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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-KSB
[X] ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES ACT OF 1934
For the fiscal year ended DECEMBER 31, 2007
[ ] TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934
For the transition period from ____________ to ____________
Commission file number 000-51859
ELECTRONIC SENSOR TECHNOLOGY, INC.
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(Name of small business issuer in its charter)
NEVADA 98-0372780
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(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification No.)
1077 BUSINESS CENTER CIRCLE, NEWBURY
PARK, CALIFORNIA 91320
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(Address of principal executive offices) (Zip Code)
Issuer's telephone number (805) 480-1994
Securities registered under Section 12(b) of the Exchange Act:
Name of each exchange on
Title of each class which registered
------------------- ------------------------
None. N/A
Securities registered under Section 12(g) of the Exchange Act:
Common Stock, Par Value $0.001
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(Title of class)
Check whether the issuer is not required to file reports pursuant to
Section 13 or 15(d) of the Exchange Act. [ ]
Check whether the issuer (1) filed all reports required to be filed by
Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such
shorter period that the registrant was required to file such reports), and (2)
has been subject to such filing requirements for the past 90 days.
Yes [X] No [ ]
Check if there is no disclosure of delinquent filers in response to
Item 405 of Regulation S-B contained in this form, and no disclosure will be
contained, to the best of registrant's knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this Form 10-KSB
or any amendment to this Form 10-KSB. [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]
State issuer's revenues for its most recent fiscal year. $2,198,204
State the aggregate market value of the voting and non-voting common
equity held by non-affiliates computed by reference to the price at which the
common equity was sold, or the average bid and asked price of such common
equity, as of a specified date within the past 60 days. $4,132,354 as of
March 1, 2008
State the number of shares outstanding of each of the issuer's classes
of common equity, as of the latest practicable date. 155,853,385 shares of
common stock as of April 1, 2008
DOCUMENTS INCORPORATED BY REFERENCE
If the following documents are incorporated by reference, briefly
describe them and identify the part of the Form 10-KSB (e.g., Part I, Part II,
etc.) into which the document is incorporated: (1) any annual report to security
holders; (2) any proxy or information statement; and (3) any prospectus filed
pursuant to Rule 424(b) or (c) of the Securities Act of 1933 ("Securities Act").
The listed documents should be clearly described for identification purposes
(e.g., annual report to security holders for fiscal year ended December 24,
1990). N/A
Transitional Small Business Disclosure Format (Check one):
Yes [ ] No [X]
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Certain statements in this annual report on Form 10-KSB, 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. 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
Item 1. Description of Business.
In this annual report, references to the "company," "we," "our," or
"us" refers to Electronic Sensor Technology, Inc., a Nevada corporation.
We are engaged in the development, manufacture, and sale of a patented
product we call zNose(R), a device designed to detect and analyze chemical odors
and vapors, or, in another 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) identifies the chemical makeup of any fragrance, vapor
or odor. The zNose(R) does this by creating a visual image of the fragrance,
vapor or odor that it detects, so that the user of the zNose(R) may easily
identify the fragrance, vapor or odor.
We believe that our products have broad applications in the homeland
security, analytical instrumentation/quality control, and environmental
monitoring and detection markets. We are involved in ongoing product research
and development efforts in that regard. We have also concentrated our efforts on
further product development, testing and proving, and continuing to expand our
sales and support organization.
Our executive offices are located at 1077 Business Center Circle,
Newbury Park, California 91320 and our telephone number is (805) 480-1994.
HISTORY AND BACKGROUND
Electronic Sensor Technology, Inc. was originally incorporated under
the laws of the state of Nevada as Bluestone Ventures Inc. on July 12, 2000.
From the date of its incorporation until February 1, 2005, Bluestone Ventures
was in the business of acquiring and exploring potential mineral properties in
Ontario, Canada. The company's name was changed to "Electronic Sensor
Technology, Inc." on January 26, 2005 in connection with the acquisition of two
corporations that had together owned Electronic Sensor Technology, L.P. Since
the acquisition of Electronic Sensor Technology, L.P., our business has been the
development, manufacture and sale of instruments that detect and analyze vapors
and odors. The company has abandoned its mining exploration business.
Overview of Past Operations of Electronic Sensor Technology, L.P.
Electronic Sensor Technology, L.P. was formed in 1995 to develop and
manufacture, the zNose(R), an advanced technology in chemical vapor detection
and analysis. In 1999, Electronic Sensor Technology, L.P. completed beta testing
of its products and commenced commercial sales to the analytical
instrumentation/quality control market as well as the homeland security market.
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Electronic Sensor Technology, L.P. Acquisition
On February 1, 2005, pursuant to the terms of an Agreement and Plan of
Merger by and among Electronic Sensor Technology, Inc., Amerasia Technology,
Inc., holder of approximately 55% of the partnership interests of Electronic
Sensor Technology, L.P., L&G Sensor Technology, Inc., holder of approximately
45% of the partnership interests of Electronic Sensor Technology, L.P., Amerasia
Acquisition, a wholly-owned subsidiary of Electronic Sensor Technology, Inc.,
and L&G Acquisition, a wholly-owned subsidiary of Electronic Sensor Technology,
Inc., Electronic Sensor Technology, Inc., acquired 100% of the outstanding
equity partnership interest of Electronic Sensor Technology, L.P. Under the
Agreement and Plan of Merger:
(i) Amerasia Technology merged with and into Amerasia Acquisition such
that Amerasia Technology became a wholly-owned subsidiary of
Electronic Sensor Technology, Inc.;
(ii) L&G Sensor Technology merged with and into L&G Acquisition such that
L&G Sensor Technology became a wholly-owned subsidiary of Electronic
Sensor Technology, Inc.;
(iii) as a result of the mergers of (i) and (ii), Electronic Sensor
Technology, Inc. indirectly acquired the partnership interests of
Electronic Sensor Technology, L.P.; and
(iv) Electronic Sensor Technology, Inc. issued 20,000,000 shares of its
common stock to the shareholders of Amerasia Technology and L&G Sensor
Technology.
In November 2004, Electronic Sensor Technology, L.P. sold $200,000 in
limited partnership interests to certain bridge investors. Concurrent with the
mergers, these limited partnership interests were directly exchanged into
200,000 shares of common stock of Electronic Sensor Technology, Inc. and
warrants to purchase 200,000 shares of common stock of Electronic Sensor
Technology, Inc. at $1.00 per share.
In connection with the mergers, Electronic Sensor Technology, Inc.
entered into Subscription Agreements with certain investors on January 31, 2005.
Under these Subscription Agreements, Electronic Sensor Technology issued and
sold in a private placement 3,985,000 shares of its common stock and warrants to
purchase 3,985,000 shares of common stock at $1.00 per share to certain
investors for gross proceeds of $3,985,000, which were received on February 1,
2005. Electronic Sensor Technology received net proceeds of approximately
$3,821,000 less fees, including counsel fees for the investors and Electronic
Sensor Technology, L.P. of approximately $164,000.
Immediately following the mergers and the private placement, on
February 1, 2005 there were 53,968,471 shares of Electronic Sensor Technology
common stock outstanding, of which (i) shareholders of Bluestone Ventures prior
to the mergers and the private placement held 26,988,279 shares (approximately
50.0% of our common stock), (ii) the shareholders of Amerasia Technology and L&G
Sensor Technology prior to the mergers and the private placement held 22,783,471
shares (approximately 42.2% of our common stock) and (iii) investors in the
private placement occurring on February 1, 2005 and the bridge investors as a
group held 4,185,000 shares (approximately 7.8% of our common stock). The total
outstanding interests of Electronic Sensor Technology, L.P. were exchanged for
20,000,000 shares of Electronic Sensor Technology, Inc. In addition, 2,783,279
shares of Electronic Sensor Technology, Inc. were distributed to pre-merger
shareholders of Amerasia Technology and L&G Sensor Technology in exchange for
the cancellation of debt owed to such shareholders, at a conversion rate of
$1.00 per share. The conversion rate of $1.00 per share was established
immediately preceding the merger through the private placement of 3,985,000
shares of common stock at $1.00 per share and the conversion of a $200,000
equity advance to Electronic Sensor Technology, L.P. for 200,000 shares of
Electronic Sensor Technology common stock. The transaction price of $1.00 per
share was established by arms length negotiation between the former management
of Bluestone Ventures and Electronic Sensor Technology, L.P. (now management of
Electronic Sensor Technology, Inc.) in December 2004. As a condition to the
merger transactions, Bluestone Ventures agreed to raise not less than $3,000,000
of new equity capital in a private placement offering. In determining to proceed
with the merger transactions, management of Electronic Sensor Technology, L.P.
(now management of Electronic Sensor Technology, Inc.) weighed the expected cash
balance of Bluestone Ventures after giving effect to the private placement
offering discussed above and the mergers against the overall equity ownership of
Electronic Sensor Technology, Inc. post-merger that would be held by the former
owners of Electronic Sensor Technology, L.P. (i.e., the former owners of
Electronic Sensor Technology, L.P. were willing to give up 57.8% of Electronic
Sensor Technology, L.P. for not less than $3,000,000 in cash). While management
of Electronic Sensor Technology, L.P. (now management of Electronic Sensor
Technology, Inc.) was not privy to the valuation methodology used by management
of Bluestone Ventures in establishing a transaction price of $1.00 per
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share, management of Electronic Sensor Technology, L.P. (now management of
Electronic Sensor Technology, Inc.) assumes that management of Bluestone
Ventures and its advisors used one or more traditional valuation methodologies.
Following the mergers we assumed as our principal operations the
operations of Electronic Sensor Technology, L.P. and the prior operations of
Bluestone Ventures were terminated.
INDUSTRY OVERVIEW
Although there are a vast number of applications for the zNose(R)
product, we believe that the most significant demands for our product will be in
three general market categories - homeland security, analytical
instrumentation/quality control and environmental monitoring and detection.
Homeland Security. According to published sources, the homeland
security market is a multi-billion dollar market and is projected to remain as
such in the foreseeable future. We believe that detection and analysis of
chemical compounds will aid greatly in various homeland security efforts
including:
o Cargo Containers. Over 22.5 million cargo containers arrive in the
U.S. every year and only a fraction of them are being inspected by the
U.S. Customs Department. We believe cargo container security will
become a top priority with the U.S. government.
o Airports. Our zNose(R) products may be used to complement existing
x-ray and bomb detection technologies.
o Drug Interdiction. The zNose(R) has been used to detect contraband,
including illicit controlled substances along U.S. borders.
o Building Security. zNose(R) technology can be applied for continuous
and real-time chemical detection and to monitor the air in buildings
and in confined spaces. Detecting hazardous gases and poisonous
chemical agents such as sarin, VX explosives, and contrabands for
security and environmental safety purposes are the main concerns for
various government and commercial buildings, as well as military
facilities.
Analytical Instrumentation/Quality Control. The zNose(R) has been
serving the chemical vapor analysis needs in various manufacturing industries.
We estimate that the market for products such as zNose(R) will exceed $50
million during the next few years. The zNose(R) has been used for a host of
applications relating to analysis and quality control such as:
o screening incoming raw materials;
o checking ingredients in processed food and pharmaceutical products;
o inspecting packaging materials and finished goods; and
o detecting hazardous gas leaks in chemical plants.
Environmental Monitoring and Detection. The zNose(R) has been serving
rapid on-location needs in detection and monitoring of toxic chemicals in the
water for environmental protection purposes. The zNose(R) was used by the China
Environmental Protection Agency (China EPA) to detect and monitor toxic flows in
a river caused by a chemical spill after a chemical plant explosion in
northeastern China. This industrial accident contaminated the major water
sources located near the plant. The zNose(R) is also used by the China
Environmental Protection Agency (EPA) to determine the safety of drinkable water
on a near real-time basis.
CONVENTIONAL ELECTRONIC NOSE TECHNOLOGY
Conventional electronic noses are unable to meet the needs of the
market because of their fundamental construction. They are not able to identify
fragrances, vapors and odors with an acceptable degree of specificity and
preciseness. In addition, conventional electronic noses require sophisticated
computer software in order for its chemical analyses to be recognized. This type
of electronic nose is therefore not acceptable for use in scientific
measurement.
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THE ZNOSE(R) SOLUTION
Speed, precision and versatility are the key characteristics of the
zNose(R) product. The zNose(R) has been developed to replace the conventional
electronic nose. The zNose(R) operates as quickly as a conventional electronic
nose while delivering the precision and accuracy of a much more expensive
instrument. The zNose(R) has advanced chemical analysis technology by performing
vapor analysis within 10 seconds. Early models of the zNose(R) have been tested
by the U.S. Environmental Protection Agency under Environmental Technology
Verification program and by the Office of National Drug Control Policy for drug
interdiction. Tests have also been performed at the Midwest Research Institute's
Surety Laboratory in Kansas City and at the U.S. Army Dugway Proving Ground in
Utah with respect to the effectiveness of the zNose(R) in detecting chemical
agents such as sarin gases. The zNose(R) is currently approved for purchase
through the General Services Administration pre-approved procurement program.
Our VaporPrint(R) imaging ability is another major advantage of the
zNose(R) product. VaporPrint(R) allows the user of the zNose(R) to see a visual
image of the makeup of a particular fragrance, vapor or odor within 10 seconds.
In addition, VaporPrint(R) can produce high-resolution visual images of odor
intensity. VaporPrint(R) images are displayed on a laptop computer screen and
are recorded on the hard drive of the laptop computer.
OUR PRODUCTS
zNose(R)
The zNose(R) is essentially a vapor detector that uses a sensor based
on Surface Acoustic Wave technology. Basically, the zNose(R) "inhales" a
particular fragrance, vapor or odor. The fragrance, vapor or odor is carried up
through a column and the chemicals making up the fragrance, vapor or odor
condense on the crystal surface of the sensor in the zNose(R). This condensation
on the sensor causes a change in what is called the "fundamental acoustic
frequency" of the crystal surface. It is this change in fundamental acoustic
frequency that allows the zNose(R) to determine the chemical makeup of the
fragrance, vapor or odor. This change is measured by a microprocessor that
calculates the change in frequency which is related to the amount of fragrance,
vapor or odor sampled by the zNose(R). The microprocessor also measures the
arrival time (called the retention time) of the change in the fundamental
frequency. Different chemicals arrive at different times and so, once the
microprocessor has determined the retention time of the unidentified fragrance,
vapor or odor, it compares it to retention times that are stored in a computer
library. This allows the zNose(R) to identify the particular fragrance, vapor or
odor.
The zNose(R) analyzes and identifies vapor specimens in a two-step
process. In the first step, typically lasting 10 seconds, the instrument
collects a small sample of the vapor to be analyzed. The sample is then injected
in to the gas chromatography column where the individual chemicals present are
separated and measured. The chemical analysis requires as little as 10 seconds
to produce the vapor's chemical signature, or chromatogram. The vapor's chemical
signature can also be visually displayed in a graphic form called a
"VaporPrint". This chemical signature is then compared against the reference
database of chemical odor profiles. If the chemical compound of the specimen is
not in the reference database, it will not be identified by name; however, the
makeup of the unidentified specimen can be stored in the reference database for
future identification. The reference database of chemical odor profiles that is
stored on the hard drive of the laptop computer is composed of standards of
various chemicals that are available through the National Institute of Standards
and Technology (NIST). The database can be updated when standards of new
chemicals are encountered and input by way of simple software selection, or by
way of sampling unknown chemical compounds and storing the measurements of such
chemical compounds in the database. If the zNose(R) samples a non-specimen
vapor, such as clear ambient air, no signal is generated on the laptop computer
screen and no VaporPrint(R) is created. If the zNose(R) samples a complex
mixture of chemical compounds, each compound and the concentration of such
compound is measured independently of the other compounds contained in the
mixture. Due to the independent measurement of each compound in a complex
mixture, each measurement is free from the influence of the other compounds, and
the accuracy of the zNose(R) is therefore not affected by complex mixtures.
We currently manufacture and sell three zNose(R) models designated as
Model 4200 (Handheld Unit), Model 4300 (Portable Unit) and Model 7100 (Bench Top
Unit). Model 4200 is designed for portability and for applications requiring
quick and accurate vapor screening in the field. Model 4300 is also designed for
portability and can operate outdoors with the same capabilities of Model 4200
without the need for an external power source. Model 7100 is designed for
laboratory testing and is ideal for testing water and product quality control
samples. Both Model 4200 and Model 7100 weigh approximately 27 pounds, not
including a laptop computer that must be used with each zNose(R). Model 4300
weighs approximately 24 pounds, not including the laptop computer, but also
includes a battery charger that weighs approximately 8 pounds. The Model 4200
has two housings
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(the case and the detector head) and a laptop computer. The case of the Model
4200 is 10" x 12" x 6" and weighs 20 pounds and the detector head of the Model
4200 is 4.25" x 12" x 7" and weighs 7 pounds. The components and dimensions of
the Model 4300 are similar to the Model 4200, but the battery charger of the
Model 4300 is 5.5" x 13.5" x 5.5. The Model 7100 is packaged in a single housing
and also requires a laptop computer. The dimensions of the Model 7100 packaging
are 14.3" x 14.3" x 7.5". Both the Model 4200 and Model 7100 are powered by a
standard AC electrical outlet, and both models adapt to standard outlets in
North America, Asia and Europe (i.e., the zNose(R) may be operated by a 110 volt
or 220 volt power source). All three models can be produced in one of two basic
vapor sensing configurations: volatile and semi-volatile. The volatile
configuration can detect volatile organic compounds, such as benzene. The
semi-volatile configuration can detect heavier vapors such as those found in
explosives and drugs.
