10-Q 1 ed03q1final.txt QUARTERLY REPORT UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q [X] Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the quarterly period ended March 31, 2003 [ ] Transition Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the transition period from to . Commission file number 0-23862 Fonix Corporation (Exact name of registrant as specified in its charter) Delaware 22-2994719 (State of Incorporation) (I.R.S. Employer Identification No.) 180 W. Election Road, Suite 200 Draper, UT 84020 (Address of principal executive offices, including zip code) (801) 553-6600 (Registrant's telephone number, including area code) Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X or No As of May 12, 2003, 19,652,488 shares of Class A voting common stock, par value $0.0001 per share, were issued and outstanding. FONIX CORPORATION FORM 10-Q TABLE OF CONTENTS PART I - FINANCIAL INFORMATION Page Item 1. Financial Statements (Unaudited) Condensed Consolidated Balance Sheets - As of March 31, 2003 and December 31, 2002 2 Condensed Consolidated Statements of Operations and Comprehensive Loss for the Three Months Ended March 31, 2003 and 2002 3 Condensed Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2003 and 2002 4 Notes to Condensed Consolidated Financial Statements 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 17 Item 3. Quantitative and Qualitative Disclosures About Market Risk 28 Item 4. Evaluation of Disclosure Controls and Procedures 28 PART II - OTHER INFORMATION Item 1. Legal Proceedings 28 Item 2. Changes in Securities 28 Item 3. Defaults Upon Senior Securities 28 Item 4. Submission of Matters to a Vote of Security Holders 28 Item 6. Exhibits and Reports on Form 8-K 29 Fonix Corporation CONDENSED CONSOLIDATED BALANCE SHEETS (Unaudited)
March 31, December 31, ASSETS 2003 2002 ---------------- ---------------- Current assets: Cash and cash equivalents $ 20,292 $ 23,739 Accounts receivable 28,000 26,974 Convertible note receivable - 402,765 Inventory 50,495 51,937 Prepaid expenses and other current assets 78,819 185,429 ---------------- ---------------- Total current assets 177,606 690,844 Property and equipment, net of accumulated depreciation of $1,756,904 and $1,671,809, respectively 530,796 625,448 Investment in and note receivable from affiliate, net of unamortized discount of $16,715 and $58,548, respectively 1,147,598 1,259,320 Intangible assets, net of accumulated amortization of $333,207 and $299,457, respectively 1,157,835 1,191,585 Goodwill, net of accumulated amortization of $2,295,598 2,631,304 2,631,304 Other assets 121,302 124,979 ---------------- ---------------- Total assets $ 5,766,441 $ 6,523,480 ================ ================ LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Series D Debentures, net of unamortized discount of $249,251 and $582,630, respectively $ 357,816 $ 917,370 Note payable to affiliate 1,000,000 1,000,000 Note payable 134,020 250,000 Notes payable - related parties 493,175 493,175 Current portion of notes payable other 100,784 75,000 Accrued payroll 6,247,938 5,265,809 Accounts payable 3,311,754 3,083,425 Accrued liabilities 1,594,047 1,737,267 Accrued liabilities - related parties 1,443,300 1,443,300 Deferred revenues 849,250 854,248 ---------------- ---------------- Total current liabilities 15,532,084 15,119,594 ---------------- ---------------- Long-term portion of notes payable, net of current portion 87,984 - Long-term borrowings 9,068 3,312 ---------------- ---------------- Total long-term liabilities 97,052 3,312 Total liabilities 15,629,136 15,122,906 ---------------- ---------------- Commitments and contingencies (Notes 1, 3, 5, 6, 7, 8 and 12) Stockholders' deficit: Preferred stock, $0.0001 par value; 50,000,000 shares authorized; Series A, convertible; 166,667 shares outstanding (aggregate liquidation preference of $6,055,012) 500,000 500,000 Common stock, $0.0001 par value; 800,000,000 shares authorized; Class A voting, 17,177,218 and 12,306,333 shares outstanding, respectively 1,718 1,230 Class B non-voting, none outstanding - - Additional paid-in capital 186,528,173 183,514,560 Outstanding warrants to purchase Class A common stock 1,334,000 1,360,000 Cumulative foreign currency translation adjustment 50,049 31,704 Accumulated deficit (198,276,635) (194,006,920) ---------------- ---------------- Total stockholders' deficit (9,862,695) (8,599,426) ---------------- ---------------- Total liabilities and stockholders' deficit $ 5,766,441 $ 6,523,480 ================ ================
See accompanying notes to condensed consolidated financial statements. 2 Fonix Corporation CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS (Unaudited)
Three Months Ended March 31, -------------------------------------- 2003 2002 ----------------------- ------------- Revenues $ 589,670 $ 298,785 Cost of revenues 80,217 44,104 ----------------------- ------------- Gross profit 509,453 254,681 ----------------------- ------------- Expenses: Selling, general and administrative 2,250,698 3,229,403 Product development and research 1,675,113 2,126,151 ----------------------- ------------- Total expenses 3,925,811 5,355,554 ----------------------- ------------- Loss from operations (3,416,358) (5,100,873) ----------------------- ------------- Other income (expense): Interest income - 27,935 Interest expense (741,635) (57,748) ----------------------- ------------- Total other income (expense), net (741,635) (29,813) ----------------------- ------------- Loss from operations before equity in net loss of affiliate (4,157,993) (5,130,686) Equity in net loss of affiliate (111,722) (113,954) ----------------------- ------------- Net loss (4,269,715) (5,244,640) Other comprehensive income (loss) - foreign currency translation 18,345 (872) ----------------------- ------------- Comprehensive loss $ (4,251,370) $ (5,245,512) ======================= ============= Basic and diluted net loss per common share $ (0.30) $ (0.54) ======================= =============
See accompanying notes to condensed consolidated financial statements. 3 Fonix Corporation CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
Three Months Ended March 31, ------------------------------ 2003 2002 --------------- ------------- Cash flows from operating activities: Net loss $ (4,269,715) $ (5,244,640) Adjustments to reconcile net loss to net cash used in operating activities: Non-cash compensation expense related to issuance of stock options - 3,889 Accretion of discount on note receivable from affiliate 41,826 (4,518) Accretion of discount on note payable to affiliate - 34,193 Accretion of discount on note payable - 21,135 Accretion of discount on Series D Debentures 618,479 - Amortization of deferred loan costs 38,331 - Loss on disposal of property and equipment 1,066 - Depreciation and amortization 133,540 127,137 Equity in net loss of affiliate 69,896 113,954 Foreign exchange (gain)/loss 14,746 (738) Changes in assets and liabilities: Accounts receivable (1,026) 20,840 Inventory 1,442 (4,219) Prepaid expenses and other current assets 68,279 (91,919) Other assets 3,677 44 Accounts payable 342,097 (331,119) Accrued payroll 982,129 - Accrued liabilities (123,733) 390,566 Accrued liabilities - related party - (8,333) Deferred revenues (4,998) 163,675 --------------- ------------- Net cash used in operating activities (2,083,964) (4,810,053) --------------- ------------- Cash flows from investing activities: Repayment of notes receivable 402,765 - Issuance of notes receivable - (655,000) Purchase of property and equipment (2,025) (28,573) Proceeds from sale of Healthcare Solutions Group - - --------------- ------------- Net cash provided by (used in) investing activities 400,740 (683,573) --------------- ------------- Cash flows from financing activities: Proceeds from sale of Class A common stock, net 2,440,001 6,113,029 Receipt of common stock subscription receivable - 852,970 Payments on note payable to affiliate - (550,000) Proceeds from long-term debt 5,756 - Payments on Series D Debentures (650,000) - Payments on note payable (115,980) (460,000) Principal payments on capital lease obligation - (15,747) --------------- ------------- Net cash provided by financing activities 1,679,777 5,940,252 --------------- ------------- Net (decrease) increase in cash and cash equivalents (3,447) 446,626 Cash and cash equivalents at beginning of period 23,739 201,401 --------------- ------------- Cash and cash equivalents at end of period $ 20,292 $ 648,027 =============== =============
See accompanying notes to condensed consolidated financial statements. 4 Fonix Corporation CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (continued)
Three Months Ended March 31, ------------------------- Supplemental disclosure of cash flow information: 2003 2002 ----------- ------------ Cash paid during the period for interest $ 19,350 $ 55,725
Supplemental Schedule of Non-cash Investing and Financing Activities: For the Three Months Ended March 31, 2003: Issued 627,087 shares of Class A common stock in conversion of $242,933 of Series D Debentures principal and $20,067 of related accrued interest Issued 237,584 shares of Class A common stock valued at $285,100 as consideration for deferment of Series D Debentures; issuance of shares represented an increase to the discount to be amortized over the revised term of the Series D Debentures Converted $113,768 of accounts payable into a note payable For the Three Months Ended March 31, 2002: Issued 334,855 shares of Class A common stock for $1,064,970 in subscriptions receivable. See accompanying notes to condensed consolidated financial statements. 5 FONIX CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation - The accompanying unaudited condensed consolidated financial statements of Fonix Corporation and subsidiaries (collectively, the "Company" or "Fonix") have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission (the "SEC"). Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations, although the Company believes that the following disclosures are adequate to make the information presented not misleading. These condensed consolidated financial statements reflect all adjustments (consisting only of normal recurring adjustments) that, in the opinion of management, are necessary to present fairly the financial position and results of operations of the Company for the periods presented. The Company's business strategy is not without risk, and readers of these condensed consolidated financial statements should carefully consider the risks set forth under the heading "Certain Significant Risk Factors" in the Company's 2002 Annual Report on Form 10-K. Operating results for the three months ended March 31, 2003, are not necessarily indicative of the results that may be expected for the year ending December 31, 2003. The Company suggests that these condensed consolidated financial statements be read in conjunction with the consolidated financial statements and the notes thereto included in the Company's 2002 Annual Report on Form 10-K. Business Conditions - The Company's revenues increased from $298,785 for the three months ended March 31, 2002, to $589,670 for the three months ended March 31, 2003. However, the Company has incurred significant losses since inception, including a net loss of $4,269,715 for the three months ended March 31, 2003. The Company incurred negative cash flows from operating activities of $2,083,964 during the three months ended March 31, 2003. As of March 31, 2003, the Company had an accumulated deficit of $198,276,635, negative working capital of $15,354,478, accrued employee wages of $6,247,938, and accounts payable over 60 days past due of $2,610,507. Sales of products and revenue from licenses based on the Company's technologies have not been sufficient to finance ongoing operations, although the Company has limited capital available under its equity lines of credit. These matters raise substantial doubt about the Company's ability to continue as a going concern. The Company's continued existence is dependent upon several factors, including the Company's success in (1) increasing license, royalty and services revenues, (2) raising sufficient additional funding, and (3) minimizing operating costs. The accompanying condensed consolidated financial statements do not include any adjustments relating to the recoverability and classification of asset carrying amounts or the amount and classification of liabilities that might result should the Company be unable to continue as a going concern. Net Loss Per Common Share - Basic and diluted net loss per common share are calculated by dividing net loss attributable to common stockholders by the weighted average number of shares of common stock outstanding during the period. As of March 31, 2003 and 2002, there were outstanding common stock equivalents to purchase 658,031 and 807,564 shares of common stock, respectively, that were not included in the computation of diluted net loss per common share as their effect would have been anti-dilutive, thereby decreasing the net loss per common share. 6 FONIX CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) The following table is a reconciliation of the net loss numerator of basic and diluted net loss per common share for the three months ended March 31, 2003 and 2002:
