-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, VViX4s86Oy9RaP/rm0TrJMUNusOflKYV/JxPejuVyyYR+McAq4+N2F/MFBCQuadS 12vmn7514B8YuUjwicgd5w== 0001019687-05-003260.txt : 20051125 0001019687-05-003260.hdr.sgml : 20051124 20051123201351 ACCESSION NUMBER: 0001019687-05-003260 CONFORMED SUBMISSION TYPE: 10QSB PUBLIC DOCUMENT COUNT: 3 CONFORMED PERIOD OF REPORT: 20050930 FILED AS OF DATE: 20051125 DATE AS OF CHANGE: 20051123 FILER: COMPANY DATA: COMPANY CONFORMED NAME: PivX Solutions, Inc. CENTRAL INDEX KEY: 0001160420 STANDARD INDUSTRIAL CLASSIFICATION: [9995] IRS NUMBER: 870675769 STATE OF INCORPORATION: NV FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10QSB SEC ACT: 1934 Act SEC FILE NUMBER: 000-33265 FILM NUMBER: 051226295 BUSINESS ADDRESS: STREET 1: 23 CORPORATE PLAZA, SUITE 280 CITY: NEWPORT BEACH STATE: CA ZIP: 92660 BUSINESS PHONE: 949-999-1600 MAIL ADDRESS: STREET 1: 23 CORPORATE PLAZA, SUITE 280 CITY: NEWPORT BEACH STATE: CA ZIP: 92660 FORMER COMPANY: FORMER CONFORMED NAME: DRILLING INC DATE OF NAME CHANGE: 20011003 10QSB 1 pivx10q-093005.txt UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-QSB (Mark One) [X] QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2005 [ ] TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT For the transition period from ________________ to _______________ 000-33625 (Commission file number) PIVX SOLUTIONS, INC. (Exact name of small business issuer as specified in its charter) NEVADA 87-0618509 (State or other jurisdiction (IRS Employer of incorporation Identification No.) or organization) 23 CORPORATE PLAZA DRIVE, SUITE 280, NEWPORT BEACH, CALIFORNIA 92660 (Address of principal executive offices) (949) 999-1600 (Issuer's telephone number, including area code) Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X] Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.) Yes [ ] No [X] The number of shares of common stock outstanding as of November 14, 2005 was 31,351,718 Transitional Small Business Disclosure Format (check one): Yes [ ] No [X] PIVX SOLUTIONS, INC. Table of Contents Page Number PART I. FINANCIAL INFORMATION Item 1. Financial Statements 2 Consolidated Balance Sheet as of September 30, 2005 (unaudited) 2 Consolidated Statements of Operations for the three and nine months ended September 30, 2005 and2004 (unaudited) 3 Consolidated Statement of Stockholders' Deficit for the nine months ended September 30, 2005 (unaudited) 4 Consolidated Statements of Cash Flows for the nine months ended September 30, 2005 and 2004 (unaudited) 5 Notes to Consolidated Financial Statements (unaudited) 6 Item 2. Management's Discussion and Analysis or Plan of Operations 14 Item 3. Controls and Procedures 26 PART II. OTHER INFORMATION Item 1. Legal Proceedings 27 Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 27 Item 3. Defaults Upon Senior Securities 27 Item 4. Submission of Matters to a Vote of Security Holders 27 Item 5. Other Information 27 Item 6. Exhibits 27 SIGNATURES 28 Exhibits: Exhibit 31.1 - Chief Executive and Principal Financial Officer Certification Exhibit 32.1 - Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 PART I. FINANCIAL INFORMATION Item 1. Financial Statements PIVX SOLUTIONS, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET (UNAUDITED) September 30, 2005 ASSETS Current assets: Accounts receivable, net of allowance for doubtful accounts of $73,575 $ 110,306 Other current assets 34,033 ------------ Total current assets 144,339 Property and equipment (Note 6) 10,001 Intangible assets, net of accumulated amortization of $15,531 (Note 6) 166,138 Other assets 31,416 ------------ Total assets $ 351,894 ============ LIABILITIES AND STOCKHOLDERS' DEFICIT Current liabilities: Accounts payable $ 1,165,143 Accrued liabilities 437,430 Related party loans (Note 3) 562,500 Deferred revenue 68,506 Convertible notes, net of discount of $403,499 (Note 4) 168,501 Capital lease liabilities (Note 2) 458,537 ------------ Total current liabilities 2,860,617 ------------ Total liabilities 2,860,617 ------------ Commitments and contingencies (Note 2) -- Stockholders' deficit (Note 5): Preferred stock, 10,000,000 shares authorized, none outstanding -- Common stock, $.001 par value; 100,000,000 shares authorized, 31,351,718 shares issued and outstanding 31,352 Committed common stock 497,820 Additional paid-in capital 15,307,301 Deferred compensation (173,386) Accumulated deficit (18,171,810) ------------ Total stockholders' deficit (2,508,723) ------------ Total liabilities and stockholders' deficit $ 351,894 ============ The accompanying notes are an integral part of these consolidated financial statements. 2 PIVX SOLUTIONS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED) THREE MONTHS ENDED NINE MONTHS ENDED ---------------------------- ---------------------------- SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30, 2005 2004 2005 2004 ------------ ------------ ------------ ------------ Revenues: Consulting revenue $ 71,176 $ 62,171 $ 283,661 $ 86,171 License revenue 48,667 13,619 130,333 18,028 ------------ ------------ ------------ ------------ Total revenues 119,843 75,790 413,994 104,199 Cost of revenues 74,316 15,776 273,389 16,726 ------------ ------------ ------------ ------------ Gross profit 45,527 60,014 140,605 87,473 ------------ ------------ ------------ ------------ Operating Expenses: Selling 125,178 12,578 672,006 12,578 General and administrative 1,167,022 1,010,771 4,416,780 2,385,659 Research and development 93,454 462,117 531,439 811,134 Impairment loss on long lived assets 433,194 -- 2,142,765 -- ------------ ------------ ------------ ------------ Total operating expenses 1,818,848 1,485,466 7,762,990 3,209,371 ------------ ------------ ------------ ------------ Operating loss (1,773,321) (1,425,452) (7,622,385) (3,121,898) Merger-related fees -- -- -- (1,287,490) Excess fair value of common stock issued for cash at discount -- (706,291) -- (706,291) ------------ ------------ ------------ ------------ Interest and accretion expense (328,251) (19,602) (610,186) (22,949) Other income -- 1,193 -- 4,097 ------------ ------------ ------------ ------------ Net loss $ (2,101,572) $ (2,150,152) $ (8,232,571) $ (5,134,531) ============ ============ ============ ============ Basic and diluted net loss per common share $ (0.07) $ (0.09) $ (0.30) $ (0.25) ============ ============ ============ ============ Basic and diluted weighted average number of common shares outstanding 31,048,625 23,499,567 27,729,099 20,875,912 ============ ============ ============ ============ The accompanying notes are an integral part of these consolidated financial statements. 3 PIVX SOLUTIONS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' DEFICIT (UNAUDITED) Common Common Committed Additional Total Stock Stock Common Paid-In Deferred Accumulated Stockholders' Shares Amount Stock Capital Compensation Deficit Deficit ------------ ------------ ------------ ------------ ------------ ------------ ------------ Balances as of December 31, 2004 24,884,353 $ 24,884 $ 590,303 $ 11,136,227 $ (600,515) $ (9,939,239) $ 1,211,660 Stock issued for cash, net of offering costs of $ 34,124 and fair value of warrants of $2,941,607 2,907,950 2,908 424,000 1,416,942 1,843,850 Additional stock issued to shareholder in prior offering 146,825 147 40,817 40,964 Stock issued for services 921,723 922 45,604 504,606 551,132 Amortization of deferred compensation 427,129 427,129 Fair value of options issued to employees 22,185 22,185 Fair value of options and warrants issued to consultants 95,856 95,856 Fair value of services provided by CEO 79,400 79,400 Accrued salaries forgiven by former officers/ shareholders 222,852 222,852 Fair value of warrants issued with convertible debt 130,592 130,592 Fair value of warrants issued with related party loan 42,170 42,170 Fair value of beneficial conversion feature on convertible debt 756,408 756,408 Convertible notes converted to common stock 2,100,000 2,100 312,900 315,000 Issuance of committed stock 390,867 391 (546,737) 546,346 -- Cancellation of committed stock bonuses to terminated employees (15,350) (15,350) Net loss (8,232,571) (8,232,571) ------------ ------------ ------------ ------------ ------------ ------------ ------------ Balance as of September 30, 2005 31,351,718 $ 31,352 $ 497,820 $ 15,307,301 $ (173,386) $(18,171,810) $ (2,508,723) ============ ============ ============ ============ ============ ============ ============ The accompanying notes are an integral part of these consolidated financial statements. 4 PIVX SOLUTIONS, INC AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) NINE MONTHS ENDED SEPTEMBER 30, 2005 2004 ----------- ----------- Cash flows from operating activities: Net loss $(8,232,571) $(5,134,531) Adjustments to reconcile net loss to net cash used in operating activities: Depreciation and amortization 266,179 139,074 Bad debt provision 73,575 -- Bonuses forfeited by employees (15,350) -- Non-cash merger-related expenses -- 1,277,490 Excess fair value of common stock issued for cash at discount -- 706,291 Accretion of discount on convertible notes 483,501 -- Impairment of software, tradename and goodwill 1,709,571 -- Fair value of common shares issued to shareholders 40,964 -- Impairment of under utilized fixed assets 433,194 -- Fair value of options issued to employees 22,185 -- Fair value of options and warrants issued to consultants 95,856 -- Fair value of warrants issued on related party loan 42,170 -- Stock issued or committed for services rendered 551,132 357,500 Amortization of deferred compensation 427,129 18,750 Amortization of options issued to consultants -- 90,132 Fair value of services contributed by CEO 79,400 -- Changes in operating assets and liabilities, net of assets and liabilities acquired: Accounts receivable (81,352) (8,813) Other current assets 31,988 (11,785) Accounts payable 502,460 254,483 Accrued liabilities 130,045 168,089 Deferred revenue 30,979 25,583 ----------- ----------- Net cash used in operating activities (3,408,945) (2,117,737) ----------- ----------- Cash flows from investing activities: Purchases of property and equipment -- (57,389) Cash of acquired entity -- 48,271 Other assets -- (25,816) ----------- ----------- Net cash used in investing activities -- (34,934) ----------- ----------- Cash flows from financing activities: Proceeds from issuance of common stock, net of offering costs 1,843,850 2,632,776 Subscription payable -- 270,342 Proceeds from issuance of convertible promissory notes 887,000 -- Borrowings from related parties 570,000 -- Payments on borrowings from related parties (7,500) -- Payments on capital leases (84,857) (25,580) ----------- ----------- Net cash provided by financing activities 3,208,493 2,877,538 ----------- ----------- Net change in cash (200,452) 724,867 Cash, beginning of period 200,452 102,583 ----------- ----------- Cash, end of period $ -- $ 827,450 =========== =========== Supplemental disclosures for cash flow information- Cash paid for interest $ 29,467 $ 22,949 =========== =========== Non-cash investing and financing activities: Value of warrants issued in connection with private placement $ 2,941,607 $ 477,009 =========== =========== Value of shares retained for merger related expenses $ -- $ 1,277,490 =========== =========== Value of assets acquired under capital leases $ -- $ 598,650 =========== =========== Convertible notes converted into common stock $ 315,000 $ -- =========== =========== Accrued salaries forgiven by former officers/shareholders $ 222,852 $ -- =========== =========== The accompanying notes are an integral part of these consolidated financial statements. 5
