UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended June 30, 2018.

 

or

 

[  ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from _________ to __________.

 

Commission File Number: 001-33899

 

Digital Ally, Inc.

(Exact name of registrant as specified in its charter)

 

Nevada   20-0064269
(State or other jurisdiction of
incorporation or organization)
  (I.R.S. Employer
Identification No.)

 

9705 Loiret Blvd, Lenexa, KS 66219

(Address of principal executive offices) (Zip Code)

 

(913) 814-7774

(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [  ]

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

 

Yes [X] No [  ]

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of Exchange Act.

 

Large accelerated filer [  ]   Accelerated filer [  ]
     
 Non-accelerated filer [  ] (Do not check if a smaller reporting company) Smaller reporting company [X]

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

 

Yes [  ] No [X]

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:

Class  Outstanding at August 12, 2018 
Common Stock, $0.001 par value  7,698,357 

 

 

 

 
 

 

FORM 10-Q

DIGITAL ALLY, INC.

JUNE 30, 2018

 

TABLE OF CONTENTS   Page(s)
     
PART I – FINANCIAL INFORMATION    
     
Item 1. Financial Statements.    
     
Condensed Consolidated Balance Sheets – June 30, 2018 (Unaudited) and December 31, 2017   3
     
Condensed Consolidated Statements of Operations for the Three and Six Months Ended June 30, 2018 and 2017 (Unaudited)   4
     
Condensed Consolidated Statements of Stockholders’ Equity (Deficit) for the Six Months Ended June 30, 2018 (Unaudited)   5
     
Condensed Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2018 and 2017 (Unaudited)   6
     
Notes to the Condensed Consolidated Financial Statements (Unaudited)   7-30
     
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations   31-58
     
Item 3. Quantitative and Qualitative Disclosures About Market Risk.   59
     
Item 4T. Controls and Procedures.   59
     
PART II - OTHER INFORMATION    
     
Item 1. Legal Proceedings.   59
     
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.   61
     
Item 3. Defaults Upon Senior Securities   62
     
Item 4. Mine Safety Disclosures   62
     
Item 5. Other Information.   62
     
Item 6. Exhibits.   62
     
SIGNATURES   63
     
EXHIBITS   64
     
CERTIFICATIONS    

 

2
 

 

PART I – FINANCIAL INFORMATION

 

Item 1 – Financial Statements.

 

DIGITAL ALLY, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

JUNE 30, 2018 AND DECEMBER 31, 2017

 

   June 30, 2018   December 31, 2017 
     (Unaudited)      
Assets         
Current assets:          
Cash and cash equivalents  $471,840   $54,712 
Accounts receivable-trade, less allowance for doubtful accounts
of $70,000 – 2018 and 2017
   2,058,511    1,978,936 
Accounts receivable-other   457,079    338,618 
Inventories, net   7,844,806    8,750,713 
Restricted cash       500,000 
Prepaid expenses   189,967    209,163 
           
Total current assets   11,022,203    11,832,142 
           
Furniture, fixtures and equipment, net   449,213    638,169 
Intangible assets, net   494,645    497,180 
Income tax refund receivable   90,000    90,000 
Other assets   169,987    115,043 
           
Total assets  $12,226,048   $13,172,534 
           
Liabilities and Stockholders’ Equity (Deficit)          
Current liabilities:          
Accounts payable  $3,025,152   $3,193,269 
Accrued expenses   1,097,312    1,240,429 
Derivative liabilities   287,522    16,816 
Capital lease obligation-current       8,492 
Contract liabilities-current   1,541,915    1,409,683 
Subordinated and secured notes payable   250,000    1,008,500 
Secured convertible debentures, at fair value   5,354,803    3,262,807 
Income taxes payable   3,756    10,141 
           
Total current liabilities   11,560,460    10,150,137 
           
Long-term liabilities:          
Contract liabilities-long term   2,227,176    2,158,649 
           
Total liabilities   13,787,636    12,308,786 
           
Commitments and contingencies          
           
Stockholder’s Equity (Deficit):          
Common stock, $0.001 par value; 25,000,000 shares authorized; shares issued: 7,286,175 – 2018 and 7,037,799 – 2017   7,286    7,038 
Additional paid in capital   67,977,829    64,923,735 
Treasury stock, at cost (63,518 shares)   (2,157,226)   (2,157,226)
Accumulated deficit   (67,389,477)   (61,909,799)
           
Total stockholders’ equity (deficit)   (1,561,588)   863,748 
           
Total liabilities and stockholders’ equity (deficit)  $12,226,048   $13,172,534 

 

See Notes to Condensed Consolidated Financial Statements.

 

3
 

 

DIGITAL ALLY, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

FOR THE THREE AND SIX MONTHS ENDED

JUNE 30, 2018 AND 2017

(Unaudited)

 

   Three months ended June 30,   Six months ended June 30, 
   2018   2017   2018   2017 
                 
Revenue:                    
Product  $2,993,700   $3,056,810   $4,984,813   $7,742,170 
Service and other   569,850    429,692    1,050,250    974,192 
Total revenue   3,563,550    3,486,502    6,035,063    8,716,362 
                     
Cost of revenue:                    
Product  $1,831,615   $1,959,274   $3,080,360   $4,733,311 
Service and other   113,468    354,012    226,842    532,986 
                     
Total cost of revenue   1,945,083    2,313,286    3,307,202    5,266,297 
                     
Gross profit   1,618,467    1,173,216    2,727,861    3,450,065 
Selling, general and administrative expenses:                    
Research and development expense   333,760    846,460    773,880    1,664,351 
Selling, advertising and promotional expense   712,008    952,312    1,386,413    1,987,834 
Stock-based compensation expense   594,228    115,756    1,087,746    502,789 
General and administrative expense   1,415,780    1,751,285    2,890,447    3,589,901 
Total selling, general and administrative expenses   3,055,776    3,665,813    6,138,486    7,744,875 
Operating loss   (1,437,309)   (2,492,597)   (3,410,625)   (4,294,810)
                     
Interest income   684    3,797    2,300    8,858 
Interest expense   (152,975)   (80,436)   (283,203)   (160,987)
Change in warrant derivative liabilities   (310,195)   13,114    (309,306)   13,719 
Secured convertible debentures issuance expense   (220,312)       (220,312)    
Loss on the extinguishment of secured convertible debentures           (500,000)    
Change in fair value of secured convertible debentures   (842,783)   229,599    (829,976)   73,742 
Loss before income tax expense   (2,962,890)   (2,326,523)   (5,551,122)   (4,359,478)
Income tax (expense) benefit                
Net loss  $(2,962,890)  $(2,326,523)  $(5,551,122)  $(4,359,478)
                     
Net loss per share information:                    
Basic  $(0.42)  $(0.41)  $(0.78)  $(0.77)
Diluted  $(0.42)  $(0.41)  $(0.78)  $(0.77)
                     
Weighted average shares outstanding:                    
Basic   7,129,260    5,679,731    7,153,219    5,654,755 
Diluted   7,129,260    5,679,731    7,153,219    5,654,755 

 

See Notes to Condensed Consolidated Financial Statements.

 

4
 

 

DIGITAL ALLY, INC.

CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (DEFICIT)

FOR THE SIX MONTHS ENDED JUNE 30, 2018
(Unaudited)

 

   Common Stock   Additional Paid in   Treasury   Accumulated    
   Shares   Amount   Capital   stock   deficit   Total 
Balance, December 31, 2017   7,037,799   $7,038   $64,923,735   $(2,157,226)  $(61,909,799)  $863,748 
                               
Cumulative effects adjustment for adoption of ASC 606 (Note 1)                   71,444    71,444 
                               
Stock-based compensation           1,087,746            1,087,746 
                               
Restricted common stock grant   184,500    184    (184)            
                               
Restricted common stock forfeitures   (30,400)   (30)   30             
                               
Issuance of common stock purchase warrants in connection with issuance of subordinated notes payable           47,657            47,657 
                               
Issuance of common stock purchase warrants in connection with issuance of secured convertible debentures           1,684,251            1,684,251 
                               
Issuance of common stock upon conversion of secured convertible debentures and accrued interest   74,276    74    185,614            185,688 
                               
Issuance of common stock upon exercise of common stock purchase warrants   20,000    20    48,980            49,000 
                               
Net loss                   (5,551,122)   (5,551,122)
                               
Balance, June 30, 2018   7,286,175   $7,286   $67,977,829   $(2,157,226)  $(67,389,477)  $(1,561,588)

 

See Notes to Condensed Consolidated Financial Statements.

 

5
 

 

DIGITAL ALLY, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

FOR THE SIX MONTHS ENDED JUNE 30, 2018 AND 2017
(Unaudited)

 

   2018   2017 
Cash Flows from Operating Activities:          
Net loss  $(5,551,122)  $(4,359,478)
Adjustments to reconcile net loss to net cash flows used in operating activities:          
Depreciation and amortization   275,392    325,617 
Change in fair value of warrant derivative liabilities   309,306    (13,719)
Loss on extinguishment of secured convertible debentures   500,000     
Secured convertible debentures issuance expense   220,312     
Change in fair value of secured convertible note payable   829,976    (73,742)
Interest expense added to debenture   121,271     
Amortization of debt discount   47,657     
Stock based compensation   1,087,746    502,789 
Provision for inventory obsolescence   (437,538)   326,284 
           
Change in assets and liabilities:          
(Increase) decrease in:          
Accounts receivable - trade   (79,575)   395,507 
Accounts receivable - other   (118,461)   (102,707)
Inventories   1,343,445    (1,055,452)
Prepaid expenses   90,640    (244,682)
Other assets   (54,944)   83,330 
Increase (decrease) in:          
Accounts payable   (168,117)   863,442 
Accrued expenses   (132,429)   (495,489)
Income taxes payable   (6,385)   947 
Contract liabilities   200,759    472,801 
           
Net cash used in operating activities   (1,522,067)   (3,374,552)
           
Cash Flows from Investing Activities:          
Purchases of furniture, fixtures and equipment   (28,846)   (304,596)
Additions to intangible assets   (55,055)   (62,723)
Release of cash in accordance with secured convertible note   500,000     
           
Net cash provided by (used) in investing activities   416,099    (367,319)
Cash Flows from Financing Activities:          
Proceeds from subordinated notes payable   250,000    700,000 
Proceeds from secured convertible debentures and detachable common stock purchase warrants   6,250,000     
Principal payment on secured convertible debentures   (3,250,000)    
Principal payment on subordinated notes payable   (1,008,500)    
Proceeds from issuance of common stock and warrants   10,400     
Payment on extinguishment of secured convertible debentures   (500,000)    
Secured convertible debentures issuance expense   (220,312)    
Principal payments on capital lease obligation   (8,492)   (16,163)
           
Net cash provided by financing activities   1,523,096    683,837 
           
Net increase (decrease) in cash and cash equivalents   417,128    (3,058,034)
Cash and cash equivalents, beginning of period   54,712    3,883,124 
           
Cash and cash equivalents, end of period  $471,840   $825,090 
           
Supplemental disclosures of cash flow information:          
Cash payments for interest  $172,283   $80,986 
           
Cash payments for income taxes  $6,385   $9,053 
           
Supplemental disclosures of non-cash investing and financing activities:          
           
Restricted common stock grant  $184   $200 
           
Restricted common stock forfeitures  $30   $9 
           
Amounts allocated to common stock purchase warrants in connection with proceeds from secured convertible debentures  $1,684,251   $ 
           
Issuance of common stock upon conversion of secured convertible debentures and payment of accrued interest  $185,688   $ 
           
Issuance of common stock upon exercise of common stock purchase warrants accounted for as warrant liabilities  $38,600   $ 
           
Amounts allocated to common stock purchase warrants in connection with proceeds from subordinated notes payable  $47,657   $ 

 

See Notes to Condensed Consolidated Financial Statements.

 

6
 

 

DIGITAL ALLY, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

 

NOTE 1. NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

Nature of Business:

 

Digital Ally, Inc. and subsidiaries (collectively, “Digital Ally,” “Digital,” “Company,” “we”, “ours” and “us”,”) produces digital video imaging and storage products for use in law enforcement, security and commercial applications. Its current products are an in-car digital video/audio recorder contained in a rear-view mirror for use in law enforcement and commercial fleets, a system that provides its law enforcement customers with audio/video surveillance from multiple vantage points and hands-free automatic activation of body-worn cameras and in-car video systems; a miniature digital video system designed to be worn on an individual’s body; and cloud storage solutions including cloud-based fleet management and driver monitoring/training applications. The Company has active research and development programs to adapt our technologies to other applications. It can integrate electronic, radio, computer, mechanical, and multi-media technologies to create unique solutions to address needs in a variety of other industries and markets, including mass transit, school bus, taxi cab and the military. The Company sells its products to law enforcement agencies and other security organizations, and consumer and commercial fleet operators through direct sales domestically and third-party distributors internationally.

