Item 1.	Business
BUSINESS
General Information
Our business address is 420 McKinney Parkway, Lillington, North Carolina 27546, and our telephone number is 910-514-9701. We relocated from 230 Duffy Avenue, Hicksville, New York 11801, in July 2011. Our website is www.adsiarmor.com. The information contained in, or that can be accessed through, our website is not part of this annual report.
History
American Defense Systems, Inc. was incorporated in December 2002 and commenced business in May 2003 upon the acquisition of our wholly-owned subsidiary, A.J. Piscitelli & Associates, Inc., or AJPA, which was founded in 1994 and developed and distributed security-related products.
Company Overview
We are a defense and security products company engaged in two business areas: customized transparent and opaque armor solutions for construction equipment and tactical and non-tactical transport vehicles used by the military; and architectural hardening and perimeter defense, such as bullet and blast resistant transparent armor, walls and doors.
Our armor solutions for construction equipment and tactical and non-tactical transport vehicles are designed to protect their occupants from landmines, hostile fire and improvised explosive devices (IEDs).
We focus primarily on research and development, design and engineering, fabrication and providing component integration. Our technical expertise is in the development of lightweight composite ballistic, blast and bullet mitigating materials used to fortify and enhance capabilities of existing and in-service equipment and structures. Our armor solutions are used in retrofit applications for equipment already in service, and we work with original equipment manufacturers (OEMs) to provide armor solutions for new equipment purchased by the military.
We serve primarily the defense market and our sales are highly concentrated within the United States (U.S.) government and other U.S. government contractors. Our customers include various branches of the U.S. military through the U.S. Department of Defense and to a much lesser extent other U.S. government, law enforcement and correctional agencies as well as private sector customers.
On March 22, 2011, the Company entered into a Securities Redemption Agreement (the “Redemption Agreement”) with the holders of our Series A Convertible Preferred Stock, pursuant to which we sold all of the issued and outstanding membership interests in American Physical Security Group, LLC (“APSG”), the Company’s wholly-owned subsidiary, to the holders of our Series A Convertible Preferred Stock. APSG was in the business of physical security products including forced entry blast resistant curtain walls, trans barrier systems and vehicle anti-ram barriers. In exchange for the sale of the APSG interests, the holders of our Series A Convertible Preferred Stock (i) paid $1,000,000 in cash to us at the closing of the transactions contemplated by the Redemption Agreement and (ii) tendered to the Series A Convertible Preferred Stock, which had an aggregate redemption price of $16,500,000. As a result of the transactions contemplated by the Redemption Agreement, APSG is no longer a subsidiary of the Company. In connection with the Redemption Agreement, the Company and the holders of our Series A Convertible Preferred Stock entered into that certain Membership Interest Option Agreement (the "Option Agreement") pursuant to which the Company was granted an option (the “Option”) to repurchase APSG within six (6) months following the closing of the transactions contemplated by the Redemption Agreement at a cash purchase price equal to the sum of (i) $15,525,000, plus (ii) the amount of any net investment made in APSG concurrently with and following the closing of the Redemption Agreement and prior to the closing of the purchase of the APSG membership interests pursuant to exercise of the Option. The Company did not exercise the Option, which expired on September 22, 2011.
Market Opportunity
The U.S. government uses Construction Equipment/Material Handling Equipment (“CE/MHE”) as part of the infrastructure rebuilding process in Iraq and Afghanistan. CE/MHE is used to demolish compromised or condemned properties; to level unstable structures and roadways for the health and safety of the adjacent civilian population and for the preparation of new structure foundations; to trench the ground for new sewer, water, gas and telecommunication lines; to grade, scrap and roll new roadways; and to load and unload materials and goods used to support civilian and military operations.
The U.S. military, including the U.S. Marine Corps, the U.S. Navy and the U.S. Army, use many different types of CE/MHE equipment that require armoring packages, such as graders, scrapers, rollers, vib-rollers, compacters, cranes, all terrain cranes, bulldozers, loaders, backhoes, tele-handlers, skid steers, all terrain forklifts, trams (a loader/forklift combination), cement mixers, excavators, water trucks, utility trucks, shipping container lifts and convoy trucks. Armor packages are required for this equipment and many unique forms of military equipment such as high speed, high mobility loaders, backhoes and other military-specific CE/MHE equipment. Due to the varying dimensions and armoring requirements for each of these pieces of equipment, they each require highly customized armoring kits.
Increased requirements for physical security in the U.S. and abroad also have driven demand for these products. The U.S. Department of Defense is one of the world’s largest purchasers of armored equipment and “add-on” or “up-armor” kits added to vehicles. The U.S. military’s transformation initiative to address asymmetric warfare includes ongoing modification of existing equipment and integration of new armor products in future vehicles. Asymmetric warfare refers to the use of unconventional tactics, such as guerilla warfare, urban explosive devices, and targeting civilians and non-military infrastructure, to counter the overwhelming conventional military superiority of an adversary.
Our Strengths
As a result of our in-house capability to design, engineer, integrate and support military and architectural specific solutions that address mission-critical force protection needs across the U.S. Department of Defense, we are able to produce custom armor solutions and components to address specific customer requirements.
Positioned for Favorable Industry Trends. Asymmetric warfare requires a rapidly mobile force and close engagement. In order to fight the war on terror more effectively, armed forces must be capable of tracking small groups of enemies through varying terrain and to quickly assemble, secure and move bases. We believe our solutions directly address these requirements by armoring vehicles and equipment already in Iraq and Afghanistan that are used for these purposes. As a result, we believe we are positioned to grow as the U.S. Department of Defense continues to transform its forces, placing greater demands on existing equipment and infrastructure.
In addition, as the war in Iraq winds down and upon the eventual conclusion of the war in Afghanistan, we anticipate continuing opportunities as the U.S. military seeks to “reset” its equipment to reverse the effects of combat wear-and-tear and prepare such equipment for the next conflict. Moreover, we anticipate the U.S. Military will seek to refurbish certain of its equipment and sell it to Iraq and Afghanistan to assist those countries in rebuilding. In each of these cases, we believe we are well positioned to address the expected vehicle armoring requirement opportunities.
Strong Customer Relationships. We currently support the U.S. Army TACOM Life Cycle Management Command, the U.S. Marine Corps, the U.S. Navy and high profile commercial customers. We believe that these relationships and the performance of our products in Iraq and Afghanistan will provide us with a significant advantage as we compete for future government contracts. We believe our brand recognition provides us with enhanced credibility with respect to our ability to successfully design and deliver armor solutions when competing for new business. In addition, based on our experience working collaboratively with these high profile customers, including under battlefield conditions, we believe we have developed clearer visibility into future opportunities and emerging requirements relating to the armor needs of the U.S. Department of Defense, the U.S. Department of Homeland Security, the U.S. Department of State and the U.S. Department of Energy.
Proprietary Technology and Commitment to Research and Development. We focus on the research, development, design, engineering, fabrication and integration of transparent and opaque armor solutions and have created proprietary technologies. We have the ability to offer end-to-end solutions and to assist customers across a project’s life cycle from the definition of project requirements to design, development and testing and long-term maintenance and support. We have developed forty-one common size armor windows and more than fifty different add-on armor (AoA) kits for construction and material handling equipment. We are actively pursuing integration of our common parts into Joint Light Tactical Vehicles and other vehicle programs. Customers rely on us for assistance throughout the stages of a project. For example, the U.S. Marine Corps awarded us a contract for seven 644E-TRAM forklift/bucket loaders and asked us to design a complete armor cab solution under an Urgent Needs Requirement (UNS). We successfully completed the design, fabrication, production, inspection and delivery of the 644E-TRAM, including designing opaque and transparent Crew Protection Kits, or CPKs, within 40 days.
Scalable Business Model. Our business model is focused on research and development, design and engineering, fabrication, and providing component integration. We outsource our proprietary and other designs to third party manufacturers and suppliers that meet our selective standards. Our technical specialists in engineering, ballistics, program management and logistics work closely with these manufacturers and suppliers to ensure that our quality standards are met. By outsourcing the manufacture and supply of components, we believe that we are able to work on multiple programs of larger scale, including those with aggressive time-lines, while maintaining high quality standards.
Experienced Management Team. Our senior and middle managers average more than 30 years of military, architectural, construction and/or engineering experience. We believe through the experience and customer service of our senior managers and technical specialists in engineering, ballistics, government contracts, program management and logistics, we have developed long-standing customer relationships and knowledge of our customers’ mission-critical requirements.
Our Growth Strategy
Our strategy to increase our revenue, grow our company and increase shareholder value involves the following key elements:
·	increase exposure to military platforms in the U.S.;
·	develop strategic alliances and form strategic partnerships with original equipment manufacturers (OEMs);
·	focus on an advanced research and development program to capitalize on increased demand for new armor materials;
·	increase exposure to commercial markets.
Increase Exposure to Military Platforms in the U.S. We are a provider of armor solutions for tactical and non-tactical transport military vehicles and construction equipment for TACOM and the U.S. Marine Corps Systems Command. We are actively pursuing opportunities to provide additional armor solutions for military platforms, both in the U.S. and abroad. To execute upon this growth strategy, we are engaging strategic advisors who have held key military positions to advise us on product development and market segment focus, and enhancing our presence at industry trade shows and other business development contacts.
We also are placing greater emphasis on learning future trends and concepts for armoring military platforms to assist in formulating business development strategies. These efforts will consist of increasing participation of senior management, research and development and sales and marketing personnel in these activities, and also will impact our strategies to form strategic partnerships with OEMs, develop strategic alliances, and pursue opportunities to supply homeland security requirements and other non-military platforms.
Develop Strategic Alliances and Form Strategic Partnerships with OEMs. We are pursuing strategic alliances with defense contractors and leading manufacturers of tactical wheeled vehicles and construction and material handling equipment to increase our visibility and sales opportunities. In particular, we are seeking companies with complementary products and services. Partnering with such companies would allow us to bid on a greater number of contracts where we do not possess all of the products or services required, and participate in a wider variety of programs and projects. We have designed and developed armor solutions for equipment built by material handling and civil engineering equipment manufacturers such as John Deere, JCB and Caterpillar. We are aggressively pursuing strategic partnership opportunities with OEMs to provide us with opportunities to include our armor solutions in armored vehicles they produce, as well as to serve as an alternate manufacturing entity for OEMs seeking to meet tight product delivery timeframes.
To market our products to these customers, we are leveraging our past installations of blast and ballistic resistant glass products at federal buildings, a national stock exchange and a national broadcasting company, the use of our bullet resistant glass solutions during recent presidential inaugurations, and the brand recognition we have developed with the success of our products in Iraq and Afghanistan.
Focus on an Advanced Research and Development Program to Capitalize on Increased Demand for New Armor Materials. In the transparent armor market, new materials are being introduced along with new composite manufacturing methods to reduce the high cost of some composite materials, such as Alon, Spinel and Sapphire. We intend to utilize our expertise in the research and development of new armor makeup to explore the incorporation of these new materials in our existing and future products and solutions.
Increase exposure to commercial markets. We intend to build on our successes in the DOD and Government Agency market by targeting commercial entities that have requirements for similar services. For example, commercial construction vehicles used by the petroleum industry seek armor enhancements to protect their operators. We have seen an increase of requirements for critical infrastructure protection in public areas, corporate facilities and transportation hubs. We are aggressively seeking these potential opportunities.
Products and Services
We offer a variety of products and solutions incorporating our transparent and opaque armor solutions.
Current Products and Services
Crew Protection Kits (CPKs). We design, engineer, fabricate prototypes, integrate the production of and deliver CPKs to customers or install completed CPKs on vehicles. Installation may occur domestically or abroad as specified by a contract's requirements. CPKs provide comprehensive armor protection of operator compartments through the integration of opaque armor, transparent armor, specialized insulation, ingress/egress windows, combat locks and other specialized hardware, customized air conditioning units, customized windshield wipers, alternators and, for wheeled vehicles, improved tires. Our technicians are able to quickly train military personnel to install the kits themselves. Our technicians and military personnel have successfully installed our up-armor kits at bases in Iraq, Kuwait, Afghanistan and the United States.
VistaSteel Transparent Armor. VistaSteel transparent armor is a tough and resilient laminated glass that provides a defensive barrier to protect against firearms, physical attack and explosive blasts. VistaSteel transparent armor is created through a process of bonding polycarbonate and glass under pressure and heat. The VistaSteel transparent armor product is sold in varying thicknesses depending on the type and level of defense required by the customer. These products have the properties of superior protection while utilizing thinner laminates. We can provide VistaSteel in spall or no-spall configurations as well as providing de-frosting and de-icing and films for architectural applications. Spall refers to the fragments of armor material that can be released from the inner surface of armor when the outer surface is impacted by a weapon’s blast or projectile. For example, upon impact from a blast or projectile on one side of the armor material, the other side may release fragments of the armor material, such as glass shards, which may impact the personnel or equipment being protected. With no-spall configurations, no fragments are expected to be released from the inner surface of the armor so long as the armor is not penetrated. Typically, armor in spall configurations have a fragile surface on its inner surface, such as glass or acrylic. No spall transparent armor typically has an inner surface of polycarbonate.
VistaSteel Opaque Armor. VistaSteel opaque armor is utilized in conjunction with VistaSteel transparent armor to form comprehensive up-armor or add-on armor kits. A vehicle armor kit consists of full perimeter protection including front and rear vehicle armor, doors with operable and non-operable windows, windshields, rear windows, roof and undercarriage protection. These kits are engineered and installed on a wide variety of military vehicles, including many variations of the High Mobility Multipurpose Wheeled Vehicle (HMMWV’s).
Lightweight Armor Systems. At the request of TACOM and the U.S. Marine Corps, we have developed solutions to maintain the same ballistic protection but significantly reduce the weight of our current Crew Protection Kits (CPK) and third party crew protection kits on HMMWV’s. Testing was conducted for a wide range of solutions that would reduce the weight while maintaining or improving the protection level for both small arms and fragmentation. The new system is a scalable solution that permits “normal” operation at a greatly reduced armor weight with an easily upgradeable add-on for high threat operations.
VistaGuard Windows. VistaGuard windows are Forced Entry Blast Resistant (FEBR) windows, window frames and transparent armor assemblies used to mitigate forced entry, ballistic and terrorist threats in high visibility targets.
Portable Transparent Ballistic Shield (PTBS). We have responded to interest by police agencies, correctional agencies and other security agencies for a bullet-resistant, transparent mobile shield for use as a protection device in hostage negotiation and other hostile situations. PTBSs have been sold to law enforcement agencies in New York, the U.S. Department of Veterans Affairs and overseas client.
Heated Ballistic Ship Window. Our heated ballistic ship windows utilize a nearly invisible Indium Tin Oxide (ITO) coating that uniformly heats the inner surface of the glass when an electrical current is applied in order to defrost and de-ice. An exterior anti-reflective coating is also part of the window assembly. Custom coatings can be incorporated into any of our ballistic window assemblies to filter or screen electromagnetic interference (EMI) or radio frequency (RF) radiation to prevent eavesdropping or to minimize the radar signature of the vehicle or vessel. The first production set of heated ballistic ship windows were delivered for use on an Australian ship.
Proprietary Hardware. Our hinges, rotary and slam latch, combat lock and egress window have been extensively tested by the U.S. Department of Defense for survivability and vulnerability testing through live-fire arena testing and Fragmentation Simulation Projectile, or FSP, exploitation tests.
Product Testing
Our armor products and solutions are tested extensively, both during the research and development phase and during customer evaluation of product materials, prototypes and production vehicles. These tests have been and continue to be conducted at many premier U.S. Department of Defense labs including Aberdeen Proving Grounds and the Naval Air Weapons Station at China Lake, as well as at certified testing facilities at the University of Dayton, Southwest Research Institute, Chesapeake Testing and Oregon Ballistic Labs and in active military combat situations in Iraq and Afghanistan.
Testing includes ballistic and blast protection testing (both on the armor itself and the edges, seams and other related structures), determination of ease of use by soldiers (e.g., opening doors, rolling down windows, entrance or exit of vehicles) and automotive testing to evaluate the effect of the armor solution's weight and other characteristics on the vehicle's road handling, wear and tear on mechanical parts, stress points caused by the extra weight, and drive shafts and power trains. We generally only pursue contracts when we have a high degree of confidence that our existing product or planned application of our product solution will satisfy the customer's requirements.
Operations and Manufacturing
Our personnel include technical specialists in engineering, ballistics, government contracts, program management and logistics who participate in the research and development of our add-on armor (AoA) solutions. Our technical specialists work collaboratively with customers in order to determine mission specific requirements. Through feedback from the technical specialists, the appropriate products are customized to fit contract specifications.
We purchase most of the components and materials used in our products from various suppliers. The primary materials used in the manufacturing of our products are polycarbonate glass and steel. Of our suppliers, APSG, a former subsidiary, supplied approximately 11% of our overall supply needs during the year ended December 31, 2011. In particular, APSG supplies our steel pieces and hardware. We believe, however, that alternative sources are readily available.
We have implemented a quality assurance procedure for vendor management in order to obtain the highest quality materials with minimal lead times. In order for a critical production vendor to be utilized by us, they are screened for quality assurance, prior dealings with our company and our personnel, reputation in the industry, professional affiliations and quality of product. Additionally, in 2008, we initiated an effort to implement a Quality Management System (QMS) in compliance with the requirements for the International Organization for Standardization (ISO) 9001 certification. The ISO certification process has been placed on hold and will be resumed when it is feasible for the company to do so.
We have also implemented quality control procedures for the identification of non-conforming materials, corrective actions and preventative actions. Each step of production entails review and inspection by a trained and experienced area manager. The area manager coordinates with the project manager and, where applicable, ensures that quality assurance procedures and standards are applied. When required, the project manager and/or members of the Engineering Department conduct site visits of Approved Vendor facilities to review quality assurance and inspect goods during the production of the goods.
Sales and Marketing
Our sales and marketing effort focuses on developing new business opportunities as well as generating follow-on sales for our armor solutions, and architectural hardening solutions. We currently employ two dedicated sales representatives who focus on these opportunities. Various members of our senior management also serve as effective sales representatives by contribution to the generation of military and corporate business due to their long-standing customer relationships and knowledge of our customers’ mission-critical requirements.
Our sales representatives are salaried employees who have a substantial military background in addition to extensive government contract sales experience. We believe these relationships give us a competitive advantage. Additionally, our program managers and service department employees assist us in earning repeat business. We believe these employees have knowledge of local requirements and practices, laws, and regulations to best address our clients’ needs. We continue to explore various domestic and international relationships to increase our sales and market penetration. The number of projects that we will bid on in 2012 will exceed the number we bid on in 2011.
We currently attend various trade shows involving defense operations and technology, military vehicles, law enforcement technology and military force protection, including the Association of the U.S. Army Annual Meeting and Winter Symposium, Modern Day Marine Expo, and Tactical Wheeled Vehicle conferences in order to maintain our competitive edge.
Research and Development
General
Our research and development efforts are focused on improving and enhancing our existing products, solutions and processes, as well as developing new products and applications. Our core competency is in proprietary transparent and opaque armor solutions. While third party contractors often manufacture our products, it is our proprietary designs, engineering and research and development process that differentiates us from our competitors.
Our on-going research and development includes evaluations of ceramic and fiber composite materials. Fiber composites have the potential to reduce weight and improve performance of personal protective equipment and vehicle armor. Ceramics, including alumina, silicon carbide, boron carbide, Sapphire and Spinel are essential for future lightweight CPK's and personal protective equipment.
As of December 31, 2011, we had one employee engaged in research and development. We continually work to enhance the survivability and reliability of our existing products and to develop and introduce innovative new products to satisfy the evolving needs of our customers domestically and internationally.
For the years ended December 31, 2011 and 2010, we incurred approximately $198,000 or 2.3%, of net sales and $745,000 or 2.4%, of net sales, respectively, of research and development expenses.
Products in Development
Lightweight Combat Helmet. In September 2009, the Office of Naval Research (ONR) awarded the Company a Broad Agency Announcement (BAA) contract to research a wide range of potential helmet materials for ballistic performance and backface deformation. We continue development to reduce the areal density, investigate the effect of a projectile’s angle as it strikes the helmet, or shot obliquity, and the effect on the inside of a helmet upon impact from a projectile or blast, or “behind armor” effects.
Lightweight SAPI. We are working with certain of our vendors to produce a lightweight Small Arms Protective Insert (SAPI) to reduce the overall combat load of a soldier or Marine. New methods of producing and encapsulating ceramic materials are being investigated and tested under a contract with the ONR. Our development seeks to reduce the areal density of the E-SAPI while controlling the backface deformation within acceptable parameters.
Transparent Armor. We have successfully completed testing of production samples of our most commonly used transparent armor solutions in accordance with TACOM’s Transparent Armor Purchase Document (ATPD 2352P). Testing includes a full range of environmental exposure testing such as abrasion resistance, thermal shock, salt fog and others. In addition, we have successfully passed the high-temperature ballistic requirements of ATPD 2352P at two of the most often required threat levels.
Although none of the foregoing products in development is expected to require outside funding, we continue to seek opportunities to obtain supplemental research grants that may benefit our product development.
Security Clearances
A facility security clearance (FCL) is an administrative determination by the Defense Security Service (DSS), a U.S. Department of Defense component, that a particular contractor facility has the requisite level of security, procedures, and safeguards to handle classified information requirements for access to classified information. Our ability to obtain and maintain a FCL has a direct impact on our ability to compete for and perform U.S. government contracts, the performance of which require access to classified information.