2003 2002 --------------------------------- ------------------------------------ Per Share Per Share Amount Amount Amount Amount Net loss $ (4,269,715) $ (5,244,640) Preferred stock dividends - - Net loss attributable to common stockholders $ (4,269,715) $ (0.30) $ (5,244,640) $ (0.54) Weighted average common shares outstanding 14,457,162 9,765,439
Imputed Interest Expense and Income- Interest is imputed on long-term debt obligations and notes receivable where management has determined that the contractual interest rates are below the market rate for instruments with similar risk characteristics (see Notes 3 and 5). Comprehensive Loss - Other comprehensive loss presented in the accompanying condensed consolidated financial statements consists of cumulative foreign currency translation adjustments. Recently Enacted Accounting Standards - In January 2003, the Financial Accounting Standards Board ("FASB") issued Interpretation No. 46 ("FIN 46"), "Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51." FIN 46 provides guidance on the identification of entities for which control is achieved through means other than through voting rights ("variable interest entities" or "VIEs") and how to determine when and which business enterprise should consolidate the VIE (the "primary beneficiary"). This new model for consolidation applies to an entity in which either (1) the equity investors do not have a controlling financial interest, or (2) the equity investment at risk is insufficient to finance that entity's activities without receiving additional subordinated financial support from other parties. In addition, FIN 46 requires that both the primary beneficiary and all other enterprises with a significant variable interest in a VIE make additional disclosures. FIN 46 applies to variable interest entities created after January 31, 2003, and to VIEs in which an enterprise obtains an interest after that date. It also applies in the first fiscal year or interim period beginning after June 15, 2003, to VIEs in which an enterprise holds a variable interest that it acquired before February 1, 2003. The Company does not expect the provisions of FIN 46 to have a material effect on future interim or annual financial statements. Revenue Recognition - The Company recognizes revenues in accordance with the provisions of Statement of Position No. 97-2, "Software Revenue Recognition" and related interpretations. The Company generates revenues from licensing the rights to its software products to end users and from royalties. It also generates service revenues from the sale of consulting and development services. Revenues of all types are recognized when contingencies such as conditions of acceptance of functionality, rights of return and price protection are confirmed or can be reasonably estimated, as appropriate. Revenues from development and consulting services are recognized on a completed-contract basis when the services are completed and accepted by the customer. The completed-contract method is used because the contracts are either short-term in duration or the Company is unable to make reasonably dependable estimates of the costs of the contracts. Revenue for hardware units delivered is recognized when delivery is verified and collection assured. Revenue for products distributed through wholesale and retail channels and resellers is recognized upon verification of final sell-through to end users, after consideration of rights of return and price protection. Revenue for these products is recognized when the right of return on such products has expired, typically when the end user purchases 7 FONIX CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) the product from the retail outlet. Once the end user opens the package, it is not returnable unless the medium is defective. Price protection is offered to distributors in the event we reduce the price on any specific product. Such price protection is generally offered for a specific time period in which the distributor must make a claim. Resulting revenue recognized reflects the reduced price. Slotting fees paid by the Company for favorable placement in retail outlets are recorded as a reduction in gross revenues. When arrangements to license software products do not require significant production, modification, or customization of software, revenues from licenses and royalties are recognized when persuasive evidence of a licensing arrangement exists, delivery of the software has occurred, the fee is fixed or determinable, and collectibility is probable. Post-contract obligations, if any, generally consist of one year of support including such services as customer calls, bug fixes, and upgrades. Related revenue is recognized over the period covered by the agreement. Revenues from maintenance and support contracts are also recognized over the term of the related contracts. Revenues applicable to multiple-element fee arrangements are bifurcated among elements such as license agreements and support and upgrade obligations, using vendor-specific objective evidence of fair value. Such evidence consists primarily of pricing of multiple elements as if sold as separate products or arrangements. These elements vary based upon factors such as the type of license, volume of units licensed, and other related factors. Deferred revenue at March 31, 2003, and December 31, 2002, consisted of the following:
March 31, December 31, Description Criteria for Recognition 2003 2002 Deferred unit royalties Delivery of units to end users or and licence fees expiration of contract $ 807,368 $ 797,737 Deferred customer Expiration of period covered by support support agreement 41,882 59,111 Total deferred revenue $ 849,250 $ 854,248
Cost of revenues from license, royalties, and maintenance consists of costs to distribute the product (including the cost of the media on which it is delivered), installation and support personnel compensation, amortization of capitalized speech software costs, licensed technology, and other related costs. Cost of service revenues consists of personnel compensation and other related costs. Software technology development and production costs - All costs incurred to establish the technological feasibility of speech software technology to be sold, leased, or otherwise marketed are charged to product development and research expense. Technological feasibility is established when a product design and a working model of the software product have been completed and confirmed by testing. Costs to produce or purchase speech software technology incurred subsequent to establishing technological feasibility are capitalized. Capitalization of speech software costs ceases when the product is available for general release to customers. Costs to perform consulting or development services applications are charged to cost of revenues in the period in which the corresponding revenues are recognized. Cost of maintenance and customer support is charged to expense when related revenue is recognized or when these costs are incurred, whichever occurs first. Capitalized speech software technology costs are amortized on a product-by-product basis. Amortization is recognized from the date the product is available for general release to customers as the greater of (a) the ratio that current gross revenue for a product bears to total current and anticipated future gross revenues for that product, or (b) the straight-line method over the remaining estimated economic life of the products. Amortization is charged to cost of revenues. 8 FONIX CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) The Company assesses unamortized capitalized speech software costs for possible write down on a quarterly basis based on net realizable value of each related product. Net realizable value is determined based on the estimated future gross revenues from a product reduced by the estimated future cost of completing and disposing of the product, including the cost of performing maintenance and customer support. The amount by which the unamortized capitalized costs of a speech software product exceed the net realizable value of that asset is written off. Stock-based Compensation Plans - The Company accounts for its stock-based compensation issued to non- employees using the fair value method in accordance with Statement of Financial Accounting Standards ("SFAS") No. 123 and related interpretations. Under SFAS No. 123, stock-based compensation is determined as either the fair value of the consideration received or the fair value of the equity instruments issued, whichever is more reliably measurable. The measurement date for these issuances is the earlier of the date at which a commitment for performance by the recipient to earn the equity instruments is reached or the date at which the recipient's performance is complete. At March 31, 2003, the Company has stock-based employee compensation plans. The Company accounts for the plans under the recognition method and measurement principles of Accounting Principals Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees," and the related Interpretations. Had compensation expense for these options been determined in accordance with the method prescribed by SFAS No. 123, "Accounting for Stock- Based Compensation", the Company's net loss per common share would have been increased to the pro forma amounts indicated below:
Three Months Ended March 31, 2003 March 31, 2002 --------------------- ------------------------ Net loss: As reported $ (4,269,715) $(5,244,640) Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards (102,051) (119,181) Pro forma (4,371,766) (5,363,821) Basic and diluted net loss per common share: As reported $ (0.30) $ (0.54) Pro forma (0.30) (0.55)
Reclassifications - Certain reclassifications have been made in the prior period condensed consolidated financial statements to conform with the current period presentation. 2. CONVERTIBLE NOTES RECEIVABLE On December 1, 2001, the Company, as the lender, established a revolving line of credit and received a convertible promissory note from Unveil Technologies, Inc. ("Unveil"), that permitted Unveil to draw up to $2,000,000 for operations and other purposes. Unveil is a developer of natural language understanding solutions for customer resource management ("CRM") applications. Fonix desired to obtain a license to Unveil's CRM applications when completed and made the loan to Unveil to facilitate and expedite the development and commercialization of Unveil's speech-enabled CRM software. Draws on the line of credit bear interest at an annual rate of seven percent, which interest was payable quarterly beginning June 30, 2002. During the year ended December 31, 2002, Unveil drew $880,000 on the line of credit, bringing total draws on the line of credit to $1,450,000 as of December 31, 2002. Due to limited resources available to the Company, additional requests for funding by Unveil under the line of credit have not been met. This limitation in funding has resulted in a deterioration of Unveil's financial condition and has caused Unveil to slow its development process. Accordingly, due to Unveil's financial condition, the Company estimated an impairment loss during the third quarter of 2002 in the amount of $1,523,842, consisting of the outstanding balance on the line of credit plus accrued interest thereon as of that date. The Company advanced an additional $60,000 to Unveil in October 2002. This advance was treated as a research and development expense. During the first quarter of 2003, the Company entered into an agreement to terminate the revolving line of credit and satisfy the convertible promissory note with Unveil. In full settlement of the balance of $1,450,000 due under the note, the 9 FONIX CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) Company received a payment of $410,000 and 1,863,636 shares of Unveil's Series A Preferred Stock (the "Unveil Preferred Stock"). Accordingly, the Company adjusted the estimated impairment, recorded in the third quarter of 2002, such that the carrying amount of the note receivable was equal to the amount received in January 2003. The Company did not allocate value to the Unveil Preferred Stock due to Unveil's overall financial condition. 