-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, OIUCD7VbFVYzvw3T0TA+m9iWsFR//5FsppHB72qeCo2mt3/LanffxT/xFGDUg+X8 baUs9n55XIvgI+RD56eMZw== 0000950144-99-013846.txt : 19991207 0000950144-99-013846.hdr.sgml : 19991207 ACCESSION NUMBER: 0000950144-99-013846 CONFORMED SUBMISSION TYPE: 10-K405/A PUBLIC DOCUMENT COUNT: 1 CONFORMED PERIOD OF REPORT: 19981231 FILED AS OF DATE: 19991206 FILER: COMPANY DATA: COMPANY CONFORMED NAME: VSI ENTERPRISES INC CENTRAL INDEX KEY: 0000846775 STANDARD INDUSTRIAL CLASSIFICATION: RADIO & TV BROADCASTING & COMMUNICATIONS EQUIPMENT [3663] IRS NUMBER: 841104448 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K405/A SEC ACT: SEC FILE NUMBER: 001-10927 FILM NUMBER: 99769536 BUSINESS ADDRESS: STREET 1: 5801 GOSHEN SPRINGS RD CITY: NORCROSS STATE: GA ZIP: 30071 BUSINESS PHONE: 7702427566 MAIL ADDRESS: STREET 1: 5801 GOSHEN SPRINGS ROAD CITY: NORCROSS STATE: GA ZIP: 30071 FORMER COMPANY: FORMER CONFORMED NAME: FI TEK III INC DATE OF NAME CHANGE: 19910219 10-K405/A 1 VSI ENTERPRISES, INC. 1 SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 --------------------- FORM 10-K/A AMENDMENT NO. 3 --------------------- Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the Fiscal Year Ended December 31, 1998 ------------------------------ Commission File No. 1-10927 VSI ENTERPRISES, INC. A Delaware Corporation (IRS Employer Identification No. 84-1104448) 5801 Goshen Springs Road Norcross, Georgia 30071 (770) 242-7566 Securities Registered Pursuant to Section 12(b) of the Securities Exchange Act of 1934: None ---- Securities Registered Pursuant to Section 12(g) of the Securities Exchange Act of 1934: Common Stock, $.001 par value per share --------------------------------------- Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [X] The aggregate market value of the common stock of the registrant held by non-affiliates of the registrant (10,703,808 shares) on April 15, 1999 was approximately $5,351,904, based on the closing price of the registrant's common stock as quoted on the Nasdaq Small Cap Market on April 15, 1999. For the purposes of this response, officers, directors and holders of 5% or more of the registrant's common stock are considered the affiliates of the registrant at that date. The number of shares outstanding of the registrant's common stock, as of April 15, 1999: 12,300,144 shares of $.001 par value common stock. 2 DOCUMENTS INCORPORATED BY REFERENCE None. The following items are amended: Item 1. Business. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. Item 7A. Quantitative and Qualitative Disclosures About Market Risk. 2 3 ITEM 1. BUSINESS. GENERAL VSI Enterprises, Inc. (the "Company"), was incorporated under the laws of Delaware on September 19, 1988 as Fi-Tek III, Inc. ("Fi-Tek") for the purpose of raising capital and to seek out business opportunities in which to acquire an interest. On August 21, 1990, the Company acquired 89.01% of the total common stock and common stock equivalents then issued and outstanding of Videoconferencing Systems, Inc., a Delaware corporation ("VSI"). VSI was founded in 1985 through the acquisition of a portion of the assets of a Sprint Corporation videoconferencing subsidiary. In December 1990, the Company changed its name from Fi-Tek III, Inc. to VSI Enterprises, Inc. During the first half of 1991, the Company acquired the remaining additional outstanding shares of common stock of VSI. The Company operates under five wholly-owned subsidiaries that include; Videoconferencing Systems, Inc., which designs, manufactures, markets and services an interactive group of videoconferencing and control systems; VSI Network Solutions, Inc., d/b/a Eastern Telecom, Inc. ("ETI") which is a company engaged in the business of marketing and selling telecommunications services and products; Videoconferencing Systems, n.v. ("VSI Europe") which is a distributor of the Company's videoconference systems in Europe; VSI Solutions Inc. ("VSI Solutions") which is a software company whose products include a reservation system for the management of videoconferencing systems; VSI Network Services, Inc., d/b/a Integrated Network Services, Inc. ("INS") which was engaged in the design, installation and support of local and wide area networks. The Company expects to close VSI Solutions by July 1, 1999, upon the completion of a contract with a customer. Integrated Network Services, Inc., which was an integration firm specializing in the connectivity of multi-protocol environments, ranging from small, local area networks to large, enterprise-wide networks employing WAN technologies to connect multiple sites discontinued operations in December, 1998. On January 15, 1999, the Company implemented a 1-for-4 reverse split of the shares of VSI Common Stock. All shares and per share amounts included in this report reflect the effects of the reverse split. The Company's principal executive offices and manufacturing facilities are located at 5801 Goshen Springs Road, Norcross, Georgia 30071, and its telephone number is (770) 242-7566. RECENT DEVELOPMENTS Debt Restructuring. On August 31, 1999, we restructured our debt with Thomson Kernaghan & Co., Ltd., which totaled $1,089,750 at August 31, 1999. We made a cash payment of $150,000 at closing, and the remaining balance was exchanged for a 7% secured convertible debenture, with a one year term. The debenture is secured by a lien on our ownership interest in Eastern Telecom, Inc. which is junior to our converting term note holders and new investors, as discussed below. Eastern Telecom is a marketer and reseller of telecommunications services and products. Additionally, under the terms of the agreement, Thomson Kernaghan released its existing security interest in our patents. Thomson Kernaghan has the option to commence converting the debenture into shares of our common stock at the initial rate of 7.5% per month beginning January 1, 2000. This rate will increase to 15% per month commencing April 1, 2000. The conversion price is the lesser of $1.00 per share or the five-day average closing bid price of 3 4 our common stock prior to the date of any such conversion, with a floor of $0.50 per share. Furthermore, Thomson Kernaghan has the option of converting the debenture into shares of Eastern Telecom common stock at any time and at the rate of one share of Eastern Telecom common stock for each $6.50 of principal so converted. Any remaining balance of the debenture will be payable on the maturity date. As part of closing the Thomson Kernaghan transaction, $1,213,000 of our 18-month term notes due March 31, 2000 were converted into 195,099 shares of Eastern Telecom common stock which were owned by us, representing a 19.5% minority interest in Eastern Telecom. In addition, $1,040,000 of new capital was raised by selling a 16.0% minority interest in Eastern Telecom. The consideration received for the sale of shares of common stock of Eastern Telecom was based on an internal valuation of Eastern Telecom. We still hold the remaining 64.5% majority ownership interest in Eastern Telecom. Participants in the term note conversion and new equity participants also received 1,098,492 and 396,497 warrants to acquire shares of our common stock at an exercise price of $0.50 and $1.00 per share, respectively. Under the terms of the Thomson Kernaghan agreement, we have undertaken to sell our remaining interest in Eastern Telecom at not less than fair market value, provided the terms of any such transaction are otherwise acceptable to us. Additionally, Eastern Telecom's minority shareholders have a put option, which gives them the right to put their Eastern Telecom shares back to us after one year, and we have a call option to reacquire shares of Eastern Telecom at any time, both at a price of $6.50 per share of Eastern Telecom common stock. Management Changes. On May 1, 1999, we entered into consulting agreements with a Dallas, Texas based venture capital, merchant banking and consulting firm, Taconic Partners, L.L.C., and with Karen Franklin to assist with our ongoing and anticipated operational and financial restructuring. On June 7, 1999, Ms. Franklin replaced interim Chief Financial Officer, Sam Horgan. On June 8, 1999, we announced that President and Chief Executive Officer Judi North would be resigning her position, effective June 11, 1999, for personal reasons. Mrs. North was replaced, on an interim basis, by Richard E. Harrison, President of Taconic Partners. Concurrent with the announcement of Ms. North's resignation, we promoted Rick Egan to President of our Videoconferencing Systems subsidiary. Ms. North remains on our board of directors. Richard E. Harrison, age 41, is the President and a Manager of Taconic Partners, L.L.C., a Dallas, Texas based venture capital, merchant banking and consulting firm. Since October 1996, Mr. Harrison has served as Chairman, President and CEO of OHA Financial, Inc., an affiliated investment of Taconic engaged in the specialty finance industry. Before founding Taconic Partners, Inc. in 1990, the predecessor to Taconic