Intellectual Property
We rely on certain proprietary technology and seek to protect our interests through a combination of know-how, trade secrets and security measures, including confidentiality agreements. Our policy generally is to secure protection for significant innovations to the fullest extent practicable. Further, we seek to expand and improve the technological base and individual features of our products through ongoing research and development programs.
We rely on the laws of unfair competition and trade secrets to protect our proprietary rights. We attempt to protect our trade secrets and other proprietary information through confidentiality and non-disclosure agreements with customers, suppliers, employees and consultants, and through other security measures. However, we may be unable to detect the unauthorized use of, or take appropriate steps to enforce our intellectual property rights.
The laws of certain foreign countries do not protect intellectual property rights to the same extent as the laws of the United States, and we may face other obstacles to enforcing our intellectual property rights outside the United States including the ability to enforce judgments, the possibility of conflicting judgments among courts and tribunals in different jurisdictions and locating, hiring and supervising local counsel in such other countries.
Failure to adequately protect our intellectual property could harm or even destroy our brands and impair our ability to compete effectively. Further, enforcing our intellectual property rights could result in the expenditure of significant financial and managerial resources and may not prove successful. Although we intend to protect our rights vigorously, there can be no assurance that these measures will be successful.
Customers and Certain Contracts
We serve primarily the defense market and our sales are highly concentrated within the U.S. government. Our customers include various branches of the U.S. military through the U.S. Department of Defense and to a much lesser extent other U.S. government, law enforcement and corrections agencies as well as multinational companies.
A limited number of contracts have generated a substantial majority of our historical and current revenue. During 2011, three contracts with the U.S Department of Defense organizations represented 20% of our revenue. In addition, the Company derived 65% of its revenues from two private customers for the year ended December 31, 2011. During 2010, three contracts with the U.S. Department of Defense organizations represented approximately 84% of our revenue.
While we believe we have satisfied and continue to satisfy the terms of these government contracts, there can be no assurance that we will continue to receive orders under such contracts. Our government customers generally have the right to cancel any contract, or ongoing or planned orders under any contract, at any time. If any of these contracts were canceled or there are significant reductions in expected orders under any of the contracts, our revenues could decrease significantly and our business could be severely harmed.
Backlog
Our backlog as of December 31, 2011, which consisted substantially of contracts with the U.S. government, was $7 million, and our backlog as of December 31, 2010 was $14 million. Of our $7 million of backlog as of December 31, 2011, we expect all of our backlog will be filled in 2012.
We define backlog as the future revenue we expect to receive from our contracts. The contracts included in our backlog are firm fixed price contracts where we act as either the prime contractor or as a subcontractor and IDIQ contracts. Our revenue estimates for a particular contract, including IDIQ contracts, are based, to a large extent, on the amount of revenue we have recently recognized on that contract, our experience in utilizing capacity on similar types of contracts, and our professional judgment. We do not include estimated revenue from contract options that have not been exercised. Our revenue estimate for a contract included in backlog can be lower than the revenue that would result from our customers utilizing all remaining contract capacity. In particular, the receipt of revenues reflected in our backlog estimates for the following twelve months will generally be more certain than our backlog estimate for periods thereafter.
We have not historically tracked our "funded" backlog, which we define as amounts actually appropriated by a customer for payment of goods and services less actual revenue recorded as of the measurement date under that appropriation. Although we are aware of appropriations made with respect to our U.S. government contracts, our primary government customers have the ability to reallocate the funds within such appropriations among various projects and contracts included in a given appropriation. Subject to this reallocation possibility and the definition of "backlog" above, our funded backlog as of December 31, 2011 was $7 million.
Competition
We are subject to significant competition that could impact our ability to gain market share, win business and increase the price pressure on our products. We face strong competition from a wide variety of firms, including large, multinational defense and aerospace firms as well as small businesses.
We are subject to significant competition from companies that market and manufacture armored vehicles, as well as other companies that supply spare parts for armored vehicles and sustainment. This competition could harm our ability to win business and increase the price pressure on our products. Some of the companies we compete against include large, multinational vehicle, defense and aerospace firms. Most of our competitors have considerably greater financial, marketing and technological resources than we do, which may make it difficult for us to win new contracts, and we may not be able to compete successfully. Certain competitors operate fabrication facilities and have longer operating histories and presence in key markets, greater name recognition, larger customer bases and significantly greater financial, sales and marketing, manufacturing, distribution, technical and other resources. As a result, these competitors may be able to adapt more quickly to new or emerging technologies and changes in customer requirements. They may also be able to devote greater resources to the promotion, manufacturing and sale of their products.
Our primary competition in the armor products market is Armor Works, BAE Systems/Armor Holdings, Ceradyne, Inc., Ibis Tek, Plasan Sasa, and Sieraccin Corporation.
Similarly, we face strong competition in the architectural hardening and physical security products market. Some of our primary direct competitors in this market are B&B Armor Corporation, Inc., Delta Scientific Corporation, Fabrication Designs, Inc., Norshield Security Product, and Ross Technology Corporation.
We believe the principal factors that generally determine a company's competitive advantage in these markets are:
·engineering and design capabilities;
·broad product functionality;
·customer service, execution and responsiveness;
·sales and marketing capabilities; and
·reputation in the industry.
We believe that we compete favorably with respect to each of these factors. In particular, we believe our design and engineering expertise in providing fully integrated ballistic and blast protected armor products provides an advantage over our competitors who provide protection against only selected ballistic threats. We also believe that our experience creating armor solutions for applications other than in military and construction vehicles (such as bullet and blast resistant glass and glazing for infrastructure applications, forced entry blast resistant curtain walls and mobile ballistic shields) and our strategy to research and explore new armor materials and their potential applications in new and existing armor solutions, gives us a competitive advantage over our competitors who focus primarily on existing armor materials or vehicle or military applications.
Many of our products have a number of applications, such as our 34 common size armor windows and 51 different add-on armor (AoA) kits for construction and material handling equipment. We believe that the broad functionality and application of our products and product components provides us with a competitive advantage over certain of our competitors whose products are applied in more narrow applications.
Regulation
Our operations and products are subject to extensive government regulation, supervision, and licensing under various federal, state, local and foreign statutes, ordinances and regulations. Certain governmental agencies such as the Environmental Protection Agency (EPA), Occupational Safety and Health Administration (OSHA) and the Department of Labor (DoL) monitor our compliance with their regulations, require us to file periodic reports, inspect our facilities and products, and may impose substantial penalties for violations of the regulations.
The majority of our business is conducted under long term contracts which are administered by the U.S. Department of Defense. These contracts are subject to product and facility inspection by the Defense Contract Monitoring Agency (DCMA) as well as auditing by the Defense Contract Audit Administration (DCAA).
As our international sales grow, we may be exposed to certain unique and potentially greater risks than are presented in our domestic business, including becoming subject to foreign laws, regulations and procurement regimes which may differ from U.S. Government regulation. In addition, our actions with respect to international sales and business are subject to U.S. export control statutes, regulations, and policies, including the Export Administration Regulations (EAR), the International Traffic in Arms Regulations (ITAR), the Foreign Corrupt Practices Act (FCPA), United Nations Convention against Corruption (UNCAC) and the various embargo regulations and guidelines of the Office of Foreign Assets Control (OFAC).
While we believe that we maintain all requisite licenses and permits and are in compliance with all applicable federal, state, local and foreign regulations, there can be no assurance that we will be able to maintain all requisite licenses and permits. The failure to satisfy those and other regulatory requirements could have a materially adverse effect on our business, financial condition, and results of operations.
Environmental Matters
We are subject to federal, state, local and foreign laws and regulations regarding protection of the environment, including air, water, and soil. Our business involves the use, handling, storage, and contracting for recycling or disposal of hazardous or toxic substances or wastes, including environmentally sensitive materials, such as solvents, lubricants, degreasing agents, gasoline and resin. We must comply with certain requirements for the use, management, handling, and disposal of these materials. We currently maintain insurance for debris removed but do not currently maintain insurance for pollutant cleanup. If we are found responsible, however, for any hazardous contamination, we may have to pay expensive fines or penalties or perform costly cleanup. Even if we are charged and later found not responsible for such contamination or clean up the cost of defending the charges could be high. If either of the foregoing occurs, our business results from operations and financial condition could be materially adversely affected.
Employees
As of April 6, 2012, we had approximately 24 full-time employees and four consultants. Of these total employees and consultants, seven were in manufacturing, four were in engineering and research, four were in sales and marketing, and thirteen were in general management, finance and administration. Our employees are not represented by any collective bargaining agreement, and we have never experienced a work stoppage. We believe we have good relations with our employees.
U.S. law requires companies to employ only individuals who may legally work in the United States. We are an IMAGE “Best Employment Practices” certified company that ensures a legal workforce. We participate in E-Verify, an internet-based system that compares information from an employee’s Form I-9 (Employment Eligibility Verification), to data from the U.S. Department of Homeland Security and Social Security Administration.
Executive Officers
Our executive officers and their respective ages and positions as of April 6, 2012, are as follows:
Name
Age
Position
General Alfred Gray
Chairman of the Board, Acting Chief Executive Officer
Gary Sidorsky
Chief Financial Officer and Treasurer
Kevin Healy
Chief Operating Officer and General Counsel
Curtis M. Taufman
Senior Vice President, Engineering and Architecture
Fergal Foley
Senior Vice President of Government Affairs and Business Development
Charles R. Pegg
Vice President, Operations
Victor La Sala
Senior Vice President, Research & Development
Robert C. Aldrich
Chief Security Officer
General Alfred Gray has been a member of our board of directors since January 2008, chairman of our board of directors since August 2011 and our acting chief executive officer since November 2, 2011. General Gray currently is a Senior Fellow and the Chairman of the Board of Regents at Potomac Institute for Policy Studies, a non-profit public policy research institute. Since 2000, General Gray has been a member of the board of directors of SENSIS Corp., a privately held commercial and defense radar company, and Information Assurance Inc., a privately held information assurance and security company. He is also the chairman of the board of directors of GlobeSecNine, a privately held financial investment firm. From April 2003 to June 2008, General Gray was the Chairman of the board of directors of SYS Technologies, Inc., an information solution company whose shares traded on the NYSE Amex until its acquisition by Kratos Defense & Security Solutions, Inc. (NASDAQ: KTOS). General Gray received his Bachelor of Science degree from the State University of New York. He received Honorary Doctorates of Law degrees from Lafayette College and Monmouth University. He also received Honorary Doctorate degrees from Norwich University, the Defense Intelligence College, and Franklin University. General Gray also attended the Marine Corps Command and Staff College and Army War College. In 1991, General Gray retired from the U.S. Marine Corps after 41 years of service. From 1987 until 1991, he served as a member of the Joint Chiefs of Staff and was the 29th Commandant of the Marine Corps and an advisor to the President. General Gray currently serves as the Chairman of Injured Marine Semper Fi Fund and the Marine Youth Fitness Foundation. He is also the Chancellor of the Marine Military Academy and a director of the Marine Corps Law Enforcement Foundation. General Gray is a member of the National Security Agency Advisory Board and is an advisor to the National Reconnaissance Office. He is also a member of the Defense advanced Research Projects Agency, U.S. Army Senior Advisory Group and the Defense Science Study Group.
Gary Sidorsky has served as our Treasurer and our Chief Financial Officer since December 2007 and December 2006, respectively, and from January to December 2006 served as our Controller. Mr. Sidorsky also served as a member of our board of directors from December 2007 through May 2010. Mr. Sidorsky has 31 years of accounting experience with both accounting firms and manufacturing companies. He served as Accounting Manager for Diam International, a leading global manufacturer of merchandising displays, from September 2003 to January 2006. Mr. Sidorsky received his Bachelor of Art degree from Quinnipiac University and MBA from Dowling College. He has also earned course certificates in Finance for Executives from the University of Chicago School of Business and Logistics from the Defense Systems Acquisition Management (DSAM).
Kevin J. Healy has served as our Chief Operating Officer since September 6, 2011 and our General Counsel since January 2010. From October 29, 2010 until September 6, 2011, Mr. Healy served as our acting Chief Operating Officer. From February 2008 to December 2009, he was a business and legal consultant for various private and not-for-profit companies engaged in certain manufacturing industries. From June 2005 to January 2008, Mr. Healy served as General Counsel of Advanced BioPhotonics, Inc., a medical imaging technology developer whose common stock formerly traded on the OTC Bulletin Board until May 2008. He also served as Secretary of Advanced BioPhotonics, Inc. from September 2005 to January 2008. From November 2001 to January 2005, Mr. Healy served as Corporate Counsel of the General Semiconductor Division of Vishay Intertechnology, Inc. (NYSE: VSH), a discrete semiconductor and passive electronic components manufacturer. From November 1997 to November 2001, he served as Assistant General Counsel of General Semiconductor, Inc., a manufacturer of the discrete segment of the semiconductor. Mr. Healy received his Master of Business Administration from Dowling College School of Business, Juris Doctor from St. John’s University and Bachelor of Art degree from the State University of New York at Albany. He is admitted to the New Jersey Bar, the District of Columbia Bar, and the United States District Court, District of New Jersey.
Curtis M. Taufman has served as our Senior Vice President of Engineering and Architecture and our Vice President of Engineering since March 18, 2008 and July 2005, respectively. From April 2004 to July 2005, Mr. Taufman served as our Chief Operating Officer. From 1996 to 2004, Mr. Taufman was an associate at James La Salsa & Associates, an architectural engineering firm. Mr. Taufman received his Bachelors of Architecture degree from the New York Institute of Technology. Mr. Taufman is a registered architect in New York, New Jersey and Vermont and maintains National Council of Architectural Registration Boards (NCARB) certification.
Fergal Foley currently serves as our Senior Vice President of Government Affairs and Business Development. From October 2007 until October 2010, Mr. Foley served as our Chief Operating Officer. Mr. Foley was a member of our board of directors and our Secretary from December 2007 through October 2010. He is also the Secretary of the American Institute for Defense and Tactical Studies, Inc., our wholly owned subsidiary, since its formation in 2008. Mr. Foley retired from the New York Army National Guard in October 2006 and was promoted to Brigadier General on the State Retired List. His key military assignments included serving as Deputy Brigade Commander in New York City from 1999 to 2003. On September 11, 2001 through September 29, 2001, Mr. Foley served as the Chief of Staff and Acting Commander for the Joint Task Force ‘‘Operation World Trade Center.’’ In October 2008, Mr. Foley was appointed by the Governor of New York as Commander of the New York State Defense Force. Mr. Foley earned an Associates Degree in Business Management from Canton College (SUNY), a Bachelor of Science degree and Master of Public Administration degree from Marist College, and a Master of Science degree from the U.S. Army War College.
Charles R. Pegg has served as our Senior Vice President of Program Management since October 2005. From May 2005 to October 2005, Mr. Pegg served as Program Coordinator for Davis Defense Group, a defense contractor. Prior to that, from February 2003 to May 2005, he served as Program Coordinator for KC Trading, a defense contractor company. Mr. Pegg served twenty years in the United States Marine Corps, and retired in 1994 at the rank of Gunnery Sergeant. Mr. Pegg has attended various collegiate courses offered at Northern Virginia Community College and Pepperdine University. Mr. Pegg also completed a master certificate program in strategic organizational leadership from Villanova University.
Victor La Sala has served as our Senior Vice President and our Vice President of Research and Development since March 18, 2008 and June 2005, respectively. Mr. La Sala also served as our Director of Engineering from March 2004 to June 2005. Prior to that, from January 1990 to March 2004, Mr. La Sala served as Managing Partner for James, La Sala & Associates, LLP, an architectural engineering firm, and as Partner for EnerTec Consulting Engineers from February 1984 to December 1989. From May 1974 to February 1984, Mr. La Sala served as Fire Protection Engineer and Safety Specialist at the U.S. General Services Administration, Public Buildings Service. Mr. La Sala also worked at Grumman Aerospace from June 1968 to October 1970 as a Spacecraft Design Engineer for the design of the Lunar Module Spacecraft. Mr. La Sala received his Bachelors of Science degree in Aerospace Engineering from Polytechnic Institute of Brooklyn and a Master of Arts degree in Occ. Safety and Health from New York University.
Robert C. Aldrich has served as our Chief Security Officer since October 1, 2007. Mr. Aldrich was a career employee of the Federal Bureau of Investigation (FBI). Special Agent Aldrich served as Special Consultant to the Commandant of the Marine Corps (CMC) and during the administration of five CMCs. After retiring from the FBI, Mr. Aldrich served as National Coordinator for Law Enforcement, Public Safety and Civil Support at Headquarters, United States Marine Corps. He established a key nexus with local, state, and federal law enforcement and public safety authorities for shaping and implementing Marine Corps policies for combating terrorism, continuity of operations, critical infrastructure protection and support to civil authorities. Mr. Aldrich received his Bachelor of Science degree from the University of South Carolina and is a Fellow at the Potomac Institute for Policy Studies. Mr. Aldrich served in the U.S. Army with Special Forces duty in Vietnam. Mr. Aldrich is a recipient of the Department of the Navy’s Distinguished Public Service Medal.
Available Information
We make available free of charge on or through our internet website our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those reports as soon as reasonable practicable after such material is electronically filed with or furnished to the SEC. Our website is www.adsiarmor.com.
Item 1A.
Item 1A. Risk Factors
Our business, industry and common stock are subject to numerous risks and uncertainties. The discussion below sets forth all of such risks and uncertainties that we have identified as material, but are not the only risks and uncertainties facing us. Any of the following risks, if realized, could materially and adversely affect our revenues, operating results, profitability, financial condition, prospects for future growth and overall business, as well as the value of our common stock. Our business is also subject to general risks and uncertainties that affect many other companies, such as overall U.S. and non-U.S. economic and industry conditions, including a global economic slowdown, geopolitical events, changes in laws or accounting rules, fluctuations in interest and exchange rates, terrorism, international conflicts, major health concerns, natural disasters or other disruptions of expected economic and business conditions. You should carefully consider the risk factors below in conjunction with the other information contained in this report.
Risks Relating to Our Company
We have a history of operating losses and anticipate future operating losses until such time as we can generate additional sales.
We have a history of operating losses and there is a substantial doubt about our ability to continue as a going concern. As of December 31, 2011, we had a working capital deficit of $867,271, an accumulated deficit of $16,955,187, shareholders’ deficiency of $235,012 and cash on hand of $132,285. We had operating losses of $3,301,724 and $3,685,215 for the years ended December 31, 2011 and 2010, respectively. We had income from continuing operations for the year ended December 31, 2011 of $6,826,961, including a gain of $12,786,969 on the redemption of mandatorily redeemable preferred stock, and losses from continuing operations for the year ended December 31, 2010 of $8,165,463. We had net income (losses) of $9,366,609 and $(9,382,359) for the years ended December 31, 2011 and 2010, respectively. We had net cash (used in) provided by operations of $(1,700,488) and $780,754 for the year ended December 31, 2011 and 2010, respectively. We entered into an agreement with the Series A Holders on March 22, 2011 to redeem the Series A convertible preferred stock (the “Series A Preferred”), as more fully discussed in Note 7 of the accompanying consolidated financial statements. We continue to explore all sources of increasing revenue. If we are unable in the near term to raise capital on commercially reasonable terms or increase revenue, we will not have sufficient cash to sustain our operations for the next twelve months. As a result, we may be forced to further reduce or even curtail our operations. These factors raise substantial doubt about our ability to continue as a going concern. The accompanying financial statements do not include any adjustments that might be necessary if we are unable to continue as a going concern.
We depend on the U.S. Government for a substantial amount of our sales and if we do not continue to experience demand for our products within the U.S. Government, our business may fail. Moreover, our growth in the last few years has been attributable in large part to U.S. wartime spending in support of troop deployments in Iraq and Afghanistan. If such troop levels are reduced, our business may be harmed.
We primarily serve the defense market and our sales are highly concentrated within the U.S. government. Customers for our products include the U.S. Department of Defense, including the U.S. Marine Corps and U.S. Army Tank Automotive and Armaments Command (TACOM), and the U.S. Department of Homeland Security. Government tax revenues and budgetary constraints, which fluctuate from time to time, can affect budgetary allocations for these customers. Many government agencies have in the past experienced budget deficits that have led to decreased spending in defense, law enforcement and other military and security areas. Our results of operations may be subject to substantial period-to-period fluctuations because of these and other factors affecting military, law enforcement and other governmental spending.
U.S. defense spending historically has been cyclical. Defense budgets have received their strongest support when perceived threats to national security raise the level of concern over the country’s safety, such as in Iraq and Afghanistan. As these threats subside, spending on the military tends to decrease. Accordingly, while U.S. Department of Defense funding has grown rapidly over the past few years, there is no assurance that this trend will continue. Rising budget deficits, the cost of the war on terror and increasing costs for domestic programs continue to put pressure on all areas of discretionary spending, and the new administration has signaled that this pressure will most likely impact the defense budget. A decrease in U.S. government defense spending, including as a result of planned significant U.S. troop level reductions in Iraq or Afghanistan, or changes in spending allocation could result in our government contracts being reduced, delayed or terminated. Reductions in our government contracts, unless offset by other military and commercial opportunities, could adversely affect our ability to sustain and grow our future sales and earnings.
We entered into a redemption agreement with holders of our Series A Convertible Preferred Stock in which we transferred our interest in our subsidiary, American Physical Security Group, LLC.