PIVX SOLUTIONS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) NOTE 1 - BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES - ------------------------------------------------------------------ BUSINESS PivX Solutions, Inc. ("PivX" or the "Company") is a vulnerability research and security solutions company providing security software and consulting services to a variety of businesses, consumers and government agencies. In August 2004, PivX completed its initial development of PreEmpt(TM), a security software tool previously known as Qwik-Fix Pro, which enables Microsoft computer users to be pro-actively protected from worms, viruses and malware. The first subscription sales of PreEmpt (TM) were made in the quarter ended September 30, 2004. In July 2005, we released version 2.0 of PreEmpt. FINANCIAL STATEMENT PREPARATION The accompanying unaudited consolidated financial statements have been prepared by the Company pursuant to the rules and regulations of the SEC regarding interim financial reporting. Accordingly, they do not include all of the information and notes required by accounting principles generally accepted in the United States of America. The financial statements and related notes of PivX for the year ended December 31, 2004 were filed with the SEC on Form 10-KSB, as amended. The unaudited consolidated financial statements reflect all adjustments, consisting of normal recurring adjustments, which are, in the opinion of management, necessary for a fair presentation of results for the interim periods presented. Preparing financial statements requires management to make estimates and assumptions that affect the amounts that are reported in the consolidated financial statements and accompanying disclosures. Although these estimates are based on management's best knowledge of current events and actions that the Company may undertake in the future, actual results may be different from the estimates. The results of operations for the nine months ended September 30, 2005, are not necessarily indicative of the results to be expected for any future period or the full fiscal year. Consolidation The accompanying unaudited consolidated financial statements include the accounts of Drilling, Inc. from March 25, 2004 and Threat Focus from June 9, 2004. All significant intercompany accounts and transactions have been eliminated. RISKS AND UNCERTAINTIES Limited Experience of Management Recently, the Company changed management in an effort to curtail significant losses and improve working capital. The new management lacks experience in the software industry, where technology changes are rapid, and product lives are relatively short in duration. The lack of experienced management causes inherent uncertainties about the ultimate success of the Company. The Company is attempting to mitigate this risk through the utilization of consultants with extensive experience in the information security industry. Going Concern Considerations These unaudited consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. At September 30, 2005, the Company had a working capital deficit of $2,716,278. Since inception through the nine months ended September 30, 2005, the Company incurred net losses accumulating to $18,171,810. These factors raise substantial doubt about the Company's ability to continue as a going concern. The Company's future is dependent upon its ability to generate profitable operations in the future and/or to obtain the necessary financing to meet its obligations and repay its liabilities arising from normal business operations when they come due. 6 PIVX SOLUTIONS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) During the first nine months of 2005, the Company raised net proceeds of approximately $1,844,000 through the sale of and the commitment to sell a total of approximately 4,003,950 shares of common stock. The Company also raised approximately $887,000 through the issuance of convertible debt and $570,000 through related party borrowings. Management is seeking additional working capital through additional private placements of its equity and debt securities. The Company may also consider a significant corporate transaction such as a merger if a favorable opportunity should arise. There are no assurances that management will be successful with these efforts. The Company has reduced the number of full time employees from 17 at September 30, 2005 to 4 as of November 21, 2005 due to the continued incurrence of operating losses. Should the Company be unable to raise funds, the Company may be forced into, or new management may elect to file for, bankruptcy, which could significantly reduce the value of shareholder interests, as well as the carrying value of its assets and liabilities. These financial statements do not include any adjustments to the amounts and classification of assets and liabilities that may be necessary should the Company be unable to continue as a going concern. REVENUE RECOGNITION For the periods presented, the Company's revenues were derived under consulting contracts and subscription agreements for Threat Focus and PreEmpt license agreements. The revenues from the contracts are recognized as the services are completed and collection is reasonably assured. In cases where the Company did not track the hours under the consulting project, revenues were recorded at the completion of the contract. The Company recognizes software license fee revenue in accordance with the provisions of Statement of Position ("SOP") 97-2 "Software Revenue Recognition," as amended by SOP 98-9, "Software Revenue Recognition With Respect to Certain Transactions." Software license fees are charged for licenses for security software to be delivered to customers for in-house applications. Licenses range from recurring one month agreements to quarterly or annual agreements. Revenues from single-element software license agreements will be recognized upon installation and acceptance of the software. Revenues from software arrangements involving multiple elements will be allocated to the individual elements based on their relative fair values. Maintenance and rights to unspecified upgrades, as well as subscriptions to licenses will be reported ratably. Deferred revenues result from cash received for subscriptions that expire after the balance sheet date. SIGNIFICANT CUSTOMERS During the nine months ended September 30, 2005, revenues from one customer accounted for approximately 31% of total revenues. Two separate customers account for approximately 31% and 27% of the accounts receivable balance as of September 30, 2005. Management feels that the loss of one of these customers will have a significant impact on operations. Additionally, during the quarter ended September 30, 2005, the Company wrote off approximately $74,000 from one customer from which collectibility had become doubtful. Revenue recognition was ceased for this customer during the three months ended September 30, 2005. ACCOUNTING FOR STOCK-BASED COMPENSATION Employees The Company has not adopted a fair value-based method of accounting for stock-based compensation plans for employees and non-employee directors. The Company uses the intrinsic value-based approach and supplements this with disclosure of the pro forma impact on operations using the fair value-based approach as required by Statement of Financial Accounting Standards ("SFAS") SFAS No. 148 ("SFAS 148") "Accounting for Stock-Based Compensation - Transition and Disclosure." Common stock issued for services to employees is recorded based on the closing ask price of the Company's common stock. If shares are not registered, the closing ask price used to determine estimated fair value is discounted by 10%. Had compensation cost for the Company's employee stock-based compensation plan been determined based on the fair value at the grant dates, the disclosure requirements of SFAS 148, which amends the disclosure requirements of SFAS 123, would have been as follows: 7 PIVX SOLUTIONS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) Three Months Nine Months Ended Ended September 30, September 30, 2005 2005 ----------- ----------- Net loss as reported $(2,101,572) $(8,232,571) Add: Total stock-based employee compensation expense determined under the Black-Scholes fair value method for all rewards, net of related tax effects (336,514) (529,456) Minus: Total stock-based employee compensation expense currently recorded under the intrinsic value method 303,733 427,129 ----------- ----------- Pro forma net loss $(2,134,353) $(8,334,898) =========== =========== Basic and diluted net loss per share as reported $ (0.07) $ (0.30) =========== =========== Pro forma basic and diluted net loss per share $ (0.07) $ (0.30) =========== ===========
The pro forma effects for the three and nine months ended September 30, 2004 has not been presented as the majority of all options outstanding at the time had been issued while the Company was a private entity. The options were valued using the minimum value method and are immaterial. Non-Employees The Company measures the fair value of stock-based compensation issued to non-employees as required under Emerging Issues Task Force ("EITF") No. 96-18 "Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services, EITF Topic No. D-90 "Grantor Balance Sheet Presentation of Unvested, Forfeitable Equity Instruments Granted to Non-employee" and Financial Accounting Standards Board ("FASB") Interpretation No. 28 "Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans.". Accordingly, only the vested options and warrants at each reporting period date are recognized as compensation expense and additional paid-in capital. To the extent the fair value of the options and warrants decline and the cumulative required compensation expense is lower than the cumulative balance at the previous reporting period, no compensation expense is recorded. In no event does the Company record a reduction in previously reported compensation. PER SHARE INFORMATION The Company presents basic earnings per share ("EPS") and diluted EPS on the face of all statements of operations. Basic EPS is computed as net loss divided by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur from common shares issuable through stock options, warrants, and other convertible securities that are exercisable during or after the reporting period. In the event of a net loss, such incremental shares are not included in EPS since their effects are anti-dilutive. Effects of approximately 21,000 options, 1,700,000 warrants and 3,800,000 shares of common stock issuable under convertible promissory notes outstanding were excluded from the weighted average dilutive shares outstanding because they would have been anti-dilutive in consideration of the net loss during the three and nine months ended September 30, 2005. Effects of the 959,866 outstanding options outstanding for the three and nine months ended September 30, 2004 were excluded in weighted average dilutive shares outstanding because of the net loss during the three and nine months ended September 30, 2004. COST OF REVENUES Cost of revenues for the three and nine months ended September 30, 2005 primarily relate to the cost of computer forensics salaries and forensics consultants. Costs of revenues relating to subscription revenues were negligible for the three and nine months ended September 30, 2005. 8 PIVX SOLUTIONS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) IMPAIRMENT OF INTANGIBLE ASSETS SFAS No. 142, "Goodwill and Other Intangible Assets," requires intangible assets with indefinite lives be evaluated at least annually for impairment. The evaluation is performed by grouping the net book value of all long-lived assets for acquired businesses, including goodwill and other intangible assets, and comparing this value to the related estimated fair value. The determination of fair value will be based on estimated future discounted cash flows related to these long-lived assets. The discount rate that is to be used will be based on the risks associated with the acquired businesses. See Note 6 for a discussion of the impairment to the Company's intangible assets during the three and nine month periods ended September 30, 2005. IMPAIRMENT OF LONG-LIVED ASSETS The Company reviews the carrying value of property, equipment and other long-lived assets for impairment whenever events and circumstances indicate that carrying values of an asset may not be recoverable from the estimated future cash flows expected to result from their use and or eventual disposition. In cases where the undiscounted expected future cash flows are less than the carrying value, an impairment loss is recognized equal to an amount by which the carrying value exceeds the fair value of assets. The factors considered by management in performing this assessment include current operating results, trends and prospects, as well as effects of obsolescence, demand competition and other economic factors. See Note 6 for a discussion on the impairment to the Company's long-lived assets during the three month period ended September 30, 2005. WARRANTS AND BENEFICIAL CONVERSION FEATURE OF CONVERTIBLE NOTES The Company allocates the proceeds received based on the relative fair value of the warrants issued and the face value of the convertible notes. The convertible feature of convertible notes provides for a rate of conversion that is below market value. Such feature is normally characterized as a "beneficial conversion feature" ("BCF"). Pursuant to EITF Issue No. 98-5 ("EITF 98-5"), "Accounting For Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratio" and EITF Issue No. 00-27,"Application of EITF Issue No. 98-5 To Certain Convertible Instruments," the relative fair values of the BCFs are recorded as a discount from the face amount of the respective debt instrument. The Company amortizes the discount using the effective interest method through maturity. The Company records the corresponding unamortized debt discount related to the BCF as interest expense when the related instruments were converted into the Company's common stock. See Note 5 for a discussion on the calculation of the fair value of warrants and beneficial conversion feature related to convertible notes. RECENT ACCOUNTING PRONOUNCEMENTS On May 2005, the Financial Accounting Standards Board ("FASB") issued SFAS No. 154, "Accounting Changes and Error Corrections-A Replacement of APB Opinion No. 20 and FASB Statement No. 3." SFAS No. 154 applies to all voluntary changes in accounting principle and requires retrospective application to prior periods' financial statements of changes in accounting principle, unless it is impracticable. SFAS No. 154 requires that a change in depreciation, amortization or depletion method for long-lived, non-financial assets be accounted for as a change of estimate affected by a change in accounting principle. SFAS No. 154 also carries forward without change the guidance in APB Opinion No. 20 with respect to accounting for changes in accounting estimates, changes in the reporting unit and correction of an error in previously issued financial statements. The Company is required to adopt SFAS No. 154 for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The adoption of SFAS No. 154 is not expected to have a material effect on the Company's consolidated financial position or results of operations. On June 29, 2005, the FASB ratified EITF Issue No. 05-06, "Determining the Amortization Period for Leasehold Improvements." Issue No. 05-06 provides that the amortization period used for leasehold improvements acquired in a business combination or purchased after the inception of a lease be the shorter of (a) the useful life of the assets or (b) a term that includes required lease periods and renewals that are reasonably assured upon the acquisition or the purchase. The provisions of Issue No. 05-06 are effective on a prospective basis for leasehold improvements purchased or acquired in reporting periods beginning after June 29, 2005. Early application of the consensus is permitted in periods for which financial statements have not been issued. The adoption of Issue No. 05-06 is not expected to have a material effect on our consolidated financial position, results of operations or cash flows. 