Partners, L.L.C., Mr. Harrison was a senior consultant with Towers Perrin, where he specialized in post-merger integration of operations and organizations for larger international companies. Prior to joining Towers Perrin, Mr. Harrison worked for Thomson McKinnon in corporate finance. Before that, Mr. Harrison was on the marketing staff of Reliance Electric Company. Mr. Harrison holds a bachelor of business administration degree in Finance from Baylor University and a masters of business administration degree from the University of Texas at Austin where he graduated with honors. Karen T. Franklin, age 42, served as Controller of OHA Financial, Inc. from September 1997 through May 1999. Previously, she had served as Director of Financial Accounting for Jayhawk Acceptance Corporation, a publicly held specialty finance company, and in managerial positions with 4 5 PricewaterhouseCoopers, Nations Credit Corporation and US Trails, Inc. She holds a master of science degree in accounting from the University of North Texas. She is a Certified Public Accountant. Nasdaq Listing. Effective as of the close of business on September 22, 1999, our common stock was delisted from the Nasdaq SmallCap Market and began trading on the OTC Bulletin Board. The delisting occurred as a result of the minimum bid price on our common stock being less than $1.00 per share and our net tangible assets being under $2.0 million. We are appealing Nasdaq's decision to delist our shares and have been advised by Nasdaq that its review council will likely issue its decision in April 2000. Sale of VSI Europe. On September 30, 1999, we sold our European subsidiary, VSI Europe, to certain members of VSI Europe's executive management team. As a condition of such sale, we were released from all liabilities, including certain guarantees under VSI Europe's bank credit agreements. Concurrent with the sale, VSI Enterprises and VSI Europe have agreed to enter into a non-exclusive reseller agreement wherein VSI Europe will retain the right to market our videoconferencing product line in Europe. VIDEOCONFERENCING SYSTEMS The Company's core business is the design, manufacture, marketing and servicing of interactive group videoconferencing and control systems (the "VSI Systems"). Each VSI System is designed with open software and modular subsystems which allow a VSI System to be expanded or reconfigured as technologies, user requirements or new applications evolve. Its products are designed to allow multiple participants at geographically dispersed sites to see and hear each other on live television and share graphical and pictorial information using standard commercially available telecommunications transmission facilities. The Company integrates standard video, audio and transmission components with its own proprietary video, audio and computer control components and software. The Company's open software and modular subsystems streamline production and allow the product to be tailored to meet customers' specific needs, with or without the necessity of custom design. The Company's lead products are marketed under the trade name Omega(TM). Customers are offered a variety of option packages to fit specific applications. Customers are also offered upgrade packages that make the Company's new products compatible with older models. To date, the Company has sold over 1,700 videoconferencing systems to approximately 325 customers, including Bank of America, Bell Atlantic, Boeing, Duracell, MCI, General DataComm and Johnson & Johnson; various foreign, U.S. and state government departments and agencies; educational institutions; and health care facilities. VSI Systems enable participants in multiple locations to hold interactive group meetings remotely, thus avoiding costly and time-consuming travel. Participants at any connected location can be seen and heard by all other participants. If the VSI System is equipped with the appropriate options, the participants can also utilize slides, graphs, plain paper drawings, computer-generated graphics, computer data, laser discs and video tape interactively. Unlike audio teleconferencing systems which only allow voice communications, audiographic teleconferencing which is limited to voice plus still images, and business television which does not provide for interaction among the participants (also known as one-way videoconferencing), the Company believes its VSI Systems foster the look and feel of live, face-to-face meetings and promote a natural interaction among the participants. 5 6 A typical videoconference involves three major elements: (i) access to transmission services, (ii) a "codec" for coding/decoding digitized signal transmissions and (iii) the VSI System, which contains television monitors, cameras, audio system, microphones, cabinetry, various control systems for interfacing the components to the user, and various optional components specific to the user's application. As the name implies, codecs are used to encode and decode (or compress and decompress) various types of data -- particularly those that would otherwise use up inordinate amounts of disk space, such as sound and video files. Common codecs include those for converting analog video signals into compressed video files (such as MPEG) or analog sound signals into digitized sound (such as RealAudio). Codecs can be used with either streaming (live video or audio) or files-based (AVI, WAV) content. The Company designs, manufactures, assembles, installs and services the VSI Systems, and it has nonexclusive marketing agreements with codec manufacturers to resell the codecs. Customers secure the transmission services independently though telecommunications carriers for either fixed monthly or hourly usage prices. These transmission services may vary, depending upon the customer's application and preferences, and include a range of transmission bandwidths. In general, the higher the bandwidth the better the quality of the transmitted images, although the choice of codec will affect image quality for a given speed. The VSI Systems operate over the range of available transmission bandwidths and are compatible with all major brands of codecs known by the Company to be currently available; they also operate without codecs, for certain specialized networks. The primary users of VSI's videoconferencing products and services are major corporations, government agencies, educational institutions and health care facilities. Corporate and government organizations often use meetings to provide information, review operations, make plans, resolve problems, introduce new ideas or products, conduct training sessions and communicate with customers and vendors. Such conventional group meetings usually require at least some of the participants to travel to the meeting site. When meetings are required on a frequent, repetitive or emergency basis, travel costs and productivity losses can be substantial. The VSI Systems provide users with the ability to hold two-way and multi-way meetings, often at significant savings over the costs of travel and lost productivity while traveling. As an added and in some cases a more important benefit, because travel time and costs are eliminated, it may be more economic for more people to participate via videoconferencing, thereby causing the direct dissemination of pertinent information to more parties simultaneously, which may improve efficiency in problem solving and decision making. The Company also supplies and installs the VSI Systems for use in educational and training settings to connect one or more distant classrooms with a centrally-based instructor. These "distance learning" applications of videoconferencing are used by corporations, state and federal governments, hospitals and clinics, high schools, technical school, colleges and universities. The Company also provides "judicial systems" to state and local governments. Judicial systems equip court systems with the ability to link court rooms with prisons and jails, thereby reducing the costs and security risks associated with inmate-related travel including: arraignments, attorney/client conferences, booking and prisoner processing and depositions. 