On March 22, 2011, we entered into the Redemption Agreement with the holders of our Series A Convertible Preferred Stock, pursuant to which we sold all of the issued and outstanding membership interests in APSG, our wholly-owned subsidiary, to the holders of our Series A Convertible Preferred Stock. In exchange for the sale of the APSG interests, the holders of our Series A Convertible Preferred Stock (i) paid $1,000,000 in cash to us at the closing of the transactions and (ii) tendered to the Series A Convertible Preferred Stock, which had an aggregate redemption price of $16,500,000. Upon the closing of the transactions, APSG is no longer a subsidiary of the Company. APSG accounted for $9.4 million, or 23.8% of our revenues in fiscal year 2010 and generated operating income of $74,735 compared to an operating loss of approximately $4.5 million in fiscal year 2010 for the Company as a whole. APSG generated operating income of $126,518 for the period from January 1, 2011 through March 22, 2011, and $74,735 for the year ended December 31, 2010.
Our revenues historically have been concentrated in a small number of contracts obtained through the U.S. Department of Defense and the loss of, or reduction in estimated revenue under, any of these contracts, or the inability to contract further with the U.S. Department of Defense could significantly reduce our revenues and harm our business.
Our revenues historically have been generated by a small number of contracts. During the year ended December 31, 2011 three contracts with the U.S. Department of Defense organizations represented approximately 20% of our revenue. During the year ended December 31, 2010 three contracts with the U.S. Department of Defense organizations represented approximately 84% of our revenue. While we believe we have satisfied and continue to satisfy the terms of these contracts, there can be no assurance that we will continue to receive orders under such contracts. Our government customers generally have the right to cancel any contract, or ongoing or planned orders under any contract, at any time. If any of our significant contracts were canceled, or our customers reduce their orders under any of these contracts, or we were unable to contract further with the U.S. Department of Defense, our revenues could significantly decrease and our business could be severely harmed.
We are required to comply with complex laws and regulations relating to the procurement, administration and performance of U.S. government contracts, and the cost of compliance with these laws and regulations, and penalties and sanctions for any non-compliance could adversely affect our business.
We are required to comply with laws and regulations relating to the administration and performance of U.S. government contracts, which affect how we do business with our customers and impose added costs on our business. Among the more significant laws and regulations affecting our business are the following:
·The Federal Acquisition Regulations: Along with agency regulations supplemental to the Federal Acquisition Regulations, comprehensively regulate the formation, administration and performance of federal government contracts;
·The Truth in Negotiations Act: Requires certification and disclosure of all cost and pricing data in connection with contract negotiations;
·The Cost Accounting Standards and Cost Principles: Imposes accounting requirements that govern our right to reimbursement under certain cost-based federal government contracts; and
·Laws, regulations and executive orders restricting the use and dissemination of information classified for national security purposes and the export of certain products and technical data. We engage in international work falling under the jurisdiction of U.S. export control laws. Failure to comply with these control regimes can lead to severe penalties, both civil and criminal, and can include debarment from contracting with the U.S. government.
Our contracting agency customers periodically review our performance under and compliance with the terms of our federal government contracts. We also routinely perform internal reviews. As a result of these reviews, we may learn that we are not in compliance with all of the terms of our contracts. If a government review or investigation uncovers improper or illegal activities, we may be subject to civil or criminal penalties or administrative sanctions, including:
·Termination of contracts;
·Forfeiture of profits;
·Cost associated with triggering of price reduction clauses;
·Suspension of payments;
·Fines; and
·Suspension or debarment from doing business with federal government agencies.
If we fail to comply with these laws and regulations, we may also suffer harm to our reputation, which could impair our ability to win awards of contracts in the future or receive renewals of existing contracts. If we are subject to civil and criminal penalties and administrative sanctions or suffer harm to our reputation, our current business, future prospects, financial condition, and/or operating results could be materially harmed. In addition, we are subject to the industrial security regulations, protocols, and procedures of the U.S. Government as set forth in the National Industrial Security Program Operating Manual (NISPOM), which are designed to protect and safeguard classified information from unauthorized release to individuals and organizations not possessing a security clearance or the requisite level of clearance necessary to access that information. Accordingly, any failure to adhere to the requirements of the NISPOM could expose us to severe legal and administrative consequences, including, but not limited to, our suspension or debarment from government contracts, the revocation of our clearance, and the termination of our government contracts, the occurrence of any of which could substantially harm our existing business and preclude us from competing for or receiving future government contracts.
Government contracts are usually awarded through a competitive bidding process that entails risks not present in the acquisition of commercial contracts.
A significant portion of our contracts and task orders with the U.S. government is awarded through a competitive bidding process. We expect that much of the business we seek in the foreseeable future will continue to be awarded through competitive bidding. Budgetary pressures and changes in the procurement process have caused many government customers to increasingly purchase goods and services through indefinite delivery/indefinite quantity (IDIQ) contracts, General Services Administration (GSA) schedule contracts and other government-wide acquisition contracts (GWACs). These contracts, some of which are awarded to multiple contractors, have increased competition and pricing pressure, requiring us to make sustained post- award efforts to realize revenue under each such contract. Competitive bidding presents a number of risks, including without limitation:
·the need to bid on programs in advance of the completion of their design, which may result in unforeseen technological difficulties and cost overruns;
·the substantial cost and managerial time and effort that we may spend to prepare bids and proposals for contracts that may not be awarded to us;
·the need to estimate accurately the resources and cost structure that will be required to service any contract we are awarded; and
·the expense and delay that may arise if our or our partners’ competitors protest or challenge contract awards made to us or our partners pursuant to competitive bidding, and the risk that any such protest or challenge could result in the resubmission of bids on modified specifications, or in the termination, reduction or modification of the awarded contract.
If we are unable to consistently win new contract awards over any extended period, our business and prospects will be adversely affected, and that could cause our actual results to be adversely affected. In addition, upon the expiration of a contract, if the customer requires further services of the type provided by the contract, there is frequently a competitive rebidding process. There can be no assurance that we will win any particular bid, or that we will be able to replace business lost upon expiration or completion of a contract, and the termination or non-renewal of any of our significant contracts would cause our actual results to be adversely affected.
The U.S. government may reform its procurement or other practices in a manner adverse to us.
Because we derive a significant portion of our revenues from contracts with the U.S. government or its agencies, we believe that the success and development of our business will depend on our continued successful participation in federal contracting programs. The current administration has signed a Memorandum for the Heads of Executive Departments and Agencies on Government Contracting, which orders significant changes to government contracting, including the review of existing federal contracts to eliminate waste and the issuance of government-wide guidance to implement reforms aimed at cutting wasteful spending and fraud. The federal procurement reform called for in the Memorandum requires the heads of several federal agencies to develop and issue guidance on review of existing government contracts and authorizes that any contracts identified as wasteful or otherwise inefficient be modified or cancelled. If any of our contracts were to be modified or cancelled, our actual results could be adversely affected and we can give no assurance that we would be able to procure new U.S. Government contracts to offset the revenues lost as a result of any modification or cancellation of our contracts. In addition, there may be substantial costs or management time required to respond to government review of any of our current contracts, which could delay or otherwise adversely affect our ability to compete for or perform contracts. Further, if the ordered reform of the U.S. Government’s procurement practices involves the adoption of new cost-accounting standards or the requirement that competitors submit bids or perform work through teaming arrangements, that could be costly to satisfy or could impair our ability to obtain new contracts. The reform may also involve the adoption of new contracting methods to GSA or other government-wide contracts, or new standards for contract awards intended to achieve certain socio-economic or other policy objectives, such as establishing new set-aside programs for small or minority-owned businesses. In addition, the U.S. government may face restrictions from other new legislation or regulations, as well as pressure from government employees and their unions, on the nature and amount of services the U.S. government may obtain from private contractors. These changes could impair our ability to obtain new contracts. Any new contracting methods could be costly or administratively difficult for us to implement and, as a result, could harm our operating results.
Our contracts with the U.S. government and its agencies are subject to audits and cost adjustments. Unfavorable government audits could force us to adjust previously reported operating results, could affect future operating results and could subject us to a variety of penalties and sanctions.
U.S. government agencies, including the Defense Contract Audit Agency (DCAA), routinely audit and investigate government contracts and government contractors’ incurred costs, administrative processes and systems. Certain of these agencies, including the DCAA, review our performance on contracts, pricing practices, cost structure and compliance with applicable laws, regulations and standards. They also review the adequacy of our internal control systems and policies, including our purchase, property, estimation, compensation and management information systems. Any costs found to be improperly allocated to a specific contract will not be reimbursed, and any such costs already reimbursed must be refunded. Moreover, if any of the administrative processes and systems are found not to comply with government requirements, we may be subjected to increased government scrutiny and approval that could delay or otherwise adversely affect our ability to compete for or perform contracts. Therefore, an unfavorable outcome of an audit by the DCAA or another government agency could cause actual results to be adversely affected and differ materially from those anticipated. If a government investigation uncovers improper or illegal activities, we may be subject to civil and criminal penalties and administrative sanctions, including termination of contracts, forfeitures of profits, suspension of payments, fines and suspension or debarment from doing business with the U.S. government. In addition, we could suffer serious reputational harm if allegations of impropriety were made against us. Each of these events could cause our actual results to be adversely affected.
A portion of our business depends upon obtaining and maintaining required security clearances, and our failure to do so could result in termination of certain of our contracts or cause us to be unable to bid or re-bid on certain contracts.
A facility security clearance (FCL) is an administrative determination by the Defense Security Service (DSS), a U.S. Department of Defense component, that a particular contractor facility has the requisite level of security, procedures, and safeguards to handle classified information requirements for access to classified information. Our ability to obtain and maintain a FCL has a direct impact on our ability to compete for and perform U.S. government contracts, the performance of which requires access to classified information. Our inability to so obtain or maintain any facility security clearance level could result in the termination, non-renewal or our inability to obtain certain U.S. government contracts, which would reduce our revenues and harm our business.
We may not realize the full amount of revenues reflected in our backlog, which could harm our operations and significantly reduce our future revenues.
There can be no assurances that our backlog estimates will result in actual revenues in any particular fiscal period because our customers may modify or terminate projects and contracts and may decide not to exercise contract options. We define backlog as the future revenue we expect to receive from our contracts. We include potential orders expected to be awarded under IDIQ contracts. Our revenue estimates for a particular contract are based, to a large extent, on the amount of revenue we have recently recognized on that contract, our experience in utilizing capacity on similar types of contracts, and our professional judgment. Our revenue estimate for a contract included in backlog can be lower than the revenue that would result from our customers utilizing all remaining contract capacity. Our backlog includes estimates of revenues the receipt of which require future government appropriation, option exercise by our clients and/or is subject to contract modification or termination. At December 31, 2011, our backlog was approximately $7 million, of which approximately $7 million is estimated to be realized during the remainder of 2012. These estimates are based on our experience under such contracts and similar contracts, and we believe such estimates to be reasonable. However, we believe that the receipt of revenues reflected in our backlog estimate for the following twelve months will generally be more certain than our backlog estimate for periods thereafter. If we do not realize a substantial amount of our backlog, our operations could be harmed and our future revenues could be significantly reduced.
U.S. government contracts often contain provisions that are typically not found in commercial contracts and that are unfavorable to us, which could adversely affect our business.
U.S. government contracts contain provisions and are subject to laws and regulations that give the U.S. government rights and remedies not typically found in commercial contracts, including without limitation, allowing the U.S. government to:
·terminate existing contracts for convenience, as well as for default;
·establish limitations on future services that can be offered to prospective customers based on conflict of interest regulations;
·reduce or modify contracts or subcontracts;
·decline to make orders under existing contracts;
·cancel multi-year contracts and related orders if funds for contract performance for any subsequent year become unavailable;
·decline to exercise an option to renew a multi-year contract; and
·claim intellectual property rights in products provided by us.
The ownership, control or influence of our company by foreigners could result in the termination, non-renewal of or our inability to obtain certain U.S. government contracts, which would reduce our revenues and harm our business.
We are subject to industrial security regulations of the U.S. Department of Defense and other federal agencies that are designed to safeguard against unauthorized access by foreigners and others to classified and other sensitive information. If we were to come under foreign ownership, control or influence, our clearances could be revoked and our U.S. government customers could terminate, or decide not to renew, our contracts, and such a situation could also impair our ability to obtain new contracts and subcontracts. Any such actions would reduce our revenues and harm our business.
We depend on our suppliers and if we cannot obtain certain components for our products or we lose any of our key suppliers, we would have to develop alternative designs that could increase our costs or delay our operations.
We depend upon a number of suppliers for components of our products. One of our suppliers provided 11% of our overall supply needs during the year ended December 31, 2011. There is an inherent risk that certain components of our products will be unavailable for prompt delivery or, in some cases, discontinued. We have only limited control over any third-party manufacturer as to quality controls, timeliness of production, deliveries and various other factors. Should the availability of certain components be compromised through the loss of, or impairment of the relationship with, any of our three key suppliers or otherwise, it could force us to develop alternative designs using other components, which could add to the cost of goods sold and compromise delivery commitments. If we are unable to obtain components in a timely manner, at an acceptable cost, or at all, we would need to select new suppliers, redesign or reconstruct processes we use to build our transparent and opaque armored products. We may not be able to manufacture one or more of our products for a period of time, which could materially adversely affect our business, results from operations and financial condition.
If we fail to keep pace with the ever-changing market of security-related defense products, our revenues and financial condition will be negatively affected.
The security-related defense product market is rapidly changing, with evolving industry standards. Our future success will depend in part upon our ability to introduce new products, designs, technologies and features to meet changing customer requirements and emerging industry standards; however, there can be no assurance that we will successfully introduce new products or features to our existing products or develop new products that will achieve market acceptance. Any delay or failure of these products to achieve market acceptance would adversely affect our business. In addition, there can be no assurance that products or technologies developed by others will not render our products or technologies non-competitive or obsolete. Should we fail to keep pace with the ever-changing nature of the security-related defense product market, our revenues and financial condition will be negatively affected.
We believe that, in order to remain competitive in the future, we will need to continue to invest financial resources to develop new and adapt or modify our existing offerings and technologies, including through internal research and development, acquisitions and joint ventures or other teaming arrangements. These expenditures could divert our attention and resources from other projects, and we cannot be sure that these expenditures will ultimately lead to the timely development of new offerings and technologies. Due to the design complexity of our products, we may in the future experience delays in completing the development and introduction of new products. Any delays could result in increased costs of development or deflect resources from other projects. In addition, there can be no assurance that the market for our offerings will develop or continue to expand as we currently anticipate. The failure of our technology to gain market acceptance could significantly reduce our revenues and harm our business. Furthermore, we cannot be sure that our competitors will not develop competing technologies which gain market acceptance in advance of our products.
We may be subject to personal liability claims for our products and if our insurance is not sufficient to cover such claims, our expenses may increase substantially.
Our products are used in applications where the failure to use our products properly or their malfunction could result in bodily injury or death, and we may be subject to personal liability claims. Although we currently maintain general liability insurance which includes $1 million of product liability coverage, our insurance may not be adequate to cover such claims. As a result, a significant lawsuit could adversely affect our business. We may be exposed to liability for personal injury or property damage claims relating to the use of our products. Any future claim against us for personal injury or property damage could materially adversely affect our business, financial condition, and results of operations and result in negative publicity. However, although we maintain insurance coverage, we may experience legal claims outside of our insurance coverage, or in excess of our insurance coverage, or that insurance will not cover. Even if we are not found liable, the costs of defending a lawsuit can be high.
We are subject to substantial competition.
We are subject to significant competition that could harm our ability to win business and increase the price pressure on our products. We face strong competition from a wide variety of firms, including large, multinational, defense and aerospace firms. Most of our competitors have considerably greater financial, marketing and technological resources than we do, which may make it difficult to win new contracts and we may not be able to compete successfully. Certain competitors operate larger facilities and have longer operating histories and presence in key markets, greater name recognition and larger customer bases. As a result, these competitors may be able to adapt more quickly to new or emerging technologies and changes in customer requirements. They may also be able to devote greater resources to the promotion and sale of their products. Moreover, we may not have sufficient resources to undertake the continuing research and development necessary to remain competitive.
We must comply with environmental regulations or we may have to pay expensive penalties or clean up costs.
We are subject to federal, state, local and foreign laws, and regulations regarding protection of the environment, including air, water, and soil. Our manufacturing business involves the use, handling, storage, discharge and disposal of, hazardous or toxic substances or wastes to manufacture our products. We must comply with certain requirements for the use, management, handling, and disposal of these materials. If we are found responsible for any hazardous contamination, we may have to pay expensive fines or penalties or perform costly clean-up. Even if we are charged, and later found not responsible, for such contamination or clean up, the cost of defending the charges could be high. Authorities may also force us to suspend production, alter our manufacturing processes, or stop operations if we do not comply with these laws and regulations.
We may not be able to adequately safeguard our intellectual property rights and trade secrets from unauthorized use, and we may become subject to claims that we infringe on others’ intellectual property rights.
We rely on a combination of trade secrets, trademarks, and other intellectual property laws, nondisclosure agreements and other protective measures to preserve our proprietary rights to our products and production processes.
These measures afford only limited protection and may not preclude competitors from developing products or processes similar or superior to ours. Moreover, the laws of certain foreign countries do not protect intellectual property rights to the same extent as the laws of the United States, and we may face other obstacles to enforcing our intellectual property rights outside the United States including the ability to enforce judgments, the possibility of conflicting judgments among courts and tribunals in different jurisdictions and locating, hiring and supervising local counsel in such other countries.
Although we implement protective measures and intend to defend our proprietary rights, these efforts may not be successful. From time to time, we may litigate within the United States or abroad to enforce our licensed patents, to protect our trade secrets and know-how or to determine the enforceability, scope and validity of our proprietary rights and the proprietary rights of others. Enforcing or defending our proprietary rights could be expensive, require management’s attention and might not bring us timely or effective relief.
Although there are no pending or threatened intellectual property lawsuits against us, we may face litigation or infringement claims in the future. Infringement claims could result in substantial costs and diversion of our resources even if we ultimately prevail. A third party claiming infringement may also obtain an injunction or other equitable relief, which could effectively block the distribution or sale of allegedly infringing products. Although we may seek licenses from third parties covering intellectual property that we are allegedly infringing, we may not be able to obtain any such licenses on acceptable terms, if at all.
We depend on management and other key personnel and we may not be able to execute our business plan without their services.
Our success and our business strategy depend in large part on our ability to attract and retain key management and operating personnel. Such individuals are in high demand and are often subject to competing employment offers. We depend to a large extent on the abilities and continued participation of our executive officers and other key employees. We believe that, as our activities increase and change in character, additional experienced personnel will be required to implement our business plan. Competition for such personnel is intense and we may not be able to hire them when required, or have the ability to retain them.
We may partner with foreign entities, and domestic entities with foreign contacts, which may affect our business plans by increasing our costs.
We recognize that there may be opportunities for increased product sales in both the domestic and global defense markets. We have recently initiated plans to strategically team with foreign entities as well as domestic entities with foreign business contacts in order to better compete for both domestic and foreign military contracts. In order to implement these plans, we may incur substantial costs which may include additional research and development, prototyping, hiring personnel with specialized skills, implementing and maintaining technology control plans, technical data export licenses, production, product integration, marketing, warehousing, finance charges, licensing, tariffs, transportation and other costs. In the event that working with foreign entities and/or domestic entities with foreign business contacts proves to be unsuccessful, this strategy may ineffectively use our resources which may affect our profitability and the costs associated with such work may preclude us from pursuing alternative opportunities.
We are presently classified as a small business and the loss of our small business status may adversely affect our ability to compete for government contracts.
We are presently classified as a small business as determined by the Small Business Administration under certain of the codes under the North American Industry Classification Systems (NAICS) industry and product specific codes which are regulated in the United States by the Small Business Administration. We are not considered a small business under all NAICS codes. While we do not presently derive a substantial portion of our business from contracts which are set-aside for small businesses, we are able to bid on small business set-aside contracts as well as contracts which are open to non-small business entities. It is also possible that we may become more reliant upon small business set-aside contracts. As the NAICS codes are periodically revised, it is possible that we may lose our status as a small business and may sustain an adverse impact on our current competitive advantage. The loss of small business status could adversely impact our ability to compete for government contracts, maintain eligibility for special small business programs and limit our ability to partner with other business entities which are seeking to team with small business entities as may be required under a specific contract.
The outcome of litigation in which we have been named as a defendant is unpredictable and an adverse decision in any such matter could have a material adverse effect on our financial position or results of operations.
We are defendants in a number of litigation matters. These matters may divert financial and management resources that would otherwise be used to benefit our operations. Although we believe that we have meritorious defenses to the claims made in the litigation matters to which we have been named a party and intend to contest each lawsuit vigorously, no assurances can be given that the results of these matters will be favorable to us. An adverse resolution or outcome of any of these lawsuits, claims, demands or investigations could have a negative impact on our financial condition, results of operations and liquidity. See Item 1 “Legal Proceedings”.
Unanticipated changes in our tax provisions or exposure to additional income tax liabilities could affect our profitability.
We are subject to income taxes in the United States. In the ordinary course of our business, there are many transactions and calculations where the ultimate tax determination is uncertain. Furthermore, changes in domestic or foreign income tax laws and regulations, or their interpretation, could result in higher or lower income tax rates assessed or changes in the taxability of certain sales or the deductibility of certain expenses, thereby affecting our income tax expense and profitability. Although we believe our tax estimates are reasonable, the final determination of tax audits could be materially different from our historical income tax provisions and accruals. Additionally, changes in the geographic mix of our sales could also impact our tax liabilities and affect our income tax expense and profitability.
