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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-QSB
[X] QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934
For the quarterly period ended SEPTEMBER 30, 2007
[ ] TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT
For the transition period from __________ to __________
Commission file number 000-51859
ELECTRONIC SENSOR TECHNOLOGY, INC.
(Exact name of Small Business Issuer as Specified in Its Charter)
NEVADA 98-0372780
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)
1077 Business Center Drive
Newbury Park, California 91320
(Address of Principal Executive Offices)
(805) 480-1994
(Issuer's Telephone Number, Including Area Code)
Check whether the issuer (1) filed all reports required to be filed by
Section 13 or 15(d) of the Securities Exchange Act during the past 12 months (or
for such shorter period that the registrant was required to file such reports),
and (2) has been subject to such filing requirements for the past 90 days.
Yes [X] No [ ]
Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X]
State the number of shares outstanding of each of the issuer's classes of
common equity, as of the latest practicable date.
56,756,098 shares of common stock as of November 1, 2007
Transitional Small Business Disclosure Format (Check one): Yes [ ] No [X]
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Certain statements in this quarterly report on Form 10-QSB, including those
relating to the company's plans regarding business and product development;
product sales and distribution; market demands and developments in the homeland
security, analytical instrumentation/quality control and environmental
monitoring markets; and the sufficiency of the company's resources to satisfy
operation cash requirements are forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933, as amended, and Section 21E of the
Securities Exchange Act of 1934, as amended. These forward-looking statements
may contain the words "believe," "anticipate," "expect," "predict," "estimate,"
"project," "will be," "will continue," "will likely result," or other similar
words and phrases. Risks and uncertainties exist that may cause results to
differ materially from those set forth in these forward-looking statements.
Factors that could cause the anticipated results to differ from those described
in the forward-looking statements include: risks related to changes in
technology, our dependence on key personnel, our ability to protect our
intellectual property rights, emergence of future competitors, changes in our
largest customer's business and government regulation of homeland security
companies, and other factors described under the heading "Risk Factors" in our
Registration Statements on Form SB-2 File Nos. 333-130900 and 333-138977,
effective as of November 21, 2006 and December 21, 2006, respectively, as
amended and supplemented. The forward-looking statements speak only as of the
date they are made. We do not undertake to update forward-looking statements to
reflect circumstances or events that occur after the date the forward-looking
statements are made.
PART I.
FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS.
INDEX TO FINANCIAL STATEMENTS
Consolidated Balance Sheet (Unaudited) as of September 30, 2007 F-1
Consolidated Statements of Operations (Unaudited) for the Three and
Nine Months Ended September 30 2007 and 2006 F-2
Consolidated Statements of Cash Flows (Unaudited) for the Nine Months
Ended September 30, 2007 and 2006 F-3
Notes to Consolidated Financial Statements (unaudited) F-4
1
ELECTRONIC SENSOR TECHNOLOGY, INC.
CONSOLIDATED BALANCE SHEET
SEPTEMBER 30, 2007
(Unaudited)
ASSETS
CURRENT ASSETS:
Cash and cash equivalents $ 558,333
Certificate of deposit-restricted 12,384
Accounts receivable, net of allowance for doubtful accounts of $1,500 370,131
Prepaid expenses 76,743
Inventories 1,021,945
---------------
TOTAL CURRENT ASSETS 2,039,536
---------------
DEFERRED FINANCING COSTS, net of amortization of $335,006 393,354
PROPERTY AND EQUIPMENT, net of accumulated depreciation of $1,001,270 300,240
SECURITY DEPOSITS 12,817
---------------
$ 2,745,947
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LIABILITIES AND STOCKHOLDERS' DEFICIT
CURRENT LIABILITIES:
Accounts payable and accrued expenses $ 568,432
Deferred revenues 54,167
Derivative liabilities 2,852,727
Convertible debentures - current portion 2,333,333
Obligation under capital leases due within one year 17,932
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TOTAL CURRENT LIABILITIES 5,826,591
---------------
CONVERTIBLE DEBENTURES- long-term portion, net of unamortized discount
of $2,722,223 1,944,444
LONG-TERM OBLIGATION UNDER CAPITAL LEASE 41,268
---------------
TOTAL LIABILITIES 7,812,303
---------------
STOCKHOLDERS' DEFICIT:
Preferred stock, $.001 par value 50,000,000 shares authorized,
none issued and outstanding -
Common stock, $.001 par value, 200,000,000 shares authorized,
54,955,687 issued and outstanding 54,956
Additional paid-in capital 8,749,612
Accumulated deficit (13,870,924)
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TOTAL STOCKHOLDERS' DEFICIT (5,066,356)
---------------
$ 2,745,947
===============
See unaudited notes to consolidated financial statements
F-1
ELECTRONIC SENSOR TECHNOLOGY, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
Nine Months Ended Three Months Ended
September 30, September 30,
-------------------------------- --------------------------------
2007 2006 2007 2006
-------------- -------------- -------------- --------------
REVENUES $ 1,691,715 $ 1,549,757 $ 523,937 $ 395,533
COST OF SALES 891,798 731,466 306,693 138,751
-------------- -------------- -------------- --------------
GROSS PROFIT 799,917 818,291 217,244 256,782
OPERATING EXPENSES:
Research and development 566,661 616,597 155,552 200,453
Selling, general and administrative 1,959,224 2,060,898 572,477 623,936
-------------- -------------- -------------- --------------
TOTAL OPERATING EXPENSES 2,525,885 2,677,495 728,029 824,389
-------------- -------------- -------------- --------------
LOSS FROM OPERATIONS (1,725,968) (1,859,204) (510,785) (567,607)
-------------- -------------- -------------- --------------
OTHER INCOME (EXPENSE)
Other income (expense) - derivative 512,496 1,411,429 53,453 (271,690)
Other income (expense) 1,751 487 (1) 487
Interest (expense) (2,160,056) (2,105,475) (730,604) (689,197)
-------------- -------------- -------------- --------------
TOTAL OTHER INCOME (EXPENSE) (1,645,809) (693,559) (677,152) (960,400)
-------------- -------------- -------------- --------------
NET (LOSS) $ (3,371,777) $ (2,552,763) $ (1,187,937) $ (1,528,007)
============== ============== ============== ==============
Loss per share, basic $ (0.06) $ (0.05) $ (0.02) $ (0.03)
============== ============== ============== ==============
Weighted average number of shares, basic 54,307,255 54,164,569 54,570,035 54,173,745
============== ============== ============== ==============
Loss per share, diluted $ (0.06) $ (0.07) $ (0.02) $ (0.03)
============== ============== ============== ==============
Weighted average number of shares, diluted 54,307,255 54,164,569 54,570,035 54,173,745
============== ============== ============== ==============
See unaudited notes to consolidated financial statements
F-2
ELECTRONIC SENSOR TECHNOLOGY, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Nine Months Ended
September 30,
--------------------------------
2007 2006
-------------- --------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss $ (3,371,777) $ (2,552,763)
Adjustments to reconcile net loss to net
cash provided by (used in) operating activities:
Depreciation and amortization 40,620 29,836
Decrease in allowance for doubtful accounts (22,862) -
Issuance of shares for services - 21,000
Issuance of shares for payment of interest 140,000 -
Amortization of compensation expense related to issuance of
stock options 94,041 -
Amortization of debt discount 1,750,000 1,750,000
Amortization of deferred financing costs 136,160 136,160
Decrease in fair value of derivative liability (503,746) (1,411,430)
Changes in assets and liabilities:
Accounts receivable (46,856) 146,242
Inventories 263,745 (395,632)
Prepaid expenses 2,024 (622)
Accounts payable and accrued expenses 164,516 (40,816)
Deferred revenues (37,500) (37,500)
-------------- --------------
Net cash provided by (used in) operating activities (1,391,635) (2,355,525)
-------------- --------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Decrease in restricted security deposit 237,616 668,678
Decrease in certificate of deposit 702,082 -
Purchase of property and equipment (143,071) (124,057)
Increase in capital lease obligation 59,200
-------------- --------------
Net cash provided by (used in) investing activities 855,827 544,621
-------------- --------------
NET INCREASE (DECREASE) IN CASH (535,808) (1,810,904)
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 1,094,141 4,219,921
-------------- --------------
CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 558,333 $ 2,409,017
============== ==============
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Cash paid during the period for:
Interest $ 145,919 $ 434,477
============== ==============
NONCASH FINANCING AND INVESTING ACTIVITY:
Purchase of property and equipment under capital lease $ 59,200 $ -
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See unaudited notes to consolidated financial statements.
