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ISC8 INC. /DE - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) In this report, the terms "ISC8 Inc.," "ISC8," "Irvine Sensors," "Irvine Sensors Corporation," "Company," "we," "us" and "our" refer to ISC8 Inc. ("ISC8") and its subsidiaries. Introduction The following information should be read in conjunction with our unaudited condensed consolidated financial statements and notes thereto in Part I, Item 1 of this Quarterly Report on Form 10-Q ("Quarterly Report"), and with Management's Discussion and Analysis of Financial Condition and Results of Operations contained in our Annual Report on Form 10-K for the year ended September 30, 2012. Overview We are engaged in the design, development, manufacture and sale of a family of security products, consisting of cyber security solutions for government and commercial applications, secure memory products, some of which utilize technologies that we have pioneered for 3-D stacking of semiconductors, Systems in a Package (or SIP), and anti-tamper systems. In our government systems portfolio, we utilize technologies such as high-speed processor assemblies and miniaturized vision systems and sensors. In addition, we offer custom stacked solutions for other customer specific systems in package applications. We also perform customer-funded contract research and development related to these products, mostly for U.S. government customers or other prime contractors. We generally use contract manufacturers to produce our products or their subassemblies. Our current operations are located in California, Texas, and Italy with other employees and consultants in various other locations globally. Our operation in Italy was acquired in connection with our acquisition of certain software assets of Bivio in October 2012, described below. As of December 30, 2012, we had approximately $31.4 million of debt, exclusive of debt discounts, and approximately $3.6 million of accounts payable and accrued expenses. Acquisition of Bivio Software On October 12, 2012, pursuant to the terms of the Foreclosure Sale Agreement between the Company and GF Acquisition Co. 2012, LLC ("GFAC") dated October 4, 2012 (the "Foreclosure Sale Agreement"), the Company acquired substantially all of the assets of the NetFalcon and Network Content Control System Business (the "Bivio Software") of Bivio Networks, Inc. and certain of its subsidiaries (collectively, "Bivio"), an international provider of cyber security solutions and products. The purchase price of those assets (the "Acquisition") was $600,000 payable in cash to GFAC, and the issuance to GFAC of a warrant to purchase capital stock of the Company. In addition, the Company assumed certain liabilities, including accounts payable, contractual obligations, reclamation obligations and other liabilities related to Bivio Software. -16--------------------------------------------------------------------------------- Table of Contents Critical Accounting Estimates Our consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America ("GAAP"). As such, management is required to make judgments, estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. The significant accounting policies that are most critical to aid in fully understanding and evaluating reported financial results are the same as those disclosed in our Form 10-K for the fiscal year ended September 30, 2012 filed with the SEC on December 28, 2012. Results of Continuing Operations The following discussions relate to the Company's results of continuing operations after reclassifying the operations of our Thermal Imaging Business as a discontinued operation due to its sale on January 31, 2012. Total Revenues. Our total revenues are generally derived from sales of specialized chips, modules, stacked chip products and amounts realized or realizable from funded research and development contracts, largely from U.S. government agencies and other government contractors. Our total revenues decreased in the 13-week period ended December 30, 2012 as compared to the 13-week period ended January 1, 2012 and changed in composition as shown in the following table and discussed more fully below. 13-Week Comparisons Total Revenues 13 weeks ended January 1, 2012 $ 1,297,000 Dollar decrease in current comparable 13 weeks (422,000 ) 13 weeks ended December 30, 2012 $ 875,000 Percentage decrease in current 13 weeks (33%) The decrease in our total revenues in the 13-week period ended December 30, 2012 as compared to the 13-week period ended January 1, 2012 was primarily the result of a $676,000 decrease in funded research and development revenue. This decrease in total revenues was partially offset by a $254,000 increase in product sales related to our 3-D stacking business as well as our cyber business. We believe the decrease in revenues derived from funded research and development contracts in the 13-week period ended December 30, 2012 as compared to the 13-week period ended January 1, 2012 was substantially related to our current inability to obtain contracts under the Small Business Innovation Research ("SBIR") program. Our inability to receive grants under the SBA could materially adversely affect our business, results of operations and financial condition. We are unable to ascertain what future effects the U.S. defense budget timing may have on our total revenues for the balance of the fiscal year ended September 30, 2013 ("Fiscal 2013") and beyond. We are promoting sales of our other