Internal Revenue Code Section 382 limits the utilization of net operating loss carryforwards upon a change of control of a company (as defined in Section 382). We performed an evaluation as to whether a change in control has taken place and concluded that a change did occur as of December 29, 2011. As a result of the change in control, our net operating loss carryforwards are subject to limitation, which has the effect of eliminating a substantial portion of the future tax benefits of the net operating loss carryforwards.
As of December 29, 2011, we had a federal net operating loss carryforward of $14,007,343 available to offset future income through 2031. After the change in control, the federal net operating loss is subject to an annual limitation of $39,000. Similarly, as of December 29, 2011, we had state net operating loss carryforwards of $14,750,199 available to offset future state income through 2031. After the change in control, the state operating loss carryforward is subject to an annual limitation of $39,000.
Risks Relating to Our Common Stock
We have identified material weaknesses in our internal control over financial reporting as of December 31, 2011. If we are unable to remediate these material weaknesses in our internal control over financial reporting, we may not be able to report accurately our financial results. This could have a material adverse effect on our share price.
Effective internal controls are necessary for us to provide accurate financial reports. We completed documenting and testing our internal control procedures to satisfy the requirements of Section 404 of the Sarbanes Oxley Act of 2002 and the related rules of the SEC, which require, among other things, our management to assess annually the effectiveness of our internal control over financial reporting.
As a result of management’s assessment of internal controls, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures were not effective to ensure that the information required to be disclosed by us in the reports that we file or submit under the Exchange Act was recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information required to be disclosed is accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure.
Due to the reduction in accounting staff during 2011, we did not have a sufficient number of accounting personnel in order to have adequate segregation of duties. In addition, we did not have a sufficient number of trained accounting personnel with expertise in GAAP to ensure that complex, material and/or non-routine transactions were properly reflected in the consolidated financial statements. However, all such transactions have been properly disclosed in the accompanying consolidated financial statements as of December 31, 2011.
We cannot assure you if or when we will be able to remedy these material weaknesses, that additional material weaknesses or significant deficiencies in our internal control over financial reporting will not be identified in the future or that our internal control over financial reporting will be adequate in all cases to uncover inaccurate or misleading financial information that could be reported by members of management. This could result in investors losing confidence in our reported financial information and the trading price of our shares could drop significantly. In addition, we could be subject to sanctions or investigations by the stock exchange upon which our common stock may be listed, the SEC or other regulatory authorities, which would require additional financial and management resources.
Volatility of our stock price could adversely affect stockholders.
The market price of our common stock could fluctuate significantly as a result of:
· quarterly variations in our operating results;
· cyclical nature of defense spending;
· interest rate changes;
· changes in the market's expectations about our operating results;
· our operating results failing to meet the expectation of securities analysts or investors in a particular period;
· changes in financial estimates and recommendations by securities analysts concerning our company or the defense industry in general;
· operating and stock price performance of other companies that investors deem comparable to us;
· news reports relating to trends in our markets;
· changes in laws and regulations affecting our business;
· material announcements by us or our competitors;
· sales of substantial amounts of common stock by our directors, executive officers or significant stockholders or the perception that such sales could occur;
· general economic and political conditions such as recessions and acts of war or terrorism; and
· other matters discussed in Risk Factors.
Fluctuations in the price of our common stock could contribute to the loss of all or part of an investor's investment in our company.
We currently do not intend to pay dividends on our common stock and consequently your only opportunity to achieve a return on your investment is if the price of common stock appreciates.
We do not plan to declare dividends on our common stock in the foreseeable future. Any payment of cash dividends will depend upon our financial condition, capital requirements, earnings and other factors deemed relevant by our board of directors. Agreements governing future indebtedness will likely contain similar restrictions on our ability to pay cash dividends. Consequently, your only opportunity to achieve a return on your investment in the common stock of our company will be if the market price of our common stock appreciates and you sell your common stock at a profit.
Provisions in our certificate of incorporation and bylaws or Delaware law might discourage, delay or prevent a change of control of our company or changes in our management and, therefore, depress the trading price of our stock.
Our amended and restated certificate of incorporation and bylaws contain provisions that could depress the trading price of our common stock by acting to discourage, delay or prevent a change in control of our company or changes in our management that the stockholders of our company may deem advantageous. These provisions:
· establish a classified board of directors so that not all members of our board of directors are elected at one time;
· provide that directors may only be removed "for cause" and only with the approval of 66 2/3 percent of our stockholders;
· provide that only our board of directors can fill vacancies on the board of directors;
· require super-majority voting to amend our bylaws or specified provisions in our certificate of incorporation;
· authorize the issuance of "blank check" preferred stock that our board of directors could issue to increase the number of outstanding shares and to discourage a takeover attempt;
· eliminate the ability of our stockholders to call special meetings of stockholders;
· prohibit common stockholder action by written consent, which requires all common stockholder actions to be taken at a meeting of our stockholders;
· provide that the board of directors is expressly authorized to adopt, amend, or repeal our bylaws, subject to the rights of our stockholders to do the same by super-majority vote of stockholders; and
· establish advance notice requirements for nominations for election to our board of directors or for proposing matters that can be acted upon by stockholders at stockholder meetings.
In addition, Section 203 of the Delaware General Corporation Law may discourage, delay or prevent a change in control of our company.
These and other provisions contained in our amended and restated certificate of incorporation and bylaws could delay or discourage transactions involving an actual or potential change in control of us or our management, including transactions in which our stockholders might otherwise receive a premium for their shares over then current prices, and may limit the ability of stockholders to remove our current management or approve transactions that our shareholders may deem to be in their best interests and, therefore, could adversely affect the price of our common stock.
Shares of stock issuable pursuant to our stock options and warrants may adversely affect the market price of our common stock.
As of April 6, 2012, we had outstanding stock options to purchase an aggregate of 1,580,000 shares of common stock under our 2007 Incentive Compensation Plan and warrants to purchase an aggregate of 675,001 shares of common stock. In addition, we have 2,324,000 shares of common stock reserved for issuance under our 2007 Incentive Compensation Plan. Our outstanding warrants also contain provisions that increase, subject to limited exceptions, the number of shares of common stock that may be acquired upon the conversion or exercise of such securities in the event we issue (or are deemed to have issued) shares of our common stock at a per share price that is less than their then existing exercise price in the case of the warrants. The exercise of the stock options and warrants would further reduce a stockholder’s percentage voting and ownership interest. Further, the stock options and warrants are likely to be exercised when our common stock is trading at a price that is higher than the exercise price of these options and warrants, and we would be able to obtain a higher price for our common stock than we will receive under such options and warrants. The exercise, or potential exercise, of these options and warrants could adversely affect the market price of our common stock and adversely affect the terms on which we could obtain additional financing.
Trading in our common stock on the OTC Bulletin Board may be limited thereby making it more difficult for you to resell any shares you may own.
On November 22, 2011, we were notified by NYSE Amex that trading in our common stock would be suspended on NYSE Amex, with formal delisting following on December 16, 2011. We transitioned trading of our common stock to the OTCBB Marketplace beginning December 1, 2011. Although we are a reporting company and our common shares are quoted on the OTCBB, the OTCBB is not an exchange. Trading of securities on the OTCBB is often more sporadic than the trading of securities listed on a national exchange or on the Nasdaq National Market, you may have difficulty reselling any of the shares of our common stock that you may own or any attempted sale of such common stock may have the effect of lowering the market price and therefore your investment could be a partial or complete loss.
Since our common stock is thinly traded it is more susceptible to extreme rises or declines in price, and you may not be able to sell your shares at or above the price paid.
Since our common stock is thinly traded its trading price is likely to be highly volatile and could be subject to extreme fluctuations in response to various factors, many of which are beyond our control, including:
· the trading volume of our shares;
· the number of securities analysts, market-makers and brokers following our common stock;
· changes in, or failure to achieve, financial estimates by securities analysts;
· new products or services introduced or announced by us or our competitors;
· actual or anticipated variations in quarterly operating results;
· conditions or trends in our business industries;
· announcements by us of significant contracts, acquisitions, strategic partnerships, joint ventures or capital commitments;
· additions or departures of key personnel;
· sales of our common stock; and
· general stock market price and volume fluctuations of publicly-traded, and particularly microcap, companies.
You may have difficulty reselling shares of our common stock, either at or above the price you paid, or even at fair market value. The stock markets often experience significant price and volume changes that are not related to the operating performance of individual companies, and because our common stock is thinly traded it is particularly susceptible to such changes. These broad market changes may cause the market price of our common stock to decline regardless of how well we perform as a company. In addition, securities class action litigation has often been initiated following periods of volatility in the market price of a company’s securities. A securities class action suit against us could result in substantial legal fees, potential liabilities and the diversion of management’s attention and resources from our business. Moreover, and as noted below, our shares are currently traded on the OTC Bulletin Board and, further, are subject to the penny stock regulations. Price fluctuations in such shares are particularly volatile and subject to manipulation by market-makers, short-sellers and option traders.
Our common stock is subject to the “penny stock” regulations, which are likely to make it more difficult to sell.
Our common stock is considered a “penny stock,” which the SEC defines as a stock trading under $5.00 and not registered on a national securities exchange or quoted on the Nasdaq National Market. The SEC has adopted rules that regulate broker-dealer practices in connection with transactions in penny stocks. These rules generally have the result of reducing trading in such stocks, restricting the pool of potential investors for such stocks, and making it more difficult for investors to sell their shares once acquired. Prior to a transaction in a penny stock, a broker-dealer is required to:
· deliver to a prospective investor a standardized risk disclosure document that provides information about penny stocks and the nature and level of risks in the penny stock market;
· provide the prospective investor with current bid and ask quotations for the penny stock;
· explain to the prospective investor the compensation of the broker-dealer and its salesperson in the transaction;
· provide investors monthly account statements showing the market value of each penny stock held in the their account; and
· make a special written determination that the penny stock is a suitable investment for the purchaser and receive the purchaser’s written agreement to the transaction.
These requirements may have the effect of reducing the level of trading activity in the secondary market for a stock that is subject to the penny stock rules. Since our common stock is subject to the penny stock rules, investors in our common stock may find it more difficult to sell their shares.
Item 2.
Item 2.Properties
Our principal offices are located at 420 McKinney Parkway, Lillington, North Carolina 27546 and are approximately 63,000 square feet. We do not own any real property.
We believe that our current facility is suitable and adequate to meet our current needs. We maintain insurance coverage against losses, including fire, casualty and theft, for each of our locations in amounts we believe to be adequate.
Item 3.
Item 3.Legal Proceedings
On February 29, 2008, Roy Elfers, a former employee commenced an action against the Company for breach of contract arising from his termination of employment in the Supreme Court of the State of New York, Nassau County. On August 5, 2011, the case was settled for $45,000. A payment of $22,500 was made on October 14, 2011. The Company has accrued the balance at December 31, 2011. A payment of $11,250 was made on January 6, 2012. The remaining balance of $11,250 is due on July 1, 2012.
On March 4, 2008, Thomas Cusack, the Company’s former General Counsel, commenced an action with the United States Department of Labor, Occupational Safety and Health and Safety Administration, alleging retaliation in contravention of the Sarbanes-Oxley Act. On April 2, 2008, the Company filed a response to the charges. On May 12, 2011, the Department of Labor dismissed the complaint. On March 7, 2008, Mr. Cusack also commenced a second action against the Company for breach of contract and related issues arising from his termination of employment in New York State Supreme Court, Nassau County. On May 7, 2008, the Company served a motion to dismiss the complaint, and on or about September 26, 2008, the Court dismissed several claims (tortious interference with a contract, tortious interference with economic opportunity, fraudulent inducement to enter into a contract and breach of good faith and fair dealing). The remaining claims are Mr. Cusack's breach of contract claims, stock conversion claim, as well as one claim for conversion of his personal property which Mr. Cusack has also asserted against the Company’s executive officers. On October 13, 2008, Mr. Cusack filed an amended complaint as to the remaining claims, and on November 5, 2008, the Company filed an answer to the amended complaint and filed counterclaims against Mr. Cusack for fraud and rescission of his contract. The parties have completed discovery and have scheduled depositions. The parties submitted motions for summary judgment, and on August 19, 2010, the Court granted Mr. Cusack’s motion as to his stock conversion claim and narrowed certain issues as to his breach of contract claims. On July 19, 2011, the Appellate Division upheld the stock conversion decision but reversed the decision to narrow the issues as to the breach of contract claims. The trial has been scheduled for late April 2012. Mr. Cusack seeks damages in excess of $3,000,000. The Company believes meritorious defenses to the claims exist and intends to vigorously defend this action but cannot reasonable predict the outcome at this time.
On January 7, 2011, Action Group, Inc. commenced an action in the United States District Court for the Eastern District of New York. The complaint seeks $1,187,510 for goods allegedly sold to the Company, for which payment was not received. While the parties were engaged in settlement discussions, plaintiff sought and was granted entry of a default on February 8, 2011. Plaintiff then filed a motion with the Court, dated March 7, 2011, seeking entry of a default judgment in the amount of $1,246,542, representing the original demand set forth in the complaint, plus interest, costs and disbursements. On March 16, 2011, the Court issued an Order, directing Defendants to respond to the Court in writing within seven days as to why default judgment should not be entered. On March 28, 2011, counsel for the Company sought and obtained an Order from the Court extending its time to respond to the Court’s March 16, 2011 Order up to and including April 11, 2011. On April 11, 2011, Defendants served and filed a motion to set aside the default entered against them, and in opposition to plaintiff’s motion for entry of a default judgment. The Court subsequently granted the Defendants' motion, over Plaintiff's objection, and permitted Defendants to interpose an answer. The answer to the complaint was filed on June 13, 2011, and Defendants asserted several affirmative defenses to payment, including a claim for offset of amounts expended by Defendant to resolve issues with non-conforming goods supplied by Plaintiff. The parties have since engaged in document discovery, although no depositions have yet taken place in the matter. The parties have been actively engaged in settlement negotiations but cannot reasonable predict the outcome of settlement negotiations at this time.
On January 6, 2012, a group led by Dale Scales (the “Scales Group”) filed a Schedule 13D with the Securities and Exchange Commission stating that it intended to ask the Board of Directors to call a special meeting of the Company’s stockholders for the purpose of removing the Company’s directors for cause and replacing them with candidates chosen by the Scales Group. The Board of Directors believes that this filing misleads the Company’s stockholders because, among other things, it fails to disclose that the Scales Group is acting in concert with Anthony Piscitelli, the Company’s former chief executive officer. In November 2011, the Board demanded Mr. Piscitelli’s resignation as a result of mismanagement and misconduct that included providing confidential information belonging to the Company to Mr. Scales in violation of the Board’s express instructions. On January 9, 2012, the Board of Directors of the Company amended the Company’s bylaws to eliminate the ability of stockholders to request special meetings of stockholders. Subsequently, the Board has declined to call a special meeting of stockholders despite having received a request from the Scales Group purporting to have been signed by the holders of more than two thirds of the Company’s outstanding shares. On April 3, 2012, Mr. Scales and a company controlled by him filed a civil action in the Court of Chancery of the State of Delaware against the Company and the current members of its Board of Directors. The caption of the action is Armor Technologies LLC v. American Defense Systems, Inc., Civil Action No. 7394-CS. The plaintiffs allege that the Company’s current directors have breached their fiduciary duties by amending the bylaws and declining to schedule the special meeting requested by the Scales Group. The plaintiffs ask the Court to declare the bylaw amendment invalid and order the Board of Directors to call the special meeting requested by the Scales Group. The plaintiffs also seek an award of compensatory damages in an unspecified amount. The Company and the Board of Directors believe the action is without merit and intend to defend themselves vigorously but cannot reasonable predict the outcome at this time.
Item 4.
Item 4.(Removed and Reserved)
PART II
Item 5.
Item 5.Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Market for Common Stock
Our common stock traded on the NYSE Amex (formerly known as the American Stock Exchange) under the symbol "EAG" from May 30, 2008 until the transition of trading of our common stock to the OTCBB effective December 1, 2011. The following table sets forth, for the calendar quarter indicated, the quarterly high and low closing sale prices of our common stock, as reported on the NYSE Amex or by the Nasdaq Stock Market, Inc., for the applicable periods.
As of April 6, 2012, there were approximately 254 record holders of our common stock. This figure does not reflect persons or entities that hold their stock in nominee or "street" name through various brokerage firms.
Dividends
We have not paid any dividends on our common stock to date and do not anticipate paying any dividends in the foreseeable future. We intend to retain future earnings, if any, in the operation and expansion of our business. Any future determination to pay cash dividends will be made at the discretion of our board of directors and will depend on our financial condition, results of operations, capital requirements and other factors that our board of directors deemed relevant. Investors should not purchase our common stock with the expectation of receiving cash dividends.
Equity Compensation Plan Information
As of December 31, 2011, the following equity securities of our company are authorized for issuance, aggregated as follows, pursuant to our compensation plans (including individual compensation arrangements):
Recent Sales of Unregistered Securities
For the year ended December 31, 2010, we issued an aggregate of 7,380,000 shares of our common stock to the holders of our Series A Convertible Preferred Stock as dividends for 2010 pursuant to the Certificate of Designations, Preferences and Rights of Series A Convertible Preferred Stock. We relied on the exemption provided by Section 4(2) of the Securities Act of 1933 and Regulation D promulgated thereunder.
Item 6.
Item 6.Selected Financial Data
We are a smaller reporting company as defined by Rule 12b-2 of the Exchange Act and are not required to provide the information required under this Item 6.
Item 7.
Item 7.Management's Discussion and Analysis of Financial Condition and Results of Operations.
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes that appear elsewhere in this annual report. In addition to historical consolidated financial information, the following discussion contains forward-looking statements that reflect our plans, estimates and beliefs. Our actual results could differ materially from those discussed in the forward-looking statements. Factors that could cause or contribute to these differences include those discussed below and elsewhere in this annual report, particularly in "Risk Factors" in Item 1A.
Overview
We are a defense and security products company engaged in three business areas: customized transparent and opaque armor solutions for construction equipment and tactical and non-tactical transport vehicles used by the military; architectural hardening and perimeter defense, such as bullet and blast resistant transparent armor, walls and doors. We disposed of the portion of our business related to the operation of a live-fire interactive tactical training range located in Hicksville, NY, hereinafter referred to as T2, during the year ended December 31, 2011. The portion of our business related to vehicle anti-ram barriers such as bollards, steel gates and steel wedges that deploy out of the ground was sold as of March 22, 2011.
We primarily serve the defense market and our sales are highly concentrated within the U.S. government. Our customers include various branches of the U.S. military through the U.S. Department of Defense and to a much lesser extent other U.S. government, law enforcement and correctional agencies as well as private sector customers.
Our recent historical revenues have been generated primarily from a limited number of large contracts and a series of purchase orders from a single customer. To continue expanding our business, we are seeking to broaden our customer base and to diversify our product and service offerings. Our strategy to increase our revenue, grow our company and increase shareholder value involves the following key elements:
· We have put a new leadership and management team in place effective November 2, 2011 to reform Company operations which have led to a better operating performance;
· We have moved Company operations to North Carolina to better focus our efforts and to provide a more competitive business environment;
· We will diversify by selectively pursuing commercial opportunities in addition to our unique military and government activities;
· We will re-invigorate efforts to develop strategic alliances and form favorable partnerships with original equipment manufacturers (OEMs); and
· We will diligently research programs and efforts to capitalize on future requirements and demands for new armor and related force protection materials.
We are pursuing each of these growth strategies simultaneously.
Sources of Revenues
We derive our revenues by fulfilling orders under master contracts awarded by branches of the United States military, law enforcement and corrections agencies and private companies involved in the defense market and other customer purchase orders. Under these contracts and purchase orders, we provide customized transparent and opaque armor products for transport and construction vehicles used by the military, group protection kits and spare parts. We also derive revenues from sales of our architectural hardening and perimeter defense products, which we sometimes refer to as physical security products.
Our contract backlog as of December 31, 2011 was $7 million. We estimate that approximately $7 million of the backlog will be filled during the remainder of 2012. Accordingly, in order to maintain our current revenue levels and to generate revenue growth, we will need to win more contracts with the U.S. government and other commercial entities, achieve significant penetration into critical infrastructure and public safety protection markets, and successfully further develop our relationships with OEM's and strategic partners. Notwithstanding the possible significant troop reductions in Afghanistan and Iraq, we expect that demand in those countries for armored military construction vehicles will continue in order to repair significant war damage and for nation-building purposes. In addition, we are exploring interest in armored construction equipment in other countries with mine-infested regions.
We continue to aggressively bid on projects and are in preliminary talks with a number of international firms to pursue long-term government and commercial contracts, including with respect to Homeland Security. While no assurances can be given that we will obtain a sufficient number of contracts or that any contracts we do obtain will be of significant value or duration, we are confident that we will continue to have the opportunity to bid and win contracts as we have in 2011.
Cost of Revenues and Operating Expenses
Cost of Revenues.	Cost of revenues consists of parts, direct labor and overhead expenses incurred for the fulfillment of orders under contract. These costs are charged to expense upon completion and acceptance of an order. Costs of revenue also includes the costs of prototyping and engineering, which are expensed upon completion of an order as well. These costs are included as costs of revenue because they are incurred to modify products based upon government specifications and are reimbursable costs within the contract. These costs for the production of goods under contract are expensed when they are complete. We allocate overhead expenses such as employee benefits, computer supplies, depreciation for computer equipment and office supplies based on personnel assigned to the job. As a result, indirect overhead expenses are included in cost of revenues and each operating expense category.
