. The terms of the Series G Preferred Stock are identical to the terms of the Series F Preferred Stock, except that the Series G Preferred Stock terms do not include reset provisions for dilutive issuances of our common stock.

In August 2009, we entered into a second amendment to the December 2008 note and warrant purchase agreement, pursuant to which we issued DMRJ a bridge note in the principal amount of $700,000.  The note bore interest at the rate of 25% per annum. The outstanding principal balance and all interest due under this bridge note were paid in September 2009.

In September 2009, we entered into an additional credit agreement with DMRJ, pursuant to which DMRJ provided us with a revolving line of credit in the maximum principal amount of $3,000,000. In connection with the credit agreement, we issued a promissory note to DMRJ evidencing our obligations under the credit facility. Each of our subsidiaries guaranteed our obligations under the credit facility. Our obligations and our subsidiaries’ obligations are secured by grants of first priority security interests in all of our respective assets. In addition, we agreed to cause all of our receivables and collections to be deposited in a bank deposit account pledged to DMRJ pursuant to a blocked account agreement. All funds deposited in the blocked collections account are applied towards the repayment of our obligations to DMRJ under the note. Until the note and all of our obligations thereunder have been paid and satisfied in full, we will have no right to access or make withdrawals from the blocked account without DMRJ’s consent.

The revolving line of credit, which has been amended, as described below, originally bore interest at the rate of 25% per annum. Interest under the note is due on the first day of each calendar month. The principal balance of the note, together with all outstanding interest and all other amounts owed under the note, was originally due and payable in December 2009. We may prepay all or any portion of the principal amount of the note, without penalty or premium, after prior notice to DMRJ. Subject to applicable cure periods, amounts due under the note are subject to acceleration upon certain events of default, including: (i) any failure to pay when due any amount owed under the note; (ii) any failure to observe or perform any other condition, covenant or agreement contained in the note or certain conditions, covenants or agreements contained in the credit agreement; (iii) certain suspensions of the listing or trading of our common stock; (iv) a determination that any misrepresentation made by us to DMRJ in the credit agreement or in any of the agreements delivered to DMRJ in connection with the credit agreement were false or incorrect in any material respect when made; (v) certain defaults under agreements related to any of our other indebtedness; (vi) the institution of certain bankruptcy and insolvency proceedings by or against us; (vii) the entry of certain monetary judgments against us that are not dismissed or discharged within a period of 20 days; (viii) certain cessations of our business in the ordinary course; (ix) the seizure of any material portion of our assets by any governmental authority; and (x) our indictment for any criminal activity.

In lieu of paying DMRJ any commitment fees, closing fees or other fees in connection with the credit agreement, we agreed to pay DMRJ an additional amount equal to 50% of our aggregate net profits, as defined, generated between the closing date through the termination of the credit facility. For the period September 4, 2009 through January 12, 2010, the date as of which this arrangement was cancelled, we experienced a net loss and no such payments were due or payable to DMRJ.

Upon the closing of the credit facility, we requested and were granted an initial advance of approximately $1,633,000, of which we used approximately $715,000 to repay all of our outstanding indebtedness to DMRJ pursuant to the bridge note issued to DMRJ in August 2009, and approximately $548,000 to retire certain obligations owed to other parties. We used the balance of the initial advance for working capital and ordinary course general corporate purposes.



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IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


We failed to pay an aggregate of $7,505,678 in principal, together with approximately $149,292 of interest, due to DMRJ in December 2009, the maturity of each of the promissory notes described above.  On December 20, 2009, we received written notice from DMRJ, stating that we were in default of our obligations under each of the notes.

As a result of these defaults, effective December 11, 2009, (i) the interest rate that we were obligated to pay to DMRJ under the promissory note issued in March 2009 automatically increased from 11% per annum to 2.5% per month; (ii) the interest rate that we were obligated to pay to DMRJ under the promissory note issued in July 2009 automatically increased from 2.5% per month to 3.0% per month; and (iii) the interest rate that we were obligated to pay to DMRJ under the promissory note issued in September 2009 increased from 25% per annum to 30% per annum. All such default interest is payable upon demand by DMRJ.

On December 31, 2009, we received further written notice from DMRJ, withdrawing its default notice. Also, on December 31, 2009, DMRJ elected to convert $120,000 of the principal amount owed by us under the senior secured convertible promissory note into 1,500,000 shares of our common stock, at an adjusted conversion price of $.08 per share. DMRJ has subsequently converted additional portions of our indebtedness on similar terms. Under the promissory notes and related agreements, however, DMRJ may not convert any portion of the notes if the number of shares of common stock to be issued pursuant to such conversion, when aggregated with all other shares of common stock owned by DMRJ at such time, would result in DMRJ beneficially owning in excess of 4.99% of the then issued and outstanding shares of common stock. DMRJ may waive such limitation by providing us with 61 days’ prior written notice.

In January 2010, we amended each of our credit instruments with DMRJ. Pursuant to those amendments: (i) our line of credit under the September 2009 credit agreement was increased from $3,000,000 to $5,000,000; (ii) the maturity of all of our indebtedness to DMRJ under each of the notes described above was extended from December 10, 2009 to June 10, 2010; (iii) DMRJ waived all existing defaults under all of these promissory notes and all related credit agreements through the new maturity date of June 10, 2010; (iv) the interest rate payable on our obligations under each of the promissory notes was reduced to 15% per annum; (v) all arrangements pursuant to which we were to share with DMRJ any profits resulting from certain transactions were removed from the credit documents; (vi) we agreed to certain limitations on equity financings without DMRJ’s prior consent; and (vii) we agreed that we will not prepay more than $3,600,000 of the $5,600,000 of indebtedness owed to DMRJ under the March 2009 amended and restated promissory note without DMRJ’s prior consent.

In April 2010, we further amended each of our credit instruments with DMRJ. Pursuant to those amendments: (i) our line of credit under the September 2009 credit agreement was increased from $5,000,000 to $10,000,000; and (ii) the maturity of all of our indebtedness to DMRJ, including indebtedness under each of the promissory notes described in the preceding paragraphs, was extended from June 10, 2010 to September 30, 2010.

In September 2010, we further amended each of our credit instruments with DMRJ. Pursuant to those amendments, the maturity of all of our indebtedness to DMRJ, including indebtedness in the preceding paragraphs, was extended from September 30, 2010 to March 31, 2011.

In March 2011, we further amended each of our credit instruments with DMRJ. Pursuant to those amendments, the maturity of all of our indebtedness to DMRJ was extended to April 7, 2011 and our line of credit under the September 2009 credit agreement was increased from $10,000,000 to $15,000,000.

In April 2011, we further amended each of our credit instruments with DMRJ. Those amendments: (i) extended the maturity our all our indebtedness to DMRJ from April 7, 2011 to September 30, 2011; (ii) waived our compliance with certain financial covenants in the notes and all related credit agreements through maturity; (iii) removed the reset provisions from both the senior secured convertible promissory note and the amended and restated warrant; (iv) fixed the conversion and exercise price of the senior secured convertible promissory note and the amended and restated warrant at $0.08 per share; (v) established the order in which our prepayments of the notes would be applied; (vi) required that we authorize a new series of Series G Convertible Preferred Stock, with terms identical  to the Series F Preferred Stock except that the Series G Preferred Stock would not contain the reset antidilution provision; (vii) required that we issue DMRJ 0.1 share of Series G Preferred Stock in exchange for each share of Series F Preferred Stock held by it; and (viii) provided DMRJ with the right of first refusal on any new securities we may issue to any third party.



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IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


The Series G Preferred Stock is convertible into that number of shares of common stock which equals the original issue price of the Series G Preferred Stock ($0.08 per share) divided by the “Series G Conversion Price” (originally $0.08 per share), multiplied by 100. All of the 164,667 shares of Series G Preferred Stock held by DMRJ were originally convertible into 16,466,700 shares of common stock, or 25% of our common stock, calculated on a fully diluted basis. The Series G Preferred Stock is entitled to participate on an “as converted” basis in all dividends or distributions declared or paid on our common stock. In the event of any liquidation, dissolution or winding up of our company, the holders of the Series G Preferred Stock will be entitled to be paid an amount equal to $.08 per share of Series G Preferred Stock, multiplied by 100, plus any declared but unpaid dividends, prior to the payment of any amounts to the holders of our common stock by reason of their ownership of such stock.