3. INVESTMENT IN AFFILIATE In February 2001, the Company entered into a collaboration agreement with Audium Corporation ("Audium") to provide an integrated platform for generating Voice XML solutions for Internet and telephony systems. Audium is a mobile application service provider that builds and operates mobile applications that allow access to Internet information and to complete online transactions using any telephone. The collaboration includes integration of the Company's technologies with Audium's mobile applications development capability. Note Receivable - In connection with the collaboration agreement with Audium, in February and May 2001, the Company advanced an aggregate of $400,000 to Audium as a bridge loan under a note (the "Audium Note"). The Audium Note bears interest at a rate of five percent per year and has a term of four years. Additionally, the Audium Note is convertible into shares of Audium Series A Preferred Stock at a price of $1.46 per share in the event of (i) Audium's raising an additional $2,000,000 prior to October 6, 2002, (ii) Audium's merger or consolidation, (iii) a qualified public offering of Audium's common stock, (iv) an event of default under a note payable from Fonix (see Fonix Note below), or (v) Audium's aggregate gross revenues for the months of January through June 2003 exceeding $1,000,000. The Audium Note is secured by Audium's intellectual property. Further, at the closing, Audium granted the Company a fully paid, worldwide, non-exclusive license to Audium's software to make, manufacture, and use the software and any derivative works if Audium declares bankruptcy or ceases to do business. Management determined that a 12 percent annual interest rate better reflects the risk characteristics of the Audium Note. Accordingly, interest was imputed at 12 percent and the Audium Note was recorded at its original present value of $302,909. The Company is currently discussing the possibility of converting the remaining balance due under the Audium Note for additional shares of Audium's Common Stock. Investment in Affiliate - In April 2001, the Company closed a stock purchase agreement with Audium, wherein the Company agreed to purchase up to $2,800,000 of Audium Preferred Stock at a price of $1.46 per share. At closing, the Company paid $200,000 in cash and gave Audium a non-interest bearing note (the "Fonix Note," discussed below under "Note Payable to Affiliate") for the remaining $2,600,000. Interest on the Fonix Note was imputed at 12 percent resulting in a present value of $2,370,348. The resulting purchase price of the Audium Preferred Stock was $2,570,348. Each share of Audium Preferred Stock is convertible into one share of Audium's common stock. Holders of Audium Preferred Stock are entitled to eight percent cumulative dividends, a liquidation preference in excess of the original purchase price plus any declared but unpaid dividends, anti-dilution rights, and voting rights equal to the corresponding number of common shares into which it is convertible. The stock purchase agreement also entitles Fonix to elect one member of Audium's board of directors. Audium also granted Fonix certain registration rights after the closing of a public offering by Audium. At closing, Audium issued 14 Audium Preferred Stock certificates to Fonix, each certificate for 136,986 shares, and delivered one certificate in exchange for the initial payment of $200,000. The remaining certificates are held by Audium as collateral for the Fonix Note under the terms of a security agreement. For each payment of $200,000 or multiple payments that aggregate $200,000, Audium will release to Fonix one certificate for 136,986 shares of Audium Preferred Stock. The difference between the total purchase price of the Audium Preferred Stock and the Company's portion of Audium's net stockholders' deficit at the time of the purchase was $2,700,727, which was allocated to capitalized 10 FONIX CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) software technology. The excess purchase price allocated to the capitalized software technology was amortized on a straight-line basis over a period of eight years through December 31, 2001. After the impairment in the investment in Audium discussed below, the remaining excess purchase price was $1,008,002 and is being amortized over the remaining portion of the eight-year period. The investment in Audium does not provide the Company with rights to any technology developed by Audium; the Company must obtain a license should it choose to do so. Also, the Company would not own an interest sufficient to control Audium if the Company were to convert the Audium Note to Audium Preferred Stock. As a result, management has determined that it is appropriate to account for the investment, which represents 26.7 percent of Audium's voting stock at March 31, 2003, under the equity method and not as a research and development arrangement. Accordingly, for the three months ended March 31, 2003, the Company recognized a loss of $111,722, consisting of $69,896 to reflect the Company's share of Audium's net loss for the three months ended March 31, 2003, and $41,826 for the amortization of the difference between the purchase price of the Audium Preferred Stock and the Company's portion of Audium's net stockholders' deficit that is amortized on a straight-line basis over a period of eight years. The fair value of this investment is determined based on Audium's estimated future net cash flows considering the status of Audium's product development. The Company evaluates this investment for impairment annually and more frequently if indications of decline in value exist. An impairment loss that is other than temporary is recognized during the period it is determined to exist. An impairment is determined to be other-than-temporary if estimated future net cash flows are less than the carrying value of the investment. If projections indicate that the carrying value of the investment will not be recoverable, the carrying value is reduced by the estimated excess of the carrying value over the estimated discounted cash flows. There is a reasonable possibility that in the near future estimated future cash flows from the investment in Audium could change and that the effect of the change could be material to the Company's financial position or results of operation. At December 31, 2001, the Company assessed the realizability of the investment in Audium and the Company wrote down the investment by $823,275. The write-down was a result of a decrease in the estimated cash flows expected to be realized from the investment due to overall decline in the economy and the potential impact on related markets for Audium's products. As of March 31, 2003, no further write-down was deemed necessary based on the estimated future cash flows of the investment. Note Payable to Affiliate - The Fonix Note is payable in 13 monthly installments of $200,000 beginning on June 1, 2001, and bears no interest unless an event of default occurs, in which case it will bear interest at 12 percent per year. Through March 31, 2003, payments amounting to $1,800,000 had been made under the Fonix note. At March 31, 2003, the Company had an outstanding balance of $1,000,000 due under the Fonix note. The Company and Audium are currently discussing the possibility that Fonix return 684,930 shares of Audium's Preferred Stock in exchange for Audium's release of Fonix under the Fonix note. Audium has not declared Fonix to be in default under the terms of the Fonix Note. Management determined that a 12 percent annual interest rate reflects the risk characteristics of the Fonix Note. Accordingly, interest has been imputed at 12 percent and the Company recorded a present value of $2,370,348 for the Fonix Note. 4. GOODWILL AND INTANGIBLE ASSETS Goodwill resulted from the purchase of assets from Force Computers, Inc., and from the acquisition of AcuVoice, Inc. The carrying value of goodwill remained unchanged at $2,631,304 during the quarter ended March 31, 2003. During 2002, the Company engaged Houlihan Valuation Advisors, an independent valuation firm, to assess the 11 FONIX CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) Company's goodwill for impairment. The resulting appraisal indicated that goodwill was not impaired. However, should the Company's marketing and sales plans not materialize in the near term, the realization of the Company's goodwill and other intangible assets could be severely and negatively impacted. The components of intangible assets were as follows:
March 31, 2003 December 31, 2002 ---------------------------------------------- ------------------------------------------- Gross Net Gross Net Carrying Accumulated Carrying Carrying Accumulated Carrying Amount Amortization Amount Amount Amortization Amount ------------ ----------------- -------------- ------------- ----------------- ---------- Speech software technology $ 978,582 $ (130,497) $848,085 $ 978,582 $ (104,397) $ 874,185 Customer relationships 306,000 (38,250) 267,750 306,000 (30,600) 275,400 Patents 164,460 (164,460) - 164,460 (164,460) - Total Amortizing Intangible Assets $ 1,449,042 $ (333,207) 1,115,835 $1,449,042 $ (299,457) 1,149,585 Indefinite-lived Intangible Assets Trademarks 42,000 42,000 Total Intangible Assets $1,157,835 $1,191,585
Speech software technology amortization expense was $26,100 during the three months ended March 31, 2003, and $104,397 during the year ended December 31, 2002, and was charged to cost of revenues. The cost of patents include direct costs incurred by the Company in applying for patents covering its internally developed speech software technologies. Patents were fully amortized at December 31, 2002 and amortization expense related to patents was $18,938 for the year ended December 31, 2002 and was charged to selling, general and administrative expenses. Amortization expense related to customer relationships was $7,650 during the three months ended March 31, 2003, and $30,600 during the year ended December 31, 2002, and was charged to selling, general and administrative expense. 5. NOTE PAYABLE On December 14, 2001, the Company entered into an Asset Purchase Agreement with Force Computers, Inc. ("Force"). As part of the consideration for the purchase price, Fonix issued a non-interest bearing promissory note on December 14, 2001, in the amount of $1,280,000. Installment payments under the note were due over the 12 month period following the date of purchase. Management determined that a seven percent annual interest rate reflects the risk characteristics of this promissory note. Accordingly, interest has been imputed at seven percent and the Company recorded a discount of $40,245 for the note payable. The Company recorded interest expense of $4,098 from the purchase date through December 31, 2001, $37,854 for the year ended December 31, 2002. As collateral for the promissory note, 175,000 shares of the Company's Class A common stock were placed into escrow. Under the terms of the escrow, the shares will not be released to Force unless the Company is delinquent or late with respect to any payment under the note. Also, under the terms of the Asset Purchase Agreement, Fonix is required to deposit all receipts from customers acquired in this transaction into a joint depository account. Fonix has the right to withdraw such funds; however, in the event of default on any payments to Force under the terms of the promissory note, Force has the right to withdraw funds from the depository account until the deficiency in payment is covered, at which time, Fonix may again have use of the funds. Through December 31, 2002, payments required under the note were made, except the final payment of $250,000, which remained outstanding at December 31, 2002. During the first quarter of 2003, additional payments amounting to $115,000 were made. Effective March 13, 2003, Force exercised its right to withdraw all funds deposited in the joint account, as described above, until Force receives the remaining balance due under the promissory note. During the first quarter of 2003, Force has drawn $980 from the joint bank account leaving an outstanding balance of $134,020 at March 31, 2003. 6. NOTES PAYABLE OTHER 12 FONIX CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) During the second and third quarters of 2002, the Company entered into promissory notes with an unrelated third party in the aggregate amount of $75,000. These notes accrue interest at 18% annually and are due and payable with accrued interest during the second and third quarters of 2003. The notes have a conversion feature that allows the holder to convert all or any portion of the principal amount and accrued interest into shares of the Company's Common Stock. The conversion price is calculated as the arithmetic average of the last closing bid price on each trading day during the five consecutive trading days immediately preceding the conversion. During the first quarter of 2003, the Company entered into a promissory note with an unrelated third party in the aggregate amount of $113,768. This note accrues interest at 10% annually and requires monthly minimum payments of the greater of $3,000 or 2% of aggregate proceeds from the Company's Third Equity Line of Credit until the note has been fully paid. Under the loan agreement, the Company may not sell or transfer assets outside of the ordinary course of business, or enter a transaction resulting in a change of control, without written permission from the creditor. 