Sales and Marketing.	Expenses related to sales and marketing consist primarily of compensation for our sales and marketing personnel, sales commissions and incentives, trade shows and related travel. Sales and marketing costs are charged to expense as incurred. As we have implemented various cost cutting measures, including a decrease in trade show participation and a reduction in headcount, in 2011 and the last quarter of 2010, we expect that in 2012, sales and marketing expenses will remain consistent.
Research and Development. Research and development expenses are incurred as we perform ongoing evaluations of materials and processes for existing products, as well as the development of new products and processes. We expect that in 2012, research and development expenses will remain consistent with 2011 levels. Research and development costs are charged to expense as incurred.
General and Administrative. General and administrative expenses consist of compensation and related expenses for finance, accounting, administrative, legal, professional fees, other corporate expenses and allocated overhead. We expect that in 2012, general and administrative expenses will continue to decrease due to cost cutting measures implemented in 2011 and the last quarter of 2010. Cost cutting measures implemented include the Company’s relocation to Lillington, NC in July 2011, lower employee benefits due to reduced headcount, and restrictions on travel.
General and Administrative Salaries. General and administrative salaries expenses consist of compensation for the officers, and IT, design and engineering personnel. We expect that in 2012, general and administrative salaries expenses will decrease due to the cost cutting measures, which include reductions in employee headcount as well as salary reductions for remaining employees, implemented in 2011.
Critical Accounting Policies
Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States. The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, costs and expenses and related disclosures. On an ongoing basis, we evaluate our estimates and assumptions. Our actual results may differ from these estimates under different assumptions or conditions.
We believe that of our significant accounting policies, which are described in Note 1 to the consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2011, involve a greater degree of judgment and complexity. Accordingly, these are the policies we believe are the most critical to aid in fully understanding and evaluating our consolidated financial condition and results of operations.
Revenue and Cost Recognition.	We recognize revenue in accordance with Accounting Standards Codification (ASC) 605, "Revenue Recognition", which states that revenue is realized and earned when all of the following criteria are met: (a) persuasive evidence of the arrangement exists, (b) delivery has occurred or services have been rendered, (c) the seller's price to the buyer is fixed and determinable and (d) collectability is reasonably assured. Under this provision, revenue is recognized upon delivery and acceptance of the order.
We recognize revenue and report profits from purchases orders filled under master contracts when an order is complete, as defined below. Purchase orders received under master contracts may extend for periods in excess of one year. Purchase order costs are accumulated as deferred assets and billings and/or cash received are charged to a deferred revenue account during the periods of construction. However, no revenues, costs or profits are recognized in operations until the period upon completion of the order. An order is considered complete when all costs, except insignificant items, have been incurred and, the installation or product is operating according to specification or the shipment has been accepted by the customer. Provisions for estimated contract losses are made in the period that such losses are determined. As of December 31, 2011, there were no such provisions made.
All costs associated with uncompleted purchase orders under contract are recorded on the balance sheet as a deferred asset called "Costs in Excess of Billings on Uncompleted Contracts." Upon completion of a purchase order, such associated costs are then reclassified from the balance sheet to the statement of operations as costs of revenue.
Stock-Based Compensation.	 Stock based compensation consists of stock or options issued to employees, directors, consultants and contractors for services rendered. We account for the stock issued using the estimated current market price per share at the date of issuance. Such cost is recorded as compensation in our statement of operations at the date of issuance.
In December 2007, we adopted our 2007 Incentive Compensation Plan pursuant to which we have issued and intend to issue stock-based compensation from time to time, in the form of stock, stock options and other equity based awards. Our policy for accounting for such compensation in the form of stock options is as follows:
In accordance with ASC 718 “Compensation-Stock Compensation” we record stock based compensation at fair value. We use the Black-Scholes option pricing model to measure the fair value of our option awards. The Black-Scholes model requires the input of highly subjective assumptions including volatility, expected term, risk-free interest rate and dividend yield. In 2005, the SEC issued Staff Accounting Bulletin (SAB) No. 107, as codified in ASC 718-10-599, which provides supplemental implementation guidance for ASC 718.
Stock-based compensation expense recognized will be based on the estimated portion of the awards that are expected to vest. We will apply estimated forfeiture rates based on analyses of historical data, including termination patterns and other factors.
We recognized $159,126 and $131,936 in stock compensation expense for the years ended December 31, 2011 and 2010.
Fair Value Measurements.	We follow the provisions of ASC 820, “Fair Value Measurements and Disclosures” (ASC 820). ASC 820 defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles and expands disclosures about fair value investments.
Fair value, as defined in ASC 820, is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The fair value of an asset should reflect its highest and best use by market participants, whether using an in-use or an in-exchange valuation premise. The fair value of a liability should reflect the risk of nonperformance, which includes, among other things, the company’s credit risk.
Valuation techniques are generally classified into three categories: the market approach; the income approach; and the cost approach. The selection and application of one or more of the techniques requires significant judgment and are primarily dependent upon the characteristics of the asset or liability, the principal (or most advantageous) market in which participants would transact for the asset or liability and the quality and availability of inputs. Inputs to valuation techniques are classified as either observable or unobservable within the following hierarchy:
Level 1 Inputs: These inputs come from quoted prices (unadjusted) in active markets for identical assets or liabilities.
Level 2 Inputs: These inputs are other than quoted prices that are observable, for an asset or liability. This includes: quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; inputs other than quoted prices that are observable for the asset or liability; and inputs that are derived principally from or corroborated by observable market data by correlation or other means.
Level 3 Inputs: These are unobservable inputs for the asset or liability which require the company’s own assumptions.
Series A Convertible Preferred Stock.	 The Series A Convertible Preferred Stock (or Series A Preferred) was mandatorily redeemable on October 1, 2011 and was convertible into shares of common stock at $0.50 per share subject to adjustment should we issue future common stock at a lesser price. As a result we elected to record the hybrid instrument, preferred stock and conversion option together, at fair value. Subsequent reporting period changes in fair value are to be reported in the statement of operations. Pursuant to the Redemption Agreement, all outstanding shares of Series A Convertible Preferred Stock were redeemed on March 22, 2011.
The proceeds from the issuance of the Series A Preferred and accompanying common stock warrants, net of direct costs including the fair value of warrants issued to the Placement Agent in connection with the transaction, must be allocated to the instruments based upon relative fair value upon issuance as they must be measured initially at fair value. Therefore, after the initial recording of the Series A Preferred based upon net proceeds received, the carrying value of the Series A Preferred must be adjusted to the fair value at the date of issuance, with the difference recorded as a gain or loss. On March 7, 2008, the date of initial issuance, we recorded a derivative liability of $9.8 million. On April 4, 2008, the date of the second issuance, we recorded a derivative liability of $3.6 million. These liabilities were subsequently adjusted to fair value as of March 22, 2011 (date of redemption) which resulted in a loss of $2.4 million for the period from January 1, 2011 through March 22, 2011, which is recorded in the accompanying consolidated statements of operations for the year ended December 31, 2011. These liabilities were adjusted to fair value as of December 31, 2010, resulting in a loss of $0.8 million for the year ended December 31, 2010.
Consolidated Results of Operations
The following discussion should be read in conjunction with the information set forth in the consolidated financial statements and the related notes thereto appearing elsewhere in this report.
Comparison of Years Ended December 31, 2011 and 2010
Revenues. Revenues for the year ended December 31, 2011 were $8.7 million, a decrease of $22.7 million, or 72%, as compared to revenues of $31.4 million in the comparable period in 2010. This decrease was due primarily to a slow-down in government orders. The reduction is a result of decreased spending due to the withdrawal of troops from Iran and Afghanistan, and the overall reduction in defense spending by the US government. As a result of this trend, the Company is pursuing alternative revenue streams with commercial customers.
Cost of Revenues. Cost of revenues for the year ended December 31, 2011 was $5.3 million, a decrease of $16.1 million, or 75%, over cost of revenues of $21.4 million in the comparable period in 2010. This decrease resulted primarily from the decline in revenue.
Gross Profit. Gross profits for the year ended December 31, 2011 and 2010 were $3.4 million and $10.0 million, respectively. Gross profit margin was 39% and 32% for year ended December 31, 2011 and 2010, respectively. The increase in gross profit margin resulted primarily from a better product mix in 2011 from spare parts and field service representatives, as well as lower overhead costs in the third and fourth quarters of 2011 resulting from the Company’s relocation to Lillington, NC in July 2011.
Sales and Marketing Expenses. Sales and marketing expenses for the year ended December 31, 2011 and 2010 were $0.4 million and $1.9 million, respectively, representing a decrease of $1.5 million, or 79%. The decrease was due primarily to a decrease in trade show expenses and a reduction in headcount of 4 employees.
Research and Development Expenses. Research and development expenses for the year ended December 31, 2011 and 2010 were $0.2 million and $0.7 million, respectively, a decrease of $0.5 million or 71% due to a reduction in the number of employees from 3 to 1, and less R&D initiatives.
General and Administrative Expenses. General and administrative expenses for the year ended December 31, 2011 and 2010 were $2.1 million and $4.6 million, respectively. The decrease of $2.5 million or 54% was due primarily to lower overhead costs in the third and fourth quarters of 2011 resulting from the Company’s relocation to Lillington, NC in July 2011, lower general liability insurance due to decreased sales, a bad debt expense recovery in the third quarter of 2011, reduction in employee benefits related to reduced headcount, and a reduction in travel expenses.
General and Administrative Salaries Expense. General and administrative salaries expenses for the year ended December 31, 2011 and 2010 were $2.1 million and $3.5 million, respectively. The decrease of $1.4 million or 40% was due primarily to a reduction in headcount of 10 employees, as well as salary reductions for remaining employees.
Depreciation Expense. Depreciation expense was $0.6 million and $1.3 million for the year ended December 31, 2011 and 2010, respectively, a decrease of $0.7, or 54%, due to the absence of depreciation on leasehold improvements on the Company’s Hicksville, NY facility which was vacated in July 2011, as well as the sale of plane in first quarter of 2011.
Impairment of Fixed Assets. We recorded an impairment on the leasehold improvements of our Hicksville facility of $204,846 for the year ended December 31, 2011. We also recorded an impairment on an asset held for sale of $77,500 for the year ended December 31, 2011.
Professional Fees. Professional fees for the year ended December 31, 2011 and 2010 were $1.0 million and $1.6 million, respectively. The decrease of $0.6 million or 38% was due primarily to a decrease in legal and outside consulting fees resulting from legal and accounting functions being performed in-house.
Other (Income) and Expense. Our Series A Preferred was recorded at fair value through March 22, 2011 with changes in fair value recorded in the statement of operations. We experienced a loss on adjustment of fair value with respect to our Series A Preferred of $2,395,592 and $838,247 for the years ended December 31, 2011 and 2010, respectively. In addition, we incurred interest expense associated with the amortization of the deferred financing costs and discount on the Series A Preferred of $236,373 and $1,896,100 for the years ended December 31, 2011 and 2010, respectively. We recorded a gain on the redemption of the Series A Preferred of $12,786,969 for the year ended December 31, 2011 (see Note 7 of the accompanying consolidated financial statements). We also recorded interest expense related to Series A Preferred dividends of $0 and $1,500,000 for the year ended December 31, 2011 and 2010, respectively.
Income (Loss) from Discontinued Operation. We recorded income from discontinued operation of $2,539,648 which included a gain on the sale of APSG of $2,910,565 for the year ended December 31, 2011. We recorded a loss from discontinued operation of $1,216,896 for the year ended December 31, 2010. See Note 8 of the accompanying consolidated financial statements.
Liquidity and Capital Resources
The primary sources of our liquidity during the year ended December 31, 2011 were proceeds from the sale of APSG and the redemption of the Series A Preferred, as well as proceeds from the sale of a fixed asset. As of December 31, 2011, our principal sources of liquidity are net accounts receivable of approximately $0.9 million and costs in excess of billings of approximately $1.2 million as well as our ability to sell future accounts receivable under an accounts receivable purchase agreement with Republic Capital Access (RCA).
As of December 31, 2011, the Company had a working capital deficit of $867,271, an accumulated deficit of $16,955,187, shareholders’ deficiency of $235,012 and cash on hand of $132,285. The Company had operating losses of $3,301,724 and $3,685,215 for the years ended December 31, 2011 and 2010, respectively. The Company had income from continuing operations for the year ended December 31, 2011 of $6,826,961, including a gain of $12,786,969 on the redemption of mandatorily redeemable preferred stock, and losses from continuing operations for the year ended December 31, 2010 of $8,165,463. The Company had net income (losses) of $9,366,609 and $(9,382,359) for the years ended December 31, 2011 and 2010, respectively. The Company had net cash (used in) provided by operations of $(1,700,488) and $780,754 for the years ended December 31, 2011 and 2010, respectively. The Company entered into an agreement with the Series A Holders on March 22, 2011 to redeem the Series A convertible preferred stock (the “Series A Preferred”), as more fully discussed in Note 7. The Company continues to explore all sources of increasing revenue. If the Company is unable in the near term to raise capital on commercially reasonable terms or increase revenue, it will not have sufficient cash to sustain its operations for the next twelve months. As a result, the Company may be forced to further reduce or even curtail its operations. These factors raise substantial doubt about the Company’s ability to continue as a going concern. The accompanying financial statements do not include any adjustments that might be necessary if the Company is unable to continue as a going concern.
Net Cash (Used In) Provided By Operating Activities. Net cash (used in) provided by operating activities was $(1,700,488) and $780,754 for the years ended December 31, 2011 and 2010, respectively. Net cash used in operating activities during the year ended December 31, 2011 consisted primarily of changes in our operating assets and liabilities of $654,172, including changes in accounts receivable, cost in excess of billing, prepaid expenses and other current assets, and accounts payable and accrued expenses, as well as an operating loss of $3,301,724. Net cash provided by operating activities during the year ended December 31, 2010 consisted primarily of changes in our operating assets and liabilities of $3,126,150 including accounts receivable, cost in excess of billing, prepaid expenses and other current assets, and accounts payable and accrued expenses as well as an operating loss of $3,685,215.
Net Cash Provided By (Used In) Investing Activities. Net cash provided by investing activities for the year ended December 31, 2011 was $1,429,441 and consisted of $1,000,000 of proceeds from the sale of APSG and the redemption of the Series A Preferred, as well as proceeds from the sale of a fixed asset of 429,441, partially offset by purchases of computer equipment. Net cash used in investing activities for the year ended December 31, 2010 was $304,021 and consisted of purchases of general and computer equipment, and leasehold improvements.
Net Cash Used In Financing Activities. Net cash used in financing activities for the years ended December 31, 2011 and 2010 was $0 and $48,573, respectively.
Cash flows from discontinued operations were not reported separately for the year ended December 31, 2011 and 2010. Cash flows from discontinued operations were $154,800 for the year ended December 31, 2011. The absence of these cash flows is not expected to have a material effect on our future liquidity or capital resources.
Accounts Receivable Purchase Agreement
In July 2009, we entered into an accounts receivable purchase agreement with Republic Capital Access, LLC (RCA), which was amended in October 2009. Under the purchase agreement, we can sell eligible accounts receivables to RCA. Eligible accounts receivable, subject to the full definition of such term in the purchase agreement, generally are our receivables under prime government contracts.
Under the terms of the purchase agreement, we may offer eligible accounts receivable to RCA and if RCA purchases such receivables, we will receive an initial upfront payment equal to 90% of the receivable. Following RCA’s receipt of payment from our customer for such receivable, they will pay to us the remaining 10% of the receivable less its fees. In addition to a discount factor fee and an initial enrollment fee, we are required to pay RCA a program access fee equal to a stated percentage of the sold receivable, a quarterly program access fee if the average daily amount of the sold receivables is less than $2.25 million, (Program Continuance Fee), and RCA’s initial expenses in negotiating the purchase agreement and other expenses in certain specified situations. The purchase agreement also provides that in the event, but only to the extent, that the conveyance of receivables by us is characterized by a court or other governmental authority as a loan rather than a sale, we shall be deemed to have granted RCA effective as of the date of the first purchase under the purchase agreement, a security interest in all of our right, title and interest in, to and under all of the receivables sold by us to RCA, whether now or hereafter owned, existing or arising.
The initial term of the purchase agreement ended on December 31, 2009 and will renew annually after the initial term, unless earlier terminated by either of the parties. Pursuant to an amendment to the purchase agreement in October 2009, the term during which we may offer and sell eligible accounts receivable to RCA (Availability Period) was extended from December 31, 2009 to October 15, 2010, and the discount factor rate was reduced from 0.524% to 0.4075%. On November 12, 2010, the term was further extended to October 15, 2011. On November 9, 2011, we signed an amendment to the purchase agreement which extended the term to December 31, 2012, eliminated the Program Continuance Fee and added a Commitment Fee equal to 1% of the difference between the outstanding receivable balance and $1 million. As of December 31, 2011, there was approximately $55,000 of accounts receivable for which RCA had not received payment from our customer.
Series A Convertible Preferred Stock
In March and April 2008, we sold shares of our Series A Convertible Preferred Stock (or Series A Preferred) and warrants to purchase our common stock (or Investor Warrants). We received aggregate gross proceeds of $15.0 million, before fees and expenses of the placement agent in the transaction and other expenses. The Series A Preferred had a mandatory redemption date of October 1, 2011.
On March 22, 2011, the Company entered into a Securities Redemption Agreement (the “Redemption Agreement”) with the holders of our Series A Convertible Preferred Stock, pursuant to which we sold all of the issued and outstanding membership interests in American Physical Security Group, LLC (“APSG”), the Company’s wholly-owned subsidiary, to the holders of our Series A Convertible Preferred Stock. In exchange for the sale of the APSG interests, the holders of our Series A Convertible Preferred Stock (i) paid $1,000,000 in cash to us at the closing of the transactions and (ii) tendered to the Series A Convertible Preferred Stock, which had an aggregate redemption price of $16,500,000. Upon the closing of the transactions, APSG is no longer a subsidiary of our company. In connection with the Redemption Agreement, the Company and the holders of our Series A Convertible Preferred Stock entered into that certain Membership Interest Option Agreement (the "Option Agreement") pursuant to the Company was granted an option (the “Option”) to repurchase APSG within six (6) months following the closing of the transactions contemplated by the Redemption Agreement at a cash purchase price equal to the sum of (i) $15,525,000, plus (ii) the amount of any net investment made in APSG concurrently with and following the closing of the Redemption Agreement and prior to the closing of the purchase of the APSG membership interests pursuant to exercise of the Option. An analysis of the Option was performed and its value was deemed to be immaterial. The Company did not exercise the Option, which expired on September 22, 2011.
Contractual Obligations
We are a smaller reporting company as defined by Rule 12b-2 of the Exchange Act and are not required to provide tabular disclosure of contractual obligations under this Item 7.
Item 7A.
Item 7A.Quantitative and Qualitative Disclosure about Market Risk
We are a smaller reporting company as defined by Rule 12b-2 of the Exchange Act and are not required to provide the information required under this Item 7A.
Item 8.
Item 8.Financial Statements and Supplementary Data
Our consolidated financial statements and related notes required by this item are set forth as a separate section of this report. See Part IV, Item 15 of this Form 10-K.
Item 9.
Item 9.Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
Not applicable.
Item 9A.
Item 9A.Controls and Procedures
Evaluation of Disclosure Controls and Procedures
The information contained in this section covers management’s evaluation of our disclosure controls and procedures and our assessment of our internal control over financial reporting for the period since our last periodic report (December 31, 2010) through December 31, 2011. This assessment is as of December 31, 2011.
Evaluation of Disclosure Controls and Procedures
Disclosure controls and procedures, as defined in Rules 13(a)-15(e) and 15(d)-15(e) under the Securities Exchange Act of 1934 (or Exchange Act), are controls and other procedures that are designed to ensure that information required to be disclosed in reports filed or submitted under the Exchange Act is recorded, processed, summarized, and reported, within the time periods specified by the rules and forms promulgated by the SEC. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that such information is accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. As a result of this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were not effective as of December 31, 2011 because of the material weakness set forth below.
Management’s Report on Internal Control Over Financial Reporting
Our management is responsible for establishing and maintaining adequate “internal control over financial reporting”, as defined in Rules 13(a)-15(f) and 15(d)-15(f) under the Exchange Act. Our system of internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of consolidated financial statements for external reporting purposes in accordance with GAAP. Because of its inherent limitations, internal control over financial reporting may not prevent or detect every misstatement. An evaluation of effectiveness is subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with policies or procedures may decrease over time.
Our internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of our assets; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of consolidated financial statements in accordance with GAAP, and that our receipts and expenditures are being made only in accordance with authorizations of our management and directors; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized use, acquisition, or disposition of our assets that could have a material effect on the consolidated financial statements.
Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our internal control over financial reporting as of the year ended December 31, 2011. In making this assessment, we utilized the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in Internal Control - Integrated Framework.
A material weakness is a deficiency or a combination of deficiencies, in internal control over financial reporting such that there is a reasonable possibility that a material misstatement of our annual or interim financial statements will not be prevented or detected on a timely basis. As a result of this evaluation, we concluded that our internal control over financial reporting was not effective as of December 31, 2011 because of the material weaknesses set forth below.