The holders of the Series G Preferred Stock have no voting rights except as required by applicable law. However, without the consent of the holders of a majority of the Series G Preferred Stock, we may not (i) amend, alter or repeal any provision of our Restated Articles of Organization or By-laws in a manner that adversely affects the powers, preferences or rights of the Series G Preferred Stock; (ii) authorize or issue any equity securities (or any equity or debt securities convertible into equity securities) ranking prior and superior to the Series G Preferred Stock with respect to dividends, distributions, redemption rights or rights upon liquidation, dissolution or winding up; or (iii) consummate any capital reorganization or reclassification of any of our equity securities (or debt securities convertible into equity securities) into equity securities ranking prior and superior to the Series G Preferred Stock with respect to dividends, distributions, redemption rights or rights upon liquidation, dissolution or winding up.

In addition, for as long as the July 2009 note or the amended and restated senior secured convertible promissory note issued to DMRJ in March 2009 remain outstanding, we may not issue additional shares of common stock, or other securities convertible into or exercisable for common stock, if such securities would increase the number of shares of our common stock, calculated on a fully diluted basis, unless we simultaneously issue to DMRJ that number of additional shares of Series G Preferred Stock which is necessary to result in the number of shares of common stock into which all Series G Preferred Stock held by DMRJ may be converted representing the same percentage ownership of our common stock on a fully diluted basis after such issuance as immediately prior thereto.

We considered the guidance in ASC 470-50-40-15, “Debt Modifications and Extinguishments,” and have concluded that the April 2011 amendment to the DMRJ credit facility was a debt modification, not an extinguishment, and have not recognized a gain or loss on this transaction in our consolidated statements of operations.  Further, we did not recognize a beneficial conversion feature or reassess an existing beneficial conversion feature as a result of this amendment.

In September 2011, we further amended each of our credit instruments with DMRJ. Pursuant to those amendments: (i) the maturity of our indebtedness to DMRJ was extended from  September 30, 2011 to March 31, 2012; (ii) DMRJ waived our compliance with certain financial covenants in the notes and all related credit agreements through maturity; (iii) our line of credit under the September 2009 credit agreement was increased from $15,000,000 to $23,000,000; and (iv) we were required to repay sufficient amounts of our outstanding indebtedness under the notes and related credit agreements and other amounts owing to DMR such that as of December 31, 2011, the outstanding obligations to DMRJ shall not exceed $15,000,000.

In October 2011, we further amended each of our credit instruments with DMRJ, to eliminate the obligation to repay any portion of our outstanding indebtedness to DMRJ by December 31, 2011.

In February 2012, we amended each of our credit instruments with DMRJ, to extend the maturity of all of our indebtedness to DMRJ to September 30, 2012.

In September 2012, we further amended each of our credit instruments with DMRJ. Pursuant to those amendments: (i) we extended the maturity date of all of our indebtedness from September 30, 2012 to March 31, 2013 and (ii) issued to DMRJ a second senior secured convertible promissory note in the principal amount of $12,000,000 (the “September 2012 Note”).

The September 2012 Note bears interest at the rate of 15% per annum. The principal balance of this note, together with all outstanding interest and all other amounts owed thereunder, was due and payable on March 31, 2013. The Second Senior Secured Convertible Promissory Note is convertible in whole or in part, at DMRJ’s option, into shares of Series H Convertible Preferred Stock  at an initial conversion rate of $1,000 per share (as adjusted in the event of any stock dividend, stock split, combination or other similar recapitalization with respect to the Series H Preferred Stock, the “Series H Original Issue Price”).



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IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


The September 2012 Note originally gave DMRJ the option to require us to repurchase any or all of the shares of Series H Preferred Stock owned by DMRJ, at the Series H Original Issue Price per share, if we did not (i) by March 31, 2013, have at least one of our products receive qualified or approved status on the “Transportation Security Administration Air Cargo Screening Technology List (ACSTL) – For Passenger Aircraft” or placed on the Transportation Security Administration’s “Explosive Trace Detector Qualified Product List (QPL)”; or (ii) achieve revenues of at least $7,500,000 per fiscal quarter, commencing with fiscal quarter ending June 30, 2013. As described below, the note was subsequently amended to eliminate this option.

The holders of the Series H Preferred Stock will be entitled to receive, prior to the payment of any dividends with respect to our Common Stock and/or Series G Convertible Preferred Stock, cumulative dividends on each share of Series H Preferred Stock at a rate equal to 15% of the Series H Original Issue Price per annum, (i) when, as and if declared by our Board of Directors, (ii) upon a liquidation, dissolution or winding up of the Company (a “Liquidation Event”), or (iii) upon the repurchase or conversion of the Series H Preferred Stock All dividends accruing on the Series H Preferred Stock are payable by the issuance of additional shares of Series H Preferred Stock.

Upon a Liquidation Event, the holders of shares of Series H Preferred Stock then outstanding will be entitled to be paid out of the assets of the company available for distribution to its stockholders, before any payment is made to the holders of Common Stock and/or Series G Preferred Stock in respect of such stock, an amount per share equal to the Series H Original Issue Price, plus any accrued but updated dividends thereon, whether or not declared. At the option of holders of a majority of the outstanding Series H Preferred Stock, (i) a consolidation or merger of us with or into another entity or person, or any other corporate reorganization, in which the our stockholders immediately prior to such consolidation, merger or reorganization do not hold at least a majority of the resulting or surviving entities’ voting power immediately following such consolidation, merger or reorganization, or (ii) a sale or transfer of all or substantially all of our assets for cash, securities or other property, will be deemed to be a Liquidation Event.

Each share of Series H Preferred Stock will be convertible, at the option of the holder, into that number of shares of Common Stock as is determined by (i) dividing the Series H Original Issue Price by the Series H Conversion Price (as defined below) in effect at the time of conversion and (ii) multiply the result by 1,000. The “Series H Conversion Price” will initially be equal to $1,090, and is subject to adjustment in the event that (a) we issue additional shares of Common Stock as a dividend or other distribution on outstanding shares of Common Stock, (b) there is a split or subdivision of outstanding shares of Common Stock, or (c) there is a combination or reverse stock split of outstanding shares of Common Stock into a smaller number of shares of Common Stock. Assuming no adjustments to the Series H Original Issue Price or the Series H Conversion Price, the New Note will be convertible indirectly, at DMRJ’s option, into shares of Common Stock at an effective conversion price of $1.09 per share, which represents a discount of approximately 20% from the daily volume weighted average price of the Common Stock over the 20 trading days preceding the date of the amendment.

The holders of the Series H Preferred Stock will have no voting rights except as required by applicable law. However, without the consent of the holders of a majority of the outstanding Series H Preferred Stock, we may not (i) amend, alter or repeal any provision of its Articles of Organization or By-laws in a manner that adversely affects the powers, preferences or rights of the Series H Preferred Stock; (ii) authorize or issue any equity securities (or any equity or debt securities convertible into equity securities) ranking prior and superior to the Series H Preferred Stock with respect to dividends, distributions, redemption rights or rights upon liquidation, dissolution or winding up; or (iii) consummate any capital reorganization or reclassification of any of its equity securities (or debt securities convertible into equity securities) into equity securities ranking prior and superior to the Series H Preferred Stock with respect to dividends, distributions, redemption rights or rights upon liquidation, dissolution or winding up.



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IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


On February 28, 2013, we further amended each of our credit instruments with DMRJ. Pursuant to those amendments:

·

the maturity of all of our indebtedness to DMRJ was extended from March 31, 2013 to March 31, 2014;

·

DMRJ waived our compliance with certain financial covenants in each of our promissory notes and all related credit agreements through the new maturity date;

·

DMRJ’s option to require us to repurchase any or all of the shares of Series H Convertible Preferred Stock ) which may be issued upon conversion of the September 2012 Note was eliminated;

·

we issued to DMRJ a third senior secured convertible promissory note dated February 28, 2013, in the aggregate principal amount of $12,000,000 (the “February 2013 Note”). Payment for the February 2013 Note was made by the cancellation of $12,000,000 of principal of the outstanding indebtedness under our credit agreement;

·

DMRJ acquired the option to convert the amended and restated senior secured convertible promissory note dated March 12, 2012 (the “March 2009 Note”) into shares of Series J Convertible Preferred Stock in lieu of shares of Common Stock; and

·

the March 2009 Note and the September 2012 Note were amended to permit us to prepay any or all of our indebtedness thereunder on 30 days’ prior notice.

The February 2013 Note bears interest at the rate of 15% per annum. The principal balance of this note, together with all outstanding interest and all other amounts owed thereunder, will be due and payable on March 31, 2014. The February 2013 Note is convertible in whole or in part, at DMRJ’s option, into shares of Series I Convertible Preferred Stock at an initial conversion rate of $1,000 per share (as adjusted in the event of any stock dividend, stock split, combination or other similar recapitalization with respect to the Series I Preferred Stock, the “Series I Original Issue Price”). We may prepay this note on 30 days’ prior notice.

