NETWORK-1 TECHNOLOGIES, INC. — Interim / Quarterly Report 2001

Aug 20, 2001

================================================================================ U.S. SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-QSB [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2001 [ ] 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 1-14896 NETWORK-1 SECURITY SOLUTIONS, INC. ---------------------------------- (EXACT NAME OF SMALL BUSINESS ISSUER AS SPECIFIED IN ITS CHARTER) DELAWARE 11-3027591 -------- ---------- (STATE OR OTHER JURISDICTION OF (IRS EMPLOYER IDENTIFICATION NO.) INCORPORATION OR ORGANIZATION) 1601 TRAPELO ROAD, RESERVOIR PLACE, WALTHAM, MASSACHUSETTS 02451 ---------------------------------------------------------------- (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) 781-522-3400 ------------ (ISSUER'S TELEPHONE NUMBER) Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes /X/ No / / As of August 16, 2001 there were 6,467,547 shares of Common Stock, $.01 par value per share, and 231,054 shares of Series D Convertible Preferred Stock, $.01 par value per share, outstanding. Transitional Small Business Disclosure Format (check one): Yes [ ] No [X] ================================================================================ -1- NETWORK-1 SECURITY SOLUTIONS, INC. INDEX Page No. PART I. FINANCIAL INFORMATION Item 1. FINANCIAL STATEMENTS Balance Sheets as of June 30, 2001 (unaudited) and December 31, 2000...................................................3 Statements of Operations for the three and six months ended June 30, 2001 and 2000 (unaudited)............................4 Statements of Stockholders' Equity for the six months ended June 30, 2001 (unaudited) and for the years ended December 31, 2000 and 1999..........................................5 Statements of Cash Flows for the six months ended June 30, 2001 and 2000 (unaudited)..................................6 Notes to Financial Statements.......................................7 Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION...........8 PART II. OTHER INFORMATION Item 1. Legal Proceedings..................................................13 Item 2. Changes in Securities and Use of Proceeds..........................13 Item 3. Defaults Upon Senior Securities....................................13 Item 4. Submission of Matters to a Vote of Security Holders................13 Item 5. Other Information..................................................13 Item 6. Exhibits and Reports on Form 8-K...................................13 SIGNATURES..................................................................14 -2- NETWORK-1 SECURITY SOLUTIONS, INC. BALANCE SHEETS

SEE NOTES TO FINANCIAL STATEMENTS. -3- NETWORK-1 SECURITY SOLUTIONS, INC. STATEMENTS OF OPERATIONS

SEE NOTES TO FINANCIAL STATEMENTS. -4- NETWORK-1 SECURITY SOLUTIONS, INC. STATEMENTS OF STOCKHOLDERS' EQUITY

NETWORK-1 SECURITY SOLUTIONS, INC. STATEMENTS OF STOCKHOLDERS' EQUITY(continued)

SEE NOTES TO FINANCIAL STATEMENTS. -5- NETWORK-1 SECURITY SOLUTIONS, INC. STATEMENTS OF CASH FLOWS FOR THE SIX MONTHS ENDED

SEE NOTES TO FINANCIAL STATEMENTS. -6- NETWORK-1 SECURITY SOLUTIONS, INC. NOTES TO FINANCIAL STATEMENTS 1. FINANCIAL STATEMENT PRESENTATION a. The financial statements included herein have been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission with respect to Form 10-QSB. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations, although the Company believes that the disclosures made herein are adequate to make the information contained herein not misleading. These interim financial statements and the notes thereto should be read in conjunction with the financial statements included in the Company's Form 10-KSB for the year ended December 31, 2000. In the Company's opinion, all adjustments (consisting only of normal recurring adjustments) necessary for a fair presentation of the information shown have been included. b. The results of operations for the six months ended June 30, 2001 presented herein are not necessarily indicative of the results of operations that may be expected for the year ending December 31, 2001. c. Basic loss per share is calculated by dividing the net loss by the weighted average number of outstanding common shares during the period. Diluted per share data includes the dilutive effects of options, warrants and convertible securities. As all potential common shares are anti-dilutive due to the loss from continuing operations, they are not included in the calculation of diluted loss per share. d. On June 29, 2001 the Company entered into a six month consulting arrangement with CMH Capital Management Corp., whose sole shareholder is Corey M. Horowitz, the Company's Chairman of the Board of Directors, to provide strategic and financing consulting to the Company. The agreement is for $17,500 per month plus expenses. In addition, 300,000 10 year warrants were granted with an exercise price of $.70 which was the fair market price of the Company's common stock at date of grant. The warrants were valued utilizing the Black Scholes pricing model resulting in an estimated fair value of $185,000 which will be amortized and charged to expense over the six month period. No amortization expense of the warrants was charged during the period due to immateriality. -7- Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS THIS QUARTERLY REPORT ON FORM 10-QSB CONTAINS FORWARD-LOOKING STATEMENTS WITHIN THE MEANING OF SECTION 27A OF THE SECURITIES ACT OF 1933, AS AMENDED (THE "SECURITIES