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TELANETIX,INC - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion and analysis is intended as a review of significant factors affecting our financial condition and results of operations for the periods indicated. The discussion should be read in conjunction with our consolidated financial statements and the notes presented herein. See "ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA." below. In addition to historical information, the following Management's Discussion and Analysis of Financial Condition and Results of Operations contain forward-looking statements that involve risks and uncertainties. Our actual results could differ significantly from those anticipated in these forward-looking statements as a result of certain factors discussed in this report. See "Forward-Looking Statements," above. Overview Business We are a cloud based IP voice services company. Our Company philosophy is built on the belief that business telecommunication need not be expensive or complicated. Through our AccessLine-branded Voice Services, we provide customers with a range of business phone services and applications that are easy to purchase, easy to install, easy to use and most importantly provide significant savings. Our customers have the ability to easily configure their service to meet the needs unique to their business. At the core of our cloud based, hosted service is our proprietary software, which is developed internally and runs on standard commercial grade servers. By delivering business phone service to the market in this manner, our Voice Services offer flexibility and ease of use to any sized business customer, at an affordable price point. AccessLine offers the following cloud based, hosted Voice over IP services: Digital Phone System (DPS), SIP Trunking Service and a la carte, individual phone services. DPS replaces a customer's existing telephone lines and phone system with a Voice over IP alternative. It is sold as a complete turn-key solution where we bundle business-class phone equipment which is manufactured by third parties, along with our reliable voice network services. This service is primarily targeted at small businesses looking for a fully integrated solution that does not require expert assistance to install or manage. SIP Trunking Service replaces high-cost telephone lines with a low cost yet high quality IP alternative. SIP Trunking is for larger businesses that already have their own on premise equipment (PBX) and is targeted at those businesses with large calling volumes looking for cost effective alternatives to traditional carrier offerings. SIP Trunking Service can support businesses with hundreds to thousands of employees. AccessLine-branded services also offer a la carte phone services and features including conferencing calling services, find-me and follow-me services, toll-free services, and automated attendant service. Each a la carte service can be purchased individually through AccessLine's various websites. All services include easy-to-use web interfaces for simple management and customizations. Our revenues principally consist of: monthly recurring fees, activation, and usage fees from the communication services and solutions outlined above. There are some ancillary one time equipment charges associated with our DPS solution. Recent Developments Our overriding objective is to grow revenue while achieving operating profitability and generating cash from operations. In 2012 we addressed this objective through the growth in our core voice businesses. 21 -------------------------------------------------------------------------------- Table of Contents We experienced growth in revenue and gross profit for our AccessLine division in both 2012 and 2011. We increased revenue during 2012 through, in part, increased efficiency in our advertising and also through our success in selling our SIP Trunking Service through direct and agent channels. Our Digital Phone Service continues to grow month over month. We increased our year-to-date gross profit through our continued progress in optimizing our network configuration. Agreement and Plan of Merger On January 18, 2013, Intermedia Holdings, Inc., a Delaware corporation ("Parent"), Sierra Merger Sub Co., a Delaware corporation and a wholly owned subsidiary of Parent ("Merger Sub"), and Telanetix, Inc., a Delaware corporation (the "Company") entered into an Agreement and Plan of Merger (the "Merger Agreement"), pursuant to which Merger Sub will merge with and into the Company, with the Company continuing as the surviving corporation and a wholly owned subsidiary of Parent (the "Merger"). The aggregate consideration to be paid by Parent and Merger Sub in the Merger for all of the outstanding equity interests of the Company, including securities convertible into shares of the Company's common stock, par value $0.0001 per share (the "Company Common Stock"), is approximately $41.5 million, minus the sum of (i) the amount (if any) by which the Transaction Expenses (as defined in the Merger Agreement) exceed $2,525,000, (ii) the amount (if any) by which the Regulatory Expenses (as defined in the Merger Agreement) exceed $200,000 (as so adjusted, the "Merger Consideration"), and certain other potential adjustments described below. The Merger Consideration will also be increased by the proceeds of certain warrant and option exercises, if any, occurring between the date of the Merger Agreement and the closing of the Merger. At the effective time of the Merger, each share of Company Common Stock issued and outstanding immediately prior to the effective time of the Merger, other than (i) shares held in the treasury of the Company and shares owned by Parent, Merger Sub, or any subsidiary of Parent or the Company (which shares will be cancelled) and (ii) shares that are, as of immediately prior to the effective time of the Merger, owned by stockholders who have perfected and not withdrawn a demand for, or lost their right to, appraisal pursuant to Section 262 of the Delaware General Corporation Law with respect to such shares, will be converted into the right to receive an amount in cash equal to the Per Share Merger Consideration. The Merger Agreement defines "Per Share Merger Consideration" as the Merger Consideration divided by the Fully Diluted Share Number (as defined in the Merger Agreement). We originally estimated the Per Share Merger Consideration to be approximately $7.40, however, due to increases in certain Transaction Expenses and Regulatory Expenses, primarily due to regulatory issues and complexities of the transaction, we currently estimate the Per Share Merger