As amended, the March 2009 Note is convertible in whole or in part, at DMRJ’s option, into shares of Series J Convertible Preferred Stock at an initial conversion rate of $1,000 per share (as adjusted in the event of any stock dividend, stock split, combination or other similar recapitalization with respect to the Series J Preferred Stock, the “Series J Original Issue Price”).

The holders of the Series I Preferred Stock will be entitled to receive, prior to the payment of any dividends with respect to our Common Stock and/or Series G Preferred Stock, cumulative dividends on each share of Series I Preferred Stock at a rate equal to 15% of the Series I Original Issue Price per annum, (i) when, as and if declared by our Board of Directors, (ii) upon a “Liquidation Event”, or (iii) upon the conversion of the Series I Preferred Stock All dividends accruing on the Series I Preferred Stock are payable by the issuance of additional shares of Series I Preferred Stock.

The holders of Series J Preferred Stock will be entitled to participate on an “as converted” basis in all dividends or distributions declared or paid on our Common Stock.

Upon a Liquidation Event, the holders of shares of Series I Preferred Stock and Series J Preferred Stock then outstanding will be entitled to be paid out of the assets of the company available for distribution to its stockholders, pari passu with distributions made with respect to the Series H Preferred Stock but before any payment is made to the holders of Common Stock and /or Series G Preferred Stock in respect of such stock, (i) an amount per share of Series I Preferred Stock equal to the Series I Original Issue Price, plus any accrued but updated dividends thereon, whether or not declared, and (ii) an amount per share of Series J Preferred Stock equal to the Series J Original Issue Price, plus any dividends declared but unpaid thereon. At the option of holders of a majority of the outstanding Series I Preferred Stock, (i) a consolidation or merger of the company with or into another entity or person, or any other corporate reorganization, in which the stockholders of the company immediately prior to such consolidation, merger or reorganization do not hold at least a majority of the resulting or surviving entities’ voting power immediately following such consolidation, merger or reorganization, or (ii) a sale or transfer of all or substantially all of our assets for cash, securities or other property, will be deemed to be a Liquidation Event.




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IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


Upon any such Liquidation Event, and after all payments described in the preceding paragraph are made in full in respect of the Series H Preferred Stock, the Series I Preferred Stock and the Series J Preferred Stock, the holders of the Series G Preferred Stock will be entitled to be paid out of the assets of the company available for distribution to its stockholders an amount equal to $8.00 per share of Series G Preferred Stock, plus any declared but unpaid dividends, prior to the payment of any amounts to the holders of our Common Stock by reason of their ownership of such stock.

Each share of Series I Preferred Stock will be convertible, at the option of the holder, into that number of shares of Common Stock as is determined by (i) dividing the Series I Original Issue Price by the Series I Conversion Price (as defined below) in effect at the time of conversion and (ii) multiplying the result by 1,000. The “Series I Conversion Price” will initially be equal to $1,180.00, and is subject to adjustment in the event that (a) we issue additional shares of Common Stock as a dividend or other distribution on outstanding shares of Common Stock, (b) there is a split or subdivision of outstanding shares of Common Stock, or (c) there is a combination or reverse stock split of outstanding shares of Common Stock into a smaller number of shares of Common Stock. Assuming no adjustments to the Series I Original Issue Price or the Series I Conversion Price, the February 2013 Note will be convertible indirectly, at DMRJ’s option, into shares of Common Stock at an effective conversion price of $1.18 per share, which represents premium of approximately 3% over the closing price of the Common Stock on the trading day preceding the date of the February 28, 2013 amendments.

Each share of Series J Preferred Stock will be convertible, at the option of the holder, into that number of shares of Common Stock as is determined by dividing the Series J Original Issue Price by the Series J Conversion Price (as defined below) in effect at the time of conversion. The “Series J Conversion Price” will initially be equal to $.08, and is subject to adjustment in the event that (a) the Company issues additional shares of Common Stock as a dividend or other distribution on outstanding shares of Common Stock, (b) there is a split or subdivision of outstanding shares of Common Stock, or (c) there is a combination or reverse stock split of outstanding shares of Common Stock into a smaller number of shares of Common Stock. Assuming no adjustments to the Series J Original Issue Price or the Series J Conversion Price, the March 2009 Note will be convertible indirectly, at DMRJ’s option, into shares of Common Stock at an effective conversion price of $.08 per share. Prior to the execution of the amendment, the March 2009 Note was convertible directly into shares of Common Stock at a conversion price of $.08 per share. Accordingly, we do not believe this change to be material.

The holders of the Series I Preferred Stock and the Series J Preferred Stock will have no voting rights except as required by applicable law. However, without the consent of the holders of a majority of the outstanding Series I Preferred Stock or Series J Preferred Stock, as the case may be, with each such series voting as a separate class, we may not (i) amend, alter or repeal any provision of our Articles of Organization or By-laws in a manner that adversely affects the powers, preferences or rights of the Series I Preferred Stock or Series J Preferred Stock, as the case may be; (ii) authorize or issue any equity securities (or any equity or debt securities convertible into equity securities) ranking prior and superior to the Series I Preferred Stock or Series J Preferred Stock, as the case may be, with respect to dividends, distributions, redemption rights or rights upon liquidation, dissolution or winding up; or (iii) consummate any capital reorganization or reclassification of any of its equity securities (or debt securities convertible into equity securities) into equity securities ranking prior and superior to the Series I Preferred Stock or Series J Preferred Stock, as the case may be, with respect to dividends, distributions, redemption rights or rights upon liquidation, dissolution or winding up.

As of March 31, 2013, there were no shares of Series H Preferred Stock, Series I Preferred Stock or Series J Preferred Stock outstanding.

The failure to refinance this indebtedness or otherwise negotiate extensions of our obligations to DMRJ would have a material adverse impact on our liquidity and financial condition and could force us to curtail or discontinue operations entirely and/or file for protection under bankruptcy laws.

Our ability to comply with our debt covenants in the future depends on our ability to generate sufficient sales and to control expenses, and will require us to seek additional capital through private financing sources.  There can be no assurances that we will achieve our forecasted financial results or that we will be able to raise additional capital to operate our business.  Any such failure would have a material adverse impact on our liquidity and financial condition and could force us to curtail or discontinue operations entirely and/or file for protection under bankruptcy laws.  Further, upon the occurrence of an event of default under certain provisions of our agreements with DMRJ, we could be required to pay default rate interest equal to the lesser of 2.5% per month and the maximum applicable legal rate per annum on the outstanding principal balance outstanding.



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IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


As of March 31, 2013, our obligation to DMRJ under a senior secured convertible promissory note, as amended, a second senior secured convertible promissory note, a third senior secured convertible promissory note, a senior secured promissory note and under a revolving line of credit approximated $3,184,000, $12,000,000, $12,000,000, $1,000,000 and $9,586,000, respectively.  Further, as of March 31, 2013, our obligation to DMRJ for accrued interest under these instruments approximated $4,390,000 and is included in current liabilities in the condensed consolidated financial statements.

As of May 6, 2013, our obligations to DMRJ under the amended and restated senior secured convertible promissory note, the second senior secured convertible promissory note, the third senior secured convertible promissory note, the senior secured promissory note and under the credit facility approximated $3,184,000, $12,000,000, $12,000,000, $1,000,000 and $10,862,000, respectively.  Further, as of May 6, 2013, our obligation to DMRJ for accrued interest under these instruments approximated $4,189,000.

14.

Series F Convertible Preferred Stock

In connection with the July 1, 2009 amendment to the December 10, 2008 note and warrant purchase agreement with DMRJ, pursuant to which we issued a senior secured promissory note to DMRJ in the principal amount of $1,000,000, we issued 871,763 shares of our Series F Convertible Preferred Stock.   The 871,763 shares of Series F Preferred Stock issued to DMRJ are convertible at the option of DMRJ into 15% of our common stock, calculated on a fully diluted basis.

Because we did not obtain net proceeds of at least $3,000,000 from the issuance of debt and/or equity securities by August 31, 2009 (later extended by DMRJ to October 1, 2009), we were required to issue to DMRJ 774,900 additional shares of Series F Preferred Stock. Upon the issuance of those shares, all of the Series F Preferred Stock then held by DMRJ was convertible into 25% of our common stock, calculated on a fully diluted basis. In addition, for so long as the promissory note issued in July 2009 or the amended and restated promissory note issued in March 2009 remain outstanding, we may not issue additional shares of common stock, or other securities convertible into or exercisable for common stock, if such securities would increase the number of shares of our common stock, calculated on a fully diluted basis, unless we simultaneously issued to DMRJ that number of additional shares of Series F Preferred Stock which is necessary to result in the number of shares of common stock into which all Series F Preferred Stock held by DMRJ would be converted representing the same percentage ownership of our common stock on a fully diluted basis after such issuance as immediately prior thereto (see Note 13).