recently introduced products, which if achieved we believe could still become a material contributor to our total revenues in the final reporting period of Fiscal 2013. However we are not certain that such outcome will materialize during Fiscal 2013 or at all. -17--------------------------------------------------------------------------------- Table of Contents Cost of Revenues. Cost of revenues includes wages and related benefits of our personnel, as well as subcontractor, independent consultant and vendor expenses directly incurred in the manufacture of products sold or in the performance of funded research and development contracts, plus related overhead expenses and, in the case of funded research and development contracts, such other indirect expenses as are permitted to be charged pursuant to the relevant contracts. The comparison of cost of revenues for the 13-week period ended December 30, 2012 and January 1, 2012 is shown in the following table and discussed more fully below: Percentage of 13-Week Comparisons Cost of Revenues Total Revenues 13 weeks ended January 1, 2012 $ 961,000 74 % Dollar decrease in current comparable 13 weeks (332,000) 13 weeks ended December 30, 2012 $ 629,000 72 % Percentage decrease in current 13 weeks (35%) The decrease in absolute dollar cost of revenues in the 13-week period ending December 30, 2012 compared to the 13-week period ended January 1, 2012 is largely the result of comparatively low contract material costs and other direct costs relative to funded research and development revenue. Additionally, we experienced an increase in product sales, which have lower costs of revenue as compared to our funded research and development revenue. General and Administrative Expense. General and administrative expense largely consists of wages and related benefits for our executive, financial, administrative and marketing staff, as well as professional fees, primarily legal and accounting fees and costs, plus various fixed costs such as rent, utilities and telephone. The comparison of general and administrative expense for the 13-week period ended December 30, 2012 and January 1, 2012 is shown in the following table and discussed more fully below: General and Administrative Percentage of 13-Week Comparisons Expense Total Revenue 13 weeks ended January 1, 2012 $ 2,551,000 197 % Dollar increase in current comparable 13 weeks 376,000 13 weeks ended December 30, 2012 $ 2,927,000 335 % Percentage increase in current 13 weeks 15% The increase in absolute dollars of general and administrative expense in the 13-week period ended December 30, 2012 as compared to the 13-week period ended January 1, 2012 consisted of a combination of increased stock-based compensation expense, marketing and legal fees, severance expenses, as well as facilities expense related to cyber development in Texas. This was partially offset by a decrease in travel, bid and proposal fees, professional fees, and stockholder-related expenses. Research and Development Expense. Research and development expense primarily consists of wages and related benefits for our research and development staff, independent contractor consulting fees and subcontractor and vendor expenses directly incurred in support of internally funded research and development projects, plus associated overhead expenses. Research and development expense for the 13-week period ended December 30, 2012 as compared to the 13-week period ended January 1, 2012 is shown in the following table and discussed more fully below: -18--------------------------------------------------------------------------------- Table of Contents Research and Development Percentage of 13-Week Comparisons Expense Total Revenue 13 weeks ended January 1, 2012 $ 1,831,000 141 % Dollar increase in current comparable 13 weeks 613,000 13 weeks ended December 30, 2012 $ 2,444,000 279 % Percentage increase in current 13 weeks 33 % The changes in research and development expense in the 13-week period ended December 30, 2012 as compared to the 13-week period ended January 1, 2012, are largely related to the development expenses of our Texas-based cyber security office, which we opened and commenced staffing in April 2011. Many of those expenses relate to hiring of highly-skilled development and support staff, software licensing expenses, consulting fees and various operating leases of facilities and equipment to support product development. We also signed a joint development agreement with Cavium, Inc. to provide design and engineering services. We expect to continue to allocate significant resources to the development of our cyber security products in future periods, which may result in further increases in research and development expense as compared to prior fiscal periods. However, no assurances can be given that we will capitalize on our research and development initiatives. Interest Expense. Our interest expense for the 13-week period ended December 30, 2012, compared to the 13-week period ended January 1, 2012, increased as shown in the following table and discussed more fully below: 13-Week Comparisons Interest Expense 13 weeks ended January 1, 2012 $ 1,669,000 Dollar increase in current comparable 13 weeks 318,000 13 weeks ended December 30, 2012 $ 1,987,000 Percentage increase in current 13 weeks 19 % The increase in interest expense in the 13 weeks ended December 30, 2012 as compared to January 1, 2012 was attributable primarily to interest and amortization of debt discounts and financing related costs as a result