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ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.(Edgar Glimpses Via Acquire Media NewsEdge) This Quarterly Report on Form 10-Q, including this Management's Discussion and Analysis of Financial Condition and Results of Operations contains "forward-looking" statements within the meaning of the Private Securities Litigation Reform Act of 1995, which provides a "safe harbor" for statements about future events, products and future financial performance that are based on the beliefs of, estimates made by and information currently available to our management. Except for the historical information contained herein, the outcome of the events described in these forward-looking statements is subject to risks and uncertainties. See "Risk Factors" for a discussion of these risks and uncertainties. The following discussion should be read in conjunction with and is qualified in its entirety by reference to our consolidated financial statements included elsewhere in this report. Actual results and the outcome or timing of certain events may differ significantly from those stated or implied by these forward-looking statements due to the factors listed under "Risk Factors," and from time to time in our other filings with the Securities and Exchange Commission, or SEC. For this purpose, using the terms "believe," "expect," "expectation," "anticipate," "can," "should," "would," "could," "estimate," "appear," "based on," "may," "intended," "potential," "indicate," "are emerging" and "possible" or similar statements are forward-looking statements that involve risks and uncertainties that could cause our actual results and the outcome and timing of certain events to differ materially from those stated or implied by these forward-looking statements. By making forward-looking statements, we have not assumed any obligation to, and you should not expect us to, update or revise those statements because of new information, future events or otherwise. As used herein, "we," "us," "our," or the "Company" means VirnetX Holding Corporation, together with its consolidated subsidiaries where applicable. Company Overview We are developing and commercializing software and technology solutions for securing real-time communications over the Internet. Our patented GABRIEL Connection Technology™ combines industry standard encryption protocols with our patented techniques for automated domain name system, or DNS, lookup mechanisms, enabling users to create a secure communication link using secure domain names over wired or wireless (4G/LTE) networks. We also intend to establish the exclusive secure domain name registry in the United States and other key markets around the world. Our software and technology solutions provide the security platform required by next-generation Internet-based applications such as instant messaging, or IM, voice over Internet protocol, or VoIP, mobile services, streaming video, file transfer and remote desktop. Our technology generates secure connections on a "zero-click" or "single-click" basis, significantly simplifying the deployment of secure real-time communication solutions by eliminating the need for end users to enter any encryption information. Our portfolio of intellectual property is the foundation of our business model. We currently have twelve patents in the United States and eight international patents, as well as several pending U.S. and foreign patent applications. Our patent portfolio is primarily focused on securing real-time communications over the Internet, as well as related services such as the establishment and maintenance of a secure domain name registry. Our patented methods also have additional applications in operating systems and network security. On December 2, 2009, we declared to the 3GPP (3rd Generation Partnership Project) that our U.S. and international patents are or may be essential to Long Term Evolution (LTE) and 4G wireless specifications. We believe that we will hold the majority of 4G essential patents related to Series 33 specifications that define security standards for LTE/4G and are prepared to license the use of our patents for incorporation into 4G related products such as chips, servers, smartphones, tablets, netbooks, laptop computers, etc. Our employees include the core development team behind our patent portfolio, technology and software. This team has worked together for over ten years and is the same team that invented and developed this technology while working at Science Application International Corporation, or SAIC. SAIC is a FORTUNE 500® scientific, engineering and technology applications company that uses its deep domain knowledge to solve problems of vital importance to the nation and the world, in national security, energy and the environment, critical infrastructure and health. We acquired this patent portfolio in 2006, and it now serves as the foundation of our licensing business and planned service offerings. We expect to continue to derive the majority of our revenue from license fees and royalties associated with these patents. We also intend to continue our research and development efforts to further strengthen and expand our patent portfolio, and over time, we plan to leverage this portfolio to develop a product suite that can be sold to original equipment manufacturers, or OEMs, enterprise customers and developers. 