ACT"), AND SECTION 21E OF THE SECURITIES EXCHANGE ACT OF 1934, AS AMENDED (THE "EXCHANGE ACT"). ACTUAL RESULTS, EVENTS AND CIRCUMSTANCES (INCLUDING FUTURE PERFORMANCE, RESULTS AND TRENDS) COULD DIFFER MATERIALLY FROM THOSE SET FORTH IN SUCH STATEMENTS DUE TO VARIOUS RISKS AND UNCERTAINTIES, INCLUDING, BUT NOT LIMITED TO, THOSE DISCUSSED IN THE COMPANY'S ANNUAL REPORT ON FORM 10-KSB FOR THE YEAR ENDED DECEMBER 31, 2000 IN THE SECTION ENTITLED "RISK FACTORS THAT MAY AFFECT FUTURE RESULTS" AS WELL AS THOSE RISKS DISCUSSED ELSEWHERE IN THIS REPORT. Overview The Company develops, markets, licenses and supports a family of network security software products designed to provide comprehensive security to computer networks, including Internet based systems and internal networks and computing resources. The Company introduced its first network software product (FireWall/Plus) in June 1995. In January 1999, the Company introduced its CYBERWALLPLUS family of network security products. The Company has made only limited sales of its CYBERWALLPLUS product, upon which an evaluation of its prospects and future performance can be made. Such prospects must be considered in light of the risks, expenses and difficulties frequently encountered in the introduction of new products and the shift from research and product development to commercialization of products based on rapidly changing technologies in a highly specialized and emerging market. The Company will be required to significantly expand its product and development capabilities, introduce new products, introduce enhanced features to existing products, expand its in-house sales force, establish and maintain distribution channels through third-party vendors, increase marketing expenditures, and attract additional qualified personnel. In addition, the Company must adapt to the demands of an emerging and rapidly changing computer network security market, intense competition and rapidly changing technology and industry standards. The Company may not be able to successfully address such risks, and the failure to do so would have a material adverse effect on the Company's business, results of operations and financial condition. To date, the Company has incurred significant losses and, at June 30, 2001, had an accumulated deficit of $ 29,215,000. In addition, since June 30, 2001, the Company has continued to incur significant operating losses. The Company expects to incur substantial operating expenses in the future to support its product development activities, as well as continue to expand its domestic and international sales activities and marketing capabilities. Management believes it currently has cash to fund its operations until December 31, 2001 (or earlier if the Company does not achieve certain revenue assumptions) (See "Liquidity and Capital Resources" on page 11 of this report ). The Company is currently seeking additional financing, but it may not be able to secure such financing. The inability of the Company to obtain such financing would have a material adverse effect on the Company requiring it to curtail or possibly cease operations. In February 2000, the Company completed the sale of its professional services business for a sales price of $3.815 million which included $1.115 million held in escrow subject to certain former employees of the Company remaining employed by the purchaser for at least one year and the purchaser securing certain minimum purchase orders within ninety (90) days of the closing. The Company received $1,000,000 from escrow during the three months ended March 31, 2001 and received the additional $115,000 in April 2001 plus interest. In connection with the sale, the Company agreed not to offer any professional consulting services competitive with the purchaser until the second anniversary of the closing. Effective upon the sale, the Company granted options to acquire 104,063 shares of Common Stock at $2.91 per share to certain employees of the professional services business. In connection therewith, the Company incurred a compensation charge of $794,000 based upon the intrinsic value of the portion of the options vesting at such date and acceleration of other options. The balance of the options vested one year after the closing and an additional charge of $230,000 was incurred related to these options. The sale has been accounted for by the Company as a sale of a discontinued operation. The Company's software products have not yet achieved market acceptance. The future success of the Company is largely dependent upon market acceptance of its CYBERWALLPLUS family of software products. While the Company believes that its family of software products offer advantages over competing products for -8- network security, license revenue from network security software products since the introduction of FireWall/Plus (June 1995), a predecessor product line, through June 30, 2001 has only been $4,547,000, including a non-refundable pre-paid royalty of $500,000 in 1997. From January 1999 through June 30, 2001, license revenue from CYBERWALLPLUS has only been $1,815,000. CYBERWALLPLUS may not achieve significant market acceptance. Revenue from such commercial products depend on a number of factors, including the influence of market competition, technological changes in the network security market, the Company's ability to design, develop and introduce enhancements on a timely basis, and the ability of the Company to successfully establish and maintain distribution channels. The failure of CYBERWALLPLUS