of our capital structure and continued fund raising efforts. Change in Fair Value of Derivative Liability. We recorded a substantial decrease in the change in fair value of derivative liability for the 13 week period ended December 30, 2012, as compared to the 13-week period ended January 1, 2012. This is shown in the following table and discussed more fully below: Change in Fair Value of 13-Week Comparisons Derivative Liability 13 weeks ended January 1, 2012 $ (2,310,000 ) Dollar decrease in current comparable 13 weeks (7,257,000) 13 weeks ended December 30, 2012 $ 4,947,000 Percentage decrease in current 13 weeks (314 %) The Company revalued its derivatives as of December 30, 2012 and recorded a decrease in their fair value of approximately $4.9 million for the 13-week period, mainly as a result of quarterly valuations based on a decrease of our stock price from last quarter. Given the price volatility of our common stock, we anticipate that there could be additional substantial change in fair value of derivative liability expense that we will be required to record in future reporting periods, unless and until the Subordinated Notes are converted into, and/or the warrants are exercised for the purchase of common stock pursuant to their respective terms. Although no assurances can be given, in the event of such conversion or exercise, the derivative liability associated with these instruments would be eliminated. -19--------------------------------------------------------------------------------- Table of Contents Net Loss from Continuing Operations. Our net loss from continuing operations decreased in the 13-week period ended December 30, 2012, compared to the 13-week period ended January 1, 2012, as shown in the following table and discussed more fully below: Net Loss from Continuing 13-Week Comparisons Operations 13 weeks ended January 1, 2012 $ (8,027,000) Dollar decrease in current comparable 13 weeks (5,863,000) 13 weeks ended December 30, 2012 $ (2,164,000) Percentage decrease for current 13 weeks (73% ) The decrease in net loss from continuing operations in the 13-week period ended December 30, 2012 compared to the 13-week period ended January 1, 2012 was largely due to a change in fair value of derivative instruments, a non cash item, discussed above which mainly related to lower stock prices during the current period, offset in part by an increase total cost and expenses and interest expenses in the comparable periods. Liquidity and Capital Resources Our liquidity in terms of both cash and cash equivalents decreased in the first 13 weeks of Fiscal 2012, largely as a result of losses generated from continuing operations, partially offset by an increase in product sales. As a result, we continued to have a working capital deficit for the current period as shown in the following table and discussed more fully below: Cash and Working Capital Cash Equivalents (Deficit) September 30, 2012 $ 1,738,000 $ (10,091,000 ) Dollar decrease as of December 30, 2012 (1,311,000) (5,906,000) December 30, 2012 $ 427,000 $ (15,997,000 ) Percentage decrease as of December 30, 2012 (75% ) (59%) The $1.3 million use of cash during the 13-week period ended December 30, 2012 is a result of the following components: cash used in operating activities of $4.9 million, cash used in investing activities of $0.6 million, and cash provided by financing activities of $4.2 million. Cash used in operating activities was a result of the $2.2 million net loss from continuing operations and $4.9 million change in fair value of derivative liability, partially offset by $1.7 million in non-cash interest expense, and other less significant factors related to various timing and cash deployment effects. Cash used in investing activities was a result of $0.6 million related to acquisition related costs, and property and equipment expenditures. Cash provided by financing activities was a result of $4.2 million in proceeds from the issuance of the 2012 Notes. The proceeds from financing were the primary source of improvement in our working capital for the current period. As of December 30, 2012 we have used a significant portion of the cash obtained from both from the Thermal Imaging Sale, the Revolving Credit Facility and 2012 Notes to fund our operations, and have been unable to maintain positive cash flow during the 13-week period due to insufficient revenues. To continue to fund anticipated operating expenses and satisfy indebtedness, we will have to seek additional financing, and no assurances can be given that such financing would be available on a timely basis, on terms that are acceptable, or at all. Failure to do so and meet the repayment or other obligations of our existing debt could result in default and acceleration of debt maturity, which could materially adversely affect our business, and financial condition, and threaten our viability as a going concern. -20--------------------------------------------------------------------------------- Table of Contents At December 30, 2012, our funded backlog was approximately $1.3 million. Although no assurances can be given, we anticipate that a substantial portion of our funded backlog at December 30, 2012 will result in revenue recognized in the next twelve months. In addition, our government research and development contracts and product purchase orders typically include unfunded backlog, which is funded when the previously funded amounts have been expended or product delivery schedules are released. As of December 