 

The Company was originally incorporated in Nevada on December 13, 2000 as Vegas Petra, Inc. and had no operations until 2004. On November 30, 2004, Vegas Petra, Inc. entered into a Plan of Merger with Digital Ally, Inc., at which time the merged entity was renamed Digital Ally, Inc.

 

Accounting Changes:

 

Except for the changes discussed below, the Company has consistently applied the accounting policies to all periods presented in these unaudited consolidated financial statements.

 

Effective January 1, 2018 the Company adopted FASB ASC Topic 606, Revenue from Contracts with Customers, the Company changed certain characteristics of the revenue recognition accounting policy as described below. ASC 606 was applied using the modified retrospective approach, where the cumulative effect of the initial application is recognized as an adjustment to opening retained earnings at January 1, 2018. Therefore, comparative prior periods have not been adjusted and continue to be reported under FASB ASC Topic 605, Revenue Recognition, or ASC 605. The following table summarizes the impact of the adoption of ASC 606 on revenue, operating expenses and operating profit for the six months ended June 30, 2018 (in thousands):

 

   As Reported   Adjustments   Amounts without the
Adoption of ASC 606
 
Revenue   6,035        6,035 
Operating Expenses   6,138    10    6,128 
Operating Profit (Loss)   (3,411)   (10)   (3,401)

 

The impact of the adoption of ASC 606 on net (loss) for the Company was not material and the impact of the adoption of ASC 606 on the unaudited consolidated financial statements at June 30, 2018 and the unaudited consolidated statements of operations, equity (deficit) and cash flows for the six months ended June 30, 2018 was not material.

 

Upon adoption of ASC 606, the Company changed our accounting policy for the capitalization of costs to obtain contracts. Prior to the adoption of ASC 606, all commissions paid to the salesforce was recognized as commission expense including any commissions earned for future revenues. Under ASC 606, the Company is required to capitalize commissions paid to the salesforce for future revenues and recognize as commission expense as the respective revenues are earned. This change was the principal adjustment to the Company’s reported revenue and operating expenses included in the above table.

 

7
 

 

Management’s Liquidity Plan

 

The Company incurred substantial operating losses in the six months ended June 30, 2018 and for the year ended December 31, 2017 primarily due to reduced revenues and gross margins caused by specific product quality issues resulting in significant delays in customer orders and product rework expenditures and introduction by competitors of newer products with more features than those of the Company. In addition, the Company’s revenues and gross margins have been significantly and negatively impacted by its competitors’ willful infringement of the Company’s patents, specifically the auto-activation of body-worn and in-car video systems, and its competitors’ significant price cutting of their products. The Company incurred net losses of approximately $5.6 million during the six months ended June 30, 2018 and $12.3 million in the year ended December 31, 2017 and it had an accumulated deficit of $67.4 million as of June 30, 2018. In recent years the Company has accessed the public and private capital markets to raise funding through the issuance of debt and equity. In that regard, the Company raised funding in the form of subordinated and secured debt totaling $6,500,000 during the six months ended June 30, 2018 and subordinated and secured debt totaling $1,608,500 and the issuance of common stock and warrants totaling $2,776,332 during the year ended December 31, 2017. During 2016, the Company raised $4.0 million of funding in the form of convertible debentures and common stock purchase warrants. These debt and equity raises were utilized to fund its operations and management expects to continue this pattern until it achieves positive cash flows from operations, although it can offer no assurance in this regard.

 

The Company had outstanding $1,258,500 principal amount of subordinated and secured notes payable which were to mature prior to or on June 30, 2018. Additionally, the $3,250,000 million principal amount of 8% Secured Convertible Debentures (the “2016 Debentures”) issued in December 2016 matured on March 30, 2018. The notes and 2016 Debentures represent current liabilities and required the Company to negotiate extensions and/or raise substantial funds through the issuance of new debt and/or equity to liquidate such notes and Debentures. As part of the Company’s strategic alternatives process which commenced in November 2017, the Board of Directors approved a private placement (the “2018 Private Placement”) of $6.05 million principal amount of 8% Senior Secured Convertible Promissory Notes (the “Notes”) and warrants exercisable to purchase 916,667 shares of common stock of the Company. This 2018 Private Placement closed on April 3, 2018 and is described in Footnote 6. A portion of the proceeds were used to repay in full the 2016 Debentures and approximately $1,008,500 principal amount and accrued interest on the subordinated and secured notes that were due to mature. The Company negotiated an extension of the maturity date of the remaining $250,000 subordinated note that became due on June 7, 2018 to September 30, 2018. The balance of the net proceeds will be used for working capital and general corporate purposes. The Company believes that this financing has addressed its near-term liquidity needs.

 

The Company is also negotiating with Web.com golf tournament officials to terminate its sponsorship fee commitment of $500,000 annually for 2018 and 2019 tournaments. There can be no assurance that it will be successful in negotiating the termination of this sponsorship agreement or that if successful, the termination will be on terms acceptable or favorable to the Company.

 

The Company will have to restore positive operating cash flows and profitability over the next twelve months and/or raise additional capital to fund its operational plans, meet its customary payment obligations and otherwise execute its business plan. There can be no assurance that it will be successful in restoring positive cash flows and profitability, or that it can raise additional financing when needed, and obtain it on terms acceptable or favorable to the Company.

 

The Company has implemented an enhanced quality control program to detect and correct product issues before they result in significant rework expenditures affecting the Company’s gross margins and has seen progress in that regard. In addition, the Company has undertaken a number of cost reduction initiatives, including a reduction of its workforce by approximately 40%, restructuring its direct sales force and cutting other selling, general and administrative costs. In 2017 the Company introduced a new full high definition in-car video system (DVM-800 HD), which is intended to help it regain market share and improve revenues in its law enforcement division. The Company has increased its addressable market to non-law enforcement customers and obtained new non-law enforcement contracts in 2017 and the first half of 2018, which contracts include recurring revenue during the period 2018 to 2020. The Company believes that its quality control, headcount reduction and cost cutting initiatives, introduction of the DVM-800 HD for law enforcement and expansion to non-law enforcement sales channels will restore positive operating cash flows and profitability during the next year, although it can offer no assurances in this regard.

 

8
 

 

In addition to the initiatives described above, the Board of Directors is conducting a review of a full range of strategic alternatives to best position the Company for the future including, but not limited to, monetizing its patent portfolio and related patent infringement litigation against Axon Enterprise, Inc. (“Axon” formerly Taser International, Inc.) and Enforcement Video, LLC d/b/a WatchGuard Video (“WatchGuard”), the sale of all or certain assets, properties or groups of properties or individual businesses or merger or combination with another company. The result of this review may also include the continued implementation of the Company’s business plan. The Company has retained Roth Capital Partners (“Roth”) to assist in this process. The funding completed on April 3, 2018 and discussed in Note 14, “Subsequent Events,” below was a part of this strategic alternatives review. While such funding addressed the Company’s near-term liquidity needs, it continues to consider strategic alternatives to address longer-term liquidity needs and operational issues. There can be no assurance that any additional transactions or financings will result from this process. 

 

Based on the uncertainties described above, the Company believes its business plan does not alleviate the existence of substantial doubt about its ability to continue as a going concern within one year from the date of the issuance of these consolidated condensed interim financial statements.

 

The following is a summary of the Company’s Significant Accounting Policies:

 

Basis of Consolidation:

 

The accompanying financial statements include the consolidated accounts of Digital Ally and its wholly-owned subsidiaries, Digital Ally International, Inc., MP Ally, LLC, Medical Devices Ally, LLC and Digitaldeck, LLC. All intercompany balances and transactions have been eliminated during consolidation.

 

The Company formed Digital Ally International, Inc. during August 2009 to facilitate the export sales of its products. In addition, it formed Medical Devices Ally, LLC in July 2014, MP Ally, LLC in July 2015, and Digitaldeck, LLC in June 2017, all of which have been inactive since formation.

 

Fair Value of Financial Instruments:

 

The carrying amounts of financial instruments, including cash and cash equivalents, accounts receivable, accounts payable and subordinated notes payable approximate fair value because of the short-term nature of these items. The Company accounts for its derivative liabilities and its secured convertible debentures on a fair value basis.

 

Revenue Recognition:

 

The Company applies the provisions of Accounting Standards Codification (ASC) 606-10, Revenue from Contracts with Customers, and all related appropriate guidance. The Company recognizes revenue under the core principle to depict the transfer of control to the Company’s customers in an amount reflecting the consideration the Company expects to be entitled. In order to achieve that core principle, the Company applies the following five-step approach: (1) identify the contract with a customer, (2) identify the performance obligations in the contract, (3) determine the transaction price, (4) allocate the transaction price to the performance obligations in the contract, and (5) recognize revenue when a performance obligation is satisfied.

 

The Company considers customer purchase orders, which in some cases are governed by master sales agreements, to be the contracts with the customer. In situation where sales are to a distributor, the Company had concluded its contracts are with the distributor as the Company holds a contract bearing enforceable rights and obligations only with the distributor. As part of part of its consideration for the contract, the Company evaluates certain factors including the customers’ ability to pay (or credit risk). For each contract, the Company considers the promise to transfer products, each of which is distinct, to be the identified performance obligations. In determining the transaction price, the Company evaluates whether the price is subject to refund or adjustment to determine the net consideration to which the Company expects to be entitled. As the Company’s standard payment terms are less than one year, the Company has elected the practical expedient under ASC 606-10-32-18 to not assess whether a contract has a significant financing component. The Company allocates the transaction price to each distinct product based on their relative standalone selling price. The product price as specified on the purchase order is considered the standalone selling price as it is an observable input which depicts the price as if sold to a similar customer in similar circumstances. Revenue is recognized when control of the product is transferred to the customer (i.e. when the Company’s performance obligations is satisfied), which typically occurs at shipment. Further in determining whether control has been transferred, the Company considers if there is a present right to payment and legal title, along with risks and rewards of ownership having transferred to the customer. Customers do not have a right to return the product other than for warranty reasons for which they would only receive repair services or replacement product. The Company has also elected the practical expedient under ASC 340-40-25-4 to expense commissions when incurred as the amortization period of the commission asset the Company would have otherwise recognized is less than one year.

 

9
 

 

The Company sells its products and services to law enforcement and commercial customers in the following manner:

 

    Sales to domestic customers are made direct to the end customer (typically a law enforcement agency or a commercial customer) through its sales force, which is composed of its employees. Revenue is recorded when the product is shipped to the end customer.
     
  Sales to international customers are made through independent distributors who purchase products from the Company at a wholesale price and sell to the end user (typically law enforcement agencies or a commercial customer) at a retail price. The distributor retains the margin as its compensation for its role in the transaction. The distributor generally maintains product inventory, customer receivables and all related risks and rewards of ownership. Accordingly, upon application of steps one through five above, revenue is recorded when the product is shipped to the distributor consistent with the terms of the distribution agreement.
     
  Repair parts and services for domestic and international customers are generally handled by its inside customer service employees. Revenue is recognized upon shipment of the repair parts and acceptance of the service or materials by the end customer.

 

Sales taxes collected on products sold are excluded from revenues and are reported as an accrued expense in the accompanying balance sheets until payments are remitted.

 

Service and other revenue is comprised of revenues from extended warranties, repair services, cloud revenue and software revenue. Revenue is recognized upon shipment of the product and acceptance of the service or materials by the end customer for repair services. Revenue for extended warranty, cloud service or other software-based products is over the term of the contract warranty or service period. A time-elapsed method is used to measure progress because the Company transfers control evenly over the contractual period. Accordingly, the fixed consideration related to these revenues is generally recognized on a straight-line basis over the contract term, as long as the other revenue recognition criteria have been met.

 

Contracts with some of the Company’s customers contain multiple performance obligations that are distinct and accounted for separately. The transaction price is allocated to the separate performance obligations on a relative standalone selling price (“SSP”). The Company determined SSP for all the performance obligations using observable inputs, such as standalone sales and historical pricing. SSP is consistent with the Company’s overall pricing objectives, taking into consideration the type of service being provided. SSP also reflects the amount the Company would charge for the performance obligation if it were sold separately in a standalone sale. Multiple performance obligations consist of product, software, cloud subscriptions and extended warranties.

 

The Company’s multiple performance obligations may include future in-car or body-worn camera devices to be delivered at defined points within a multi-year contract, and in those arrangements, the Company allocates total arrangement consideration over the life of the multi-year contract to future deliverables using management’s best estimate of selling price.

 

Contract liabilities consist of deferred revenue and include payments received in advance of performance under the contract. Such amounts are generally recognized as revenue over the contractual period.