to achieve significant market acceptance as a result of competition, technological change or other factors, would have a material adverse effect on the Company's business, operating results and financial condition. The Company has committed significant product and development resources to its CYBERWALLPLUS family of products. The Company's anticipated levels of expenditures for product development are based on its plans for product enhancements and new product development. The Company capitalizes and amortizes software development costs in accordance with Statement of Financial Accounting Standards No. 86. These costs consist of salaries, consulting fees and applicable overhead. RESULTS OF OPERATIONS SIX MONTHS ENDED JUNE 30, 2001 COMPARED TO SIX MONTHS ENDED JUNE 30, 2000 Revenues increased by $221,000 or 41%, from $544,000 for the six months ended June 30, 2000 to $765,000 for the six months ended June 30, 2001, primarily as a result of an increase in license and service revenues during the six months ended June 30, 2001. License revenues increased by $173,000 or 37%, from $474,000 for the six months ended June 30, 2000 to $647,000 for the six months ended June 30, 2001, primarily due to the increased demand in security products. Revenue for the six months ended June 30, 2001 included a large CyberwallPLUS server license issued to a major government sub-contractor totaling $64,000. The Company recognized $118,000 in revenue from its distributor in China whose contract has been cancelled due to non payment of additional amounts due. In addition, management believes that customers are becoming more aware of the potential impact of internal server security breaches, and that companies are allocating increasing resources to safeguard their assets. Service revenues increased by $48,000 or 69%, from $70,000 for the six months ended June 30, 2000 to $118,000 for the six months ended June 30, 2001 primarily due to increased support revenue. The Company's revenues from customers in the United States represented 93% of its revenues during the six months ended June 30, 2000 and 77% of its revenues during the six months ended June 30, 2001, respectively. Cost of revenues consists of amortization of software development costs, cost of licenses and cost of services. Amortization of software development costs increased by $1,000 or 1%, from $124,000 for six months ended June 30, 2000 to $125,000 for the six months ended June 30, 2001, representing 26% and 19% of license revenues, respectively. Cost of licenses consists of software media (disks), documentation, product packaging, production costs and product royalties. Cost of licenses decreased by $7,000 or 24%, from $29,000 for the six months ended June 30, 2000 to $22,000 for the six months ended June 30, 2001, each representing 6% and 3% of license revenues, respectively. Cost of licenses as a percentage of license revenues may fluctuate from period to period due to changes in product mix, changes in the number or size of transactions recorded in a given period or an increase or decrease in licenses of products which would require the Company to pay royalties to third parties. -9- Cost of services consists of salaries, benefits and overhead associated with the technical support of maintenance contracts. Cost of services increased by $53,000 or 80%, from $66,000 for the six months ended June 30, 2000 to $119,000 for the six months ended June 30, 2001, representing 94% and 101% of service revenues, respectively. The increase in cost of services in dollar amount and as a percentage of service revenues resulted primarily from increased personnel costs to support the projected sales growth. Cost of services as a percentage of service revenues may fluctuate from period to period due to changes in support headcount and related benefit costs. Gross profit was $325,000 for the six months ended June 30, 2000 compared to a gross profit of $499,000 for the six months ended June 30, 2001, representing 60% and 65% of revenues, respectively. The increase in gross profit was primarily due to the increase in license revenue. Product development consists of salaries, benefits, bonuses, travel and related costs of the Company's product development personnel, including consulting fees, the costs of computer equipment used in product and technology development. Product development expense increased $667,000 or 108%, from $618,000 for six months ended June 30, 2000 to $1,285,000 for the six months ended June 30, 2001, representing 114% and 168% of revenues, respectively. Total product development costs, including capitalized costs of $200,000 for the six months ended June 30, 2000 and $235,000 for the six months ended June 30, 2001, were $818,000 and $1,520,000 for the six months ended June 30, 2000 and June 30, 2001, respectively. The increase in total product development costs was due primarily to the use of outside programmer's services of $691,000 including non cash compensation of $225,000 recognized for the issuance of warrants. Selling and marketing expenses consist primarily of salaries, including commissions, benefits, bonuses, travel, advertising, public relations, consultants and trade shows. Selling and marketing expenses increased by $535,000 or 45%, from $1,177,000 for the six months ended June 30, 2000 to $1,712,000 for the six months ended June 30, 2001, representing 216% and 224% of revenues, respectively. The increase in selling and marketing expenses was due primarily to an increase of $419,000 in sales personnel