6 7 Products The Company believes that the videoconferencing world is becoming a world of "networks of systems" where all systems from boardroom to rollabout to desktop will have to interconnect. The Company believes that most systems in use today are not equipped to handle these demands. The Company's lead products are marketed under the trade name Omega. The key features and benefits of the Omega(TM) platform include: - Compression Technology Independence - separating control system from compression technology - Open Network Architecture - wide support for options and peripherals; flexibility; support for most network connection technologies; and centralized network management - Ease of Use - point-and-click camera control and on-screen icons to control all functions - System Management - remote management support and open system support of industry standards - Software-Based System - remote upgrades of software; customization; and sign-on security and system accounting The Omega(TM) product line offers a complete range of group videoconferencing systems, through three product families: Achiever, Performer and Ovation. The Achiever product family is designed for low to moderate usage of videoconferencing. The systems utilize the best board level codec on the market, a patented mouse driven graphical user interface and click and zoom camera control. These products can be upgraded to include remote diagnostics capabilities, sign on security and additional peripherals. The Performer product family is designed for moderate to high usage of videoconferencing. The system encompasses the highest quality codec, advanced audio and video processors, SCAN technology that supports onscreen control of peripheral devices and supplies information to a database in the system controller, remote diagnostics and an open architecture. The Ovation product family is designed for videoconferencing users with specific needs. These systems are specially designed for use in distance learning, video arraignment, large conference rooms and auditoriums. Customers are offered a menu of options which allows them to tailor systems to meet their specific needs. The Omega(TM) is sold on a standalone basis, with or without codec. The Omega(TM) is offered with single, dual or more color monitors of 27" to 35" size, for rollabout cabinets or in-the-wall installation. Other options include: audio and video expansion packages, multiple cameras (either single or three chip), a graphics stand, a computer graphics interface, facsimile transmission and reception, transmission network interface, and a variety of videocassette recorders, slides chains and peripheral devices. Proprietary Technology The Company has developed proprietary technology in the areas of videoconferencing control systems, system diagnostics, information access and communications access. While VSI Systems make use of 7 8 some other manufacturers' components, the Omega(TM) utilizes internally developed proprietary software and products as key elements in differentiating the Company's systems in the marketplace. Since VSI Systems use standards-based codecs, they are interoperable with systems of other standards-compliant manufacturers. The heart of the Omega(TM) is the System Controller, a proprietary software suite that must be installed on a properly configured personal computer. The software suite includes the Omega(TM) real time operating system, Omega(TM) videoconferencing application package, device drivers, and a third party SQL database engine (as licensed to VSI for resale). This software is delivered in object code format. The Company has also developed and manufactures certain proprietary components: Omega(TM) Audio Processor, Omega(TM) Video Processor, Omega(TM) Power Supply, the Omega(TM) Basic/Serial IQ Connectors, the Omega(TM) Pan/Tilt/Zoom/Focus Controller, the Omega(TM) Infra-red User Control Panel and proprietary cabinetry. These proprietary components are designed to work exclusively with the Omega(TM) System Controller software. The Company regards its Omega(TM) software as proprietary and has implemented protective measures of both a legal (copyright) and practical nature. The Company derives considerable practical protection for its software by supplying and licensing only a non-modifiable run-time version to its customers and keeping confidential all versions that can be modified. By licensing the software rather than transferring title, the Company in most cases has been able to incorporate restrictions in the licensing agreements which impose limitations on the disclosure and transferability of the software. No determination has yet been made, however, as to the legal or practical enforceability of these restrictions or the extent of customer liability for violations. The Company has been granted seven patents from the U.S. Patent and Trademark Office that cover certain aspects of the Omega(TM) user interface, remote management and system architecture (which is a network videoconferencing system which combines the advantages of central and distributed intelligence systems). The patents protect the Company's innovative technology and enables the Company to pursue opportunities to license its technology to other manufacturers. Currently, the patents secure payment of a $900,000 promissory note at an interest rate of 14% per annum, with $300,000 due February 16, 1999 and $600,000 due May 16, 1999. In the event of default, the debt holder could foreclose on its security interest in the patents. (See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations -- Factors Affecting Future Performance.") The Company also has confidentiality agreements with certain of its employees and has implemented other security measures. New Product Development The Company continues to upgrade its present products and to develop new and innovative products for the videoconferencing market. Extensions of its product line will include a LAN-based gateway offering and software upgrades of existing products. Additional system and network management products are under development. Customer Service The Company generally provides a warranty for parts and labor on its systems for 90 days from the date 8 9 of delivery. The Company maintains videoconference rooms and the necessary transmission facilities and codecs to provide on-line assistance to its installed customers at its executive offices near Atlanta, Georgia and at its European office. It also provides a telephone helpline to assist customers in the diagnosis of system failures. Approximately 90% of all customer calls for assistance have been resolved through telephone or videoconference contact. The remaining 10% have generally been resolved by the removal and replacement of field replaceable units by Company or customer personnel. The Company maintains a spare parts inventory, and its policy is to replace failed units which are under warranty or subject to a service contract within 24 hours of notification. The Company offers several different maintenance programs, ranging from "helpline" telephone consultation to extended field service on a contract basis, which includes parts, labor, and travel service with a guaranteed on-site response within 48 hours. Warranty and contract service is provided from the Company's U.S. and European locations. Markets The Company has defined its target markets as the "Fortune 1,000" companies in North America and Europe. Typically, these large companies, often with numerous offices in different cities, are more likely to realize significant savings on travel and related costs by installing a videoconferencing network. Cost/benefit analyses are generally performed by the Company's customers themselves prior to purchasing a system. In addition, the Company has targeted as a secondary market small to mid-sized companies, as well as educational institutions, governments and healthcare providers. The Company's systems are marketed through a direct sales force, as well as through a select group of co-marketing partners and distributors, including partners for whom the Company is an original equipment manufacturer ("OEM"). For each of the fiscal years ended December 31, 1998, 1997 and 1996, international sales (sales outside of the United States and Canada) represented approximately 27%, 14% and 20%, respectively, of the Company's total sales. Net product sales attributable to VSI Europe increased from approximately $2.8 million during the year ended December 31, 1997 to $2.9 million for the year ended December 31, 1998. VSI Europe has historically contributed substantially all of the Company's international sales, although sales in China of $2.3 million were recorded in 1998 by VSI. See "-Videoconferencing Systems, n.v. ("VSI Europe")." No sales opportunities in China are being pursued in 1999. The Company believes it presently maintains an approximate 1% to 2% share of the total worldwide videoconferencing equipment market as measured by 1998 total sales volume for the industry. Customers The Company's customers include Fortune 1,000 companies, mid-sized corporations, agencies of state, local and federal governments, and health care facilities. They include Bank of America, Boeing, MCI, Duracell, BellSouth, Bell Atlantic and Johnson & Johnson. NETWORK SERVICES ("ETI") The Company, through its ETI subsidiary, serves as a sales agent for a number of major telecommunications clients, which include the regional Bell operating companies ("RBOCs"), Cable and Wireless and 3Com Corporation. ETI is paid a commission by its clients for products and services sold to 9 10 other entities. Among ETI's core product offerings are high speed data transfer systems, internet connections, T-1 connections, network services such as Centrex, frame relay and basic rate interface, primary rate interface and ISDN connections. ETI's business is conducted primarily in the northeastern United States Market The large