Debt Instruments

12 Months Ended

Sep. 30, 2012

Derivative Instruments and Hedging Activities Disclosure [Abstract]

Debt Instruments

At September 30, 2012, the Company had the following outstanding debt instruments:

		Principal balance at issuance date		Principal balance at September 30, 2012
Senior Secured Revolving Credit Facility	$	5,000,000	$	5,000,000
Senior Subordinated Secured Convertible Promissory Notes		1,200,000		1,200,000
Senior Subordinated Secured Promissory Notes		4,000,000		4,790,400
Subordinated Secured Convertible Promissory Notes,		15,051,200		16,122,400

Secured Promissory Note

Timothy Looney, Barbara Looney and TWL Group, L.P. (collectively, “Looney”), on the one hand, and the Company and its then Chief Executive Officer, John C. Carson and its then Chief Financial Officer, John J. Stuart, Jr., on the other hand, had been engaged in litigation since January 2008 regarding the Company’s acquisition of Optex Systems, Inc. (“Optex”) and related matters (collectively, the “Disputed Matters”). In March 2010, the Company and Messrs. Carson and Stuart entered into a Settlement and Release Agreement with Looney pursuant to which the Company and Messrs. Carson and Stuart, on the one hand, and Looney, on the other hand, settled and released all claims and agreed to dismiss all litigation against each other relating to the Disputed Matters (the “Looney Settlement Agreement”).

Pursuant to the terms of the Looney Settlement Agreement, the Company issued to Mr. Looney a secured promissory note in the principal amount of $2,500,000 (the “Secured Promissory Note”).

In December 2011, the Company repaid the remaining amount of principal, interest, fees and other amounts owed by the Company under the Secured Promissory Note, thereby satisfying all remaining obligations of the Company pursuant to the Settlement and Release Agreement.

Senior Secured Revolving Credit Facility

In December 2011, the Company entered into a Loan and Security Agreement with Partners for Growth III, L.P. (“PFG”) pursuant to which the Company obtained a two-year, $5,000,000 revolving credit facility from PFG (the “Revolving Credit Facility”). As additional consideration for entering into the Revolving Credit Facility, the Company issued to PFG, and two of its affiliated entities, 7-year warrants to purchase an aggregate of 15,000,000 shares of the Company’s Common Stock (the “PFG Warrants”) at the exercise price of $0.11 per share. If the Company attains certain specified revenue and EBITDA thresholds for calendar year 2012, the aggregate number of shares issuable upon exercise of the PFG Warrants will be reduced to 10,000,000 shares. The PFG Warrants were originally valued at $682,000 and recorded as a debt discount. Of the total value of the PFG Warrants, the Company recorded $250,000 as derivative liability relating to the value of the warrants that could be adjusted, and $432,000 as an increase to paid in capital relating to the value of the remaining warrants to purchase 10,000,000 shares.

The maturity date for the Revolving Credit Facility is December 14, 2013 (the “Maturity Date”). Interest on the Loan accrues at the rate of 12% per annum, payable monthly and the remaining balance is payable on the Maturity Date. Each of Costa Brava Partnership III L.P. (“Costa Brava”) and The Griffin Fund LP (“Griffin”), major stockholders and debt holders of the Company, individually and collectively, jointly and severally, have unconditionally guaranteed repayment to PFG of $2,000,000 of the Company’s monetary obligations under the Loan Agreement.

To secure the payment of all of the Company’s obligations under the Loan when due, the Company granted to PFG a first position, continuing security interest in substantially all of the Company’s assets, including substantially all of its intellectual property. In addition, Costa Brava, Griffin and certain other existing creditors of the Company have agreed that, while any obligations remain outstanding by the Company to PFG under the Loan Agreement, their security interests in and liens on the Company’s assets shall be subordinated and junior to those of PFG.