9 In December 2004, FASB issued SFAS No. 123 (revised 2004), "Share-Based Payment" ("SFAS 123R"). Under SFAS 123R, companies will be required to recognize as expense the estimated fair value of all share-based payments to employees, including the fair value of employee stock options. Pro forma disclosure of the estimated impact of such awards is no longer an alternative to financial statement recognition. SFAS 123R is effective for public companies in the first annual reporting period beginning after June 15, 2005. Accordingly, the Company will adopt the provisions of SFAS 123R in its 2006 fiscal year. There are two transition alternatives for public companies adopting the statement: the modified prospective method and the modified retrospective method. Under the modified prospective method, companies are required to recognize compensation costs for share-based payments to employees based on the grant date estimate of fair value from the beginning of the fiscal period in which the recognition provisions of SFAS 123R are first applied. Prior period financial information would not be restated under this method. Under the modified retrospective method, companies would restate prior periods to include the recognition of compensation cost based on amounts previously reported in the pro forma disclosures relating to stock based compensation under the existing requirements of SFAS 123, "Accounting for Stock-Based Compensation", such as is presented above in Note 1 to our unaudited financial statements. We have not yet determined which method of adoption we will elect. We expect the adoption of SFAS 123R to have a material effect on our financial statements, in the form of additional compensation expense, on a quarterly and annual basis. It is not possible to precisely determine the expense impact of adoption since a portion of the ultimate expense that is recorded will likely relate to awards that we have not yet granted, but are likely to grant prior to the January 1, 2006 adoption date. The expense associated with these future awards can only be determined based on factors such as the price of our common stock, volatility of our stock price and risk-free interest rates as measured at the grant date. NOTE 2 - COMMITMENTS AND CONTINGENCIES - -------------------------------------- CAPITAL LEASES The Company has entered into fourteen (14) leases for computer and other equipment. These leases are accounted for as capital leases. The leases range in term from 36 to 60 months and require aggregate monthly lease payments of approximately $18,800. The total amount of assets under these capital leases as of September 30, 2005 is approximately $609,000, which includes impaired long-lived assets under Note 6. The Company is currently in default of these leases due to its inability to service them, and the lessor may repossess the assets at any time. All liabilities related to the capital leases have been presented as current liabilities on the consolidated balance sheet. The Company is required to fund any deficiency resulting from the sale of the assets by the lessor. NOTE 3 - RELATED PARTY TRANSACTIONS - ----------------------------------- On January 27, 2005, a shareholder who subsequently became the Chief Executive Officer of the Company advanced the Company a working capital loan in the amount of $115,000. The loan accrued interest at 2% per annum and was due in full on January 27, 2006. In connection with the issuance of the convertible debentures, the Company amended the Chief Executive Officer's note to reflect the same terms as the convertible debentures (see Note 4). On July 22, 2005, the Chief Executive Officer assigned his interest, rights and title to this note to a third party who then immediately converted the note into 766,667 shares of the Company's common stock. On April 8, 2005, a former employee of the Company loaned the Company $30,000 to help cover operating expenses during the period. Under the terms of the note agreement, the note did not initially bear any interest and was due on April 13, 2005. If the note was not fully repaid by the due date, the note bears interest at a rate of $1,000 per week. As of September 30, 2005, the Company has repaid $7,500 on this note. The Company is currently seeking negotiations with the former employee to amend the interest portion of the note agreement. As of September 30, 2005, the Company has accrued $20,357 in interest related to this note. On March 23, 2005, the two founders of the Company entered into a revolving loan agreement effective January 20, 2005, under which they were to advance the Company amounts not to exceed $500,000 outstanding at any one time. The agreement was to terminate on July 20, 2005 and all advances made up to July 20, 2005 would not bear any interest. If the advances were not fully repaid as of July 20, 2005, any remaining amounts outstanding were to bear interest at the rate of 10% per annum. Subsequently, on April 3, 2005, the Company entered into an amendment (the "Loan Amendment") to this promissory note and revolving loan agreement. The Loan Amendment modifies the repayment provisions of the original agreement to provide that for a 24 month term beginning on May 15, 2005, and on the 15th of every month thereafter, the Company was to collectively pay the executives $19,584 per month, for a total of $470,000 by the end of the term. 10 The Company is currently in discussions with the founders on further amending the repayment terms. As of September 30, 2005, there have been no payments made on this loan. In addition, pursuant to a letter agreement (the "Share Transfer Restriction Agreement") dated as of April 3, 2005, the founders agreed that for a period of six months beginning on May 15, 2005, they would not offer, sell, contract to sell, pledge, grant or otherwise dispose of more than 20,000 shares of common stock, par value $0.001 per share, of the Company in any one-month period. In addition, as part of the Loan Amendment, accrued contractual salaries in the amount of $222,852 owed to the founders were forgiven. The forgiven amounts were accounted for as capital contributions and recorded in additional paid-in capital during the nine months ended September 30, 2005. On September 19, 2005, a shareholder loaned the Company $45,000 (the "Loan") due on September 23, 2005, bearing an interest rate of 8% per annum. The Loan was personally guaranteed by the Company's CEO. In addition, the shareholder received a warrant to purchase 1,500,000 shares of common stock at an exercise price of $0.08 per share. The warrant was exercisable upon issuance and for accounting purposes the relative fair value of the warrants issued with the Loan was $42,170, using the Black-Scholes option pricing model assuming volatility of 160%, a risk free rate of 4.03%, an expected life of 5 years and no dividend yield. The $42,170 was recorded as discount and accreted to interest expense during the three months ended September 30, 2005. As of September 30, 2005, the Loan was still outstanding. NOTE 4 - CONVERTIBLE PROMISSORY NOTES - ------------------------------------- During the quarter ended September 30, 2005, the Company received gross cash proceeds of $75,000 from the issuance of 12% redeemable Convertible Promissory Notes (the "Notes"), due one year from the date of issuance. To date, the Company received gross cash proceeds of $887,000 from the issuance of the Notes. In addition, the holders received a warrant to purchase one-half share of common stock for every dollar invested, resulting in the issuance of warrants to purchase 37,500 shares of common stock. The Notes are convertible at the option of the holder at any time. The conversion price of the Notes is $0.15 per share of common stock. Interest on these Notes accrues from the execution date. Principal and interest shall become due and payable one year after the original execution date of the Notes unless converted to common stock prior thereto. If the Notes are not repaid or converted with in two years of the execution date, the Company will deliver to the Note holder a security agreement granting a first priority security interest in the intellectual property held by the Company in the PreEmpt software. Each warrant issued entitles the holder to purchase one of the Company's common shares and is exercisable at a price of $0.50 on or before the fifth anniversary date of the Note's execution. For accounting purposes, the relative fair value of warrants issued with the Notes is $11,920, using the Black-Scholes option pricing model assuming volatility of 160%, a risk free rate of 4.03%, an expected life of 5 years and no dividend yield and initially recorded this value as additional paid-in capital. The intrinsic value of the beneficial conversion feature is the amount by which the fair value of the underlying common shares at the date of the agreement exceeded the value of shares issuable based on the carrying value of the Notes, after reducing such carrying value for the fair value of the warrants. The beneficial conversion feature of the warrants issued with the Notes is $63,080. These aggregate values assigned of $75,000, were recorded as a reduction to the amount initially assigned to the Notes and as additional paid-in capital. The carrying value of the liability is being accreted to the carrying value of the Notes over the one-year period beginning with the execution of the Notes. Proceeds from the issuance of convertible promissory notes were $887,000 during the nine months ended September 30, 2005. During the three and nine month periods ended September 30, 2005, $143,001 and $168,501, respectively, of the accretion expense has been recorded as interest expense and an increase in the carrying value of the all debt issued with warrants or beneficial conversion features. The unamortized discount at September 30, 2005 was $403,499. During the three and nine months ended September 30, 2005, $115,000 and $315,000 of these Notes were converted into 766,667 and 2,100,000 shares of common stock in accordance with their original terms. Any unamortized discount at the time of conversion was accreted to the Notes' carrying value and recorded as interest expense. NOTE 5 - STOCKHOLDERS' EQUITY - ----------------------------- PREFERRED STOCK The Company is authorized to issue 10,000,000 shares of preferred stock. The preferred stock will be available in an amount adequate to provide for the Company's future needs. The additional shares are available for issuance from time to time by the Company at the discretion of the board of directors with such rights, preferences and privileges as the board may determine. As of September 30, 2005 the Company had not issued any shares of preferred stock. 