30, 2012, our total backlog, including unfunded portions, was approximately $1.4 million. Contracts with government agencies may be suspended or terminated by the government at any time, subject to certain conditions. Similar termination provisions are typically included in agreements with prime contractors. While we have only experienced a small number of contract terminations, none of which were recent, we cannot assure you that we will not experience suspensions or terminations in the future. Any such termination, if material, could cause a disruption of our revenue stream, materially adversely affect our liquidity and results of operations and result in employee layoffs. Off-Balance Sheet Arrangements Our conventional operating leases are either immaterial to our financial statements or do not contain the types of guarantees, retained interests or contingent obligations that would require their disclosures as an "off-balance sheet arrangement" pursuant to Regulation S-K Item 303(a)(4). As of December 30, 2012 and September 30, 2012, we did not have any other relationships with unconsolidated entities or financial partners, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. Contractual Obligations and Commitments Debt. At December 30, 2012, we had approximately $31.4 million of debt, exclusive of discounts, which consisted of (i) a Senior Secured Revolving Credit Facility, in the original principal amount of $5.0 million; (ii) Senior Subordinated Convertible Notes with an aggregate principal balance of approximately $5.4 million.; (iii) Senior Subordinated Notes with an aggregate principal balance of approximately $4.9 million, and (iv) Subordinated Secured Convertible Notes with an aggregate principal balance of approximately $16.1 million. Each of these instruments are described more fully below. Senior Secured Revolving Credit Facility In December 2011, we entered into a Loan and Security Agreement (the "Loan Agreement") with Partners for Growth, L.P. ("PFG") pursuant to which we obtained the two-year, $5.0 million line of credit (the "Revolving Credit Facility"). Upon execution of the Loan Agreement, we borrowed the entire $5.0 million available thereunder and used approximately $1.9 million of that Revolving Credit Facility to repay the Secured Promissory Note. We used the remaining proceeds of the Revolving Credit Facility, less expenses thereof, for general working capital purposes. The maturity date for the Revolving Credit Facility is December 14, 2013 (the "Maturity Date"). Interest on the Revolving Credit Facility accrues at the rate of 12% per annum. Interest on the Revolving Credit Facility is payable monthly on the third business day of each month for interest accrued during the prior month, and the remaining balance is payable on the Maturity Date. Each of Costa Brava and Griffin, individually and collectively, jointly and severally, have unconditionally guaranteed repayment to PFG of $2.0 million of our monetary obligations under the Loan Agreement. To secure the payment of all of our obligations under the Revolving Credit Facility when due, we granted to PFG a first position, continuing security interest in substantially all of our assets, including substantially all of our intellectual property, subject to the commitment by PFG to release any security interests in the assets of the Thermal Imaging Business that we sold. That sale was consummated on January 31, 2012, and PFG subsequently released the related security interests. In addition, Costa Brava, Griffin and certain other of our existing creditors have agreed that, while any obligations remain outstanding by us to PFG, their respective security interests in and liens on our assets shall be subordinated and junior to those of PFG. -21--------------------------------------------------------------------------------- Table of Contents Senior Subordinated Convertible Notes Effective as of September 28, 2012, the Company issued and sold to The Griffin Fund LP Senior Subordinated Secured Convertible Promissory Notes due November 30, 2012 in the aggregate principal amount of $1.2 million (the "2012 Notes"). The 2012 Notes are convertible at $0.12 per share, or the price of shares sold by the Company to one or more investors and raising gross proceeds to the Company of at least $1.0 million. During the 13 week period ended December 30, 2012 the Company issued $4,210,000 of 2012 Notes. Payment in cash of an amount equal to all outstanding principal and accrued, but unpaid interest on the 2012 Notes was initially due November 30, 2012. The 2012 Notes were amended effective November 30, 2012 to change the maturity date of the 2012 Notes to March 31, 2013 (the "Maturity Date"). Subsequent to December 30, 2012, the Company authorized the issuance of Senior Subordinated Convertible Promissory Notes (the "2013 Notes") that are a part of a series of notes, along with the 2012 Notes, in the aggregate amount of $10 million. As additional consideration for the purchase of the 2013 Notes, the Company shall issue shares of its common stock to each investor with a value equal to 25% of the principal amount of the 2013 Notes purchased by such investor. The 2012 Notes previously issued were cancelled and exchanged by each investor for 2013 Notes. The maturity date of the 2013 Notes is the earlier of 6 months after issuance, or the closing of a debt or equity financing resulting in gross proceeds to the Company in excess of $5 million (a "Qualified Financing"). Further, within fifteen (15) business days after the closing of a Qualified Financing, each investor may convert the outstanding principal and interest under their 2013 Note into the securities issued in the Qualified Financing, on the same terms and conditions as the other investors in the Qualified Financing. As of February 6, 2013 the Company has issued $7.4 million of the $10 million aggregate amount of these series of Notes. Senior Subordinated Notes In March 2011, the Company issued and sold to two accredited investors, Costa Brava Partnership III L.P. ("Costa Brava") and The Griffin Fund LP ("Griffin") 12% Senior Subordinated Secured Promissory Notes due March 2013 (the "Senior Subordinated Notes") in the aggregate principal amount of $4.0 million. In July 2011, the Senior Subordinated Notes were amended to permit the holders to demand repayment any time on or after July 16, 2012, in partial consideration for permitting the issuance of additional Subordinated Secured Convertible Promissory Notes as discussed below. Because of this demand, the Senior Subordinated Notes have been classified as current obligations in the Company's Consolidated Balance Sheet as of December 30, 2012. The Senior Subordinated Notes bear interest at a rate of 12% per annum paid by adding the amount of such interest to the outstanding principal amount of the Senior Subordinated Notes as "paid-in-kind" ("PIK") interest. As a result of the addition of such interest, the outstanding principal amount of the Senior Subordinated Notes at December 30, 2012 was $4.9 million. The Senior Subordinated Notes are secured by substantially all of the assets of the Company pursuant to Security Agreements dated March 16, 2011 and March 31, 2011 between the Company and Costa Brava as representative of the Senior Subordinated Note holders, but the liens securing the Senior Subordinated Notes are subordinate to the liens securing the indebtedness of the Company to PFG under the Revolving Credit Facility. Subordinated Secured Convertible Notes In December 2010, the Company entered into a Securities Purchase Agreement with Costa Brava and Griffin, pursuant to which the Company issued and sold to Costa Brava and Griffin 12% Subordinated Secured Convertible Notes due December 23, 2015 (the "Subordinated Notes") in the aggregate principal amount of $7.8 million and sold in a subsequent closing in March 2011 additional Subordinated Notes to Costa Brava and Griffin for an aggregate purchase price of $1.2 million. In July 2011, the Company sold additional Subordinated Notes to five accredited investors, including Costa Brava and Griffin, in the aggregate principal amount of $5,000,000. In addition, holders of existing notes with a principal balance of $1.1 million converted their Bridge Notes into Subordinated Notes during Fiscal 2011. -22--------------------------------------------------------------------------------- Table of Contents The Subordinated Notes bear interest at a rate of 12% per annum, due and payable quarterly. For the first two years of the term of the Subordinated Notes, the Company has the option to pay all or a portion of the interest due on each interest payment date in shares of common stock, with the price per share calculated based on the weighted average price of the Common Stock over the last 20 trading days ending on the second trading day prior to the interest payment date. While the Revolving Credit Facility is outstanding, interest on the Subordinated Notes that is not paid in shares of Common Stock must be paid by adding the amount of such interest to the outstanding principal amount of the Subordinated Notes as PIK interest. The principal and accrued but unpaid interest under the Subordinated Notes is convertible at the option of the holder into shares of the Common Stock at an initial conversion price of $0.07 per share. The conversion price is subject to a full price adjustment feature for certain price dilutive issuances of securities by the Company and proportional adjustment for events such as stock splits, dividends, combinations and the like. Beginning after the first two years of the term of the Subordinated Notes, the Company may force the Subordinated Notes to be converted to Common Stock if certain customary equity conditions have been satisfied and the volume weighted average price of the common stock is $0.25 or greater for 30 consecutive trading days. During the 13 week period ended December 30, 2012, the Company paid approximately $483,000 of interest costs in the form of 4,357,000 shares of common stock. As a result of the issuances of Subordinated Notes discussed above, the conversion of existing notes to Subordinated Notes, the conversion of Subordinated Notes to common stock, and the application of PIK interest, the aggregate principal balance of the Subordinated Notes at December 30, 2012, exclusive of the effect of debt discounts, was $16.1 million. The balance of the Subordinated Notes, net of unamortized discounts comprised of derivative liability, at December 30, 2012 was $6.8 million. The debt discounts will be amortized over the term of the Subordinated Notes, unless such amortization is accelerated due to earlier conversion of the Subordinated Notes pursuant to their terms. The Company paid a total of $1,000,000 in cash commissions to an investment banker for services related to issuance of the Subordinated Notes, $682,000 of which was recorded as a deferred financing cost and the balance recorded as an offset to equity. The Subordinated Notes are