As of July 31, 2012, the Company was not in compliance with the financial covenants in the Revolving Credit Facility. On August 21, 2012, the Company and PFG entered into a Forbearance, Limited Waiver and Consent under Loan and Security Agreement (the “Waiver”) by which, subject to certain terms and conditions, PFG waived that default and consented to other actions taken or to be taken by the Company, including the issuance of securities to finance a pending acquisition of certain assets of Bivio. The Company agreed to pay to PFG a $30,000 fee and issue to PFG warrants to purchase 2,045,045 shares of common stock (the “Waiver Warrants”). The exercise price of the Waiver Warrants was equal to the effective price of the next equity financing completed by December 31, 2012 or $0.11 per share. Since the exercise price of the Waiver Warrants was not fixed, such instrument was considered to be a derivative. As such, the Company recorded approximately $185,000 as a derivative liability, and expensed the cost of the Waiver Warrants as interest expense. The Waiver also amended the terms of the PFG Warrants to include an adjustment to the exercise price should the Company issue securities in the future with an exercise or effective conversion price below such warrant. Since the exercise price of the PFG Warrants was no longer fixed, the PFG warrants were also considered to be a derivative. As such, approximately $1,049,000 of paid-in capital was reclassified as derivative liability from equity. The Company also provided to PFG a general release of any claims the Company may have had against PFG as of the date of the Waiver.

The Waiver, by its terms, expired on September 30, 2012. As of September 28, 2012, in light of the Company’s continuing non-compliance with the financial covenants in the Loan Agreement, the Company and PFG entered into an Extension of Forbearance under Loan and Security Agreement (the “Forbearance Extension”). In consideration of granting the Forbearance Extension, the Company issued to PFG a warrant to purchase 2,045,045 shares of common stock (the “Extension Waiver Warrants”). The exercise price of the Extension Waiver Warrants was equal to the effective price of the next equity financing completed by December 31, 2012 or $0.11 per share. Since the exercise price of the Waiver Warrants was not fixed, such instrument was considered to be a derivative. As such, the Company recorded approximately $185,000 as a derivative liability and expensed the cost of the Extension Waiver Warrants as interest expense.On October 31, 2012 the Company obtained a second forbearance extension (the “Second Forbearance”) from PFG which remained in effect until October 31, 2012 and subsequently extended to remain in effect until December 15, 2012. The Company and PFG entered into a third forbearance extension (the “Third Forbearance”) that extended PFG’s forbearance until January 31, 2013. As compensation for the Second Forbearance and the Third Forbearance the Company issued to PFG Extension Waiver Warrants to purchase an additional 4,090,910 shares of common stock.

Due to certain subjective acceleration clauses in the Revolving Credit Facility, the Company classified the outstanding amounts, net of discount, as current liabilities at September 30, 2012.

Senior Subordinated Secured Convertible Promissory Notes

Effective as of September 28, 2012, the Company issued and sold to The Griffin Fund LP Senior Subordinated Secured Convertible Promissory Notes due November 30, 2012 in the aggregate principal amount of $1,200,000 (the “2012 Notes”). The 2012 Notes are convertible at $0.12 per share or the price of shares sold by the Company to one or more investors and raising gross proceeds to the Company of at least $1.0 million. Since the conversion price was not fixed, such instrument was considered to be a derivative. As such, the Company recorded approximately $81,000 as a derivative liability and related debt discount for the 2012 Notes sold prior to September 30, 2012. Subsequent to year end the Company issued $4,210,000 of 2012 Notes.

Payment in cash of an amount equal to all outstanding principal and accrued and unpaid interest on the 2012 Notes was initially due November 30, 2012. The 2012 Notes were amended effective November 30, 2012 to change the maturity date of the 2012 Notes to March 31, 2013 (the “Maturity Date”).

Senior Subordinated Secured Promissory Notes

In March 2011, the Company issued and sold to two accredited investors, Costa Brava Partnership III L.P. (“Costa Brava”) and The Griffin Fund LP (“Griffin”) 12% Senior Subordinated Secured Promissory Notes due March 2013 (the “Senior Subordinated Notes”) in the aggregate principal amount of $4,000,000. In July 2011, the Senior Subordinated Notes were amended to permit the holders to demand repayment any time on or after July 16, 2012, in partial consideration for permitting the issuance of additional Subordinated Secured Convertible Promissory Notes as discussed below. Because of this demand, the Senior Subordinated Notes have been classified as current obligations in the Company’s Consolidated Balance Sheets of September 30, 2012 and October 2, 2011.

The Senior Subordinated Notes bear interest at a rate of 12% per annum paid by adding the amount of such interest to the outstanding principal amount of the Senior Subordinated Notes as “paid-in-kind” (“PIK”) interest. As a result of the addition of such interest, the outstanding principal amount of the Senior Subordinated Notes at September 30, 2012 was $4,790,400.