11 -------------------------------------------------------------------------------- Table of Contents Microsoft Corporation is our first licensee and has been granted a worldwide, irrevocable, nonexclusive, non-sublicenseable fully paid up license of our patents for Microsoft products. The license will not impact our plans to operate a Secure Domain Name Service. We also intend to license our patents and our GABRIEL Connection Technology™ to manufacturers of chips, servers, smart phones, tablets, e-Readers, laptops, net books and other devices, within the IP-telephony, mobility, fixed-mobile convergence and unified communications markets including 4G/LTE. The leaders in these markets include Alcatel-Lucent, Apple Inc., Avaya Inc., Cisco Systems, Inc., Juniper Networks, Inc., LM Ericsson Telephone Company, Motorola, Inc., NEC Corporation, Nokia Corporation, Nortel Networks Corporation, Samsung Electronics Co. Ltd. and Sony Ericsson Mobile Communications AB, among others. The beta testing of our GABRIEL Connection Technology™ has been progressing well and has now become part of our Secure Domain Name Initiative (SDNI) that was announced on April 13, 2010. We have been in active discussions with leading 4G/LTE companies (domain infrastructure providers, chipset manufacturers, service providers, and others) to participate in a design pilot for delivering to end-users and consumers of the Internet and mobile devices the needed and necessary security requirements for the next generation 4G/LTE wireless networks. The pilot will implement our patented Secure Domain Name and our GABRIEL Connection Technology™. We also intend to license our patent portfolio, technology and software, including our secure domain name registry service, to domain infrastructure providers, communication service providers as well as to system integrators. We believe that the market opportunity for our software and technology solutions is large and expanding as secure domain names are now an integral part of securing the next generation 4G/LTE wireless networks. All 4G mobile devices will require their own individual and unique secure domain name and become part of a secure domain name registry. As part of our licensing strategy, ipCapital Group, a leading advisor on licensing technology and intellectual property, continues to assist us in building relationships with several major potential licensees. Since its founding in 1998, ipCapital Group has supported the licensing efforts of clients across a variety of technologies and markets, resulting in transactions representing several hundred million dollars of value. We intend to continue using an outsourced and leveraged model to maintain efficiency and manage costs as we grow our licensing business by offering incentives to early licensing targets or asserting our rights for use of our patents. We also intend to expand our design pilot in participation with leading 4G/LTE companies (domain infrastructure providers, chipset manufacturers, service providers, and others) and build our secure domain name registry. Recent Developments in the Three Months Ended June 30, 2010 On April 27, 2010, we entered into an engagement letter with McKool Smith, a professional corporation, confirming McKool as our lead counsel in our lawsuit filed in March 2010 against Microsoft, as the March 2010 Litigation. In the event of a judgment or settlement of the March 2010 Litigation, we agreed to pay McKool a portion of the total proceeds of the March 2010 Litigation, and a portion of any judgment or settlement paid in our litigation against Microsoft filed in February 2007, as the February 2007 Litigation. Under the April 2010 engagement letter, McKool agreed to represent us at McKool's standard hourly rates subject to a cap of $7.5 million, plus a contingency fee. As a result of the March 2010 Litigation and February 2007 Litigation being settled together in connection with the Settlement and License Agreement with Microsoft, as further described below, the contingency fee payable to McKool was 10% of the settlement proceeds, plus expenses. On May 14, 2010, we entered into a Settlement and License Agreement with Microsoft to settle all claims asserted by us against Microsoft in the Microsoft litigation, or the Microsoft Settlement. Pursuant to the Microsoft Settlement, Microsoft agreed to make a one-time cash payment of $200,000,000 to us in exchange for dismissing both lawsuits and a worldwide, irrevocable, nonexclusive, non-sub licensable fully paid up license under our patents. The foregoing description of the Microsoft Settlement does not purport to be complete and is qualified in its entirety by reference to the complete terms of the Settlement and License Agreement, by and between VirnetX, Inc. and the Microsoft Corporation, dated as of May 14, 2010, a copy of which is attached to this Quarterly Report on Form 10-Q for the quarter ended June 30, 2010 as Exhibit 10.1. We have submitted a request for confidential treatment for certain portions of the Microsoft Settlement Agreement. Those portions have been redacted and have been provided separately to the U.S. Securities and Exchange Commission. 12 -------------------------------------------------------------------------------- Table of Contents In connection with the Microsoft Settlement, on May 25, 2010 and June 1, 2010, the District Court entered two Orders of Dismissal whereby all claims asserted by us against Microsoft with respect to the Microsoft litigation were dismissed with prejudice. In addition, on May 18, 2010, Microsoft filed Notices of Non-Participation with the United States Patent and Trademark Office, or USPTO, whereby Microsoft stated that it will not participate further in the Inter Partes Reexamination of certain of our patents. On June 16, 2010, the USPTO confirmed all our claims in our U.S. Patent No. 6,502,135 and U.S. Patent No. 7,188,180 as patentable and valid and stated that it has closed all Reexamination proceedings for these patents. Subsequent Events In June the Board of Directors declared a special cash dividend of $.50 per share to our shareholders of record on July 1, 2010. In connection with the cash dividend, the Board of Directors also approved a cash distribution to holders of stock options under our 2007 Stock Plan. In connection with the July 15, 2010 payments, we paid out approximately $26,157,000 to our stockholders and holders of our stock options. On July 30, 2010, warrants issued in our January 2009 public offering representing 3,705,000 shares of our common stock expired. All warrants issued to public investors in connection with the January 2009 offering have expired and are no longer outstanding. Critical Accounting Policies There were no