secured by substantially all of the assets of the Company pursuant to a Security Agreement dated December 23, 2010 and July 1, 2011, as applicable, between the Company and Costa Brava as representative of the holders of Subordinated Note, but the liens securing the Subordinated Notes are subordinate in right of payment to Loans issued pursuant to the Revolving Credit Facility. Capital Lease Obligations. The outstanding principal balance on our capital lease obligations of $76,000 at December 30, 2012 relates primarily to computer equipment and software and is included as part of current and non-current liabilities within our consolidated balance sheet. Operating Lease Obligations. We have various operating leases covering equipment and facilities located at our offices in California, Texas, Italy, and Dubai. Deferred Compensation. We have a deferred compensation plan, the Executive Salary Continuation Plan (the "ESCP"), for select key employees. Benefits payable under the ESCP are established on the basis of years of service with the Company, age at retirement and base salary, subject to a maximum benefits limitation of $137,000 per year for any individual. The ESCP is an unfunded plan. The recorded liability for future expense under the ESCP is determined based on expected lifetimes of participants using Social Security mortality tables and discount rates comparable to those of rates of return on high quality investments providing yields in amount and timing equivalent to expected benefit payments. At the end of each fiscal year, we determine the assumed discount rate to be used to discount the ESCP liability. We considered various sources in making this determination for Fiscal 2012, including the Citigroup Pension Liability Index, which at September 30, 2012 was 3.94%. Based on this review, we used a 3.94% discount rate for determining the ESCP liability at September 30, 2012. Presently, two of our retired executives are receiving benefits aggregating $184,700 per annum under the ESCP. As of December 30, 2012, $1,159,000 has been accrued in the accompanying consolidated balance sheet for the ESCP, of which amount $185,000 is a current liability we expect to pay during Fiscal 2013. -23--------------------------------------------------------------------------------- Table of Contents Stock-Based Compensation Aggregate stock-based compensation attributable to continuing operations for the 13-week periods ended December 30, 2012 and January 1, 2012 was $204,000 and $836,000, respectively, and was attributable to the following: 13 Weeks Ended 13 Weeks Ended December 30, 2012 January 1, 2012 Cost of revenues $ 38,000 $ 63,000 General and administrative expense 166,000 773,000 $ 204,000 $ 836,000 All transactions in which goods or services are the consideration received for equity instruments issued to non-employees are accounted for based on the fair value of the consideration received or the fair value of the equity instrument issued, whichever is more reliably measurable. The measurement date used to determine the fair value of any such equity instrument is the earliest to occur of (i) the date on which the third-party performance is complete, (ii) the date on which it is probable that performance will occur, or (iii) if different, the date on which the compensation has been earned by the non-employee. In the year ended September 30, 2012, we issued to PFG warrants to purchase 15,000,000 shares of our common stock, valued at $250,000 pursuant to which the Company obtained the Revolving Credit Facility. We have recorded this expense as a debt discount, which is being amortized over the two-year term of the Revolving Credit Facility. We calculate stock option-based compensation by estimating the fair value of each option granted using the Black-Scholes option valuation model and various assumptions that are described in Note 1 of the Accompanying Notes to Condensed Consolidated Financial Statements included in this Quarterly Report. Once the compensation cost of an option is determined, we recognize that cost on a straight-line basis over the requisite service period of the option, which is typically the vesting period for options granted by us. We calculate compensation expense of both vested and non-vested stock grants by determining the fair value of each such grant as of their respective dates of grant using our stock price at such dates with no discount. We recognize compensation expense on a straight-line basis over the requisite service period of a non-vested stock award. For the 13-week period ended December 30, 2012, stock-based compensation included compensation costs attributable to such periods for those options that were not fully vested upon adoption of ASC 718, Compensation - Stock Compensation, adjusted for estimated forfeitures. We have estimated forfeitures to be 7%, which reduced stock-based compensation cost by $15,000 in the 13-week period ended December 30, 2012. The Company did not grant options to purchase shares of common stock in the 13-week period ended December 30, 2012. The Company granted of options to purchase 1,187,500 shares of common stock in the 13-week period ended January 1, 2012. At December 30, 2012, the total compensation costs related to non-vested option awards not yet recognized was $997,000. The weighted-average remaining vesting period of non-vested options at December 30, 2012 was 0.8 years. -24--------------------------------------------------------------------------------- Table of Contents |