telecommunications companies have pared fixed costs and overhead by outsourcing many functions including marketing to the lower tier business customer which is the niche that ETI has successfully captured. ETI usually targets customers who generate less than $250,000 per year in telecommunications/network service billings. The desire and willingness of Bell Atlantic to enter into a three year contract with the Company is an indication of a stable outsourcing attitude of large providers. Competition Competition has been limited by the large telecommunications companies' agent selection criteria, and as a result, new entrants have been limited in numbers. While the agency agreement is non-exclusive, it is in the providers best interest to limit competition. Product Line ETI's products fall under the classifications of : - Data Services - Voice Products - Account Management Services - Long Distances Services Data Services include internet connections, dedicated data transmission lines, and other information technology related services. Voice Products include interexhange services, on-premises voice mail products, toll free number telephone lines, and a broad range of other services. Account Management Services provides the customer with technical and customer service assistance , as well as, manage customer accounts for its vendors. Long Distance Services is a new area of the market that ETI has begun to sell. This service along with cellular and other telecommunication products and services offer significant potential additional revenues. During fiscal 1998 and 1997, approximately 37% of the Company's revenue primarily, commissions earned by ETI -- were from Bell Atlantic. VIDEOCONFERENCING SYSTEMS, N.V. ("VSI EUROPE") VSI Europe is a distributor of the Company's videoconference systems in Europe and conducts most of 10 11 its international business through two offices located in London and Antwerp, Belgium. For each of the fiscal years ended December 31, 1998, 1997 and 1996, international sales (sales outside of the United States and Canada) represented approximately 27%, 14% and 20%, respectively, of the Company's total sales. Net product sales attributable to VSI Europe increased from approximately $2.8 million during the year ended December 31, 1997 to $2.9 million for the year ended December 31, 1998. VSI Europe has historically contributed substantially all of the Company's international sales, although sales in China of $2.3 million were recorded in 1998 by Videoconferencing Systems, Inc. VSI SOLUTIONS INC. VSI Solutions is a software company whose products include a reservation system for the management of videoconferencing systems. Its principal product is "Video Administrator" which is a custom software package that facilitates network management, offered through VSI Solutions. Video Administrator will cease to be provided upon the completion in June 1999 of a project with one customer, and the operations of VSI Solutions will be discontinued at that time. COMPETITION The Company competes in the videoconferencing industry by providing application-specific and custom solutions (products and services) for its customers' videoconferencing needs. Because the Company's videoconferencing systems are compression technology-independent, they can be sold to customers with standard codecs, high speed codecs, board-level codecs or specialty codecs, as well as with direct links to ATM and fiber optic networks. The videoconferencing industry covers a broad spectrum of videoconferencing services available to businesses and others, all of which are, in a general sense, competitive with the Company's systems. The VSI Systems, however, are designed and marketed primarily for the group and custom videoconferencing segment of the industry. Within this segment of the industry, the Company presently competes primarily with two companies which presently have significantly greater resources and market shares than the Company. In addition, three of the Company's suppliers of codecs directly compete with the Company in the group videoconferencing segment. The Company believes demand for videoconferencing will continue to increase, which will attract additional competitors to the industry, some of which may have greater financial and other resources than the Company. RESEARCH AND DEVELOPMENT All of the Company's product engineering, including costs associated with design and configuration of fully-developed VSI Systems for particular customer applications, is accounted for in the Company's financial statements as research and development expenses. During the years ended December 31, 1998, 1997 and 1996, the Company's aggregate expenditures for research and development of new products or new components for existing VSI Systems were $800,000, $1.1 million and $1.2 million, respectively. During fiscal 1998, the Company's research and development expenses decreased by approximately 24% due to a reduction in workforce. EMPLOYEES As of March 15, 1999, the Company employed 124 persons full time, including five executive officers. 11 12 Of the full-time employees who were not executive officers, 45 were engaged in sales and marketing, 6 in production, 38 in service, seven in research and development, and 23 in general administration. The workforce has been reduced by approximately 15% since December 31, 1998, due to the closing of INS and consolidation of VSI's operations. Employee relations are considered good, and the Company has no collective bargaining contracts covering any of its employees. 12 13 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. As a result of the Company's recurring losses from operations and the Company's ratio of current assets/current liabilities, the Company's independent auditors for the year ended December 31, 1998 have included a paragraph in their audit report accompanying the Company's consolidated financial statements regarding the Company's ability to continue as a going concern. In response to those concerns, the Company has undertaken a restructuring of its business operations and balance sheet that, when fully implemented, are intended to achieve profitable operations and provide positive operating cash flows, as well as improve prospects for additional equity capital investments. This restructuring includes aggressive management of accounts receivable and inventory, sale of non- strategic assets and raising of funds through either private placement or restructuring of its current debt. During the first quarter of 1999, the Company reviewed its operating expenses and substantially reduced fixed management and overhead expenses. In addition, the Company restructured certain of its outstanding indebtedness. (See "Item 1. Business Recent Developments.") As of December 31, 1998, the Company had an accumulated deficit of $46,877,847, of which $16,935,972 was realized in 1998. The Company believes that its ongoing effort to restructure and refocus the strategic direction of the organization, and to eliminate assets that are either non-performing, impaired or unrelated to the core business (resulting in a non-recurring charge of approximately $10.3 million in 1998), will enable it to compete in the domestic videoconferencing and control system market. FINANCIAL CONDITION During the year ended December 31, 1998, the Company's total assets decreased approximately 52% to $10,960,965 from $22,880,459 at December 31, 1997. A large part of the decrease resulted from a $7,767,444 impairment charge of most of the goodwill from two non-core assets. Other factors were: - 92% decrease in other long-term assets, primarily due to the sale and impairment of investments in two other companies - 57% decrease in inventories, primarily due to an approximately $1.68 million write-down of obsolete or slow-moving videoconferencing inventory - 86% decrease in rental and demonstration inventory, due to write-downs of obsolete demonstration inventory and the closing of several sales offices - 89% decrease in software development costs, net, due to impairment of capitalized costs Cash and cash equivalents as of December 31, 1998 increased $282,732, or approximately 32%, to $1,134,231 from $859,684 on December 31, 1997. Total stockholders' equity decreased $14,588,279, or approximately 94%, from December 31, 1997, primarily because of the $16,935,972 net loss for the year. 13 14 RESULTS OF OPERATIONS YEAR ENDED DECEMBER 31, 1998 COMPARED TO YEAR ENDED DECEMBER 31, 1997 As part of an ongoing effort to restructure and refocus the strategic direction of the Company, and to eliminate assets that are either non-performing, impaired or unrelated to the core business, the Company took a non-cash and non-recurring charge of approximately $10.3 million in 1998. The charge included: the write-down of obsolete or slow-moving videoconferencing and demonstration inventory ($1.88 million); the loss from the sale of investments in two companies ($450,000); a write-down of capitalized software development costs ($180,000); and the write-off of most of the goodwill from the