Due to the reduction in accounting staff during 2011, we did not have a sufficient number of accounting personnel in order to have adequate segregation of duties. In addition, we did not have a sufficient number of trained accounting personnel with expertise in GAAP to ensure that complex, material and/or non-routine transactions were properly reflected in the consolidated financial statements. However, all such transactions have been properly disclosed in the accompanying consolidated financial statements as of December 31, 2011.
Changes in Internal Control Over Financial Reporting
The following material weaknesses in internal control over financial reporting as of December 31, 2010 were remediated as of December 31, 2011. This was accomplished by hiring a Chief Accountant with GAAP and SEC reporting experience in August 2010, and implementing formalized timely documented review processes. Follow up testing was performed and all items listed below were resolved.
The following is a summary of our material weakness as of December 31, 2010:
Due to a lack of adequate systems, processes, and resources we did not maintain effective controls over the period-end financial close and reporting processes as of December 31, 2010. Due to the actual and potential effect on financial statement balances and disclosures, and the importance of the financial closing and reporting processes, we concluded that, in the aggregate, these deficiencies in internal controls over the period-end financial close and reporting process constituted a material weakness in internal control over financial reporting. The specific deficiencies contributing to this material weakness were as follows:
·Inadequate documentation of review process. We did not maintain procedures for a formalized timely documented review process to ensure significant, complex, and non-routine transactions are recorded correctly in the financial statements.
·Inadequate policies and procedures for inventory. We did not design, establish, and maintain effective documented financial accounting policies and procedures related to inventory counting, pricing and valuation.
Our efforts to improve our internal controls are ongoing and focused on expanding our organizational capabilities to improve our control environment and on implementing process changes to strengthen our internal control and monitoring activities.
Other than as described above, there were no other changes that occurred during the fourth quarter of 2011 that materially affected, or are reasonably likely to materially affect, internal controls over financial reporting.
Item 9B.
Item 9B.Other Information
None.
PART III
Item 10.
Item 10.Directors, Executive Officers, and Corporate Governance
A listing of our executive officers and their biographies are included under the caption “Executive Officers” under Part I Item 1. Business of this Form 10-K. The remaining information required by this Item is incorporated herein by reference to the definitive Proxy Statement to be filed pursuant to Regulation 14A of the Exchange Act for our 2012 Annual Meeting of Stockholders.
Item 11.
Item 11.Executive Compensation
The information required by this Item is incorporated herein by reference to the definitive Proxy Statement to be filed pursuant to Regulation 14A of the Exchange Act for our 2012 Annual Meeting of Stockholders.
Item 12.
Item 12.Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
The information required by this Item is incorporated herein by reference to the definitive Proxy Statement to be filed pursuant to Regulation 14A of the Exchange Act for our 2012 Annual Meeting of Stockholders.
Item 13.
Item 13.Certain Relationships and Related Transactions, and Director Independence
The information required by this Item is incorporated herein by reference to the definitive Proxy Statement to be filed pursuant to Regulation 14A of the Exchange Act for our 2012 Annual Meeting of Stockholders.
Item 14.
Item 14.Principal Accountant Fees and Services
The information required by this Item is incorporated herein by reference to the definitive Proxy Statement to be filed pursuant to Regulation 14A of the Exchange Act for our 2012 Annual Meeting of Stockholders.
Part IV
Item 15.
Item 15. Exhibits and Financial Statement Schedules
(a)Documents filed as part of this report:
Consolidated Financial Statements:
·Report of Marcum LLP Independent Registered Public Accounting Firm;
·Consolidated Balance Sheets as of December 31, 2011 and 2010;
·Consolidated Statements of Operations for the years ended December 31, 2011 and 2010;
·Consolidated Statements of Shareholders’ Deficiency for the years December 31, 2011 and 2010;
·Consolidated Statements of Cash Flows for the years ended December 31, 2011 and 2010; and
·Notes to Consolidated Financial Statements.
All other financial schedules are not required under the related instructions or are inappropriate and therefore have been omitted.
(b)Exhibits
Exhibit
Numbers
Exhibits
3.1
Third Amended and Restated Certificate of Incorporation (5)
3.2
Amended and Restated Bylaws (5)
3.3
Certificate of Designation of Series A Convertible Preferred Stock (2)
3.4
First Amendment to Amended and Restated Bylaws (20)
3.5
Amendment No. 2 of the Company’s Amended and Restated Bylaws (23)
4.1
Form of common stock certificate (1)
4.2
Registration Rights Agreement by and among the Registrant and the holders of the Registrant’s Series A Convertible Preferred Stock, dated May 22, 2009 (13)
4.3
Form of 2009 financial advisor warrant (1)
4.4
Form of 2008 investor warrant (2)
4.5
Form of 2008 placement agent warrant (2)
4.6
Form of Series A Convertible Preferred Stock Certificate (2)
10.1
Agreement of Lease, dated 9/23/2004, between the Registrant and Industrial Management LLC (1)
10.2
Amendment to Lease, dated 5/31/2006, between the Registrant and Industrial Management LLC (1)
10.3
Second Amendment to Lease dated 2/1/2007, between the Registrant and Industrial Management LLC (1)
10.4
Contract between the Registrant and Marine Corps Systems Command dated 2/15/07, as amended by the Modification of Contract, dated 9/17/2007 (1)
10.5
Contract between the Registrant and the U.S. Army Tank and Automotive Command, Life Cycle Management Command, dated 10/7/2005, as amended (1)
10.6
Contract between the Registrant and the U.S. Army Tank and Automotive Command, Life Cycle Management Command, dated 10/21/2005, as amended (1)
10.7
Contract between the Registrant and NAVFAC Southwest Specialty Center Contracts Core, dated 6/7/2007, as amended (1)
10.8
Subcontract between CH2M Hill Constructors, Inc. and American Physical Security Group, LLC (10)
10.9
Employment Agreement with Anthony J. Piscitelli dated 1/1/2007 (1)
10.10
Amendment to Employment Agreement with Gary Sidorsky dated 1/9/2009 (9)
10.11
Employment Agreement with Gary Sidorsky dated 1/1/2007 (1)
10.13
Employment Agreement with Curtis Taufman dated 1/1/2007 (1)
10.14
Employment Agreement with Fergal Foley dated 1/9/2009 (9)
10.15
Agreement between the Registrant and Stifel, Nicolaus & Company, Inc., dated 8/29/2006 (1)
10.16
Agreement between the Registrant and Action Group (2)
10.17
2007 Incentive Compensation Plan (1)
10.18
Amendment to Forbearance Agreement by and among the Registrant, A. J. Piscitelli & Associates, Inc., American Physical Security Group, LLC and TD Bank, N.A., dated May 27, 2009 (15)
10.19
Second Amendment to Forbearance Agreement by and among the Registrant, A. J. Piscitelli & Associates, Inc., American Physical Security Group, LLC and TD Bank, N.A., dated June 15, 2009 (15)
10.20
Forbearance Agreement and Amendment to Loan Agreement by and among American Defense Systems, Inc., A. J. Piscitelli & Associates, Inc., American Physical Security Group, LLC and TD Bank, N.A., dated as of April 27, 2009 (11)
10.21
First Amendment to Loan Agreement between the Registrant, A.J. Piscitelli & Associates, Inc. and Commerce Bank, N.A., dated July 12, 2007 (11)
10.22
Assumption Agreement made by American Physical Security Group, LLC, dated January 28, 2008(11)
10.23
Loan Agreement, dated May 2, 2007, with Commerce Bank, N.A. (2)
10.24
Settlement Agreement, Agreement and Waiver by and among the Registrant and the Series A Holders, dated May 22, 2009 (13)
10.25
Form of Lock-Up Agreement executed by each of the directors and executive officers of the Registrant (13)
10.26
Irrevocable Proxy and Voting Agreement by and among Anthony Piscitelli and the Series A Holders, dated May 22, 2009 (13)
10.27
Consent and Agreement of Series A Convertible Preferred Stockholders, dated May 23, 2008 (5)
10.28
Form of Voting Agreement for Anthony Piscitelli, Gary Sidorsky and Curtis Taufman (5)
10.29
Letter Agreement between the Registrant and West Coast Opportunity Fund, LLC, dated May 29, 2008 (6)
10.30
Letter Agreement between the Registrant and Centaur Value Fund, LP and United Centaur Master Fund dated May 29, 2008 (6)
10.31
Securities Purchase Agreement, dated March 7, 2008 (2)
10.32
Form of Lock-Up Agreement for Anthony Piscitelli, Gary Sidorsky, Fergal Foley, Victor La Sala, John Rutledge and Curtis Taufman (2)
10.33
Consulting Services Agreement between the Registrant and Berthel Fisher & Company Financial Services, Inc. dated February 29, 2008 (3).
10.34
Amendment No. 1 to Independent Consulting Agreement between Richard Torykian and the Registrant dated July 23, 2008 (8)
10.35
Independent Consulting Agreement between the Registrant and Richard Torykian dated August 1, 2007 (3)
10.36
Asset Purchase Agreement among the Registrant, Tactical Applications Group and Lisa Sue Quinlan dated November 15, 2007 (3)
10.37
Side letter between the Registrant and West Coast Opportunity Fund, LLC dated March 28, 2008(3).
10.38
Contract No. M67854-09-D-5069 between the Registrant and the U.S. Marine Corps Systems Command, effective as of March 27, 2009 (12)
10.39
Contract No. M67854-09-D-5038 between the Registrant and the U.S. Marine Corps Systems Command, effective as of May 20, 2009 (14)
10.40
Accounts Receivable Purchase Agreement between the Registrant and Republic Capital Access, LLC, dated July 23, 2009 (16)
10.41
Form of Incentive Stock Option Agreement (21)
10.42
Form of Non-Qualified Stock Option Agreement (21)
10.43
Form of Director and Officer Indemnification Agreement (21)
10.44
First Amendment to Account Receivable Purchase Agreement between the Registrant and Republic Capital Access, LLC dated October 20, 2009 (18)
10.45
Employment Agreement with Victor La Sala dated January 1, 2007 (21)
10.46
Employment Agreement with Chuck Pegg dated January 1, 2007 (21)
10.47
Employment Agreement with Robert Aldrich dated August 1, 2008 (21)
10.48
Contact No. W56HZV-08-C-0311 between the Registrant and the U.S. Army TACOM, effective as of March 10, 2008 (21)
10.49
Amendment/Modification No. P00042 to Contract No. W56HZV-05-D-0382 between the Registrant and the U.S. Army Tank and Automotive Command, Life Cycle Management Command, effective as of December 28, 2009 (19)
10.50
Securities Redemption Agreement, dated March 22, 2011, by and among American Defense Systems, Inc.; West Coast Opportunity Fund, LLC; and Centaur Value Fund, L.P. (22)
10.51
Membership Interest Option Agreement, dated March 22, 2011, by and among American Defense Systems, Inc.; West Coast Opportunity Fund, LLC; and Centaur Value Fund, L.P. (22)
21.1
Subsidiaries of Registrant*
23.1
Consent of Marcum LLP*
31.1
Certification of Chief Executive Officer pursuant to Rules 13a-14 and 15d-14 promulgated under the Securities Exchange Act of 1934.*
31.2
Certification of Chief Financial Officer pursuant to Rules 13a-14 and 15d-14 promulgated under the Securities Exchange Act of 1934.*
32.1
Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 906 of the Sarbanes-Oxley Act of 2002.*
*Filed herewith
(1)Previously filed as an Exhibit to the Form 10, filed on February 11, 2008.
(2)Previously filed as an Exhibit to Amendment No. 1 to the Form 10, filed on March 21, 2008.
(3)Previously filed as an Exhibit to Amendment No. 2 to the Form 10, filed on April 11, 2008.
(4)Previously filed as an Exhibit to Amendment No. 3 to the Form 10, filed on April 22, 2008.
(5)Previously filed as an Exhibit to the Form 8-A filed on May 23, 2008.
(6)Previously filed as an Exhibit to the Current Report on Form 8-K filed on May 27, 2008.
(7)Previously filed as an Exhibit to the Current Report on Form 8-K filed on May 30, 2008.
(8)Previously filed as an Exhibit to the Current Report on Form 8-K filed on August 8, 2008.
(9)Previously filed as an Exhibit to the Current Report on Form 8-K filed on January 15, 2009.
(10)Previously filed as an Exhibit to the Current Report on Form 8-K filed on January 16, 2009.
(11)Previously filed as an Exhibit to the Current Report on Form 8-K filed on May 1, 2009.
(12)Previously filed as an exhibit to the Current Report on Form 8-K filed on May 20, 2009.
(13)Previously filed as an exhibit to the Current Report on Form 8-K filed on May 26, 2009.
(14)Previously filed as an exhibit to the Current Report on Form 8-K filed on May 26, 2009.
(15)Previously filed as an exhibit to the Current Report on Form 8-K filed on June 17, 2009.
(16)Previously filed as an exhibit to the Current Report on Form 8-K filed on July 28, 2009.
(17)Previously filed as an exhibit to the Current Report on Form 8-K filed on August 26, 2009.
(18)Previously filed as an exhibit to the Current Report on Form 8-K filed on October 26, 2009.
(19)Previously filed as an exhibit to the Current Report on Form 8-K filed on January 15, 2010.
(20)Previously filed as an exhibit to the Current Report on Form 8-K filed on January 28, 2010.
(21)Previously filed as an exhibit to Amendment No. 1 to the Annual Report on Form 10-K filed on April 15, 2010
(22)Previously filed as an exhibit to the Annual Report on Form 10-K filed on March 28, 2010
(23)Previously filed as an exhibit to the Current Report on Form 8-K filed on January 10, 2012
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
AMERICAN DEFENSE SYSTEMS, INC.
By:
/s/ General Alfred M. Gray
General Alfred M. Gray
Acting Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities and on the date indicated.
AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES
FINANCIAL INFORMATION
PART I - FINANCIAL INFORMATION
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Audit Committee of the
Board of Directors and Shareholders of
American Defense Systems, Inc.
We have audited the accompanying consolidated balance sheets of American Defense Systems, Inc. and Subsidiaries (the “Company”) as of December 31, 2011 and 2010 and the related consolidated statements of operations, changes in shareholders’ deficiency and cash flows for the years then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of American Defense Systems, Inc. and Subsidiaries, as of December 31, 2011 and 2010, and the results of its operations and its cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America.
The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the consolidated financial statements, as of December 31, 2011, the Company had a working capital deficiency of $867,281, an accumulated deficit of $16,955,187, shareholders’ deficiency of $235,012 and cash on hand of $132,285. The Company had operating losses of $3,301,724 and $3,685,215 for the years ended December 31, 2011 and 2010, respectively. The Company had income from continuing operations for the year ended December 31, 2011 of $6,826,961, including a gain of $12,786,969 on the redemption of mandatorily redeemable preferred stock, and a loss from continuing operations for the year ended December 31, 2010 of $8,165,463. The Company had net income (losses) of $9,366,609 and $(9,382,359) for the years ended December 31, 2011 and 2010, respectively. These conditions raise substantial doubt about the Company’s ability to continue as a going concern. Management’s plan in regard to these matters is also described in Note 1. The consolidated financial statements do not include any adjustments that might result from the outcome of these uncertainties.
/s/ Marcum LLP
Marcum LLP
Melville, New York
April 16, 2012
PART I
Item 1. Consolidated Financial Statements
AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
The accompanying notes are an integral part of these consolidated financial statements.
AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
The accompanying notes are an integral part of these consolidated financial statements.
AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
The accompanying notes are an integral part of these consolidated financial statements.
AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ DEFICIENCY
FOR THE YEARS ENDED DECEMBER 31, 2011 AND
The accompanying notes are an integral part of these consolidated financial statements.
AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
The accompanying notes are an integral part of these consolidated financial statements.
AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)
The accompanying notes are an integral part of these consolidated financial statements.
AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1.NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Organization
American Defense Systems, Inc. (the “Company” or “ADSI”) was incorporated under the laws of the State of Delaware on December 6, 2002. The consolidated financial statements of the Company have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”) for annual reports on Form 10-K.
On May 1, 2003, the stockholder of A. J. Piscitelli & Associates, Inc. (“AJP”) exchanged all of his issued and outstanding shares for shares of American Defense Systems, Inc. The exchange was accounted for as a recapitalization of the Company, wherein the stockholder retained all the outstanding stock of American Defense Systems, Inc. At the time of the acquisition American Defense Systems, Inc. was substantially inactive.
In January 2008, American Physical Security Group, LLC (“APSG”) was established as a wholly owned subsidiary of the Company for the purposes of acquiring the assets of American Anti-Ram, Inc., a manufacturer of crash tested vehicle barricades. On March 22, 2011, the Company entered into a Securities Redemption Agreement, as more fully discussed in Note 6, with the holders of its Series A convertible preferred stock (the “Series A Holders”), pursuant to which the Company sold to the Series A Holders all of the issued and outstanding membership interests in APSG. As such the results of APSG have been reflected in discontinued operations for all periods presented.
In July 2011, the Company relocated its corporate headquarters and operations from Hicksville, NY to Lillington, NC. The Company's new address is 420 McKinney Pkwy, Lillington, NC 27546, see Note 5.
Nature of Business
The Company designs and supplies transparent and opaque armor solutions for both military and commercial applications. Its primary customers are United States government agencies and general contractors who have contracts with governmental entities. These products, sold under Vista trademarks, are used in transport and fighting vehicles, construction equipment, sea craft and various fixed structures which require ballistic and blast attenuation.
The Company also provides engineering and consulting services, develops and installs detention and security hardware, entry control and monitoring systems, intrusion detection systems, and security glass.
Principles of Consolidation
The consolidated financial statements include the accounts of American Defense Systems, Inc. and its wholly-owned subsidiaries, AJP and American Institute for Defense and Tactical Studies, Inc. (“AI”). A portion of AI’s business consisting of the operation of a live-fire interactive tactical training range located in Hicksville, NY, hereinafter referred to as “T2”, was discontinued during the quarter ended June 30, 2011. As such the results of T2 have been reflected in discontinued operations for all periods presented, see Note 8. All significant intercompany accounts and transactions have been eliminated in consolidation.
Management Liquidity Plans and Going Concern
As of December 31, 2011, the Company had a working capital deficit of $867,271, an accumulated deficit of $16,955,187, shareholders’ deficiency of $235,012 and cash on hand of $132,285. The Company had operating losses of $3,301,724 and $3,685,215 for the years ended December 31, 2011 and 2010, respectively. The Company had income from continuing operations for the year ended December 31, 2011 of $6,826,961, including a gain of $12,786,969 on the redemption of mandatorily redeemable preferred stock, and a loss from continuing operations for the year ended December 31, 2010 of $8,165,463. The Company had net income (losses) of $9,366,609 and $(9,382,359) for the years ended December 31, 2011 and 2010, respectively. The Company had net cash (used in) provided by operations of $(1,700,488) and $780,754 for the years ended December 31, 2011 and 2010, respectively. The Company entered into an agreement with the Series A Holders on March 22, 2011 to redeem the Series A convertible preferred stock (the “Series A Preferred”), as more fully discussed in Note 7. The Company continues to explore all sources of increasing revenue. If the Company is unable in the near term to raise capital on commercially reasonable terms or increase revenue, it will not have sufficient cash to sustain its operations for the next twelve months. As a result, the Company may be forced to further reduce or even curtail its operations. These factors raise substantial doubt about the Company’s ability to continue as a going concern. The accompanying financial statements do not include any adjustments that might be necessary if the Company is unable to continue as a going concern.
AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Reclassifications
Certain amounts in the prior year financial statements have been reclassified for comparative purposes to conform to the presentation in the current year financial statements. These reclassifications had no effect on previously reported income.
Use of Estimates
The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates.
Significant estimates for all periods presented include cost in excess of billings, allowance for doubtful accounts, liabilities associated with the Series A Preferred, and valuation of deferred tax assets.
Subsequent Events
The Company has evaluated events that occurred subsequent to December 31, 2011 through the date these financial statements were issued. Management concluded that no subsequent events required disclosure in these financial statements except as disclosed in Note 5.
Revenue and Cost Recognition
The Company recognizes revenue in accordance with the provisions of Accounting Standards Codification (“ASC”) 605, “Revenue Recognition”, which states that revenue is realized and earned when all of the following criteria are met:
(a) persuasive evidence of the arrangement exists,
(b) delivery has occurred or services have been rendered,
(c) the seller’s price to the buyer is fixed and determinable, and
(d) collectibility is reasonably assured.
The Company recognizes revenue and reports profits from purchase orders filled under master contracts when an order is complete. Purchase orders received under master contracts may extend for periods in excess of one year. However, no revenues, costs or profits are recognized in operations until the period of completion of the order. An order is considered complete when all costs, except insignificant items, have been incurred and the installation or product is operating according to specification or the shipment has been accepted by the customer. Provisions for estimated contract losses are made in the period that such losses are determined. As of December 31, 2011 and 2010, there were no such provisions made.
Contract Revenue
Cost in Excess of Billing
All costs associated with uncompleted customer purchase orders under contract are recorded on the balance sheet as a current asset called “Costs in Excess of Billings on Uncompleted Contracts, net.” Such costs include direct material, direct labor, and project-related overhead. Upon completion of a purchase order, costs are then reclassified from the balance sheet to the statement of operations as costs of revenue. A customer purchase order is considered complete when a satisfactory inspection has occurred, resulting in customer acceptance and delivery.
Series A Convertible Preferred Stock, Investor Warrants and Placement Agent Warrants
See Note 7 for the Company’s accounting policy related to its preferred stock, investor warrants and placement agent warrants.