During 2007, we developed Models 8100 and 7300. Model 8100 is designed
as a fixed installation unit for indoor ambient air monitoring. It can also be
used for building security monitoring applications. It is designed to be
operated remotely from a central control station via a Bluetooth control link.
Model 7300 is a bench top unit similar in configuration to the Model 7100 minus
the internal helium container. Operation of the Model 7300 requires an external
helium source.
We have designs to produce a hand-held zNose(R) that is smaller than
the Model 4300 for the commercial market. This model is designed to meet the
needs of law enforcement, manufacturing process monitoring, and environmental
monitoring. We plan to develop a separate version of the mini-zNose(R) to be
used as a personal nerve agent detector for the military and security markets.
Accessories
We offer several lines of accessory products such as calibration
devices, sample desorbers, MicroSense Software(C), and GPS receivers. An example
is our Model 3100 which provides a calibrated vapor source as well as a tool for
extracting vapors from solid and liquid samples.
SALES AND DISTRIBUTION
We sell our zNose(R) product through distribution channels including
equipment distributors and sales representatives both in the U.S. and in over 20
foreign countries, e-commerce, customer referrals, and GSA contracted suppliers.
We entered into an agreement with eScreen Sensor Solutions to be a distributor
in Israel, the Caribbean, the State of Florida, and Central and South America on
October 16, 2003. As part of the agreement, eScreen paid us an up-front fee of
$250,000 in 2004. We entered into an agreement with TechMondial, Ltd. to be a
distributor in the countries of the European Community, Romania, Bulgaria,
Turkey, Croatia and Switzerland on October 21, 2005. In 2005, we selected
Beijing R&D Technology Co., Ltd. to be our exclusive distributor in China. We
entered into an agreement with Macrochem JSC to be a distributor in the
countries of Germany, Russia, and Ukraine on March 27, 2006. We entered into an
agreement with Analytical Solutions and Product B.V. to be a distributor in the
Benelux countries on January 15, 2007. Also, on December 3, 2007, we entered
into an agreement with Breckbuhler, AG to be a distributor in the countries of
Switzerland, France, Austria, and Italy.
All sales representatives and distributors are required to attend a
three-day training course conducted at our headquarters in Newbury Park,
California. We advertise in selected industry trade journals and trade
conventions. We are working to build a dedicated marketing and sales team. We
historically generated sales from both domestic and international customers,
each of which accounted for approximately 50% of our sales in the past. However,
for the fiscal years ending December 31, 2006 and December 31, 2007,
international customers accounted for approximately two-thirds of our total
sales. We expect a similar split among domestic and international sales to
continue. All of our customers pay us in U.S. dollars. Major domestic customers
include the U.S. Armed Forces, Proctor & Gamble, United States Department of
Agriculture, and S.C. Johnson. Major international customers include Beijing R&D
Technology Company Ltd. in China, Kosmo Scientific Co. in Korea, and Macrochem
Corp. in Ukraine.
COMPETITION
We are unaware of any direct competitor to the zNose(R) product on the
market today. In the homeland security markets, we face competition from
manufacturers of x-ray machines, ion-mobility spectrometers and chemical coated
sensors. X-ray machines have been widely used for security purposes in detecting
metal objects but not for chemical compounds. Ion-mobility spectrometer
equipment is a vapor detector and is designed to detect certain compounds but is
blind to other compounds. Hence, it
5
can only see a small dot in a space but cannot see the total picture. It employs
a different sample collection technique by wiping the surfaces of the object
placed for screening. The ion-mobility spectrometer also uses materials in its
construction which may be offensive to users in certain countries.
Chemical coated sensors are the conventional electronic noses. They
use an array of chemical sensors each reacting to certain specific compounds. As
mentioned earlier, electronic noses cannot be calibrated with chemical standards
and therefore cannot be used effectively for scientific measurement.
We have another set of competitors manufacturing portable vapor and
odor analysis products for the instrumentation market from major corporations
such as Agilent Technologies, Inc. (NYSE: A), Perkin-Elmer, Inc. (NYSE: PKI) and
Varian, Inc. (NASDAQ: VARI). We believe that our zNose(R)product is competitive
with these companies' products based on speed and cost.
Many of our current and potential competitors, including the
aforementioned competitors, have larger customer bases, greater brand
recognition and significantly greater financial, marketing and other resources
than we do and may enter into strategic or commercial relationships with larger,
more established companies. Some of our competitors may be able to secure
alliances with customers and affiliates on more favorable terms, devote greater
resources to marketing, advertising and promotional campaigns and devote
substantially more resources to research and development than we do. In
addition, new technologies and the expansion of existing technologies may
increase the competitive pressures on us.
We cannot assure you that we will be able to compete successfully
against current or future competitors, and competitive pressures faced by us
could harm our business, operating results and financial condition. We do not
currently represent a significant competitive presence in the homeland security
or analytic instrumentation markets.
MANUFACTURING AND RAW MATERIALS
We design, prototype and manufacture our products at our headquarters.
Our manufacturing facilities adhere to ISO9001 manufacturing methods (quality
standards developed by the International Organization for Standardization, which
have been adopted by many countries around the world). We contract out the
manufacturing and assembling of certain components to subcontractors. Our
current annual manufacturing capacity is approximately 300 zNose(R) units. The
principal components to our products are computer chips, circuit boards,
transformers and sensory devices. The prices for these components are subject to
market forces largely beyond our control, including energy costs, market demand,
and freight costs. The prices for these components have varied significantly in
the past and may vary significantly in the future. Our principal suppliers of
components and raw materials include: Sigma Aldrich Co. of Bellefonte,
Pennsylvania, American Precision of Chatsworth, California, Machine Works LLC of
Santa Paula California, Clayton Controls of Costa Mesa, California, and Syncor
Industries, Inc. of Ventura, California.
CUSTOMERS
In 2007, we had approximately 41 customers. Our largest customer in
2007, Beijing R&D Technology Company Ltd. (which is our exclusive distributor in
China), purchased 36 of the total 66 zNose(R) units sold by us in 2007,
constituting approximately 55% of the zNose(R) units sold in 2007. Our largest
customers are (1) Beijing R&D Technology Company Ltd. of China, (2) United
States Armed Forces and (3) Proctor and Gamble Co.
PATENTS, TRADEMARKS AND OTHER PROPRIETARY RIGHTS
We regard our patents, trademarks, trade names and similar
intellectual property as critical to our success. We rely on patent and
trademark laws, trade secret protection and confidentiality agreements with
employees, distributors, customers, partners and others to protect our
proprietary rights.
We own four United States patents covering our zNose(R) product,
including:
o No. 5,289,715, "Vapor Detection Apparatus and Method Using an Acoustic
Interferometer" issued March 1, 1994;
o No. 5,970,803, "Method and Apparatus for Identifying and Analyzing
Vapor Elements", issued October 26, 1999;
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o No. 6,212,938, "Method of Detecting Smell of a Vapor and Producing a
Unique Visual Representation thereof," issued April 10, 2001;
o No. 6,354,160, "Method and Apparatus for Identifying and Analyzing
Vapor Elements," issued December 3, 2002.
We may not be able to obtain patent protection for any derivative uses
of zNose(R), or for any other products we may later acquire or develop. We also
cannot assure you that we will be able to obtain other foreign patents to
protect our products.
We have copyrighted our MicroSense Windows software and Xilinx gate
array firmware, which controls the operation of the zNose(R) and produces visual
images. These images, trademarked as VaporPrint(R) images, make it possible to
display vapor analysis data from any vapor analysis system, as unique visual
images and facilitate pattern recognition of complex odors and fragrances.
We currently hold registered trademarks for zNose(R) and
VaporPrint(R). We intend to evaluate the possible application for new patents
and trademarks as needed to cover current and future applications of our
technology and product developments. We intend to undertake all steps necessary
to preserve and protect our patents, trademarks and intellectual property
generally.
We are not aware that our products, trademarks or other proprietary
rights infringe the rights of third parties, nor are we aware of any
infringements of our proprietary rights. We continually evaluate potential
infringements of our proprietary rights and intend to take such legal and other
actions as may be necessary to protect those rights. However, there can be no
assurance that third parties will not assert infringement claims against us in
the future with respect to current or future products or that any such assertion
may not require us to enter into royalty arrangements or result in costly
litigation.
GOVERNMENT REGULATION
Government agencies, in particular, the Department of Defense, are
principal customers for our products. As a result, we are required to comply
with the Federal Acquisition Regulations, a comprehensive set of regulations
governing how vendors do business with the U.S. federal government, to the
extent we contract with departments or agencies of the U.S. government, as well
as similar regulations to the extent we contract with state or local
governments. Sales to or grants from foreign governments or organizations
generally have their own regulatory framework, which may or may not be similar
to present U.S. standards or requirements.
RESEARCH AND DEVELOPMENT
Our research and development program consists of developing
technologies related to enhancing our electronic nose product and making it more
portable. Fees related to research and development include consulting fees,
technical fees, and research, development and testing of our zNose(R) product.
We spent approximately $834,000 in 2006 and $745,000 in 2007 on research and
development activities, none of which was borne directly by customers.
EMPLOYEES
As of December 31, 2007 we had a total of 19 full-time employees and 1
consultant. In addition to management, we employ sales people, administrative
staff, and development and technical personnel. From time to time, we may employ
independent consultants or contractors to support our research and development,
marketing, sales and support, and administrative organizations. No collective
bargaining units represent our employees and Electronic Sensor Technology is not
party to any labor contracts.
7
CAPITALIZATION
The following table sets forth our capitalization as of December 31,
2007. The figures in the table are derived from our audited financial statements
and should be read in conjunction with our consolidated financial statements and
related notes included elsewhere in this annual report. All information below
excludes any securities issued subsequent to December 31, 2007.
December 31, 2007
Long-term debt.............................................. $ 2,527,777
Stockholders' deficit:
Common stock; $0.001 par value; 200,000,000
Shares authorized; 56,756,098 shares issued
and outstanding.................................... $ 56,756
Additional paid-in capital.......................... $ 8,939,562
Accumulated deficit................................. $ (14,873,789)
----------------
Total Stockholders' deficit................................. $ (5,877,471)
----------------
Total capitalization........................................ $ (3,349,694)
================
Item 2. Description of Property.
We lease approximately 13,500 square feet of office space and
production facilities at 1077 Business Center Circle, Newbury Park, California.
Our current lease expires on September 30, 2010. The lease payments are
currently $11,774 per month, and increase by 3% per annum on October 1, 2008.
The facility serves as our headquarters and research and development and
manufacturing facility. This property is in good condition and is suitable and
adequate for our uses. We do not believe this property is subject to any
material competitive conditions. Our management is of the opinion that this
property is adequately covered by insurance.
INVESTMENT POLICIES
We do not invest, nor do we plan to invest in the foreseeable future
in real estate, interests in real estate, real estate mortgages or securities of
or interests in persons primarily engaged in real estate activities. This policy
may be changed without a vote of security holders.
Item 3. Legal Proceedings.
We are not a party to any pending legal proceeding, other than routine
litigation that is incidental to our business, and are not aware of any
proceeding contemplated by a governmental authority against us.
Item 4. Submission of Matters to a Vote of Security Holders.
There were no matters submitted to a vote of security holders during
the fourth quarter of the fiscal year ended December 31, 2007.
PART II
Item 5. Market for Common Equity and Related Stockholder Matters.
MARKET FOR COMMON EQUITY
Our common stock has been quoted on the Over-the-Counter Bulletin
Board since February 1, 2005 under the symbol "ESNR.OB". Prior to February 1,
2005 Bluestone Ventures's common stock was quoted on the Over-the-Counter
Bulletin Board under the symbol "BLUV.OB". There is currently no broadly
followed, established public trading market for our common stock. The quarterly
range of high and low Over-the-Counter Bulletin Board quotation information for
our common stock for the last two
8
fiscal years is set forth below. These quotations reflect inter-dealer prices,
without retail mark-up, mark-down or commission, and may not represent actual
transactions.
QUARTERLY COMMON STOCK PRICE RANGES
2007
---------------
QUARTER ENDED HIGH LOW
----------------- ------ ------
December 31 $ .19 $ .04
September 30 .22 .06
June 30 .26 .18
March 31 .29 .13
2006
---------------
QUARTER ENDED HIGH LOW
----------------- ------ ------
December 31 $ .48 $ .21
September 30 .40 .20
June 30 .29 .17
March 31 .41 .19
Source: Yahoo! Finance.
There were 43 record holders of our common stock as of March 1, 2008.
This number does not include an indeterminate number of shareholders whose
shares are held by brokers in street name.
We have not paid dividends on our common stock since our inception.
The decision to pay dividends on common stock is within the discretion of our
Board of Directors. It is our current policy to retain any future earnings to
finance the operations and growth of our business. Accordingly, we do not
anticipate paying any dividends on common stock in the foreseeable future.
9
SECURITIES AUTHORIZED FOR ISSUANCE UNDER EQUITY COMPENSATION PLANS
The following table illustrates, as of December 31, 2007, information
relating to all of our equity compensation plans:
EQUITY COMPENSATION PLAN INFORMATION
Number of securities
Number of securities to Weighted average remaining available
be issued upon exercise exercise price of for future issuance
of outstanding options, outstanding options, under the equity
Plan Category warrants and rights warrants and rights compensation plan
----------------------------- ----------------------- -------------------- --------------------
Equity compensation plans
approved by security holders 0 N/A 0
Equity compensation plans not
approved by security holders 3,437,950 $ .41 1,562,050(1)
Total 3,437,950 $ .41 1,562,050
(1) This amount represents the remainder of the 5,000,000 shares of our common
stock authorized for issuance under the Electronic Sensor Technology, Inc. 2005
Stock Incentive Plan, less 3,437,950, the number of shares of common stock
underlying outstanding options granted pursuant to the Stock Incentive Plan as
of December 31, 2007.
ELECTRONIC SENSOR TECHNOLOGY, INC. 2005 STOCK INCENTIVE PLAN
A description of the Electronic Sensor Technology, Inc. 2005 Stock
Incentive Plan is set forth in Note 7 to the company's consolidated financial
statements under the heading "Options" included in this annual report and is
incorporated herein by reference.
RECENT SALES OF UNREGISTERED SECURITIES
We did not repurchase any of our equity securities during the period
covered by this annual report. All sales of unregistered equity securities
during the period covered by this annual report have previously been included on
our current report on Form 8-K filed January 16, 2008.
Item 6. Management's Discussion and Analysis or Plan of Operations.
You should read the following discussion and analysis of our financial condition
and results of operations together with the financial statements and the related
notes appearing in this annual report.
CRITICAL ACCOUNTING POLICIES
Electronic Sensor Technology records revenue from direct sales of
products to end-users when the products are shipped, collection of the purchase
price is probable and Electronic Sensor Technology has no significant further
obligations to the customer. Costs of remaining insignificant obligations of
Electronic Sensor Technology, 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.
10
Electronic Sensor Technology 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 December 31, 2007 no assets were
impaired.
We account for liquidated damages during 2006 and 2005 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 our accounting of the liquidated damages.
We registered all shares underlying the convertible debentures as well
as all shares underlying the warrants related to the convertible debentures on
November 21, 2006, and December 21, 2006, respectively.
We account for 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.
Accounts receivable are reported at net realizable value. We have
established an allowance for doubtful accounts based upon factors pertaining to
the credit risk of specific customers, historical trends, and other information.
Delinquent accounts are written-off when it is determined that the amounts are
uncollectible.
Inventories are stated at the lower of cost or market, cost determined
by the first-in, first-out (FIFO) method. The company writes down its inventory
for estimated obsolescence or unmarketable inventory using the difference
between the cost of inventory and the estimated market value based upon
assumptions about future demand and market conditions.
We are required to estimate our income taxes in each of the
jurisdictions in which we operate as part of the process of preparing our
consolidated financial statements. SFAS No. 109, "Accounting for Income Taxes",
requires a valuation allowance to reduce the deferred tax assets reported if,
based on the weight of the evidence, it is not more likely than not that some
portion or all of the deferred tax assets will be realized. Management reviews
deferred tax assets periodically for recoverability and makes estimates and
judgments regarding the expected geographic sources of taxable income, gains
from investments, as well as tax planning strategies in assessing the need for a
valuation allowance. We determined that a valuation allowance of approximately
$3,300,000 relating to net operating loss carryovers was necessary to reduce our
deferred tax assets to the amount that will more likely than not be realized. As
a result, at December 31, 2007 the company has no net deferred tax assets. If
the estimates and assumptions used in our determination change in the future, we
could be required to revise our estimates of the valuation allowances against
our deferred tax assets and adjust our provisions for additional income taxes.
In the ordinary course of global business, there are transactions for which the
ultimate tax outcome is uncertain, thus judgment is required in determining the
worldwide provision for income taxes. We provide for income taxes on
transactions based on our estimate of the probable liability. We adjust our
provision as appropriate for changes that impact our underlying judgments.
Changes that impact provision estimates include such items as jurisdictional
interpretations on tax filing positions based on the results of tax audits and
general tax authority rulings.