As of the date of issuance, we recorded the relative fair value of the Series F Preferred Stock of approximately $274,000 against the July 1, 2009 senior secured promissory note, which was accreted to the note over the life of the note.  The fair value of the Series F Preferred Stock is equal to the fair value of the company, defined as the product of our common shares outstanding times the closing price of our common stock on the date of issuance, multiplied by 25%. For the year ended June 30, 2010, $274,000 was accreted to the note and was recorded as interest expense in our consolidated statement of operations. Accounting Standards Codification (“ASC”) 470-20 “Debt with Conversion and Other Options,” addresses the accounting for convertible instruments with beneficial conversion features.  In accordance with ASC 470-20, a conversion feature is beneficial, or “in the money,” when the conversion rate of the convertible security is below the market price of the underlying common stock.  A beneficial conversion feature, calculated as of the commitment date, is the difference between the convertible instruments conversion price and the fair value of the company’s common stock on that date multiplied by the number of common shares the Series F Preferred Stock converts into. On July 1, 2009 and August 31, 2009, the commitment dates for the Series F Preferred stock issuances, the fair value of our common stock was $0.10. The initial conversion price of the Series F Preferred Stock was $0.08 per share.  As of July 1, 2009, the beneficial conversion feature on the Series F Preferred Stock was $329,000 and was accounted for as a deemed dividend. On April 7, 2011, we entered into an omnibus fifth amendment to the credit agreement and seventh amendment to the note and warrant purchase agreement and issued shares of a new series of Series G Convertible Preferred Stock in exchange for the Series F Preferred Stock (see Note 15).



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IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


15.

Series G Convertible Preferred Stock

In April 2011, in conjunction with the amendment to the December 10, 2008 note and warrant purchase agreement with DMRJ, we issued 164,667 shares of our Series G Convertible Preferred Stock to DMRJ in exchange for 1,646,663 shares of our Series F Convertible Preferred Stock.

The Series G Preferred Stock is convertible into that number of shares of common stock which equals the original issue price of the Series G Preferred Stock ($0.08 per share) divided by the “Series G Conversion Price” (originally $0.08 per shares) multiplied by 100. All of the 164,667 shares of Series G Preferred Stock held by DMRJ were convertible into 16,466,700 shares of common stock, or 25% of our common stock, calculated on a fully diluted basis.  We have concluded that the April 2011 amendment to the DMRJ credit facility was a debt modification, not an extinguishment, and have not recognized a gain or loss on this transaction in our statements of operations.  Further, we did not recognize a beneficial conversion feature on the Series G Preferred Stock or reassess an existing beneficial conversion feature as a result of this amendment.

During the three and nine months ended March 31, 2013, DMRJ converted 75,500 and 128,500 shares of Series G Preferred Stock into 7,550,000 and 12,850,000 shares of our common stock, respectively.  As of March 31, 2013, DMRJ held 36,167 shares of Series G Preferred Stock.

16.

Stockholders’ Deficit

Common Shares Authorized

On January 17, 2013, we filed Articles of Amendment to our Restated Articles of Organization with the Commonwealth of Massachusetts increasing the total number of shares of common stock we are authorized to issue to 200,000,000 from 50,000,000 and decreased the par value of our common stock from $0.10 to $0.001. We reclassified $5,450,000 from common stock to additional paid in capital as a result of the change in par value. Our shareholders approved the proposal to increase the number of shares of common stock we are authorized to issue in June 2010.

Common Stock Options and Warrants

In connection with various financing agreements and services provided by consultants, we have issued warrants to purchase shares of our common stock.  The fair value of warrants issued is determined using a binomial option pricing model.  In December 2008, in conjunction with the issuance of the senior secured convertible note to DMRJ, we issued five-year warrants to purchase 1,000,000 shares of common stock at an initial exercise price of $0.26 per share.  The warrant is exercisable between December 10, 2008 and December 10, 2013.  We recorded the fair value of this warrant of approximately $160,000 against the senior secured convertible promissory note, which was accreted to the note and interest expense was recorded over the life of the note. In consideration of DMRJ’s execution of the letter agreement on March 12, 2009, we issued an amended and restated warrant to purchase shares of common stock, to reduce the initial exercise price of the warrant from $0.26 to $0.18. As a result of the issuance of the Series F Preferred Stock, in July 2009, the exercise price of the warrant was automatically reduced under its reset provisions to $0.08.  In April 2011, the conversion price of the warrant was fixed at $0.08 per share.  In March 2013, DMRJ exercised their warrant, via a cashless exercise, to purchase 929,204 shares of common stock.

In May 2011, we entered into two advisory and consulting services agreements, pursuant to which we agreed to issue up to an aggregate of 4,000,000 shares of our common stock.  In the three months and nine ended March 31, 2012, we issued 333,334 and 1,333,334 shares of common stock, respectively, having a value of $197,000 and $799,000, respectively, under these agreements. As of June 30, 2012, we had issued all of the shares under the consulting services agreements to the two advisors.  

As of March 31, 2013, there were warrants outstanding to purchase 1,830,352 shares of our common stock at exercise prices ranging from $0.30 to $1.40 expiring at various dates between January 1, 2014 and January 14, 2018.

We issued 1,229,204 and 120,000 shares of common stock during the three months ended March 31, 2013 and 2012, respectively, and 2,517,303 and 200,000 shares of common stock during the nine months ended March 31, 2013 and 2012, respectively, as a result of the exercise of options by employees and the exercise of warrants by consultants.



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IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


17.

Income Taxes

We are required to file federal and state income tax returns in the United States.  The preparation of these tax returns requires us to interpret the applicable tax laws and regulations in effect in such jurisdictions, which could affect the amount of tax paid by us. In consultation with our tax advisors, we base our tax returns on interpretations that are believed to be reasonable under the circumstances. The tax returns, however, are subject to routine reviews by the various federal and state taxing authorities in the jurisdictions in which we file tax returns. As part of these reviews, a taxing authority may disagree with respect to the income tax positions taken by us (“uncertain tax positions”) and, therefore, may require us to pay additional taxes. As required under applicable accounting rules, we accrue an amount for our estimate of additional income tax liability, including interest and penalties, which we could incur as a result of the ultimate or effective resolution of the uncertain tax positions. We account for income taxes using the asset and liability method. Under the asset and liability method, deferred tax assets and liabilities are recognized for the future tax consequences attributed to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences and carry-forwards are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.  A valuation allowance is established when necessary to reduce deferred tax assets to amounts expected to be realized.

We account for uncertain income tax positions by accruing for the estimated additional amount of taxes for the uncertain tax positions when the uncertain tax position does not meet the more likely than not standard for sustaining the position. We review and update our accrual as more definitive information becomes available from taxing authorities, upon completion of tax audits, upon expiration of statutes of limitation, or upon occurrence of other events.  This requires significant judgment, the use of estimates, and the interpretation and application of complex tax laws. Significant judgment is required in assessing the timing and amounts of deductible and taxable items and the probability of sustaining uncertain tax positions. The benefits of uncertain tax positions are recorded in our consolidated financial statements only after determining a more-likely-than-not probability that the uncertain tax positions will withstand challenge, if any, from tax authorities. When facts and circumstances change, we reassess these probabilities and record any changes in the consolidated financial statements as appropriate.

Deferred tax assets and liabilities are determined based on the differences between the financial statement carrying amounts and the tax basis of the assets and liabilities using the enacted tax rate in effect in the years in which the differences are expected to reverse.  A valuation allowance has been recorded against the deferred tax asset as it is more likely than not, based upon our analysis of all available evidence, that the tax benefit of the deferred tax asset will not be realized.

As of June 30, 2012, the Company has the following unused net operating loss and tax credit carryforwards available to offset future federal and state taxable income, both of which expire at various times as noted below:


(In thousands)

 

Net Operating Losses

 

Investment AMT & Research Credits

 

Expiration Dates

 

Federal

 

$

59,612

 

$

937

 

2023 to 2032

 

State

 

 

47,587

 

 

655   

 

2013 to 2027

 

We have recorded a full valuation allowance against our net deferred tax assets of $25,230,000 as of June 30, 2012 and March 31, 2013, due to uncertainties related to our ability to utilize these assets. The valuation allowance is based on our estimates of taxable income and the period over which our deferred tax assets will be recoverable.