material changes in the application of the Company's critical accounting policies since the end of the most recent fiscal year. For further information, see the "Critical Accounting Policies" section of Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations," in our Annual Report on Form 10-K for the year ended December 31, 2009, filed with the SEC on March 31, 2010. Recent Accounting Pronouncements In January 2010, the Financial Accounting Standards Board required new disclosures about fair value of financial instruments for interim and annual reporting periods. These new disclosures are effective for interim and annual reporting periods beginning after December 15, 2009, except for disclosures about purchase, sales, issuances and settlements of so-called Level 3 financial instruments, which are effective for interim and annual reporting periods in fiscal years beginning after December 15, 2010. Adoption is not expected to have a material effect on the Company's consolidated financial statements. For further information, see the "Recent Accounting Pronouncements" section of Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations," in our Annual Report on Form 10-K for the year ended December 31, 2009, filed with the SEC on March 31, 2010. 13 -------------------------------------------------------------------------------- Table of Contents Results of Operations Three and Six Months Ended June 30, 2010 Compared with Three and Six Months Ended June 30, 2009 Revenue - Royalties Revenue generated increased to $200,023,392 for the three months ended June 30, 2010, from $7,207 for the three months ended June 30, 2009, and to $200,044,161 for the six months ended June 30, 2010, from $10,361 for the six months ended June 30, 2009. Our revenue in 2009 was solely limited to the royalties earned under our single license agreement through our Japanese subsidiary. We expect the revenue from this license to decrease substantially in the future. We do not intend to seek additional licenses or other revenue through our Japanese subsidiary. Our revenue in 2010 was largely attributable to the revenue generated from the Settlement and License Agreement entered into with Microsoft Corporation on May 14, 2010. See Part II, Item 1 "Legal Proceedings" for additional information regarding the Microsoft Settlement. Royalty Expense Under our agreements with SAIC, we were obligated to pay SAIC 35% of the proceeds from the settlement of litigation with Microsoft after reduction for costs, including legal fees and expenses, incurred by us and SAIC in connection with the Microsoft litigation. In June we paid SAIC $59,239,274 in connection with our obligations under the SAIC agreements. We remain obligated to make future payments to SAIC equal to a portion of certain revenues we may generate in the future, as described in our Report on Form 10-K dated December 31, 2009. Research and Development Expenses Research and development costs include expenses paid to outside development consultants and compensation related expenses for our engineering staff. Research and development costs are expensed as incurred. Our research and development expenses increased by $1,007,130 to $1,227,688 for the three months ended June 30, 2010, from $220,558 for the three months ended June 30, 2009, and to $1,749,923 for the six months ended June 30, 2010, from $442,257 for the six months ended June 30, 2009. This increase is primarily due to increased engineering activities for product development, salary increase and bonuses paid in March 2010 as well as compensation paid to options holders as of June 15, 2010. Selling, General and Administrative Expenses Selling, general and administrative expenses include management and administrative personnel, as well as outside legal, accounting, and consulting services. Our selling, general and administrative expenses increased by $20,740,062 to $24,455,057 for the three months ended June 30, 2010 from $3,714,995 for the three month period ended June 30, 2009, and to $28,410,942 for the six months ended June 30, 2010, from $6,901,684 for the six months ended June 30, 2009. The increase was primarily due to increased legal fees and expenses associated with our Microsoft litigation and the settlement license agreement. Within selling, general and administrative expenses, legal fees increased by $19,183,919 to $21,548,727 for the three months ended June 30, 2010 from $2,364,808 for the three months ended June 30, 2009, and to $23,665,206 for the six months ended June 30, 2010, from $4,221,197 for the six months ended June 30, 2009. The increase in fees incurred was due primarily to fees and expenses associated with our Microsoft litigation and the settlement license agreement. 14 -------------------------------------------------------------------------------- Table of Contents Liquidity and Capital Resources As of June 30, 2010, our cash, cash equivalents and short-term investments totaled $127,179,912. In the quarter ended June 30, 2010, we received $200,000,000 in cash from Microsoft Corporation in connection with our May 2010 settlement. We have paid $59,239,274 to SAIC, and $20,000,000 to McKool Smith. In July 2010, we paid a special dividend to our common shareholders aggregating $23,598,589. We expect to pay taxes on our taxable income for 2010 and have estimated and accrued a $34,000,000 tax provision. As such, the proceeds of the Microsoft settlement expected to be retained by us are approximately $63,000,000. Before entering into the Microsoft Settlement, we allocated a large part of our cash and cash equivalents to the fees and expenses associated with the Microsoft litigation. We expect to use the net proceeds expected to be retained by us from the Microsoft settlement to be sufficient to fund our operations and provide working capital for general corporate purposes for at least the next 12 months. We expect to derive the majority of our future revenue from license fees and royalties associated with our patent portfolio, technology and software. Off-Balance Sheet Arrangements None. |