11
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
Fiscal Year Ended December 31, 2007 Compared to Fiscal Year Ended December 31,
2006
The following table sets forth certain items included in our Income
Statements (see Financial Statements and Notes) for the periods indicated:
Year Ended
December 31, Variation $ Variation %
-------------------------------- 2007 vs 2007 vs
2007 2006 2006 2006
-------------- -------------- -------------- --------------
In $
REVENUES $ 2,198,204 $ 2,180,208 17,996 1.0%
COST OF SALES 1,356,719 1,085,056 (271,663) (25.0%)
-------------- -------------- --------------
GROSS PROFIT 841,485 1,095,152 (253,667) (23.2%)
OPERATING EXPENSES:
Research and development 744,646 833,791 89,145 10.7%
Selling 664,838 822,954 158,116 19.2%
Compensation 787,114 655,045 (132,069) (20.2%)
General and administrative 1,078,651 1,200,800 122,149 10.2%
-------------- -------------- --------------
TOTAL OPERATING EXPENSES 3,275,249 3,512,590 237,341 6.8%
-------------- -------------- --------------
LOSS FROM OPERATIONS (2,433,764) (2,417,438) (16,326) (1.0%)
OTHER INCOME AND EXPENSE:
Other income - derivative liabilities 987,805 2,414,605 (1,426,800) (59.1%)
Other income 1,854 2,140 (286) (13.4%)
Gain (loss) on sale of property and equipment (6,051) (1,615) (4,436) (274.7%)
Interest expense (2,924,486) (2,809,682) (114,804) (4.1%)
-------------- -------------- --------------
TOTAL OTHER INCOME (EXPENSE) (1,940,878) (394,552) (1,546,326) (391.1%)
-------------- -------------- --------------
NET INCOME (LOSS) $ (4,374,642) $ (2,811,990) (1,562,652) (55.6%)
============== ============== ==============
12
The following table sets forth, as a percentage of revenues, certain
items included in our Income Statements (see Financial Statements and Notes) for
the periods indicated:
Year Ended
December 31,
---------------
2007 2006
------ ------
As a % of revenues
REVENUES 100% 100%
COST OF SALES 62% 49%
GROSS PROFIT 38% 51%
OPERATING EXPENSES 149% 161%
LOSS FROM OPERATIONS (111%) (110%)
OTHER INCOME AND EXPENSE (88%) (18%)
NET INCOME (LOSS) (199%) (128%)
Revenues primarily consist of the sale of our zNose products. Revenues
in 2007 were flat compared to 2006. Product revenues increased approximately
4.4% over 2006 as a result of a greater number of zNose units shipped, 66 units
versus 58 units. The increase in product revenues was offset by a 45% decrease
in product support revenues. The decline in product support sales was due
primarily to a decrease in training and after-sales support. A majority of our
sales were to overseas customers whose training and after-sales support needs
are performed by the respective sales representative or distributor servicing
their accounts. Training and after-sales support functions for domestic
customers are performed by the company.
Cost of Sales primarily consist of manufacturing costs and licensing
fees. The increase in cost of sales for the year ended December 31, 2007,
compared to the respective period in 2006 was due primarily to $193,000 in labor
and overhead spending variances which resulted from an extended slow down of
production to work-off on-hand inventories. Cost of sales was also negatively
impacted by an unfavorable sales mix as shipments of our lowest margin
instrument more than doubled that shipped in 2006, and an increase in inventory
write-offs related to materials identified as excess or obsolete.
Research and development expenses primarily consist of salaries and
related benefits, material and supplies associated with our efforts in
developing and enhancing our products. In 2007, research and development
expenses decreased 10.7% from 2006. The decrease is primarily attributable to a
reduction of personnel expenses due to a reduction of census ($81,000),
reduction of overhead expenses ($21,000), offset by an increase in patent
attorney fees incurred to register the company's new technologies ($13,000).
Selling expenses primarily consist of salaries, commissions and
related benefits associated with our selling and marketing efforts. The decrease
in selling expenses during 2007 when compared to 2006 resulted from savings
through reduction of consulting expenses ($148,000), selective attendance at
trade shows ($22,000), reduction of overhead expenses ($32,000), offset by an
increase in commissions paid to outside sales representatives ($44,000).
Compensation expenses primarily consist of salaries and related
benefits of our general and administrative personnel. The increase in
compensation expenses during 2007 when compared to 2006 is primarily
attributable to stock based compensation expenses ($114,000) and an increase in
personnel to support our operations. There were no stock based compensation
expenses in 2006.
General and administrative expenses for 2007 were approximately 10%
less than 2006. The improvement of approximately $122,000 resulted primarily
from reduction of legal and professional expenses ($198,000), offset by the cost
to implement the ISO 9001 program, and the occurrence of additional Board of
Directors meetings during the year.
13
Other income - derivative liabilities primarily consists of the
decrease in the fair value of derivative liabilities between balance sheet
dates. The decrease in other income-derivative liabilities during 2007 when
compared to 2006 is primarily attributable to a decrease in the fair value of
our stock between issuance of the derivative contracts and the measurement dates
during 2005.
Interest expense primarily consists of debt discount amortization and
interest on certain debt. The slight increase in interest expense during 2007
when compared to 2006 is primarily attributable to the lack of offsetting
interest income from a certificate of deposit the company had in 2006 but
liquidated in 2007 for funds used in operations.
LIQUIDITY AND CAPITAL RESOURCES
Our cash and cash equivalents amounted to approximately $249,000 at
December 31, 2007.
During 2007, we used approximately $1.807 million in our operating
activities which is the result of the following:
o A net loss of approximately $4.375 million adjusted for:
o the amortization of debt discount of approximately
$2.333 million, amortization of deferred financing
costs of approximately $182,000, issuance of shares for
payment of interest of $311,000, and stock based
compensation of $115,000, and a decrease in the fair
value of the derivative liabilities of approximately
$980,000.
o A decrease in inventories of approximately $410,000 due to
an extended slow down of production to work-off on-hand
materials, and an increase in accounts payable and accrued
expenses of approximately $117,000 due to better management
of cash expenditures.
During 2007, investing activities provided approximately $22,000 from
proceeds received from the sale of property and equipment.
During 2007, we generated approximately $940,000 from financing
activities by liquidating a certificate of deposit that was used to satisfy
collateral requirement of our line of credit which we cancelled.
A certificate of deposit in the amount of approximately $12,000 at
December 31, 2007 is used to secure and collateralize the company's credit card
liability.
During 2006, we used approximately $2.963 million in our operating
activities which is the result of the following:
o A net loss of approximately $2.812 million adjusted for:
o the amortization of debt discount of approximately
$2.333 million, amortization of deferred financing
costs of approximately $182,000 and a decrease in the
fair value of the derivative liabilities of
approximately $2.415 million.
o An increase in inventories of approximately $383,000 for
materials required for the production of several new
products introduced during the year. A decrease in accounts
receivable and accounts payable and accrued expenses of
approximately $165,000, and $77,000 respectively, due to
better collection efforts and control over expenditures.
During 2006, we used approximately $129,000 in investing activities
mostly for purchase of property and equipment.
During 2006, we used approximately $33,000 in financing activities for
purchase of a certificate of deposit to satisfy collateral requirement of our
line of credit.
There can be no assurance that any required or desired financing will
be available through any other bank borrowings, debt, or equity offerings, or
otherwise, on acceptable terms. If future financing requirements are satisfied
through the issuance of
14
equity securities, investors may experience significant dilution in the net book
value per share of common stock. There is no guarantee that a market will exist
for the sale of our shares.
Our primary capital needs are to fund our growth strategy, which
includes expanding our 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. We do not believe that we will have to incur significant capital
expenditures in the near future in order to meet our growth strategy goals.
As of December 31, 2007, our cash balance and working deficit were
$249,000 and $3,848,000, respectively. Excluding the impact of derivative
liabilities, our working deficit is $1,471,000. The first principal payment of
approximately $780,000 is due on the convertible debentures that we issued on
December 7, 2005, which such payment is due on January 1, 2008. On December 27,
2007, the company entered into a First Amendment Agreement with the holders of
the convertible debentures, which provides for certain amendments to the
debentures issued to them on December 7, 2005 and under the related Securities
Purchase Agreement, Registration Rights Agreement, and Forbearance and Amendment
Agreement, the terms of which are described in the Registration Statement
numbers 333-130900 and 333-138977, effective November 11, 2006 and December 21,
2006, respectively, as amended and supplemented. Pursuant to the Agreement, the
convertible debenture holders agreed to extend the initial principal payment
date on the convertible debentures from January 1, 2008 to April 1, 2008.
On March 28, 2008, the company received $5.5 million from an investor,
$3.5 million of which will be for the purchase of common stock of the company,
and $2.0 million of which will be in exchange for a 9% convertible debenture to
be issued by the company. The company issued to the investor common stock shares
at a price of $0.0405 per share. The 9% convertible debenture will have a five
(5)-year term, and the conversion rate of the debenture will be at $0.0486. A
condition of the new investment requires the company to use $3.5 million to
extinguish the 8% convertible debentures held by the current holders.
A Conversion and Termination Agreement entered into with the current
debentures holders on February 26, 2008, provides that in exchange for $3.5
million, the current debenture holders will convert $3.5 million of the
principal amount of their 8% convertible debentures, together with interest
thereon, at a conversion price of $0.35 per share of Common Stock. Upon receipt
of the foregoing sum and the conversion shares of Common Stock, the current
debenture holders agreed to cancel the remainder of their 8% convertible
debentures and 50% of the shares of Common Stock underlying warrants. With
respect to the remaining 6,065,158 shares of Common Stock underlying the
warrants, they will otherwise continue in full force and effect in accordance
with their terms.
Absent other transactions which would warrant the same accounting
treatment, the company will discontinue the recognition of derivative
liabilities once it can assert that it has a sufficient amount of authorized and
unissued shares to settle its obligations which can be settled in shares. As a
result of the satisfaction of the company's obligations under its convertible
debentures, the company can assert that it has a sufficient amount of authorized
and unissued shares to settle its obligations which can be settled in shares at
March 31, 2008. Accordingly, the company will reclassify all contracts,
warrants, and other convertible instruments outstanding at March 31, 2008 from
liability to equity.
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
We do not have any off-balance sheet arrangements.
15
Item 7. Financial Statements.
FINANCIAL STATEMENTS
INDEX TO FINANCIAL STATEMENTS
Report of Independent Registered Public Accounting Firm F-1
Consolidated Balance Sheet as of December 31, 2007 F-2
Consolidated Statements of Operations for the Year Ended
December 31, 2007 F-3
Consolidated Statement of Changes in Stockholders' Deficit for the
Period from January 1, 2006 to December 31, 2007 F-4
Consolidated Statements of Cash Flows for the Year Ended
December 31, 2007 F-5
Notes to Consolidated Financial Statements F-6
16
805 Third Avenue
21st Floor
New York, NY 10022
Tel: 212-838-5100
Fax: 212-838-2676
e-mail: info@sherbcpa.com
[GRAPHIC OMITTED] SHERB&CO., LLP Offices in New York and Florida
--------------------------------------------------------------------------------
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and Stockholders
Electronic Sensor Technology, Inc.
We have audited the accompanying balance sheet of Electronic Sensor
Technology, Inc. as of December 31, 2007 and the related consolidated statements
of operations, changes in stockholders' deficit and cash flows for the years
ended December 31, 2007 and 2006. These financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audit.
We conducted our audit in accordance with the standards of the Public
Company Accounting Oversight Board (United States). Those standards require that
we plan and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. The Company is not
required to have, nor were we engaged to perform, an audit of its internal
control over financial reporting as a basis for designing audit procedures that
are appropriate in the circumstances, but not for the purpose of expressing an
opinion on the effectiveness of the Company's internal control over financial
reporting. Accordingly we express no such opinion. An audit includes examining,
on a test basis, evidence supporting the amounts and disclosures in the
financial statements. An audit also includes assessing the accounting principles
used and significant estimates made by management, as well as evaluating the
overall financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the financial statements referred to above present
fairly, the consolidated financial position of Electronic Sensor Technology,
Inc., as of December 31, 2007 and the consolidated results of its operations and
its cash flows for the years ended December 31, 2007 and 2006 in conformity with
accounting principles generally accepted in the United States of America.
/s/ Sherb & Co., LLP
Sherb & Co., LLP
Certified Public Accountants
New York, New York
March 31, 2008
F-1
ELECTRONIC SENSOR TECHNOLOGY, INC.
CONSOLIDATED BALANCE SHEET
DECEMBER 31, 2007
ASSETS
CURRENT ASSETS:
Cash and cash equivalents $ 248,587
Certificate of deposit-restricted 12,384
Accounts receivable, net of allowance for doubtful accounts
of $1,500 281,400
Prepaid expenses 80,761
Inventories 818,989
-----------
TOTAL CURRENT ASSETS 1,442,121
-----------
DEFERRED FINANCING COSTS, net of amortization of $380,393 347,967
PROPERTY AND EQUIPMENT, net of accumulated depreciation of $363,544 174,111
SECURITY DEPOSITS 12,817
-----------
$ 1,977,016
===========
LIABILITIES AND STOCKHOLDERS' DEFICIT
CURRENT LIABILITIES:
Accounts payable and accrued expenses $ 520,685
Deferred revenues 41,667
Derivative liabilities 2,376,543
Convertible debentures - current portion 2,333,333
Obligation under capital lease due within one year 17,875
-----------
TOTAL CURRENT LIABILITIES 5,290,103
-----------
CONVERTIBLE DEBENTURES, long-term portion, net of unamortized
discount of $2,138,890 2,527,777
LONG-TERM OBLIGATION UNDER CAPITAL LEASE 36,607
-----------
TOTAL LIABILITIES 7,854,487
-----------
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, 56,756,098 issued and outstanding 56,756
Additional paid-in capital 8,939,562
Accumulated deficit (14,873,789)
-----------
TOTAL STOCKHOLDERS' DEFICIT (5,877,471)
-----------
$ 1,977,016
===========
See notes to consolidated financial statements
F-2
ELECTRONIC SENSOR TECHNOLOGY, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
Year Ended
December 31,
----------------------------
2007 2006
------------ ------------
REVENUES $ 2,198,204 $ 2,180,208
COST OF SALES 1,356,719 1,085,056
------------ ------------
GROSS PROFIT 841,485 1,095,152
------------ ------------
OPERATING EXPENSES:
Research and development 744,646 833,791
Selling 664,838 822,954
Compensation 787,114 655,045
General and administrative 1,078,651 1,200,800
------------ ------------
TOTAL OPERATING EXPENSES 3,275,249 3,512,590
------------ ------------
LOSS FROM OPERATIONS (2,433,764) (2,417,438)
------------ ------------
OTHER INCOME AND EXPENSE:
Other income - derivative liabilities 987,805 2,414,605
Other income 1,854 2,140
Gain (loss) on sale of property and equipment (6,051) (1,615)
Interest expense (2,924,486) (2,809,682)
------------ ------------
TOTAL OTHER INCOME (EXPENSE) (1,940,878) (394,552)
------------ ------------
NET INCOME (LOSS) $ (4,374,642) $ (2,811,990)
============ ============
Earnings (loss) per share, basic $ (0.08) $ (0.05)
============ ============
Weighted average number of shares, basic 54,884,012 54,166,872
============ ============
Earnings (loss) per share, diluted $ (0.10) $ (0.10)
============ ============
Weighted average number of shares, diluted 54,884,012 54,166,872
============ ============
See notes to consolidated financial statements
F-3
ELECTRONIC SENSOR TECHNOLOGY, INC.
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' DEFICIT
Common Stock Preferred Stock Additional Total
------------------------ ------------------------ Paid-In Accumulated Stockholders'
Shares Amount Shares Amount Capital Deficit Deficit
----------- ----------- ----------- ----------- ----------- ----------- -------------
BALANCE - January 1, 2006 54,098,745 $ 54,099 - $ - $ 8,495,429 $(7,687,157) $ 862,371
Issuance of shares for
services 75,000 75 - - 20,925 - 21,000
Net (loss) - - - - - (2,811,990) (2,811,990)
----------- ----------- ----------- ----------- ----------- ------------ -------------
BALANCE - December 31, 2006 54,173,745 54,174 - - 8,516,354 (10,499,147) (1,928,619)
Issuance of shares for
interest 2,582,353 2,582 - - 308,529 - 311,111
Stock based compensation - - - - 114,679 - 114,679
Net (loss) - - - - - (4,374,642) (4,374,642)
----------- ----------- ----------- ----------- ----------- ------------ -------------
BALANCE - December 31, 2007 56,956,098 $56,756 - - $ 8,939,562 $(14,873,789) $ (5,877,471)
=========== =========== =========== =========== =========== ============ =============
See notes to consolidated financial statements.