 

Sales returns and allowances aggregated $34,227 and $13,736 for the three months ended June 30, 2018 and 2017, respectively, and $54,246 and $(27,585) for the six months ended June 30, 2018 and 2017, respectively. Obligations for estimated sales returns and allowances are recognized at the time of sales on an accrual basis. The accrual is determined based upon historical return rates adjusted for known changes in key variables affecting these return rates. A customer paid under a sales transaction in March 2017 that had been accrued to be returned at December 31, 2016, which then caused the negative sales returns for the six months ended June 30, 2017.

 

10
 

 

Revenues for six month ended June 30, 2018 and 2017 were derived from the following sources

 

   Six months ended June 30, 
   2018   2017 
DVM-800  $2,860,907   $4,181,151 
DVM-250 Plus   366,351    1,022,160 
FirstVu HD   642,665    1,014,465 
DVM-100 & DVM-400   64,401    145,964 
DVM-750   213,935    163,840 
VuLink   133,001    170,542 
Repair and service   627,874    279,513 
Cloud service revenue   326,741    141,946 
Other service revenue   95,635    552,733 
Laser Ally   22,530    20,938 
Accessories and other revenues   681,023    1,023,110 
   $6,035,063   $8,716,362 

 

Use of Estimates:

 

The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of revenues and expenses during the reporting period. Actual results could differ from those estimates.

 

Cash and cash equivalents:

 

Cash and cash equivalents include funds on hand, in bank and short-term investments with original maturities of ninety (90) days or less.

 

Cash and cash equivalents that are restricted as to withdrawal or use under the terms of the secured convertible debentures are presented as restricted cash separate from cash and cash equivalents on the accompanying balance sheet.

 

Accounts Receivable:

 

Accounts receivable are carried at original invoice amount less an estimate made for doubtful receivables based on a review of all outstanding amounts on a weekly basis. The Company determines the allowance for doubtful accounts by regularly evaluating individual customer receivables and considering a customer’s financial condition, credit history, and current economic conditions. Trade receivables are written off when deemed uncollectible. Recoveries of trade receivables previously written off are recorded when received.

 

A trade receivable is considered to be past due if any portion of the receivable balance is outstanding for more than thirty (30) days beyond terms. No interest is charged on overdue trade receivables.

 

Inventories:

 

Inventories consist of electronic parts, circuitry boards, camera parts and ancillary parts (collectively, “components”), work-in-process and finished goods, and are carried at the lower of cost (First-in, First-out Method) or market value. The Company determines the estimate for the reserve for slow moving or obsolete inventories by regularly evaluating individual inventory levels, projected sales and current economic conditions.

 

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Furniture, fixtures and equipment:

 

Furniture, fixtures and equipment is stated at cost net of accumulated depreciation. Additions and improvements are capitalized while ordinary maintenance and repair expenditures are charged to expense as incurred. Depreciation is recorded by the straight-line method over the estimated useful life of the asset, which ranges from three to ten years. Amortization expense on capitalized leases is included with depreciation expense.

 

Intangible assets:

 

Intangible assets include deferred patent costs and license agreements. Legal expenses incurred in preparation of patent application have been deferred and will be amortized over the useful life of granted patents. Costs incurred in preparation of applications that are not granted will be charged to expense at that time. The Company has entered into several sublicense agreements under which it has been assigned the exclusive rights to certain licensed materials used in its products. These sublicense agreements generally require upfront payments to obtain the exclusive rights to such material. The Company capitalizes the upfront payments as intangible assets and amortizes such costs over their estimated useful life on a straight-line method.

 

Secured convertible debentures:

 

The Company has elected to record its Debentures at their fair value. Accordingly, the Debentures will be marked-to-market at each reporting date with the change in fair value reported as a gain (loss) in the Condensed Consolidated Statement of Operations. All issuance costs related to the Debentures were expensed as incurred in the statement of operations.

 

Long-Lived Assets:

 

Long-lived assets such as property, plant and equipment and purchased intangible assets subject to amortization are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. If circumstances require a long-lived asset or asset group be tested for possible impairment, the Company first compares undiscounted cash flows expected to be generated by that asset or asset group to its carrying value. If the carrying value of the long-lived asset or asset group is not recoverable on an undiscounted cash flow basis, an impairment is recognized to the extent that the carrying value exceeds its fair value. Fair value is determined through various valuation techniques, including discounted cash flow models, quoted market values and third-party appraisals, as considered necessary.

 

Warranties:

 

The Company’s products carry explicit product warranties that extend up to two years from the date of shipment. The Company records a provision for estimated warranty costs based upon historical warranty loss experience and periodically adjusts these provisions to reflect actual experience. Accrued warranty costs are included in accrued expenses. Extended warranties are offered on selected products and when a customer purchases an extended warranty the associated proceeds are treated as deferred revenue and recognized over the term of the extended warranty.

 

Shipping and Handling Costs:

 

Shipping and handling costs for outbound sales orders totaled $20,317 and $19,661 for the three months ended June 30, 2018 and 2017, respectively, and $34,284 and $40,091 for the six months ended June 30, 2018 and 2017, respectively. Such costs are included in selling, general and administrative expenses in the Condensed Consolidated Statements of Operations.

 

Advertising Costs:

 

Advertising expense includes costs related to trade shows and conventions, promotional material and supplies, and media costs. Advertising costs are expensed in the period in which they are incurred. The Company incurred total advertising expense of approximately $111,677 and $143,053 for the three months ended June 30, 2018 and 2017, respectively, and $191,246 and $270,329 for the six months ended June 30, 2018 and 2017, respectively. Such costs are included in selling, general and administrative expenses in the Condensed Consolidated Statements of Operations.

 

12
 

 

Income Taxes:

 

Deferred taxes are provided for by the liability method in which deferred tax assets are recognized for deductible temporary differences and operating loss and tax credit carryforwards and deferred tax liabilities are recognized for taxable temporary differences. Temporary differences are the differences between the reported amounts of assets and liabilities and their tax basis. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all the deferred tax assets will not be realized. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment.

 

The Company applies the provisions of the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) No. 740 - Income Taxes that provides a framework for accounting for uncertainty in income taxes and provided a comprehensive model to recognize, measure, present, and disclose in its financial statements uncertain tax positions taken or expected to be taken on a tax return. It initially recognizes tax positions in the financial statements when it is more likely than not the position will be sustained upon examination by the tax authorities. Such tax positions are initially and subsequently measured as the largest amount of tax benefit that is greater than 50% likely of being realized upon ultimate settlement with the tax authority assuming full knowledge of the position and all relevant facts. Application requires numerous estimates based on available information. The Company considers many factors when evaluating and estimating its tax positions and tax benefits, and it recognized tax positions and tax benefits may not accurately anticipate actual outcomes. As it obtains additional information, the Company may need to periodically adjust its recognized tax positions and tax benefits. These periodic adjustments may have a material impact on its Consolidated Statements of Operations.

 

The Company’s policy is to record estimated interest and penalties related to the underpayment of income taxes as income tax expense in the consolidated statements of operations. There was no interest expense related to the underpayment of estimated taxes during the six months ended June 30, 2018 and 2017. There have been no penalties in the six months ended June 30, 2018 and 2017.

 

The Company is subject to taxation in the United States and various states. As of June 30, 2018, the Company’s tax returns filed for 2014, 2015, and 2016 and to be filed for 2017 are subject to examination by the relevant taxing authorities. With few exceptions, as of June 30, 2018, the Company is no longer subject to Federal, state, or local examinations by tax authorities for years before 2014.

 

Research and Development Expenses:

 

The Company expenses all research and development costs as incurred. Development costs of computer software to be sold, leased, or otherwise marketed are subject to capitalization beginning when a product’s technological feasibility has been established and ending when a product is available for general release to customers. In most instances, the Company’s products are released soon after technological feasibility has been established. Costs incurred subsequent to achievement of technological feasibility were not significant, and software development costs were expensed as incurred during the six months ended June 30, 2018 and 2017.

 

Common Stock Purchase Warrants:

 

The Company has common stock purchase warrants that are accounted for as liabilities under the caption of derivative liabilities on the condensed consolidated balance sheet and recorded at fair value due to the warrant agreements containing anti-dilution provisions. The change in fair value is being recorded in the condensed consolidated statement of operations.

 

The Company has common stock purchase warrants that are accounted for as equity based on their relative fair value and are not subject to re-measurement.

 

Stock-Based Compensation:

 

The Company grants stock-based compensation to its employees, board of directors and certain third-party contractors. Share-based compensation arrangements may include the issuance of options to purchase common stock in the future or the issuance of restricted stock, which generally are subject to vesting requirements. The Company records stock-based compensation expense for all stock-based compensation granted based on the grant-date fair value. The Company recognizes these compensation costs on a straight-line basis over the requisite service period of the award.

 

13
 

 

The Company estimates the grant-date fair value of stock-based compensation using the Black-Scholes valuation model. Assumptions used to estimate compensation expense are determined as follows:

 

  ●  Expected term is determined using the contractual term and vesting period of the award;
     
  Expected volatility of award grants made in the Company’s plan is measured using the weighted average of historical daily changes in the market price of the Company’s common stock over the period equal to the expected term of the award;
     
    Expected dividend rate is determined based on expected dividends to be declared;
     
    Risk-free interest rate is equivalent to the implied yield on zero-coupon U.S. Treasury bonds with a maturity equal to the expected term of the awards; and
     
    Forfeitures are accounted for as they occur.

 

Segments of Business:

 

Management has determined that its operations are comprised of one reportable segment: the sale of digital audio and video recording and speed detection devices. For the three and six months ended June 30, 2018 and 2017, sales by geographic area were as follows:

 

   Three Months Ended June 30,   Six Months Ended June 30, 
   2018   2017   2018   2017 
Sales by geographic area:                    
United States of America  $3,386,146   $3,426,461   $5,824,934   $8,626,515 
Foreign   177,404    60,041    210,129    89,847 
                     
   $3,563,550   $3,486,502   $6,035,063   $8,716,362 

 

Sales to customers outside of the United States are denominated in U.S. dollars. All Company assets are physically located within the United States.

 

Adoption of New Accounting Pronouncement:

 

In February 2016, the FASB issued ASU 2016-2, Leases (Topic 842), in order to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet for those leases classified as operating leases under existing GAAP guidance. ASU 2016-02 requires a lessee to recognize a liability to make lease payments (the lease liability) and a right-of-use asset representing its right to use the underlying asset for the lease term on the balance sheet. ASU 2016-02 is effective for the fiscal year beginning after December 15, 2018 (including interim periods within that year) using a modified retrospective approach and early adoption is permitted. The Company is currently in the process of evaluating the impact of adoption of this ASU on its consolidated financial statements, but expects that the adoption of ASU 2016-02 will not have a material impact on the Company’s consolidated balance sheet.

 

In August 2016, the FASB issued ASU 2016-15, Clarification on Classification of Certain Cash Receipts and Cash Payments on the Statement of Cash Flows, to create consistency in the classification of eight specific cash flow items. This standard is effective for calendar-year SEC registrants beginning in 2018. The adoption of this guidance had no effect on our consolidated condensed financial statements.

 

In November 2016, the FASB issued ASU 2016-18, Statement of Cash Flows - Restricted Cash (Topic 230), which amends the existing guidance relating to the disclosure of restricted cash and restricted cash equivalents on the statement of cash flows. ASU 2016-18 is effective for the fiscal year beginning after December 15, 2017, and interim periods within that fiscal year, and early adoption is permitted. The adoption of ASU 2016-18 had no effect on our Consolidated Condensed Statements of Cash Flows.

 

In May 2017, the FASB issued ASU 2017-09, Stock Compensation (Topic 718)-Scope of Modification Accounting, to provide guidance on determining which changes to terms and conditions of share-based payment awards require an entity to apply modification accounting under Topic 718. The ASU is effective for annual periods beginning after December 15, 2017, and interim periods within those annual periods. The adoption of this guidance had no effect on our consolidated condensed financial statements.

 

14
 

 

NOTE 2. BASIS OF PRESENTATION

 

The condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles in the United States for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all the information and footnotes required by generally accepted accounting principles in the United States for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the six-month period ended June 30, 2018 are not necessarily indicative of the results that may be expected for the year ending December 31, 2018.

 

The balance sheet at December 31, 2017 has been derived from the audited financial statements at that date, but does not include all the information and footnotes required by generally accepted accounting principles in the United States for complete financial statements.

 

For further information, refer to the financial statements and footnotes included in the Company’s annual report on Form 10-K for the year ended December 31, 2017.

 

NOTE 3. CONCENTRATION OF CREDIT RISK AND MAJOR CUSTOMERS

 

Financial instruments that potentially subject the Company to concentrations of credit risk consist of accounts receivable. Sales to domestic customers are typically made on credit and the Company generally does not require collateral while sales to international customers require payment before shipment or backing by an irrevocable letter or credit. The Company performs ongoing credit evaluations of its customers’ financial condition and maintains an allowance for estimated losses. Accounts are written off when deemed uncollectible and accounts receivable are presented net of an allowance for doubtful accounts. The allowance for doubtful accounts totaled $70,000 as of June 30, 2018 and December 31, 2017.