F-3
ELECTRONIC SENSOR TECHNOLOGY, INC.
NOTES TO FINANCIAL STATEMENTS
(Unaudited)
SEPTEMBER 30, 2007
1) BASIS OF PRESENTATION
The accompanying unaudited consolidated financial statements have been
prepared in accordance with generally accepted accounting principles for
interim financial statements and with the instructions to Form 10-QSB and
Item 10 of Regulation S-B. Accordingly, they do not include all the
information and disclosures required for annual financial statements. These
financial statements should be read in conjunction with the consolidated
financial statements and related footnotes for the year ended December 31,
2006, included in the Annual Report filed on Form 10-KSB for the year then
ended.
In the opinion of the management of Electronic Sensor Technology, Inc. (the
"Company"), all adjustments (consisting of normal recurring accruals)
necessary to present fairly the Company's financial position as of
September 30, 2007, and the results of operations and cash flows for the
nine month period ending September 30, 2007 have been included. The results
of operations for the nine month period ended September 30, 2007 are not
necessarily indicative of the results to be expected for the full year. For
further information, refer to the consolidated financial statements and
footnotes thereto included in the Company's Annual Report filed on Form
10-KSB as filed with the Securities and Exchange Commission for the year
ended December 31, 2006, included in the Annual Report filed on Form 10-KSB
for the year then ended.
2) BASIS OF CONSOLIDATION
The accompanying financial statements include the accounts of the Company
and its wholly owned subsidiaries. All intercompany balances and
transactions have been eliminated in consolidation.
3) NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
a) NATURE OF BUSINESS
The Company develops and manufactures electronic devices used for
vapor analysis. It markets its products through distribution channels
in over 20 countries.
b) CASH AND CASH EQUIVALENTS
The Company considers highly liquid financial instruments with
maturities of three months or less at the time of purchase to be cash
equivalents.
c) CERTIFICATE OF DEPOSIT - RESTRICTED
The Company's credit card liability is secured and collateralized with
a certificate of deposit in the amount of approximately $12,000.
d) ALLOWANCE FOR DOUBTFUL ACCOUNTS
The allowance for doubtful accounts is based on the Company's
assessment of the collectibility of customer accounts and the aging of
the accounts receivable. If there is a deterioration of a major
customer's credit worthiness or actual defaults are higher than the
Company's historical experience, the Company's estimates of the
recoverability of amounts due it could be adversely affected. The
Company regularly reviews the adequacy of the Company's allowance for
doubtful accounts through identification of specific receivables where
it is expected that payments will not be received. The Company also
establishes an unallocated reserve that is applied to all amounts that
are not specifically identified. In determining specific receivables
where collections may not
2
be received, the Company reviews past due receivables and gives
consideration to prior collection history and changes in the
customer's overall business condition. The allowance for doubtful
accounts reflects the Company's best estimate as of the reporting
dates. Changes may occur in the future, which may require the Company
to reassess the collectibility of amounts and at which time the
Company may need to provide additional allowances in excess of that
currently provided.
e) REVENUE RECOGNITION
The Company records revenue from direct sales of products to end-users
when the products are shipped, collection of the purchase price is
probable and the Company has no significant further obligations to the
customer. Costs of remaining insignificant Company obligations, if
any, are accrued as costs of revenue at the time of revenue
recognition. Cash payments received in advance of product shipment or
service revenue are recorded as deferred revenue.
f) SHIPPING AND HANDLING
The Company accounts for shipping and handling costs as a component of
"Cost of Sales".
g) INVENTORIES
Inventories are comprised of raw materials, work in process, and
finished goods. Inventories are stated at the lower of cost or market
and are determined using the first-in, first-out method.
h) DEFERRED FINANCING COSTS
Deferred financing costs consist of direct costs incurred by the
Company in connection with the issuance of its convertible debentures.
The direct costs include cash payments and fair value of warrants
issued to the placement agent, which secured the financing. Deferred
financing costs are amortized over 48 months using the effective
interest rate method.
i) PROPERTY AND EQUIPMENT
Property and equipment are stated at cost, net of accumulated
depreciation. Depreciation is computed using the straight-line method
over the estimated useful lives of five years.
j) RESEARCH AND DEVELOPMENT
Research and development costs are charged to operations as incurred
and consists primarily of salaries and related benefits, raw materials
and supplies.
k) USE OF ESTIMATES
The preparation of the financial statements in conformity with
generally accepted accounting principles requires management to make
estimates and assumptions that affect the reported amounts of assets
and liabilities and disclosures of contingent assets and liabilities
at the date of the financial statements and the recorded amounts of
revenues and expenses during the reporting period. Actual results
could differ from those estimates.
l) FAIR VALUE OF FINANCIAL INSTRUMENTS
The fair value of certain financial instruments, including accounts
receivable, accounts payable and accrued liabilities, approximate
their carrying values due to the short maturity of these instruments.
The fair value of the convertible debentures issued by the Company in
December 2005 amounts to $7,000,000, based on the Company's
incremental borrowing rate. The carrying
3
value of the derivative liabilities associated with the convertible
debentures represents its fair value.
m) LONG-LIVED ASSETS
The Company reviews long-lived assets, such as property and equipment,
to be held and used or disposed of, for impairment whenever events or
changes in circumstances indicate that the carrying amount of an asset
may not be recoverable. If the sum of the expected cash flows,
undiscounted and without interest, is less than the carrying amount of
the asset, an impairment loss is recognized as the amount by which the
carrying amount of the asset exceeds its fair value. At September 30,
2007 no assets were impaired.
n) CAPITAL LEASE
On June 28, 2007, the Company entered into a capital lease under which
the present value of the minimum lease payments amounted to $59,200.
The present value of the minimum lease payments was calculated using a
discount rate of 11.41%. The principal balance of the capital lease
obligation amounted to $59,200 at June 30, 2007, including $17,900
included in the current portion of capital lease obligations in the
accompanying consolidated balance sheet.
o) DERIVATIVE LIABILITIES
The Company accounts for its liquidated damages pursuant to Emerging
Issue Task Force ("EITF") 05-04, View C, "The Effect of a Liquidated
Damages Clause on a Freestanding Financial Instrument Subject to EITF
Issue No. 00-19, "Accounting for Derivative Financial Instruments
Indexed to, and Potentially Settled in, a Company's Own Stock". In
December 2006, FASB issued FASB Staff Position No. EITF 00-19-2
"Accounting for Registration Payment Arrangements" ("FSP 00-19-2"),
which superseded EITF 05-04. FSP 00-19-2 provides that the contingent
obligation to make future payments or otherwise transfer consideration
under a registration payment arrangement, should be separately
recognized and measured in accordance with FASB Statement No.5,
"Accounting for Contingencies". The registration statement payment
arrangement should be recognized and measured as a separate unit of
account from the financial instrument(s) subject to that arrangement.
If the transfer of consideration under a registration payment
arrangement is probable and can be reasonably estimated at inception,
such contingent liability is included in the allocation of proceeds
from the related financing instrument. Pursuant to EITF 05-04, View C,
the liquidated damages paid in cash or stock are accounted for as a
separate derivative, which requires a periodical valuation of its fair
value and a corresponding recognition of liabilities associated with
such derivative. FSP00-19-2 did not have an impact on the Company's
accounting of the liquidated damages.
The Company has registered all shares underlying the convertible
debentures as well as all shares underlying the warrants related to
the convertible debentures.