F-4
ELECTRONIC SENSOR TECHNOLOGY, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
Year Ended
December 31,
----------------------------
2007 2006
------------ ------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) $ (4,374,642) $ (2,811,990)
Adjustments to reconcile net income (loss) to net
cash provided by (used in) operating activities:
Depreciation and amortization 56,511 43,756
Decrease in allowance for doubtful accounts (22,862) -
Increase in reserve for obsolescence 56,320 36,483
Issuance of shares for services - 21,000
Issuance of shares for payment of interest 311,112 -
Amortization of stock based compensation 114,679 -
Amortization of debt discount 2,333,334 2,333,333
Amortization of deferred financing costs 181,548 181,547
Decrease in fair value of derivative liability (979,930) (2,414,606)
Changes in assets and liabilities:
Accounts receivable 41,875 165,363
Inventories 410,381 (382,551)
Prepaid expenses (1,991) (8,834)
Accounts payable and accrued expenses 116,765 (76,880)
Deferred revenues (50,000) (50,000)
------------ ------------
Net cash provided by (used in) operating activities (1,806,900) (2,963,379)
CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from sale of property and equipment 21,647 (128,997)
------------ ------------
Net cash provided by (used in) investing activities 21,647 (128,997)
CASH FLOWS FROM FINANCING ACTIVITIES:
Decrease in certificate of deposit - restricted 939,698 (33,404)
------------ ------------
Net cash provided by (used in) financing activities 939,698 (33,404)
------------ ------------
NET DECREASE IN CASH (845,555) (3,125,780)
CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR 1,094,141 4,219,921
------------ ------------
CASH AND CASH EQUIVALENTS AT END OF YEAR $ 248,587 $ 1,094,141
============ ============
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Cash paid during the period for:
Interest $ 147,888 $ 578,280
============ ============
NON-CASH INVESTING AND FINANCING ACTIVITIES
Purchase of property and equipment under capital
lease $ 54,482 $ -
============ ============
See notes to consolidated financial statements.
F-5
ELECTRONIC SENSOR TECHNOLOGY, INC.
Notes to Financial Statements
December 31, 2007
(1) Nature of Business and Summary of Significant Accounting Policies
Nature of Business
Electronic Sensor Technology, Inc. develops and manufactures electronic
devices used for vapor analysis. It markets its products through
distribution channels in over 20 countries.
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.
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. The
Company had cash and cash equivalents amounting to $248,587 at December 31,
2007.
Certificate of Deposit - Restricted
The Company credit card liability is secured and collateralized with a
certificate of deposit in the amount of approximately $12,000 at December
31, 2007.
Allowance for Doubtful Accounts
The allowance for doubtful accounts is based on the Company's assessment of
the collectibilty 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 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.
Fair Value of Financial Instruments
The carrying value of cash and cash equivalents, certificate of deposit,
accounts receivables, accounts payable and accrued expenses approximate
their fair value due to their short-term maturities. 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.
Concentration of Credit Risks
The Company is subject to concentrations of credit risk primarily from cash
and cash equivalents and accounts receivable. The Company maintains
accounts with financial institutions, which at times exceeds the insured
limit of approximately $100,000. The Company minimizes its credit risks
associated with cash by periodically evaluating the credit quality of its
primary financial institutions. The Company's accounts receivables are due
from distributors in all other countries in which it markets its products.
The Company does not require collateral to secure its accounts receivables.
The Company's two largest
F-6
customers accounted for 96% of its net accounts receivable at December 31,
2007. No other customers accounted for more than 5% of its net accounts
receivables.
Product Concentration Risk
Substantially all of the Company's revenues derive from the sale of
electronic devices used for vapor analysis.
Customer Concentration Risk
One of the Company's customers accounted for 47% of its revenues during
2007. This same customer accounted for 42% of the Company's revenues in
2006. No other customers accounted for more than 10% of its revenues.
Inventories
Inventories are comprised of raw materials, work-in-process, and finished
goods. Inventories are stated at the lower of cost or market, cost
determined by the first-in, first-out (FIFO) method. The Company writes
down its inventory for estimated obsolescence or unmarketable inventory
using the difference between the cost of inventory and the estimated market
value based upon assumptions about future demand and market conditions. The
Company writes down inventory during the period in which such products are
no longer marketable in any of their markets due to governmental
regulations as well as inventory which matures within the next three
months.
Property and Equipment
Property and equipment are recorded at cost and are depreciated on a
straight-line basis over their estimated useful lives of five years.
Maintenance and repairs are charged to expense as incurred. Significant
renewals and betterments are capitalized.
Property and equipment consist of the following as of December 31, 2007:
Machinery and equipment $ 352,500
Leasehold improvements 39,500
Office furniture and equipment 145,600
---------
537,600
Accumulated depreciation (363,500)
---------
$ 174,100
=========
Depreciation expense amounted to approximately $56,500 and $43,800 during
2007 and 2006, respectively.
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 lease
expires in September 2010. 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 $54,500 at December 31, 2007, of
which $17,900 is included in the current portion of capital lease
obligations in the accompanying consolidated balance sheet. As of December
31, 2007, the total future minimum lease payments on this lease is
approximately $54,500 (if stated by year, the minimum lease payments are:
2008 - $17,900, 2009 - $20,000, and 2010 - $16,600).
F-7
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 the term of the related convertible debentures using the
effective interest rate method.
Income Taxes
Income taxes are accounted for in accordance with SFAS No. 109, Accounting
for Income Taxes. SFAS No. 109 requires the recognition of deferred tax
assets and liabilities to reflect the future tax consequences of events
that have been recognized in the Company's financial statements or tax
returns. Measurement of the deferred items is based on enacted tax laws. In
the event the future consequences of differences between financial
reporting bases and tax bases of the Company's assets and liabilities
result in a deferred tax asset, SFAS No. 109 requires an evaluation of the
probability of being able to realize the future benefits indicated by such
assets. A valuation allowance related to a deferred tax asset is recorded
when it is more likely than not that some or the entire deferred tax asset
will not be realized.
Use of Estimates
The preparation of financial statements in accordance with accounting
principles generally accepted in the United States 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 amounts of revenues and
expenses during the reporting periods. Significant estimates made by
management include, but are not limited to, the realization of receivables,
recognition of stock based compensation and the valuation of the derivative
liability. Actual results may differ from these estimates.
Basic and Diluted Earnings per Share
Basic earnings per share is calculated by dividing income available to
stockholders by the weighted-average number of common shares outstanding
during each period. Diluted earnings per share is 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 113,604,126 and 54,190,546 at
December 31, 2007 and 2006, respectively. The outstanding options, warrants
and shares equivalent issuable pursuant to embedded conversion features and
warrants at December 31, 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 reported 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 for the year ended December 31:
2007 2006
------------ ------------
Numerator:
Net (loss) income $ (4,374,642) $ (2,811,990)
Net other income (expense) associated
with derivative contracts (987,805) (2,414,605)
------------ ------------
Net loss for diluted earnings per share
purposes $ (5,362,447) $ (5,226,595)
============ ============
Denominator:
Denominator for basic earnings per
share - Weighted average shares
outstanding 54,884,012 54,166,872
Effect of dilutive warrants, embedded
conversion features and liquidated
damages - -
------------ ------------
F-8
Denominator for diluted earnings per
share - Weighted average shares
outstanding 54,884,012 54,166,872
============ ============
Basic earnings (loss) per share $ (0.04) $ (0.05)
============ ============
Diluted earnings (loss) per share $ (0.10) $ (0.10)
============ ============
Stock-Based Compensation
The Company adopted SFAS No. 123R, "Share Based Payments." SFAS No. 123R
requires companies to expense the value of employee stock options and
similar awards and applies to all outstanding and vested stock-based
awards.
In computing the impact, the fair value of each option is estimated on the
date of grant based on the Black-Scholes options-pricing model utilizing
certain assumptions for a risk free interest rate; volatility; and expected
remaining lives of the awards. The assumptions used in calculating the fair
value of share-based payment awards represent management's best estimates,
but these estimates involve inherent uncertainties and the application of
management judgment. As a result, if factors change and the Company uses
different assumptions, the Company's stock-based compensation expense could
be materially different in the future. In addition, the Company is required
to estimate the expected forfeiture rate and only recognize expense for
those shares expected to vest. In estimating the Company's forfeiture rate,
the Company analyzed its historical forfeiture rate, the remaining lives of
unvested options, and the amount of vested options as a percentage of total
options outstanding. If the Company's actual forfeiture rate is materially
different from its estimate, or if the Company reevaluates the forfeiture
rate in the future, the stock-based compensation expense could be
significantly different from what we have recorded in the current period.
The impact of applying SFAS No. 123R approximated $114,000 in additional
compensation expense during the year ended December 31, 2007. Such amount
is included in general and administrative expenses on the statement of
operations.
Accounts Payable and Accrued Expenses
Accounts payable and accrued expenses at December 31, 2007 consist
primarily of vendor payables.
Deferred Revenues
Deferred revenues at December 31, 2007 amounted to $41,667. The deferred
revenues consist of a one-time licensing fee received by the Company during
2004 and is recognized over the term of the agreement which is five years.
The Company recognized revenues of $50,000 and $50,000 pursuant to this
agreement during 2007 and 2006, respectively.
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
F-9
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.
The reclassification of a contract is reassessed at each balance sheet
date. If a contract is reclassified from permanent equity to an asset or a
liability, the change in the fair value of the contract during the period
the contract was classified as equity is accounted for as an adjustment to
equity. If a contract is reclassified from an asset or liability to equity,
gains or losses recorded to account for the contract at fair value during
the period that contract was classified as an asset or a liability are not
reversed and are accounted for as an adjustment to equity.
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.
Segment reporting
The Company operates in one segment, manufacturing of electronic devices
used for vapor analysis. The Company's chief operating decision-maker
evaluates the performance of the Company based upon revenues and expenses
by functional areas as disclosed in the Company's statements of operations.
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 or service revenue are recorded as deferred revenue.
Shipping and Handling
The Company accounts for shipping and handling costs as a component of
"Cost of Sales".
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 December 31, 2007 no assets were
impaired.
Recently Issued Accounting Pronouncements
FASB Statement Number 157
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
F-10
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.
FASB Interpretation Number 48
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.
SFAS No. 159
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.
FASB Statement Number 141 (revised 2007)
In December 2007, the FASB issued FASB Statement No. 141 (revised 2007),
Business Combinations. This Statement replaces FASB Statement No. 141,
Business Combinations. This Statement retains the fundamental requirements
in Statement 141 that the acquisition method of accounting (which Statement
141 called the purchase method) be used for all business combinations and
for an acquirer to be identified for each business combination. This
Statement defines the acquirer as the entity that obtains control of one or
more businesses in the business combination and establishes the acquisition
date as the date that the acquirer achieves control. This Statement's scope
is broader than that of Statement 141, which applied only to business
combinations in which control was obtained by transferring consideration.
By applying the same method of accounting--the acquisition method--to all
transactions and other events in which one entity obtains control over one
or more other businesses, this Statement improves the comparability of the
information about business combinations provided in financial reports.
This Statement requires an acquirer to recognize the assets acquired, the
liabilities assumed, and any noncontrolling interest in the acquiree at the
acquisition date, measured at their fair values as of that date, with
limited exceptions specified in the Statement. That replaces Statement
141's cost-allocation process, which required the cost of an acquisition to
be allocated to the individual assets acquired and liabilities assumed
based on their estimated fair values.
This Statement applies to all transactions or other events in which an
entity (the acquirer) obtains control of one or more businesses (the
acquirer), including those sometimes referred to as "true mergers" or
"mergers of equals" and combinations achieved without the transfer of
consideration, for example, by contract alone or through the lapse of
minority veto rights. This Statement applies to all business entities,
including mutual entities that previously used the pooling-of-interests
method of accounting for some business combinations. It does not apply to:
(a) The formation of a joint venture, (b) The acquisition of an asset or a
group of assets that does not constitute a business, (c) A combination
between entities or businesses under
F-11
common control, (d) A combination between not-for-profit organizations or
the acquisition of a for-profit business by a not-for-profit organization.
This Statement applies prospectively to business combinations for which the
acquisition date is on or after the beginning of the first annual reporting
period beginning on or after December 15, 2008. An entity may not apply it
before that date. Management believes this Statement will have no impact on
the financial statements of the Company once adopted.
FASB Statement Number 160
In December 2007, the FASB issued FASB Statement No. 160 - Noncontrolling
Interests in Consolidated Financial Statements - an amendment of ARB No.
51. This Statement applies to all entities that prepare consolidated
financial statements, except not-for-profit organizations, but will affect
only those entities that have an outstanding noncontrolling interest in one
or more subsidiaries or that deconsolidate a subsidiary. Not-for-profit
organizations should continue to apply the guidance in Accounting Research
Bulletin No. 51, Consolidated Financial Statements, before the amendments
made by this Statement, and any other applicable standards, until the Board
issues interpretative guidance.
This Statement amends ARB 51 to establish accounting and reporting
standards for the noncontrolling interest in a subsidiary and for the
deconsolidation of a subsidiary. It clarifies that a noncontrolling
interest in a subsidiary is an ownership interest in the consolidated
entity that should be reported as equity in the consolidated financial
statements. Before this Statement was issued, limited guidance existed for
reporting noncontrolling interests. As a result, considerable diversity in
practice existed. So-called minority interests were reported in the
consolidated statement of financial position as liabilities or in the
mezzanine section between liabilities and equity. This Statement improves
comparability by eliminating that diversity.
A noncontrolling interest, sometimes called a minority interest, is the
portion of equity in a subsidiary not attributable, directly or indirectly,
to a parent. The objective of this Statement is to improve the relevance,
comparability, and transparency of the financial information that a
reporting entity provides in its consolidated financial statements by
establishing accounting and reporting standards that require: (a) The
ownership interests in subsidiaries held by parties other than the parent
be clearly identified, labeled, and presented in the consolidated statement
of financial position within equity, but separate from the parent's equity,
(b) The amount of consolidated net income attributable to the parent and to
the noncontrolling interest be clearly identified and presented on the face
of the consolidated statement of income, (c) Changes in a parent's
ownership interest while the parent retains its controlling financial
interest in its subsidiary be accounted for consistently. A parent's
ownership interest in a subsidiary changes if the parent purchases
additional ownership interests in its subsidiary or if the parent sells
some of its ownership interests in its subsidiary. It also changes if the
subsidiary reacquires some of its ownership interests or the subsidiary
issues additional ownership interests. All of those transactions are
economically similar, and this Statement requires that they be accounted
for similarly, as equity transactions, (d) When a subsidiary is
deconsolidated, any retained noncontrolling equity investment in the former
subsidiary be initially measured at fair value. The gain or loss on the
deconsolidation of the subsidiary is measured using the fair value of any
noncontrolling equity investment rather than the carrying amount of that
retained investment, (e) Entities provide sufficient disclosures that
clearly identify and distinguish between the interests of the parent and
the interests of the noncontrolling owners.
This Statement is effective for fiscal years, and interim periods within
those fiscal years, beginning on or after December 15, 2008 (that is,
January 1, 2009, for entities with calendar year-ends). Earlier adoption is
prohibited. This Statement shall be applied prospectively as of the
beginning of the fiscal year in which this Statement is initially applied,
except for the presentation and disclosure requirements. The presentation
and disclosure requirements shall be applied retrospectively for all
periods presented. Management believes this Statement will have no impact
on the financial statements of the Company once adopted.
(2) Inventory
Inventory at December 31, 2007 consist of the following:
Finished goods $ 475,091
Work-in-process 360,671
Raw materials 76,030
Reserve for obsolescence (92,803)
----------
$ 818,989
==========
F-12
Inventories are stated at the lower of cost or market, cost determined by
the first-in, first-out (FIFO) method. The Company writes down its
inventory for estimated obsolescence or unmarketable inventory equal to the
difference between the cost of inventory and the estimated market value
based upon assumptions about future demand and market conditions. The
Company writes down inventory during the period in which such products are
no longer marketable in any of their markets due to governmental
regulations as well as inventory which matures within the next three months
of the measurement date.
(3) 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 5), and can be redeemed at the lesser of
$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 (which was subsequently postponed to April 1,
2008 as per a First Amendment Agreement (see Note 6) with the holders of
the convertible debentures dated December 27, 2007), 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 5), 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 5).
Furthermore, the Company granted liquidated damages pursuant to a
registration rights agreement.
The convertible debentures and related agreements provide, among other
things, for:
a. 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 5). The registration statement covering the shares
underlying the convertible debentures was declared effective on
November 21, 2006;
b. 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 5) - 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;
c. 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
d. 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
F-13
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 5), 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
warrants - see Note 5). 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 $181,500 and $181,500 for the years ending December 31, 2006
and 2007, respectively.
See Note 4 - 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 December 31, 2007 is approximately
$2,333,333.
On March 31, 2008 the Company satisfied its obligations under its
convertible debentures. Reference Note 11, Subsequent events.
(4) 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
F-14
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.
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 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 December 31, 2007 is as follows:
At December
At issuance 31, 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 December
At issuance 31, 2007
----------- -----------
Market price: $ 2.40 $ 0.09
Exercise price: $ 1.00 $ 1.00
Term: 3 years .26 years
Volatility: 39% 36%
Risk-free interest rate: 2.78% 3.07%
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 than the debenture
conversion price, whereby the aforementioned variable conversion price of
the convertible debentures is adjusted to the new lower effective
F-15
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
5), 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 5). 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 December 31, 2007 are as follows:
At Issuance At December 31, 2007
----------- --------------------
Freestanding warrants $ 3,532,348 $ 2,376,543
Embedded conversion features 3,463,542 0
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:
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.
F-16
The Company used the following assumptions to measure the identified
derivatives, using the Lattice valuation model, as follows:
Embedded conversion features
At issuance At December 31, 2007
----------- --------------------
Market price: $ 0.4880 $ 0.09
Conversion price: $ 0.4544 $ 0.08
Term: 4 years 1.93 years
Volatility: 39% 36%
Risk-free interest rate: 4.39% 3.07%
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 December 31, 2007
----------- --------------------
Market price: $ 0.488 $ 0.09
Exercise price: $ 0.4761 $ 0.43
Term: 5 years 2.93 years
Volatility: 39% 36%
Risk-free interest rate: 4.39% 3.07%
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 December 31, 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 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 December 31,
amounted to approximately $1.0 million and $2.4 million, and have been
recorded as other income in 2007 and 2006, respectively.