 

The Company uses primarily a network of unaffiliated distributors for international sales and employee-based direct sales force for domestic sales. No international distributor individually exceeded 10% of total revenues for the six months ended June 30, 2018 and 2017. No individual customer receivable balance exceeded 10% of total accounts receivable as of June 30, 2018. One individual customer receivable balance exceeded 10% of total accounts receivable at June 30, 2017, and totaled $289,499.

 

The Company purchases finished circuit boards and other proprietary component parts from suppliers located in the United States and on a limited basis from Asia. Although the Company obtains certain of these components from single source suppliers, it generally owns all tooling and management has located alternative suppliers to reduce the risk in most cases to supplier problems that could result in significant production delays. The Company has not historically experienced significant supply disruptions from any of its principal vendors and does not anticipate future supply disruptions. The Company acquires most of its components on a purchase order basis and does not have long-term contracts with its suppliers.

 

NOTE 4. INVENTORIES

 

Inventories consisted of the following at June 30, 2018 and December 31, 2017:

 

   June 30, 2018   December 31, 2017 
Raw material and component parts  $4,377,264   $4,621,704 
Work-in-process   287,311    155,087 
Finished goods   5,733,395    6,964,624 
           
Subtotal   10,397,970    11,741,415 
Reserve for excess and obsolete inventory   (2,553,164)   (2,990,702)
           
Total  $7,844,806   $8,750,713 

 

Finished goods inventory includes units held by potential customers and sales agents for test and evaluation purposes. The cost of such units totaled $369,715 and $680,805 as of June 30, 2018 and December 31, 2017, respectively.

 

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NOTE 5. FURNITURE, FIXTURES AND EQUIPMENT

 

Furniture, fixtures and equipment consisted of the following at June 30, 2018 and December 31, 2017:

 

     Estimated
Useful Life
  June 30, 2018   December 31, 2017 
Office furniture, fixtures and equipment    3-10 years  $882,676   $881,306 
Warehouse and production equipment    3-5 years   519,167    515,368 
Demonstration and tradeshow equipment    2-5 years   426,582    426,582 
Leasehold improvements    2-5 years   160,198    160,198 
Rental equipment    1-3 years   117,269    93,592 
                
Total cost        2,105,892    2,077,046 
Less: accumulated depreciation and amortization        (1,656,679)   (1,438,877)
                
Net furniture, fixtures and equipment       $449,213   $638,169 

 

Depreciation and amortization of furniture, fixtures and equipment aggregated $217,802 and $261,938 for the six months ended June 30, 2018 and 2017, respectively.

 

NOTE 6. DEBT AND CAPITAL LEASE OBLIGATIONS

 

Secured convertible debentures is comprised of the following:

 

   June 30, 2018   December 31, 2017 
2016 Secured convertible debentures, at fair value  $   $3,262,807 
2018 Secured convertible debentures, at fair value   5,354,803     
           
Secured convertible debentures, at fair value  $5,354,803   $3,262,807 

 

2016 Secured Convertible Debentures.

 

On December 30, 2016, the Company completed a private placement (the “2016 Private Placement”) of $4.0 million in principal amount of the secured convertible debentures (the “2016 Debentures”) and common stock warrants (the “2016 Warrants”) to two institutional investors. The 2016 Debentures and 2016 Warrants were issued pursuant to a Securities Purchase Agreement between the Company and the purchasers’ signatory thereto. The 2016 Private Placement resulted in gross proceeds of $4.0 million before placement agent fees and other expenses associated with the transaction totaling $281,570, which was expensed as incurred.

 

The Company elected to account for the 2016 Debentures on the fair value basis. Therefore, the Company determined the fair value of the 2016 Debentures utilizing Monte Carlo simulation models which yielded an estimated fair value of $4.0 million for the Debentures including their embedded derivatives as of the origination date. No value was allocated to the detachable 2016 Warrants as of the origination date because of the relative fair value of the convertible debentures including their embedded derivative features approximated the gross proceeds of the financing transaction. The Company made principal payments of $750,000 on August 24, 2017 on the 2016 Debentures.

 

The Company paid the remaining balances of the 2016 Debentures on April 3, 2018 from proceeds of the 2018 secured convertible debentures described below. The Company recorded debt extinguishment costs of $500,000 during the six months ended June 30, 2018 related to the repayment and extinguishment of these 2016 Debentures.

 

The change in fair value of the 2016 Debentures was $0 and $(12,807) for the three and six months ended June 30, 2018 and 2017, respectively.

 

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2018 Secured Convertible Debentures.

 

On April 3, 2018, and May 11, 2018, the Company completed a private placement (the “2018 Private Placement”) of $6.875 million in principal amount of senior secured convertible promissory notes (the “2018 Debentures”) and warrants to purchase 916,667 shares of common stock of the Company (the “2018 Warrants”) to institutional investors. The 2018 Debentures and 2018 Warrants were issued pursuant to a securities purchase agreement between the Company and the purchasers’ signatory thereto. Additionally, a portion of the 2018 Debentures and 2018 Warrants were issued to two institutional investors pursuant to their respective participation rights under a securities purchase agreement, dated August 21, 2017. One of the institutional investors that participated pursuant to the 2017 common stock issuance closed its tranche with the Company on May 11, 2018. The 2018 Private Placement resulted in gross cash proceeds of $6.25 million ($6.875 million par value) before placement agent fees and other expenses associated with the transaction. The proceeds were used primarily for full repayment of the 2016 Debentures described above, other outstanding subordinated debt of the Company, working capital, and general corporate purposes.

 

The Company elected to account for the 2018 Debentures on the fair value basis. Therefore, the Company determined the fair value of the 2018 Debentures and 2018 Warrants which yielded estimated fair values of the 2018 Debentures including their embedded derivatives and the detachable 2018 Warrants as follows:

 

Secured convertible debentures  $4,565,749 
Common stock purchase warrants   1,684,251 
      
Gross cash proceeds  $6,250,000 

 

The following represents activity in the 2018 Debentures during the six months ended June 30, 2018:

 

Beginning balance as of January 1, 2018  $- 
Origination date at fair value of the Debentures   4,565,749 
Conversions exercised during the period   (175,000)
Interest accrued and added to principal balance   121,271 
Change in the fair value during the period   842,783 
Ending balance as of June 30, 2018  $5,354,803 

 

Prior to the maturity date, the 2018 Debentures bear interest at 8% per annum, which twelve (12) months’ interest amounts are guaranteed; provided, however, that if a cash prepayment or amortization is made respecting the 2018 Debentures, then the Company will only be required to pay an amount equal to the annualized additional interest due on their then outstanding principal balance. Interest can be paid at the Company’s discretion in cash, or subject to the equity conditions contained in the 2018 Debentures, in shares of the Company’s common stock. The 2018 Debentures rank senior to the Company’s existing and future indebtedness and are secured to the extent and as provided in the security agreement.

 

The 2018 Debentures are convertible at any time after their date of issue at the option of the holders into shares of common stock at a conversion price of $2.50 per share. The 2018 Debentures mature on May 3, 2019. Commencing on July 1, 2018, and continuing for each fiscal month thereafter through the maturity date, the Company will make payments of principal and interest to the holders in order to fully amortize the 2018 Debentures. The conversion price is subject to adjustment upon stock splits, reverse stock splits, and similar capital changes.

 

At any time after issuance of the 2018 Debentures, so long as there is no event of default under the 2018 Debentures, the Company may deliver to the holders a notice of prepayment with respect to any portion of the principal amount of the 2018 Debentures, any accrued and unpaid (including, without limitation, guaranteed interest on any outstanding principal), and any other amounts due under the 2018 Debentures. If the Company exercises its right to prepay the 2018 Debentures, it will pay the holders an amount in cash equal to the sum of the then outstanding principal amount of the 2018 Debentures and guaranteed interest as follows: (i) from the initial issuance date of the Debentures to August 1, 2018, a 0% premium; (ii) from August 2, 2018 to December 1, 2018, a 10% premium; and (iii) from December 2, 2018 to the Maturity Date, a 15% premium.

 

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At any time after issuance of the 2018 Debentures, if the Company (i) consummates any public or private offering or other financing or capital-raising transaction of any kind (each a “Subsequent Offering”), in which the Company receives, in one or more contemporaneous transactions, gross proceeds of $10,000,000, (ii) receives cash, in the aggregate, of at least $10,000,000 from any action (as defined in the 2018 Purchase Agreement), at any time upon ten (10) days written notice to the holders, but subject to the holders’ conversion rights set forth in the 2018 Debentures, the Company must make a mandatory redemption in full of the 2018 Debentures to the holders. The required redemption of the 2018 Debentures would be at an amount equal to the outstanding principal amount of the 2018 Debentures, any accrued and unpaid interest (including, without limitation, guaranteed interest), and any other amounts due under the 2018 Debentures at the same premium described above with respect to prepayments.

 

The 2018 Debentures also provide for mandatory conversion by the holders if at any time (x) the volume weighted average price (VWAP- as defined in the 2018 Debentures) of the common stock listed on the NASDAQ exceeds $4.50 for twenty (20) consecutive trading days, and (y) no failure of the equity conditions (as defined in the 2018 Debentures) then exists, the Company shall have the right to require the holders to convert all, or any part, of the then outstanding principal and accrued interest amount into fully paid, validly issued and nonassessable shares of common stock in accordance with 2018 Debentures at the conversion price.

 

So long as the 2018 Debentures are outstanding, the Company is prohibited from entering into any variable rate transactions (as defined in the 2018 Debentures).

 

Upon the occurrence of an event of default under the 2018 Debentures, the Company must repay to the holders, in cash or in shares of common stock at the greater of (i) a 135% premium of the outstanding principal amount of the 2018 Debentures and accrued and unpaid interest hereon, in addition to the payment of all other amounts, costs, expenses and liquidated damages due in respect of the 2018 Debentures; and (ii) the outstanding principal amount of the 2018 Debentures and accrued and unpaid interest hereon, in addition to the payment of all other amounts, costs, expenses and liquidated damages due in respect of the 2018 Debentures, divided by the conversion price, multiplied by (b) the highest closing price for the common stock on the NASDAQ during the period beginning on the date of first occurrence of the event of fault and ending one (1) day prior to the mandatory prepayment date in the prepayment section of the 2018 Debentures.

 

The 2018 Warrants issued in conjunction with the 2018 Debentures are exercisable to purchase up to an aggregate of 916,667 shares of common stock commencing on the date of issuance at an exercise price of $3.00 per share. The 2018 Warrants will expire on the fifth (5th) anniversary of their date of issuance. The exercise price is subject to adjustment upon stock splits, reverse stock splits, and similar capital changes. The holders have no right to convert the 2018 Debentures or exercise the 2018 Warrant to the extent that such conversion or exercise would result in the holder being the beneficial owner in excess of 4.99% (or, upon election of purchaser, 9.99%), which beneficial ownership limitation may be increased or decreased up to 9.99% upon notice to the Company, provided that any increase in such limitation will not be effective until 61 days following notice to the Company.

 

Subordinated and Secured Notes Payable. Subordinated and secured notes payable is comprised of the following:

 

   June 30, 2018   December 31, 2017 
Subordinated and secured notes payable, at par  $250,000   $1,008,500 

 

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On June 30, 2017, the Company, in two separate transactions, borrowed an aggregate of $700,000 under two unsecured notes payable to private, third-party lenders. The loans were funded on June 30, 2017 and both were represented by promissory notes (the “June Notes”) that bore interest at the rate of 8% per annum with principal and accrued interest payable on or before their maturity date of September 30, 2017. The June Notes were unsecured and subordinated to all existing and future senior indebtedness, as such term was defined in the June Notes. The Company granted the lenders warrants (the “Warrants”) exercisable to purchase a total of 200,000 shares of its common stock at an exercise price of $3.65 per share until June 29, 2022. The Company allocated $288,895 of the proceeds of the Notes to additional paid-in-capital, which represented the grant date relative fair value of the Warrants issued to the lenders. The discount was amortized to interest expense ratably over the terms of the Note. On September 30, 2017, the Company obtained an extension of the maturity date of one of the June Notes to December 31, 2017 and then an extension to March 31, 2018. In connection with the initial extension, the Company issued warrants to purchase 100,000 shares of stock at $2.60 per share until November 15, 2022. On March 16, 2018, the Company issued warrants to purchase 60,000 shares of stock at $3.25 per share until March 15, 2029 for the subsequent extension. The Company treated the initial extension of this debt as an extinguishment for financial accounting purposes. Accordingly, the estimated fair value of the warrants granted totaled $180,148, which was recorded as additional paid-in-capital and a loss on extinguishment of subordinated notes payable. The Company allocated $32,370 of the proceeds of the Notes to additional paid-in-capital, which represented the grant date relative fair value of the Warrants for the subsequent extension. The discount was amortized to interest expense ratably over the terms of the Note. The Company paid the second June Note in full in August 2017.