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IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


Potential 382 Limitation

Our net operating loss carryforwards are subject to review and possible adjustment by the Internal Revenue Service.  Our ability to utilize our net operating loss (“NOL”) and alternative minimum tax (“AMT”) and research and development credit (“R&D”) carryforwards may be substantially limited due to ownership changes that may have occurred or that could occur in the future, as required by Section 382 of the Internal Revenue Code of 1986, as amended (the “Code”), as well as similar state provisions.  These ownership changes may limit the amount of NOL, AMT and R&D credit carryforwards that can be utilized annually to offset future taxable income and tax, respectively.  In general, an ownership change, as defined in Section 382 of the Code, results from a transaction or series of transactions over a three-year period resulting in an ownership change of more than 50% of the outstanding stock of a company by certain stockholders or public groups.

We have not completed a study to assess whether one or more ownership changes have occurred since we became a loss corporation as defined in Section 382 of the Code, but we believe that it is likely that an ownership change has occurred.  If we have experienced an ownership change, utilization of the NOL, AMT and R&D credit carryforwards would be subject to an annual limitation, which is determined by first multiplying the value of our common stock at the time of the ownership change by the applicable long-term, tax-exempt rate, and then could be subject to additional adjustments, as required.  Any such limitation may result in the expiration of a portion of the NOL, AMT or R&D credit carryforwards before utilization.  Until a study is completed and any limitation known, no amounts are being considered as an uncertain tax position or disclosed as an unrecognized tax benefit under FIN No. 48.  Any carryforwards that expire prior to utilization as a result of such limitations will be removed from deferred tax assets with a corresponding adjustment to the valuation allowance.  Due to the existence of the valuation allowance, it is not expected that any potential limitation will have a material impact on our operating results.

Our net operating loss carryforwards are subject to review and possible adjustment by the Internal Revenue Service and are subject to certain limitations in the event of cumulative changes in the ownership interest of significant stockholders over a three-year period in excess of 50%.

From time to time we may be assessed interest or penalties by major tax jurisdictions, namely the states of Massachusetts and California.  At the adoption date and as of March 31, 2013, we had no material unrecognized tax benefits and no adjustments to liabilities or operations were required. No interest and penalties have been recognized by the Company to date.

Tax years 2009 through 2012 are subject to examination by the federal and state taxing authorities.  There are no income tax examinations currently in process.

For the three and nine months ended March 31, 2013 and 2012, we provided for no taxes in our consolidated condensed statement of operations as we have significant net loss carryforwards.

18.

Commitments and Contingencies

We lease manufacturing, research and office space in Wilmington, Massachusetts, the lease of which expires on January 31, 2015.  Under the terms of the lease, we are responsible for our proportionate share of real estate taxes and operating expenses relating to this facility.  As a result of the Ion Metrics acquisition, we assumed a lease for research and office space in San Diego, California, which was renewed and expires on March 31, 2016.  Total rent expense, including assessments for maintenance and real estate taxes for the nine months ended March 31, 2013 and 2012, was $308,000 and $254,000, respectively.

In April 2007, in conjunction with our plans to conduct research, development and minor manufacturing work in New Mexico, we executed an operating lease which was initially to expire on May 1, 2010.  The lease allowed for early termination, which we elected in February 2008.  As a result of the early termination, we are responsible for reimbursing the landlord for certain leasehold improvements over a 24-month period.  As of March 31, 2013 and June 30, 2012, the balance due is approximately $27,000 and is included in current liabilities in the condensed consolidated balance sheets.



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IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


19.

Financial Information By Segment

Operating segments are defined as components of an enterprise about which separate financial information is available that is regularly evaluated by the chief operating decision maker or decision making group, in determining how to allocate resources and in accessing performance.  Our chief operating decision making group is composed of the chief executive officer and members of senior management.  Based on qualitative and quantitative criteria, we have determined that we operate within one reportable segment, which is the Security Products Segment.

20.

Legal Proceedings

In January 2011, Fulong Integrated Technique, Ltd. filed a complaint against us in the Middlesex Superior Court of the Commonwealth of Massachusetts, alleging non-payment of amounts owed for services provided to us in connection with the sale of handheld explosives detection equipment to a customer in China in the first quarter of fiscal 2009. Fulong sought general monetary damages, other statutory damages, attorneys’ fees and costs.

In March 2013, we entered into a settlement agreement with Fulong, which provided for the payment of $200,000 and the transfer of ownership of five QS-H150 detectors to Fulong.  We recognized a non-cash benefit of $295,000 in the three months ended March 31, 2013 as a result of the settlement.

We are not currently a party to any other legal proceedings, other than routine litigation incidental to our business that which we believe will not have a material effect on our business, assets or results of operations.  From time to time, we are subject to various claims, legal proceedings and investigations covering a wide range of matters that arise in the ordinary course of our business activities.  Each of these matters may be subject to various uncertainties.

21.

Subsequent Events

On April 1, 2013, we entered into a lease with Wakefield Investments, Inc. to lease approximately 58,000 square feet in Wilmington, Massachusetts, which facility will serve as our corporate offices. In addition to our corporate offices, this facility will house research and development, sales and marketing, and production. We anticipate moving to this location during the summer of 2013. Upon commencement of the lease term, our existing lease for space in Wilmington will terminate.

On April 22, 2013, we entered into two advisory and consulting services agreements, pursuant to which we agreed to issue an aggregate of 600,000 shares of our common stock and we issued warrants to purchase an aggregate of 2,000,000 shares of our common stock, at an exercise price of $1.10 per share.





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Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations


Cautionary Note Regarding Forward-Looking Statements

This Quarterly Report on Form 10-Q contains certain statements that are “forward-looking” within the meaning of the federal securities laws. These forward looking statements and other information are based on our beliefs as well as assumptions made by us using information currently available.

The words “anticipate,” “believe,” “estimate,” “expect,” “intend,” “will,” “should” and similar expressions, as they relate to us, are intended to identify forward-looking statements.  Such statements reflect our current views with respect to future events, are subject to certain risks, uncertainties and assumptions, and are not guaranties of future performance.  Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results may vary materially from those described herein as anticipated, believed, estimated, expected, intended or using other similar expressions.

We are making investors aware that such forward-looking statements, because they relate to future events, are by their very nature subject to many important factors that could cause actual results to differ materially from those contemplated by the forward-looking statements contained in this Report. Important factors that could cause actual results to differ from our predictions include those discussed under this “Management’s Discussion and Analysis” and under “Risk Factors,” as well as those discussed under “Risk Factors,” “Management’s Discussion and Analysis” and “Business” in our Annual Report on Form 10-K for the fiscal year ended June 30, 2012. Although we have sought to identify the most significant risks to our business, we cannot predict whether, or to what extent, any of such risks may be realized, nor can there be any assurance that we have identified all possible issues which we might face.  In addition, assumptions relating to budgeting, marketing, product development and other management decisions are subjective in many respects and thus susceptible to interpretations and periodic revisions based on actual experience and business developments, the impact of which may cause us to alter our marketing, capital expenditure or other budgets, which may in turn affect our financial position and results of operations.  For all of these reasons, the reader is cautioned not to place undue reliance on forward-looking statements contained herein, which speak only as of the date hereof.  We assume no responsibility to update any forward-looking statements as a result of new information, future events, or otherwise except as required by law.  We urge readers to review carefully the risk factors described in this Quarterly Report, in our Annual Report on Form 10-K for the fiscal year ended June 30, 2012 and in the other documents that we file with the Securities and Exchange Commission.  You can read these documents at www.sec.gov.

When we say “we,” “us,” “our,” “Company,” or “Implant Sciences,”, we mean Implant Sciences Corporation and its subsidiaries.

Overview

We develop, manufacture and sell sophisticated sensors and systems for the security, safety and defense industries.  A variety of technologies are currently used worldwide in security and inspection applications.  In broad terms, the technologies focus on detection in two major categories: (i) the detection of “bulk” contraband, which includes materials that would be visible to the eye, such as weapons, explosives, narcotics and chemical agents; and (ii) the detection of “trace” amounts of contraband, which includes trace particles or vapors of explosives, narcotics and chemical agents.  Technologies used in the detection of “bulk” materials include computed tomography, transmission and backscatter x-ray, metal detection, trace detection and x-ray, gamma-ray, passive millimeter wave, and neutron analysis.  Trace detection techniques used include mass spectrometry, gas chromatography, chemical luminescence, and ion mobility spectrometry.