(5) 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
F-17
$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.
(6) First Amendment Agreement
On December 27, 2007, the Company entered into a First Amendment Agreement
with the holders of the convertible debentures, which provides for certain
amendments to the debentures issued to them on December 7, 2005 and under
the related Securities Purchase Agreement, Registration Rights Agreement,
and Forbearance and Amendment Agreement, the terms of which are described
in the Registration Statement numbers 333-130900 and 333-138977, effective
November 11, 2006 and December 21, 2006, respectively, as amended and
supplemented. Pursuant to the Agreement, Midsummer and Islandia agreed to
extend the initial principal payment date on the convertible debentures
from January 1, 2008 to April 1, 2008.
The Company satisfied its obligations under its convertible debentures.
Reference Note 11, Subsequent events. Absent other transactions which would
warrant the same accounting treatment, the Company will discontinue the
recognition of derivative liabilities once it can assert that it has a
sufficient amount of authorized and unissued shares to settle its
obligations which can be settled in shares. As a result of the satisfaction
of the Company's obligations under its convertible debentures, the Company
can assert that it has a sufficient amount of authorized and unissued
shares to settle its obligations which can be settled in shares at March
31, 2008. Accordingly, the Company will reclassify all contracts, warrants,
and other convertible instruments outstanding at March 31, 2008 from
liability to equity.
(7) Stockholders' Deficit
Common Stock
Shares issued for payment of interest
During 2007, the Company elected to pay second and third quarter interest
on the convertible debentures in shares of the Company's common stock,
rather than in cash. The Company issued 2,582,353 shares of the Company's
common stock to the holders of the convertible debentures.
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.
F-18
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 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 100% 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.
Management used Black Scholes methodology to determine the fair value of
the options on the date of issue based on the following assumptions. The
expected volatility was based on the average historical volatility of
comparable publicly-traded companies.
Exercise price $ 0.19 - $ 0.24
Market value $ 0.19 - $ 0.24
Expected dividend yield 0%
Expected volatility 36% - 39%
Risk free interest rate 4.03% - 4.54%
Expected life of option 5 years
The fair value of the granted stock options shares was approximately
$237,000 or $0.09 per share. Approximately $114,000 was charged to
compensation expense in 2007. 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 $112,000 at
December 31, 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.
The following tables summarize all stock option grants to employees and
non-employees as of December 31, 2007:
Weighted
Number of Average
Stock Options Options Exercise Price
---------------------------------------------------------------------------------------------
Balance at December 31, 2005 1,219,500 $ 0.93
Granted - $ -
Exercised - $ -
Forfeited - $ -
--------------- -----------
Balance at December 31, 2006 1,219,500 $ 0.93
Granted 2,657,950 $ 0.22
Exercised - $ -
Forfeited (439,500) $ 0.73
--------------- -----------
Balance at December 31, 2007 3,437,950 $ 0.41
=============== ===========
Options exercisable at December 31, 2007 1,839,750 $ 0.58
=============== ===========
Weighted average fair value of options granted during 2007 2,657,950 $ 0.09
=============== ===========
A summary of the status of the Company's nonvested shares as of December
31, 2007, and changes during the fiscal year then ended as presented below.
Nonvested Shares Shares Weighted
Average Grant
Date Fair Value
-----------------------------------------------------------------------------------------------
Nonvested at December 31, 2006 - -
Granted 2,657,950 $ 0.22
Vested (898,250) $ 0.09
Cancelled (161,500) $ 0.09
------------ ------------
Nonvested at December 31, 2007 1,598,200 $ 0.09
============ ============
Options Outstanding Options Exercisable
--------------------------------------------------------------------------------------------
Number Weighted
Outstanding Average Weighted Number Weighted
as of Remaining Average Exercisable Average
Exercise December 31, Contractual Exercise at December Exercise
Price 2007 Years Price 31, 2007 Price
----------- ------------ ------------- ------------- ------------ -----------
$ 0.19 330,750 9.17 $ 0.19 330,750 $ 0.19
$ 0.20 1,000,000 9.50 $ 0.20 100,000 $ 0.20
$ 0.24 1,165,700 9.08 $ 0.24 467,500 $ 0.24
$ 0.64 250,000 7.83 $ 0.64 250,000 $ 0.64
$ 1.00 691,500 7.08 $ 1.00 691,500 $ 1.00
------------- ------------- -------------- ------------- ------------
3,437,950 8.72 $ 0.41 1,839,750 $ 0.57
============= ============== ============== ============= ============
F-19
(8) Commitments and Contingencies
Leases
The Company rents office space and production facilities in Newbury Park,
California. The lease expires in September 2010. The rental expense
associated with this lease was approximately $180,000 and $196,800 in 2007
and 2006, respectively. As of December 31, 2007, the total future minimum
rental payments on this lease is approximately $393,900 (if stated by year,
the minimum rental payments are: 2008 - 140,300, 2009 - 144,500, and 2010 -
109,100).
During 2007, the Company entered into a lease for equipment used in
administration. Lease payments in 2007 totaled approximately $2,200. As of
December 31, 2007, the total future minimum lease payments on this lease is
approximately $9,800 (if stated by year, the minimum lease payments are:
2008 - $2,400, 2009 - $2,400, 2010 - $2,400, 2011 - $2,400, and 2012 -
$200).
(9) Retirement savings plan
The Company sponsors a safe harbor 401(k) retirement savings plan (the
plan) which covers most of its full-time employees. The Company contributes
3% of compensation for each payroll period to all eligible employees.
Eligible employees may also elect to contribute a percentage of their
compensation to the Plan. During 2007 and 2006, the Company contributed
approximately $32,300 and $40,500, respectively, to the Plan.
(10) Income Taxes
Deferred income taxes reflect the net tax effect of temporary differences
between the carrying amounts of assets and liabilities for financial
reporting purposes and the amounts used for income tax purposes.
Significant components of the net deferred taxes, as of December 31, 2007,
are as follows:
Deferred tax assets:
Net operating loss carryforward $ 3,300,000
Less valuation allowance (3,300,000)
--------------
Total net deferred tax assets: $ -
==============
The Company's net operating losses totaled approximately $8.1 million at
December 31, 2007, and will expire in 2027.
SFAS No. 109 requires a valuation allowance to reduce the deferred tax
assets reported, if any, based on the weight of the evidence, it is more
likely than not that some portion or all of the deferred tax assets will
not be realized. Management has determined that a valuation allowance of
$3,300,000 at December 31, 2007 is necessary to reduce the deferred tax
assets to the amount that will more likely than not be realized. The change
in the valuation allowance during 2007 and 2006 was an increase of
approximately $1,300,000 and $1,100,000 respectively.
The federal statutory tax rate reconciled to the effective tax rate during
2007 and 2006, respectively, is as follows:
2007 2006
------ ------
Tax at U.S. Statutory Rate: 35.0% 35.0%
State tax rate, net of federal benefits 5.7 5.7
F-20
2007 2006
------ ------
Change in valuation allowance (40.7) (40.7)
------ ------
Effective tax rate 0.0% 0.0%
====== ======
(11) Subsequent events
On March 28, 2008, the Company received $5.5 million from an investor, $3.5
million of which will be for the purchase of common stock of the Company,
and $2.0 million of which will be in exchange for a 9% convertible
debenture to be issued by the Company. The Company will issue to the
investor common stock shares at a price of $0.0405 per share. The 9%
convertible debenture will have a five (5)-year term, and the conversion
rate of the debenture will be at $.0486. A condition of the new investment
requires the Company to use $3.5 million to extinguish the 8% convertible
debentures held by the current holders.
A Conversion and Termination Agreement entered into with the current
debentures holders on February 26, 2008, provides that in exchange for $3.5
million, the current debenture holders will convert $3.5 million of the
principal amount of their 8% convertible debentures, together with interest
thereon, at a conversion price of $0.35 per share of Common Stock. Upon
receipt of the foregoing sum and the conversion shares of Common Stock, the
current debenture holders agreed to cancel the remainder of their 8%
convertible debentures and 50% of the shares of Common Stock underlying
warrants. With respect to the remaining 6,065,158 shares of Common Stock
underlying the warrants, they will otherwise continue in full force and
effect in accordance with their terms.
Absent other transactions which would warrant the same accounting
treatment, the Company will discontinue the recognition of derivative
liabilities once it can assert that it has a sufficient amount of
authorized and unissued shares to settle its obligations which can be
settled in shares. As a result of the satisfaction of the Company's
obligations under its convertible debentures, the Company can assert that
it has a sufficient amount of authorized and unissued shares to settle its
obligations which can be settled in shares at March 31, 2008. Accordingly,
the Company will reclassify all contracts, warrants, and other convertible
instruments outstanding at March 31, 2008 from liability to equity.
F-21
Item 8. Changes in and Disagreements With Accountants on Accounting and
Financial Disclosure.
None.
Item 8A(T). Controls and Procedures.
EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES
The company's Chief Executive Officer and Chief Financial Officer,
after evaluating the effectiveness of the company's disclosure controls and
procedures (as defined in Rules 13a-15(e) under the Securities Exchange Act of
1934, as amended) as of the end of the period covered by this annual report on
Form 10-KSB, have concluded that, based on such evaluation, the company's
disclosure controls and procedures were effective to ensure that material
information relating to the company is recorded, processed, summarized, and
reported in a timely matter. In designing and evaluating the disclosure controls
and procedures, the company's management recognized that any controls and
procedures, no matter how well designed and operated, can provide only
reasonable assurance of achieving the desired control objectives, and the
company's management necessarily was required to apply its judgment in
evaluating the cost-benefit relationship of possible controls and procedures.
MANAGEMENT'S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
The management of the company is responsible for establishing and
maintaining adequate internal control over financial reporting. Internal control
over financial reporting is defined in Rule 13a-15(f) and Rule 15d-15(f)
promulgated under the Securities Exchange Act of 1934, as amended, as a process
designed by, or under the supervision of, the company's principal executive and
principal financial officers and effected by the company's Board of Directors,
management and other personnel, to provide reasonable assurance regarding the
reliability of financial reporting and the preparation of financial statements
for external purposes in accordance with generally accepted accounting
principles. The company's internal control over financial reporting includes
those policies and procedures that:
o pertain to the maintenance of records that, in reasonable detail,
accurately and fairly reflect the transactions and dispositions of the
assets of the company;
o provide reasonable assurance that transactions are recorded as
necessary to permit preparation of financial statements in accordance
with generally accepted accounting principles, and that receipts and
expenditures of the company are being made only in accordance with
authorizations of management and directors of the company; and
o provide reasonable assurance regarding prevention or timely detection
of unauthorized acquisition, use or disposition of the company's
assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting
may not prevent or detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.
The company's management assessed the effectiveness of the company's internal
control over financial reporting as of December 31, 2007. In making this
assessment, it used the criteria set forth in the Internal Control-Integrated
Framework issued by the Committee of Sponsoring Organizations of the Treadway
Commission (COSO). Based on its assessment, the company's management has
concluded that, as of December 31, 2007, the company's internal control over
financial reporting is effective based on those criteria. This report does not
include an attestation report of our registered public accounting firm regarding
internal control over financial reporting. Management's report was not subject
to attestation by our registered public accounting firm pursuant to temporary
rules of the Securities and Exchange Commission that permit us to provide only
management's report in this annual report.
CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING
During the quarter ended December 31, 2007, there were no changes in
our internal control over financial reporting that materially affected, or are
reasonably likely to materially affect, our internal control over financial
reporting.
17
Item 8B. Other Information.
None.
PART III
Item 9. Directors, Executive Officers, Promoters, Control Persons and
Corporate Governance; Compliance With Section 16(a) of the Exchange
Act.
Barry S. Howe
Barry S. Howe, age 52, currently serves as President and Chief
Executive Officer and a director of Electronic Sensor Technology. Mr. Howe has
served as a director and as President and Chief Executive Officer of Electronic
Sensor Technology since July 16, 2007. From April 11, 2007 to July 15, 2007, Mr.
Howe served as Chief Operating Officer of Electronic Sensor Technology. Prior to
joining the company, Mr. Howe held various executive positions at Thermo
Electron Corporation (now Thermo Fisher Scientific), including President and
Chief Executive Officer of Thermo Electron subsidiaries. Thermo Fisher
Scientific is a leading supplier of analytical instruments, equipment, and
supplies to laboratories and process industries. From 2002 to 2004, Mr. Howe
served as Corporate Vice President and President of the Measurement and Control
Sector. Mr. Howe also serves on the Board of Directors and as Chairman of the
Audit Committee of Glenrose Instruments Inc., positions he has held since 2006.
Mr. Howe received a B.S. in Business Administration from Boston University.
Philip Yee
Philip Yee, age 58, currently serves as Secretary, Treasurer and Chief
Financial Officer of Electronic Sensor Technology. Mr. Yee has served as
Secretary, Treasurer and Chief Financial Officer of Electronic Sensor Technology
since November 1, 2006. From April 2006 through November 1, 2006, Mr. Yee served
as Controller of Electronic Sensor Technology. From February 2005 through April
2006, Mr. Yee was Corporate Controller of Sleepwell Laboratories, Inc., a
regional healthcare provider, and its related companies. From 2001 through
February 2005, Mr. Yee was Corporate Controller of BLT Enterprises, Inc., a
regional recycling company and real estate developer, and its related companies.
Mr. Yee received a B.A. and an M.B.A. from the University of Michigan.
Gary Watson
Gary Watson, age 58, currently serves as Vice President of Engineering
and interim Chief Scientist of Electronic Sensor Technology. Mr. Watson has
served as Vice President of Engineering since September 8, 2005. Mr. Watson is
the co-inventor of the zNose(R). Mr. Watson has over twenty years experience in
gas chromatography. Mr. Watson joined Amerasia Technology in 1988 and directed
Amerasia Technology's research in adapting gas chromatographic techniques with
surface acoustic wave (SAW) detectors. He received his B.S. degree from the
University of Southern California in 1972.
James H. Frey
James H. Frey, age 70, currently serves as Chairman of the Board of
Directors of Electronic Sensor Technology. Mr. Frey has served as Chairman since
February 21, 2005. From June 1999 to March 2003, Mr. Frey served as Chief
Executive Officer of TASC Inc., a subsidiary of Litton/Northrup Grumman. He also
served as the Vice President of Information Technology at Litton from March 2001
to March 2002. Mr. Frey is currently a director of SSG Precision Optronics, a
privately-held optical component manufacturing company. Mr. Frey received a B.S.
in Electrical Engineering from Duke University in 1960. Mr. Frey does not serve
as a director of any other publicly reporting company.
Teong C. Lim
Teong C. Lim, age 68, currently serves as a director of Electronic
Sensor Technology. Dr. Lim has served as a director of Electronic Sensor
Technology since January 31, 2005, served as President and Chief Executive
Officer from January 26, 2006 through July 15, 2007, and served as Vice
President of Corporate Development from February 1, 2005 through January 25,
2006. Dr. Lim was the Director of Corporate Development of Electronic Sensor
Technology, L.P. from March 1995 through August 2000 and was the Manager of
Corporate Development of Electronic Sensor Technology, L.P. from August 2000
through February
18
2005. Dr. Lim has been the President of Amerasia Technology, Inc., a subsidiary
of Electronic Sensor Technology, since 1984. Since 1997, Dr. Lim has been a
director of Crystal Clear Technology, Sdn. Bhd., a privately-owned Malaysian
company that manufactures and markets a high-contrast liquid crystal display
(LCD) product line. Dr. Lim received a Ph.D. in Electrical Engineering from
McGill University in 1968 and an M.B.A. from Pepperdine University in 1982. Dr.
Lim also serves as a director of Chatsworth Data Solutions, Inc., which is a
public reporting company.
Francis H. Chang
Francis H. Chang, age 73, currently serves as a director of Electronic
Sensor Technology. Mr. Chang has served as a director of Electronic Sensor
Technology since January 31, 2005 and served as Secretary and Vice President of
Finance and Administration from February 1, 2005 through November 1, 2006. Mr.
Chang serves on our audit committee and compensation committee. Mr. Chang was
the Vice President of Finance and Operations of Electronic Sensor Technology,
L.P. from March 1995 through February 2005. Mr. Chang received a B.A. in
Economics from National Taiwan University in Taiwan in 1956 and an M.B.A. from
Pepperdine University in 1978. Mr. Chang does not serve as a director of any
other publicly reporting company.
James Wilburn
James Wilburn, age 75, currently serves as a director of Electronic
Sensor Technology. Dr. Wilburn has served as a director of Electronic Sensor
Technology since September 8, 2005. Dr. Wilburn serves as the chairman of both
our audit committee and compensation committee. Dr. Wilburn has served as dean
of Pepperdine University's School of Public Policy since September 1996. Dr.