 

On September 29, 2017, the Company borrowed $300,000 under an unsecured note payable with a private, third party lender. Such note bore interest at 8% per annum and was due and payable in full on November 30, 2017. The note was unsecured and subordinated to all existing and future senior indebtedness, as such term was defined in the note. The Company issued warrants to the lender exercisable to purchase 100,000 shares of common stock for $2.75 per share until September 30, 2022. The Company allocated $117,000 of the proceeds of the note to additional paid-in-capital, which represented the grant date relative fair value of the warrants issued to the lender. The discount was amortized to interest expense ratably over the terms of the note. On December 29, 2017 the Company borrowed an additional $350,000 with the same private, third party lender and combined the existing note payable plus accrued interest into a new note (the “Secured Note”) for $658,500 that was due and payable in full on March 1, 2018 and may be prepaid without penalty. The Secured Note is secured by the Company’s intellectual property portfolio, as such term is defined in the security agreement relating to the Secured Note. In connection with issuance of the Secured Note the Company issued warrants to the lender exercisable to purchase 120,000 shares of common stock for $3.25 per share until December 28, 2022. The Company treated the issuance and extension of this debt as an extinguishment for financial accounting purposes. Accordingly, the estimated fair value of the warrants granted totaled $244,379, which was recorded as additional paid-in-capital and a loss on extinguishment of subordinated notes payable.

 

The Company paid the remaining balances of the Secured Note and subordinated note with an aggregate principal balance of $1,008,500 on April 3, 2018. The maturity date of the remaining subordinated note with an outstanding principal balance of $250,000 was extended to September 30, 2018, as described below.

 

On March 7, 2018 the Company borrowed $250,000 under a secured note payable with a private, third party lender (the “March Note”). The March Note bears interest at 12% per annum and contained an original maturity date of June 7, 2018. The Company negotiated an extension of the maturity date to September 30, 2018. The March Note is secured by the inventory of the Company and junior to senior liens held by the holders of the 2018 Debentures and subordinated to all existing and future senior indebtedness, as such term was defined in the March Note. Such Note is convertible at any time after its date of issue at the option of the holder into shares of the Company’s common stock at a conversion price of $3.25 per share. The conversion price and exercise price are subject to adjustment upon stock splits, reverse stock splits, and similar capital changes. The Company issued warrants to the lender exercisable to purchase 36,000 shares of common stock for $3.50 per share until March 7, 2019. The Company allocated $15,287 of the proceeds of the note to additional paid-in-capital, which represented the grant date relative fair value of the warrants issued to the lender. The discount was amortized to interest expense ratably over the terms of the note.

 

The discount amortized to interest expense totaled $47,657 and $-0- for the six months ended June 30, 2018, and 2017, respectively.

 

NOTE 7. FAIR VALUE MEASUREMENT

 

In accordance with ASC Topic 820 — Fair Value Measurements and Disclosures (“ASC 820”), the Company utilizes the market approach to measure fair value for its financial assets and liabilities. The market approach uses prices and other relevant information generated by market transactions involving identical or comparable assets, liabilities or a group of assets or liabilities, such as a business.

 

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ASC 820 utilizes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value into three broad levels. The following is a brief description of those three levels:

 

Level 1 — Quoted prices in active markets for identical assets and liabilities
   
Level 2 — Other significant observable inputs (including quoted prices in active markets for similar assets or liabilities)
   
Level 3 — Significant unobservable inputs (including the Company’s own assumptions in determining the fair value)

 

The following table represents the Company’s hierarchy for its financial assets and liabilities measured at fair value on a recurring basis as of June 30, 2018 and December 31, 2017.

 

   June 30, 2018 
   Level 1   Level 2   Level 3   Total 
Liabilities:                    
Secured convertible debentures  $   $   $5,354,803   $5,354,803 
Warrant derivative liability  $   $   $287,522   $287,522 
   $   $   $5,642,325   $5,642,325 

 

   December 31, 2017 
   Level 1   Level 2   Level 3   Total 
Liabilities:                    
Secured convertible debentures  $   $   $3,262,807   $3,262,807 
Warrant derivative liability  $   $   $16,816   $16,816 
   $   $   $3,279,623   $3,279,623 

 

The following table represents the change in Level 3 tier value measurements:

 

       2016   2018     
   Warrant   Secured   Secured     
   derivative   Convertible   Convertible     
   liability   Debentures   Debentures   Total 
                 
Balance, December 31, 2017  $16,816   $3,262,807   $   $3,279,623 
                     
Principal payments made on debentures       (3,250,000)       (3,250,000)
                     
New secured convertible debentures           4,565,749    4,565,749 
                     
Conversion of secured convertible debentures           (175,000)   (175,000)
                     
Interest           121,271    121,271 
                     
Common stock purchase warrants exercised   (38,600)           (38,600)
                     
Change in fair value of secured convertible debentures       (12,807)   842,783    829,976 
                     
Change in fair value of warrant derivative   309,306            309,306 
Balance, June 30, 2018  $287,522   $   $5,354,803   $5,642,325 

 

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NOTE 8. ACCRUED EXPENSES

 

Accrued expenses consisted of the following at June 30, 2018 and December 31, 2017:

 

   June 30, 2018   December 31, 2017 
Accrued warranty expense  $235,908   $325,001 
Accrued sales commissions   32,638    19,500 
Accrued payroll and related fringes   198,903    242,508 
Accrued insurance   33,926    53,888 
Accrued rent   108,429    134,684 
Accrued sales returns and allowances   35,500    17,936 
Other   452,008    446,912 
           
   $1,097,312   $1,240,429 

 

Accrued warranty expense was comprised of the following for the six months ended June 30, 2018:

 

   2018 
Beginning balance  $325,001 
Provision for warranty expense   92,509 
Charges applied to warranty reserve   (181,602)
      
Ending balance  $235,908 

 

NOTE 9. INCOME TAXES

 

The effective tax rate for the six months ended June 30, 2018 and 2017 varied from the expected statutory rate due to the Company continuing to provide a 100% valuation allowance on net deferred tax assets. The Company determined that it was appropriate to continue the full valuation allowance on net deferred tax assets as of June 30, 2018 primarily because of the Company’s history of operating losses.

 

NOTE 10. COMMITMENTS AND CONTINGENCIES

 

Operating Leases. The Company has a non-cancelable long-term operating lease agreement for office and warehouse space that expires during April 2020. It has also entered into month-to-month leases for equipment and facilities. Rent expense was $99,431 and $99,431 for the three months ended June 30, 2018 and 2017, respectively, and $198,862 and $198,862, for the six months ended June 30, 2018 and 2017, respectively. Following are the minimum lease payments for each year and in total.

 

Year ending December 31:     
2018 (period from July 1, 2018 to December 31, 2018)    $226,131 
2019    457,327 
2020    154,131 
       
    $837,589 

 

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License agreements. The Company had several license agreements under which it had been assigned the rights to certain licensed materials used in its products. Certain of these agreements required the Company to pay ongoing royalties based on the number of products shipped containing the licensed material on a quarterly basis. Royalty expense related to these agreements aggregated $0 and $6,250 for the three months ended June 30, 2018 and 2017, respectively, and $2,083 and $8,688 for the six months ended June 30, 2018 and 2017, respectively.

 

Litigation. The Company is subject to various legal proceedings arising from normal business operations. Although there can be no assurances, based on the information currently available, management believes that it is probable that the ultimate outcome of each of the actions will not have a material adverse effect on the Consolidated Financial Statements of the Company. However, an adverse outcome in certain of the actions could have a material adverse effect on the financial results of the Company in the period in which it is recorded.

 

Axon

 

The Company owns U.S. Patent No. 9,253,452 (the “ ‘452 Patent”), which generally covers the automatic activation and coordination of multiple recording devices in response to a triggering event, such as a law enforcement officer activating the light bar on the vehicle.

 

The Company filed suit on January 15, 2016 in the U.S. District Court for the District of Kansas (Case No: 2:16-cv-02032) against Axon, alleging willful patent infringement against Axon’s body camera product line and Signal auto-activation product. The Company is seeking both monetary damages and a permanent injunction against Axon for infringement of the ‘452 Patent.

 

In addition to the infringement claims, the Company brought claims alleging that Axon conspired to keep the Company out of the marketplace by engaging in improper, unethical, and unfair competition. The amended lawsuit alleges Axon bribed officials and otherwise conspired to secure no-bid contracts for its products in violation of both state law and federal antitrust law. The Company’s lawsuit also seeks monetary and injunctive relief, including treble damages, for these alleged violations.

 

Axon filed an answer, which denied the patent infringement allegations on April 1, 2016. In addition, Axon filed a motion to dismiss all allegations in the complaint on March 4, 2016 for which the Company filed an amended complaint on March 18, 2016 to address certain technical deficiencies in the pleadings. Digital amended its complaint and Axon renewed its motion to seek dismissal of the allegations that it had bribed officials and otherwise conspired to secure no-bid contracts for its products in violation of both state law and federal antitrust law on April 1, 2016. Formal discovery commenced on April 12, 2016 with respect to the patent related claims. In January 2017, the Court granted Axon’s motion to dismiss the portion of the lawsuit regarding claims that it had bribed officials and otherwise conspired to secure no-bid contracts for its products in violation of both state law and federal antitrust law. On May 2, 2018, the Federal Circuit affirmed the District Court’s ruling and the Company is appealing this decision to the United States Supreme Court.

 

In December 2016 and January 2017, Axon filed two petitions for Inter Partes Review (“IPR”) against the ‘452 Patent. The United States Patent and Trademark Office (“USPTO”) rejected both of Axon’s petitions. Axon is now statutorily precluded from filing any more IPR petitions against the ‘452 Patent.

 

The District Court litigation in Kansas was temporarily stayed following the filing of the petitions for IPR. However, on November 17, 2017, the Federal District Court of Kansas rejected Axon’s request to maintain the stay. With this significant ruling, the parties will now proceed towards trial. Since litigation has resumed, the Court has issued a claim construction order (also called a Markman Order) where it sided with the Company on all disputes and denied Axon’s attempts to limit the scope of the claims. Following the Markman Order, the Court set all remaining deadlines in the case. Fact discovery will now close on September 17, 2018, and the Final Pretrial Conference has been set for January 16, 2019.

 

WatchGuard

 

On May 27, 2016 the Company filed suit against WatchGuard, (Case No. 2:16-cv-02349-JTM-JPO) alleging patent infringement based on WatchGuard’s VISTA Wifi and 4RE In-Car product lines.

 

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The USPTO has granted multiple patents to the Company with claims covering numerous features, such as automatically activating all deployed cameras in response to the activation of just one camera. Additionally, Digital Ally’s patent claims cover automatic coordination as well as digital synchronization between multiple recording devices. It also has patent coverage directed to the coordination between a multi-camera system and an officer’s smartphone, which allows an officer to more readily assess an event on the scene while an event is taking place or immediately after it has occurred.

 

The Company’s lawsuit alleges that WatchGuard incorporated this patented technology into its VISTA Wifi and 4RE In-Car product lines without its permission. Specifically, Digital Ally is accusing WatchGuard of infringing three patents: the U.S Patent No. 8,781,292 (the “ ‘292 Patent”) and ‘452 Patents and U.S. Patent No. 9,325,950 the (“ ‘950 Patent”). The Company is aggressively challenging WatchGuard’s infringing conduct, seeking both monetary damages, as well as seeking a permanent injunction preventing WatchGuard from continuing to sell its VISTA Wifi and 4RE In-Car product lines using Digital Ally’s own technology to compete against it. On May 8, 2017, WatchGuard filed a petition seeking IPR of the ‘950 Patent. The Company opposed that petition and on December 4, 2017, The Patent Trial and Appeal Board (“PTAB”) rejected the request of WatchGuard Video to institute an IPR on the ‘950 Patent. The lawsuit also involves the ‘292 Patent and the ‘452 Patent, the same two patents asserted against Axon. The ‘292 Patent previously was subject to the IPR process with the USPTO, but in June 2018 the PTO found the ‘292 Patent valid and rejected Axon’s arguments. WatchGuard had previously agreed to be bound by TASER’s IPRs and, as such, WatchGuard is now statutorily barred from any further IPR’s challenges with respect to the ‘950, ‘452, and ‘292 Patents. Since the defeat of Axon’s ‘292 Patent IPR, the Court has lifted the stay and set a schedule moving the case towards trial. Discovery will close on December 17, 2018, and the Final Pretrial Conference will take place on April 9, 2019.