We have developed proprietary technologies used in explosives and narcotics trace detection (“ETD” and “NTD”, respectively) applications and market and sell handheld ETD and benchtop ETD and NTD systems that use our proprietary technologies.  Our products are marketed and sold to a growing number of locations domestically and internationally.  These systems are used by private companies and government agencies to screen baggage, cargo, other objects and people for the detection of trace amounts of explosives and narcotics.

On January 16, 2013, our QS-B220 Benchtop Explosives and Narcotics Detector was accepted into the “Approved” section of the Transportation Security Administration’s Air Cargo Screening Technology List.

Please see our Annual Report on Form 10-K for the fiscal year ended June 30, 2012 for a complete description of our business.



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Critical Accounting Policies

Our significant accounting policies are summarized in Note 2 to our condensed consolidated financial statements included in Item 7 of our Annual Report on Form 10-K, for the fiscal year ended June 30, 2012.  However, certain of our accounting policies require the application of significant judgment by our management, and such judgments are reflected in the amounts reported in our condensed consolidated financial statements.  In applying these policies, our management uses  judgment to determine the appropriate assumptions to be used in the determination of estimates.  Those estimates are based on our historical experience, terms of existing contracts, our observance of market trends, information provided by our strategic partners and information available from other outside sources, as appropriate.  Actual results may differ significantly from the estimates contained in our condensed consolidated financial statements.  

Results of Operations

Three Months Ended March 31, 2013 vs. March 31, 2012

Revenues

Revenues for the three months ended March 31, 2013 were $1,262,000 as compared with $686,000 for the comparable prior year period, an increase of $576,000, or 84.0%.  The increase in revenue is due primarily to the shipment of an order to an agency of the U.S. Government, resulting in a 104% increase in the number of QS-H150 handheld units sold and increased sales of parts and supplies during the three months ended March 31, 2013, as compared to the comparable prior year period, and to a lesser extent by a 3.1% increase in average unit sell prices on sales our QS-H150 handheld units.

Cost of Revenues

Cost of revenues for the three months ended March 31, 2013 were $959,000 as compared with $504,000 for the comparable prior year period, an increase of $455,000 or 90.3%.  The increase in cost of revenues recorded in the three months ended March 31, 2013 is primarily due to increased unit sales of our security products, increased manufacturing overhead spending due to stock-based compensation recorded on the September 2012 officer and director option grants and increased manufacturing personnel costs, as compared to the comparable prior year period.

Gross Margin

Gross margin for the three months ended March 31, 2013 was $303,000 or 24.0% of revenues as compared with gross margin of $182,000 or 26.5% of revenues for the comparable prior year period.  The decrease in gross margin is primarily the result of increased manufacturing overhead spending due to stock-based compensation recorded on the September 2012 officer and director option grants and increased manufacturing personnel costs, as compared to the comparable prior year period.

Research and Development Expense

Research and development expense for the three months ended March 31, 2013 was $1,116,000 as compared with $799,000 for the comparable prior year period, an increase of $317,000 or 39.7%.  The increase in research and development expense is due primarily to increased payroll and related benefit costs, stock-based compensation recorded on the September 2012 officer and director option grants, partially offset by decreased contracted engineering. We continue to expend funds to further the development of new products in the areas of explosives and narcotics detection, as well as to prepare for certain government laboratory acceptance testing. Spending on research and development will increase in the next nine to twelve months due to the ongoing development of the QS-B220 benchtop explosives and narcotics detector and the development of a hyphenated system employing conventional ion mobility, differential mobility and quadrupole mass spectrometry.



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Selling, General and Administrative Expenses

Selling, general and administrative expenses for the three months ended March 31, 2013 were $3,191,000 as compared with $2,258,000 for the comparable prior year period, an increase of $933,000, or 41.3%.  The increase in selling, general and administrative expenses is due primarily a $1,244,000 increase in stock-based compensation recorded on the September 2012 officer and director option grants and warrants to purchase shares of our common stock, increased payroll, related benefit costs and travel expense resulting from the addition of sales personnel, legal costs incurred to increase our authorized shares, partially offset by lower consulting fees due to the issuance of our common stock to certain consultants in the comparable prior year period and the $295,000 benefit recognized as a result of the litigation settlement with Fulong.

Other Income and Expense, Net

For the three months ended March 31, 2013, other expense, net was $1,335,000 as compared with other expense, net of $1,015,000, for the comparable prior year period, an increase of $320,000. The increase was primarily due to increased interest expense on higher borrowings under our credit facility with DMRJ. Interest expense increased $320,000 to $1,336,000 in the three months ended March 31, 2013 from $1,016,000 in the comparable prior year period.

Net Loss

Our net loss for the three months ended March 31, 2013 was $5,339,000 as compared with a net loss of $3,890,000 for the comparable prior year period, an increase of $1,449,000, or 37.2%.  The increase in the net loss is primarily due to stock-based compensation recorded on the September 2012 officer and director option grants, increased operating expenses and increased interest expense.

Results of Operations

Nine Months Ended March 31, 2013 vs. March 31, 2012

Revenues

Revenues for the nine months ended March 31, 2013 were $9,615,000 as compared with $2,854,000 for the comparable prior year period, an increase of $6,761,000, or 236.9%.  The increase in revenue is due primarily to the shipment of the India Ministry of Defence order, sales to U.S. Government agencies, resulting in a 244% increase in the number of QS-H150 handheld units sold and increased sales of parts and supplies during the nine months ended March 31, 2013, as compared to the comparable prior year period and, to a lesser extent, incremental sales of our QS-B220 benchtop units, which we began shipping commercially in the third quarter of fiscal 2012, partially offset by an 6.4% decrease in average unit sell prices on sales our QS-H150 handheld units.

Cost of Revenues

Cost of revenues for the nine months ended March 31, 2013 were $6,883,000 as compared with $1,908,000 for the comparable prior year period, an increase of $4,975,000 or 260.7%.  The increase in cost of revenues recorded in the nine months ended March 31, 2013 is primarily due to increased unit sales of our security products, increased manufacturing overhead spending due to stock-based compensation recorded on the September 2012 officer and director option grants, costs incurred to support the India Ministry of Defence order and increased manufacturing personnel costs, as compared to the comparable prior year period.

Gross Margin

Gross margin for the nine months ended March 31, 2013 was $2,732,000 or 28.4% of revenues as compared with gross margin of $946,000 or 33.1% of revenues for the comparable prior year period.  The decrease in gross margin is primarily the result of increased manufacturing overhead spending due to stock-based compensation recorded on the September 2012 officer and director option grants, increased manufacturing personnel costs, costs incurred to support the India Ministry of Defence order and by the 6.4% decrease in the average unit sell prices on sales of our QS-H150 handheld units in the nine months ended March 31, 2013, as compared to the comparable prior year period.



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Research and Development Expense

Research and development expense for the nine months ended March 31, 2013 was $3,521,000 as compared with $2,365,000 for the comparable prior year period, an increase of $1,156,000 or 48.9%.  The increase in research and development expense is due primarily to stock-based compensation recorded on the September 2012 officer and director option grants and increased payroll and related benefit costs, partially offset by decreased contracted engineering. We continue to expend funds to further the development of new products in the areas of explosives and narcotics detection, as well as to prepare for certain government laboratory acceptance testing. Spending on research and development will increase in the next nine to twelve months due to the ongoing development of the QS-B220 benchtop explosives and narcotics detector and the development of a hyphenated system employing conventional ion mobility, differential mobility and quadrupole mass spectrometry.  

Selling, General and Administrative Expenses

Selling, general and administrative expenses for the nine months ended March 31, 2013 were $17,115,000 as compared with $6,053,000 for the comparable prior year period, an increase of $11,062,000, or 182.8%.  The increase in selling, general and administrative expenses is due primarily to a $10,847,000 increase in stock-based compensation recorded on the September 2012 officer and director option grants and warrants to purchase shares of our common stock, increased payroll, related  benefit costs and travel expense resulting from the addition of sales personnel, the imposition of liquidated damages of $298,000 under our contact with the India Ministry of Defence, due to delayed shipment, increased legal fees and costs incurred to increase our authorized shares, and increased bank fees, partially offset by lower consulting fees due to the issuance of our common stock to certain consultants in the comparable prior year period and the $295,000 benefit recognized as a result of the litigation settlement with Fulong.