Wilburn has also served Pepperdine as Vice President of University Affairs, and
as provost and Chief Operating Officer. He is also a member of the European
Parliament Industrial Council. Dr. Wilburn has served as a director of several
companies in the United States and Europe, including Signet Scientific, George
Fisher (Switzerland), The Olsen Company, Flowline, Brentwood Square Savings Bank
and First Fidelity Thrift and Loan. Dr. Wilburn received his Ph.D. in economic
history from the University of California at Los Angeles, a masters degree from
Midwestern State University and an MBA from Pepperdine's Presidential/Key
Executive program. He received his bachelors degree from Abilene Christian
University. Dr. Wilburn currently serves as a director of Virco Manufacturing,
which is a publicly reporting company.
Lewis E. Larson
Lewis E. Larson, age 61, currently serves as a director of Electronic
Sensor Technology. Mr. Larson has served as a director of Electronic Sensor
Technology since September 7, 2006. Mr. Larson serves on our audit committee and
compensation committee. Mr. Larson is the founder and President of The Lion
Group which has provided consulting and system engineering services to the
Federal Government and supporting industries since 1994. He has 15 years of
Federal service with the National Security Agency (NSA) and the Central
Intelligence Agency (CIA). Mr. Larson holds professional certifications from NSA
and the Department of Defense in Collection Management; Traffic Analysis and
Special Research; Education and Training; and Arabic language. After leaving the
Federal Government as a senior executive in 1984, Mr. Larson co-founded
Analytical Decisions Inc. which was acquired by the Ball Corporation. Mr. Larson
received his BSEE from the University of Minnesota and has conducted post-
graduate studies at the University of Maryland; New Mexico; California;
Georgetown; Naval Post Graduate School; and John Hopkins. He also completed the
Senior Executive Education business program at Stanford University and also the
John F. Kennedy School of Government at Harvard University. Mr. Larson currently
serves as a director of Digital Media Broadcasting Corporation, Global Wireless
Networks, Fortress Technologies and Universal Scientific Technologies Ltd in
England.
Rita Benoy Bushon
Rita Benoy Bushon, age 47, currently serves as a director of
Electronic Sensor Technology. Ms. Bushon has served as a director of Electronic
Sensor Technology since October 26, 2007. Ms. Bushon has served as President of
L&G Resources (1994) Inc. since September 2007. Ms. Bushon has served as
Executive Director and as a member of the Executive Committee of Land & General
Berhad since December 2006. Previously, she was a Director of Land & General
Berhad, a position she was appointed to in March 2002. From December 1984 to her
retirement in October 2007, Ms. Bushon held various senior executive positions
with Employees Provident Fund (Malaysia) including Head of Private Equity and
Head of Public Equity Research. Ms. Bushon was a Director and a founding member
of the Minority Shareholder Watchdog Group, a Malaysian public company, from
December 2001 to February 2007. Ms. Bushon does not serve as a director of any
other publicly reporting company in the United States. From 2003 through
December 2007, Ms. Bushon served on the Board of Directors of Kentucky Fried
Chicken Ltd. (Malaysia). Ms. Bushon received a Masters in Business
Administration from Henley/Brunel University, West London in 1993, and earned an
honours degree in Economic Statistics from Universiti Kebangsaan Malaysia in
1984.
19
FAMILY RELATIONSHIPS AND INVOLVEMENT IN CERTAIN LEGAL PROCEEDINGS
Each of our directors holds office until the next annual meeting of
our shareholders, or until his prior death, resignation or removal. There are no
family relationships among our directors or executive officers. Within the past
five years, there has not been any bankruptcy petition filed by or against any
business of which any of our officers, directors or control persons were a
general partner or executive officer either at the time of the bankruptcy or
within two years prior to that time. None of our officers, directors or control
persons has been convicted in a criminal proceeding in the past five years or is
subject to a pending criminal proceeding (excluding traffic violations and other
minor offenses). None of our officers, directors or control persons is subject
to any order, judgment, or decree, not subsequently reversed, suspended or
vacated, of any court of competent jurisdiction, permanently or temporarily
enjoining, barring, suspending or otherwise limiting his involvement in any type
of business, securities or banking activities. None of our officers, directors
or control persons has been found by a court of competent jurisdiction (in a
civil action), the Securities and Exchange Commission or the Commodity Futures
Trading Commission to have violated a federal or state securities or commodities
law, where the judgment has not been reversed, suspended, or vacated.
SECTION 16(A) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE
Section 16(a) of the Securities Exchange Act of 1934 requires that the
company's officers, directors and persons who beneficially own more than ten
percent (10%) of the company's outstanding common stock, file reports of
ownership and changes in ownership with the Security Exchange Commission. Such
persons are required by the Securities and Exchange Commission to furnish the
company with copies of all Section 16(a) reports they file. To the best of our
knowledge, based solely on review of copies of such reports, including Forms 3,
4 and 5 and amendments thereto, we believe each of our directors, officers and
persons who beneficially own more than ten percent (10%) of our outstanding
common stock have complied with all filing requirements applicable to such
persons.
CODE OF ETHICS
We have adopted a code of ethics that applies to our principal
executive officer, principal financial officer and principal accounting officer
or controller, or persons performing similar functions. A copy of our code of
ethics is attached as Exhibit 14 to our annual report on Form 10-KSB for the
fiscal year ended December 31, 2004. Our code of ethics will be provided to any
person without charge, upon request. Requests should be addressed to: Electronic
Sensor Technology, Inc., Attn: Investor Relations Department, 1077 Business
Center Circle, Newbury Park, California 91320.
NOMINATING COMMITTEE
There have been no material changes to the procedures by which
security holders may recommend nominees to the company's Board of Directors.
AUDIT COMMITTEE FINANCIAL EXPERT
Our board of directors has determined that we have one audit committee
financial expert serving on our audit committee. Our audit committee financial
expert is Francis Chang. Although there are no standards applicable to us
regarding the independence of our audit committee members, Mr. Chang would not
be considered independent using the standards contained in the NASDAQ
Marketplace Rules, as described further below under "Item 12. Certain
Relationships and Related Transactions, and Director Independence."
Item 10. Executive Compensation.
SUMMARY COMPENSATION
The table below outlines the total compensation of the named executive
officers of Electronic Sensor Technology for the fiscal years ended December 31,
2006 and December 31, 2007.
20
SUMMARY COMPENSATION TABLE(1)
Name and Stock Option All Other
Principal Salary Awards Awards Compensation
Position Year ($)(2) Bonus ($) ($) ($)(3) ($)(4) Total ($)
------------------------- ---- --------- --------- --------- ------- ------------ ---------
Barry S. Howe, 2006 - - - - - -
President and Chief 2007 116,923
Executive Officer - - 80,000(6) - 196,923
(July 16, 2007-Present)
Former Chief Operating
Officer (April 11,
2007-July 15, 2007)
Director (July
16, 2007-Present)(5)
------------------------- ---- -------- --------- --------- ------- ------------ ---------
Gary Watson, 2006 145,172 - - - 4,355(7) 149,527
Vice President of 2007 142,773 - - 10,000(8) 4,283(7) 157,056
Engineering (May 26,
2005-Present)
Interim Chief
Scientist (March 8,
2007-Present)
------------------------- ---- -------- --------- --------- ------- ------------ ---------
Philip Yee, 2006 64,750 - - - - 64,750
Secretary, Treasurer 2007 120,961 - - 10,000(9) 3,629(7) 134,590
and Chief Financial
Officer (November 1,
2006-Present)
------------------------- ---- -------- --------- --------- ------- ------------ ---------
Edward J. Staples, 2006 206,360 - - - 6,160(7) 212,550
Former President and 2007 52,439(10) 5,000(11) 118,797(12) 176,236
Chief Executive
Officer (February 1,
2005-May 26, 2005)
Former Chief
Scientific Officer
(May 26, 2005-March 8,
2007)
Former Director
(February 1,
2005-March 8, 2007)
(5)
------------------------- ---- -------- --------- --------- ------- ------------ ---------
Teong C. Lim, 2006 165,229 - - - 4,957(7) 170,186
Former President and
Chief Executive
21
Name and Stock Option All Other
Principal Salary Awards Awards Compensation
Position Year ($)(2) Bonus ($) ($) ($)(3) ($)(4) Total ($)
------------------------- ---- -------- --------- --------- ------- ------------ ---------
Officer (January 26,
2006-July 15, 2007) 2007 100,532 - - 10,000(13) 74,049(14) 184,581
Former Vice President
of Corporate
Development (February
1, 2005-January 25,
2006)
Director (January 31,
2005-Present) (5)
(1) The columns entitled "Non-Equity Incentive Plan Compensation" and
"Nonqualified Deferred Compensation Earnings" have been omitted from the Summary
Compensation Table because there has been no compensation awarded to, earned by,
or paid to any of the named executive officers required to be reported in such
columns.
(2) Amounts represent all pre-tax salaries and include any amounts earned but
deferred under the company's 401(k) plan.
(3) The manner in which the company values stock and option awards is outlined
in Note 1 to the company's consolidated financial statements under the heading
"Stock-Based Compensation" as well as Note 7 under the heading "Stockholders'
Deficit" included in this annual report. We did not grant any stock awards to
the named executive officers during our 2006 fiscal year or our 2007 fiscal
year.
(4) All named executive officers are covered by the company's health insurance
plan, which does not discriminate in scope, terms or operation, in favor of
named executive officers or directors and is generally available to all salaried
employees. As a result, the information regarding health insurance premiums paid
to the named executive officers has been omitted from the Summary Compensation
Table.
(5) Barry Howe did not receive any compensation for his services as a director
of the company in 2007. Teong Lim and Edward Staples did not receive any
compensation for their services as directors of the company in either 2006 or
2007.
(6) On July 16, 2007, Barry Howe was granted an option under our 2005 Stock
Incentive Plan to acquire 1,000,000 shares of our common stock, par value $0.001
per share, at an exercise price of $0.20 per share, which is the average of the
quoted closing price of our common stock over the five trading days ending on
July 16, 2007. The option shares will vest as follows: 100,000 were fully vested
upon grant, 225,000 will vest on April 11, 2008, 225,000 will vest on April 11,
2009, 225,000 will vest on April 11, 2010 and 225,000 will vest on April 11,
2011. The manner in which the company values the option awards is outlined in
Note 1 to the company's consolidated financial statements under the heading
"Stock-Based Compensation" as well as Note 7 under the heading "Stockholders'
Deficit" included in this annual report.
(7) Amounts represent 401(k) contributions by the company, as described under
the heading "401(k) Plan" below.
(8) On January 16, 2007, Gary Watson was granted an option under our 2005 Stock
Incentive Plan to acquire 100,000 shares of our common stock, par value $0.001
per share, at an exercise price of $0.24 per share. The option shares granted to
Mr. Watson will vest as follows: 12,500 of the option shares vested on January
16, 2008, 12,500 will vest on January 16, 2009, 12,500 will vest on January 16,
2010, 12,500 will vest on January 16, 2011, 12,500 vested on September 8, 2007,
12,500 vested on September 8, 2008, 12,500 will vest on September 8, 2009 and
12,500 will vest on September 8, 2010. On March 5, 2007, Mr. Watson was granted
an option under our 2005 Stock Incentive Plan to acquire 87,500 shares of our
common stock, par value $0.001 per share, at an exercise price of $0.19 per
share. The option shares were fully vested upon grant. The manner in which the
company values
22
the option awards is outlined in Note 1 to the company's consolidated financial
statements under the heading "Stock-Based Compensation" as well as Note 7 under
the heading "Stockholders' Deficit" included in this annual report.
(9) On January 16, 2007, Philip Yee was granted an option under our 2005 Stock
Incentive Plan to acquire 100,000 shares of our common stock, par value $0.001
per share, at an exercise price of $0.24 per share. The option shares granted to
Mr. Yee will vest as follows: 15,000 of the option shares were fully vested upon
grant of the options, 6,250 vested on January 16, 2008, 6,250 will vest on
January 16, 2009, 6,250 will vest on January 16, 2010, 6,250 will vest on
January 16, 2011, 15,000 vested on April 3, 2007, 15,000 will vest on April 3,
2008, 15,000 will vest on April 3, 2009 and 15,000 will vest on April 3, 2010.
The manner in which the company values the option awards is outlined in Note 1
to the company's consolidated financial statements under the heading
"Stock-Based Compensation" as well as Note 7 under the heading "Stockholders'
Deficit" included in this annual report.
(10) Amount represents the salary paid to Dr. Staples for the period from
January 1 ,2007 through March 8, 2007.
(11) On January 16, 2007, Edward Staples was granted an option under our 2005
Stock Incentive Plan to acquire 50,000 shares of our common stock, par value
$0.001 per share, at an exercise price of $0.24 per share. The option shares are
scheduled to vest as follows: one quarter vested on January 16, 2008, one
quarter will vest on January 16, 2009, one quarter will vest on January 16, 2010
and one quarter will vest on January 16, 2011. On March 5, 2007, Dr. Staples was
granted an option under our 2005 Stock Incentive Plan to acquire 50,000 shares
of our common stock, par value $0.001 per share, at an exercise price of $0.19
per share. The option shares were fully vested upon grant. The manner in which
the company values the option awards is outlined in Note 1 to the company's
consolidated financial statements under the heading "Stock-Based Compensation"
as well as Note 7 under the heading "Stockholders' Deficit" included in this
annual report.
(12) Amount represents (i) $116,324 received as severance pursuant to the
Severance Agreement, Mutual Release and Promotion Agreement, as more fully
described under the heading "Severance and Termination Agreements" below (ii) a
total of $900 for Dr. Staples' services promoting the company and its products
in exchange for $100 per hour and reimbursement of reasonable business costs and
expenses incurred in connection with such promotion and (iii) $1,573 in 401(k)
contributions by the company.
(13) On January 16, 2007, Teong Lim was granted an option under our 2005 Stock
Incentive Plan to acquire 100,000 shares of our common stock, par value $0.001
per share, at an exercise price of $0.24 per share. The option shares will vest
as follows: one quarter vested on January 16, 2008, one quarter will vest on
January 16, 2009, one quarter will vest on January 16, 2010 and one quarter will
vest on January 16, 2011. On March 5, 2007, Dr. Lim was granted an option under
our 2005 Stock Incentive Plan to acquire 40,000 shares of our common stock, par
value $0.001 per share, at an exercise price of $0.19 per share. The option
shares were fully vested upon grant. The manner in which the company values the
option awards is outlined in Note 1 to the company's consolidated financial
statements under the heading "Stock-Based Compensation" as well as Note 7 under
the heading "Stockholders' Deficit" included in this annual report.
(14) Amount represents (i) $67,185 paid to Dr. Lim in exchange for consulting
services, (ii) $3,016 in 401(k) contributions by the company and (iii) $3,848
paid to Dr. Lim as reimbursement for health insurance premiums.
NARRATIVE DISCLOSURE TO SUMMARY COMPENSATION TABLE AND ADDITIONAL NARRATIVE
DISCLOSURE
Employment and Consulting Agreements
Philip Yee. On March 16, 2006, Philip Yee accepted an offer letter
extended by Electronic Sensor Technology regarding his employment with
Electronic Sensor Technology as Controller, which is attached as Exhibit 10.2 to
our amended current report on Form 8-K/A filed February 14, 2007 and is
incorporated herein by reference. The offer letter set Mr. Yee's salary at
$75,000 per year, to be adjusted to $80,000 per year after completion of a
three-month trial period, and included an agreement by Electronic Sensor
Technology to grant to Mr. Yee an option to purchase 75,000 shares of common
stock, subject to approval by the Board of Directors (an option to purchase
100,000 shares of common stock of the company, was approved by the Board of
Directors and granted to Mr. Yee on January 16, 2007). On October 16, 2006, the
Board of Directors appointed Mr. Yee to become Secretary, Treasurer and Chief
Financial Officer of the company, effective November 1, 2006. In connection with
the appointment of Mr. Yee as Secretary, Treasurer and Chief Financial Officer
of Electronic Sensor Technology, Electronic Sensor Technology and Mr. Yee
entered into an oral agreement to increase Mr. Yee's annual salary to $110,000
through April 1, 2007, at which point Electronic Sensor
23
Technology and Mr. Yee have orally agreed to increase Mr. Yee's annual salary to
$125,000.
Francis Chang. On October 16, 2006, Francis Chang announced his
retirement as Secretary, Treasurer and Vice President of Finance and
Administration to the Board of Directors of the company, effective November 1,
2006. Mr. Chang continues to serve as a director of and consultant to the
company. On November 1, 2006 Mr. Chang and the company entered into a letter
agreement regarding the company's engagement of Mr. Chang as a consultant
through April 30, 2007 for a biweekly retainer fee of $3,000, as more fully
described in Exhibit 10.1 to our amended current report on Form 8-K/A filed
February 14, 2007 and is incorporated herein by reference.
Barry Howe. On March 28, 2007, Barry Howe accepted an offer letter
extended by Electronic Sensor Technology regarding his employment with
Electronic Sensor Technology as Chief Operating Officer, which is attached as
Exhibit 10.1 to our current report on Form 8-K filed April 3, 2007 and is
incorporated herein by reference. The offer letter provides that Mr. Howe will
serve as Chief Operating Officer of Electronic Sensor Technology for a trial
period of three months, at the end of which the Board of Directors will evaluate
Mr. Howe and consider him for the position of Chief Executive Officer. The
letter also contemplates nominating Mr. Howe to serve as a director of the
Electronic Sensor Technology at such time. The offer letter sets Mr. Howe's
salary at $150,000 per year, to be reviewed after the three-month trial period,
and provides for an option to purchase 1 million shares of the company's common
stock to be granted to Mr. Howe at the end of such trial period if Mr. Howe is
appointed Chief Executive Officer at such time, of which 100,000 of the option
shares will be vested on the date of the grant and 900,000 of the option shares
will vest in installments of 25% per year on each anniversary of Mr. Howe's
employment. On July 16, 2007, the Board of Directors appointed Mr. Howe to
become President and Chief Executive Officer of the company. In connection with
his appointment, Mr. Howe's annual salary was increased from $150,000 to
$185,000. In addition, the Board of Directors approved the grant of an option to
acquire 1 million shares of common stock of the company.