and costs related to the hiring of a direct sales force. General and administrative expenses include employee costs, including salary, benefits, travel and other related expenses associated with management, finance and accounting operations, and legal and other professional services provided to the Company. General and administrative expenses increased by $37,000, from $973,000 for the six months ended June 30, 2000 to $1,010,000 for the six months ended June 30, 2001, representing 179% and 132% of revenues, respectively. Increases in non-cash charges of $81,000 relating to the amortization of the value of warrants granted to outside consultants in November 2000, which was offset by decreases in non-cash charges of $47,000 relating to the amortization of the value of stock options granted to the Company's then Chief Executive Officer in May 1998. Net interest expense was $1,402,000 for the six months ended June 30, 2000 as compared to net interest income of $126,000 for the six months ended June 30, 2001, respectively. The Company completed a Series D Preferred Stock, warrant and promissory note financing of $3,000,000 on December 22, 1999 and recorded interest expense of $1,500,000 related to the beneficial conversion feature of the promissory notes for the six months ended June 30, 2000. Income from discontinued operations decreased by $1,438,000 or 69%, from $2,087,000 for the six months ended June 30, 2000 to $649,000 for the six months ended June 30, 2001. Income from discontinued operations for the six months ended June 30, 2001 was due to the receipt of $1,000,000 for retention of all the employees of the professional services group for a period of one year and additional contingent purchase price consideration of $56,000 less the $177,000 retention bonus plus taxes due the employees of the professional services group and a non-cash charge of $230,000 relating to the vesting of non-qualified options upon the employees completing a year of service. In connection with such sale, the Company agreed not to offer any professional or consulting services competitive with those services offered by purchaser for a period of two years from the closing date. No provision for or benefit from federal, state or foreign income taxes was recorded for six months ended June 30, 2000 or June 30, 2001 because the Company incurred net operating losses and fully reserved its deferred tax assets as their future realization could not be determined. As a result of the foregoing, the Company had a net loss of $1,758,000 for the six months ended June 30, 2000 compared with a net loss of $2,733,000 for the six months ended June 30, 2001. -10- Liquidity and Capital Resources The Company's capital requirements have been and will continue to be significant, and its cash requirements have been exceeding its cash flow from operations. At June 30, 2001, the Company had $2,535,000 of cash and cash equivalents and working capital of $1,209,000. The Company has financed its operations primarily through private sales of equity and debt securities and the sale of its professional services division on February 10, 2000. Net cash used in operating activities from continuing operations was $2,366,000 during the six months ended June 30, 2000 and net cash used in operating activities from continuing operations was $2,563,000 during the six months ended June 30, 2001. Net cash used in operating activities from continuing operations for six months ended June 30, 2001 was primarily attributable to the net loss from continuing operations of $3,382,000, an increase in accounts receivable of $73,000, and a decrease in deferred revenue of $27,000, which was partially offset by the amortization and expense of compensatory stock options and warrants for services rendered of $107,000, depreciation and amortization expense of $194,000, the issuance of common stock and warrants for services rendered of $225,000, an increase in accounts payable, accrued expenses and other current liabilities of $249,000 and an increase in accrued interest payable of $24,000. Cash provided by investing activities was $673,000 resulting from $938,000 net proceeds received in 2001 realted to the sale of the Company's professional services group in February 2000, less capitalized software costs of $235,000 and $30,000 of other investing expenditures. The Company does not currently have a line of credit from a commercial bank or other institution. The Company anticipates, based on currently proposed plans and assumptions (including the timetable of, costs and expenses associated with, and success of, its marketing efforts), that its current cash balance of approximately $2,535,000 as of June 30, 2001 together with certain revenue assumptions from operations, will be sufficient to satisfy the Company's operations and capital requirements through December 2001. There can be no assurance, however, that such funds will not be expended prior thereto. In the event the Company's plans change, or its assumptions change, or prove to be inaccurate (due to unanticipated expenses, difficulties, delays or otherwise), the Company may have insufficient funds to support its operations through to December 31, 2001. In the second and third quarter of 2001, the Company instituted certain measures to reduce its overhead and has decreased its headcount by 20 employees representing an annual payroll savings of $1.6 million. In addition, the Company is currently seeking financing; however, it does not have any definitive arrangements with