acquisitions of VSI n.v. in 1992 and ETI in 1996 ($7.76 million). As a result, many of the comparisons between 1998 and 1997 financial results in several categories have been significantly impacted by the non-recurring charges and/or the related changes in organizational structure and strategic direction. Also, results for 1998 and 1997 reflect the December 1998 closure of INS. Results for years presented have been restated to reflect the discontinuance of operations of INS. REVENUES Revenues for the year ended December 31, 1998 were $19.4 million, an approximately 1% decrease over revenues for the year ended December 31, 1997. An approximately 12% increase in videoconferencing systems revenues was more than offset by an approximately 21% decrease in commissions from telephone network reselling. The increase in videoconferencing systems revenues was due to a large order from a customer in China of $2.3 million. The decrease in commissions from telephone network reselling in 1998 was due primarily to a large number of chargebacks for disconnections and cancellations. GROSS MARGIN Gross margin as a percentage of revenues for the year ended December 31, 1998 was approximately 37%, down from 51% for the year ended December 31, 1997. The decrease was due to higher than usual sales of lower margin videoconferencing products during the second and third quarters of 1998, primarily from a $2.3 million order to a customer in China, and to lower revenues during the first quarter of 1998 at ETI. ETI revenues are basically all generated through commissions on the sale of services from third parties and do not have any cost of sales, therefore their margins are 100%. If their revenues decrease as a percentage of total sales then the overall margin of the Company decreases. SELLING, GENERAL & ADMINISTRATIVE EXPENSES Selling, general and administrative expenses for the year ended December 31, 1998 were $13,023,732, a decrease of $479,808, or approximately 4%, over the year ended December 31, 1997, due to improvements in parts procurement and ongoing cost reduction programs; and an approximately 10% reduction in workforce during 1998. 14 15 RESEARCH AND DEVELOPMENT EXPENSES The Company charges research and development costs to expense as incurred until technological feasibility of a software product has been established. Software development costs incurred after technological feasibility has been established are capitalized and amortized over the useful life of the product. For the year ended December 31, 1998, the Company's research and development expenses were $786,103, an approximately 24% decrease over the year ended December 31, 1997. The decrease was due to a reduction in workforce. IMPAIRMENT LOSS At December 31, 1998, an impairment loss of $7,767,444 was charged to operations. The majority of that loss - $6,995,211 - was charged to operations as an impairment of the original goodwill recorded with the Company's acquisition of ETI. The Company compared the carrying value of ETI at December 31, 1998 to the undiscounted anticipated cash flows for the next ten years to determine if there had been an impairment. As the anticipated undiscounted cash flows were lower than the carrying value of ETI, the Company then used the present value of estimated expected future cash flows using a 15% discount rate (discounted cash flows) to determine the impairment charge. This evaluation was triggered by ETI's net operating loss during 1998, a reduction in commissions paid to ETI by Bell Atlantic during 1998 and an informal valuation of ETI performed during the fourth quarter of 1998. An additional $577,077 impairment loss was recorded to eliminate all remaining goodwill related to VSI Europe, and an additional $195,156 impairment loss was recorded to write down VSI Europe's net assets to zero. Management recorded the impairment loss in light of VSI Europe's continuing operating losses. See Note A-7 and A-10 to the consolidated financial statements. LOSS ON SALE OF INVESTMENTS The loss on the sale of investments was the result of the Company's reevaluation of its investment in Global TeleMedix, Inc., which was sold in October 1998 at a loss of $302,000 and the loss of $150,000 in the investment in Educational Video Conferencing, Inc., which was sold on December 31, 1998. OTHER EXPENSES Other expenses, primarily finance charges, were $1,682,303 for the year ended December 31, 1998, an increase of $1,606,134 over the year ended December 31, 1997. The increase was primarily due to amortization of debt discount costs during the vesting period (the second and third quarters of 1998) of the conversion feature of the Company's convertible debentures; the amortization of debt issuance costs associated with the Company's convertible debentures; and interest expense from the convertible debentures. DISCONTINUED OPERATIONS The Company discontinued operations of its wholly-owned subsidiary, VSI Network Services, Inc. on December 31, 1998. The net loss attributed to the discontinued operations was $418,973 which included the loss from operations for the year ended December 31, 1998 of $763,705 and a gain of $344,732 recorded from the extinguishment of debt. 15 16 NET LOSS Net loss for the year ended December 31, 1998 was $16,935,972, a $11,118,606, or approximately 191%, increase over the net loss of $5,817,366 for the year ended December 31, 1997. Net loss from continuing operations was $16,516,999, a $11,645,395, or approximately 239%, increase over the net loss of $4,871,604 for the year ended December 31, 1997. The increase in net loss was due primarily to non-cash and non-recurring charges of approximately $10.3 million in 1998. Excluding the non-recurring charges of approximately $10.3 million, the net loss was approximately $6.6 million, an approximately $800,000 increase over the net loss for the year ended December 31, 1997. The non-recurring charges included: the write-down of obsolete or slow-moving videoconferencing and demonstration inventory ($1.88 million); the loss from the sale of investments in two companies ($450,000); a write-down of capitalized software development costs ($180,000); and the write-off of most of the goodwill from the acquisitions of VSI Europe in 1992 and ETI in 1996 ($7.76 million). YEAR ENDED DECEMBER 31, 1997 COMPARED TO YEAR ENDED DECEMBER 31, 1996 REVENUES Revenues for the year ended December 31, 1997 were $19.6 million, an approximately 54% increase over revenues for the year ended December 31, 1996. The increase was primarily due to the recognition of a full year of revenue from wholly-owned subsidiary ETI in 1997, compared to three months of revenue from ETI in 1996. ETI was acquired in October 1996. GROSS MARGIN Gross margin as a percentage of revenues for the year ended December 31, 1997 was 51%, up from 28% for the year ended December 31, 1996, due to the addition of high margin sales and account management commissions from ETI, a sales agency for a number of major telecommunications companies. SELLING, GENERAL & ADMINISTRATIVE EXPENSES Selling, general and administrative expenses for the year ended December 31, 1997 were $13,503,540, an increase of $5,248,453, or 64%, over the year ended December 31, 1996, due to an increase in the Company's sales, marketing and distribution initiatives in the United States (primarily due to the October 1996 acquisition of ETI and its sales force) and the Far East. RESEARCH AND DEVELOPMENT EXPENSES The Company charges research and development costs to expense as incurred until technological feasibility of a software product has been established. Software development costs incurred after technological feasibility has been established are capitalized and amortized over the useful life of the product. For the year ended December 31, 1997, the Company's research and development expenses were $1,031,814, a 13% decrease over the year ended December 31, 1996. Expenses in 1996 had been somewhat higher than historical levels, due to an expansion in the research and development workforce to accommodate projects related to forthcoming generations of the Omega product line and other 16 17 software projects. Many of those projects were completed or were winding down by first quarter 1997, and the workforce -- primarily at subsidiary VSI Solutions, Inc. -- was reduced. OTHER EXPENSES/INCOME TAXES Non-operating expenses and income taxes for the year ended December 31, 1997 were $269,410, a 94% increase over non-operating expenses and income taxes for the year ended December 31, 1996. The increase was primarily due to the payment of state taxes in Rhode Island by ETI, which was profitable in 1997. NET LOSS Net loss for the year ended December 31, 1997 was $5,817,366, a 13% improvement over the net loss for the year ended December 31, 1996. Excluding a charge to reflect obsolescence of certain inventory of approximately $2.1 million, the net loss for the year was approximately $3.7 million, a 44% improvement over 1996. The decrease in the loss was primarily due to a 54% increase in revenues and a substantial