 

Utility Associates, Inc.

 

On October 25, 2013, the Company filed a complaint in the United States District Court for the District of Kansas (2:13-cv-02550-SAC) to eliminate threats by a competitor, Utility Associates, Inc. (“Utility”), of alleged patent infringement regarding U.S. Patent No. 6,831,556 (the “ ‘556 Patent”). Specifically, the lawsuit seeks a declaration that the Company’s mobile video surveillance systems do not infringe any claim of the ‘556 Patent. The Company became aware that Utility had mailed letters to current and prospective purchasers of its mobile video surveillance systems threatening that the use of such systems purchased from third parties not licensed to the ‘556 Patent would create liability for them for patent infringement.

 

In addition, the Company began proceedings to invalidate the ‘556 Patent through a request for IPR of the ‘556 patent at the USPTO. On July 27, 2015, the USPTO invalidated key claims in Utility’s ‘556 Patent. The Final Decision from the USPTO significantly curtailed Utility’s ability to threaten law enforcement agencies, municipalities, and others with infringement of the ‘556 Patent. Utility appealed this decision to the United States Court of Appeals for the Federal Circuit. The United States Court of Appeals for the Federal affirmed the ruling of the USPTO summarily thus concluding the matter.

 

On June 6, 2014 the Company filed a separate Unfair Competition lawsuit against Utility in the United States District Court for the District of Kansas. In that lawsuit it contended that Utility has disparaged the Company and illegally interfered with its contracts, customer relationships and business expectancies by falsely asserting to its customers and others that its products violate the ‘556 Patent, of which Utility claims to be the holder. In addition to damages, the Company sought permanent injunctive relief, prohibiting Utility from continuing to threated or otherwise interfere with the Company’s customers. On March 4, 2015, an initial hearing was held upon the Company’s request for injunctive relief.

 

Based upon facts revealed at a March 4, 2015 injunction hearing, on March 16, 2015, the Company sought leave to amend its Complaint in the unfair competition suit to assert additional claims against Utility. Those new claims included claims of actual or attempted monopolization, in violation of § 2 of the Sherman Act, claims arising under a new Georgia statute that prohibits threats of patent infringement in “bad faith,” and additional claims of unfair competition/false advertising in violation of § 63(a) of the Lanham Act. The Court concluded its injunction hearing on April 22, 2015, and allowed the Company leave to add these claims, but denied its preliminary injunction. Subsequent to the injunction hearing, Utility withdrew from the market the in-car video recording device that it had sold in competition with the Company’s own products of similar function and which Utility had attempted to market using threats of patent infringement. After discovery closed, Utility filed a Motion for Summary Judgment and the Company filed a Motion for Partial Summary Judgment. On March 30, 2017, the Court entered its order granting Utility’s motion and denying the Company’s motion for summary judgment. The Company believed the District Court had made several errors when ruling on the motions for summary judgment, and filed an appeal to the United States Court of Appeals for the Tenth Circuit (10th Circuit”). While the appeal was pending, Utility filed a motion for the recovery from the Company of some $800,000 in alleged attorney’s fees as provided, purportedly, under the Lanham Patent and Uniform Trade Secrets Act. That motion was denied in its entirety by final judgement entered February 14, 2018. On February 16, 2018, the 10th Circuit issued its decision affirming the decision of the District Court. The Company filed a petition for rehearing by the panel and en banc, which has also been denied. Utility has filed its own motion for the recovery of attorney fees, on appeal in the alleged amount of $125,000. That motion has not yet been fully briefed, but will be opposed by the Company on substantially the same grounds up which Utility’s prior motion for attorney’s fees was denied by the District Court.

 

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The Company is also involved as a plaintiff and defendant in ordinary, routine litigation and administrative proceedings incidental to its business from time to time, including customer collections, vendor and employment-related matters. The Company believes the likely outcome of any other pending cases and proceedings will not be material to its business or its financial condition.

 

Sponsorship. On April 16, 2015 the Company entered into a Title Sponsorship Agreement (the “Agreement”) under which it became the title sponsor for a Web.com Tour golf tournament (the “Tournament”) held annually in the Kansas City Metropolitan area. The Agreement provides the Company with naming rights and other benefits for the 2015 through 2019 annual Tournament in exchange for the following sponsorship fee:

 

Year   Sponsorship
fee
 
 2015   $375,000 
 2016   $475,000 
 2017   $475,000 
 2018   $500,000 
 2019   $500,000 

 

The Company has the right to sell and retain the proceeds from the sale of additional sponsorships, including but not limited to a presenting sponsorship, a concert sponsorship and founding partnerships for the Tournament. The Company recorded a net sponsorship expense of $0 and $6,595 for the six months ended June 30, 2018 and 2017. The Company is negotiating with the Web.com Tour golf tournament officials to terminate the Agreement and the sponsorship fee commitments for the 2018 and 2019 Tournaments. There can be no assurance that it will be successful in negotiating the termination of this sponsorship agreement or that if successful in such negotiations, on terms acceptable or favorable to the Company.

 

401 (k) Plan. In July 2008, the Company amended and restated its 401(k) retirement savings plan. The amended plan requires the Company to provide 100% matching contributions for employees who elect to contribute up to 3% of their compensation to the plan and 50% matching contributions for employee’s elective deferrals on the next 2% of their contributions. The Company has made matching contributions totaling $28,973 and $47,055 for the three months ended June 30, 2018 and 2017, respectively, and $58,348 and $94,326 for the six months ended June 30, 2018 and 2017, respectively. Each participant is 100% vested at all times in employee and employer matching contributions.

 

Consulting and Distributor Agreements. The Company entered into an agreement that required it to make monthly payments that will be applied to future commissions and/or consulting fees to be earned by the provider. The agreement is with a limited liability company (“LLC”) that is minority owned by a relative of the Company’s chief financial officer. Under the agreement, dated January 15, 2016 and as amended on February 13, 2017, the LLC provides consulting services for developing a new distribution channel outside of law enforcement for its body-worn camera and related cloud storage products to customers in the United States. The Company paid amounts to the LLC as advances against commissions ranging from $5,000 to $6,000 per month plus necessary and reasonable expenses for the period through June 30, 2017, which can be automatically extended based on the LLC achieving minimum sales quotas. The agreement was renewed in January 2017 for a period of three years, subject to yearly minimum sales thresholds that would allow the Company to terminate the contract if such minimums are not met. As of June 30, 2018, the Company had advanced a total of $280,807 pursuant to this agreement and established an allowance reserve of $85,835 for a net advance of $194,972. The minimum sales threshold has not been met, and the Company has discontinued all advances, although the contract has not been formally terminated.

 

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On June 1, 2018 the Company entered into an agreement with an individual that required it to make monthly payments that will be applied to future commissions and/or consulting fees to be earned by the provider. Under the agreement, the individual provides consulting services for developing new distribution channels both inside and outside of law enforcement for its in-car and body-worn camera systems and related cloud storage products to customers within and outside the United States. The Company is required to advance amounts to the individual as an advance against commissions of $7,000 per month plus necessary and reasonable expenses for the period through August 31, 2018, which can be extended to December 31, 2018 by mutual agreement of the parties at $6,000 per month. As of June 30, 2018, the Company had advanced a total of $5,720 pursuant to this agreement.

 

NOTE 11. STOCK-BASED COMPENSATION

 

The Company recorded pretax compensation expense related to the grant of stock options and restricted stock issued of $594,228 and $115,756 for the three months ended June 30, 2018 and 2017 and $1,087,747 and $502,789 for the six months ended June 30, 2018 and 2017, respectively.

 

As of June 30, 2018, the Company had adopted seven separate stock option and restricted stock plans: (i) the 2005 Stock Option and Restricted Stock Plan (the “2005 Plan”), (ii) the 2006 Stock Option and Restricted Stock Plan (the “2006 Plan”), (iii) the 2007 Stock Option and Restricted Stock Plan (the “2007 Plan”), (iv) the 2008 Stock Option and Restricted Stock Plan (the “2008 Plan”), (v) the 2011 Stock Option and Restricted Stock Plan (the “2011 Plan”), (vi) the 2013 Stock Option and Restricted Stock Plan (the “2013 Plan”) and (vii) the 2015 Stock Option and Restricted Stock Plan (the “2015 Plan”). The 2005 Plan, 2006 Plan, 2007 Plan, 2008 Plan, 2011 Plan, 2013 Plan and 2015 Plan are referred to as the “Plans.”

 

These Plans permit the grant of stock options or restricted stock to its employees, non-employee directors and others for up to a total of 2,425,000 shares of common stock. The 2005 Plan terminated during 2015 with 4,616 shares not awarded or underlying options, which shares are now unavailable for issuance. Stock options granted under the 2005 Plan that remain unexercised and outstanding as of June 30, 2018 total 23,125. The 2006 Plan terminated during 2016 with 20,587 shares not awarded or underlying options, which shares are now unavailable for issuance. Stock options granted under the 2006 Plan that remain unexercised and outstanding as of June 30, 2018 total 46,387. The 2007 Plan terminated during 2017 with 82,151 shares not awarded or underlying options, which shares are now unavailable for issuance. Stock options granted under the 2007 Plan that remain unexercised and outstanding as of June 30, 2018 total 12,500. The 2008 Plan terminated during 2018 with 3,124 shares not awarded or underlying options, which shares are now unavailable for issuance. Stock options granted under the 2008 Plan that remain unexercised and outstanding as of June 30, 2018 total 32,875.

 

The Company believes that such awards better align the interests of our employees with those of its stockholders. Option awards have been granted with an exercise price equal to the market price of its stock at the date of grant with such option awards generally vesting based on the completion of continuous service and having ten-year contractual terms. These option awards typically provide for accelerated vesting if there is a change in control (as defined in the Plans). The Company has registered all shares of common stock that are issuable under its Plans with the SEC. A total of 8,926 shares remained available for awards under the various Plans as of June 30, 2018.

 

The fair value of each option award is estimated on the date of grant using a Black-Scholes option valuation model. There were no stock options issued during the six months ended June 30, 2018.

 

Activity in the various Plans during the six months ended June 30, 2018 is reflected in the following table:

 

Options  Number of
Shares
   Weighted
Average
Exercise Price
 
Outstanding at January 1, 2018   350,269   $13.44 
Granted        
Exercised        
Forfeited   (75,632)   (45.67)
Outstanding at June 30, 2018   274,637   $4.55 
Exercisable at June 30, 2018   274,637   $4.55 

 

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The fair value of each option award is estimated on the date of grant using a Black-Scholes option valuation model. There were no stock options issued during the six months ended June 30, 2018.

 

The Plans allow for the cashless exercise of stock options. This provision allows the option holder to surrender/cancel options with an intrinsic value equivalent to the purchase/exercise price of other options exercised. There were no shares surrendered pursuant to cashless exercises during the six months ended June 30, 2018.

 

At June 30, 2018, the aggregate intrinsic value of options outstanding was approximately $-0-, and the aggregate intrinsic value of options exercisable was approximately $-0-. No options were exercised in the six months ended June 30, 2018.

 

As of June 30, 2018, the unrecognized portion of stock compensation expense on all existing stock options was $-0-.

 

The following table summarizes the range of exercise prices and weighted average remaining contractual life for outstanding and exercisable options under the Company’s option plans as of June 30, 2018:

 

   Outstanding options  Exercisable options
Exercise price
range
  Number of
options
 

Weighted

average
remaining
contractual life

  Number of
options
  Weighted
average
remaining
contractual life
             
$ 0.01 to $3.49   133,500   8.2 years   133,500  8.2 years
$ 3.50 to $4.99   67,625   5.7 years   67,625  5.7 years
$ 5.00 to $6.49      —years     —years
$ 6.50 to $7.99   9,312   3.3 years   9,312  3.3 years
$ 8.00 to $9.99   2,500   2.9 years   2,500  2.9 years
$ 10.00 to $19.99   55,450   2.0 years   55,450  2.0 years
$ 20.00 to $24.99   5,625   1.2 years   5,625  1.2 years
$ 25.00 to $27.50   625   0.4 years   625  0.4 years
    274,637   6.0 years   274,637  6.0 years

 

Restricted stock grants. The Board of Directors has granted restricted stock awards under the Plans. Restricted stock awards are valued on the date of grant and have no purchase price for the recipient. Restricted stock awards typically vest over nine months to four years corresponding to anniversaries of the grant date. Under the Plans, unvested shares of restricted stock awards may be forfeited upon the termination of service to or employment with the Company, depending upon the circumstances of termination. Except for restrictions placed on the transferability of restricted stock, holders of unvested restricted stock have full stockholder’s rights, including voting rights and the right to receive cash dividends.