The Company accounts for its embedded conversion features and
freestanding warrants pursuant to SFAS No. 133, "Accounting for
Derivative Instruments and Hedging Activities", which requires a
periodic valuation of their fair value and a corresponding recognition
of liabilities associated with such derivatives. The recognition of
derivative liabilities related to the issuance of shares of common
stock is applied first to the proceeds of such issuance, at the date
of issuance, and the excess of derivative liabilities over the
proceeds is recognized as other expense in the accompanying
consolidated financial statements. The recognition of derivative
liabilities related to the issuance of convertible debt is applied
first to the proceeds of such issuance as a debt discount, at the date
of issuance, and the excess of derivative liabilities over the
proceeds is recognized as other expense in the accompanying
consolidated financial statements. Any subsequent increase or decrease
in the fair value of the derivative liabilities, which are measured at
the balance sheet date, are recognized as other expense or other
income, respectively.
4
p) BASIC AND DILUTED EARNINGS PER SHARE
Basic earnings per share are calculated by dividing income available
to stockholders by the weighted-average number of common shares
outstanding during each period. Diluted earnings per share are
computed using the weighted average number of common and dilutive
common share equivalents outstanding during the period. Dilutive
common share equivalents consist of shares issuable upon the exercise
of stock options and warrants embedded conversion features (calculated
using the reverse treasury stock method). The outstanding options,
warrants and shares equivalent issuable pursuant to embedded
conversion features amounted to 113,691,626 and 45,278,509 at
September 30, 2007 and 2006, respectively. The outstanding options,
warrants and shares equivalent issuable pursuant to embedded
conversion features and warrants at September 30, 2007 and 2006,
respectively, are excluded from the loss per share computation for
that period due to their antidilutive effect. The Company adjusted the
numerator for any changes in income or loss that would result if the
contract had been recorded as an equity instrument for accounting
purposes during the period. However, the Company did not adjust the
numerator for interest charges during the period on the convertible
debentures because it would have been anti-dilutive.
The following sets forth the computation of basic and diluted earnings
per share at September 30:
2007 2006
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Numerator:
Net (loss) $ (3,371,777) $ (2,552,763)
Net other income/(expense) associated with
derivative contracts 512,496 1,411,429
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Net (loss) for diluted earnings per share purposes $ (3,884,273) $ (3,964,192)
============ ============
Denominator:
Denominator for basic earnings per share-
Weighted average shares outstanding 54,307,255 54,164,569
Effect of dilutive warrants, embedded
conversion features and liquidated damages 0 0
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Denominator for diluted earnings per share-
Weighted average shares outstanding 54,307,255 54,164,569
============ ============
Basic earnings (loss) per share $ (0.06) $ (0.05)
============ ============
Diluted earnings (loss) per share $ (0.07) $ (0.07)
============ ============
q) STOCK BASED COMPENSATION
In December 2004, the FASB issued SFAS No. 123(R), "Share-Based
Payment," which replaces SFAS No. 123 and supersedes APB Opinion No.
25. Under SFAS No. 123(R), companies are required to measure the
compensation costs of share-based compensation arrangements based on
the grant-date fair value and recognize the costs in the financial
statements over the period during which employees are required to
provide services. Share-based compensation arrangements include stock
options, restricted share plans, performance-based awards, share
appreciation rights and employee share purchase plans. In March 2005
the SEC issued Staff Accounting Bulletin No. 107, or "SAB 107". SAB
107 expresses views of the staff regarding the interaction between
SFAS No. 123(R) and certain SEC rules and regulations and provides the
staff's views regarding the valuation of share-based payment
arrangements for public companies. SFAS No. 123(R) permits public
companies to adopt its requirements using one of two methods. On April
14, 2005, the SEC adopted a new rule amending the compliance dates for
SFAS No. 123(R). Companies may elect to apply this statement either
prospectively, or on a modified version of retrospective application
under which financial statements for prior periods are adjusted on a
basis consistent with the pro forma disclosures required for those
periods under SFAS 123. Effective January 1, 2006, the Company has
fully adopted the provisions of SFAS No. 123(R) and related
5
interpretations as provided by SAB 107. As such, compensation cost is
measured on the date of grant as the excess of the current market
price of the underlying stock over the exercise price. Such
compensation amounts are amortized over the respective vesting periods
of the option grant. The Company applies this statement prospectively.
r) RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In September 2006, the FASB issued FASB Statement No. 157. This
Statement defines fair value, establishes a framework for measuring
fair value in generally accepted accounting principles (GAAP), and
expands disclosures about fair value measurements. This Statement
applies under other accounting pronouncements that require or permit
fair value measurements, the Board having previously concluded in
those accounting pronouncements that fair value is a relevant
measurement attribute. Accordingly, this Statement does not require
any new fair value measurements. However, for some entities, the
application of this Statement will change current practices. This
Statement is effective for financial statements for fiscal years
beginning after November 15, 2007. Earlier application is permitted
provided that the reporting entity has not yet issued financial
statements for that fiscal year. Management believes this Statement
will have no impact on the financial statements of the Company once
adopted.
On July 13, 2006, the Financial Accounting Standards Board (FASB)
issued FASB Interpretation No. 48, ("FIN 48"), entitled, "Accounting
for Uncertainty in Income Taxes - an Interpretation of FASB Statement
No. 109". Concurrently, FASB issued a FASB staff position (FSP)
relating to income taxes, (FSP) No. FAS 13-2, "Accounting for a Change
or Projected Change in the Timing of Cash Flows Relating to Income
Taxes Generated by a Leveraged Lease Transaction." FASB's summary of
FIN 48 notes that differences between tax positions recognized in the
financial statements and tax positions taken in the tax return
(referred to commonly as "book" vs. "tax") will generally result in:
(a) an increase in a liability for income taxes payable or a reduction
of an income tax refund receivable, (b) a reduction in a deferred tax
asset or an increase in a deferred tax liability, or (c) both of the
above. FIN 48 requires the affirmative evaluation that it is more
likely than not, based on the technical merits of a tax position, that
an enterprise is entitled to economic benefits resulting from
positions taken in income tax returns. Further, if a tax position does
not meet the more-likely-than-not recognition threshold, the benefit
of that position is not recognized in the financial statements.
Additionally, FIN 48 establishes guidance for "derecognition" of
previously recognized deferred tax items, and sets forth disclosure
requirements. The effective date of FIN 48 is for fiscal years
beginning after December 15, 2006. The Company does not believe that
FIN 48, once adopted, will have a significant impact on its financial
position, operating results, or cash flows.
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option
for Financial Assets and Financial Liabilities -- including an
amendment of FAS 115 ("SFAS No. 159"). SFAS No. 159 allows companies
to choose, at specified election dates, to measure eligible financial
assets and liabilities at fair value that are not otherwise required
to be measured at fair value. Unrealized gains and losses shall be
reported on items for which the fair value option has been elected in
earnings at each subsequent reporting date. SFAS No. 159 also
establishes presentation and disclosure requirements. SFAS No. 159 is
effective for fiscal years beginning after November 15, 2007 and will
be applied prospectively. The Company is currently evaluating the
impact of adopting SFAS No. 159 on our consolidated financial
position, results of operations and cash flows.
4) CONVERTIBLE DEBENTURES
During December 2005, we issued in a private offering, $7,000,000 aggregate
principal amount of convertible debentures due December 7, 2009. The
convertible debentures are convertible at any time on or prior to the
maturity date at the option of the debenture holder at a conversion price
of $0.4544, which was subsequently reduced to $0.4000 as per a Forbearance
and Amendment Agreement, dated September 7, 2006, with the holders of the
convertible debentures (see Note 7), and can be redeemed at the lesser of
6
$0.4000 or 90% of the average of the volume weighted average price for the
20 consecutive trading days immediately prior to the conversion date. The
Company received $7,000,000 in cash as consideration. The convertible
debentures bear interest at 8%, payable in cash or stock, at the Company's
option, and are required to be redeemed in 9 equal quarterly payments
commencing January 1, 2008, in cash or stock, at the Company's option. If
the Company chooses to pay interest on or redeem the debentures in shares
of the Company's common stock, rather than in cash, the conversion rate for
such stock payment is the lesser of $0.4544, which was subsequently reduced
to $0.4000 as per a Forbearance and Amendment Agreement, dated September 7,
2006, with the holders of the convertible debentures (see Note 7), or 90%
of the average of the volume weighted average price for the 20 consecutive
trading days immediately prior to the interest payment or redemption date,
as applicable.