11 COMMON STOCK OFFERINGS Committed stock On occasion, the Company enters into agreements to sell common stock for which cash has been received, but for which actual stock certificates are not issued at an accounting period end. Under these circumstances, the Company records committed common stock. Upon subsequent issuance of the certificates, the Company then reclassifies the committed stock to common stock and additional paid in capital. For the nine months ended September 30, 2005, the Company recorded $546,737 from committed stock to common stock and additional paid-in capital. Stock issued for cash On August 8, 2005, the Company began a private placement offering of up to 3 million shares of Common Stock at $0.25 per share to accredited investors, with every 2 shares purchased receiving 1 warrant to purchase a share of common stock with an exercise price of $0.50. As of September 30, 2005, $274,000 has been raised through this offering for a commitment to issue 1,096,000 shares of common stock. These sales were intended to be exempt from registration under the Securities Act pursuant to Section 4(2) of the Securities Act of 1933, as amended (the "Securities Act") or Regulation D under the Securities Act. The Company is also committed to issue warrants to purchase 548,000 shares of common stock at an exercise price of $0.50. The warrants are exercisable until the earlier of (i) two years from their effective issuance or (ii) thirty days after a "Call" by the Company. The Company may call the Warrants at any time the closing price per share of the Company's common stock equals or exceeds $1.00. If not exercised with thirty days after a Call, the Warrants will expire and will no longer be exercisable. Using the Black Scholes model and assuming volatility of 160%, a risk free rate of 4.03%, an expected life of 2 years with no dividend yield, the warrants have a fair value of $0.21 per share or a total fair value of $115,080. During the nine months ended September 30, 2005, the Company issued or was committed to issue 4,003,950 shares of common stock for net cash proceeds of $1,843,850. In connection with these issuances, the Company issued warrants to purchase 3,455,950 shares of common stock. The warrants had a fair value of $2,941,607. Stock issued for services >From time to time the Company has issued common stock to consultants for services performed. During the nine months ended September 30, 2005, the Company issued 921,723 shares with a prescribed value of $505,528. In addition, the Company incurred the obligation to issue shares of common stock for services valued at $45,604, which is included in committed stock at September 30, 2005. Employee stock option/stock issuance plan On November 5, 2004, the Board of Directors of the Company approved the 2004 Incentive Stock Option Plan (the "Plan") under which all stock options issued by the Company to date have been granted. The maximum number of shares that can be issued under the Plan is 4,000,000. During the nine months ended September 30, 2005, the Company entered into employment agreements with certain key personnel, which provided for options to purchase an aggregate of 130,000 shares of common stock. As of September 30, 2005 there are 720,000 options outstanding under the Plan. The options generally vest over a period between one and three years. Substantially all employee options have, or will be, forfeited or cancelled due to terminations of employment subsequent to September 30, 2005. Non-employee options and warrants In January 2005, the Company issued 20,000 options to purchase the Company's common stock at an exercise price of $1.15 to a consultant. The options vested immediately and expire 5 years from issuance. Using the Black-Scholes valuation model, the options were valued at $41,245 (assuming volatility of 340%, a risk free rate of 3.38%, an expected life of 5 years with no dividend yield). In March 2005, the Company issued 20,000 options to purchase the Company's common stock at an exercise price of $1.00 to Vector. The options vested immediately and expire 10 years from issuance. Using the Black-Scholes valuation model, the options were valued at $27,785 (assuming volatility of 340%, a risk free rate of 3.38%, an expected life of 5 years with no dividend yield) and immediately charged to expense. In April 2005, the Company cancelled a consulting contract with Vector. In connection with the cancellation of the agreement, the Company reversed certain options granted to them in the previous year for prepaid services to be performed. The value of the options reversed, which was recorded in additional paid in capital, was $42,874. 12 Website purchase On June 7, 2005, the Company entered into an agreement with a third party for the purchase of a website and its domain name. Additionally, the agreement calls for the seller to act as an advisor to the Company. The Company issued to the seller 270,000 options to purchase the Company's common stock at $0.25 per share as payment. Using the Black-Scholes valuation model, the options were valued at $69,700 (assuming volatility of 340%, a risk free rate of 3.38%, an expected life of 5 years with no dividend yield). The Company expensed the $69,700 during the nine months ended September 30, 2005 because the website was not actively utilized. OTHER EQUITY TRANSACTIONS Fair value of services The current CEO of the Company took office on April 21, 2005 and has been performing services without a salary. The fair value of the CEO's salary expense from April 21, 2005 through September 30, 2005, had it been paid, was estimated to be $79,400. This amount has been reflected as contributed capital to the Company and may be settled at a future date by the issuance of additional common shares to our CEO. Re-pricing of shares In the fall of 2004, the Company issued stock in a "friends and family" round of financing during which the Company sold shares of common stock at a price of $2.00 and $1.55 per share. Upon discovery of the pricing discrepancy, the Company amended the subscription agreements of those who purchased at $2.00 per share and issued additional shares to them sufficient to bring their cost basis per share to $1.55. In doing so, the Company issued an additional 146,825 shares of common stock valued at $40,964. This fair value was recorded under selling, general and administrative expense with the offset to common stock and additional paid-in capital in the accompanying financial statements. NOTE 6 - IMPAIRMENT OF LONG-LIVED ASSETS - ---------------------------------------- During the quarter ended June 30, 2005, the Company conducted the a review of its intangible assets. The Company assessed the recoverability of the carrying value of software, trade name and goodwill stemming from the Threat Focus acquisition in June 2004. The assessment resulted in an impairment loss of $1,709,571 according to the following: $572,715 relating to software, $83,300 relating to trade name and $1,053,556 relating to goodwill. This loss reflects the amount by which the carrying values of these assets exceeded their estimated fair values and was determined by their estimated future discounted cash flows. During the quarter ended September 30, 2005, the Company concluded that, due to the substantial reduction in headcount, continuing operating losses, lack of sufficient working capital and under utilization of fixed assets consisting of furniture and fixtures as well as computer hardware and software, that the recoverability of the carrying value of these assets was impaired. Management assessed that the fair value of fixed assets approximated $10,001, which was substantially less then the net carrying value of $443,195 and, therefore, recorded an impairment loss of $433,194. 13 PIVX SOLUTIONS, INC. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATIONS PLAN OF OPERATION Since our inception, our revenues had been primarily generated from our security consulting services. In the last quarter of 2003, we elected to change the primary focus of our business model from a purely professional services-oriented business to a product-oriented business, with a focus on providing Proactive Threat Mitigation(TM) software products and services to the enterprise, government, education and consumer markets. We have recently begun to generate revenues from the licensing of our host-based intrusion prevention software, PreEmpt 2.0. By providing proactive solutions that protect computer users from worms, viruses and malware before they are attacked (rather than reactively in the manner of antivirus, firewall and intrusion detection solutions), we believe our software products have a competitive advantage in the network and desktop security market. We are leveraging our expert domain knowledge to create proactive solutions that effectively address today's increasing and omni-present problems of worms and viruses. PreEmpt uses Active System Hardening to protect Windows desktops, laptops and servers, by blocking the underlying vulnerabilities exploited by worms and viruses. Active System Hardening is the process PreEmpt uses to harden the Windows operating systems against attack, by encapsulating and deploying across customers' networks the expertise of our security researchers. An updated version of PreEmpt 2.0, our flagship software product, was available for shipment to the market on July 25, 2005. PreEmpt 2.0 is the result of a 6 month effort to re-engineer and update Qwik-Fix Pro (our first generation product), to include new protection architectures and a completely updated user interface. Feedback from consumers and Enterprises led us to implement the new product features. PreEmpt 2.0 includes two key security architectures: Run Time Process Injection and Virtual Registry Protection. Run Time Process Injection secures application functions at the source. Input can be analyzed directly with no false positives or updates for new threats. The Virtual Registry provides advanced desktop security by differentiating between Microsoft's Internet Explorer (IE) as a web browser and IE as a platform for HTML applications. This approach allows PreEmpt 2.0 to eliminate the vast majority of port 80 vulnerabilities. PreEmpt 2.0 also includes the addition of real-time attack detection. In addition to our core active system hardening, the new protection technologies introduced in PreEmpt 2.0 detect attacks that would have otherwise succeeded, and triggers both a visual alert and an alert recorded to system logs. Active System Hardening protects against many worms and viruses well before they are developed and released on the Internet due to shutting down the pathways by which they are deployed. Among the worms, viruses and malware that were protected against were: Bagle, Bizex, MyDoom, Doom Juice, Netsky, Blaster and the recent Sasser and its 37 plus variants. Moreover, PreEmpt defended its users against a "Zero Day" exploit that successfully attacked all versions of Windows, including a fully patched version of Windows XP SP2, on October 20, 2004. PreEmpt is an engineered and tested software product that extends that concept with a breadth of additional protections, improved user interface, and a management console that provides tools for group policy management and reporting of an enterprise installation of the product. PreEmpt also provides significant benefit to enterprises by reducing the urgency of distributing software patches across the network, allowing IT staff the extra time necessary to test patches from Microsoft to ensure that they do not interfere with the performance of their network or other applications. PreEmpt is sold on an annual subscription basis with discounts based on the numbers of seats and length of contract. Given that we have no long term revenue history for a product of PreEmpt's type, the market acceptance of our software remains untested. We encountered barriers in the Enterprise market related to product features that were required to support large scale deployments which were addressed in the release of PreEmpt 2.0. Specifically, we added two significant components called the Local Update Server and Enterprise Reporting. The Local Update Server allows Enterprises to deploy software that does not require PreEmpt 2.0 desktop updates to update in a distributed fashion directly over the Internet, thereby saving local bandwidth and providing the Enterprise a level of control over outbound Internet traffic that they require. The Management Reporting component is also a critical piece of the Enterprise sales effort. Enterprise deployments can now get a visual summary of PreEmpts deployment footprint and also receive real-time reports on the status of Fixes and blocked malware which are essential for security compliance reporting. In addition to PreEmpt 2.0 software platform, we offer consultant services in the areas of computer forensics, security quality assurance, vulnerability alerts and network scans. These services will serve both as a revenue stream and an on-going source of access to real-world business problems, resulting in continued critical input into our product development roadmap. 