The Senior Subordinated Notes are secured by substantially all of the assets of the Company pursuant to Security Agreements dated March 16, 2011 and March 31, 2011 between the Company and Costa Brava as representative of the Senior Subordinated Note holders, but the liens securing the Senior Subordinated Notes are subordinate to the liens securing the indebtedness of the Company to PFG under the Revolving Credit Facility.

Subordinated Secured Convertible Promissory Notes

In December 2010, the Company entered into a Securities Purchase Agreement with Costa Brava and Griffin, pursuant to which the Company issued and sold to Costa Brava and Griffin 12% Subordinated Secured Convertible Notes due December 23, 2015 (the “Subordinated Notes”) in the aggregate principal amount of $7,774,800 and sold in a subsequent closing in March 2011 additional Subordinated Notes to Costa Brava and Griffin for an aggregate purchase price of $1,200,000. In July 2011, the Company sold additional Subordinated Notes to five accredited investors, including Costa Brava and Griffin, in the aggregate principal amount of $5,000,000. In addition, holders of existing notes with a principal balance of $1,076,400 converted their Bridge Notes into Subordinated Notes during Fiscal 2011.

The Subordinated Notes bear interest at a rate of 12% per annum, due and payable quarterly. For the first two years of the term of the Subordinated Notes, the Company has the option to pay all or a portion of the interest due on each interest payment date in shares of common stock, with the price per share calculated based on the weighted average price of the Common Stock over the last 20 trading days ending on the second trading day prior to the interest payment date. While the Revolving Credit Facility is outstanding, interest on the Subordinated Notes that is not paid in shares of Common Stock must be paid by adding the amount of such interest to the outstanding principal amount of the Subordinated Notes as PIK interest. The principal and accrued but unpaid interest under the Subordinated Notes is convertible at the option of the holder into shares of the Common Stock at an initial conversion price of $0.07 per share. The conversion price is subject to a full price adjustment feature for certain price dilutive issuances of securities by the Company and proportional adjustment for events such as stock splits, dividends, combinations and the like. Beginning after the first two years of the term of the Subordinated Notes, the Company may force the Subordinated Notes to be converted to Common Stock if certain customary equity conditions have been satisfied and the volume weighted average price of the common stock is $0.25 or greater for 30 consecutive trading days. During Fiscal 2012, the Company paid approximately $1,447,000 of interest costs in the form of 13,162,700 shares of Common Stock.

The Subordinated Notes are secured by substantially all of the assets of the Company pursuant to a Security Agreement dated December 23, 2010 and July 1, 2011, as applicable, between the Company and Costa Brava as representative of the holders of Subordinated Note, but the liens securing the Subordinated Notes are subordinate in right of payment to Loans issued pursuant to the Revolving Credit Facility.

As a result of the issuances of Subordinated Notes discussed above, the conversion of existing notes to Subordinated Notes and the application of PIK interest, the aggregate principal balance of the Subordinated Notes at September 30, 2012, exclusive of the effect of debt discounts, was $16,122,400. The balance of the Subordinated Notes, net of unamortized discounts comprised of derivative liability, at September 30, 2012 was $6,470,300. The debt discounts will be amortized over the term of the Subordinated Notes, unless such amortization is accelerated due to earlier conversion of the Subordinated Notes pursuant to their terms. The Company paid a total of $1,000,000 in cash commissions to an investment banker for services related to issuance of the Subordinated Notes, $682,000 of which was recorded as a deferred financing cost and the balance recorded as an offset to equity.

Derivative Liability

The Subordinated Notes, the 2012 Notes, the PFG Warrants, the Waiver warrants and Extension Waiver Warrants, contain provisions that adjust the conversion or exercise price in the event of certain dilutive issuances of securities or exercise/conversion prices that are not fixed. The Company re-measured the fair value of the derivative liability to be $19,925,400 as of September 30, 2012.

The following outlines the significant assumptions the Company used to estimate the fair value information presented, with respect to derivative liability utilizing the Binomial Lattice pricing model at the date of issuance and September 30, 2012:

Risk free interest rate		0.3457	%
Expected volatility		92.78	%
Expected dividends	None