Other Income and Expense, Net

For the nine months ended March 31, 2013, other expense, net was $3,906,000 as compared with other income, net of $2,780,000, for the comparable prior year period, an increase of $1,126,000. The increase was primarily due to increased interest expense on higher borrowings under our credit facility with DMRJ. Interest expense increased $1,125,000 to $3,908,000 in the nine months ended March 31, 2013 from $2,783,000 in the comparable  prior year period.

Net Loss

Our net loss for the nine months ended March 31, 2013 was $21,810,000 as compared with a net loss of $10,252,000 for the comparable prior year period, an increase of $11,558,000, or 112.7%.  The increase in the net loss is primarily due to stock-based compensation recorded on the September 2012 officer and director option grants, increased operating expenses and increased interest expense.

Liquidity and Capital Resources

As of March 31, 2013 and June 30, 2012, we had cash and cash equivalents of $0 and $84,000, respectively. On March 31, 2014, we must repay in full our obligations to DMRJ under four secured promissory notes and a revolving credit facility. As of March 31, 2013, our obligation to DMRJ under a senior secured convertible promissory note, as amended, a second senior secured convertible promissory note, a third senior secured convertible note, a senior secured promissory note and under a revolving line of credit approximated $3,184,000, $12,000,000, $12,000,000, $1,000,000 and $9,586,000, respectively.  Further, as of March 31, 2013, our obligation to DMRJ for accrued interest under these instruments approximated $4,390,000.  

As of May 6, 2013, our obligations to DMRJ under the amended and restated senior secured convertible promissory note, the second senior secured convertible promissory note, the senior secured promissory note and under the credit facility approximated $3,184,000, $12,000,000, $12,000,000, $1,000,000 and $10,862,000, respectively.  Further, as of May 6, 2013, our obligation to DMRJ for accrued interest under these instruments approximated $4,189,000.

Each of these notes and the credit facility are described in Note 13 of the Notes to Condensed Consolidated Financial Statements, accompanying this Quarterly Report.



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During the nine months ended March 31, 2013, we had net cash outflows of $7,336,000 from operating activities as compared to net cash outflows from operating activities of $7,358,000 for the comparable prior year period.  The approximately $22,000 decrease in net cash outflows used in operating activities during the three months ended March 31, 2013, as compared to the comparable prior year period, was due to the shipment of our order with the India Ministry of Defence, resulting in the following changes to working capital (i) a $975,000 decrease in inventories due to the shipment of the India Ministry of Defence order, compared to a $654,000 increase in inventories; (ii) a $512,000 decrease in prepaid expenses, compared to a $4,000 decrease due to primarily to a decrease in prepaid inventory, which inventory was shipped in the period ended March 31, 2013; (iii) an increase in accounts payable of $211,000, compared to an increase in accounts payable of $40,000 in the prior period, due to vendor terms dating;  (iv) a $1,548,000 increase in accrued expenses, compared to a $565,000 increase in accrued expenses in the prior year due primarily to increased accruals for unpaid interest on our borrowings with DMRJ, the imposition of liquidated damages under our contact with the India Ministry of Defence, due to delayed shipment and increased warranty reserves. These increases were partially offset by (v) a $777,000 decrease in deferred revenue, compared to a $71,000 increase in the prior year, due to the shipment of the India Ministry of Defence order; and, (vi) a $566,000 increase in accounts receivable, compared to a $904,000 decrease in accounts receivable due to the timing of product shipments in the current fiscal year.

During the nine months ended March 31, 2013, we had net cash outflows of $104,000 from investing activities as compared to net cash outflows of $178,000 from investing activities for the comparable prior year period.  The $74,000 decrease in net cash used in investing activities during the nine months ended March 31, 2013, as compared to the comparable prior year period, was primarily due to a $36,000 decrease in purchases of equipment, partially offset by a $18,000 decrease in cash transferred to restricted funds and the proceeds from the sale of equipment of $22,000.

During the nine months ended March 31, 2013 we had net cash inflows of $7,356,000 from financing activities as compared to net cash inflows of $7,274,000 from financing activities for the comparable prior year period.  The $82,000 increase in net cash from financing activities during the nine months ended March 31, 2013, as compared to the comparable prior year period, was primarily due to increased borrowings under our credit facility with DMRJ, compared to the prior fiscal year. During the nine months ended March 31, 2013, we received proceeds of $26,000 due to the exercise of employee stock options.

Credit Facilities with DMRJ Group LLC

In December 2008, we entered into a note and warrant purchase agreement with DMRJ, pursuant to which we issued a senior secured convertible promissory note in the principal amount of $5,600,000 and a warrant to purchase 1,000,000 shares of our common stock.  Thereafter, we entered into a series of amendments, waivers and modifications of this facility.  On February 28, 2013, we amended our credit agreements with DMRJ (see Note 13) pursuant to which we extended the maturity date of all of our indebtedness from March 31, 2013 to March 31, 2014 and issued to DMRJ a third senior secured convertible promissory note in the principal amount of $12,000,000. This note is convertible in whole or in part, at DMRJ’s option, into shares of Series I Convertible Preferred Stock at an initial conversion rate of $1,000 per share. There can be no assurance that we will be successful in refinancing or extending our obligations to DMRJ.  

Our ability to comply with our debt covenants in the future depends on our ability to generate sufficient sales and to control expenses, and will require us to seek additional capital through private financing sources.  In addition, we will require substantial funds for further research and development, regulatory approvals, and the marketing of our explosives detection products.  Our capital requirements depend on numerous factors, including but not limited to the progress of our research and development programs; the cost of filing, prosecuting, defending and enforcing any intellectual property rights; competing technological and market developments; changes in our development of commercialization activities and arrangements; and the hiring of additional personnel, and acquiring capital equipment.  There can be no assurances that we will achieve our forecasted financial results or that we will be able to raise additional capital to operate our business.  

Any failure to comply with our debt covenants, to achieve our projections and/or obtain sufficient capital on acceptable terms would have a material adverse impact on our liquidity, financial condition and operations and could force us to curtail or discontinue operations entirely and/or file for protection under bankruptcy laws.  Further, upon the occurrence of an event of default under certain provisions of our agreements with DMRJ, we could be required to pay default rate interest equal to the lesser of 3.0% per month and the maximum applicable legal rate per annum on the outstanding principal balance outstanding.



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Based on current sales, operating expense and cash flow projections, and the cash available from our line of credit, management believes there are plans in place to sustain operations for the next several months. Because there can be no assurances that sales will materialize as forecasted, and/or that management will be successful in refinancing or extending our obligations with DMRJ, management will continue to closely monitor and attempt to control our costs and will continue to actively seek the needed capital through government grants and awards, strategic alliances, private financing sources, and through its lending institutions.  Future expenditures for research and product development are discretionary and can be adjusted as can certain selling, general and administrative expenses, based on the availability of cash.  The financial statements do not include any adjustments relating to the recoverability and classification of asset amounts or the amounts and classification of liabilities that might be necessary should we be unable to continue as a going concern.

Despite our current sales, expense and cash flow projections and the cash available from our line of credit with DMRJ, we will require additional capital in the third quarter of fiscal 2014 to fund operations and continue the development, commercialization and marketing of our products. Our failure to achieve our projections and/or obtain sufficient additional capital on acceptable terms would have a material adverse effect on our liquidity and operations and could require us to file for protection under bankruptcy laws. These conditions raise substantial doubt as to our ability to continue as a going concern.

Off-Balance Sheet Arrangements

As of March 31, 2013, we had three irrevocable standby letters of credit outstanding in the approximate amount of $1,562,000.  These letters of credit (1) provide performance security equal to 5% of the amount of our contract with the India Ministry of Defence; (2) provide warranty performance security equal to 5% of the contract amount; and (3) provide security equal to 15% of the contract amount against an advance deposit under the terms of the contract.  We have amended each of the letters of credit, extending the expiration dates. As amended, the letters of credit expire between August 2, 2013 and May 4, 2015. On May 1, 2013, the letter of credit providing security for the advance deposit was cancelled, resulting in the release of $937,000 held in a certificate of deposit. The funds were applied to reduce our obligation for accrued interest and borrowings under the credit facility with DMRJ.  

As of March 31, 2013, we did not have any other off-balance sheet arrangements that have, or are reasonably likely to have, a current or future material effect on our consolidated financial condition, results of operations, liquidity, capital expenditures or capital resources.

New Accounting Pronouncements

In May 2011, the FASB issued Accounting Standards Update 2011-04, “Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS” (“ASU 2011-04”). The adoption of ASU 2011-04 gives fair value the same meaning between U.S. generally accepted accounting principles (“U.S. GAAP”) and International Financial Reporting Standards (“IFRS”), and improves consistency of disclosures relating to fair value. The provisions of ASU 2011-04 will be effective for fiscal years and interim periods beginning after December 15, 2011 and can be applied prospectively. However, changes in valuation techniques shall be treated as changes in accounting estimates.  The adoption of this update did not have a material effect on our consolidated financial position and results of operations.