improvement in gross margins. LIQUIDITY AND SOURCES OF CAPITAL General As of December 31, 1998, the Company had cash and cash equivalents of $1,134,231. The Company's liquidity sources include existing cash and credit facilities. In order to meet its cash flow requirements, short-term debt and approximately $600,000 in accrued but unpaid sales tax obligations, the Company will require additional funding in 1999. This additional funding could be in the form of the sale of assets, debt, equity, or a combination. A further reduction in operating expenses has also been effected in order to maximize the Company's allocation of cash resources. However, there can be no assurance that the Company will be able to obtain such financing if and when needed, or that if obtained, such financing will be sufficient or on terms and conditions acceptable to the Company. On February 23, 1998, the Company issued $3,000,000 of 5% Convertible Debentures due February 2000 ("the Debentures") to Thomson Kernaghan & Co. Ltd. ("Thomson Kernaghan"), the proceeds of which were utilized for working capital purposes. The debentures were convertible into shares of common stock of the Company at the option of the holder at the lesser of (i) $8.00 per share or (ii) 85% of the average closing bid price of the Company's common stock. The debenture holder was also granted warrants to purchase 9,375 shares of common stock of the Company, at an exercise price of $2.40 per share. An agent involved in the placement of the debentures received warrants to purchase 9,375 shares of common stock of the Company, at an exercise price of $10.00 per share. During the year, $710,000 of debentures, plus accrued interest of $13,531, were converted by the debenture holder into 445,956 shares of common stock of the Company. The Company also paid $128,858 in accrued interest and fees. Also, in November 1998, $1,440,000 of debentures were redeemed by the Company at face value as follows: (i)$1,040,000 of debentures were bought back at face value on October 1, 1998 (at which time the Company paid $128,858 in accrued interest and fees); and (ii) $400,000 of debentures were bought 17 18 back at face value on November 16, 1998 (at which time the Company paid a fee of $50,000). The remaining debentures were converted on November 16, 1998 into a $900,000 term note to Thomson Kernaghan, at an interest rate of 14% per annum, due on or before May 16, 1999. At that time, Thomson Kernaghan was issued warrants to purchase 25,000 shares of common stock of the Company, at an exercise price of $2.40 per share. Of the 445,956 shares issued upon conversion of the debentures, 50,000 shares were held in escrow at December 31, 1998, with 25,000 of these shares issued in January 1999 and 25,000 issued in February 1999. To secure payment of the note, VSI granted the debt holder a security interest in VSI's seven patents issued by the U.S. Patent & Trademark Office. In the event of default, the debt holder could foreclose on its security interest in the patents. VSI has not paid a $300,000 installment of principal under the term note, which installment was due February 16, 1999. The failure to make this payment subjects VSI to a $30,000 per month penalty fee until the full balance is repaid. If VSI does not repay the note on or before May 16, 1999, VSI will be obligated to pay the debt holder an additional penalty of $30,000 on the 16th of each month until the debt is paid. As of March 30, 1999, the outstanding balance under this note, including accrued interest and penalties, was $1,006,257. Effective August 31, 1999, the Company restructured its term note with Thomson Kernaghan. See "Item 1. Business - Recent Developments." The cash redemption of a portion of the convertible debentures was funded in part from the proceeds of a private placement of term notes by the Company in October and November of 1998. These term notes were restructured on August 31, 1999 in connection with the Thomson Kernaghan debt restructuring. See "Item 1. Business - Recent Developments." In December 1998, the Company received $250,000 from the sale of the Company's investment in Educational Video Conferencing, Inc., a New York-based provider of distance education services. In October 1998, the Company received $243,000 from the sale of the Company's investment in Global TeleMedix, Inc., a Massachusetts-based provider of telemedicine software. In October, 1998, the Board of Directors of the Company authorized a stock repurchase program pursuant to which management is authorized to repurchase up to 250,000 shares of common stock of the Company. As of March 15, 1999, the Company had not repurchased any shares of its common stock. Any future purchases will be financed from the Company's cash reserves. Credit Facilities VSI Since June 1995, Videoconferencing Systems, Inc. (VSI), a subsidiary of the Company, has had a revolving credit and security agreement with Fidelity Funding of California Inc. This credit facility provides the Company with up to $4,000,000 at an interest rate of prime plus 2% per annum. Funds available under the credit facility are based on 80% of eligible VSI accounts receivable invoices, with certain restrictions. The credit facility is secured by the accounts receivable, inventory and certain fixed assets of VSI. As of December 31, 1998, approximately $83,000 was owed to Fidelity Funding. 18 19 ETI On October 8, 1998, ETI entered into a financing agreement with RFC Capital, Inc., whereby RFC Capital, Inc. purchases eligible accounts receivable for 90% of the accounts receivable amount, up to $1,500,000, at an interest rate of prime plus 2.75% per annum. This amount may be increased, subject to additional payment of commitment fees by ETI, to $5,000,000. If any account receivable is not paid within 90 days, ETI is required to buy back the account receivable for the full purchase price. The credit facility is secured by eligible accounts receivable. As of December 31, 1998, approximately $1,403,000 was owed to RFC Capital, Inc. INS In December 1996, VSI Network Services, Inc. (d/b/a Integrated Network Services, or INS), a wholly owned subsidiary of the Company, established a revolving credit and security agreement with Presidential Financial Corporation. This credit facility provides INS with up to $750,000 at an interest rate of prime plus 3% per annum. Funds available under the credit facility are based on 80% of eligible accounts receivable invoices, with certain restrictions. The credit facility is secured by accounts receivable, inventory and fixed assets of INS. As of December 31, 1998, approximately $248,000 was owed to Presidential Financial Corporation. With INS ceasing operations on December 31, 1998, VSI is obligated to repay the balance owed Presidential Financial Corporation. On March 31, 1999, that amount was approximately $138,000. The Company expects to repay the full amount during 1999 upon the collection of outstanding INS accounts receivable. VSI n.v. In February 1998, Videoconferencing Systems, n.v., a wholly owned subsidiary of the Company, entered into a revolving credit and security agreement with Kredietbank, n.v. This credit facility provides Videoconferencing Systems, n.v. with up to $550,000 at an interest rate of 5% per annum. The credit facility is secured by 137,500 shares of common stock of the Company, held in escrow by Kredietbank, n.v. At December 31, 1998, approximately $253,000 was owed to Kredietbank, n.v. As of December 31, 1998, Videoconferencing Systems, n.v. had a secured bank facility with Generale Bank of approximately $166,000, of which approximately $157,000 was outstanding at that time. OPERATING LOSS CARRYFORWARDS As of December 31, 1998, the Company had operating loss carryforwards for U.S. income tax purposes of approximately $29,389,000 available to reduce future taxable income through 2013. The Company also has investment and research and experimental credits of approximately $89,000 available to reduce future income taxes payable through 2013. During 1993, the Company experienced a change in control, as defined under Section 382 of the Internal Revenue Code. As a result, the utilization of approximately $7,000,000 in tax loss carryforwards will be limited to approximately $1,000,000 annually. 