In connection with the issuance of the convertible debentures, the Company
issued five-year warrants to purchase 12,130,314 shares of common stock at
an exercise price of $0.4761 per share, which was subsequently reduced to
$0.4300 per share as per a Forbearance and Amendment Agreement, dated
September 7, 2006, with the holders of the warrants (see Note 7).
Furthermore, the Company granted liquidated damages pursuant to a
registration rights agreement.
The convertible debentures and related agreements provide, among other
things, for:
1) Liquidated damages amounting to 2% per month of the outstanding
principal amount, payable in cash or stock, to the debenture
holders in the event that a registration statement covering the
shares underlying the convertible debentures is not declared
effective within 150 days of the date the debentures were issued
(which was subsequently extended to February 28, 2007 as per a
Forbearance and Amendment Agreement, dated September 7, 2006,
with the holders of the convertible debentures and warrants - see
Note 7). The registration statements covering the shares
underlying the convertible debentures were declared effective on
November 21, 2006 and December 21, 2006, respectively.
2) Default interest rate of 18% and a default premium of 30% of the
principal amount of the debentures, payable in cash or stock.
Events of default include, among other things, if a payment,
whether cash or stock is not paid on time and cured within three
days, if the Company's common stock is not quoted for trading for
at least five trading days, if a registration is not effective
within 180 days after December 7, 2005 (which was subsequently
extended to February 28, 2007 as per a Forbearance and Amendment
Agreement, dated September 7, 2006 with the holders of the
convertible debentures and warrants (see Note 7) - the
registration statements covering the shares underlying the
convertible debentures and warrants were declared effective on
November 21 and December 21, 2006, respectively). The default
interest rate and the default premium may be converted in shares
of common stock at the same prevailing rate as the remaining
principal amount of the convertible debentures;
3) A reset feature of the conversion price in the event of a
subsequent equity or convertible financing with an effective
price lower than the debenture conversion price, whereby the
aforementioned variable conversion price of the convertible
debentures is adjusted to the new lower effective price of the
subsequent equity or convertible financing; and
4) The warrants require that the Company reimburse any holder of a
warrant in respect of any trading loss resulting from the failure
of the Company to timely deliver shares issued pursuant to the
exercise of warrants. This compensation may be paid in shares of
common stock or cash. The exercise price of the warrants, which
is $0.4761 per share at the date of the agreement (and was
subsequently reduced to $0.4300 per share as per a Forbearance
and Amendment Agreement, dated September 7, 2006, with the
holders of the warrants - see Note 7), may be further reduced if
the registration statement we are required to file at the request
of the warrant holders with respect to the common stock
underlying the warrants is not declared effective within six
months of the date of issuance of the warrants (which was
subsequently extended to February 28, 2007 as per a Forbearance
and Amendment Agreement, dated September 7, 2006 with the holders
of the
7
warrants - see Note 7). The registration statement covering the
shares underlying the warrants was declared effective on December
21, 2006.
In connection with the issuance of the convertible debentures, we issued
485,213 warrants to a company in partial consideration for financial
advisory services, as well as paid $490,000 to this company. The warrants
have the same terms as those granted to the debenture holders. The fair
value of the warrants at the date of issuance amounted to approximately
$136,000. We also incurred approximately $102,500 in additional
professional fees relating to the issuance of the convertible debentures
and warrants. The payments of professional fees and the fair value of the
warrants, aggregating approximately $729,000 have been recorded as deferred
financing costs. The deferred financing costs are amortized over the term
of the convertible debentures. The amortization of deferred financing costs
approximated $45,400 for the three-month period ending September 30, 2007.
See Note 5- Derivative Liabilities for further information on the
accounting and measurement of the derivative liabilities associated with
the issuance of the convertible debentures and related agreements.
We recognized a debt discount of $7,000,000 at the date of issuance of the
convertible debentures and the excess amount has been recorded as liability
and a corresponding increase to other expense. The debt discount is
recognized over the term of the convertible debentures.
Amounts due on the convertible debentures within the next twelve months are
classified as a current liability. The amount of convertible debentures
payable within the next twelve months at September 30, 2007 is
approximately $2,333,333.
5) DERIVATIVE LIABILITIES
FEBRUARY 2005 TRANSACTION
During February 2005, we recognized derivative liabilities of approximately
$6.0 million pursuant to the issuance of 3,985,000 freestanding warrants
and granting certain registration rights which provided for liquidated
damages in the event of failure to timely register the shares in connection
with the issuance of shares of common stock and the related warrants.
There are no liquidated damages provided for untimely effectiveness of the
registration of shares pursuant to piggy-back registration rights. The
Company intends to register all shares and warrants pursuant to the
subscriber piggy-back registration rights.
The agreement pursuant to which the warrants were issued and the
registration rights were granted provided for liquidated damages pursuant
to demand registration rights in the event of a failure to timely register
the shares after demand is made by the holders of a majority of the
warrants and shares of common stock issued pursuant to such agreement. The
demand registration rights of these investors are such that if the Company
fails to register the investors shares, including the shares underlying the
warrants, the Company will pay a cash penalty amounting to 1% of the amount
invested per month, $39,850, if the registration statement is not filed
within 60 days of demand or is not declared effective within 150 days from
the date of initial filing. The maximum liability associated with the
liquidated damages amounts to 49% of the gross proceeds associated with the
issuance of shares of common stock, which amounts to $1,952,650. The
percentage of liquidated damages amounts to the difference between 60
months, which is the inherent time limitation under which the underlying
shares would be free-trading (three year term and two year holding period)
and 11 months, which is the grace period for registering the shares (no
demand permitted for four months, two-month period to file and five-month
period to become effective), times the penalty percentage, which is 1%. The
Company believes that the likelihood that it will incur any liabilities
resulting from the liquidated damages pursuant to the demand registration
rights is remote considering that it will register the shares and the
shares underlying the warrants pursuant to piggy-back registration rights,
which do not contain liquidated damages.
8
Because the registration rights were not granted under a separate
registration rights agreement, we considered those features in evaluating
whether the associated warrants should be classified as derivative
liabilities. Considering that the amount of the maximum penalty is 49%, the
Company cannot conclude that that this discount represents a reasonable
approximation of the difference between registered and unregistered shares
under paragraph 16 of EITF 00-19. Accordingly, the warrants issued in
connection with the February 2005 transaction are considered derivative
liabilities.
The fair value of the warrants issued in connection with the February 2005
transaction at the date of issuance of the warrants and the granting of
registration rights and at September 30, 2007 is as follows:
At issuance At September 30, 2007
----------------------- -----------------------
Freestanding warrants $ 6,017,350 $ 0
The Company used the following assumptions, using the Black Scholes Model
to measure the identified derivatives as follows:
Freestanding warrants
At issuance At September 30, 2007
--------------------- -----------------------
Market price: $ 2.40 $ 0.09
Exercise price: $ 1.00 $ 1.00
Term: 3 years 0.51 years
Volatility: 39% 36%
Risk-free interest rate: 2.78% 4.03%
Number of warrants: 3,985,000 3,985,000
DECEMBER 2005 TRANSACTION
During December 2005, in connection with the issuance of the convertible
debentures, the Company determined that the conversion feature of the
convertible debentures represents an embedded derivative since the
debentures are convertible into a variable number of shares upon
conversion. Because there is no explicit number of shares that are to be
delivered upon satisfaction of the convertible debentures and that there is
no cap on the number of shares to be delivered upon expiration of the
contract to a fixed number, the Company is unable to assert that it had
sufficient authorized and unissued shares to settle its obligations under
the convertible debentures and therefore, net-share settlement is not
within the control of the Company. Accordingly, the convertible debentures
are not considered to be conventional debt under EITF 00-19 and the
embedded conversion feature must be bifurcated from the debt host and
accounted for as a derivative liability.
The embedded conversion features are as follows:
Default Interest Rate and Premium: The default interest rate is 18% while
the stated rate of the convertible debentures is 8%. Additionally, the
Company is liable to pay for a premium amounting to 30% of the principal
amount of the convertible debentures in the event of default. This embedded
derivative could at least double the investor's initial rate of return on
the host contract and could also result in a rate of return that is at
least twice what otherwise would be the market return for a contract that
has the same terms as the host contract and that involves a debtor with a
similar credit quality. Furthermore, the default interest rate may be
triggered by certain events of defaults which are not related to
credit-risk-related covenants or the Company's creditworthiness (e.g., if a
registration statement is not timely filed). The default provisions are
effective, at the holders' option, upon an event of default.