Teong C. Lim. On July 16, 2007, Teong C. Lim announced his retirement
as President and Chief Executive Officer to the Board of Directors of the
company, effective as of such date. Dr. Lim continues to serve as a director of
and a consultant to the company. On July 17, 2007, Dr. Lim and the company
entered into a letter agreement regarding the company's engagement of Dr. Lim as
a consultant through January 17, 2008 for a monthly fee of $13,437, as more
fully described in Exhibit 10.1 to our current report on Form 8-K filed July 18,
2007 and is incorporated herein by reference. The consulting agreement with Dr.
Lim was extended on January 17, 2008 on a month-to-month basis at the same
retainer fee.
Severance and Termination Agreements
Edward Staples. On March 8, 2007, Electronic Sensor Technology
accepted the resignation of Edward Staples as Chief Scientific Officer and a
director of the company. In connection and concurrently with such resignation,
the company and Dr. Staples entered into a Severance Agreement, Mutual Release
and Promotion Agreement, which is attached as Exhibit 10.1 to our current report
on Form 8-K filed March 13, 2007 and is incorporated herein by reference. The
Severance Agreement, Mutual Release and Promotion Agreement provides for (i)
payment of nine months' salary to Dr. Staples (totaling $116,324.52) in eighteen
equal biweekly installments, (ii) reimbursement of major medical insurance
premiums paid by Dr. Staples for twelve months, pursuant to the Consolidated
Omnibus Budget Reconciliation Act (COBRA), provided that such amount does not
exceed the insurance coverage presently maintained by Dr. Staples through the
company's group policy and (iii) a mutual release of claims by the company and
Dr. Staples. Dr. Staples also agreed, in the Severance Agreement, Mutual Release
and Promotion Agreement, to spend one hour per month for nine months, promoting
the company and its products in exchange for $100 per hour and reimbursement of
reasonable business costs and expenses incurred in connection with such
promotion.
Retirement Agreements
The company has an agreement with each of Francis Chang, Teong Lim and
Gary Watson, under which, so long as the individual continues to be employed by
the company until retirement age, which is currently 65 years of age, the
company shall provide Medigap insurance, also known as Medicare supplemental
insurance, to the individual after retirement until the individual's death.
24
401(k) Plan
The company sponsors a 401(k) retirement savings plan which covers its
full-time employees who have been employed by the company for at least one (1)
year. Eligible employees may elect to contribute a percentage of their
compensation to the 401(k) plan, subject to the maximum amount established
annually under Section 401(k) of the Internal Revenue Code. In each of 2006 and
2007, the company contributed an amount equal to three percent (3%) of each
employee's respective compensation to the 401(k) plan account of each eligible
employee.
Other than the agreements mentioned herein, we have no employment
agreements with any of our named executive officers, nor do we have any
compensatory plans or arrangements with respect to any named executive officers
that results or will result from the resignation, retirement or any other
termination of such executive officer's employment with Electronic Sensor
Technology or from a change-in-control of Electronic Sensor Technology or a
change in the named executive officer's responsibilities following a
change-in-control wherein the amount involved, including all periodic payments
or installments, exceeds $100,000.
OUTSTANDING EQUITY AWARDS AT FISCAL YEAR-END
The following table outlines all outstanding equity awards held by
named executive officers as of the fiscal year ended December 31, 2007.
OUTSTANDING EQUITY AWARDS AT FISCAL YEAR-END(1)
Option Awards
---------------------------------------------------------------------------------
Equity Incentive
Plan Awards:
Number of Number of Number of
Securities Securities Securities
Underlying Underlying Underlying Option
Unexercised Unexercised Unexercised Exercise Option
Options Options (#) Unearned Price Expiration
Name (#) Exercisable Unexercisable Options (#) ($) Date
-------------- --------------- ------------- ---------------- -------- -----------------
Barry S. Howe 325,000(2) 675,000 675,000 $0.20 July 16, 2017
Gary Watson 175,000(3) - - $1.00 February 1, 2015
25,000(2) 75,000 75,000 $0.24 January 16, 2017
87,500(2) - - $0.19 March 5, 2017
Philip Yee 51,250(2) 48,750 48,750 $0.24 January 16, 2017
Edward Staples 100,000(4) - - $1.00 February 1, 2015
12,500(2) 37,500 37,500 $0.24 January 16, 2017
50,000(2) - - $0.19 March 5, 2017
Teong C. Lim 80,000(5) - - $1.00 February 1, 2015
25,000(2) 75,000 75,000 $0.24 January 16, 2017
25
Option Awards
---------------------------------------------------------------------------------
Equity Incentive
Plan Awards:
Number of Number of Number of
Securities Securities Securities
Underlying Underlying Underlying Option
Unexercised Unexercised Unexercised Exercise Option
Options Options (#) Unearned Price Expiration
Name (#) Exercisable Unexercisable Options (#) ($) Date
-------------- --------------- ------------- ---------------- -------- -----------------
40,000(2) - - $0.19 March 5, 2017
(1) The columns related to stock awards have been omitted because there were no
outstanding unvested stock awards as of the fiscal year ended December 31, 2007.
(2) For the vesting dates of such options, see the footnotes to the Summary
Compensation Table.
(3) Gary Watson was granted options to purchase (i) 50,000 limited partnership
interests of Electronic Sensor Technology, L.P. at $1.00 per limited partnership
interest on March 15, 1999, (ii) 50,000 limited partnership interests of
Electronic Sensor Technology, L.P. at $1.05 per limited partnership interest on
July 1, 2000, (iii) 50,000 limited partnership interests of Electronic Sensor
Technology, L.P. at $1.05 per limited partnership interest on May 15, 2001 and
(iv) 25,000 limited partnership interests of Electronic Sensor Technology, L.P.
at $1.05 per limited partnership interest on September 15, 2002. Such options
were terminated in connection with the merger whereby Electronic Sensor
Technology, L.P. became an indirect subsidiary of Electronic Sensor Technology,
Inc., and were replaced with an option to purchase 175,000 shares of common
stock at $1.00 per share. Such option was accounted for at the time of the
original grants of Electronic Sensor Technology, L.P. options and no dollar
amount was recognized in connection therewith for financial statement reporting
purposes with respect to the 2005 fiscal year.
(4) Edward Staples was granted an option to purchase 100,000 limited
partnership interests of Electronic Sensor Technology, L.P. at $1.00 per limited
partnership interest on December 31, 2003. Such option was terminated in
connection with the merger whereby Electronic Sensor Technology, L.P. became an
indirect subsidiary of Electronic Sensor Technology, Inc., and was replaced with
an option to purchase 100,000 shares of common stock of Electronic Sensor
Technology, Inc. at $1.00 per share. Such option was accounted for at the time
of the original grant of Electronic Sensor Technology, L.P. options and no
dollar amount was recognized in connection therewith for financial statement
reporting purposes with respect to the 2005 fiscal year.
(5) Teong Lim was granted an option to purchase 80,000 limited partnership
interests of Electronic Sensor Technology, L.P. at $1.00 per limited partnership
interest on December 31, 2003. Such option was terminated in connection with the
merger whereby Electronic Sensor Technology, L.P. became an indirect subsidiary
of Electronic Sensor Technology, Inc. and was replaced with an option to
purchase 80,000 shares of common stock of Electronic Sensor Technology, Inc. at
$1.00 per share. Such option was accounted for at the time of the original grant
of Electronic Sensor Technology, L.P. options and no dollar amount was
recognized in connection therewith for financial statement reporting purposes
with respect to the 2005 fiscal year.
DIRECTOR COMPENSATION
The following table sets forth the compensation paid by Electronic
Sensor Technology to all non-employee directors for the fiscal year ended
December 31, 2007.
DIRECTOR COMPENSATION(1)
Fees Earned or All Other
Paid in Cash Option Awards(3) Compensation Total
Name(2) ($) ($) ($)(4) ($)
-------------------------- -------------- ---------------- ------------ ---------
James Frey 38,000(5) 20,000(6) - 58,000
(February 21, 2005-
Present)
James Wilburn 22,500(7) 15,000(8) - 37,500
(September 2005-
26
Fees Earned or All Other
Paid in Cash Option Awards(3) Compensation Total
Name(2) ($) ($) ($)(4) ($)
-------------------------- -------------- ---------------- ------------ ---------
Present)
Francis Chang 6,000(9) 5,000(10) 43,096(11) 54,096
(January 31, 2005-Present)
Lewis E. Larson 8,000(12) 10,000(13) 22,500(14) 40,500
(September 7, 2006-
Present)
Rita Benoy Bushon 5,000(15) - - 5,000
(October 26, 2007-Present)
Michel A. Amsalem - - - -
(September 7, 2006-
December 14, 2007)
Mike Krishnan 5,000(16) 15,000(17) - 20,000
(February 21, 2005-
September 10, 2007)
(1) The columns entitled "Stock Awards," "Non-Equity Incentive Plan
Compensation" and "Nonqualified Deferred Compensation Earnings" have been
omitted from the Director Compensation Table because there has been no
compensation awarded to, earned by, or paid to any of the directors required to
be reported in such columns.
(2) Barry Howe, Teong Lim and Edward Staples are not included in the Director
Compensation Table because any compensation received by Mr. Howe, Dr. Lim and
Dr. Staples as directors of Electronic Sensor Technology for the fiscal year
ended December 31, 2007 is reflected in the Summary Compensation Table above.
(3) The manner in which the company values stock and option awards is outlined
in Note 1 to the company's consolidated financial statements under the heading
"Stock-Based Compensation" as well as Note 7 under the heading "Stockholders'
Deficit" included in this annual report. We did not grant any stock awards to
the directors during our 2006 fiscal year or our 2007 fiscal year.
(4) With the exception of Michel Amsalem, the company reimburses each director
who is not an officer or employee of the company for reasonable out-of-pocket
expenses for attending board meetings. In 2007, with respect to each director,
the aggregate amount of such expenses amounted to less than $10,000.
(5) James Frey received an attendance fee of $2,000 per meeting and an annual
retainer fee of $2,000, which was paid quarterly.
(6) On January 16, 2007, James Frey was granted an option under our 2005 Stock
Incentive Plan to acquire 200,000 shares of our common stock, par value $0.001
per share, at an exercise price of $0.24 per share. The options granted to Mr.
Frey vested as follows: 100,000 of the option shares were fully vested upon
grant of the options, 25,000 vested on February 21, 2007 and 75,000 vested on
January 16, 2008. The manner in which the company values the option awards is
outlined in Note 1 to the company's consolidated financial statements under the
heading "Stock-Based Compensation" as well as Note 7 under the heading
"Stockholders' Deficit" included in this annual report.
(7) In 2007, James Wilburn received an attendance fee of $1,500 per meeting and
a monthly retainer fee of $1,000, which was paid quarterly.
27
(8) On January 16, 2007, James Wilburn was granted an option under our 2005
Stock Incentive Plan to acquire 150,000 shares of our common stock, par value
$0.001 per share, at an exercise price of $0.24 per share. The options granted
to Dr. Wilburn vested as follows: 75,000 of the option shares were fully vested
upon grant of the options, 25,000 vested on September 8, 2007 and 50,000 vested
on January 16, 2008. The manner in which the company values the option awards is
outlined in Note 1 to the company's consolidated financial statements under the
heading "Stock-Based Compensation" as well as Note 7 under the heading
"Stockholders' Deficit" included in this annual report.
(9) In 2007, Francis Chang received an attendance fee of $1,500 per meeting.
(10) On January 16, 2007, Francis Chang was granted an option under our 2005
Stock Incentive Plan to acquire 50,000 shares of our common stock, par value
$0.001 per share, at an exercise price of $0.24 per share. The options granted
to Mr. Chang vested as follows: one half of the option shares were fully vested
upon grant of the options and one half vested on November 1, 2007. On March 5,
2007, Mr. Chang was granted an option under our 2005 Stock Incentive Plan to
acquire 40,000 shares of our common stock, par value $0.001 per share, at an
exercise price of $0.19 per share. The option shares were fully vested upon
grant. The manner in which the company values the option awards is outlined in
Note 1 to the company's consolidated financial statements under the heading
"Stock-Based Compensation" as well as Note 7 under the heading "Stockholders'
Deficit" included in this annual report.
(11) Amount represents (i) $39,000 paid to Francis Chang in exchange for
consulting services and (ii) $4,096 in health insurance premiums paid
by the Company on behalf of Francis Chang.
(12) In 2007, Lewis Larson received an attendance fee of $2,000 per meeting.
(13) On January 16, 2007, Lewis Larson was granted an option under our 2005
Stock Incentive Plan to acquire 100,000 shares of our common stock, par value
$0.001 per share, at an exercise price of $0.24 per share. The options granted
to Mr. Larson vested as follows: one half of the option shares were fully vested
upon grant of the options and one half vested on January 16, 2008. The manner in
which the company values the option awards is outlined in Note 1 to the
company's consolidated financial statements under the heading "Stock-Based
Compensation" as well as Note 7 under the heading "Stockholders' Deficit"
included in this annual report.
(14) Includes $22,500 paid to The Lion Group in exchange for consulting
services. Lewis Larson is the founder and the President of The Lion Group.
(15) In 2007, Rita Benoy Bushon received an attendance fee of $2,000 per
meeting.
(16) In 2007, Mike Krishnan received $5,000 in attendance fees.
(17) On January 16, 2007, Mike Krishnan was granted an option under our 2005
Stock Incentive Plan to acquire 150,000 shares of our common stock, par value
$0.001 per share, at an exercise price of $0.24 per share. The options granted
to Mr. Krishnan vested as follows: 75,000 of the option shares were fully vested
upon grant of the options, 25,000 vested on February 20, 2007 and 50,000 vested
on January 16, 2008. The manner in which the company values the option awards is
outlined in Note 1 to the company's consolidated financial statements under the
heading "Stock-Based Compensation" as well as Note 7 under the heading
"Stockholders' Deficit" included in this annual report.
NARRATIVE TO DIRECTOR COMPENSATION
Agreements with Directors
The company has agreements with each of the directors listed in the
Director Compensation Table, with the exception of Michel Amsalem and Mike
Krishnan, to continue to pay the retainer fees and meeting attendance fees set
forth in such table, as well as to reimburse such directors for reasonable
out-of-pocket expenses for attending board meetings.
28
Item 11. Security Ownership of Certain Beneficial Owners and Management and
Related Stockholder Matters.
The following table sets forth information, as of the date of this
annual report, concerning our issued and outstanding stock beneficially owned
(i) by each director and each named executive officer of Electronic Sensor
Technology, (ii) by all directors and executive officers of Electronic Sensor
Technology as a group and (iii) by each shareholder known by Electronic Sensor
Technology to be the beneficial owner of more than 5% of the outstanding common
stock. The information regarding beneficial owners of 5% or more of our common
stock was gathered by us from the filings made by such owners with the SEC or
from other sources. Shares that may be acquired within 60 days are treated as
outstanding for purposes of determining the amount and percentage beneficially
owned.
Amount and Nature of
Name and Address Beneficial Ownership Percentage
Title of Class of Beneficial Owner(1) (Shares of Stock) of Class(2)
-------------- --------------------------------- -------------------- -----------
Common stock Barry Howe+* 325,000(3) 0.21%
Common stock Philip Yee+ 51,250(4) 0.03%
Common stock Gary Watson+ 287,500(5) 0.18%
Common stock James Frey* 450,000(6) 0.29%
Common stock Teong Lim* 5,312,908(7) 3.40%
Common stock Francis Chang* 4,023,160(8) 2.57%
Common stock Rita Benoy Bushon* 0(9) 0.00%
Common stock James Wilburn* 150,000(10) 0.10%
Common stock Lewis Larson* 100,000(11) 0.06%
Common stock L&G Resources (1994), Inc. (Wholly
owned by Land & General Berhad)++ 9,948,801(12) 6.37%
Common stock Midsummer Investment Ltd.++ 13,708,957(13) 8.58%
Common stock Halfmoon Bay Capital Ltd++ 127,572,016(14) 64.76%
Common stock All directors and named 10,699,818(15) 8.26%
executive officers as a group
* Director
+ Named executive officer
++ 5% or more beneficial owner
29
(1) The address of each director and named executive officer is c/o Electronic
Sensor Technology, Inc., 1077 Business Center Circle, Newbury Park, California
91320. The address of Midsummer Investment Ltd. is 295 Madison Avenue, 38th
Floor, New York, New York 10017. The address of each of L&G Resources (1994),
Inc. and Land & General Berhad is 7 Persiaran Dagang, Bandar Sri Damansara,
Kuala Lumpur, Malaysia 52200. The address of Halfmoon Bay Capital Ltd is
Trident Chambers, P.O. Box 146, Road Town Tortola, British Virgin Islands.