14 PreView, our new Security Assessment and Scoring tool was released on March 21, 2005. PreView is the first security application that lets users understand the relative security of their Windows computer against known threats by providing a numerical score. By examining the four critical elements in a layered security approach, we are able to generate a Security Score. This Security Score is based on the core system security configurations, installed commercial security software, installed security patches, and how effective the user's firewall protection is configured. PreView's Security Score is analogous to a credit score. PreView looks at all of the core risk areas on a user's computer, compares that against known threats and assigns a risk score to each area. Users are able to obtain an overall picture of their computer's security health, and identify measures as to what they can do to improve their Security Score. Initially distributed for free, PreView has been driving increases in PreEmpt home user trials and has been a key driver toward developing new OEM and third-party relationships. What PreView brings to an OEM relationship is a platform that can easily and quickly be re-branded and enable the partner to target the security results toward their products and services. This will create potential new revenue opportunities to be created because PreView can then recommend specific security products based on the actual weaknesses discovered on a given user's PC. PreView is a tool that uses the world class security research from PivX labs to evaluate thousands of Windows system options and compares those against known threats (viruses, worms, trojans, malware, etc.) and displays an easy to understand matrix to show users if they are protected against those threats. The market pressures that validate the opportunity for PreEmpt are apparent to others and therefore we expect to experience direct competition in the marketplace although we are not aware of any product in the market today that delivers the same capability as PreEmpt. The closest competitor is a UK-based company, PrevX. Their product offering includes some features of PreEmpt, but is primarily a traditional behavioral, intrusion prevention solution that relies on complex rule sets to trap abnormal or potentially malicious behavior. We also expect to compete to some extent with anti-virus vendors as they also provide desktop computer security protection. However, their approach is reactive and our approach is proactive, which is an important distinction. We continue to pursue revenue opportunities outside of North America through partners and distributors in those regions. On September 16, 2004 we entered into a Master Reseller Agreement with Detto Technologies to be the exclusive North American reseller for the Consumer PC OEMs and retail channel. On June 7, 2005, we signed a reseller agreement to have PreEmpt sold in Europe through Preventon, a software security provider to internet service providers and their subscribers. Preview has been translated into two languages and is currently scheduled for localized trials in Europe during the fourth quarter. To further protect our Intellectual Property, we filed three Patent applications during the quarter. Two patents were related to Run Time Process Injection and Virtual Registry security protection architectures, and one method patent for Preview. In April 2004, our Chief Executive Officer and Chief Technology Officer resigned. We brought in new management and have been aggressively cutting costs wherever possible through headcount reductions and limiting non-essential expenditures. We expect to further reduce our monthly cash expenditures going forward. Since March 31, 2005, we have implemented cost controls and reduced our staff to 15 employees as of September 30, 2005. As of November 21, 2005, due to working capital deficiencies, we have further reduced our headcount to four employees which will adversely impact our ability to generate future revenues and maintain day to day operations of the Company. In addition, we are currently in default on all 14 of our capital leases, our facility leases for our corporate headquarters and certain loan agreements. There can be no assurance that adequate funds will be available when needed, or on acceptable terms to meet our future working capital requirements. Management is currently attempting to develop alternatives for the business including raising future capital through stock or debt offerings or identifying a party interested in assuming the business. If the Company is unable to identify an interested party or raise an adequate level of additional capital, the Company may cease as a going concern. CRITICAL ACCOUNTING POLICIES REVENUE RECOGNITION We recognize software license fee revenue in accordance with the provisions of Statement of Position ("SOP") 97-2 "Software Revenue Recognition," as amended by SOP 98-9, "Software Revenue Recognition, With Respect to Certain Transactions." Software license fees are charged for licenses for security software to be delivered to customers for in-house applications. Licenses range from recurring one month agreements to quarterly or annual agreements. Revenues from single-element software license agreements will be recognized upon installation and acceptance of the software. Revenues from software arrangements involving multiple elements will be allocated to the individual elements based on their relative fair values. Maintenance and rights to unspecified upgrades, as well as subscriptions to licenses will be reported ratably. To date predominantly all of our software license fee revenues have been on the subscription basis and recognized ratably over the subscription period. 15 ESTIMATING FAIR VALUE ON STOCK-BASED COMPENSATION AND SALES OF SECURITIES AT SIGNIFICANT DISCOUNTS We have not adopted a fair value-based method of accounting for stock-based compensation plans for employees and non-employee directors. We will use the intrinsic value-based approach, and supplement disclosure of the pro forma impact on operations using the fair value-based approach as required by SFAS No. 148 "Accounting for Stock-Based Compensation - Transition and Disclosure". In accordance with SFAS No. 123 "Accounting for Stock-Based Compensation" prior to the acquisition of PivX LLC by Drilling stock-based compensation issued to non-employees and consultants was not measured at fair value and the minimum value method was instead applied since PivX LLC securities were not publicly traded. Stock-based compensation issued to non-employees and consultants since March 2004 has been and will be measured at fair value using the Black-Scholes valuation model. Common stock issued for services is recorded based on the closing ask price of our common stock. If shares are not registered, the closing ask price used to determine estimated fair value is discounted by 10%. ANNUAL ASSESSMENT AND EVALUATION FOR IMPAIRMENTS OF INTANGIBLE ASSETS We account for acquisitions under the purchase method of accounting in accordance with SFAS No. 141, "Business Combinations". In accordance with SFAS 142, "Goodwill and Other Intangible Assets" software is amortized over an estimated life of five years; trade names and goodwill, which have an indefinite life are not amortized and will be evaluated at least annually. The evaluation will be performed by grouping the net book value of all long-lived assets for acquired businesses, including goodwill and other intangible assets, and comparing this value to the related estimated fair value. The determination of fair value will be based on estimated future discounted cash flows related to these long-lived assets. The discount rate that is to be used will be based on the risks associated with the acquired businesses. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This Management's Discussion and Analysis of Financial Condition and Results of Operations discusses the significant factors affecting our consolidated operating results, financial condition, liquidity and cash flow during the three and nine months ended September 30, 2005 and 2004. This discussion should be read in conjunction with the consolidated financial statements and financial statement footnotes included elsewhere in this report and in our most recent Annual Report on Form 10-KSB as well as our amended Annual Report of Form 10-KSB/A. RESULTS OF OPERATIONS: THREE MONTHS ENDED SEPTEMBER 30, 2005 AND 2004 The following table sets forth the percentage relationship to total revenues of items included in the Company's Consolidated Statements of Operations for the quarters ended September 30, 2005 and 2004. REVENUES LICENSE REVENUES Three months Three months Change ended September 30, ended September 30, 2005 2004 ----------------------------------------------------------------------------- License Revenues $ 48,667 $ 13,619 $ 35,048 % to Total Revenues 41% 18% License revenues in the third quarter of 2005 increased by $35,048 from $13,619 in 2004 to $48,667 in 2005. The increase is primarily due to the launch of PreEmpt, also sold as Qwik-Fix Pro in certain venues, in August 2004 whereby the three months ended September 30, 2005 contained PreEmpt sales and the same quarter of the prior year had lower sales due to its start up. CONSULTING REVENUES Three months Three months Change ended September 30, ended September 30, 2005 2004 ----------------------------------------------------------------------------- Consulting Revenues $ 71,176 $ 62,171 $ 9,005 % to Total Revenues 59% 82% Consulting services in the third quarter of 2005 and 2004 primarily relate to computer forensic work and related expert testimony. 16 The nature of our consulting services has changed in the current year. In the prior year's quarter we consulted on computer security whereas in the current quarter we performed consulting services related to computer forensics. COST OF REVENUES Three months Three months Change ended September 30, ended September 30, 2005 2004 ----------------------------------------------------------------------------- Cost of Revenues $ 74,116 $ 15,776 $ 58,340 % to Total Revenue 62% 21% While revenues increased, our cost of revenues also increased by $58,340 in the third quarter of 2005 compared to the second quarter of 2004. The increase is primarily the result of our direct costs associated with our computer forensic services. It also includes the direct cost of travel and other costs associated with our computer forensic services. OPERATING EXPENSES SELLING Three months Three months Change ended September 30, ended September 30, 2005 2004 ----------------------------------------------------------------------------- Selling $ 125,178 $ 12,578 $ 112,600 % of Total Revenue 104% 17% Selling expenses consist of salaries and employee benefits for sales and marketing personnel, as well as direct selling expenses such as advertising and travel. The Company used a direct sales force for sales of PreEmpt as well as sales distributors. The increase is due to the direct salespeople in the current quarter whereas there were no direct sales people in the prior year as the product was just made available for sale in August 2004. GENERAL AND ADMINISTRATIVE Three months Three months Change ended September 30, ended September 30, 2005 2004 ----------------------------------------------------------------------------- General and $ 1,167,022 $ 1,010,771 $ 156,251 Administrative % of Total Revenue 974% 1334% General and administrative expenses consist of salaries and employee benefits for finance, information technology, human resources and general management personnel as well as corporate expenses such as the cost of consultants, marketing, insurance, facilities, telephone and other. The increase was a result of various non-cash expenditures such as amortization deferred compensation, partially offset by reduced headcounts and curtailment of non-essential expenditures, primarily in the area of marketing. RESEARCH AND DEVELOPMENT Three months Three months Change ended September 30, ended September 30, 2005 2004 ----------------------------------------------------------------------------- Research and $ 93,454 $ 462,117 $ (368,663) Development % to Total Revenues 78% 610% Research and development expenses consist primarily of salaries and benefits for software developers as well as an allocation of corporate expenses such as corporate insurance, telephone, rent, depreciation, and other allocable expenses. 17 Research and development expenses decreased $368,663 in the second quarter of 2005 as compared to the second quarter of 2004 due primarily to lower headcounts and lesser utilization of outside consultants as PreEmpt has been developed whereas in the prior year it was still being developed. IMPAIRMENT ON LONG LIVED ASSETS During the quarter ended September 30, 2005, the Company concluded that, due to the substantial reduction in headcount, continuing operating losses and under utilization of fixed assets consisting of furniture and fixtures as well as computer hardware and software, that the recoverability of the carrying value of these assets was impaired. Management assessed that the fair value of fixed assets approximated $10,001 which was substantially less then the net carrying value of $443,195 and therefore recorded an impairment loss of $433,194. INTEREST EXPENSE Three months Three months Change ended September 30, ended September 30, 2005 2004 ----------------------------------------------------------------------------- Interest Expense $ 328,251 $ 19,602 $308,649 Interest expense increased primarily due to accretion relating to the discount on our convertible notes. Additionally, we incurred the imputed interest charged on our 14 capital leases. The Company only had imputed lease interest expenses in the same quarter of the prior year. RESULTS OF OPERATIONS: NINE MONTHS ENDED SEPTEMBER 30, 2005 AND 2004 The following table sets forth the percentage relationship to total revenues of items included in the Company's Consolidated Statements of Operations for the nine month periods ended September 30, 2005 and 2004. REVENUES LICENSE REVENUES Nine months Nine months Change ended September 30, ended September 30, 2005 2004 ----------------------------------------------------------------------------- License Revenues $ 130,333 $18,028 $ 112,305 % to Total Revenues 31% 17% Our license revenues in the nine months ended September 30, 2005 increased by $112,305 from $18,028 in 2004 to $130,333 in 2005. The increase is primarily due to the launch of PreEmpt, also sold as Qwik-Fix Pro in certain venues, in August 2004 whereby the Nine months ended September 30, 2005 contained on-going Pre-Empt sales and the same quarter of the prior contained the beginning of Pre-Empt sales. CONSULTING REVENUES Nine months Nine months Change ended September 30, ended September 30, 2005 2004 ----------------------------------------------------------------------------- Consulting Revenues $ 283,661 $ 86,171 $ 197,490 % to Total Revenues 69% 83% Consulting services for the nine months ended September 2005 primarily relate to computer forensic work and related expert testimony. We had no computer forensic consulting services in the same period of the prior year, but did perform information security consulting services. 