Reset Feature Following Subsequent Financing: The debenture provides for a
reset feature of the conversion price in the event of a subsequent equity
or convertible financing with an effective price lower
9
than the debenture conversion price, whereby the aforementioned variable
conversion price of the convertible debentures is adjusted to the new lower
effective price of the subsequent equity or convertible financing, which
amounts to 10% of the shares issuable pursuant to the convertible
debentures, which is the effective discount to market value we would offer
in the event we provide for a subsequent private placement financing. This
reset does not constitute a standard anti-dilution provision and is indexed
to an underlying other than an interest rate or credit risk.
Conversion Rate: The convertible debentures are convertible at a variable
conversion price, which is the lesser of $0.4544, which was subsequently
reduced to $0.4000 as per a Forbearance and Amendment Agreement, dated
September 7, 2006, with the holders of the convertible debentures (see Note
7), or 90% of the average of the volume weighted average price for the 20
consecutive trading days immediately prior to the conversion date. The
convertible debentures are convertible at any time on or prior to the
maturity date at the option of the debenture holder. The implied conversion
embedded feature amounts to a conversion discount of 10% to market.
The Company believes that the aforementioned embedded derivatives meet the
criteria of SFAS 133, including Implementation issue No. B16 and EITF
00-19, when appropriate, and should be accounted for as derivatives with a
corresponding value recorded as a liability.
In connection with the issuance of the convertible debentures, the Company
issued warrants to the debenture holders. The related warrants require that
the Company reimburse any holder of a warrant in respect of any trading
loss resulting from the failure of the Company to timely deliver shares
issued pursuant to the exercise of warrants. This compensation may be paid
in shares of common stock or cash. Accordingly, we have accounted for such
warrants as derivatives.
In connection with the issuance of the convertible debentures, the Company
granted liquidated damages pursuant to a registration rights agreement. The
liquidated damages results in the event that a registration statement
covering the shares underlying the convertible debentures is not declared
effective within 150 days of the date the debentures were issued (which was
subsequently extended to February 28, 2007 as per a Forbearance and
Amendment Agreement, dated September 7, 2006 with the holders of the
convertible debentures - see Note 7). The registration statement covering
the shares underlying the convertible debentures was declared effective on
November 21, 2006.
Additionally, because there is no explicit number of shares that are to be
delivered upon satisfaction of the convertible debentures, the Company is
unable to assert that it had sufficient amount of authorized and unissued
shares to settle its obligations under the convertible debentures.
Accordingly, all of the Company's previously issued and outstanding
instruments, such as warrants, as well as those issued in the future, would
be classified as liabilities as well, effective with the issuance of the
convertible debentures and until the Company is able to assert that it has
a sufficient amount of authorized and unissued shares to settle its
obligations under all outstanding instruments. At the date of the issuance
of the convertible debentures, the Company had 1,941,871 warrants
outstanding which were classified as derivatives.
The fair value of the derivative liabilities at the date of issuance of the
convertible debentures and at September 30, 2007 are as follows:
At Issuance At September 30, 2007
--------------- ---------------------
Freestanding warrants $ 3,532,348 $ 875
Embedded conversion features 3,463,542 2,851,852
Liquidated damages 192,500 0
Other outstanding warrants 143,268 0
The Company used the following methodology to value the embedded conversion
features and liquidated damages:
10
It estimated the discounted cash flows payable by the Company, using
probabilities and likely scenarios, for event of defaults triggering the
30% penalty premium and 18% interest accrual, subsequent financing reset,
and liquidated damages, such as the untimely effectiveness of a
registration statement. If the additional cash consideration was payable in
cash or stock, it determined the amount of additional shares that would be
issuable pursuant to its assumptions. The Company revisits the weight of
probabilities and the likelihood of scenarios at each measurement date of
the derivative liabilities, which are the balance sheet dates.
The Company used the following methodology to value the embedded conversion
features and liquidated damages:
It estimated the discounted cash flows payable by the Company, using
probabilities and likely scenarios, for event of defaults triggering the
30% penalty premium and 18% interest accrual, subsequent financing reset,
and liquidated damages, such as the untimely effectiveness of a
registration statement. If the additional cash consideration was payable in
cash or stock, it determined the amount of additional shares that would be
issuable pursuant to its assumptions. The Company revisits the weight of
probabilities and the likelihood of scenarios at each measurement date of
the derivative liabilities, which are the balance sheet dates.
The Company used the following assumptions to measure the identified
derivatives, using the Lattice valuation model, as follows:
Embedded conversion features
At issuance At September 30, 2007
-------------------- ---------------------
Market price: $ 0.4880 $ 0.09
Conversion price: $ 0.4544 $ 0.08
Term: 4 years 2.2 years
Volatility: 39% 36%
Risk-free interest rate: 4.39% 4.03%
Freestanding warrants
The derivative liability amounts to the fair value of the warrants issuable
upon exercise. We computed the fair value of this embedded derivative using
the Black Scholes valuation model with the following assumptions:
At issuance At September 30, 2007
-------------------- ---------------------
Market price: $ 0.488 $ 0.09
Exercise price: $ 0.4761 $ 0.43
Term: 5 years 3.17 years
Volatility: 39% 36%
Risk-free interest rate: 4.39% 4.03%
Liquidated damages
The liquidated damages, payable in cash, are valued using the weighting
probabilities and likely scenarios to estimate the amount of liquidated
damages and were valued at approximately $192,500 and $0 at the date of the
grant of the registration rights and at September 30, 2007, respectively.
The aggregate fair value of the derivative liabilities associated with the
warrants, embedded conversion features, and liquidated damages in
connection with the issuance of the convertible debentures and related
agreements amounted to approximately $7.05 million at the date of issuance
which exceeded the principal amount of the convertible debentures by
approximately $50,000. The Company recognized $7,000,000 as
11
debt discount and the excess amount was recorded as other expenses in
December 2005. Additionally, approximately $136,000 of the fair value of
the warrants was recorded as deferred financing costs.
The aggregate fair value of all derivative liabilities upon their issuance
in 2005 of the various debt and equity instruments amounted to $13.3
million, of which $10.7 million was allocated to the net proceeds of the
issuance of common stock and convertible debentures, $2.4 million was
allocated and charged to other expenses (in 2005), and approximately
$136,000 was allocated to deferred financing costs (in 2005).
The decrease in fair value of the derivative liabilities between
measurement dates, which are the date of issuance of the various debt and
equity instruments and the balance sheet date, which is September 30,
amounted to approximately $0.5 million and $1.4 million, and have been
recorded as other income in 2007 and 2006, respectively.
6) STOCKHOLDERS' DEFICIT
OPTIONS
In 2005, the Board of Directors adopted the Electronic Sensor Technology,
Inc. 2005 Stock Incentive Plan. The purpose of the Stock Incentive Plan is
to attract and retain the services of experienced and knowledgeable
individuals to serve as our employees, consultants and directors. On the
date the Stock Incentive Plan was adopted, the total number of shares of
common stock subject to it was 5,000,000. The Stock Incentive Plan is
currently administered by the Board of Directors, and may be administered
by any Committee authorized by the Board of Directors, so long as any such
Committee is made up of Non-Employee Directors, as that term is defined in
Rule 16(b)-3(b) of the Securities Exchange Act of 1934.
The Stock Incentive Plan is divided into two separate equity programs: the
Discretionary Option Grant Program and the Stock Issuance Program. Under
the Discretionary Option Grant Program, eligible persons may, at the
discretion of the administrator, be granted options to purchase shares of
common stock and stock appreciation rights. Under the Stock Issuance
Program, eligible persons may, at the discretion of the administrator, be
issued shares of common stock directly, either through the immediate
purchase of such shares or as a bonus for services rendered for Electronic
Sensor Technology (or a parent or subsidiary of Electronic Sensor
Technology).