7. RELATED-PARTY NOTES PAYABLE In connection with the acquisition of certain entities in 1998, the Company issued unsecured demand notes payable to former stockholders of the acquired entities in the aggregate amount of $1,710,000. Of the notes payable, $77,625 remained unpaid as of March 31, 2003. During 2000, the holders of these notes made demand for payment and the Company commenced negotiating with the holders of these notes to reduce the outstanding balance. No additional demands have been made and no payments have been made by the Company to the holders of these notes. During 2002, two executive officers of the Company (the "Lenders") sold shares of the Company's Class A common stock owned by them and advanced the resulting proceeds amounting to $333,308 to the Company under the terms of a revolving line of credit and related promissory note. The funds were advanced for use in Company operations. The advances bear interest at 10 percent per annum, which interest is payable on a semi-annual basis. The entire principal, along with unpaid accrued interest and any other unpaid charges or related fees, is due and payable on June 10, 2003. After December 11, 2002, all or part of the outstanding balance and unpaid interest could be converted at the option of the Lenders into shares of Class A common stock of the Company. The conversion price is the average closing bid price of the shares at the time of the advances. To the extent the market price of the Company's shares is below the conversion price at the time of conversion, the Lenders are entitled to receive additional shares equal to the gross dollar value received from the original sale of the shares. A beneficial conversion option of $14,917 was recorded as interest expense in connection with this transaction. The Lenders may also receive additional compensation as determined appropriate by the Board of Directors. In October 2002, the Lenders pledged 30,866 shares of the Company's Class A common stock to the Equity Line Investor in connection with an advance of $182,676 to the Company under the Third Equity Line (see Note 10 below). The Equity Line Investor subsequently sold the pledged shares and applied $82,242 of the proceeds as a reduction of the advance. The value of the pledged shares of $82,242 was treated as an additional advance from the Lenders. The aggregate advances of $415,550 are secured by the Company's intellectual property rights. As of March 31, 2003, the Lenders had deferred the interest payment due December 10, 2002 and had not converted any of the outstanding balance or interest into common stock. 8. SERIES D CONVERTIBLE DEBENTURES On October 11, 2002, the Company issued $1,500,000 of Series D 12% Convertible Debentures (the "Debentures") and 194,444 shares of Class A common stock to Breckenridge Fund, LLC ("Breckenridge"), an unaffiliated third party, for $1,500,000 before offering costs of $118,282. The outstanding principal amount of the Debentures is convertible at any time at the option of the holder into shares of the Company's common stock at a conversion price 13 FONIX CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) equal to the average of the two lowest closing bid prices of the Company's Class A common stock for the twenty trading days immediately preceding the conversion date multiplied by 90%. The Debenture and accrued interest were originally due April 9, 2003. The Company determined that Breckenridge had received a beneficial conversion option on the date the Debentures were issued. The net proceeds of $1,381,718, were allocated to the Debentures and to the Class A common stock based upon their relative fair values and resulted in allocating $524,445 to the Debentures, $571,111 to the related beneficial conversion option, $372,552 to the 194,444 shares of Class A common stock, less $86,390 of deferred loan costs. The resulting $975,555 discount on the Debentures and the deferred loan costs are being amortized over the term of the Debentures as interest expense. Related interest expense recognized during the three months ended March 31, 2003, and the year ended December 31, 2002, was $618,479 and $427,720, respectively. In connection with the issuance of the Debentures, the Company issued, as collateral to secure its performance under the Debenture, 2,083,333 shares of Class A common stock (the "Collateral Shares"), which were placed into an escrow pursuant to an escrow agreement. Under the escrow agreement, the Collateral Shares will not be released to Breckenridge unless the Company is delinquent with respect to payments under the Debenture. The Debentures were originally due April 9, 2003. However, the Company and Breckenridge agreed in January 2003 to modify the terms of the Debentures requiring the following principal payments plus accrued interest: $400,000 in January 2003; $350,000 in February 2003; $250,000 in March 2003; $250,000 in April 2003; and $250,000 in May 2003. Additionally, the Company agreed to release 237,583 of the Collateral Shares to Breckenridge as consideration (the "Released Shares") to Breckenridge for revising the terms of the purchase agreement. The additional shares were accounted for as an additional discount of $285,100. The value of the shares on the date issued will be amortized over the modified term as interest expense. If Breckenridge declares the Company delinquent under the revised payment schedule, Breckenridge is entitled to receive a penalty of five percent of the then-outstanding principal amount of the Debentures, payable in cash or shares released from the Collateral Shares. In connection with the issuance of the Debentures, the Company entered into a registration rights agreement in which the Company agreed to register the resale of the shares underlying the Debentures, the Collateral Shares, and the Additional Shares. The Company filed a registration statement on Form S-2, which became effective February 14, 2003. The Company is obligated to file such post-effective amendments as necessary to keep the registration statement effective as required by the registration rights agreement. On March 26, 2003, the Company received a conversion notice from Breckenridge wherein Breckenridge converted a principal amount of $242,933, plus $20,067 of accrued interest under the Debentures. The Company subsequently issued 627,087 shares of the Company's Class A common stock. The current outstanding principal balance due under the Debenture agreement at March 31, 2003 was $607,067. 9. PREFERRED STOCK The Company's certificate of incorporation allows for the issuance of preferred stock in such series and having such terms and conditions as the Company's board of directors may designate. Series A Convertible Preferred Stock - At March 31, 2003, there were 166,667 shares of Series A convertible preferred stock outstanding. Holders of the Series A convertible preferred stock have the same voting rights as common stockholders, have the right to elect one person to the board of directors and are entitled to receive a one time preferential dividend of $2.905 per share of Series A convertible preferred stock prior to the payment of any dividend on any class or series of stock. At the option of the holders, each share of Series A convertible preferred stock is convertible into one share of Class A common stock and in the event that the common stock price has 14 FONIX CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) equaled or exceeded $10 for a 15 day period, the shares of Series A convertible preferred stock are automatically converted into Class A common stock. In the event of liquidation, the holders are entitled to a liquidating distribution of $36.33 per share and a conversion of Series A convertible preferred stock at an amount equal to .0375 shares of common stock for each share of Series A convertible preferred stock. 10. EQUITY LINES OF CREDIT Equity Line of Credit - In August 2000, the Company entered into a Private Equity Line Agreement ("Equity Line") with a third party investor ("Equity Line Investor") which gave the Company the right to draw up to $20,000,000 for operations and other purposes. The Initial Investment Amount of $7,500,000 was drawn as part of the 2000 Note described above. The balance remaining under the Equity Line was available to the Company through a mechanism of draws and puts of stock. The Company was entitled to draw funds and to "put" to the Equity Line Investor shares of Class A common stock in lieu of repayment of the draw. The number of shares issued was determined by dividing the dollar amount of the draw by 90 percent of the average of the two lowest closing bid prices of Class A common stock over the seven trading-day period following the date the Company tenders the put notice. The Equity Line Investor funded the amounts requested by the Company within two trading days after the seven trading-day period. From its inception through December 31, 2000, draws taken under the Equity Line, excluding the Initial Investment Amount, amounting to $3,973,508, less commissions and related fees of $119,206, were converted into 312,317 shares of Class A common stock. During 2001, draws amounting to $5,510,000, less commissions and related fees of $165,300, were converted into 658,829 shares of Class A common stock. For the year ended December 31, 2002, the Company received $3,633,817 in funds drawn under the Equity Line, less commissions and related fees of $84,825, and issued 1,017,323 shares of Class A common stock to the Equity Line investor. Second Equity Line of Credit - In April 2001, the Company entered into a second private equity line agreement (the "Second Equity Line") with the Equity Line Investor. Under the Second Equity Line, the Company had the right to draw up to $20,000,000 under terms substantially identical to the initial Equity Line. From the inception of the Second Equity Line through December 31, 2001, draws under the Second Equity Line amounting to $13,425,000, less commissions and fees of $497,750, were converted to 2,950,325 shares of Class A common stock. For the year ended December 31, 2002, the Company received $5,728,846 in funds drawn under the Second Equity Line, less commissions and fees of $189,805, and issued 2,339,675 shares of Class A common stock to the Equity Line investor. Third Equity Line of Credit - In June 2002, the Company entered into a third equity line agreement (the "Third Equity Line") with the Equity Line Investor. Under the Third Equity Line, the Company has the right to draw up to $20,000,000 under terms substantially identical to the initial Equity Line. On June 27, 2002, the Company filed with the SEC a registration statement on Form S-2 to register the resale of up to 5,000,000 shares of the Company's Class A common stock by the Equity Line Investor, which became effective during January 2003. During the third and fourth quarters of 2002, the Equity Line Investor advanced the Company $182,676 against future draws on the Third Equity Line (see Note 7 above). The balance owing on the advance is included in accrued liabilities in the accompanying financial statements at December 31, 2002. As of December 31, 2002, no shares had been issued under the Third Equity Line. For the quarter ended March 31, 2003, the Company received $2,500,000 in funds drawn under the Equity Line, less commissions and fees of $64,120, and issued 4,006,212 shares of Class A common stock to the Equity Line investor. 15 FONIX CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 11. COMMON STOCK, STOCK OPTIONS AND WARRANTS Reverse Stock Split - On March 24, 2003, the Company's shareholders approved a one-for-forty reverse stock split of its outstanding Class A common stock and common stock options and warrants. The stock split has been retroactively reflected in the accompanying consolidated financial statements for all periods presented. Class A Common Stock - During the three months ended March 31, 2003, 4,006,212 shares of Class A common stock were issued in connection with draws on the equity lines (see Note 10). No shares of Class A common stock were issued as a result of the exercise of stock options or warrants during the same period. Stock Options - During the three months ended March 31, 2003, the Company granted options to an employee to purchase 1,125 shares of Class A common stock. The options have an exercise price of $1.60 per share, which was the quoted fair market value of the stock on the dates of grant. The options granted vest over the three years following issuance. Options expire within ten years from the date of grant if not exercised. Using the Black-Scholes pricing model, the weighted average fair value of the employee options was $1.60 per share. As of March 31, 2003, the Company had a total of 611,781 options to purchase Class A common shares outstanding. Warrants - As of March 31, 2003, the Company had warrants to purchase a total of 46,250 shares of Class A common stock outstanding that expire through 2010. 