18 COST OF REVENUES Nine months Nine months Change ended September 30, ended September 30, 2005 2004 ----------------------------------------------------------------------------- Cost of Revenues $ 273,389 $ 16,726 $ 256,663 % to Total Revenue 66% 16% While revenues increased, our cost of revenues also increased by $256,663 in the nine months ended September 30, 2005 compared to the same period of 2004. The increase is primarily the result of our direct costs associated with our computer forensic services. It also includes the direct cost of travel and other direct costs associated with our computer forensic services. OPERATING EXPENSES SELLING Nine months Nine months Change ended September 30, ended September 30, 2005 2004 ----------------------------------------------------------------------------- Selling $ 672,006 $ 12,578 $ 659,428 % of Total Revenue 162% 12% Selling expenses consist of marketing, public relations, advertising, salaries and employee benefits for sales and marketing personnel, as well as direct selling expenses such as advertising and travel. The Company uses a direct sales force for sales of PreEmpt as well as sales distributors. GENERAL AND ADMINISTRATIVE Nine months Nine months Change ended September 30, ended September 30, 2005 2004 ----------------------------------------------------------------------------- General and $ 4,416,780 $ 2,385,659 $ 2,031,121 Administrative % of Total Revenue 1067% 2290% General and administrative expenses consist of salaries and employee benefits for finance, information technology, human resources, legal and general management personnel as well as corporate expenses such as the cost of consultants, marketing, insurance, facilities, telephone and other. The Company increased headcount significantly in the first quarter of 2005 to a high of 42 employees which was later decreased to 17 by September 30, 2005. RESEARCH AND DEVELOPMENT Nine months Nine months Change ended September 30, ended September 30, 2005 2004 ----------------------------------------------------------------------------- Research and $ 531,439 $ 811,134 $ (279,695) Development % to Total Revenues 128% 778% Research and development expenses consist primarily of salaries and benefits for software developers as well as an allocation of corporate expenses such as corporate insurance, telephone, rent, depreciation, and other allocable expenses. 19 Research and development expenses decreased $279,695 in the nine months ended September 30, 2005 as compared to the same period of 2004 due primarily to a reduction in R&D staff and consultant usage. IMPAIRMENT LOSS ON LONG LIVED ASSETS During the prior quarter ended June 30, 2005, the Company conducted the annual review of its long lived assets. The Company assessed the recoverability of the carrying value of software, tradename and goodwill stemming from the Threat Focus Acquisition. The assessment resulted in an impairment loss of $1,709,571 according to the following: $572,715 relating to software, $83,300 relating to trade name and $1,053,556 relating to goodwill. This loss reflects the amount by which the carrying values of these assets exceeded their estimated fair values as were determined by their estimated future discounted cash flows. Also during the current quarter ended September 30, 2005, the Company concluded that, due to the substantial reduction in headcount, continuing operating losses and under utilization of fixed assets consisting of furniture and fixtures as well as computer hardware and software, that the recoverability of the carrying value of these assets was impaired. Management assessed that the fair value of fixed assets approximated $10,001 which was substantially less then the net carrying value of $443,195 and therefore recorded an impairment loss of $433,194. INTEREST EXPENSE Nine months Nine months Change ended September 30, ended September 30, 2005 2004 ----------------------------------------------------------------------------- Interest Expense $ 610,186 $ 22,949 $ 587,237 % of Total Revenue 147% 22% Interest expense increased primarily due to accretion of the discount on our convertible notes. Additionally, we incurred the imputed interest charged on our 14 capital leases. The Company did not have any such expenses in the same period of the prior year. CASH POSITION AND USES OF CASH As of September 30, 2005, our cash position was a negative $1,215 and, accordingly, was recorded as an overdraft and has been included in accounts payable in our consolidated balance sheet. During the nine months ended September 30, 2005, we used $3,408,945 in cash in our operating activities, as compared to $2,117,737 for the nine months ended September 30, 2004. We continued to use cash to fund operations and overhead costs through September 30, 2005. However, we initiated additional significant reductions in cash expenditures during the quarter ended September 30, 2005 and will continue these reductions until we have resolved our working capital deficit. During the nine months ended September 30, 2005, our financing activities provided cash through placements of common stock and debt issuances and related-party loans in the aggregate amount of $3,208,493 as compared to $2,877,538 for the nine months ended September 30, 2004. Given our negative working capital situation, we must manage the use of cash closely. Should we be unable to satisfy our liabilities on a timely basis through the payment of cash or issuance of equities, our operations may be negatively impacted and we may be forced into bankruptcy. LIQUIDITY AND CASH RESOURCES The accompanying consolidated financial statements, included elsewhere in this Quarterly Report on Form 10-QSB, have been prepared in conformity with accounting principles generally accepted in the United States of America, which contemplate continuation as a going concern. We have incurred a net loss of $8,232,571 for the nine months ended September 30, 2005. As of September 30, 2005, we had an accumulated deficit of $18,171,810. At September 30, 2005, we had negative working capital of $2,716,278. We need additional capital to market PreEmpt and fund losses from operations as we build revenue and strive to achieve profitability. 20 Should the Company be unable to raise sufficient funds, its ability to continue as a going concern will be materially adversely affected. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty. We are currently in discussions with capital funding sources. OFF-BALANCE SHEET ARRANGEMENTS We do not have any off-balance sheet financing arrangements. RISK FACTORS Our business, financial condition and operating results can be impacted by a number of factors, any of which could cause our actual results to vary materially from recent results or from our anticipated future results. You should carefully consider the following risk factors that may affect the Company. The risks and uncertainties described below are those that we currently deem to be material and that we believe are specific to our Company. If any of these or other risks actually occur, our business, financial condition and results of operations could be materially and adversely affected, which in turn could materially and adversely affect the trading price of our common stock. WE HAVE A HISTORY OF LOSSES AND WE MAY NEVER BECOME PROFITABLE. We have experienced a net loss of approximately $8.2 million for the first nine months of 2005. We have also experienced net losses of $8.6 million and $0.6 million in fiscal 2004 and 2003, respectively, and we expect to continue to incur net losses for the foreseeable future. In order to become profitable, we will need to significantly increase our revenues from our flagship product, PreEmpt. If we fail to increase revenues from subscription fees for PreEmpt, we will continue to experience losses indefinitely. Our current working capital deficiency is adversely affecting our ability to effectively market PreEmpt to current and prospective customers. We can provide no assurance that we will be able to obtain the resources necessary to market PreEmpt successfully which has and will continue to have a materially adverse effect on our business, operating results and financial condition. OUR SECURITIES ARE QUOTED ON THE OTC BULLETIN BOARD, WHICH WILL LIMIT THE LIQUIDITY AND PRICE OF OUR SECURITIES MORE THAN IF OUR SECURITIES WERE QUOTED ON A NATIONAL SECURITIES EXCHANGE OR THE NASDAQ STOCK MARKET. Our common stock is quoted for trading on the Over the Counter Bulletin Board. Our ability to have a liquid trading market develop for our common stock will be diminished if our common stock is not approved for quotation on a national securities exchange or the NASDAQ stock market. OUR COMMON STOCK IS SUBJECT TO THE SEC'S PENNY STOCK RULES AND THEREFORE OUR STOCKHOLDERS MAY FIND IT DIFFICULT TO SELL THEIR STOCK. The trading price of our common stock has been less that $5.00 per share and, therefore, is subject to the SEC's penny stock rules. Before a broker-dealer can sell a penny stock, the penny stock rules require that the firm first approve the transaction and receive from the customer a written agreement to the transaction. The firm must furnish the customer a document describing the risks of investing in penny stocks. The broker-dealer must tell the customer the current market quotation, if any, for the penny stock and the compensation the firm and its broker will receive for the trade. Finally, the firm must send monthly account statements showing the market value of each penny stock held in the customer's account. These disclosure requirements tend to make it more difficult for a broker-dealer to make a market in penny stocks, and could reduce the level of trading activity in a stock that is subject to the penny stock rules. Consequently, because our common stock is subject to the penny stock rules, our stockholders may find it difficult to sell their shares. WE ARE AN EARLY-STAGE COMPANY WITH AN UNPROVEN BUSINESS MODEL, WHICH MAKES IT DIFFICULT TO EVALUATE OUR CURRENT BUSINESS AND FUTURE PROSPECTS. We have only a limited operating history upon which to base an evaluation of our current business and future prospects. We released our commercial version of PreEmpt in August 2004, and we have directed a majority of our focus on this market. As a result, the revenue and income potential of our business and our market are unproven. Due to our limited operating history and because the market for security software products and services is relatively new and rapidly evolving, we have limited insight into trends that may emerge and affect our business. We may make errors in predicting and reacting to relevant business trends, which could harm our business. 