 

A summary of all restricted stock activity under the equity compensation plans for the six months ended June 30, 2018 is as follows:

 

   Number of
Restricted
shares
   Weighted
average
grant date
fair
value
 
Nonvested balance, January 1, 2018   791,725   $4.37 
Granted   184,500    2.52 
Vested   (109,250)   (8.10)
Forfeited   (30,400)   (4.05)
Nonvested balance, June 30, 2018   836,575   $3.87 

 

26
 

 

The Company estimated the fair market value of these restricted stock grants based on the closing market price on the date of grant. As of June 30, 2018, there were $982,865 of total unrecognized compensation costs related to all remaining non-vested restricted stock grants, which will be amortized over the next 30 months in accordance with the respective vesting scale.

 

The nonvested balance of restricted stock vests as follows:

 

Year ended December 31,   Number of
shares
 
      
2018 (July 1, 2018 to December 31, 2018)    361,925 
2019    459,525 
2020    15,125 

 

NOTE 12. COMMON STOCK PURCHASE WARRANTS

 

The Company has issued common stock purchase warrants in conjunction with various debt and equity issuances. The warrants are either immediately exercisable, or have a delayed initial exercise date, no more than six months from issue date, and allow the holders to purchase up to 3,329,466 shares of common stock at $2.60 to $16.50 per share as of June 30, 2018. The warrants expire from December 3, 2018 through February 23, 2023 and allow for cashless exercise.

 

In addition to the warrants described in Note 6, the Company issued warrants in conjunction with the equity offering in August 2017. The investors were issued 680,000 Series A-1 warrants that have an initial exercise date of February 23, 2018, terminate on February 23, 2023 and are exercisable at $3.36 per share. The investors also received 200,000 Series A-2 warrants that are exercisable at $3.36 per share until August 23, 2022. In addition, the placement agent received 94,000 of warrants with an initial exercise date of February 23, 2018 at an exercise price of $3.75 per share until August 21, 2022.

 

The Series A-1 and A-2 warrants provide that if, at the time of exercise, there is no effective registration statement registering, or no current prospectus available for, the issuance of the shares of common stock upon exercise, then they may also be exercised, in whole or in part, at such time by means of a cashless exercise, or “net share settlement.” Because the Company and the holders of the warrants have met applicable requirements under the Securities Act of 1933, as amended, no further action is needed on the part of the Company to issue the shares of common stock issuable upon exercise of the warrants on an unrestricted basis through a cashless exercise if for some reason the registration statement was not effective at the point of exercise. These warrants are accounted for as equity, as it is only a transaction within the control of the Company that would give the holder the option for cash settlement.

 

There were 60,000 of pre-funded Series B warrants issued with the August 2017 equity offering, at a price of $2.99 and an exercise price of $0.01. All Series B warrants were exercised for common stock in September 2017. Certain common stock purchase warrants issued in August 2014 contained anti-dilution provisions that triggered a reset as a result of the April 2018 financing transaction. The reset provisions resulted in the 12,200 warrants held at an exercise price of $7.32 per share increased by 159,538 warrants resulting in a final reset to 172,038 warrants at an exercise price of $0.52 per share.

 

   Warrants   Weighted
average
exercise price
 
Vested Balance, January 1, 2018   3,233,466   $6.57 
Granted   1,012,667    3.03 
Warrant reset   159,538    0.52 
Exercised   (20,000)   (0.52)
Cancelled        
Vested Balance, June 30, 2018   4,385,671   $5.56 

 

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The total intrinsic value of all outstanding warrants aggregated $277,681 as of June 30, 2018 and the weighted average remaining term is 40 months.

 

The following table summarizes the range of exercise prices and weighted average remaining contractual life for outstanding and exercisable warrants to purchase common shares as of June 30, 2018:

 

   Outstanding and exercisable warrants
Exercise price  Number of options    Weighted average
remaining
contractual life
$0.52   151,738    1.2 years
$2.60   100,000    4.4 years
$2.75   100,000    4.2 years
$3.00   916,667    4.8 years
$3.25   180,000    3.2 years
$3.36   880,000    4.4 years
$3.50   36,000    0.7 years
$3.65   200,000    4.0 years
$3.75   94,000    4.1 years
$5.00   800,000    3.5 years
$8.50   42,500    0.4 years
$13.43   879,766    2.6 years
$16.50   5,000    2.0 years
           
     4,385,671    3.3 years

 

NOTE 13. NET LOSS PER SHARE

 

The calculations of the weighted average number of shares outstanding and loss per share outstanding for the three and six months ended June 30, 2018 and 2017 are as follows:

 

   Three Months Ended June 30,   Six Months Ended June 30, 
   2018   2017   2018   2017 
Numerator for basic and diluted income per share – Net loss  $(2,962,890)  $(2,326,523)  $(5,551,122)  $(4,359,478)
                     
Denominator for basic loss per share – weighted average shares outstanding   7,129,260    5,679,731    7,153,219    5,654,755 
Dilutive effect of shares issuable under stock options and warrants outstanding                
                     
Denominator for diluted loss per share – adjusted weighted average shares outstanding   7,129,260    5,679,731    7,153,219    5,654,755 
                     
Net income (loss) per share:                    
Basic  $(0.42)  $(0.41)  $(0.78)  $(0.77)
Diluted  $(0.42)  $(0.41)  $(0.78)  $(0.77)

 

Basic loss per share is based upon the weighted average number of common shares outstanding during the period. For the three and six months ended June 30, 2018 and 2017, all outstanding stock options to purchase common stock were antidilutive, and, therefore, not included in the computation of diluted net loss per share.

 

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NOTE 14. SUBSEQUENT EVENTS

 

Strategic Review and Subsequent Financing

 

The Company’s Board of Directors has initiated a review of strategic alternatives to best position the Company for the future, including, but not limited to, monetizing its patent portfolio and related patent infringement litigation against Axon and WatchGuard, the sale of all or certain assets, properties or groups of properties or individual businesses or merger or combination with another company. The result of the strategic review may also include the continued implementation of the Company’s business plan with additional debt or equity financing. The Company retained Roth to assist in this review and process. Thus, the Company is considering alternatives to address its near-term and long-term liquidity and operational issues. There can be no assurance that a transaction or financing will result from this process. As part of this strategic alternatives process, the Board of Directors approved the Proceeds Investment Agreement described below. Management believes this financing will address the Company’s near-term liquidity needs, which primarily included the repayment of principal and interest on the senior convertible debentures and subordinated notes payable.

 

On July 31, 2018, the Company entered into a Proceeds Investment Agreement (the “PIA Agreement”) with Brickell Key Investments LP (“BKI”), pursuant to which BKI funded an aggregate of $500,000 (the “First Tranche”) to be used (i) to fund the Company’s litigation proceedings relating to the infringement of certain patent assets listed in the PIA Agreement (the “Patent Assets”) and (ii) to repay the Company’s existing debt obligations and for certain working capital purposes set forth in the PIA Agreement. Pursuant to the PIA Agreement, BKI was granted an option to provide the Company with an additional $9.5 million, at BKI’s sole discretion (the “Second Tranche,” and collectively with the First Tranche, the “Financing Amount”).

 

Pursuant to the PIA Agreement and in consideration for the Financing Amount, the Company agreed to assign to BKI (i) 100% of all gross, pre-tax monetary recoveries paid by any defendant(s) to the Company or its affiliates agreed to in a settlement or awarded in judgment in connection with the Patent Assets, plus any interest paid in connection therewith by such defendant(s) (the “Patent Assets Proceeds”), up to the minimum return (as defined in the Agreement) and (ii) if BKI has not received its minimum return by the earlier of (x) a liquidity event (as defined in the Agreement) and (y) July 31, 2020, then the Company agreed to assign to BKI 100% of the Patent Asset Proceeds until BKI has received an amount equal to the minimum return on $4 million.

 

Pursuant to the PIA Agreement and subject to BKI funding the Second Tranche, the Company will grant BKI (i) a senior security interest in the Patent Assets, the claims (as defined in the Agreement) and the Patent Assets Proceeds until such time as the minimum return is paid, in which case, the security interest on the Patent Assets, the Claims and the Patent Assets Proceeds will be released, and (ii) a senior security interest in all other assets of the Company until such time as the minimum return is paid on $4.0 million, in which case, the security interest on such other assets will be released.

 

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The security interest will be enforceable by BKI if the Company is in default under the PIA Agreement which would occur if (i) the Company fails, after five (5) days’ written notice, to pay any due amount payable to BKI under the PIA Agreement, (ii) the Company fails to comply with any provision of the PIA Agreement, the PIA Warrant or any other agreement or document contemplated under the PIA Agreement, (iii) the Company becomes insolvent or insolvency proceedings are commenced (and not subsequently discharged) with respect to the Company, (iv) the Company’s creditors commence actions against the Company (which are not subsequently discharged) that affect material assets of the Company, (v) the Company, without BKI’s consent, incurs indebtedness other than immaterial ordinary course indebtedness up to $500,000, (vi) the Company fails, within five (5) business days following the closing of the Second Tranche, to fully satisfy its obligations to certain holders of the Company’s senior secured convertible promissory notes listed in the PIA Agreement and fails to obtain unconditional releases from such holders as to the Company’s obligations to such holders and the security interests in the Company held by such holders or (vii) there is an uncured non-compliance of the Company’s obligations or misrepresentations by the Company under the PIA Agreement.

 

Under the PIA Agreement, the Company issued BKI a warrant to purchase up to 465,712 shares of the Company’s common stock, par value $0.001 per share (the “PIA Warrant”), at an exercise price equal to the higher of (i) $2.60 per share or (ii) the closing market price as quoted on the trading market (as defined in the PIA Warrant) on the day prior to the issuance date of the PIA Warrant, provided that the holder of the PIA Warrant will be prohibited from exercising the PIA Warrant if, as a result of such exercise, such holder, together with its affiliates, would own more than 4.99% of the total number of shares of the Company’s common stock outstanding immediately after giving effect to such exercise. However, such holder may increase or decrease such percentage to any other percentage not in excess of 9.99%, provided that any increase in such percentage shall not be effective until 61 days after such notice to the Company. The PIA Warrant is exercisable for five years from the date of issuance and is exercisable on a cashless exercise basis if there is no effective registration statement. No contractual registration rights were given. In connection with the issuance of the PIA Warrant, the Company and BKI entered into a letter agreement providing that if the Second Tranche is not funded, then BKI would be entitled to a pro-rata percentage ($500,000 divided by $10,000,000) of the PIA Warrant. The Company has agreed to promptly issue a new PIA Warrant reflecting this adjustment.

 

Nasdaq Listing

 

On April 17, 2018 the Company received a letter from The Nasdaq Stock Market (“Nasdaq”) indicating that it was not compliant with the minimum stockholders’ equity requirement under Nasdaq Listing Rule 5550(b)(1) for continued listing on The Nasdaq Capital Market because its stockholders’ equity, as reported in its Annual Report on Form 10-K for the year ended December 31, 2017, was below the required minimum of $2.5 million. Further, as of April 17, 2018, the Company did not meet the alternative compliance standards relating to the market value of listed securities or net income from continuing operations. This notice of noncompliance has had no immediate impact on the continued listing or trading of the Company’s common stock on The Nasdaq Capital Market.

 

Under Nasdaq Listing Rule 5810(c)(2), the Company had until June 1, 2018 to submit a plan to regain compliance. The Company submitted its compliance plan and on June 27, 2018 Nasdaq granted it an extension until September 30, 2018 to provide evidence of compliance with Rule 5550(b)(1).

 

There can be no assurance that the Company will be able to regain compliance with the stockholders’ equity requirement or meet the alternatives of market value of listed securities or net income from continuing operations, or otherwise maintain compliance with the other listing requirements.

 

VieVu acquisition by Axon

 

On May 4, 2018, Axon announced that it had acquired 100% ownership of VieVu, LLC in a deal that includes cash, stock and a stock earn-out. On July 27, 2018, the Company and VieVu, LLC mutually agreed to and executed a termination of the supply and distribution agreement which provided for the return of all confidential information and the survival of certain provisions regarding non-disclosure of proprietary information. Effective July 27, 2018 VieVu, LLC will discontinue all sales and marketing efforts involving the Company’s patented VuLink product.

 


*************************************

 

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operation.

 

This Report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. The words “believe,” “expect,” “anticipate,” “intend,” “estimate,” “may,” “should,” “could,” “will,” “plan,” “future,” “continue,” and other expressions that are predictions of or indicate future events and trends and that do not relate to historical matters identify forward-looking statements. These forward-looking statements are based largely on our expectations or forecasts of future events, can be affected by inaccurate assumptions, and are subject to various business risks and known and unknown uncertainties, a number of which are beyond our control. Therefore, actual results could differ materially from the forward-looking statements contained in this document, and readers are cautioned not to place undue reliance on such forward-looking statements. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. A wide variety of factors could cause or contribute to such differences and could adversely impact revenues, profitability, cash flows and capital needs. There can be no assurance that the forward-looking statements contained in this document will, in fact, transpire or prove to be accurate.