respect to any additional financing. Consequently, additional financing may not be available to the Company if needed, on commercially reasonable terms or at all. The inability of the Company to obtain additional financing could have a material adverse effect on the Company, requiring it to curtail and possibly cease its operations. In addition, any additional equity financing may involve substantial dilution to the interests of the Company's then existing stockholders. -11- Fluctuations in Operating Results The Company anticipates significant quarterly fluctuations in its operating results in the future. The Company generally ships orders for commercial products as they are received and, as a result, does not have any material backlog. As a result, quarterly revenues and operating results depend on the volume and timing of orders received during the quarter, which are difficult to forecast. Operating results may fluctuate on a quarterly basis due to factors such as the demand for the Company's products, purchasing patterns and budgeting cycles of customers, the introduction of new products and product enhancements by the Company or its competitors, market acceptance of new products introduced by the Company or its competitors and the size, timing, cancellation or delay of customer orders, including cancellation or delay in anticipation of new product introduction or enhancement. Therefore, comparisons of quarterly operating results may not be meaningful and should not be relied upon, nor will they necessarily reflect the Company's future performance. Because of the foregoing factors, it is likely that in some future quarters the Company's operating results will be below the expectations of public market analysts and investors. In such event, the price of the Common Stock would likely be materially adversely affected. The sales cycle for the Company's products can be lengthy and generally commences at the time a prospective customer demonstrates an interest in licensing a CYBERWALLPLUS solution, typically includes a 28-day free evaluation period and ends upon execution of a purchase order by the customer. The length of the sales cycle varies depending on the type and sophistication of the customer and the complexity of the operating system. Year 2000 Issue The Company did not incur material costs with respect to potential software issues associated with the Year 2000. Possible Delisting of the Company's Securities From Nasdaq The Company's common stock is listed on the Nasdaq SmallCap Market under the symbol "NSSI". In order to continue to be listed on Nasdaq, however, the Company must comply with certain maintenance standards (including, among others, a minimum stock price of $1.00 and net tangible assets of a minimum $2,000,000). On July 31, 2001, the Company was notified by Nasdaq that its Common Stock failed to maintain a minimum bid price of $1.00 over the previous 30 trading days as required by The Nasdaq SmallCap Market Rules. In accordance with such rules, the Company has until October 29, 2001, for its Common Stock to trade at a closing bid price of at least $1.00 for 10 consecutive trading days or its securities will be delisted from Nasdaq. In the event of a delisting, an investor could find it more difficult to dispose of or to obtain accurate quotations as to the market value of the Company's Common Stock. -12- PART II. OTHER INFORMATION Item 1. LEGAL PROCEEDINGS. None. Item 2. CHANGES IN SECURITIES AND USE OF PROCEEDS. On April 12, 2001, the Company issued to Sage Alliance, Inc. (and its consultants) five year warrants to purchase 179,706 shares of the Company's common stock at $2.03 per share. Such warrants were issued in consideration for programming services rendered. On July 2, 2001, the Company issued to Sage Alliance, Inc. (and or its consultants) five year warrants to purchase 178,627 shares of the Company's common stock at $2.00 per share. Such warrants were issued in consideration for programming services rendered. On July 11, 2001, the Company issued to CMH Capital Management Corp. 10 year warrants to purchase 300,000 shares of the Company's common stock at $.70 per share. Such warrants were issued pursuant to a financial consulting agreement. Item 3. DEFAULTS UPON SENIOR SECURITIES. None. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. None. Item 5. OTHER INFORMATION. None. Item 6. EXHIBITS AND REPORTS ON FORM 8-K. a). Exhibits The exhibits in the following table have been filed as part of this Quarterly Report on Form 10-QSB: 10.19 Employment Agreement, dated June 29, 2001, between the Company and Murray P. Fish. 10.20 Consulting Agreement, dated June 29, 2001, between the Company and CMH Capital Management Corp. b). Reports of Form 8-K. On June 15, 2001 a report on Form 8-K was filed to announce the resignation of the Company's CEO and President. No other reports on Form 8-K were filed during the three (3) months ended June 30, 2001 -13- 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. NETWORK-1 SECURITY SOLUTIONS, INC. By: /s/ Murray P. Fish ---------------------------------- Murray P. Fish, Acting President and Chief Financial Officer (Principal Executive Officer and Principal Financial and Accounting Officer) Date: August 20, 2001 -14- EXHIBIT INDEX Exhibit Number Description of Exhibit -------------- ---------------------- 10.19 Employment Agreement, dated June 29, 2001, between the Company and Murray P. Fish. 10.20 Consulting Agreement, dated June 29, 2001, between the Company and CMH Capital Management Corp. -15-