19 20 Videoconferencing Systems, n.v. has net operating loss carryforwards of approximately $3,350,000 that can be used to offset future taxable income. These carryforwards can be carried forward indefinitely. The resulting deferred income tax asset has been reduced to zero by a related valuation allowance. YEAR 2000 The Company has assessed the impact of the Year 2000 issue on its computer systems and is in the process of remediating the affected hardware and software. The Company utilizes various computer workstations and software packages as tools in running its accounting and operations areas. Most are PC-based and are Year 2000 compliant, with the exception of some older workstations that will be phased out by 2000. Also, the primary accounting system is not currently Year 2000 compliant, and management plans during 1999 to implement any necessary vendor upgrades and modifications to ensure continued functionality with respect to any accounting software problems associated with Year 2000. The Company presently has two well known and widely used software packages that run its accounting and management systems. These two different softwares will be converted to one Companywide software package that has been upgraded by the vendor and implementation is expected to start in the summer of 1999, with completion slated for late fall 1999. With respect to the production of its own proprietary software and hardware, the Company has taken the necessary steps to ensure that its proprietary technology is Year 2000 compliant. The Company's videoconferencing products use PC controllers of recent vintage that are computed in and displayed in four-digit format. In addition, the Company's Omegaa software uses "C" libraries that compute the date based on a count of the number of seconds from January 1970. Those software libraries are in no danger of being out of compliance before the year 2038. Also, the Company has surveyed the vendors who supply key computer-based components for its videoconferencing systems and services, and found that all are Year 2000 compliant. The Company will continue to monitor and assess the Year 2000 situation on an ongoing basis, especially in its dealings with new vendors or suppliers, and will take appropriate corrective action as needed. Contingency planning is a normal part of VSI's sales cycle, given lead time for parts and installation windows. VSI has included Year 2000 concerns into normal contingency planning without forming a separate department or task force to address these concerns. The Company has not developed a separate Year 2000 contingency plan, since to date no adverse effect from the Year 2000 issue has been identified. Should it be determined that any major vendors, service providers or partners may be negatively impacted by the Year 2000 issue, the Company will develop contingency plans for affected areas or make use of alternate suppliers. Expenditures for the Year 2000 project have to date been immaterial and are being expensed as incurred. These expenditures have not had, and are not expected to have, a material impact on the consolidated financial position, results of operation or cash flows of the Company. FORWARD-LOOKING STATEMENTS Certain statements contained in this filing are "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995, such as statements relating to financial results and 20 21 plans for future business development activities, and are thus prospective. Such forward-looking statements are subject to risks, uncertainties and other factors which could cause actual results to differ materially from future results expressed or implied by such forward-looking statements. Potential risks and uncertainties include, but are not limited to, economic conditions, competition and other uncertainties detailed from time to time in the Company's Securities and Exchange Commission filings. (See "-Factors Affecting Future Performance" in the section that follows). FACTORS AFFECTING FUTURE PERFORMANCE The following summarizes certain of the risks inherent in the Company's business: WE MAY NOT BE ABLE TO OBTAIN ADDITIONAL CAPITAL TO FINANCE OUR OPERATIONS WHEN NEEDED. We will require additional capital or other financing to finance our operations, new market development and continued growth. We may seek additional equity financing through the sale of securities on a public or a private placement basis on such terms as are reasonably attainable. We may not be able to obtain such financing when needed, or that if obtained, it may not be sufficient or on terms and conditions acceptable to us. Sales and potential sales of substantial amounts of our common stock included in the registration in the public market could adversely affect the prevailing market prices for the common stock and impair our ability to raise additional capital through the sale of equity securities. WE HAVE SUFFERED RECURRING LOSSES FROM OPERATIONS, AND OUR CURRENT LIABILITIES EXCEED CURRENT ASSETS, WHICH MAY PREVENT US FROM CONTINUING AS A GOING CONCERN. As a result of our recurring losses from operations in recent years and our ratio of current assets to current liabilities, our auditors have expressed substantial doubt about our ability to continue as a going concern. Although we have undertaken a restructuring of the business operations that is intended to achieve profitable operations and provide positive operating cash flows as well as provide for additional equity capital investments, our restructuring may not be successful. WE MAY NOT BE ABLE TO ACHIEVE OR SUSTAIN PROFITABILITY IN THE FUTURE. After 13 years of operations, we have not reported any profits for a full year of operations and, as of September 30, 1999, we had an accumulated deficit of $49.4 million. We may not be able to achieve or sustain profitability in the future. Whether or not we are able to operate profitably, we will require additional capital to finance our operations. OPERATING RESULTS COULD BE ADVERSELY AFFECTED IF WE FAIL TO SECURE SUFFICIENT CAPITAL AND FAIL TO CREATE A STRONG MARKETING SUPPORT TEAM THAT CAN PENETRATE NEW MARKETS. Our core technology, developed for videoconferencing applications, can also be used as the foundation for products and services in other markets, particularly for command and control applications for general business and industrial users. Entering that market successfully will require sufficient capital for further software product development, and the creation of sales channels and a marketing support team. The inability to secure sufficient capital or the failure to create a strong sales channel/marketing support organization could result in a failed effort to penetrate these new markets, and adversely affect operating results and cash flow. 21 22 DUE TO A FLOATING CONVERSION RATE FOR THE OUTSTANDING CONVERTIBLE DEBENTURE, WE DO NOT KNOW THE EXACT NUMBER OF SHARES THAT WILL BE ISSUED UPON CONVERSION. Upon full conversion of the outstanding convertible debenture held by Thomson Kernaghan, we would issue a maximum of 1,879,500 shares of common stock to Thomson Kernaghan. Based on the recent trading price of our common stock, if the debenture were to be converted at the present time, Thomson Kernaghan could be entitled to receive the maximum number of shares. These common shares would represent approximately 13.3% of our total outstanding common shares. Due to the floating conversion rate and depending on the timing of any conversions by Thomson Kernaghan, we do not know the exact number of shares that we will issue upon conversion. THOMSON KERNAGHAN COULD CONVERT THE DEBENTURE AT A LOW STOCK PRICE, RESULTING IN MORE SHARES FOR THOMSON KERNAGHAN AND CAUSING A SUBSTANTIAL DILUTION TO THE OTHER COMMON SHAREHOLDERS SINCE THOMSON KERNAGHAN MAY SELL THE FULL AMOUNT ISSUABLE UPON CONVERSION. The outstanding debenture held by Thomson Kernaghan converts at a floating rate, based upon the market price of our common stock at the time of conversion, subject to a floor of $0.50 per share. The lower the stock price at the time Thomson Kernaghan converts the debenture, the more common shares Thomson Kernaghan will receive. Furthermore, the conversion of the convertible debentures may result in substantial dilution to the interests of other holders of common stock since Thomson Kernaghan may ultimately convert and sell the full amount issuable on conversion. THOMSON KERNAGHAN COULD CONVERT THE CONVERTIBLE DEBENTURES INTO GREATER AMOUNTS OF COMMON STOCK, THE SALES OF WHICH WOULD FURTHER DEPRESS OUR STOCK PRICE. To the extent that Thomson Kernaghan converts and then sells its common stock, the common stock price may decrease due to the additional shares in the market. This could allow Thomson Kernaghan to convert its convertible preferred stock into even greater amounts of common stock. And, the subsequent sale of the common stock could further depress the stock price. THE PRICE OF OUR COMMON STOCK COULD BE FURTHER DEPRESSED BY SHORT SALES BY THOMSON KERNAGHAN OR OTHERS. The significant downward pressure on the price of the common stock as Thomson Kernaghan converts and sells material amounts of common stock could encourage short sales by Thomson Kernaghan or others. This could place further downward pressure on the price of the common stock. FUTURE ACQUISITIONS MAY NOT BE SUCCESSFULLY INTEGRATED WITH OUR EXISTING OPERATIONS, AND OUR ACQUISITION STRATEGY MAY NOT BE SUCCESSFUL. An important element of our growth strategy is to expand when appropriate through acquisitions. Our future success is dependent upon our ability to finance and effectively integrate acquired businesses with our operations. Our inability to do so could harm our operating results. Future acquisitions may not be successfully integrated with our existing operations, and our acquisition strategy as a whole may not be successful. In addition, our financial performance is now and will continue to be subject to various risks associated with the acquisition of businesses, including the financial effects associated with the integration of such businesses. 