21 We may not be able to successfully address any or all of these risks. Failure to adequately do so could cause our business, results of operations and financial condition to suffer. OUR INDEPENDENT AUDITORS' OPINION ON OUR AUDITED FINANCIAL STATEMENTS AS OF AND FOR THE YEAR ENDED DECEMBER 31, 2004 INCLUDES A GOING CONCERN QUALIFICATION. Our independent auditors have included an explanatory paragraph in their audit report issued in connection with our financial statements that states that our recurring operating losses since inception raise substantial doubt about our ability to continue as a going concern. Our financial statements do not include any adjustments to the amounts and classification of assets and liabilities that may be necessary should we be unable to continue as a going concern. Our ability to continue as a going concern is dependent upon our ability to generate profitable operations in the future and/or to obtain the necessary financing to meet our obligations and repay our liabilities arising from normal business operations when they come due. The outcome of these matters cannot be predicted with any certainty at this time. Since inception, we have satisfied our capital needs primarily by issuing equity securities. With the introduction of our primary product into the market and following the results of the first evaluation sales, our management believes that the technology is a viable revenue stream. There is no guarantee that the product will be accepted or provide a marketable advantage and therefore no guarantee that the product will ever be profitable. In addition, we currently do not have sufficient capital to provide for our capital needs and we will have to issue equity securities or obtain financing to continue our operations. However, there is no guarantee that we will be successful in obtaining sufficient capital through borrowings or selling equity securities. Obtaining additional financing may be more difficult because of the uncertainty regarding our ability to continue as a going concern. If we are unable to generate additional revenues or profits from our product sales or we are unable to secure additional financing on acceptable terms or at all, we may be forced to discontinue product development, forgo sales and marketing efforts or forgo attractive business opportunities to improve our liquidity to enable us to continue operations. BECAUSE WE EXPECT TO DERIVE THE MAJORITY OF OUR FUTURE REVENUE FROM SUBSCRIPTION FEES, ANY FAILURE OF OUR PRODUCT TO SATISFY CUSTOMER DEMANDS OR TO ACHIEVE MORE WIDESPREAD MARKET ACCEPTANCE WILL SERIOUSLY HARM OUR BUSINESS. We have traditionally relied on forensics and consulting fees, but with the introduction of PreEmpt substantially all of our future revenues are expected to come from software subscriptions. As a result, if for any reason revenues from PreEmpt and other software products decline, our operating results and our business will continue to suffer. If PreEmpt fails to meet the needs of our target customers, or if it does not compare favorably in price and performance to competing products, our growth will be limited. We cannot assure you that PreEmpt will achieve further market acceptance. Our future financial performance also will depend, in part, on our ability to diversify our offerings by successfully developing, introducing and gaining customer acceptance of new products and enhanced versions of PreEmpt. We cannot assure you, however, that we will be successful in achieving market acceptance of any new products that we develop or of enhanced versions of PreEmpt. Any failure or delay in diversifying our existing offerings could harm our business, results of operations and financial condition. THE MARKET FOR NETWORK SECURITY PRODUCTS IS EMERGING, AND IF WE ARE NOT SUCCESSFUL IN PROMOTING AWARENESS OF THE NEED FOR PREEMPT AND OUR PREEMPT BRAND, OUR GROWTH MAY BE LIMITED. Based on our experience with customers and potential customers, we believe that many corporations are unaware of the scope of problems caused by worms and viruses. In addition, there may be a time-limited opportunity to achieve and maintain a significant share of the market for network security software products due in part to the emerging nature of this market and the substantial resources available to our existing and potential competitors. We intend to promote awareness of the problems caused by worms and viruses and the efficiency of PreEmpt to proactively prevent these threats, but we cannot assure you that we will be successful in this effort. The market for PreEmpt may develop more slowly than we expect, which could adversely affect our operating results. Developing and maintaining awareness of PreEmpt is critical to achieving widespread acceptance of our existing and future Internet management products. Furthermore, we believe that the importance of brand recognition will increase as competition in our market develops. Successful promotion of our PreEmpt brand will depend largely on the effectiveness of our marketing efforts and on our ability to develop reliable and useful products at competitive prices. We currently do not have sufficient working capital to effectively market PreEmpt on a large scale, which has and will continue to hurt our results of operations and financial condition. 22 WE MUST DEVELOP AND EXPAND OUR INDIRECT SALES CHANNELS TO INCREASE REVENUE AND IMPROVE OUR OPERATING RESULTS. We currently sell our products both indirectly and directly; however, we intend to rely increasingly on our indirect sales channels. We depend on our indirect sales channels, including value-added resellers, distributors and original equipment manufacturers, to offer PreEmpt to a larger customer base than we can reach through our direct sales efforts. We will need to expand our existing relationships and enter into new relationships to increase our current and future market share and revenue. We cannot assure you that we will be able to maintain and expand our existing relationships or enter into new relationships, or that any new relationships will be available on commercially reasonable terms. If we are unable to maintain and expand our existing relationships or enter into new relationships, we would lose customer introductions and co-marketing benefits and our operating results could suffer. OUR RELIANCE ON INDIRECT SALES CHANNELS COULD RESULT IN REDUCED REVENUE GROWTH BECAUSE WE HAVE LITTLE CONTROL OVER OUR VALUE-ADDED RESELLERS, DISTRIBUTORS AND ORIGINAL EQUIPMENT MANUFACTURERS. We anticipate that sales from our various indirect sales channels, including value-added resellers, distributors, original equipment manufacturers, and others, will account for an increasing percentage of our total revenues in future periods. None of these parties is obligated to continue selling our products or to make any purchases from us. Our ability to generate increased revenue depends significantly upon the ability and willingness of our indirect sales channels to market and sell our products to organizations worldwide. If they are unsuccessful in their efforts, our operating results will suffer. We cannot control the level of effort these parties expend or the extent to which any of them will be successful in marketing and selling our products. Many of our indirect sales channels also market and sell products that compete with PreEmpt. We may not be able to prevent these parties from devoting greater resources to support our competitors' products. WE FACE INCREASING COMPETITION FROM BETTER ESTABLISHED COMPANIES THAT MAY HAVE SIGNIFICANTLY GREATER RESOURCES, WHICH COULD PREVENT US FROM INCREASING REVENUE OR ACHIEVING PROFITABILITY. The market for our products is intensely competitive and is likely to become even more so in the future. Increased competition could result in pricing pressures, reduced sales, reduced margins or the failure of PreEmpt to achieve or maintain more widespread market acceptance, any of which would have a material adverse effect on our business, results of operations and financial condition. Our current principal competitors include Symantec Corporation, McAfee, Inc., Cisco Systems, Inc., Sophos Plc, PrevX Limited, Panda Software, and Trend Micro Incorporated. Many of our current and potential competitors enjoy substantial competitive advantages, such as: o greater name recognition and larger marketing budgets and resources; o established business reputations and marketing relationships and access to larger customer bases; o substantially greater financial, technical and other resources. As a result, they may be able to use their extensive resources to: o develop and deploy new products and services more quickly and effectively than we can; o adapt more swiftly and completely to new or emerging technologies and changes in customer requirements; o offer bundles of related services that we are unable to offer; o take advantage of acquisition and other opportunities more readily; and o devote greater resources to the marketing and sales of their products. For all of the foregoing reasons, we may not be able to compete successfully against our current and future competitors. OUR FUTURE GROWTH DEPENDS ON OUR EXISTING CUSTOMERS RENEWING AND PURCHASING ADDITIONAL SUBSCRIPTIONS TO PREEMPT. Our future success depends on achieving substantial revenue from customer renewals for subscriptions to PreEmpt. Subscriptions for PreEmpt typically have duration of 12 months. Our customers have no obligation to renew their subscriptions upon expiration. We cannot assure you that we will generate significant revenue from renewals. To maintain our revenues we must continue to sell renewal subscriptions. 23 Our future success also depends on our ability to sell subscriptions to existing customers for additional employees within their respective organizations. This may require increasingly sophisticated sales efforts targeting senior management and other management personnel associated with our customers' infrastructure. PREEMPT MAY NOT MEET CUSTOMER EXPECTATIONS. We may not succeed in accurately preventing worms and viruses with PreEmpt to meet our customers' expectations. Any failure by PreEmpt to prevent a breach of an enterprise network or home user desktop security will impair the growth of our business and our efforts to increase brand acceptance. PREEMPT MAY FAIL TO KEEP PACE WITH THE RAPID GROWTH AND TECHNOLOGICAL CHANGE OF THE INTERNET. The success of PreEmpt depends on the breadth and accuracy of our security software. We cannot assure that our software will be able to keep pace with the growth in complexity of worms and viruses. Further, the ongoing evolution of network security will require us to continually improve the functionality, features and reliability of our software. Any failure of our software to keep pace with the rapid growth and technological changes will impair market acceptance, which in turn will harm our business, results of operations and financial condition. IF WE ACQUIRE ANY COMPANIES OR TECHNOLOGIES IN THE FUTURE, THEY COULD PROVE DIFFICULT TO INTEGRATE, DISRUPT OUR BUSINESS, DILUTE STOCKHOLDER VALUE AND ADVERSELY AFFECT OUR OPERATING RESULTS. In June 2004 we acquired Threat Focus, Inc. and we may continue to acquire or make investments in complementary companies, services and technologies in the future. Acquisitions and investments involve numerous risks, including: o difficulties in integrating operations, technologies, services and personnel; o diversion of financial and management resources from existing operations; o risk of entering new markets; o potential loss of key employees; and o inability to generate sufficient revenues to offset acquisition or investment costs. In addition, if we finance acquisitions by issuing convertible debt or equity securities, our existing stockholders may be diluted which could affect the market price of our stock. As a result, if we fail to properly evaluate and execute acquisitions or investments, our business and prospects may be seriously harmed. WE ARE DEPENDENT ON OUR MANAGEMENT TEAM, AND THE LOSS OF ANY KEY MEMBER OF THIS TEAM MAY PREVENT US FROM IMPLEMENTING OUR BUSINESS PLAN IN A TIMELY MANNER. Our success depends largely upon the continued services of our executive officers and other key management and development personnel. We are also substantially dependent on the continued service of our existing engineering personnel because of the complexity of our products and technologies. We do not maintain key person life insurance policies on any of our employees. The loss of one or more of our key employees could seriously harm our business, results of operations and financial condition. We cannot assure you that in such an event we would be able to recruit personnel to replace these individuals in a timely manner, or at all, on acceptable terms. BECAUSE COMPETITION FOR OUR TARGET EMPLOYEES IS INTENSE, WE MAY NOT BE ABLE TO ATTRACT AND RETAIN THE HIGHLY SKILLED EMPLOYEES WE NEED TO SUPPORT OUR PLANNED GROWTH. To execute our growth plan, we must attract and retain highly qualified personnel. We need to retain personnel in virtually all operational areas, including selling and marketing, research and development, operations and technical support, customer service, finance/accounting and administration. Competition for these personnel is intense, especially for engineers with high levels of experience in designing and developing software products. We cannot assure you that we will be successful in attracting and retaining qualified personnel. We have from time to time in the past experienced, and we expect to continue to experience in the future, difficulty in hiring and retaining highly skilled employees with appropriate qualifications. Many of the companies with which we compete for experienced personnel have greater resources than we have. If we fail to attract new personnel or retain and motivate our current personnel, our business and future growth prospects could be severely harmed. 