 

Factors that could cause or contribute to our actual results differing materially from those discussed herein or for our stock price to be adversely affected include, but are not limited to: (1) our losses in recent years, including the three months and six months ended June 30, 2018 and fiscal 2017, and our ability to pay the March Note when  due; (2) macro-economic risks from the effects of the decrease in budgets for the law-enforcement community; (3) our ability to increase revenues, increase our margins and return to consistent profitability in the current economic and competitive environment, including whether deliveries will resume under the AMR contract; (4) our operation in developing markets and uncertainty as to market acceptance of our technology and new products; (5) the availability of funding from federal, state and local governments to facilitate the budgets of law enforcement agencies, including the timing, amount and restrictions on such funding; (6) our ability to deliver our new product offerings as scheduled in 2018, have such new products perform as planned or advertised and whether they will help increase our revenues; (7) whether we will be able to increase the sales, domestically and internationally, for our products in 2018; (8) our ability to maintain or expand our share of the market for our products in the domestic and international markets in which we compete, including increasing our international revenues to their historical levels; (9) our ability to produce our products in a cost-effective manner; (10) competition from larger, more established companies with far greater economic and human resources; (11) our ability to attract and retain quality employees; (12) risks related to dealing with governmental entities as customers; (13) our expenditure of significant resources in anticipation of sales due to our lengthy sales cycle and the potential to receive no revenue in return; (14) characterization of our market by new products and rapid technological change; (15) our dependence on sales of our DVM-800, DVM-800 HD, FirstVU, First VU HD and DVM-250 products; (16) potential that stockholders may lose all or part of their investment if we are unable to compete in our markets and return to profitability; (17) defects in our products that could impair our ability to sell our products or could result in litigation and other significant costs; (18) our dependence on key personnel; (19) our reliance on third-party distributors and sales representatives for part of our marketing capability; (20) our dependence on a few manufacturers and suppliers for components of our products and our dependence on domestic and foreign manufacturers for certain of our products; (21) our ability to protect technology through patents and to protect our proprietary technology and information as trade secrets and through other similar means; (22) our ability to generate more recurring cloud and service revenues; (23) risks related to our license arrangements; (24) our revenues and operating results may fluctuate unexpectedly from quarter to quarter; (25) sufficient voting power by coalitions of a few of our larger stockholders, including directors and officers, to make corporate governance decisions that could have significant effect on us and the other stockholders; (26) sale of substantial amounts of our common stock that may have a depressive effect on the market price of the outstanding shares of our common stock; (27) possible issuance of common stock subject to options and warrants that may dilute the interest of stockholders; (28) our nonpayment of dividends and lack of plans to pay dividends in the future; (29) future sale of a substantial number of shares of our common stock that could depress the trading price of our common stock, lower our value and make it more difficult for us to raise capital; (30) our additional securities available for issuance, which, if issued, could adversely affect the rights of the holders of our common stock; (31) our stock price is likely to be highly volatile due to a number of factors, including a relatively limited public float; (32) whether the litigation against Utility Associates, Axon and WatchGuard will achieve their intended objectives and result in monetary recoveries for the Company; (33) whether the USPTO rulings will curtail, eliminate or otherwise have an effect on the actions of Axon, WatchGuard and Utility Associates respecting us, our products and customers; (34) whether the remaining two claims under the ’556 Patent have applicability to us or our products ; and (35) whether our patented VuLink technology is becoming the de-facto “standard” for agencies engaged in deploying state-of-the-art body-worn and in-car camera systems and will increase our revenues; (36) whether such technology will have a significant impact on our revenues in the long-term; and (37) indemnification of our officers and directors.

 

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Current Trends and Recent Developments for the Company

 

Overview

 

We supply technology-based products utilizing our portable digital video and audio recording capabilities, for the law enforcement and security industries and for the commercial fleet and mass transit markets. We have the ability to integrate electronic, radio, computer, mechanical, and multi-media technologies to create unique solutions to our customers’ requests. We began shipping our flagship digital video mirror product in March 2006. We have developed additional products to complement our original in-car digital video products, including the DVM-800 and DVM-800 HD, both in-car digital video mirror products, and body-worn camera including the FirstVU One and the FirstVU HD products designed for law enforcement usage. In recent years we launched the patented and revolutionary VuLink product which integrates our body-worn cameras with our in-car systems by providing hands-free automatic activation; and a commercial line of digital video mirrors (the DVM-250 and DVM-250 Plus) that serve as “event recorders” for the commercial fleet and mass transit markets in order to expand our customer base beyond the traditional law enforcement agencies. We have additional research and development projects that we anticipate will result in several new product launches in 2018 and beyond involving in-car and body-worn systems for both the law enforcement and commercial markets, as well as expanding our cloud-based evidence management systems. We believe that the launch of these new products will help to reinvigorate our in-car and body-worn systems revenues while diversifying and broadening the market for our product offerings.

 

We experienced operating losses for all quarters during 2018 and 2017. The following is a summary of our recent operating results on a quarterly basis:

 

   June 30,   March 31,   December 31,   September 30,   June 30,   March 31, 
   2018   2018   2017   2017   2017   2017 
Total revenue  $3,563,550   $2,471,513   $2,877,661   $2,983,577   $3,486,502   $5,229,860 
Gross profit   1,618,467    1,109,394    86,295    1,008,613    1,173,216    2,276,849 
Gross profit margin percentage   45.4%   44.9%   3.0%   33.8%   33.7%   43.5%
Total selling, general and administrative expenses   3,055,776    3,082,710    3,874,255    4,125,308    3,665,813    4,079,062 
Operating loss   (1,437,309)   (1,973,316)   (3,787,960)   (3,116,695)   (2,492,597)   (1,802,213)
Operating income percentage   (40.3)%   (79.8)%   (131.6)%   (104.5)%   (71.5)%   (34.5)%
Net loss  $(2,962,890)  $(2,588,232)  $(4,399,673)  $(3,493,306)  $(2,326,523)  $(2,032,955)

 

Our business is subject to substantial fluctuations on a quarterly basis as reflected in the significant variations in revenues and operating results in the above table. These variations result from various factors, including but not limited to: 1) the timing of large individual orders; 2) the traction gained by our newer products, such as the FirstVU HD, VuLink and FleetVU; 3) production, quality and other supply chain issues affecting our cost of goods sold; 4) unusual increases in operating expenses, such as our sponsorship of the Digital Ally Open golf tournament, the timing of trade shows and bonus compensation; and 5) litigation and related expenses respecting outstanding lawsuits. We reported an operating loss of $1,437,309 on revenues of $3,563,550 for second quarter 2018, which continued a series of quarterly losses resulting from competitive pressures, increases in inventory reserves as our current product suite ages, product quality control issues, product warranty issues, infringement of our patents by direct competitors such as Axon and WatchGuard that reduced our revenues, litigation expenses relating to the patent infringement and the reduction of our gross margins.

 

32
 

 

A number of factors and trends affected our recent performance, which include:

 

Revenues increased in second quarter 2018 to $3,563,550 compared to previous quarters. The primary reason for the revenue increases in second quarter 2018 is that we rectified the supply chain issues that had prevented us from shipping our revenue backlog during the March 31, 2018 quarter. Our in-car and body-worn systems are facing increased competition as our competitors have released new products with advanced features. We have development projects that will address this issue by introducing a new product platform specifically for in-car systems, which we expect to be in production by fourth quarter 2018. This new product platform will utilize advanced chipsets that will generate new and highly advanced products for our law enforcement and commercial customers. Our law enforcement revenues declined over the prior period due to price-cutting, willful infringement of our patents and other actions by our competitors and adverse marketplace effects related to the patent litigation. For example, one of our competitors introduced a body-camera including cloud storage free for one year that disrupted the market during 2017 and 2018 and has continued to pressure our revenues.

 

Recognizing a critical limitation in law enforcement camera technology, during 2014 we pioneered the development of our VuLink ecosystem that provided intuitive auto-activation functionality as well as coordination between multiple recording devices. The USPTO has recognized these pioneering efforts by granting us multiple patents with claims covering numerous features, such as automatically activating an officer’s cameras when the light bar is activated or when a data-recording device such as a smart weapon is activated. Additionally, our patent claims cover automatic coordination between multiple recording devices. Prior to this innovation, officers were forced to manually activate each device while responding to emergency scenarios - a requirement that both decreased the usefulness of the existing camera systems and diverted officers’ attention during critical moments. We believe law enforcement agencies have recognized the value of our VuLink technology and that a trend has developed where the agencies are seeking information on “auto-activation” features in requests for bids and requests for information involving the procurement process of body-worn cameras and in-car systems. We believe this trend may result in our patented VuLink technology becoming the de-facto “standard” for agencies engaged in deploying state-of-the-art body-worn and in-car camera systems. However, the willful infringement of our VuLink patent by Axon, WatchGuard and others has substantially and negatively impacted revenues that otherwise would have been generated by our VuLink system and indirectly our body-worn and in-car systems. We believe that the results of the current patent litigation will largely set the competitive landscape for body-worn and in-car systems for the foreseeable future. We are seeking other ways to monetize our VuLink patents, which may include entering into license agreements or supply and distribution agreements with competitors. We expect that this technology will have a significant positive impact on our revenues in the long-term, particularly if we are successful in our prosecution of the patent infringement litigation pending with Axon and WatchGuard, and we can successfully monetize the underlying patents, although we can make no assurances in this regard.

 

We recently announced a multi-year official partnership with NASCAR, naming us “A Preferred Technology Provider of NASCAR.” As part of the new relationship, we will provide cameras that will be mounted in the Monster Energy NASCAR Cup Series garage throughout the season, bolstering both NASCAR’s commitment to safety at every race track, as well as enhancing its officiating process through technology. We believe this new partnership with NASCAR will demonstrate the flexibility of our product offerings and help expand the appeal of our products and service capabilities to new commercial markets.

 

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Our objective is to expand our recurring service revenue to help stabilize our revenues on a quarterly basis. Revenues from cloud storages have been increasing in recent quarters and reached approximately $181,000 in Q-2 2018, an increase of $89,000 (96%) over the comparable quarter in 2017. Additionally, revenues from extended warranties have also been increasing and were approximately $273,000 for the three months ended June 30, 2018, compared to $208,000 for the prior year period for an increase of $65,000 (31%). We are pursuing several new market channels that do not involve our traditional law enforcement and private security customers, such as our NASCAR affiliation, which we believe will help expand the appeal of our products and service capabilities to new commercial markets. If successful, we believe that these new market channels could yield recurring service revenues for us in 2018 and beyond. We are testing a new revenue model that involves the long-term lease of our body-worn and/or in-car hardware, together with a monthly subscription for our cloud storage, search and archiving services for the underlying audio and video material. The goal of this new service revenue model is to positively impact our revenues and improve the stability of our quarter-to-quarter revenues and operating results, although we can make no assurances in this regard. We believe this service revenue model may appeal to our customers, in particular our commercial and other non-law enforcement customers, because it reduces the initial capital outlay and eliminates repairs and maintenance in exchange for making level monthly payments for the utilization of the equipment, data storage and management services.

 

Our international revenues increased to $210,129 (3% of total revenues) during the six months ended June 30, 2018, compared to $89,847 (1% of total revenues) during the six months ended June 30, 2017. We are marketing our newer products, including the FleetVu driver monitoring and management service, the VuLink and the FirstVU HD internationally.

 

The Company has undertaken a program in recent quarters to substantially reduce selling, general and administrative (“SG&A”) expenses through headcount reductions and other SG&A cost reduction measures. Our operating results reflect significant reductions in overall SG&A expenses compared to previous quarters. Management expects this trend to continue throughout 2018.

 

Off-Balance Sheet Arrangements

 

We do not have any off-balance sheet debt nor did we have any transactions, arrangements, obligations (including contingent obligations) or other relationships with any unconsolidated entities or other persons that may have material current or future effect on financial conditions, changes in the financial conditions, results of operations, liquidity, capital expenditures, capital resources, or significant components of revenue or expenses.

 

We are a party to operating leases, title sponsorship, and license agreements that represent commitments for future payments (described in Note 10 to our condensed consolidated financial statements) and we have issued purchase orders in the ordinary course of business that represent commitments to future payments for goods and services.

 

For the Three Months Ended June 30, 2018 and 2017

 

Results of Operations

 

Summarized immediately below and discussed in more detail in the subsequent sub-sections is an analysis of our operating results for the three months ended June 30, 2018 and 2017, represented as a percentage of total revenues for each respective year:

 

  

Three Months Ended

June 30,

 
  2018   2017 
Revenue