12. LITIGATION, COMMITMENTS AND CONTINGENCIES The Company is involved in various claims and proceedings arising in the ordinary course of business. Management believes, after consultation with legal counsel, that the ultimate disposition of these matters will not materially impact the consolidated financial position, liquidity or results of operations of the Company. U.S. Department of Labor Settlement Agreement - On March 5, 2003, the Company entered into a settlement agreement with the U.S. Department of Labor relating to back wages owed to former and current employees during 2002. Under the agreement the Company will pay an aggregate of $4,755,041 to each former and current employees in twenty-four installment payments. The first installment payment was due May 1, 2003. The remaining payments are due on the first day of each month, until paid in full, If any of the installment payments are more than fifteen days late, the entire balance may become due and payable. The Company did not have sufficient cash to pay the first installment payment due May 1, 2003. The Company is presently negotiating with the Department of Labor to extend the commencement date for installment payments to August 2003. The Company presently anticipates that it will have sufficient cash resources to commence installment payments in August 2003. There can be no assurance that the Department of Labor will agree to extend the installment payment commencement date. Employees may elect to receive a portion of their wages in registered shares of the Company's Class A common stock. However, the amount that represents minimum wage and overtime, if any, as defined in the Fair Labor Standards Act of 1938, may not be paid with the Company's Class A common stock. 13. SUBSEQUENT EVENTS Fourth Equity Line of Credit - On May 12, 2003, the Company entered into a fourth private equity line agreement (the "Fourth Equity Line Agreement") with the Equity Line Investor, on terms substantially similar to those of the Third Equity Line. Under the Fourth Equity Line Agreement, the Company has the right to draw up to $20,000,000 against an equity line of credit (the "Fourth Equity Line") from the Equity Line Investor. The Company is entitled under the Fourth Equity Line Agreement to draw certain funds and to put to the Equity Line Investor shares of the Company's Class A common stock in lieu of repayment of the draw. The number of shares to be issued is determined by dividing the amount of the draw by 90% of the average of the two lowest closing bid prices of the Company's Class A common stock over the twenty trading days after the put notice is tendered. The Equity Line Investor is required under the Fourth Equity Line Agreement to tender the funds requested by us within two trading days after the twenty-trading-day period used to determine the market price. The Company plans to file with the SEC a registration statement on Form S-2 to register the resale of up to 50,000,000 shares of the Company's Class A 16 FONIX CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) common stock by the Equity Line Investor. The Company anticipates that upon the effectiveness of this registration statement, it will terminate the Third Equity Line and cease further draws or issuances of shares in connection with the Third Equity Line. Upon the effectiveness of this registration statement and following our termination of the Third Equity Line, the only active equity line of credit will be the Fourth Equity Line. Third Equity Line of Credit - Subsequent to March 31, 2003 and through May 12, 2003, the Company received $125,000 in funds drawn under the Third Equity Line and issued 993,788 shares of Class A common stock to the Equity Line investor. Series D Debentures - On May 9 2003, the Company received a conversion notice from Breckenridge wherein Breckenridge converted a principal amount of $160,146, plus $9,854 of accrued interest under the Debentures. The Company subsequently issued 1,481,482 shares of the Company's Class A common stock. 17 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This quarterly report on Form 10-Q contains, in addition to historical information, forward-looking statements that involve substantial risks and uncertainties. Actual results could differ materially from the results the Company anticipates and which are discussed in the forward-looking statements. Factors that could cause or contribute to such differences are discussed in the Company's Annual Report on Form 10-K for the year ended December 31, 2002. To date, we have earned only limited revenue from operations and intend to continue to rely primarily on financing through the sale of our equity and debt securities to satisfy future capital requirements. Overview Since inception, we have devoted substantially all of our resources to research, development and acquisition of software technologies that enable intuitive human interaction with computers, consumer electronics, and other intelligent devices. Through March 31, 2003, we have incurred significant cumulative losses, and losses are expected to continue until the effects of recent marketing and sales efforts begin to take effect, if ever. We continue to emphasize delivery and sales of our applications and solutions ("Products") while achieving technology upgrades to maintain our perceived competitive advantages. Fonix Products are based on the Company's speech-enabling technologies, which include text-to-speech ("TTS") and neural network-based automated speech recognition ("ASR"). ASR and TTS technologies are sometimes collectively referred to in this report as "Core Technologies." In our current marketing efforts, we seek to form relationships with third parties who can incorporate our speech- enabling Products into new or existing products. Such relationships may be structured in any of a variety of ways including traditional technology licenses, collaboration or joint marketing agreements, co-development relationships through joint ventures or otherwise, and strategic alliances. The third parties with whom we presently have such relationships and with which we may have similar relationships in the future include developers of application software, operating systems, computers, microprocessor chips, consumer electronics, automobiles, telephony, and other products. We are currently in negotiation with customers and potential customers to enter into additional third- party licensing, collaboration, co-marketing and distribution arrangements. Our revenues increased from $298,785 for the three months ended March 31, 2002, to $589,670 for the three months ended March 31, 2003. However, we incurred negative cash flows from operating activities of $2,083,964 during the three months ended March 31, 2003. Sales and licensing of Products have not been sufficient to finance ongoing operations. As of March 31, 2003, we had negative working capital of $15,354,478 and an accumulated deficit of $198,276,635. We have drawn all capital available under our initial and second equity lines. A third equity line is in place and $17,500,000 remains available to us under that equity line, and we are presently negotiating the terms of a fourth equity line of credit agreement. Our continued existence is dependent upon several factors, including our success in (1) increasing license, royalty, Product sales, and services revenues, (2) raising sufficient additional equity and debt funding through the use of the fourth equity line or other facilities, and (3) minimizing and reducing operating costs. Until sufficient revenues are generated from operating activities, we expect to continue to fund our operations through the sale of our equity securities, primarily the fourth equity line. In 2002, we experienced slower development of markets for speech applications than had been anticipated due to several factors. First, the limited resources with which we have been operating (due to the delay in accessing funds from the third equity line) have hampered our ability to aggressively support marketing and sales as originally anticipated. Additionally, time and resources required to develop certain Products have been greater than originally anticipated, and, with limited resources available, we have not been able to expedite such development. Further, the ongoing U.S. economic slowdown has slowed customer acceptance in target markets, especially in the telecommunications sector where previously expected recovery has yet to materialize, and has in fact deteriorated further. The occurrence of these conditions has caused us to (i) reduce our emphasis on consumer applications because of the significant resources required to develop retail markets, (ii) reduce our development and marketing efforts in the computer telephony and server-based markets, and (iii) increase our emphasis and focus on mobile and wireless applications, automotive speech interface solutions, and assistive markets, where management believes we 18 enjoy the greatest technological and market advantage. We assess unamortized capitalized computer software costs for possible write down based on net realizable value of each related product. Net realizable value is determined based on the estimated future gross revenues from a product reduced by the estimated future cost of completing and disposing of the product, including the cost of performing maintenance and customer support. In order to assess future gross revenues, we have evaluated the life cycle of our Products and the periods in which we will receive revenues from them. Widespread deployment of speech applications, solutions, and interface products is growing, especially for the Products we develop and market. However, certain speech Products, specifically those which are useful in the telecommunications segment, have been severely impacted by declining market conditions over the past 18 to 24 months. Nevertheless, speech applications and interface solutions useful in devices such as smart-phones, PDAs, cell phones, assistive devices for the sight-impaired, and other mobile and wireless devices are beginning to enjoy user acceptance and market demand. Our experience has indicated that original equipment manufacturers ("OEMs"), value added resellers ("VARs"), software developers, and other users typically integrate a new application or interface product (such as speech) initially into only one or two products. Then, as market and user acceptance of the technology increases, as applications are proven reliable, and as cost of production and delivery decreases on a per-unit basis, the applications typically are expanded into broader product lines. As a result, initial sales volumes in early OEM integration periods are expected to be low, but will grow at a substantial pace in subsequent periods as (i) OEM customers expand product offerings and (ii) the customers of OEMs commit to and release speech applications in their products. We expect growth to continue for four to six years, but expect the rate of growth to slow as the market matures toward the end of that period. Significant Accounting Policies The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of sales and expenses during the reporting period. Significant accounting policies and areas where substantial judgements are made by management include: Accounting Estimates - The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosures of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Valuation of Long-lived Assets - The carrying values of our long-lived intangible assets are reviewed for impairment on a quarterly basis or otherwise whenever events or changes in circumstances indicate that they may not be recoverable. We assess unamortized capitalized software costs for possible write down based on net realizable value of each related product. Net realizable value is determined based on the estimated future gross revenues from a product reduced by the estimated future cost of completing and disposing of the product, including the cost of performing maintenance and customer support. The amount by which the unamortized capitalized costs of a software product exceed the net realizable value of that asset is written off. The speech software technology was tested for impairment in December 2001 and December 2002. Due to the down-turn in the software industry and the U.S. economy, operating losses and cash used in operating activities during the fourth quarter of 2001 were greater than anticipated. Based on that trend, management revised estimated net future cash flows from the speech technology, which resulted in recognition of an impairment loss of $5,832,217 during the fourth quarter of 2001. The impairment loss was charged to cost of revenues. No further impairment was deemed necessary at December 31, 2002 or at March 31, 2003. 