(2) These percentages are calculated based upon the total amount of outstanding
shares of common stock beneficially owned by each person or group, including
shares of common stock that person or group has the right to acquire within 60
days pursuant to options, warrants, conversion privileges or other rights,
divided by 155,853,385, which represents the total number of shares of common
stock issued and outstanding as of the date of this annual report, plus, for
each person or group, any shares of common stock that person or group has the
right to acquire within 60 days pursuant to options, warrants, conversion
privileges or other rights.
(3) Includes 325,000 shares of common stock underlying an option exercisable
within 60 days of the date of this annual report.
(4) Includes 51,250 shares of common stock underlying an option exercisable
within 60 days of the date of this annual report.
(5) Includes 287,500 shares of common stock underlying options exercisable
within 60 days of the date of this annual report.
(6) Includes 450,000 shares of common stock underlying options exercisable
within 60 days of the date of this annual report.
(7) Includes 145,000 shares of common stock underlying options exercisable
within 60 days of the date of this annual report, and 438,796 shares of common
stock underlying warrants exercisable within 60 days of the date of this annual
report and 4,729,112 shares of common stock held by TC Lim, LLC and beneficially
owned by Dr. Lim by virtue of his position as sole member of TC Lim, LLC.
(8) Includes 170,000 shares of common stock underlying options exercisable
within 60 days of the date of this annual report, and 257,247 shares of common
stock underlying warrants exercisable within 60 days of the date of this annual
report and 3,595,913 shares of common stock held by 3 Springs, LLC and
beneficially owned by Mr. Chang by virtue of his position as sole member of 3
Springs, LLC.
(9) Ms. Bushon is the Executive Director of Land & General Berhad and President
of L&G Resources (1994), Inc., a wholly owned subsidiary of Land & General
Berhad. By virtue of her position, Ms. Bushon may be deemed to share dispositive
power over the 9,948,801 shares of common stock beneficially owned by Land &
General Berhad and L&G Resources (1994), Inc. Ms. Bushon is one of six directors
on the Board of Directors of Land & General Berhad and the Board of Directors of
Land & General Berhad makes the ultimate voting and investment decisions with
respect to the 9,948,801 shares of common stock. Ms. Bushon disclaims beneficial
ownership of such shares of common stock.
(10) Includes 150,000 shares of common stock underlying an option exercisable
within 60 days of the date of this annual report.
(11) Includes 100,000 shares of common stock underlying an option exercisable
within 60 days of the date of this annual report.
(12) Includes 9,632,534 shares of common stock and 316,267 shares of common
stock underlying a warrant exercisable within 60 days of the date of this annual
report held by L&G Resources (1994), Inc., a wholly-owned subsidiary of Land &
General Berhad, of which Land & General Berhad is a beneficial owner. Rita Benoy
Bushon is President of L&G Resources (1994), Inc. and Executive Director of Land
& General Berhad. By reason of such relationships, Ms. Bushon may be deemed to
share dispositive power over the shares of common stock beneficially owned by
L&G Resources (1994), Inc. Ms. Bushon expressly disclaims beneficial ownership
as Ms. Bushon is one of six directors on the Board of Directors of Land &
General Berhad and the Board of Directors of Land & General Berhad makes the
ultimate voting and investment decisions with respect to the 9,948,801 shares of
common stock.
30
(13) Includes 3,899,030 shares of common stock underlying a warrant exercisable
within 60 days of the date of this annual report. The exercise of the warrant is
contractually capped such that such exercise shall not cause Midsummer's
beneficial ownership to exceed 4.99%, unless waived by Midsummer, and in no
event to exceed 9.99% (without giving effect to shares of common stock
underlying any unexercised portion of the warrant). Midsummer Capital, LLC, a
New York limited liability company, serves as investment advisor to Midsummer
Investment Ltd., a Bermuda company. By reason of such relationships, Midsummer
Capital may be deemed to share dispositive power over the shares of common stock
beneficially owned by Midsummer Investment. Midsummer Capital disclaims
beneficial ownership of such shares of common stock. Michel A. Amsalem and Scott
D. Kaufman are members of Midsummer Capital. By reason of such relationships,
Mr. Amsalem and Mr. Kaufman may be deemed to share dispositive power over the
shares of common stock stated as beneficially owned by Midsummer Investment. Mr.
Amsalem and Mr. Kaufman disclaim beneficial ownership of such shares of common
stock.
(14) Includes 41,152,263 shares of common stock underlying a debenture
convertible within 60 days of this annual report held by Halfmoon Bay Capital
Ltd and beneficially owned by each of Wan Azmi Wan Hamzah and Nik Anida Bte Nik
Manshor by virtue of their positions as shareholders and directors of Halfmoon
Bay Capital Ltd. Halfmoon Bay Capital Ltd has three shareholders, who are Wan
Azmi Wan Hamzah, Nik Anida Bte Nik Manshor and Wan Afzal Bin Wan Azmi and two
directors, who are Wan Azmi Wan Hamzah and Nik Anida Bte Nik Manshor. Wan Afzal
Bin Wan Azmi may be deemed to share dispositive power over the shares of common
stock beneficially owned by Halfmoon Bay Capital Ltd. Wan Afzal Bin Wan Azmi
expressly disclaims beneficial ownership as Wan Afzal Bin Wan Azmi is not a
director of Halfmoon Bay Capital Ltd and the Board of Directors of Halfmoon Bay
Capital Ltd makes the ultimate voting and investment decisions with respect to
the 127,572,016 shares of common stock.
(15) Includes 1,678,750 shares of common stock underlying options exercisable
within 60 days of the date of this annual report and 696,043 shares of common
stock underlying warrants exercisable within 60 days of the date of this annual
report, as well as 3,595,913 shares of common stock held by 3 Springs, LLC and
4,729,112 shares of common stock held by TC Lim, LLC.
SECURITIES AUTHORIZED FOR ISSUANCE UNDER EQUITY COMPENSATION PLANS
See disclosure under Item 5 of this annual report with respect to
information regarding securities authorized for issuance under equity
compensation plans.
Item 12. Certain Relationships and Related Transactions, and Director
Independence.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Securities Purchase Agreement with Halfmoon Bay Capital Ltd
On March 28, 2008, Electronic Sensor Technology issued $2 million
aggregate principal amount of 9% convertible debentures with a conversion price
of $0.0486 to Halfmoon Bay Capital Ltd and 86,419,753 shares of the company's
common stock in exchange for $5.5 million from Halfmoon Bay, pursuant to a
Securities Purchase Agreement dated March 28, 2008 between the company and
Halfmoon Bay, as more fully described on our current report on Form 8-K filed
on or about the date of this annual report.
Midsummer Investment, Ltd. and Islandia, L.P.
On September 7, 2006, Electronic Sensor Technology entered into a
Forbearance and Amendment Agreement with Midsummer Investment, Ltd. and
Islandia, L.P., which, at such time, each held an 8% convertible debenture and a
warrant, the common stock underlying which represented more than 5% of the
beneficial ownership of our outstanding shares of common stock. The Forbearance
and Amendment Agreement is attached as Exhibit 10.1 to, and is more fully
described in, our current report on Form 8-K filed September 8, 2006, which
description is incorporated herein by reference. On December 27, 2007,
Electronic Sensor Technology entered into a First Amendment Agreement with
Midsummer and Islandia, which is attached as Exhibit 10.1 to, and is more fully
described in, our amended current report on Form 8-K/A filed January 14, 2008,
which description is incorporated herein by reference.
31
On February 26, 2008, the company entered into a Conversion and
Termination Agreement with Midsummer and Islandia, which is attached as Exhibit
10.2 to, and is more fully described in, our current report on Form 8-K filed
February 27, 2008, which description is incorporated herein by reference.
Pursuant to the Conversion and Termination Agreement, on March 31, 2008, the
company paid to Midsummer and Islandia an aggregate amount of $3.5 million of
the $7 million outstanding principal amount of the convertible debentures.
Further, pursuant to the Conversion and Termination Agreement, Midsummer and
Islandia converted the remaining $3.5 million of the principal amount of their
8% convertible debentures, together with interest thereon, at a conversion price
of $0.35 per share of common stock, and the remaining shares of common stock
underlying the warrants held by Midsummer and Islandia were reduced by 50%.
DIRECTOR INDEPENDENCE
Although we are not required to have independent directors on our
Board of Directors because our securities are not listed on a national
securities exchange or an inter-dealer quotation system which has director
independence requirements, three of the seven directors on our Board are
independent using the definition of "independent director" contained in Rule
4200(15) of the NASDAQ Marketplace Rules. Our independent directors are James
Frey, James Wilburn and Lewis Larson. Under Rule 4200(a)(15) of the NASDAQ
Marketplace Rules, an "independent director" is generally defined as a person
other than an executive officer or employee of the company or another individual
having a relationship which, in the opinion of the company's Board of Directors,
would interfere with the exercise of independent judgment in carrying out the
responsibilities of a director.
The members of our audit committee and compensation committee include
James Wilburn, who is also the chairman of both committees, Francis Chang and
Lewis Larson. In addition to being an independent director under Rule
4200(a)(15), the NASDAQ audit committee independence standards (which are also
not applicable to us) contain NASDAQ Marketplace Rule 4350(d), which requires
that audit committee members meet certain additional independence requirements.
James Wilburn is independent under the NASDAQ audit committee independence
standards. Francis Chang, however, is not independent under either
Rule 4200(a)(15) or the audit committee standards. Although Lewis Larson is an
independent director under Rule 4200(a)(15), he is not independent under the
audit committee standards.
Item 13. Exhibits.
See Exhibit Index.
32
Item 14. Principal Accountant Fees and Services.
AUDIT FEES
The aggregate fees billed for the 2006 and 2007 fiscal years for
professional services rendered by our principal accountant, Sherb & Co., LLP,
for the audit of our annual financial statements and review of financial
statements included in our periodic reports on Form 10-QSB and other services
provided in connection with statutory and regulatory filings were $60,000 and
$53,000 respectively.
AUDIT-RELATED FEES
No assurance or related services that are reasonably related to the
performance of the audit or review of our financial statements were rendered by
our principal accountants during the 2006 or 2007 fiscal year.
TAX FEES
The aggregate fees to be billed for professional services rendered by
our current principal accountant, Sherb & Co., LLP, for tax compliance and tax
advice were $7,500 for each of the 2006 and 2007 fiscal years.
ALL OTHER FEES
No other products or services were provided by our principal
accountants during the 2006 or 2007 fiscal year, other than the services
outlined in the foregoing sections.
AUDIT COMMITTEE
Our audit committee has not to date adopted any pre-approval policies
or procedures.
33
Exhibit Index
Exhibit
Number Description
------- ----------------------------------------------------------------------
3.1 Articles of Incorporation of Electronic Sensor Technology, as amended
(incorporated by reference from Exhibit 3.1 of the registration
statement on Form SB-2 filed on January 6, 2006).
4.1 Description of our common stock in Article Fourth of the Amendment to
Electronic Sensor Technology's Articles of Incorporation dated January
25, 2005 (incorporated by reference from Exhibit 3.1 of the
registration statement on Form SB-2 filed on January 6, 2006).
4.2 Description of rights of shareholders of Electronic Sensor Technology
in Article I and Article IX of Electronic Sensor Technology's Amended
and Restated Bylaws (incorporated by reference from Exhibit 3.1 of the
quarterly report on Form 10-QSB filed on August 16, 2006).
10.1 Electronic Sensor Technology, Inc. 2005 Stock Incentive Plan
(incorporated by reference from Exhibit 10.1 of the annual report on
Form 10-KSB filed on April 15, 2005).
10.2 Form of Stock Option Agreement (incorporated by reference from Exhibit
10.2 of the annual report on Form 10-KSB filed on April 15, 2005).
10.3 Letter agreement dated as of October 3, 2005, between Electronic
Sensor Technology, Inc. and James Frey (incorporated by reference from
Exhibit 10.1 of the current report on Form 8-K filed on October 7,
2005).
10.4 Letter agreement dated as of February 21, 2005, between Electronic
Sensor Technology, Inc. and James Frey (incorporated by reference from
Exhibit 10.2 of the current report on Form 8-K filed on October 7,
2005).
10.5 Addendum dated as of April 1, 2005 to the letter agreement dated
February 21, 2005, between Electronic Sensor Technology, Inc. and
James Frey (incorporated by reference from Exhibit 10.3 of the current
report on Form 8-K filed on October 7, 2005).
10.6 International Distributorship Agreement dated August 2005, between
Electronic Sensor Technology, Inc. and Beijing R&D Technology Co.,
Ltd. (incorporated by reference from Exhibit 10.12 of the amended
registration statement on Form SB-2/A filed on February 15, 2006).
10.7 International Distributorship Agreement dated October 21, 2005,
between Electronic Sensor Technology, Inc. and TechMondial, Ltd.
(incorporated by reference from Exhibit 10.13 of the amended
registration statement on Form SB-2/A filed on February 15, 2006).
10.8 Form of Securities Purchase Agreement dated as of December 7, 2005,
among Electronic Sensor Technology, Inc., Midsummer Investment, Ltd.
and Islandia, L.P. (incorporated by reference from Exhibit 10.1 of the
current report on Form 8-K filed on December 8, 2005).
10.9 Form of Registration Rights Agreement dated as of December 7, 2005,
among Electronic Sensor Technology, Inc., Midsummer Investment, Ltd.
and Islandia, L.P. (incorporated by reference from Exhibit 10.2 of the
current report on Form 8-K filed on December 8, 2005).
10.10 Forbearance and Amendment Agreement dated as of September 7, 2006,
among Electronic Sensor Technology, Inc., Midsummer Investment, Ltd.
and Islandia L.P. (incorporated by reference from Exhibit 10.1 of the
current report on Form 8-K filed on September 8, 2006).
34
Exhibit
Number Description
------- ----------------------------------------------------------------------
10.11 Letter Agreement dated November 1, 2006 between Electronic Sensor
Technology, Inc. and Francis Chang (incorporated by reference from
Exhibit 10.1 of the amended current report on Form 8-K/A filed on
February 14, 2007).
10.12 Offer letter dated March 15, 2006 between Electronic Sensor
Technology, Inc. and Philip Yee (incorporated by reference from
Exhibit 10.2 of the amended current report on Form 8-K/A filed on
February 14, 2007).
10.13 Severance Agreement, Mutual Release and Promotion Agreement effective
as of March 8, 2007 between Electronic Sensor Technology, Inc. and
Edward Staples (incorporated by reference from Exhibit 10.1 of the
current report on Form 8-K filed on March 13, 2007).
10.14 Offer letter dated March 28, 2007 between Electronic Sensor
Technology, Inc. and Barry S. Howe (incorporated by reference from
Exhibit 10.1 of the current report on Form 8-K filed on April 3,
2007).
10.15 Offer letter dated July 17, 2007 between Electronic Sensor Technology,
Inc. and Teong C. Lim (incorporated by referenced from Exhibit 10.1 of
the current report on Form 8-K filed on July 18, 2007).
10.16 First Amendment Agreement dated as of December 27, 2007, among
Electronic Sensor Technology, Inc., Midsummer Investment, Ltd. and
Islandia L.P. (incorporated by reference from Exhibit 10.1 of the
amended current report on Form 8-K/A filed on January 14, 2008).
10.17 Conversation and Termination Agreement dated as of February 26, 2008,
among Electronic Sensor Technology, Inc., Midsummer Investment, Ltd.
and Islandia L.P. (incorporated by referenced from Exhibit 10.2 of the
current report on Form 8-K filed on February 28, 2008).
10.18 Securities Purchase Agreement dated as of March 28, 2008, between
Electronic Sensor Technology, Inc. and Halfmoon Bay Capital Ltd
(incorporated by referenced from Exhibit 10.1 of the current report
on Form 8-K filed on April 3, 2008).
14.1 Code of Ethics (incorporated by reference from Exhibit 14 of the
annual report on Form 10-KSB for the fiscal year ended December 31,
2004 filed on April 15, 2005).
21.1 Subsidiaries of Electronic Sensor Technology (incorporated by
reference from Exhibit 21.1 of the registration statement on Form SB-2
filed on January 6, 2006).
24.1 Power of Attorney.
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.
35
SIGNATURES
In accordance with Section 13 or 15(d) 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.
Date: April 8, 2008 By:/s/ Barry S. Howe
-------------------------------
Barry S. Howe
President and Chief Executive
Officer (Principal Executive
Officer)
In accordance with the Exchange Act, this report has been signed below
by the following persons on behalf of the registrant and in the capacities and
on the dates indicated.
Date: April 8, 2008 By:/s/ Barry S. Howe
-------------------------------
Barry S. Howe
President and Chief Executive
Officer (Principal Executive
Officer)
Date: April 8, 2008 By:/s/ Philip Yee
-------------------------------
Philip Yee
Secretary, Treasurer and Chief
Financial Officer
(Principal Financial Officer
and Principal Accounting
Officer)
Date: April 8, 2008 By: *
-------------------------------
James H. Frey, Chairman
Date: April 8, 2008 By: *
-------------------------------
Francis H. Chang, Director
Date: April 8, 2008 By: *
-------------------------------
Teong C. Lim, Director
Date: April 8, 2008 By: *
-------------------------------
Barry S. Howe, Director
Date: April 8, 2008 By: *
-------------------------------
James Wilburn, Director
Date: April 8, 2008 By: *
-------------------------------
Rita Benoy Bushon, Director
Date: April 8, 2008 By: *
-------------------------------
Lewis Larson, Director
*By:/s/ Philip Yee
----------------
Philip Yee
Attorney-in-Fact