Item 3.

Quantitative and Qualitative Disclosures About Market Risk

Not required pursuant to Item 305(e) of Regulation S-K.



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Item 4.

Controls and Procedures

The certifications of our Chief Executive Officer and Chief Financial Officer attached as Exhibits 31.1 and 31.2 to this Quarterly Report on Form 10-Q include, in paragraph 4 of such certifications, information concerning our disclosure controls and procedures, and internal control over financial reporting.  Such certifications should be read in conjunction with the information contained in this Item 4 for a more complete understanding of the matters covered by such certifications.

Disclosure Controls and Procedures

Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures as of March 31, 2013.  The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by the company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized, and reported, within the time periods specified in the rules and forms of the Securities and Exchange Commission.  Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions to be made regarding required disclosure.  It should be noted that any system of controls and procedures, however well designed and operated, can provide only reasonable, and not absolute, assurance that the objectives of the system are met and that management necessarily applies its

judgment in evaluating the cost-benefit relationship of possible controls and procedures. Our Chief Executive Officer and Chief Financial Officer, concluded that we did maintain effective internal control over financial reporting as of March 31, 2013 and further concluded that, as of such date, our disclosure controls and procedures were effective at the reasonable assurance level.

Changes in Internal Control Over Financial Reporting

There were no changes to our internal control over financial reporting during the quarter ended March 31, 2013 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.



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PART II.

OTHER INFORMATION

Item 1.

Legal Proceedings

From time to time, we are subject to various claims, legal proceedings and investigations covering a wide range of matters that arise in the ordinary course of our business activities. Each of these matters is subject to various uncertainties.

As previously reported, in January 2011, Fulong Integrated Technique, Ltd. filed a complaint against us in the Middlesex Superior Court of the Commonwealth of Massachusetts, alleging non-payment of amounts owed for services provided to us in connection with the sale of handheld explosives detection equipment to a customer in China in the first quarter of 2009.

In March 2013, we entered into a settlement agreement with Fulong, which provided for the payment of $200,000 and the transfer of ownership of five QS-H150 detectors to Fulong.  We recognized a non-cash benefit of $295,000 in the three and nine months ended March 31, 2013 as a result of the settlement.

We are not a party to any other legal proceedings, other than ordinary routine litigation incidental to our business, which we believe will not have a material affect on our business, assets or results of operations.

Item 1A.

Risk Factors

Other than as set forth below, there have not been any material changes from the risk factors previously disclosed under Item 1A of our Annual Report on Form 10-K, for the fiscal year ended June 30, 2012.

We will be required to repay our borrowings from DMRJ Group LLC on March 31, 2014.  

We will be required to repay all of our borrowings from DMRJ on March 31, 2014.  Our obligations to DMRJ are secured by a security interest in substantially all of our assets. As of May 6, 2013, our obligations to DMRJ under four secured promissory notes and our revolving credit facility approximated $3,184,000, $12,000,000, $12,000,000, $1,000,000 and $10,862,000, respectively.  Further, as of May 6, 2013, our obligation to DMRJ for accrued interest under these instruments approximated $4,189,000.

  If we are unable to repay these amounts as required, refinance our obligations to DMRJ, or negotiate extensions of these obligations, DMRJ may seize our assets and we may be forced to curtail or discontinue operations entirely and/or file for protection under bankruptcy laws.

We will require additional capital to fund operations and continue the development, commercialization and marketing of our product.  Our failure to raise capital could have a material adverse effect on the business.

Management continually evaluates plans to reduce our operating expenses, increase sales and increase our cash flow from operations.  Despite our current sales, expense and cash flow projections, we will require additional capital in the third quarter of fiscal 2014 to fund operations and continue the development, commercialization and marketing of our products. Our failure to achieve our projections and/or obtain sufficient additional capital on acceptable terms would have a material adverse effect on our liquidity and operations and could require us to file for protection under bankruptcy laws.



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Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

In January 2013, we issued warrants to purchase an aggregate 50,000 shares of our common stock, at exercise prices of $1.14 per share, to two consultants, in consideration of services rendered to us under consulting agreements. The issuance of this warrant was exempt from registration under the Securities Act pursuant to an exemption provided by Section 4(2) of the Securities Act.

In January 2013 and in February 2013, in a series of transactions, DMRJ converted 55,500 and 20,000 shares, respectively, of the Series G Convertible Preferred Stock into 5,550,000 and 2,000,000 shares of our common stock. The issuance of these securities to DMRJ is exempt from registration under the Securities Act of 1933, as amended, pursuant to an exemption provided by Section 3(a)(9) and/or Section 4(2) of the Securities Act.

In March 2013, DMRJ exercised a warrant, on a “cashless” basis, to purchase 929,204 shares of our common stock. The issuance of these securities to DMRJ is exempt from registration under the Securities Act of 1933, as amended, pursuant to an exemption provided by Section 3(a)(9) and/or Section 4(2) of the Securities Act.

In April 2013, we agreed to issue up to an aggregate 600,000 shares of our common stock and we issued warrants to purchase an aggregate of 2,000,000 shares of our common stock, at an exercise price of $1.10 per share, to two consultants, in consideration of services rendered to us under two consulting agreements. The issuance of these warrants was exempt from registration under the Securities Act pursuant to an exemption provided by Section 4(2) of the Securities Act.

Item 3.

Defaults Upon Senior Securities

None.

Item 4.

Mine Safety Disclosures

None.

Item 5.

Other Information

None.



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Item 6.

Exhibits

Exhibit No.

Ref. No.

Description

3.1

(1)

Restated Articles of Organization, as amended, of Implant Sciences Corporation.

10.1

(1)

Lease, dated April 1, 2013, between Implant Sciences Corporation and Wakefield Investments, Inc.

10.2

(2)

Omnibus Tenth Amendment to Credit Agreement and Twelfth Amendment to Note and Warrant Purchase Agreement, dated as of February 28, 2013 between Implant Sciences Corporation and DMRJ Group LLC.

10.3

(2)

Senior Secured Convertible Promissory Note, dated as of February 28, 2013, issued by Implant Sciences Corporation

31.1

(1)

Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2

(1)

Certification of the Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1

(3)

Certification of the Chief Executive Officer Pursuant to 18 U.S.C. 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2

(3)

Certification of the Chief Financial Officer Pursuant to 18 U.S.C. 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

101.INS

(4)

XBRL Instance Document.

101.SCH

(4)

XBRL Taxonomy Extension Schema Document.

101.CAL

(4)

XBRL Taxomony Extension Calculation Linkbase Document.

101.LAB

(4)

XBRL Taxonomy Extension Label Linkbase Document.

101.PRE

(4)

XBRL Taxonomy Extension Presentation Linkbase Document.

101.DEF

(4)

XBRL Taxonomy Extension Definition Linkbase Document.


 

(1)

Filed herewith.

 

(2)

Filed as an Exhibit to Implant Sciences Corporation’s Form 8-K dated February 28, 2013 and filed March 1, 2013, and incorporated herein by reference.

 

(3)

In accordance with Item 601(b)(32)(ii) of Regulation S-K, the certifications furnished in Exhibits 32.1 and 32.2 hereto are deemed to accompany this Form 10-Q and will not be deemed to be “filed” for purposes of Section 18 of the Exchange Act.  Such certifications will not be deemed to be incorporated by reference into any filings under the Securities Act or the Exchange Act, except to the extent that the registrant specifically incorporates it by reference.

 

(4)

In accordance with Rule 406T of Regulation S-T, the information in these exhibits shall not be deemed to be “filed” or part of a registration statement for purposes of Sections 11 and 12 of the Securities Act, shall not be deemed “filed” for purposes of Section 18 of the Exchange Act and is not otherwise subject to liability under these sections, and shall not be incorporated by reference into any registration statement or other document filed under the Securities Act, except as expressly set forth by specific reference in such filing.

 

 

 




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SIGNATURES

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


 

Implant Sciences Corporation

 

By:

/s/ Glenn D. Bolduc

 

 

Glenn D. Bolduc

President and, Chief Executive Officer

(Principal Executive Officer)

 

 

 

 

By:

/s/ Roger P. Deschenes

 

 

Roger P. Deschenes

Vice President, Finance and Chief Financial Officer

(Principal Financial Officer and Chief Accounting Officer)

 

 

 

Dated:  May 17, 2013

 

 




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