22 23 IF WE FAIL TO DEVELOP COMPETITIVE PRODUCTS IN RESPONSE TO TECHNOLOGICAL CHANGES, OUR BUSINESS COULD BE NEGATIVELY AFFECTED. The market for our products is characterized by rapidly changing technology, evolving industry standards and frequent product introductions. Product introductions are generally characterized by increased functionality and better picture quality at reduced prices. If we are unable, for technological or other reasons, to develop competitive products in a timely manner in response to changes in the industry, our business and operating results could be materially and adversely affected. Our ability to successfully develop and introduce on a timely basis new and enhanced products that embody new technology, and achieve levels of functionality and prices that are acceptable to the market will be a significant factor in our ability to grow and to remain competitive. For instance, the ability to transact business via the Internet is becoming increasingly important. Accordingly, in order to remain competitive, we are currently developing a system which will allow our customers remote access of command and control systems via the Internet. There is no guarantee that we can timely or effectively implement this strategy. OPERATING RESULTS COULD BE ADVERSELY AFFECTED BY A DISRUPTION IN SUPPLY OR A SIGNIFICANT PRICE INCREASE OF VIDEOCONFERENCING COMPONENTS OR FAILURE OF A THIRD PARTY SUPPLIER TO REMAIN COMPETITIVE IN PRICE. Substantially all of our videoconferencing components, subsystems and assemblies are made by outside vendors. Disruption in supply, a significant increase in price of one or more of these components or failure of a third-party supplier to remain competitive in functionality or price could have a material adverse effect on our business and operating results. We could experience such problems in the future. Similarly, excessive rework costs associated with defective components or process errors associated with our anticipated new product line of videoconferencing systems could adversely affect our business and operating results. OUR OPERATIONS COULD BE ADVERSELY AFFECTED BY THE LOSS OF A MAJOR CUSTOMER. We sell videoconferencing systems and related control services and network services to a number of major customers. During the year ended December 31, 1998, approximately 37% of our revenues were from Bell Atlantic. The loss of Bell Atlantic or other customers could have an adverse effect on our operations. THE LOSS OF KEY MANAGEMENT OR TECHNICAL PERSONNEL COULD ADVERSELY AFFECT OUR OPERATIONS. Our development, management of our growth and other activities depend on the efforts of key management and technical employees. Competition for such persons is intense. Since we do not have long-term employment agreements with our key management personnel or technical employees, we could lose one or more of our key management or technical personnel which could adversely affect our operations. Our future success is also dependent upon our ability to effectively attract, retain, train, motivate and manage our employees, and failure to do so could have a material adverse effect on our business and operating results. 23 24 WE EXPECT COMPETITORS MAY ENTER THE MARKET WHICH HAVE FAR GREATER TECHNICAL AND FINANCIAL RESOURCES THAN WE HAVE. Competition in the video communications and command and control markets is intense. We expect other competitors, some with significantly greater technical and financial resources, may enter these markets. If we cannot continue to offer new videoconferencing and command and control products with improved performance and reduced cost, our competitive position will erode. Moreover, competitive price reductions may adversely affect our results of operations. In the videoconferencing market, our primary competitors are PictureTel Corporation, VTEL Corporation and Polycom Inc. In the command and control market, our primary competitors are Panja, Inc. and Crestron Electronics, Inc. FLUCTUATIONS IN OUR QUARTERLY PERFORMANCE COULD ADVERSELY AFFECT OUR TOTAL REVENUES AND NET INCOME LEVELS. Our product sales have historically been derived primarily from the sale of videoconferencing systems and related equipment, the market for which is still developing. In addition, our revenues occur predominantly in the third month of each fiscal quarter. Accordingly, our quarterly results of operations are difficult to predict, and delays in the closing of sales near the end of the quarter could cause quarterly revenues and, to a greater degree, operating and net income to fall substantially short of anticipated levels. Our total revenues and net income levels could also be adversely affected by: - cancellations or delays of orders, - interruptions or delays in the supply of key components, - changes in customer base or product mix, - seasonal patterns of capital spending by customers, - delays in purchase decisions due to new product announcements by us or our competitors, and - increased competition and reductions in average selling prices. WE MAY NOT BE ABLE TO SUSTAIN CONTINUED TRADING MARKET IN OUR COMMON STOCK. Our common stock is traded on the OTC Bulletin Board. While we believe there are several securities broker/dealers making a market in our common stock, a public market for our common stock may not continue to be made or persons purchasing our securities may not be able to avail themselves of a public trading market for the common shares in the future. WE MAY NOT BE ABLE TO REGAIN OUR NASDAQ LISTING. Effective as of the close of business on September 22, 1999, our common stock was delisted from the Nasdaq SmallCap Market and began trading on the OTC Bulletin Board. The delisting occurred as a result of the minimum bid price on our common stock being less than $1.00 per share and our net tangible assets being under $2.0 million. We are appealing Nasdaq's decision to delist our shares and have been advised by Nasdaq that its review council will likely issue its decision in April 2000. If our appeal is unsuccessful, our common stock will continue to trade on the OTC Bulletin Board until such time as we qualify for inclusion on the Nasdaq Stock Market. Because the requirements for a new listing on the Nasdaq Stock Market are substantially more onerous than the requirements for continued listing, we may not be in a position in the future to reapply for listing on Nasdaq. 24 25 IF WE ISSUE PREFERRED STOCK, THE VALUE OF OUR COMMON STOCK MAY DECREASE. The issuance of any preferred stock could affect the rights of the holders of common stock, and therefore, reduce the value of the common stock and make it less likely that holders of common stock would receive a premium for the sale of their shares of common stock. In particular, specific rights granted to future holders of preferred stock could be issued to restrict our ability to merge with or sell our assets to a third party. No preferred stock is currently outstanding, and we have no present plans to issue any preferred stock. THE SEC'S RULES REGARDING "PENNY STOCKS" MAY RESTRICT YOUR ABILITY TO RESELL OUR SHARES. Our common stock is subject to a Securities and Exchange Commission rule that imposes additional sales practice requirements on broker/dealers who sell such securities to persons other than established customers and accredited investors (generally, institutions with assets in excess of $5,000,000 or individuals with net worths in excess of $1,000,000 or annual incomes exceeding $200,000 or $300,000 jointly with their spouses). For transactions covered by the rule, the broker/dealer must make a special suitability determination for the purchaser and receive the purchaser's written agreement to the transaction prior to the sale. Consequently, the rule may affect the ability of broker/dealers to sell our common stock and therefore may affect the ability of purchasers of our stock to resell those shares. 25 26 ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. The Company conducts most of its business in the United States and therefore, the Company believes its exposure to foreign currency exchange rate risk at December 31, 1998 was not material. The value of the Company's financial instruments is generally not significantly impacted by changes in the interest rates and the Company has no investments in derivatives. Fluctuations in interest rates are not expected to have a material impact on interest expense incurred under the Company's credit facilities due to the relative short term nature of its debt. 26 27 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this amendment to be signed on its behalf by the undersigned, thereunto duly authorized. VSI ENTERPRISES, INC. By: /s/ Richard E. Harrison ----------------------------------- Date: November 30, 1999 Richard E. Harrison, Chief Executive Officer 27 -----END PRIVACY-ENHANCED MESSAGE-----