Pursuant to the terms of the Discretionary Option Grant Program, the
exercise price per share is fixed by the administrator, but may not be less
than 85% of the fair market value of the common stock on the date of grant,
unless the recipient of a grant owns 10% or more of Electronic Sensor
Technology's common stock, in which case the exercise price of the option
must not be less than 110% of the fair market value. An option grant may be
subject to vesting conditions. Options may be exercised in cash, with
shares of the common stock of Electronic Sensor Technology already owned by
the person or through a special sale and remittance procedure, provided
that all applicable laws relating to the regulation and sale of securities
have been complied with. This special sale and remittance procedure
involves the optionee concurrently providing irrevocable written
instructions to: (i) a designated brokerage firm to effect the immediate
sale of the purchased shares and remit to Electronic Sensor Technology, out
of the sale proceeds available on the settlement date, sufficient funds to
cover the aggregate exercise price payable for the purchased shares plus
all applicable federal, state and local income and employment taxes
required to be withheld by Electronic Sensor Technology by reason of such
exercise and (ii) Electronic Sensor Technology to deliver the certificates
for the purchased shares directly to such brokerage firm in order to
complete the sale. The term of an option granted pursuant to the
Discretionary Option Grant Program may not be more than 10 years.
The Discretionary Option Grant Program also allows for the granting of
Incentive Options to purchase common stock, which may only be granted to
employees, and are subject to certain dollar limitations. Any options
granted under the Discretionary Option Grant Program that are not Incentive
Options are considered Non-Statutory Options and are governed by the
aforementioned terms. The exercise price of an Incentive Option must be no
less than 100% of the fair market value of the common stock on the date of
grant, unless the recipient of an award owns 10% or more of Electronic
Sensor Technology's common
12
stock, in which case the exercise price of an incentive stock option must
not be less than 110% of the fair market value. The term of an Incentive
Option granted may not be more than five years if the option is granted to
a recipient who owns 10% or more of Electronic Sensor Technology's common
stock, or 10 years for all other recipients of Incentive Options. Incentive
Options are otherwise governed by the general terms of the Discretionary
Option Grant Program.
Pursuant to the terms of the Stock Issuance Program, the purchase price per
share of common stock issued is fixed by the administrator, but may not be
less than 85% of the fair market value of the common stock on the issuance
date, unless the recipient of a such common stock owns 10% or more of
Electronic Sensor Technology's common stock, in which case the purchase
price must not be less than 110% of the fair market value. Common stock may
be issued in exchange for cash or past services rendered to Electronic
Sensor Technology (or any parent or subsidiary of Electronic Sensor
Technology). Common stock issued may be fully and immediately vested upon
issuance or may vest in one or more installments, at the discretion of the
administrator.
During the first quarter ended March 31, 2007, 1,520,450 stock option
shares, with varying vesting terms, were granted to directors and employees
of the company. The fair value of the granted stock options shares, as
calculated using Black Scholes methodology was approximately $145,000. The
fair value of the options issued was based on the following assumptions:
exercise price: $0.19-0.24, market value: $0.19-0.24, risk-free interest
rate: 4.54%, expected dividend rate: 0%, expected volatility: 39%, and
term: 5 years. The expected volatility was based on the average historical
volatility of comparable publicly-traded companies.
During the three months ended September 30, 2007, the Company granted stock
options to the CEO/President to acquire a total of 1,000,000 shares of
common stock at $0.20 per share. The fair value of the granted stock
options shares, using Black Scholes methodology was approximately $80,000.
Stock options totaling 100,000 shares were vested when granted, and the
remaining 900,000 option shares will vest as follow: 225,000 on April 11,
2008; 225,000 on April 11, 2009; 225,000 on April 11, 2010; and 225,000 on
April 11, 2011. The fair value of the options issued was based on the
following assumptions: exercise price: $0.20, term: 4.46 years, expected
volatility: 36%, expected dividend rate: zero, and risk-free interest rate:
4.03%. The expected volatility was based on the average historical
volatility of comparable publicly-traded companies.
During the three months ended September 30, 2007, no options were
exercised.
Approximately $54,000, $18,000 and $22,000 were charged to compensation
expense in the first, second and third quarters, respectively. The
remaining amount will be amortized to compensation expense over future
periods based on the vesting schedule of the respective stock option
shares. The total compensation cost related to nonvested awards not yet
recognized amounted to approximately $131,000 at September 30, 2007. This
compensation cost will be recognized over the weighted average period of
the remaining terms of the stock options, unless the options are terminated
sooner.
There were a total of 3,765,150 stock option shares issued and outstanding
at September 30, 2007, of which 2,077,250 were fully vested. The remaining
stock option shares will vest as follows:
Number of stock
Year option Shares
----------------- ---------------
Remainder of 2007 25,000
2008 591,350
2009 366,350
2010 366,350
2011 338,850
13
7) FORBEARANCE AND AMENDMENT AGREEMENT
On September 7, 2006, the Company entered into a Forbearance and Amendment
Agreement with the holders of the convertible debentures and warrants that
we issued in a private placement on December 7, 2005. The terms of the
convertible debentures and warrants required that we register the shares of
our common stock underlying such debentures and warrants within 180 days of
the date of issuance of the debentures and warrants. The failure to do so
is an event of default under the debentures, giving the holders the right
to accelerate the debentures and receive a premium of approximately 30% of
the outstanding amounts due under the debentures upon acceleration. The
failure to do so also reduces the exercise price of the warrants by $0.03
per month until such shares are registered. In addition, the failure to
register such shares within 150 days of the date of issuance of the
debentures and warrants gives the holders the right to receive liquidated
damages in the amount of 2% per month of the purchase price of the
debentures and warrants, pursuant to a registration rights agreement, and
the failure to pay such liquidated damages relating to the debentures is an
event of default under the debentures.
Pursuant to the Forbearance and Amendment Agreement, the holders agreed,
among other things, to abstain from exercising the aforementioned rights
and remedies arising out of the existing defaults under the debentures and
warrants unless we were unable to register the shares underlying the
convertible debentures and the warrants by February 28, 2007. In exchange
for such forbearance, the Company agreed to reduce the conversion price of
the debentures issued on December 7, 2005 from $0.4544 per share to $0.4000
per share and to reduce the exercise price of the warrants issued to the
holders of the convertible debentures on such date from $0.4761 per share
to $0.4300 per share. The registration statements covering the shares
underlying the convertible debentures and warrants were declared effective
on November 21 and December 21, 2006, respectively.
The Forbearance and Amendment Agreement provides for revised probabilities
and likely outcomes that the Company will use in its valuation of the
embedded conversion features, the freestanding warrants and the liquidated
damages associated with the issuance of the convertible debentures, as
required by SFAS 133, paragraph 17. Such valuation is performed at each
balance sheet date.
14
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION.
You should read the following discussion and analysis of our financial condition
and results of operations together with our interim financial statements and the
related notes appearing at the beginning of this report. The interim financial
statements and this Management's Discussion and Analysis of Financial Condition
and Results of Operations should be read in conjunction with the financial
statements and notes thereto for the year ended December 31, 2006 and the
related Management's Discussion and Analysis of Financial Condition and Results
of Operations, both of which are contained in our Annual Report on Form 10-KSB
filed with the Securities and Exchange Commission.
--------------------------------------------------------------------------------
OVERVIEW
The Company is engaged in the development, manufacturing, and sales of a
patented product called zNose(R); a device designed to detect and analyze
chemical odors and vapors, or, in other words, an electronic "nose." We believe
the zNose(R) is superior to other electronic "noses" because of its speed,
specificity and sensitivity. The zNose(R) is capable of measuring and
quantifying the chemistry of any compound, fragrance, vapor or odor with parts
per trillion sensitivity in 10 seconds. We also believe the zNose(R) has the
unique ability to quantify and speciate the subject chemical vapor by creating
visual olfactory images. This enables the measured odor or vapor to be easily
identified by the user.
We believe that our products will have broad applications in the homeland
security, environmental and laboratory instrumentation markets. The Company is
involved in ongoing product research and development efforts in that regard. The
Company has also concentrated its efforts on further product development,
testing and proving and assembling a sales and support organization.