Cash
The Company’s cash balance consists of cash held in bank accounts. The Company’s bank accounts are maintained in financial institutions. Deposits held with banks may exceed the amount of insurance provided on such deposits. Generally, these deposits may be redeemed upon demand and therefore bear minimal risk.
AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Property and Equipment
Property and equipment is carried at original cost. Depreciation is recorded on a straight-line basis over the estimated useful lives of the related assets. The Company depreciates general equipment, light vehicles, trailers, and fire arms over three to five years; office equipment over three to five years; and furniture and fixtures over five years. Leasehold improvements are capitalized and amortized on a straight-line basis over the shorter of their useful life or the remaining term of the lease. Maintenance and repairs are expensed as incurred. When the property or equipment is retired or otherwise disposed of, related costs and accumulated depreciation are removed from the accounts and any resulting gain or loss is included in the consolidated statement of operations.
Allowance for Doubtful Accounts
The allowance for doubtful accounts reflects management’s best estimate of probable losses inherent in the account receivable balance. Management determines the allowance based on known troubled accounts, historical experience, and other currently available evidence. Management performs on-going credit evaluations of its customers and adjusts credit limits based upon payment history and the customer’s current credit worthiness, as determined by the review of their current credit information. Collections and payments from customers are continuously monitored. While such bad debt expenses have historically been within expectations and allowances established, the Company cannot guarantee that it will continue to experience the same credit loss rates that it has in the past. At December 31, 2011 and 2010, the allowance for doubtful accounts was $451,761 and $380,756, respectively.
Long-Lived Assets
The Company periodically reviews long-lived assets and certain identifiable assets related to those assets for impairment whenever circumstances and situations change, such that there is an indication that the carrying amounts may not be recoverable. If the anticipated undiscounted cash flows of the long-lived assets are less than the carrying amount, their carrying amounts are reduced to fair value, and an impairment loss is recognized. During the year ended December 31, 2011, the Company recorded an impairment loss of approximately $205,000 on long-lived assets related to leasehold improvements on its Hicksville, NY facility, see Note 5, an impairment loss of approximately $199,000 on long-lived assets related to T2, see Note 8, and an impairment loss of approximately $78,000 on assets held for sale at December 31, 2011.
Segment Reporting
As a result of the sale of APSG on March 22, 2011 (see Note 8) the Company currently classifies its business operations into one reportable segment.
Goodwill and Indefinite-Lived Intangible Assets
In accordance with ASC 350, “Intangibles - Goodwill and Other,” goodwill represents the excess of the purchase price over the fair value of net assets, including the amount assigned to identifiable intangible assets. The Company accounts for business combinations using the purchase method of accounting and accordingly, the assets and liabilities of the acquired entities are recorded at their estimated fair values at the acquisition date. The primary driver that generates goodwill is the value of synergies between the acquired entities and the company, which does not qualify as an identifiable intangible asset. The Company does not amortize the goodwill balance.
The Company assesses goodwill and indefinite-lived intangible assets for impairment annually during the fourth quarter, or more frequently if events and circumstances indicate impairment may have occurred. If the carrying value of a reporting unit’s goodwill exceeds its implied fair value, the Company records an impairment loss equal to the difference. ASC 350 also requires that the fair value of indefinite-lived purchased intangible assets be estimated and compared to the carrying value. The Company recognizes an impairment loss when the estimated fair value of the indefinite-lived purchased intangible assets is less than the carrying value. There was no impairment recorded for the year ended December 31, 2010. Goodwill was written off as part of the sale of APSG in 2011, see Note 8.
AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Advertising Costs
The Company expenses all advertising costs as incurred. The Company incurred advertising costs of approximately $7,000 and $117,000 during the years ended December 31, 2011 and 2010, respectively.
Shipping and Handling
The Company expenses all shipping and handling costs as incurred, which are recorded in costs of goods sold in the accompanying consolidated financial statements. The Company incurred shipping and handling costs of approximately $109,000 and $242,000 during the years ended December 31, 2011 and 2010, respectively.
Research and Development
Research and development expenses are incurred as the Company performs ongoing evaluations of materials and processes for existing products, as well as the development of new products and processes. Research and development costs are charged to expense as incurred. The Company incurred research and development costs of approximately $198,000 and $745,000 during the years ended December 31, 2011 and 2010, respectively.
Stock-Based Compensation
The Company accounts for stock based compensation in accordance with ASC 718, “Compensation - Stock Compensation” (“ASC 718”). ASC 718 establishes accounting for stock-based awards exchanged for employee services. Under the provisions of ASC 718, share-based compensation cost is measured at the grant date, based on the fair value of the award, and is recognized as expense over the employee’s requisite service period (generally the vesting period of the equity grant). The fair value of the Company’s common stock options are estimated using the Black Scholes Model with the following assumptions: stock price, exercise price, expected volatility, dividend rate, risk free interest rate and the expected life. The Company expenses stock-based compensation by using the straight-line method. In accordance with ASC 718, excess tax benefits realized from the exercise of stock-based awards are classified in cash flows from financing activities. The future realization of the reserved deferred tax assets related to these tax benefits associated with the exercise of stock options will result in a credit to additional paid in capital if the related tax deduction reduces taxes payable. The Company has selected a “with-and-without” approach regarding the accounting for the tax effects of share-based compensation awards.
Income (Loss) per Share
Basic income (loss) per share is computed using the weighted-average number of common shares outstanding during the period. Diluted net income (loss) per share is computed using the weighted-average number of common shares and excludes dilutive potential common shares outstanding, as their effect is anti-dilutive. Dilutive potential common shares would primarily consist of employee stock options, warrants and convertible preferred stock.
AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Securities that could potentially dilute basic EPS in the future that were not included in the computation of the diluted EPS because to do so would be anti-dilutive consist of the following:
* The Company entered into an agreement with the Series A Holders on March 22, 2011 to redeem the Series Preferred as more fully discussed in Note 7. On April 9, 2010, pursuant to the amendment of the Company’s certificate of incorporation, the conversion price of the Series A Preferred was reduced to $0.50 and all of the outstanding shares of the Series A Preferred were convertible into 30,000,000 shares of common stock.
Fair Value of Financial Instruments
Fair value of certain of the Company’s financial instruments including cash, accounts receivable, accounts payable, accrued compensation, and other accrued liabilities approximate cost because of their short maturities. The Company measures and reports fair value in accordance with ASC 820, “Fair Value Measurements and Disclosure” which defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles, and expands disclosures about fair value investments.
Fair value, as defined in ASC 820, is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The fair value of an asset should reflect its highest and best use by market participants, principal (or most advantageous) markets, and an in-use or an in-exchange valuation premise. The fair value of a liability should reflect the risk of nonperformance, which includes, among other things, the Company’s credit risk.
Valuation techniques are generally classified into three categories: the market approach; the income approach; and the cost approach. The selection and application of one or more of the techniques may require significant judgment and are primarily dependent upon the characteristics of the asset or liability, and the quality and availability of inputs. Valuation techniques used to measure fair value under ASC 820 must maximize the use of observable inputs and minimize the use of unobservable inputs. ASC 820 also provides fair value hierarchy for inputs and resulting measurement as follows:
Level 1
Quoted prices (unadjusted) in active markets that are accessible at the measurement date for identical assets or liabilities;
Level 2
Quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; inputs other than quoted prices that are observable for the asset or liability; and inputs that are derived principally from or corroborated by observable market data for substantially the full term of the assets or liabilities; and
Level 3
Unobservable inputs for the asset or liability that are supported by little or no market activity and that are significant to the fair values.
Fair value measurements are required to be disclosed by the Level within the fair value hierarchy in which the fair value measurements in their entirety fall. Fair value measurements using significant unobservable inputs (in Level 3 measurements) are subject to expanded disclosure requirements including a reconciliation of the beginning and ending balances, separately presenting changes during the period attributable to total gains or losses for the period (realized and unrealized), segregating those gains or losses included in earnings, and a description of where those gains or losses included in earning are reported in the statement of operations.
AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The Company did not have any assets or liabilities categorized as Level 1 or Level 2 as of December 31, 2011 and 2010. There were no transfers into or out of Level 1 or Level 2 during the years ended December 31, 2011 and 2010. There were no assets or liabilities categorized as Level 3 as of December 31, 2011.
The following summarizes the Company’s assets and liabilities measured at fair value as of December 31, 2010:
(1)Methods and significant inputs and assumptions are discussed in Note 7 below.
The following is a reconciliation of the beginning and ending balances for the Company’s liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the year ended December 31, 2011 and 2010:
AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The change in fair value recorded for Level 3 liabilities for the periods above are reported in other income (expense) on the consolidated statement of operations.
Income Taxes
The Company accounts for income taxes according to ASC 740 “Income Taxes” which requires an asset and liability approach to financial accounting for income taxes. Deferred income tax assets and liabilities are computed annually for the difference between the financial statement and tax bases of assets and liabilities that will result in taxable or deductible amounts in the future, based on enacted tax laws and rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized. Income tax expense is the tax payable or refundable for the period, plus or minus the change during the period in deferred tax assets and liabilities.
The Company follows the guidance in ASC 740-10 “Accounting for Uncertainty in Income Taxes” effective January 1, 2007. ASC 740-10 prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. Benefits from tax positions should be recognized in the financial statements only when it is more likely than not that the tax position will be sustained upon examination by the appropriate taxing authority that would have full knowledge of all relevant information. A tax position that meets the more-likely-than-not recognition threshold is measured at the largest amount of benefit that is greater than fifty percent likely of being realized upon ultimate settlement. Tax positions that previously failed to meet the more-likely-than-not recognition threshold should be recognized in the first subsequent financial reporting period in which that threshold is met. Previously recognized tax positions that no longer meet the more-likely-than-not recognition threshold should be derecognized in the first subsequent financial reporting period in which that threshold is no longer met. ASC 740-10 also provides guidance on the accounting for and disclosure of unrecognized tax benefits, interest and penalties. The Company classifies tax related penalties and interest as income tax expense in the consolidated statement of operations. The Company is subject to taxation in the United States and various state jurisdictions. The Company remains subject to examination by tax authorities for tax years 2003 through 2011.
The Company files income tax returns in the U.S. federal jurisdiction and various states. The Company has not been subject to U.S. federal income tax examinations by tax authorities nor state authorities since its inception in 2000.
2.COSTS IN EXCESS OF BILLINGS (BILLINGS IN EXCESS OF COSTS) ON UNCOMPLETED CONTRACTS AND ACCOUNTS RECEIVABLE
Costs in Excess of Billings and Billing in Excess of Costs
The cost in excess of billings on uncompleted purchase orders issued pursuant to contracts reflects the accumulated costs incurred on purchase orders in production but not completed. Upon completion, inspection and acceptance by the customer, the purchase order is invoiced and the accumulated costs are charged to the statement of operations as costs of revenues earned. During the production cycle of the purchase order, should any progress billings occur or any interim cash payments or advances be received, such billings and/or receipts on uncompleted contracts are accumulated as billings in excess of costs. The Company fully expects to collect net costs incurred in excess of billings within twelve months and periodically evaluates each purchase order and contract for potential disputes related to overruns and uncollectable amounts.
Costs in excess of billing on uncompleted contracts were $1,178,584 and $1,472,606 as of December 31, 2011 and 2010, respectively. The Company recorded inventory reserve expense of $96,164 and $155,397 for the years ended December 31, 2011 and 2010, respectively.
Backlog
The estimated gross revenue on work to be performed on backlog was approximately $7 million and $14 million as of December 31, 2011 and 2010, respectively.
Accounts Receivable
The Company records accounts receivable related to its long-term contracts, based on billings or on amounts due under the contractual terms. Accounts receivable consist primarily of receivables from completed purchase orders and progress billings on uncompleted contracts. Allowance for doubtful accounts is based upon a review of outstanding receivables, historical collection information, and existing economic conditions. Any amounts considered recoverable under the customer’s surety bonds are treated as contingent gains and recognized only when received.
Accounts receivable throughout the year may decrease based on payments received, credits for change orders, or back charges incurred. At December 31, 2011 and 2010, the Company had accounts receivable of $891,033 and $1,035,016, respectively, and an allowance for doubtful accounts of $451,761 and $380,756, respectively. The Company recorded bad debt expense of $71,005 and $417,983 for the years ended December 31, 2011 and 2010, respectively.
AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
3. PROPERTY AND EQUIPMENT
Property and equipment at December 31, 2011 and 2010 consisted of the following:
For the years ended December 31, 2011 and 2010, the Company recorded $617,763 and $1,304,015 in depreciation and amortization expense, respectively.
4. MAJOR CUSTOMERS AND SUPPLIERS
The Company serves primarily the defense market and its sales are highly concentrated within the U.S. government and other U.S. government contractors. The Company’s customers include various branches of the U.S. military through the U.S. Department of Defense and to a much lesser extent other U.S. government, law enforcement and corrections agencies as well as multinational companies.
A limited number of contracts have generated a substantial majority of the Company’s historical and current revenue. During the year ended December 31, 2011, three contracts with the U.S. Department of Defense organizations represented approximately 20% of the Company’s revenue, and revenue from two other customers represented approximately 65% of the Company’s revenue. During the year ended December 31, 2010, three contracts with the U.S. Department of Defense organizations represented approximately 84% of the Company’s revenue. The accounts receivable balance for the U.S. Department of Defense organizations was $.5 million and $1.7 million as of December 31, 2011 and 2010, respectively.
The Company purchases most of the components and materials used in its products from various suppliers. The primary materials used in the manufacturing of the Company’s products are polycarbonate glass and steel. One of the Company’s suppliers, a former subsidiary, supplied approximately $.6 million, or 11% of the costs of revenue earned during the year ended December 31, 2011. Another one of the Company’s suppliers supplied approximately $5.7 million, or 27% of the costs of revenue earned during the year ended December 31, 2010.
AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
5.COMMITMENTS AND CONTINGENCIES
Legal Proceedings
The Company is subject to various claims and contingencies in the ordinary course of its business, including those related to litigation, business transactions, employee-related matters, and others. When the Company is aware of a claim or potential claim, it assesses the likelihood of any loss or exposure. If it is probable that a loss will result and the amount of the loss can be reasonably estimated, the Company will record a liability for the loss. If the loss is not probable or the amount of the loss cannot be reasonably estimated, the Company discloses the claim if the likelihood of a potential loss is reasonably possible and the amount involved could be material. While there can be no assurances, the Company does not expect that any of its pending legal proceedings will have a material financial impact on the Company’s results. Legal fees are expensed as incurred and are included in general and administrative expenses in the consolidated statements of operations.
On February 29, 2008, Roy Elfers, a former employee commenced an action against the Company for breach of contract arising from his termination of employment in the Supreme Court of the State of New York, Nassau County. On August 5, 2011, the case was settled for $45,000. A payment of $22,500 was made on October 14, 2011. The Company has accrued the balance at December 31, 2011. A payment of $11,250 was made on January 6, 2012. The remaining balance of $11,250 is due on July 1, 2012.
On March 4, 2008, Thomas Cusack, the Company’s former General Counsel, commenced an action with the United States Department of Labor, Occupational Safety and Health and Safety Administration, alleging retaliation in contravention of the Sarbanes-Oxley Act. On April 2, 2008, the Company filed a response to the charges. On May 12, 2011, the Department of Labor dismissed the complaint. On March 7, 2008, Mr. Cusack also commenced a second action against the Company for breach of contract and related issues arising from his termination of employment in New York State Supreme Court, Nassau County. On May 7, 2008, the Company served a motion to dismiss the complaint, and on or about September 26, 2008, the Court dismissed several claims (tortious interference with a contract, tortious interference with economic opportunity, fraudulent inducement to enter into a contract and breach of good faith and fair dealing). The remaining claims are Mr. Cusack's breach of contract claims, stock conversion claim, as well as one claim for conversion of his personal property which Mr. Cusack has also asserted against the Company’s executive officers. On October 13, 2008, Mr. Cusack filed an amended complaint as to the remaining claims, and on November 5, 2008, the Company filed an answer to the amended complaint and filed counterclaims against Mr. Cusack for fraud and rescission of his contract. The parties have completed discovery and have scheduled depositions. The parties submitted motions for summary judgment, and on August 19, 2010, the Court granted Mr. Cusack’s motion as to his stock conversion claim and narrowed certain issues as to his breach of contract claims. On July 19, 2011, the Appellate Division upheld the stock conversion decision but reversed the decision to narrow the issues as to the breach of contract claims. The trial has been scheduled for late April 2012. Mr. Cusack seeks damages in excess of $3,000,000. The Company intends to vigorously defend this action. While it is reasonably possible that an unfavorable outcome may occur, management has concluded that it is not probable that a loss has been incurred and it is unable to estimate the possible loss or range of loss that could result from an unfavorable outcome and accordingly, has not provided any amounts in the consolidated financial statements for an unfavorable outcome.
On January 7, 2011, Action Group, Inc. commenced an action in the United States District Court for the Eastern District of New York. The complaint seeks $1,187,510 for goods allegedly sold to the Company, for which payment was not received. This amount is included in accounts payable in the consolidated balance sheet as of December 31, 2011. While the parties were engaged in settlement discussions, plaintiff sought and was granted entry of a default on February 8, 2011. Plaintiff then filed a motion with the Court, dated March 7, 2011, seeking entry of a default judgment in the amount of $1,246,542, representing the original demand set forth in the complaint, plus interest, costs and disbursements. On March 16, 2011, the Court issued an Order, directing Defendants to respond to the Court in writing within seven days as to why default judgment should not be entered. On March 28, 2011, counsel for the Company sought and obtained an Order from the Court extending its time to respond to the Court’s March 16, 2011 Order up to and including April 11, 2011. On April 11, 2011, Defendants served and filed a motion to set aside the default entered against them, and in opposition to plaintiff’s motion for entry of a default judgment. The Court subsequently granted the Defendants' motion, over Plaintiff's objection, and permitted Defendants to interpose an answer. The answer to the complaint was filed on June 13, 2011, and Defendants asserted several affirmative defenses to payment, including a claim for offset of amounts expended by Defendant to resolve issues with non-conforming goods supplied by Plaintiff. The parties have since engaged in document discovery, although no depositions have yet taken place in the matter. The parties have been actively engaged in settlement negotiations but cannot reasonable predict the outcome of settlement negotiations at this time.
AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
On January 6, 2012, a group led by Dale Scales (the “Scales Group”) filed a Schedule 13D with the Securities and Exchange Commission stating that it intended to ask the Board of Directors to call a special meeting of the Company’s stockholders for the purpose of removing the Company’s directors for cause and replacing them with candidates chosen by the Scales Group. The Board of Directors believes that this filing misleads the Company’s stockholders because, among other things, it fails to disclose that the Scales Group is acting in concert with Anthony Piscitelli, the Company’s former chief executive officer. In November 2011, the Board demanded Mr. Piscitelli’s resignation as a result of mismanagement and misconduct that included providing confidential information belonging to the Company to Mr. Scales in violation of the Board’s express instructions. On January 9, 2012, the Board of Directors of the Company amended the Company’s bylaws to eliminate the ability of stockholders to request special meetings of stockholders. Subsequently, the Board has declined to call a special meeting of stockholders despite having received a request from the Scales Group purporting to have been signed by the holders of more than two thirds of the Company’s outstanding shares. On April 3, 2012, Mr. Scales and a company controlled by him filed a civil action in the Court of Chancery of the State of Delaware against the Company and the current members of its Board of Directors. The caption of the action is Armor Technologies LLC v. American Defense Systems, Inc., Civil Action No. 7394-CS. The plaintiffs allege that the Company’s current directors have breached their fiduciary duties by amending the bylaws and declining to schedule the special meeting requested by the Scales Group. The plaintiffs ask the Court to declare the bylaw amendment invalid and order the Board of Directors to call the special meeting requested by the Scales Group. The plaintiffs also seek an award of compensatory damages in an unspecified amount. The Company and the Board of Directors believe the action is without merit and intend to defend themselves vigorously but cannot reasonable predict the outcome at this time.
Operating Leases
The Company occasionally rents various storage facilities and equipment from unrelated parties for in-progress jobs. The Company rents these items on a short-term basis.
The Company entered into a five-year lease with Long Island Industrial for 230 Duffy Avenue, Hicksville, New York (the “Premises”) dated September 23,2004, as amended and/or modified on or around May 31, 2006, January 31, 2007, October 24, 2008, and June 27, 2011 (the “Lease”) commencing on September 23, 2004 for corporate offices, R&D center, and warehouse facility. This lease was amended on October 24, 2008 to include the rental of additional space. This amendment extended the existing lease through September 30, 2016 and included a three percent per annum rent increase. In connection with the Company’s relocation of its corporate headquarters and operations from Hicksville, NY to Lillington, NC, the Company surrendered the Premises on July 15, 2011. On April 9, 2012, the Company entered into a lease termination agreement (the “Agreement”) with the landlord of the Premises. The Agreement states that the Company’s remaining payment obligation under the Lease is $82,878 as of April 9, 2012. This represents the balance of rental arrears on the Premises. The balance due on these rental arrears was $182,878 at December 31, 2011 and is included in accounts payable in the Company’s consolidated balance sheet at December 31, 2011.
On February 25, 2010, the Company entered into a lease agreement for manufacturing and office space in Lillington, NC. The lease agreement expires on January 31, 2015.
For the years ended December 31, 2011 and 2010, the Company incurred rent expense of $540,491 and $1,494,228, respectively.