19 During the fourth quarter of 2001, management determined that its handwriting recognition ("HWR") software technology was impaired. Without immediate customer prospects or current license agreements, management has chosen not to provide further funding to develop or market the HWR technology. Accordingly, the unamortized balance of $2,056,295 was recorded in cost of revenues in 2001. With respect to our other long-lived assets, we project undiscounted cash flows to be generated from the use of the asset and its eventual disposition over the remaining life of the asset. If projections indicate that the carrying value of the long-lived asset will not be recovered, the carrying value of long-lived assets is reduced by the estimated excess of the carrying value over the projected discounted cash flows. Management does not consider any of our other long-lived assets to be impaired at December 31, 2002 or at March 31, 2003. However, should our marketing and sales plans not materialize in the near term, the realization of our intangible assets could be severely and negatively impacted. The accompanying consolidated financial statements have been prepared based on management's estimates of realizability, which estimates may change due to factors beyond our control. (See "Recently Enacted Accounting Standards" below.) Revenue Recognition - We recognize revenues in accordance with the provisions of Statement of Position No. 97-2, "Software Revenue Recognition" and related interpretations. We generate revenues from licensing the rights to its software products to end users and from royalties. We also generate service revenues from the sale of consulting and development services. Revenues of all types are recognized when acceptance of functionality, rights of return, and price protection are confirmed or can be reasonably estimated, as appropriate. Revenues from development and consulting services are recognized on a completed-contract basis when the services are completed and accepted by the customer. The completed-contract method is used because our contracts are either short-term in duration or we are unable to make reasonably dependable estimates of the costs of the contracts. Revenue for hardware units delivered is recognized when delivery is verified and collection assured. Revenue for products distributed through wholesale and retail channels and through resellers is recognized upon verification of final sell-through to end users, after consideration of rights of return and price protection. Typically, the right of return on such products has expired when the end user purchases the product from the retail outlet. Once the end user opens the package, it is not returnable unless the medium is defective. Price protection is offered to distributors in the event we reduce the price on any specific product. Such price protection is generally offered for a specific time period in which the distributor must make a claim. Resulting revenue recognized reflects the reduced price. Slotting fees paid by us for favorable placement in retail outlets are recorded as a reduction in gross revenues. When arrangements to license software products do not require significant production, modification, or customization of software, revenue from licenses and royalties are recognized when persuasive evidence of a licensing arrangement exists, delivery of the software has occurred, the fee is fixed or determinable, and collectibility is probable. Post-contract obligations, if any, generally consist of one year of support including such services as customer calls, bug fixes, and upgrades. Related revenue is recognized over the period covered by the agreement. Revenues from maintenance and support contracts are also recognized over the term of the related contracts. Revenues applicable to multiple-element fee arrangements are bifurcated among elements such as license agreements and support and upgrade obligations, using vendor-specific objective evidence of fair value. Such evidence consists primarily of pricing of multiple elements as if sold as separate products or arrangements. These elements vary based upon factors such as the type of license, volume of units licensed, and other related factors. 20 Deferred revenue as of March 31, 2003 and December 31, 2002, consisted of the following:
March 31, December 31, Description Criteria for Recognition 2003 2002 Deferred unit royalties Delivery of units to end users or and licence fees expiration of contract $ 807,368 $ 797,737 Deferred customer Expiration of period covered by support support agreement 41,882 59,111 Total deferred revenue $ 849,250 $ 854,248
Cost of revenues - Cost of revenues from license, royalties, and maintenance consists of costs to distribute the product (including the cost of the media on which it is delivered), installation and support personnel compensation, amortization and impairment of capitalized speech software costs, licensed technology, and other related costs. Cost of service revenues consists of personnel compensation and other related costs. Software technology development and production costs - All costs incurred to establish the technological feasibility of speech software technology to be sold, leased, or otherwise marketed are charged to product development and research expense. Technological feasibility is established when a product design and a working model of the software product have been completed and confirmed by testing. Costs to produce or purchase software technology incurred subsequent to establishing technological feasibility are capitalized. Capitalization of software costs ceases when the product is available for general release to customers. Costs to perform consulting services or development of applications are charged to cost of revenues in the period in which the corresponding revenues are recognized. Cost of maintenance and customer support is charged to expense when related revenue is recognized or when these costs are incurred, whichever occurs first. Capitalized software technology costs are amortized on a product-by-product basis. Amortization is recognized from the date the product is available for general release to customers as the greater of (a) the ratio that current gross revenue for a product bears to total current and anticipated future gross revenues for that product or (b) the straight- line method over the remaining estimated economic life of the products. Amortization is charged to cost of revenues. We assess unamortized capitalized software costs for possible write down on a quarterly basis based on net realizable value of each related product. Net realizable value is determined based on the estimated future gross revenues from a product reduced by the estimated future cost of completing and disposing of the product, including the cost of performing maintenance and customer support. The amount by which the unamortized capitalized costs of a software product exceed the net realizable value of that asset is written off. Stock-based Compensation Plans - We account for our stock-based compensation issued to employees and directors under Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees." Under APB Opinion No. 25, compensation related to stock options, if any, is recorded if an option's exercise price on the measurement date is below the fair value of our common stock, and amortized to expense over the vesting period. Compensation expense for stock awards or purchases, if any, is recognized if the award or purchase price on the measurement date is below the fair value of our common stock, and is recognized on the date of award or purchase. Statement of Financial Accounting Standards ("SFAS") No. 123, "Accounting for Stock Based Compensation," requires pro forma information regarding net loss and net loss per common share as if we had accounted for our stock options granted under the fair value method. This pro forma disclosure is presented in Note 1 of the consolidated financial statements. We account for our stock-based compensation issued to non-employees using the fair value method in accordance with SFAS No. 123 and related interpretations. Under SFAS No. 123, stock-based compensation is determined as either the fair value of the consideration received or the fair value of the equity instruments issued, whichever is 21 more reliably measurable. The measurement date for these issuances is the earlier of the date at which a commitment for performance by the recipient to earn the equity instruments is reached or the date at which the recipient's performance is complete. Imputed Interest Expense and Income - Interest is imputed on long-term debt obligations and notes receivable where management has determined that the contractual interest rates are below the market rate for instruments with similar risk characteristics (see Notes 5 and 7 to the condensed consolidated financial statements). Recently Enacted Accounting Standards - In January 2003, the Financial Accounting Standards Board ("FASB") issued Interpretation No. 46 ("FIN 46"), "Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51." FIN 46 provides guidance on the identification of entities for which control is achieved through means other than through voting rights ("variable interest entities" or "VIEs") and how to determine when and which business enterprise should consolidate the VIE (the "primary beneficiary"). This new model for consolidation applies to an entity in which either (1) the equity investors do not have a controlling financial interest, or (2) the equity investment at risk is insufficient to finance that entity's activities without receiving additional subordinated financial support from other parties. In addition, FIN 46 requires that both the primary beneficiary and all other enterprises with a significant variable interest in a VIE make additional disclosures. FIN 46 applies to VIEs created after January 31, 2003, and to VIEs in which an enterprise obtains an interest after that date. It applies in the first fiscal year or interim period beginning after June 15, 2003, to variable interest entities in which an enterprise holds a VIEs that it acquired before February 1, 2003. Results of Operations Three months ended March 31, 2003, compared with three months ended March 31, 2002 During the three months ended March 31, 2003, we recorded revenues of $589,670, reflecting an increase of $290,885 over the same period in the previous year. The majority of the increase is attributable to $205,232 in revenues generated from licensing and $87,000 generated from non-recurring engineering contracts completed during the first quarter of 2003. Cost of revenues were $80,217 for the three months ended March 31, 2003, an increase of $36,113 over the same period in the previous year. Amortization of capitalized software costs and hardware sales represent the largest portions of the increase during the first quarter of 2003. Selling, general and administrative expenses for the three months ended March 31, 2003, were $2,250,698, a decrease of $978,705. The decrease includes decreases of $295,380 compensation-related expenses due to reductions in personnel, $121,935 in legal and accounting expenses, $229,802 in other operating expenses primarily related to insurance for directors and officers, $149,102 in promotion and advertising expenses and $177,001 in travel related expenses. Product development and research expenses were $1,675,113 and $2,126,151 for the three months ended March 31, 2003 and 2002, respectively. The decrease of $451,038 resulted primarily from decreased compensation-related expenses of $347,779 and consulting and outside service-related expenses of $178,005 related to product application and development activities. Liquidity and Capital Resources We must raise additional funds to be able to satisfy our cash requirements during the next 12 months. Research and development, corporate operations and marketing expenses will continue to require additional capital. Because we presently have only limited revenue from operations, we intend to continue to rely primarily on financing through the sale of our equity and debt securities to satisfy future capital requirements until such time as we are able to enter into additional third-party licensing, collaboration or co-marketing arrangements such that it will be able to finance ongoing operations from license, royalty and services revenues. There can be no assurance that we will be able to enter into such agreements. Furthermore, the issuance of equity or debt securities which are or may become convertible into our equity securities in connection with such financing could result in substantial additional dilution 22 to the our stockholders. At March 31, 2003, we had $17,500,000 available to draw under the third equity line of credit, and we are presently negotiating the terms of a fourth equity line of credit agreement. Net cash used in operating activities of $2,083,964 for the three months ended March 31, 2003, resulted principally from the net loss incurred of $4,269,715 offset by increases in accrued payroll of $982,129, non-cash expenses pertaining to depreciation, amortization and accretion of $832,176, accounts payable of $342,097, and equity in net loss of affiliate of $69,896. Net cash provided by investing activities of $400,740 for the three months ended March 31, 2003, consisted primarily of collections under a convertible note payable of $402,765. Net cash used in operating activities was offset by net cash provided by financing activities of $1,679,777 consisting primarily of the receipt of $2,440,001 in cash related to the sale of shares of Class A common stock offset, in part, by $650,000 in payments on Series D Debentures. We had negative working capital of $15,354,478 at March 31, 2003, compared to negative working capital of $14,428,750 at December 31, 2002. Current assets decreased by $513,238 to $177,606 from December 31, 2002, to March 31, 2003. Current liabilities increased by $500,474 to $15,620,068 during the same period. The change in working capital from December 31, 2002, to March 31, 2003, was primarily attributable to the collection of the convertible note receivable and the increase in accrued payroll. Total assets were $5,766,441 at March 31, 2003, compared to $6,523,480 at December 31, 2002. Convertible Note Receivable and Line of Credit On December 1, 2001, we, as the lender, established a revolving line of credit and received a convertible promissory note from