The Company was originally incorporated under the laws of the state of Nevada as
"Bluestone Ventures, Inc." on July 12, 2000. From inception until February 1,
2005, we engaged in the business of acquiring, exploring and developing certain
mining properties in Ontario, Canada. Upon acquisition of Electronic Sensor
Technology, L.P. ("ELP"), we abandoned our mining business and adopted ELP's
business of developing, manufacturing and selling the vapor analysis device. On
January 26, 2005, we changed our name to "Electronic Sensor Technology, Inc."
Our executive offices are located at 1077 Business Center Circle, Newbury Park,
California 91320 and our telephone number is (805) 480-1994.
CRITICAL ACCOUNTING POLICIES
The Company records revenue from direct sales of products to end-users when the
products are shipped, collection of the purchase price is probable and the
Company has no significant further obligations to the customer. Costs of
remaining insignificant Company obligations, if any, are accrued as costs of
revenue at the time of revenue recognition. Cash payments received in advance of
product shipment or service revenue are recorded as deferred revenue.
The preparation of the financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosures of contingent assets and liabilities at the date of the financial
statements and the recorded amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
The Company reviews long-lived assets, such as property and equipment, to be
held and used or disposed of, for impairment whenever events or changes in
circumstances indicate that the carrying amount of an asset may not be
recoverable. If the sum of the expected cash flows, undiscounted and without
interest, is less than the carrying amount of the asset, an impairment loss is
recognized as the amount by which the carrying amount of the asset exceeds its
fair value. At September 30, 2007 no assets were impaired.
The Company accounts for its liquidated damages pursuant to Emerging Issue Task
Force ("EITF") 05-04, View C, "The Effect of a Liquidated Damages Clause on a
Freestanding Financial Instrument Subject to EITF Issue No. 00-
15
19, "Accounting for Derivative Financial Instruments Indexed to, and Potentially
Settled in, a Company's Own Stock". In December 2006, FASB issued FASB Staff
Position No. EITF 00-19-2 "Accounting for Registration Payment Arrangements"
("FSP 00-19-2"), which superseded EITF 05-04. FSP 00-19-2 provides that the
contingent obligation to make future payments or otherwise transfer
consideration under a registration payment arrangement, should be separately
recognized and measured in accordance with FASB Statement No.5, "Accounting for
Contingencies". The registration statement payment arrangement should be
recognized and measured as a separate unit of account from the financial
instrument(s) subject to that arrangement. If the transfer of consideration
under a registration payment arrangement is probable and can be reasonably
estimated at inception, such contingent liability is included in the allocation
of proceeds from the related financing instrument. Pursuant to EITF 05-04, View
C, the liquidated damages paid in cash or stock are accounted for as a separate
derivative, which requires a periodical valuation of its fair value and a
corresponding recognition of liabilities associated with such derivative.
FSP00-19-2 did not have an impact on the Company's accounting of the liquidated
damages.
The Company has registered all shares underlying the convertible debentures as
well as all shares underlying the warrants related to the convertible
debentures.
The Company accounts for its embedded conversion features and freestanding
warrants pursuant to SFAS No. 133, "Accounting for Derivative Instruments and
Hedging Activities", which requires a periodic valuation of their fair value and
a corresponding recognition of liabilities associated with such derivatives. The
recognition of derivative liabilities related to the issuance of shares of
common stock is applied first to the proceeds of such issuance, at the date of
issuance, and the excess of derivative liabilities over the proceeds is
recognized as other expense in the accompanying consolidated financial
statements. The recognition of derivative liabilities related to the issuance of
convertible debt is applied first to the proceeds of such issuance as a debt
discount, at the date of issuance, and the excess of derivative liabilities over
the proceeds is recognized as other expense in the accompanying consolidated
financial statements. Any subsequent increase or decrease in the fair value of
the derivative liabilities, which are measured at the balance sheet date, are
recognized as other expense or other income, respectively.
PLAN OF OPERATIONS
Over the course of the next 12 months, we intend to execute our business plan
and focus our business development efforts in the following key areas:
o By diversifying our product offerings to enhance the usefulness of our
solutions for customers who will have already adopted one or more
products;
o By enhancing our product lines and developing new products to attract
new customers; and
o By developing partnering relationships with wide-ranging sales and
distribution channel leaders already serving our vertical market space
in a way that assists them in developing new revenue streams and
opportunities through improved technical and sales support and
customer services.
RESULTS OF OPERATIONS
The following tables sets forth, in $ and as a percentage of revenues, certain
items included in the Company's Income Statements (see Financial Statements and
Notes) for the periods indicated:
NINE MONTHS ENDED SEPTEMBER 30
------------------------------
STATEMENT OF OPERATIONS DATA: 2007 2006
----------------------------------- -------------- -------------
Revenues........................... 100% 100%
Cost of Sales...................... 53% 47%
Gross Profit....................... 47% 53%
Operating Expenses................. 149% 173%
(Loss) From Operations............. (102%) (120%)
Other Income (Expense)............. (97%) (45%)
16
NINE MONTHS ENDED SEPTEMBER 30
------------------------------
STATEMENT OF OPERATIONS DATA: 2007 2006
----------------------------------- -------------- -------------
Net Income (Loss).................. (199%) (165%)
Nine Months Ended September 30, 2007 Compared to Nine Months Ended September 30,
2006
Revenues are derived from product sales and product support services. For the
nine months ending September 30, 2007, revenues were $1,691,700, compared to
$1,549,800 for the same period in 2006. Product revenues were 15% greater than
in 2006. The increase in product revenues results from a greater number of
zNose(R) instruments shipped during the period, 52 instruments versus 39
instruments in 2006. Through September 30, 2007, product support revenues are
49% below last year due primarily to a decrease in training and after-sales
support. A majority of our shipments for the nine month period were to overseas
customers whose training and after-sale needs are performed by the respective
sales representative or distributor servicing their accounts. Training and
after-sale support functions for domestic customers are performed by the
Company.
Cost of Sales consist of product costs and expenses associated with product
support services. For the nine months ending September 30, 2007, cost of sales
was $891,800, compared to $731,500 for the same period 2006. For the period,
cost of sales, as a percentage of revenues, were 58% versus 35% in 2006. Cost of
sales for the period was negatively impacted by overhead spending variances of
approximately $93,000 resulting from a shut down of production to work-off
on-hand inventory. Excluding the impact of the variances, cost of sales for
third quarter 2007 would be 41% of revenues. Production will be limited for the
remainder of the year as the Company continues its effort to reduce on-hand
inventory.
Gross profit was $799,900 for the nine months ending September 30, 2007,
compared to $818,300 for the same period in 2006. Despite the increase in
revenues, the decrease in gross profit is attributed to write-off of overhead
production variances to cost of sales as noted above, and to a lesser extent, to
sales mix in which a proportionately larger number of lower margin instruments
were sold in 2007 than in 2006.
Research and Development costs for the nine months ending September 30, 2007
were $566,700 versus $616,600 for the same period in 2006. The $49,900 decrease
in R&D expenses is attributed a reduction of personnel expenses due to a
reduction of census ($48,000), reduction of overhead expenses ($17,700), offset
by an increase in patent attorney fees incurred to register the company's new
technologies ($15,800).
Selling, General and Administrative expenses for the nine months ending
September 30, 2007 were $1,959,200, compared to $2,060,900 for the same period
in 2006. The $101,700 decrease in S, G & A expenses resulted from savings
through reduction of outside services of approximately $166,500, selective
attendance at industry conferences and trade shows of approximately $90,900;
offset by increases in personnel costs of approximately $78,200 for additional
personnel, and operating expenses of approximately $77,500 to support the
company's infrastructure.
Interest expense for the nine months ending September 30, 2007 was $2,160,100,
as compared to $2,105,500 for the same period in 2006. Interest expense results
primarily from the amortization of debt discount and stated interest associated
with our convertible debentures, which were issued in December 2005. The
increase in interest expense for 2007 is due primarily to a reduction of
offsetting interest income earned from short-term investment of the company's
excess funds.
Other income-derivatives primarily consist of the decrease in the fair value of
derivative liabilities between the measurement dates. The decrease in other
income for the nine month period ending September 30, 2007, as compared to the
prior period, is primarily attributable to a decrease in the quoted price of our
common stock. Please refer to Note 5 of our accompanying financial statements
for further explanation of the origin and nature of such income. We are unable
to determine whether we will record further decreases in the fair value of
derivative liabilities in the foreseeable future, which would be recorded as
other income-derivatives. Such decreases would be generally triggered by a
decrease in the fair value of our stock price, or, possibly, upon satisfaction
of our convertible debentures.