Total future minimum rental commitments for the lease agreements noted above for the years ended December 31 are as follows:
AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Employment Agreements
The Company is obligated under five employment agreements. Compensation under all the agreements includes aggregate annual salaries of approximately $625,000. The employment agreements provide for annual bonuses based upon year to year increases in EBITDA or net income when the Company is profitable, with bonuses triggered by EBITDA or net income increases, as applicable, ranging from 1.25% to 2.5%. One of the contracts expires in January 2014 and four of the contracts expire at the end of 2015.
Employee Benefit Plan
The Company sponsors the American Defense Systems, Inc. 401(k) Plan (“the Plan”) established in December 2004 to provide retirement benefits for its employees. As allowed under Section 401(k) of the Internal Revenue Code, the Plan provides tax-deferred salary contributions for eligible employees.
Employee contributions are limited to a maximum annual amount as set periodically by the Internal Revenue Service. Under the Plan the Company may make discretionary matching contributions. For the years ended December 31, 2011 and 2010, the Company made matching contributions in the amount of approximately $0 and $30,000, respectively.
6.SHAREHOLDERS’ DEFICIENCY
Warrants
The following is a summary of stock warrants outstanding at December 31, 2011:
Stock Option Plan
The Company accounts for all stock based compensation as an expense in the financial statements and associated costs are measured at the fair value of the award. The Company also recognizes the excess tax benefit related to stock option exercises as financing cash inflows instead of operating inflows. As a result, the Company’s net income (loss) before taxes for the years ended December 31, 2011 and 2010 included $159,126 and $131,936 of stock based compensation, respectively. The stock based compensation expense is included in general and administrative expense in the consolidated statements of operations. The Company has selected a “with-and-without” approach regarding the accounting for the tax effects of share-based compensation awards.
AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The following is a summary of stock options outstanding at December 31, 2011:
As of December 31, 2011, there was a total of $150,156 of unrecognized compensation on arrangements granted under the Company’s 2007 Incentive Compensation Plan (the “2007 Plan”). The cost is expected to be recognized through 2015.
The Company did not issue any options during the year ended December 31, 2011.
On January 25, 2010, the Company issued an option to purchase 100,000 shares of its common stock to an officer as compensation under the 2007 Plan pursuant to an amendment to the officer’s employment agreement. The exercise price for the option is $0.40 per share and 40% of the option vested on the grant date and 20% of the option vests annually thereafter with the first 20% vesting upon the first anniversary of the grant date.
On July 31, 2010, the Company issued an option to purchase 175,000 shares of its common stock to a consultant as compensation under the 2007 Plan. The exercise price for the option is $0.26 per share and vests at the rate of 20% per year with the first 20% vesting upon the first anniversary of the grant date.
The Black-Scholes method option pricing model was used to estimate fair value as of the date of grant for options granted in 2010 using the following assumptions:
Based on the assumptions noted above, the fair market value of the options issued during the year ended December 31, 2010 was $87,655.
Stock Grants
On June 10, 2011, the Company issued 170,507 shares of its common stock to the Company’s non-employee directors as part of the director compensation under the 2007 Plan. The fair value on the date of the grant was $8,550 based on the stock price on the date of issuance.
On September 10, 2011, the Company issued 100,000 shares of its common stock to employees as compensation under the 2007 Plan. The fair value on the date of the grant was $11,000 based on the stock price on the date of issuance.
On October 3, 2011, the Company issued 375,000 shares of its common stock to employees as compensation and to the Company’s non-employee directors as part of the director compensation under the 2007 Plan. The fair value on the date of the grant was $18,750 based on the stock price on the date of issuance.
On January 1, 2010, the Company issued 125,000 shares of its common stock to the Company’s non-employee directors as part of the director compensation under the 2007 Plan. The fair value on the date of grant was $50,000 based on the stock price on the date of issuance.
On January 19, 2010, the Company issued 75,000 shares of its common stock to an employee as compensation under the 2007 Plan. The fair value on the date of the grant was $28,500 based on the stock price on the date of issuance.
AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
On March 2, 2010, the Company issued 12,500 shares of its common stock to a consultant as compensation for services rendered under the 2007 Plan. The fair value on the date of the grant was $4,500 based on the stock price on the date of issuance.
On May 7, 2010, the Company issued 17,361 shares of common stock to a consultant as compensation for services rendered under the 2007 Plan. The fair value on the date of grant was $5,729 based on the stock price on the date of issuance.
On May 28, 2010, the Company issued 26,136 shares of common stock to a consultant as compensation for services rendered under the 2007 Plan. The fair value on the date of grant was $7,318 based on the stock price on the date of issuance.
On August 24, 2010, the Company issued 75,000 shares of common stock to a consultant as compensation for services rendered under the 2007 Plan. The fair value on the date of grant was $16,500 based on the stock price on the date of issuance.
On September 1, 2010, the Company issued 19,231 shares of common stock to a consultant as compensation for services rendered under the 2007 Plan. The fair value on the date of grant was $3,654 based on the stock price on the date of issuance.
All of these awards were fully vested on the date of grant. The Company recorded stock based compensation of approximately $38,300 and $116,201 for the years ended December 31, 2011 and 2010, respectively, related to these awards.
On March 31, 2010, the Company issued 1,035,000 shares of its common stock to the Series A Holders as settlement of $375,000 of dividends pursuant to the terms of such Series A Preferred. The Company recorded this payment of dividends as interest expense for the three months ended March 31, 2010.
On June 30, 2010, the Company issued 1,455,000 shares of its common stock to the Series A Holders as settlement of $375,000 of dividends pursuant to the terms of such Series A Preferred. The Company recorded this payment of dividends as interest expense for the three months ended June 30, 2010.
On September 30, 2010, the Company issued 2,520,000 shares of its common stock to the Series A Holders as settlement of $375,000 of dividends pursuant to the terms of such Series A Preferred. The Company recorded this payment of dividends as interest expense for the three months ended September 30, 2010.
On December 31, 2010, the Company issued 2,370,000 shares of its common stock to the Series A Holders as settlement of $375,000 of dividends pursuant to the terms of such Series A Preferred. The Company recorded this payment of dividends as interest expense for the three months ended December 31, 2010.
7.MANDATORILY REDEEMABLE SERIES A CONVERTIBLE PREFERRED STOCK AND WARRANT LIABILITIES
Series A Preferred
The Series A Preferred was redeemable on October 1, 2011 and convertible into shares of common stock at a rate of 2,000 shares of common stock for each share of Series A Preferred. On March 22, 2011, the Company entered into a Securities Redemption Agreement (the "Redemption Agreement") with the Series A Holders, pursuant to which the Company sold to the Series A Holders all of the issued and outstanding membership interests in APSG, the Company’s wholly-owned subsidiary. The Series A Holders owned an aggregate of 15,000 shares of the Series A Preferred. In exchange for the sale of the APSG interests to the Series A Holders, the Series A Holders (i) paid the Company $1,000,000 in cash at the closing of the transactions and (ii) tendered to the Company the Series A Preferred, which had an aggregate redemption price of $16,500,000. Upon the closing of the transactions, the Series A Holders own 100% of the APSG interests and APSG is no longer be a subsidiary of the Company.
In connection with the Redemption Agreement, the Company and the Series A Holders entered into a Membership Interest Option Agreement (the "Option Agreement") pursuant to which the Series A Holders granted the Company an option (the “Option”) to repurchase the APSG interests within six months following the closing of the transactions contemplated by the Redemption Agreement at a cash purchase price equal to the sum of (i) $15,525,000, plus (ii) the amount of any net investment made in APSG concurrently with and following the closing of the Redemption Agreement and prior to the closing of the purchase of the APSG membership interests pursuant to exercise of the Option. An analysis of the Option was performed and its value was deemed to be immaterial.
The total consideration the Company received in connection with the Redemption Agreement was $1.0 million in cash and the return and extinguishment of the mandatorily redeemable Series A Preferred which had a redemption value of $16.5 million. The Company prepared an estimate of the fair value of APSG and allocated $4.4 million of the consideration to the sale of APSG and the residual amount of the consideration was allocated to the redemption of the Series A Preferred. The Company recorded a gain on the redemption of the Series A Preferred, which had been previously accounted for as a liability, of approximately $13 million, net of the write off of the unamortized deferred financing costs, for the year ended December 31, 2011.
AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
A scenario analysis was utilized to estimate the fair value of the Series A Preferred as of December 31, 2010. Two scenarios were considered: 1) the Series A Preferred would be redeemed-in-full; 2) the Series A Preferred would be restructured in order to reduce the redemption price. The probability of the "redeem-in-full" scenario was estimated to be 10% and the probability of the "restructure" scenario was estimated to be 90%. Both scenarios consider the key features of the Series A Preferred, as noted above, and are subject to the significant assumptions discussed below.
An option pricing model ("OPM") was used in the "redeem-in-full" scenario. The OPM assumes that the Series A Preferred would be redeemed in full on October 1, 2011, as specified in the waiver agreement entered into on November 12, 2010. The OPM further assumes that the Company’s publicly traded common stock price appropriately reflected the fair value of the Company’s common equity. Using the Company’s publicly traded common stock price and its capital structure, an implied firm value was calculated and then allocated to each of the Company’s equity securities. This model requires the following key inputs with respect to the Company and/or instrument:
In the "restructure" scenario, a discounted cash flow analysis was performed using a distressed debt discount rate. This method requires the following key inputs:
The following are significant assumptions utilized in developing the inputs:
¨Stock volatility was estimated by considering (i) the annualized daily volatility of the Company’s stock price during the historical period preceding the respective valuation dates and measured over a period corresponding to the remaining life of the instruments and (ii) the annualized daily volatility of comparable companies’ stock price during the historical period preceding the respective valuation dates and measured over a period corresponding to the remaining life of the instrument. Historic prices of the Company and comparable companies’ common stock were used to estimate volatility as the Company did not have traded options as of the valuation dates;
¨Based on the Company’s historical operations and management’s expectations for the near future, the Company’s stock was assumed to be a non-dividend-paying stock;
¨Based on management’s expectations for the near future, the Company is expected to settle the future quarterly dividends due to the Series A Holders via shares;
¨The quoted market price of the Company’s stock was utilized in the valuations because ASC 820-10 requires the use of quoted market prices, if available, without considerations of blockage discounts (if the input is considered as a Level 1 input). Because the stock is thinly traded, the quoted market price may not reflect the market value of a large block of stock; and
¨The quoted market price of the Company’s stock as of measurement dates and expected future stock prices were assumed to reflect the effect of dilution upon conversion of the instruments to shares of common stock.
The changes in fair value estimate between reporting periods are related to the changes in the price of the Company’s common stock as of the measurement dates, the expected volatility of the Company’s common stock during the remaining term of the instrument, changes in the conversion price and estimated discount rate.
AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
2005 Warrants, 2006 Warrants, and Placement Agent Warrants
Upon issuance, the 2005 Warrants, 2006 Warrants, and Placement Agent Warrants met the requirements for equity classification set forth in Emerging Issues Task Force (“EITF”) Issue 00-19, Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in a Company’s Own Stock, and Statement of Financial Accounting Standards (“SFAS”) No. 133, as codified in ASC 815. However, effective January 1, 2009, the Company was required to analyze its then outstanding financial instruments in accordance with EITF 07-5 as codified in ASC 815-40. Based on the Company’s analysis, its 2005 Warrants, 2006 Warrants, and Placement Agent Warrants, include price protection provisions whereby the exercise price could be adjusted upon certain financing transactions at a lower price per share and could no longer be viewed as indexed to the Company’s common stock. As a result, the 2005 Warrants, 2006 Warrants, and Placement Agent Warrants are accounted for as “derivatives” under ASC 815 and recorded as liabilities at fair value as of January 1, 2009 with changes in subsequent period fair value recorded in the statement of operations. The 2005 and 2006 Warrants expired in June 2010.
Fair values for the Company’s derivatives and financial instruments are estimated by utilizing valuation models that consider current and expected stock prices, volatility, dividends, market interest rates, forward yield curves and discount rates. Such amounts and the recognition of such amounts are subject to significant estimates which may change in the future. The methods and significant inputs and assumptions utilized in estimating the fair value of the Placement Agent Warrants are discussed below. Each of the measurements is considered a Level 3 measurement as a result of at least one unobservable input.
Placement Agent Warrants
The Company estimated the fair value of the Placement Agent Warrants as of December 31, 2011 to be immaterial. The model used is subject to the significant assumptions discussed below and requires the following key inputs with respect to the Company and/or instrument:
8.DISCONTINUED OPERATIONS
APSG
On March 22, 2011, the Company entered into a Securities Redemption Agreement (the "Redemption Agreement") with the Series A Holders, pursuant to which the Company sold to the Series A Holders all of the issued and outstanding membership interests in APSG, the Company’s wholly-owned subsidiary. The Series A Holders owned an aggregate of 15,000 shares of the Series A Preferred. In exchange for the sale of the APSG interests to the Series A Holders, the Series A Holders (i) paid the Company $1,000,000 in cash at the closing of the transactions and (ii) tendered to the Company the Series A Preferred, which had an aggregate redemption price of $16,500,000. Upon the closing of the transactions, the Series A Holders own 100% of the APSG interests and APSG is no longer a subsidiary of the Company.
In connection with the Redemption Agreement, the Company and the Series A Holders entered into a Membership Interest Option Agreement (the "Option Agreement") pursuant to which the Series A Holders granted the Company an option (the “Option”) to repurchase the APSG interests within six months following the closing of the transactions contemplated by the Redemption Agreement at a cash purchase price equal to the sum of (i) $15,525,000, plus (ii) the amount of any net investment made in APSG concurrently with and following the closing of the Redemption Agreement and prior to the closing of the purchase of the APSG membership interests pursuant to exercise of the Option. An analysis of the Option was performed and its value was deemed to be immaterial.
The presentation herein of the results of continuing operations excludes APSG for all periods presented. The following APSG amounts have been segregated from continuing operations and are reflected as discontinued operations in the consolidated statement of operations for the years ended December 31, 2011 and 2010:
AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The following APSG amounts have been segregated from continuing operations and are reflected as discontinued operations in the consolidated balance sheet at December 31, 2010:
The total consideration the Company received in connection with the Redemption Agreement was $1.0 million in cash and the return and extinguishment of the mandatorily redeemable Series A Preferred which had a redemption value of $16.5 million. The Company allocated $4.4 million of the consideration to the sale of APSG based on a calculation of the fair value of APSG with the residual amount of the consideration allocated to the redemption of the Series A Preferred. The Company recorded a gain on the sale of APSG of approximately $3 million for the year ended December 31, 2011 based on the difference between the allocated consideration and the net book value of APSG, including goodwill.
T2
During the second quarter of 2011, management decided to establish a plan to sell and or discontinue the operations of T2, therefore, the presentation herein of the results of continuing operations excludes T2 for all periods presented.
The following T2 amounts have been segregated from continuing operations and are reflected as discontinued operations in the consolidated statement of operations for the years ended December 31, 2011 and 2010:
The following T2 amounts have been segregated from continuing operations and are reflected as discontinued operations in the consolidated balance sheets at December 31, 2011and 2010:
During the year ended December 31, 2011, the Company recorded an impairment loss of $199,454 on long-lived assets related to T2.
AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Tactical Applications Group (“TAG”)
On January 2, 2009, the Company entered into an agreement with the prior owners of TAG to sell certain assets and liabilities previously acquired from TAG back to TAG. In accordance with the terms of the agreement, the original owners of TAG agreed to repay $1,000,000 of the original $2,000,000 in consideration in annual installments from 2009 to 2013. TAG repaid $25,000 of the balance due to the Company during 2009 and has not made any additional payments. The Company recorded an additional $400,000 reserve against the note receivable for the year ended December 31, 2010. The Company recorded a reserve of $50,000 during the year ended December 31, 2011.
Cash flows from discontinued operations were not reported separately for the years ended December 31, 2011 and 2010.
9. ACCOUNTS RECEIVABLE PURCHASE AGREEMENT
On July 27, 2009, the Company entered into an accounts Receivable Purchase Agreement with Republic Capital Access, LLC (“RCA”), as of July 23, 2009 (the “RCA Purchase Agreement”). Under the RCA Purchase Agreement, the Company can sell eligible accounts receivables to RCA. Eligible accounts receivable, subject to the full definition of such term in the RCA Purchase Agreement, generally are our receivables under prime government contracts.
Under the terms of the RCA Purchase Agreement, the Company may offer eligible accounts receivable to RCA and if RCA purchases such receivables, the Company will receive an initial upfront payment equal to 90% of the receivable. Following RCA’s receipt of payment from our customer for such receivable, RCA will pay the remaining 10% of the receivable less its fees. In addition to the Discount Factor fee and an initial enrollment fee, the Company is required to pay RCA a program access fee equal to a stated percentage of the sold receivable, a quarterly program access fee if the average daily amount of the sold receivables is less than $2.25 million, (Program Continuance Fee), and RCA’s initial expenses in negotiating the RCA Purchase Agreement and other expenses in certain specified situations. The RCA Purchase Agreement also provides that in the event, but only to the extent, that the conveyance of receivables by us is characterized by a court or other governmental authority as a loan rather than a sale, the Company shall be deemed to have granted RCA effective as of the date of the first purchase under the RCA Purchase Agreement, a security interest in all of the Company’s right, title and interest in, to and under all of the receivables sold by us to RCA, whether now or hereafter owned, existing or arising.
The initial term of the purchase agreement ended on December 31, 2009 and will renew annually after the initial term, unless earlier terminated by either of the parties. Pursuant to an amendment to the purchase agreement in October 2009, the term during which we may offer and sell eligible accounts receivable to RCA (Availability Period) was extended from December 31, 2009 to October 15, 2010, and the discount factor rate was reduced from 0.524% to 0.4075%. On November 12, 2010, the term was further extended to October 15, 2011. On November 9, 2011, the Company signed an amendment to the purchase agreement which extended the term to December 31, 2012, eliminated the Program Continuance Fee and added a Commitment Fee equal to 1% of the difference between the outstanding receivable balance and $1 million.
The sale of the receivables is accounted for in accordance with the accounting guidance for transfers and servicing of financial assets and extinguishments of liabilities. In accordance with the Codification, receivables are considered sold when they are transferred beyond the reach of the Company and its creditors, the purchaser has the right to pledge or exchange the receivables, and the Company has surrendered control over the transferred receivables. Receivables factored net of advances from the factor were $5,112 and $84,463 as of December 31, 2011 and 2010, respectively.
10. REGULATORY MATTERS
On November 22, 2011, the Company was notified by NYSE Amex that trading in its common stock would be suspended on NYSE Amex, with formal delisting following on December 16, 2011. The Company transitioned trading of its common stock to the OTCBB Marketplace beginning December 1, 2011. Although the Company is a reporting company and our common shares are quoted on the OTCBB, the OTCBB is not an exchange. Trading of securities on the OTCBB is often more sporadic than the trading of securities listed on a national exchange or on the Nasdaq National Market.
AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
11. INCOME TAXES
There is no income tax expense for 2011 or 2010.
The difference in income tax expense computed by applying the federal statutory corporate tax rate and effective rate is as follows:
Deferred income taxes result from temporary differences in the recognition of income and expenses for the financial reporting purposes and for tax purposes. The net deferred tax assets and liabilities are comprised of the following:
AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Total current and noncurrent deferred tax asset and liabilities are as follows:
The changes in the valuation allowance for deferred tax asset for the years ended December 31, 2011 and 2010 are as follows:
Internal Revenue Code Section 382 limits the utilization of net operating loss carryforwards upon a change of control of a company (as defined in Section 382). The Company performed an evaluation as to whether a change in control has taken place and concluded that a change did occur as of December 29, 2011. As a result of the change in control, the Company’s net operating loss carryforwards are subject to limitation, which has the effect of eliminating a substantial portion of the future tax benefits of the net operating loss carryforwards.
As of December 29, 2011, the Company had a federal net operating loss carryforward of $14,007,343 available to offset future income through 2031. After the change in control, the federal net operating loss is subject to an annual limitation of $39,000. Similarly, as of December 29, 2011, the Company had state net operating loss carryforwards of $14,750,199 available to offset future state income through 2031. After the change in control, the state operating loss carryforward is subject to an annual limitation of $39,000. The deferred tax asset for the limited federal and state loss carryforwards was written off through deferred tax expense in 2011 and offset by a corresponding reduction in the valuation allowance of $4,300,000.
The implementation of ASC 740-10 did not result in any current or any cumulative effect adjustment. Therefore, no adjustment was recorded to retained earnings upon adoption. For the years ended December 31, 2011 and 2010, the Company performed a tax analysis in accordance with ASC 740-10. Based upon that analysis, the Company was not required to accrue liabilities for uncertain tax positions pursuant to ASC 740-10 for the years ended December 31, 2011 and 2010, respectively, If the Company were to have any liabilities for uncertain tax positions, its accounting policy with respect to interest and penalties is to classify these amounts as income taxes. Since no liabilities for tax uncertainties have been recorded, there is no interest recognized in the statement of operations as of December 31, 2011 and 2010 and no interest is accrued as of December 31, 2011 and 2010.
EXHIBIT INDEX
Exhibit
Numbers
Exhibits
21.1
Subsidiaries of Registrant
23.1
Consent of Marcum LLP
31.1
Certification of Chief Executive Officer pursuant to Rules 13a-14 and 15d-14 promulgated under the Securities Exchange Act of 1934.
31.2
Certification of Chief Financial Officer pursuant to Rules 13a-14 and 15d-14 promulgated under the Securities Exchange Act of 1934.
32.1
Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 906 of the Sarbanes-Oxley Act of 2002.