Unveil Technologies, Inc. ("Unveil"), that permitted Unveil to draw up to $2,000,000 for operations and other purposes. Unveil is a developer of natural language understanding solutions for customer resource management ("CRM") applications. We desired to obtain a license to Unveil's CRM applications when completed and made the loan to Unveil to facilitate and expedite the development and commercialization of Unveil's speech- enabled CRM software. Draws on the line of credit bear interest at an annual rate of seven percent, which interest was payable quarterly beginning June 30, 2002. During the year ended December 31, 2002, Unveil drew $880,000 on the line of credit, bringing total draws on the line of credit to $1,450,000 as of December 31, 2002. Due to limited resources available to the Company, additional requests for funding by Unveil under the line of credit have not been met. This limitation in funding has resulted in a deterioration of Unveil's financial condition and has caused Unveil to slow its development process. Accordingly, due to Unveil's financial condition, the Company estimated an impairment loss during the third quarter of 2002 in the amount of $1,523,842, consisting of the outstanding balance on the line of credit plus accrued interest thereon as of that date. The Company advanced an additional $60,000 to Unveil in October 2002. This advance was treated as a research and development expense. During the first quarter of 2003, we entered into an agreement to terminate the revolving line of credit and satisfy the convertible promissory note with Unveil. In full payment of the balance of $1,450,000 due under the note, the Company received a payment of $410,000 and 1,863,636 shares of Unveil's Series A Preferred Stock (the "Unveil Preferred Stock"). Accordingly, we adjusted the estimated impairment, recorded in the third quarter of 2002, such that the carrying amount of the note receivable was equal to the amount received in January 2003. We did not allocate value to the Unveil Preferred Stock due to Unveil's overall financial condition. Investment in Affiliate In February 2001, we entered into a collaboration agreement with Audium Corporation ("Audium") to provide an integrated platform for generating Voice XML solutions for Internet and telephony systems. Audium is a mobile application service provider that builds and operates mobile applications that allow access to Internet information and to complete online transactions using any telephone. The collaboration includes integration of our technologies with Audium's mobile applications development capability. Note Receivable - In connection with the collaboration agreement with Audium, in February and May 2001, we advanced an aggregate of $400,000 to Audium as a bridge loan under a note (the "Audium Note"). The Audium Note bears interest at a rate of 5 percent per year, has a term of four years and is convertible into shares of Audium Series A Convertible Preferred Stock ("Audium Preferred Stock"). The Audium Note is convertible into shares of Audium Preferred Stock at a price of $1.46 per share in the event of (i) Audium's raising an additional $2,000,000 prior to October 6, 2002, (ii) Audium's merger or consolidation, (iii) a qualified public offering of Audium's common stock, (iv) an event of default under a note payable from Fonix (see Fonix Note below), or (v) Audium's aggregate gross revenues for the months of January through June 2003 exceeding $1,000,000. The Audium Note is secured by Audium's intellectual property. Further, at the closing, Audium granted to us a fully paid, worldwide, non-exclusive license to Audium's software to make, manufacture, and use the software and any derivative works if Audium declares bankruptcy or ceases to do business. 23 Management determined that a 12 percent annual interest rate better reflects the risk characteristics of the Audium Note. Accordingly, interest was imputed at 12 percent and the Audium Note was recorded at its original present value of $302,909. We are currently discussing the possibility of converting the remaining balance due under the Audium Note for additional shares of Audium's Common Stock. Investment in Affiliate - In April 2001, we closed a stock purchase agreement with Audium, wherein we agreed to purchase up to $2,800,000 of Audium Preferred Stock at a price of $1.46 per share. At closing, we paid $200,000 in cash and gave Audium a non-interest bearing note (the "Fonix Note") for the remaining $2,600,000. Interest on the Fonix Note was imputed at 12 percent resulting in a present value of $2,370,348. The resulting purchase price of the Audium Preferred Stock was $2,570,348. Each share of Audium Preferred Stock is convertible into one share of Audium's common stock. Holders of Audium Preferred Stock are entitled to eight percent cumulative dividends, a liquidation preference in excess of the original purchase price plus any declared but unpaid dividends, anti-dilution rights, and voting rights equal to the corresponding number of common shares into which it is convertible. The stock purchase agreement also entitles Fonix to elect one member of Audium's board of directors. Audium also granted to us certain registration rights after the closing of a public offering by Audium. At closing, Audium issued 14 Audium Preferred Stock certificates to us, each certificate for 136,986 shares, and delivered one certificate in exchange for the initial payment of $200,000. The remaining certificates are held by Audium as collateral for the Fonix Note under the terms of a security agreement. For each payment of $200,000 or multiple payments that aggregate $200,000, Audium will release to us one certificate for 136,986 shares of Audium Preferred Stock. The difference between the total purchase price of the Audium Preferred Stock and our portion of Audium's net stockholders' deficit at the time of the purchase was $2,700,727, which was allocated to capitalized software technology. The excess purchase price allocated to the capitalized software technology was amortized on a straight- line basis over a period of eight years through December 31, 2001. After the impairment in the investment in Audium discussed below, the remaining excess purchase price was $1,008,002 and is being amortized over the remaining portion of the 8-year period. The investment in Audium does not provide us with rights to any technology developed by Audium; we must obtain a license should we choose to do so. Also, we would not own an interest sufficient to control Audium if we were to convert the Audium Note to Audium Preferred Stock. As a result, management has determined that it is appropriate to account for the investment, which represents 26.7 percent of Audium's voting stock at March 31, 2003, under the equity method and not as a research and development arrangement. Accordingly, for the three months ended March 31, 2003, the Company recognized a loss of $111,722, consisting of $69,896 to reflect our share of Audium's net loss for the three months ended March 31, 2003, and $41,826 for the amortization of the difference between the purchase price of the Audium Preferred Stock and our portion of Audium's net stockholders' deficit that is amortized on a straight-line basis over a period of eight years. The fair value of this investment is determined based on Audium's estimated future net cash flows considering the status of Audium's product development. We evaluate this investment for impairment annually and more frequently if indications of decline in value exist. An impairment loss that is other than temporary is recognized during the period it is determined to exist. An impairment is determined to be other-than-temporary if estimated future net cash flows are less than the carrying value of the investment. If projections indicate that the carrying value of the investment will not be recoverable, the carrying value is reduced by the estimated excess of the carrying value over the estimated discounted cash flows. There is a reasonable possibility that in the near future estimated future cash flows from the investment in Audium could change and that the effect of the change could be material to our financial position or results of operation. At December 31, 2001, we assessed the realizability of the investment in Audium and we wrote down the investment by $823,275. The write-down was a result of a decrease in the estimated cash flows expected to be realized from the 24 investment due to overall decline in the economy and the potential impact on related markets for Audium's products. As of March 31, 2003, no further write-down was deemed necessary based on the estimated future cash flows of the investment. Note Payable to Affiliate - The Fonix Note is payable in 13 monthly installments of $200,000 beginning on June 1, 2001, and bears no interest unless an event of default occurs, in which case it will bear interest at 12 percent per year. Through March 31, 2003, payments amounting to $1,800,000 had been made under the Fonix note. At March 31, 2003, we had an outstanding balance of $1,000,000 due under the Fonix note. We are currently discussing with Audium the possibility that we return 684,930 shares of Audium's Preferred Stock in exchange for Audium's release of us under the Fonix note. Audium has not declared us to be in default under the terms of the Fonix Note. Management determined that a 12 percent annual interest rate reflects the risk characteristics of the Fonix Note. Accordingly, interest has been imputed at 12 percent, and we recorded a present value of $2,370,348 for the Fonix Note. Note Payable On December 14, 2001, we entered into an Asset Purchase Agreement with Force Computers, Inc. ("Force"). As part of the consideration for the purchase price, we issued a non-interest bearing promissory note on December 14, 2001 in the amount of $1,280,000. Installment payments under the note were due over the 12 month period following the date of purchase. Management determined that a seven percent annual interest rate reflects the risk characteristics of this promissory note. Accordingly, interest has been imputed at seven percent and we recorded a discount of $40,245 for the note payable. We recorded interest expense of $4,098 from the purchase date through December 31, 2001, $37,854 for the year ended December 31, 2002. As collateral for the promissory note, 175,000 shares of our Class A common stock were placed into escrow. Under the terms of the escrow, the shares will not be released to Force unless we are delinquent or late with respect to any payment under the note. Also, under the terms of the Asset Purchase Agreement, we are required to deposit all receipts from customers acquired in this transaction into a joint depository account. We have the right to withdraw such funds; however, in the event of default on any payments to Force under the terms of the promissory note, Force has the right to withdraw funds from the depository account until the deficiency in payment is covered, at which time, we may again have use of the funds. Through December 31, 2002, payments required under the note have been made, except the final payment of $250,000, which remained outstanding at December 31, 2002. During the first quarter of 2003, additional payments amounting to $115,000 were made. Effective March 13, 2003, Force exercised its right to withdraw all funds deposited in the joint account, as described above, until Force receives the remaining balance due under the promissory note. During the first quarter of 2003, Force has drawn $980 from the joint bank account leaving an outstanding balance of $134,020 at March 31, 2003. Equity Lines of Credit Equity Line of Credit - In August 2000, as entered into a Private Equity Line Agreement ("Equity Line") with a third party investor ("Equity Line Investor") which gave us the right to draw up to $20,000,000 for operations and other purposes. The Initial Investment Amount of $7,500,000 was drawn as part of the 2000 Note described above. The balance remaining under the Equity Line was available to us through a mechanism of draws and puts of stock. We were entitled to draw funds and to "put" to the Equity Line Investor shares of Class A common stock in lieu of repayment of the draw. The number of shares issued is determined by dividing the dollar amount of the draw by 90 percent of the average of the two lowest closing bid prices of Class A common stock over the seven trading-day period following the date the Company tenders the put notice. The Equity Line Investor funded the amounts requested by the us within two trading days after the seven trading-day period. From its inception through December 31, 2000, draws taken under the Equity Line, excluding the Initial Investment Amount, amounting to $3,973,508, less commissions and related fees of $119,206, were converted into 312,317 shares of Class A common stock. During 2001, draws amounting to $5,510,000, less commissions and related fees of $165,300, were converted into 658,829 shares of Class A common stock. 