17
LIQUIDITY AND CAPITAL RESOURCES
For the nine months ending September 30, net cash used by the Company for
operating activities were $1,391,635 and $2,355,525 for 2007 and 2006
respectively. Cash used for the nine months ending September 30, 2007 was
comprised of the net loss for the period of $3,371,777, plus net non-cash items
(including depreciation and amortization expenses of $40,620, issuance of common
shares for payment of interest of $140,000, issuance of stock option shares of
$94,041, amortization of debt discount of $1,750,000, amortization of deferred
financing costs of $136,160, less decrease in fair value of derivative liability
of $503,746, decrease in allowance for doubtful accounts of $22,862) of
$1,634,213 plus the net change in operating assets and liabilities of $345,929.
Cash used in operations during the same nine months of 2006 was comprised of the
net loss for the period of $2,552,763, plus net non-cash expenses (including
depreciation and amortization expenses of $29,836, issuance of common shares for
services of $21,000, amortization of debt discount of $1,750,000, amortization
of deferred financing costs of $136,160, less decrease in fair value of
derivative liability of $1,411,430) of $525,566, and less the net change in
operating assets and liabilities of $328,328.
Investing activities provided cash of $855,827 in the first nine months of 2007
and provided cash of $544,621 during the same period in 2006. Cash of $143,071
in 2007, and $124,057 in 2006 were used to purchase capital equipment. In 2007,
there was a decrease in our certificate of deposit of $702,082 and $237,616 was
additionally provided through our cancellation of the company's line of credit
which freed up collateral required by the credit line. In 2006, $668,678 was
provided through a reduction in the amount of collateral required for the
company's reduced line of credit.
There were no financing activities for the first nine months of 2007 and 2006.
On September 30, 2007 the Company's cash (including cash equivalents) was
$558,000, compared to $2,409,000 on September 30, 2006. The Company had a
working deficit on September 30, 2007 of $3,787,100. The working deficit
includes $2,852,700 for derivative liabilities - excluding this amount from
current liabilities; the Company's working capital deficit be $934,400. The
Company's working deficit at September 30, 2006 was $519,400 - excluding
derivative liabilities; working capital would be $3,840,200.
During the quarter, the Company has cancelled its credit facility with East West
Bank.
The Company's current cash balance is not expected to be adequate to fund
operations beyond the first quarter of 2008. As such, the Company is actively
seeking additional funding to provide necessary working capital for operations
and implementation of its business strategy of creating a sales and marketing
staff for the marketing, advertising and selling of the zNose(R) family of
chemical detection products, increasing distribution channels both in the U.S.
and foreign countries, introducing new products, improving existing product
lines and development of a strong corporate infrastructure. There can be no
assurance that any financing will be available through any bank borrowings,
debt, or equity offerings, or otherwise, on acceptable terms. If future
financing requirements are satisfied through the issuance of equity securities,
investors may experience significant dilution in the net book value per share of
common stock and there is no guarantee that a market will exist for the sale of
the Company's shares.
SEASONALITY AND QUARTERLY RESULTS
We do not foresee any seasonality to our revenues or our results of operations.
INFLATION
Although we currently use a limited number of sources for most of the supplies
and services that we use in the manufacturing of our vapor detection and
analysis technology, our raw materials and finished products are sourced from
cost-competitive industries. While prices for our raw materials may vary
significantly based on market trends, we do not foresee any material
inflationary trends for our product sources.
OFF-BALANCE SHEET ARRANGEMENTS
18
We do not have any off-balance sheet arrangements.
ITEM 3. CONTROLS AND PROCEDURES.
We have carried out an evaluation, under the supervision and with the
participation of our management, including our President and Chief Executive
Officer and our Treasurer and Chief Financial Officer, on the effectiveness of
the design and operation of our disclosure controls and procedures as of
September 30, 2007 pursuant to Exchange Act Rule 13a-15(b). Based upon that
evaluation, our President and Chief Executive Officer and our Treasurer and
Chief Financial Officer concluded that our disclosure controls and procedures
are effective to ensure that information required to be disclosed by us in the
reports that we file or submit under the Exchange Act is recorded, processed,
summarized and reported within the time periods specified in the Securities and
Exchange Commission's rules and forms.
There were no changes in the company's internal control over financial reporting
that have materially affected, or are reasonably likely to materially affect,
the company's internal control over financial reporting.
19
PART II.
OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS.
We are not a party to any pending material legal proceedings and are not aware
of any threatened or contemplated proceeding by any governmental authority
against us.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.
We issued 502,677 shares of our common stock to Midsummer Investment, Ltd. on
August 14, 2007 and 279,265 shares of our common stock to Islandia, LP on August
17, 2007 as interest on the debentures issued to Midsummer and Islandia on
December 7, 2005, which are more fully described in our Registration Statements
numbers 33-130700 and 333-138977, effective November 11, 2006 and December 21,
2006, respectively, as amended and supplemented, at a conversion rate of
$0.1790415 per share. The issuance of such shares of common stock was
unregistered; however, the resale of such shares by Midsummer and Islandia is
registered pursuant to such Registration Statements. Each of Midsummer and
Islandia represented that is an "accredited investor", as defined in Rule
501(a)(1), (2), (3), (7) or (8) under the Securities Act, or a "qualified
institutional buyer", as defined in Rule 144A(a) under the Securities Act, and
is not required to be registered as a broker-dealer under Section 15 of the
Securities Exchange Act of 1934, as amended.
We did not repurchase any of our equity securities during the three months ended
September 30, 2007.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES.
During the three months ended September 30, 2007, there were no material
defaults upon senior securities.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
On July 16, 2007, we held our annual meeting of shareholders, at which the
following directors were elected: James H. Frey, Teong C. Lim, Francis H. Chang,
Mike Krishnan, James Wilburn, Lewis Larson and Michel Amsalem. The vote
tabulation for each such director was as follows:
Abstentions and Broker
Director Votes For Votes Against or Withheld Non-Votes
---------------- --------- ------------------------- ----------------------
James H. Frey 46,110,591 672,717 0
Teong C. Lim 46,071,591 711,717 0
Francis H. Chang 46,099,991 683,317 0
Mike Krishnan 46,113,641 669,667 0
James Wilburn 46,110,691 672,617 0
Lewis Larson 46,113,091 670,217 0
Michel Amsalem 46,100,891 682,417 0
Since the annual meeting, our board of directors has been expanded and our
President and Chief Executive Officer, Barry S. Howe, was appointed to fill the
vacancy, and Mike Krishnan retired and was replaced by Rita Benoy
20
Bushon, as more fully described in our Current Reports on Form 8-K filed on July
18, 2007 and December 31, 2007, respectively.
ITEM 5. OTHER INFORMATION.
None.
ITEM 6. EXHIBITS.
Exhibit
No. Description
------- --------------------------------------------------------------------
31.1 Certification of Chief Executive Officer Pursuant to Section 302 of
the Sarbanes-Oxley Act.
31.2 Certification of Principal Financial and Accounting Officer Pursuant
to Section 302 of the Sarbanes-Oxley Act.
32.1 Certification of Chief Executive Officer Pursuant to Section 906 of
the Sarbanes-Oxley Act.
32.2 Certification of Principal Financial and Accounting Officer Pursuant
to Section 906 of the Sarbanes-Oxley Act.
21
SIGNATURES
In accordance with the requirements of the Exchange Act, the registrant caused
this report to be signed on its behalf by the undersigned, thereunto duly
authorized.
ELECTRONIC SENSOR TECHNOLOGY, INC.
By: /s/ Barry S. Howe
----------------------------------------
Dated: November 9, 2007 Name: Barry S. Howe
Title: President and Chief Executive Officer
(Principal Executive Officer)
Dated: November 9, 2007 By: /s/ Philip Yee
----------------------------------------
Name: Philip Yee
Title: Secretary, Treasurer and Chief
Financial Officer
(Principal Financial and Accounting
Officer)