24 OUR RESULTS MAY FLUCTUATE SIGNIFICANTLY, AND THESE FLUCTUATIONS MAY CAUSE OUR STOCK PRICE TO FALL. Our results have varied significantly in the past, and will likely vary in the future as the result of a number of factors, many of which are beyond our control. These factors include, among others: o fluctuations in our operating expenses; o marketing expenses for activities such as trade shows and advertising campaigns; o general and administrative expenses, such as recruiting expenses and professional services fees; o research and development costs; o the gain or loss of significant customers; o market acceptance of our products; o our ability to develop, introduce and market new products and technologies on a timely basis; o the timing and extent of product development costs; o new product and technology introductions by competitors; and o the effect of competitive pricing pressures. The foregoing factors are difficult to forecast, and these as well as other factors could materially adversely affect our results. As a result, it is possible that in some future periods, our results of operations may be below the expectations of current or potential investors. If this occurs, the price of our common stock may decline. ANY FAILURE TO PROTECT OUR INTELLECTUAL PROPERTY RIGHTS COULD IMPAIR OUR ABILITY TO PROTECT OUR PROPRIETARY TECHNOLOGY AND ESTABLISH OUR PREEMPT BRAND. Intellectual property is critical to our success, and we rely upon trademark, copyright and trade secret laws in the United States and other jurisdictions as well as confidentiality procedures and contractual provisions to protect our proprietary technology and our PreEmpt brand. Any of our trademarks may be challenged by others or invalidated through administrative process or litigation. We currently have no issued patents and may be unable to obtain patent protection in the future. In addition, any issued patents may not provide us with any competitive advantages, or may be challenged by third parties. Furthermore, legal standards relating to the validity, enforceability and scope of protection of intellectual property rights are uncertain. Effective patent, trademark, copyright and trade secret protection may not be available to us in every country in which our products are available. The laws of some foreign countries may not be as protective of intellectual property rights as United States laws, and mechanisms for enforcement of intellectual property rights may be inadequate. As a result, we cannot assure you that our means of protecting our proprietary technology and brands will be adequate. Furthermore, despite our efforts, we may be unable to prevent third parties from infringing upon or misappropriating our intellectual property. Any such infringement or misappropriation could have a material adverse effect on our business, results of operations and financial condition. WE MAY BE SUED BY THIRD PARTIES FOR ALLEGED INFRINGEMENT OF THEIR PROPRIETARY RIGHTS. The software and Internet industries are characterized by the existence of a large number of patents, trademarks and copyrights and by frequent litigation based on allegations of patent infringement or other violations of intellectual property rights. As the number of entrants into our market increases, the possibility of an intellectual property claim against us grows. Our technologies and products may not be able to withstand any third-party claims or rights against their use. Any intellectual property claims, with or without merit, could be time-consuming and expensive to litigate or settle, and could divert management attention from executing our business plan. 25 WE MAY NOT BE ABLE TO DEVELOP ACCEPTABLE NEW PRODUCTS OR ENHANCEMENTS TO OUR EXISTING PRODUCTS AT A RATE REQUIRED BY OUR RAPIDLY CHANGING MARKET. Our future success depends on our ability to develop new products or enhancements to our existing products that keep pace with rapid technological developments and that address the changing needs of our customers. We will need to continuously modify and enhance PreEmpt to keep pace with changes in Internet-related hardware, software, communication and browser technologies. We may not be successful in either developing such products or timely introducing them to the market. In addition, uncertainties about the timing and nature of new network platforms or technologies, or modifications to existing platforms or technologies, could increase our research and development expenses. The failure of our products to operate effectively with the existing and future network platforms and technologies will limit or reduce the market for our products, result in customer dissatisfaction and seriously harm our business, results of operations and financial condition. OTHER VENDORS MAY DEVELOP PRODUCTS SIMILAR TO OURS FOR INCORPORATION INTO THEIR HARDWARE OR SOFTWARE, AND THEREBY REDUCE DEMAND FOR PREEMPT. In the future, vendors of Internet-related hardware and software may enhance their products or develop separate products that include functions that are currently provided by PreEmpt. If network security software functions become standard features of Internet-related hardware or software, the demand for PreEmpt will decrease. OUR SYSTEMS MAY BE VULNERABLE TO SECURITY RISKS OR SERVICE DISRUPTIONS THAT COULD HARM OUR BUSINESS. Our servers are vulnerable to physical or electronic break-ins and service disruptions, which could lead to interruptions, delays, loss of data or the inability to process customer requests. Such events could be very expensive to remedy, could damage our reputation and could discourage existing and potential customers from using our products. We may experience break-ins in the future. Any such events could substantially harm our business, results of operations and financial condition. BECAUSE OUR PRODUCTS ARE COMPLEX AND ARE DEPLOYED IN A WIDE VARIETY OF COMPLEX NETWORK ENVIRONMENTS, THEY MAY HAVE ERRORS OR DEFECTS THAT USERS IDENTIFY AFTER DEPLOYMENT, WHICH COULD HARM OUR REPUTATION AND OUR BUSINESS. Products as complex as ours frequently contain undetected errors when first introduced or when new versions or enhancements are released. We have from time to time found errors in versions of PreEmpt, and we may find such errors in the future. The occurrence of errors could adversely affect sales of our products, divert the attention of engineering personnel from our product development efforts and cause significant customer relations problems. Because customers rely on PreEmpt to prevent worms and viruses, any significant defects or errors in our products may result in negative publicity or legal claims. Negative publicity or legal claims could seriously harm our business, results of operations and financial condition. ITEM 3.CONTROLS AND PROCEDURES As required by SEC rules, we have evaluated the effectiveness of the design and operation of our disclosure controls and procedures for the three and nine months ended September 30, 2005. This evaluation was carried out under the supervision and with the participation of our management, including our principal executive officer and principal financial officer. Based on this evaluation, these officers have concluded that the design and operation of our disclosure controls and procedures are effective, to ensure that the information required to be disclosed in our reports filed or submitted under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the requisite time periods. We are enhancing our internal control procedures in preparation of having to make the required management report on internal control over financial reporting required by Section 404 of the Sarbanes-Oxley Act of 2002 ("Sarbanes-Oxley"). We will also engage a financial and auditing consultant to ensure timely compliance with the requirements of the Sarbanes-Oxley. 26 PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS The Company is currently the defendant to legal proceedings in which certain vendors are seeking payment for services. The Company has included these liabilities in accounts payable. The Company intends to settle these matters to the best of its abilities. ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS During the fiscal quarter ended September 30, 2005, the Company issued and sold an aggregate of approximately $75,000 in principal amount of Convertible Promissory Notes (the "Notes"). The Notes are convertible into shares of Common Stock at a conversion price of $0.15 per share. The Notes bear interest at an annual rate of 12% and mature one year after the date of issuance. In addition, each investor received warrants to purchase a number of additional shares of Common Stock equal to fifty percent (50%) of the principal amount of the their Notes at an exercise price of $0.50 per share. If all Notes were converted and all warrants exercised, a total of 5,819,333 shares of Common Stock would be issued. The Notes were issued to an aggregate of 14 investors of whom 6 were residents of the United States. All investors were "accredited investors." The securities were issued in a transaction not involving a public offering and were issued in reliance upon the exemption from registration provided by Section 4(2) of the Securities Act of 1933 (including Regulation D promulgated thereunder) or were exempt from registration pursuant to Regulation S promulgated under Section 5 of the Securities Act of 1933. The entities and individuals to whom the securities were issued had access to full information concerning the Company. The instruments representing the securities contain a restrictive legend advising that the securities may not be offered for sale, sold or otherwise transferred without having first been registered under the Securities Act of 1933 or pursuant to an exemption from registration under such act. The securities were placed directly by the Company and by Falcon Capital which served as a placement agent for the Company. On August 8, 2005, the Company began a private placement offering of up to 3 million shares of Common Stock at $0.25 per share to accredited investors, with every 2 shares purchased receiving 1 warrant to purchase a share of common stock with an exercise price of $0.50. As of September 30, 2005, $274,000 has been raised through this offering for a commitment to issue 1,096,000 shares of common stock. These sales were exempt from registration under the Securities Act pursuant to Section 4(2) of the Securities Act of 1933, as amended (the "Securities Act") or Regulation D under the Securities Act. The Company is also committed to issue warrants to purchase 548,000 shares of common stock at an exercise price of $0.50. The warrants are exercisable until the earlier of (i) two years from their effective issuance or (ii) thirty days after a "Call" by the Company. The Company may call the Warrants at any time the closing price per share of the Company's common stock equals or exceeds $1.00. If not exercised with thirty days after a Call, the Warrants will expire and will no longer be exercisable. Using the Black Scholes model and assuming volatility of 160%, a risk free rate of 4.03%, an expected life of 2 years with no dividend yield, the warrants have a fair value of $0.21 per share or a total fair value of $115,080. ITEM 3. DEFAULTS UPON SENIOR SECURITIES None. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. ITEM 5. OTHER INFORMATION None. ITEM 6. EXHIBITS EXHIBITS DESCRIPTION 31.1 Rule 13a-14(a) Certification of Chief Executive Officer and Interim Principal Financial Officer 32.1 Certification of Chief Executive Officer Interim Principal Financial Officer pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 27 SIGNATURES In accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. PIVX SOLUTIONS, INC. November 21, 2005 By: /s/ Tydus Richards ----------------------------------- Tydus Richards Chief Executive and Interim Principal Financial Officer 28 EX-31.1 2 pivx_ex3101.txt EXHIBITS EXHIBIT 31.1 CERTIFICATIONS I, Tydus Richards, Chief Executive Officer, Interim Principal Financial Officer and Chairman of the Board of PivX Solutions, Inc., certify that: 1. I have reviewed this Quarterly Report on Form 10-QSB of PivX Solutions, Inc.; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the small business issuer as of, and for, the periods presented in this report; 4. I am responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e) for the small business issuer and have: a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the small business issuer, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) evaluated the effectiveness of the small business issuer's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and c) disclosed in this report any changes in the small business issuer's internal control over financial reporting that occurred during the small business issuer's most recent fiscal quarter (the small business issuer's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the small business issuer's internal control over financial reporting; and 5. I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the small business issuer's auditors and the audit committee of small business issuer's board of directors (or persons performing the equivalent functions): a) all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the small business issuer's ability to record, process, summarize and report financial information; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the small business issuer's internal control over financial reporting. Date: November 21, 2005 /s/ Tydus Richards ----------------------------------- Tydus Richards Chief Executive Officer Interim Principle Financial Officer Chairman of the Board EX-32.1 3 pivx_ex3201.txt EXHIBIT 32.1 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Quarterly Report of PivX Solutions, Inc. (the "Company") on Form 10-QSB for the quarter ending September 30, 2005 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), Tydus Richards, as Chief Executive Officer, and interim Principal Financial Officer of the Company, hereby certifies, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that to the best of his knowledge, that: (1) The report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. November 21, 2005 By: /s/ Tydus Richards ----------------------------------- Tydus Richards Chief Executive Officer Interim Principle Financial Officer Chairman of the Board -----END PRIVACY-ENHANCED MESSAGE-----