25 For the year ended December 31, 2002, the Company received $3,633,817 in funds drawn under the Equity Line, less commissions and related fees of $84,825, and issued 1,017,323 shares of Class A common stock to the Equity Line investor. Second Equity Line of Credit - In April 2001, we entered into a second private equity line agreement (the "Second Equity Line") with the Equity Line Investor. Under the Second Equity Line, we had the right to draw up to $20,000,000 under terms substantially identical to the initial Equity Line. From the inception of the Second Equity Line through December 31, 2001, draws under the Second Equity Line amounting to $13,425,000, less commissions and fees of $497,750, were converted to 2,950,325 shares of Class A common stock. For the year ended December 31, 2002, the Company received $5,728,846 in funds drawn under the Second Equity Line, less commissions and fees of $189,805, and issued 2,339,675 shares of Class A common stock to the Equity Line investor. Third Equity Line of Credit - In June 2002, we entered into a third equity line agreement (the "Third Equity Line") with the Equity Line Investor. Under the Third Equity Line, we have the right to draw up to $20,000,000 under terms substantially identical to the initial Equity Line. On June 27, 2002, we filed with the SEC a registration statement on Form S-2 to register the resale of up to 5,000,000 shares of our Class A common stock by the Equity Line Investor, which became effective during January 2003. During the third and fourth quarters of 2002, the Equity Line Investor advanced to us $182,676 against future draws on the Third Equity Line (see Note 10 to the condensed consolidated financial statements). The balance owing on the advance is included in accrued liabilities in the accompanying financial statements at December 31, 2002. As of December 31, 2002, no shares had been issued under the Third Equity Line. For the quarter ended March 31, 2003, we received $2,500,000 in funds drawn under the Equity Line, less commissions and fees of $64,120, and issued 4,006,212 shares of Class A common stock to the Equity Line investor. Fourth Equity Line of Credit - On May 12, 2003, we entered into a fourth private equity line agreement (the "Fourth Equity Line Agreement") with the Equity Line Investor, on terms substantially similar to those of the Third Equity Line. Under the Fourth Equity Line Agreement, we have the right to draw up to $20,000,000 against an equity line of credit (the "Fourth Equity Line") from the Equity Line Investor. We are entitled under the Fourth Equity Line Agreement to draw certain funds and to put to the Equity Line Investor shares of our Class A common stock in lieu of repayment of the draw. The number of shares to be issued is determined by dividing the amount of the draw by 90% of the average of the two lowest closing bid prices of our Class A common stock over the twenty trading days after the put notice is tendered. The Equity Line Investor is required under the Fourth Equity Line Agreement to tender the funds requested by us within two trading days after the twenty-trading-day period used to determine the market price. We plan to file with the SEC a registration statement on Form S-2 to register the resale of up to 50,000,000 shares of our Class A common stock by the Equity Line Investor. We anticipate that upon the effectiveness of this registration statement, it will terminate the Third Equity Line and cease further draws or issuances of shares in connection with the Third Equity Line. Upon the effectiveness of this registration statement and following our termination of the Third Equity Line, the only active equity line of credit will be the Fourth Equity Line. Stock Options and Warrants Reverse Stock Split - On March 24, 2003, our shareholders approved a one-for-forty reverse stock split to our outstanding Class A common stock and common stock options and warrants. The stock split has been retroactively reflected in the accompanying consolidated financial statements for all periods presented. Class A Common Stock - During the three months ended March 31, 2003, 4,006,212 shares of Class A common stock were issued in connection with draws on the equity lines (see Note 10 to the condensed consolidated financial 26 statements ). No shares of Class A common stock were issued as a result of the exercise of stock options or warrants during the same period. Stock Options - During the three months ended March 31, 2003, we granted options to an employee to purchase 1,125 shares of Class A common stock. The options have an exercise price of $1.60 per share, which was the quoted fair market value of the stock on the dates of grant. The options granted vest over the three years following issuance. Options expire within ten years from the date of grant if not exercised. Using the Black-Scholes pricing model, the weighted average fair value of the employee options was $1.60 per share. As of March 31, 2003, we had a total of 611,781 options to purchase Class A common shares outstanding.. Warrants - As of March 31, 2003, we had warrants to purchase a total of 46,250 shares of Class A common stock outstanding that expire through 2010. Other We presently have no plans to purchase new research and development or office facilities. Outlook Corporate Mission Statement and Objectives "Empowering people with conversational speech solutions for systems and devices" is our Mission Statement. Our objectives include: o Delivering real speech solutions for human interaction with multiple devices based on our Core Technologies. o Becoming the platform for current and next generation speech-enabling applications and products. o Developing leading market position through differentiating solution strategy. o Focusing on clearly quantified market solutions. o Creating customer awareness and mind-share. o Beating competition by increased value-added solutions, portability and ease of use. o Developing positive monthly cash flow from sales. o Delivering predictable revenue and earnings. o Providing return on shareholder equity. Most speech recognition products offered by other companies are based on technologies that are largely in the public domain and represent nothing particularly "new" or creative. The Fonix speech Products and Core Technologies are based on proprietary technology that is protected by various patents and trade secrets. Management believes our speech-enabled Products provide a superior competitive advantage compared to other technologies available in the marketplace. In addition, we believe our market focus on speech-enabled Products will be a substantial differentiator. To accomplish this objective, we intend to proceed as follows: Substantially Increase Marketing and Sales Activities. We intend to expand our sales through partners, OEMs, VARs, direct sales, and existing sales channels, both domestically and internationally, who will focus on the wireless and mobile devices, telephony and server phone solutions, assistive and language learning devices, automotive integrated multi-media systems, and end-to-end or distributive speech systems. To address global opportunities, we will continue to develop and expand its sales and marketing teams in Asia, Europe, and the 27 United States. Expand Strategic Relationships. We have a number of strategic collaboration and marketing arrangements with developers and VARs. We intend to expand such relationships and add additional similar relationships, specifically in the wireless and mobile devices, assistive and language learning devices, automotive systems, and end-to-end solutions. Further, when we are able to identify "first mover" speech-enabling applications in which it can integrate our Products and Core Technologies, we intend to investigate investment opportunities so we can obtain preferred or priority collaboration rights. Continue to Develop Standard Speech Solutions Based on the Core Technologies. We plan to continue to invest resources in the development and acquisition of standard speech solutions and enhancements to the Core Technologies of speech-enabling technologies, developer tools, and development frameworks to maintain our competitive advantages. As we proceed to implement our strategy and to reach our objectives, we anticipate further development of complementary technologies, added product and applications development expertise, access to market channels and additional opportunities for strategic alliances in other industry segments. Our strategy has significant risks, and shareholders and others interested in Fonix and our Class A common stock should carefully consider the risks set forth under the heading "Certain Significant Risk Factors" in the Company's 2002 Annual Report on Form 10-K, Item 1, Part I. Item 3. Quantitative and Qualitative Disclosures About Market Risk To date, all of our revenues have been denominated in United States dollars and received primarily from customers in the United States. Our exposure to foreign currency exchange rate changes has been insignificant. We expect, however, that future product license and services revenue may also be derived from international markets and may be denominated in the currency of the applicable market. As a result, operating results may become subject to significant fluctuations based upon changes in the exchange rate of certain currencies in relation to the U.S. dollar. Furthermore, to the extent that we engage in international sales denominated in U.S. dollars, an increase in the value of the U.S. dollar relative to foreign currencies could make our products less competitive in international markets. Although we will continue to monitor our exposure to currency fluctuations, we cannot assure that exchange rate fluctuations will not adversely affect financial results in the future. Item 4. Evaluation of Disclosure Controls and Procedures (a) Evaluation of Disclosure Controls and Procedures. The Company's chief executive officer and chief financial officer, after evaluating the effectiveness of the Company's "disclosure controls and procedures" (as defined in the Securities Exchange Act of 1934, Rules 13a-14(c) and 15-d-14(c)) as of a date (the "Evaluation Date") within 90 days before the filing date of this quarterly report, have concluded that, as of the Evaluation Date, the Company's disclosure controls and procedures were adequate and designed to ensure that material information relating to the Company and its consolidated subsidiaries would be made known to them by others within those entities. (b) Changes in Internal Controls. There were no significant changes in the Company's internal controls, or, to the Company's knowledge, in other factors that could significantly affect these controls subsequent to the Evaluation Date. PART II - OTHER INFORMATION Item 1. Legal Proceedings We are involved in various claims and proceedings arising in the ordinary course of business. Management believes, after consultation with legal counsel, that the ultimate disposition of these matters will not materially impact our consolidated financial position, liquidity, or results of operations. 28 Item 2. Changes in Securities None Item 3. Defaults Upon Senior Securities None Item 4. Submission of Matters to a Vote of Security Holders March 2003 Special Meeting of Shareholders The share totals listed in this discussion are given in pre-reverse stock split numbers. On March 24, 2003, we held a Special Meeting of Shareholders in Salt Lake City, Utah. The record date for the meeting was February 7, 2003, on which date there were 636,614,693 shares of the Company's Class A common stock issued, of which 80,830,000 shares were held as collateral under escrow agreements and were not entitled to vote. The first matter voted upon at the special meeting was the approval of the Board of Directors' selection of Hansen, Barnett & Maxwell as the Company's independent public accountants for the fiscal year ending December 31, 2002. The results of the voting were 453,747,161 shares in favor, 7,400,444 shares against, and 6,102,196 shares withheld or abstaining. The second matter voted upon at the special meeting was to consider and act upon a proposed amendment to the Company's certificate of incorporation to effect a reverse stock split of the Company's Class A common stock at a ratio of one share for forty shares. The results of the voting were 415,418,995 shares in favor, 49,607,889 shares against, and 2,222,917 shares withheld or abstaining. The 1 share for 40 shares reverse stock split took effect April 4, 2003. Item 6. Exhibits and Reports on Form 8-K a. Exhibits: The following Exhibits are filed with this Form 10-Q pursuant to Item 601(a) of Regulation S-K: Exhibit No. Description of Exhibit 99.1 Certification of President and Chief Financial Officer 99.2 Certification of President and Chief Financial Officer Pursuant to Section 906 of the Sarbanes- Oxley Act of 2002. b. Reports filed on Form 8-K during the three-month period ended March 31, 2003: 8-K filed on March 24, 2003, regarding results of special meeting of shareholders held March 24, 2003. 8-K filed April 4, 2003, regarding effectiveness and terms of reverse stock split. 29 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. Fonix Corporation Date: May 13, 2003 /s/ Roger D. Dudley Roger D. Dudley, Executive Vice President, Chief Financial Officer (Principal financial officer) 30