Consideration to be in the range of $7.33 to $7.27. Please note that this estimate of the Per Share Merger Consideration reflects currently available information and does not include additional Transaction Expenses or Regulatory Expenses that may be incurred in connection with regulatory reviews and stockholder matters. If expenses beyond what is currently estimated are required, there are likely to be further downward adjustments to the Per share Merger Consideration, which expenses and adjustments are more fully described in the Merger Agreement. The Merger Consideration is subject to decrease in certain circumstances described above, and also may be decreased for amounts, if any, placed in escrow to cover certain matters that arise, if any, prior to the Merger closing, up to a maximum aggregate amount of $5,000,000, or for Merger Consideration held back under certain circumstances. The Company's senior and subordinated debt will be paid in full in connection with the closing of the Merger, which payments will not affect the amount of Merger Consideration. Each (i) outstanding option to purchase shares of Company Common Stock (a "Company Stock Option") and granted under any stock option plan to which the Company or any of its subsidiaries is a party, whether or not then exercisable and (ii) outstanding warrant to purchase shares of Company Common Stock (a "Company Warrant") shall, as of the effective time of the Merger, be cancelled, and the holder thereof shall be entitled to the right to receive, without any interest thereon, an amount in cash payable immediately following the cancellation of such Company Stock Option or Company Warrant, as the case may be, equal to (i) the number of shares of Company Common Stock subject to the Company Stock Option or Company Warrant, as the case may be, in each case, as of immediately prior to the effective time of the Merger and (ii) the difference (if any) between (x) the Per Share Merger Consideration and (y) the per share exercise price with respect to such Company Stock Option or Company Warrant, as the case may be. The completion of the Merger is subject to the satisfaction or waiver of certain conditions, including, among other things, the approval of the Merger by the Federal Communications Commission and applicable state public service or public utility commissions or other similar state regulatory bodies, and the adoption and approval of the Merger Agreement by the Company's stockholders, which was effected on January 19, 2013 by the written consent of the holders of 4,358,942 shares of Company Common Stock, or approximately 85.1% of the outstanding shares entitled to cast a vote with respect to the adoption and approval of the Merger Agreement. Parent's and Merger Sub's obligations to consummate the Merger are not subject to a financing condition; provided, that Parent's and Merger Sub's obligations to close the Merger are subject to certain caps on liability set forth in the Merger Agreement. The Merger Agreement contains customary termination provisions, including, without limitation, that the Merger Agreement may be terminated by either the Company or Parent if the Merger has not been consummated by the close of business on August 16, 2013 (which date may be extended to October 15, 2013 in certain limited circumstances), other than due to the failure of the terminating party to fulfill its obligations under the Merger Agreement. The Merger Agreement requires the Company to pay a $2,000,000 termination fee to Parent under certain limited circumstances. In addition, the Merger Agreement requires Parent to pay a $5,250,000 termination fee to the Company under certain limited circumstances. 22 -------------------------------------------------------------------------------- Table of Contents The Merger Agreement contains customary representations and warranties made by the Company, Parent and Merger Sub. In addition, the Company has agreed to various covenants in the Merger Agreement, including, among other things, covenants to continue to conduct its business in the ordinary course and in accordance with past practices and not to take certain actions prior to the closing of the Merger without the prior consent of Parent. The foregoing description of the terms of the Merger Agreement are not complete and are qualified in their entirety by reference to the Merger Agreement, a copy of which is attached as Exhibit 2.1 to this Current Report on Form 8-K and incorporated herein by reference. The Merger Agreement has been attached to provide investors with information regarding its terms. It is not intended to provide any other factual information about the Company or Parent. In particular, the assertions embodied in the representations and warranties contained in the Merger Agreement are qualified by information in a confidential Disclosure Schedule provided by the Company to Parent in connection with the signing of the Merger Agreement. The confidential Disclosure Schedule contains information that modifies, qualifies and creates exceptions to the representations and warranties set forth in the Merger Agreement. Moreover, certain representations and warranties in the Merger Agreement were used for the purpose of allocating risk between the Company and Parent rather than establishing matters as facts. Accordingly, you should not rely on the representations and warranties in the Merger Agreement as characterizations of the actual state of facts about the Company or Parent. Loan Agreement On December 14, 2012, Telanetix, Inc., a Delaware corporation ("Telanetix"), entered into a Loan and Security Agreement (the "Loan Agreement") by and among itself, its direct and indirect subsidiaries (together with Telanetix, the "Borrowers"), and East West Bank ("East West"). The Loan Agreement provided the Borrowers a term loan in the principal amount of $7,500,000 with principal and interest payable on a monthly basis over four years subject to the terms of a Promissory Note by the Borrowers in favor of East West (the "East West Note"). The unpaid balance of the East West Note accrues interest at a rate per annum equal to the daily Wall Street Journal Prime Rate, as quoted in the "Money Rates" column of The Wall Street Journal (Western Edition), rounded to two decimal places, as determined by East West, plus a margin of 1.750 percentage points (the "Applicable Interest Rate"). Payments on the East West Note are as follows: (i) consecutive monthly principal payments of $125,000, beginning January 2, 2013, (ii) consecutive monthly interest payments, beginning January 2, 2013, and (iii) one principal and interest payment on December 13, 2016 of all principal and accrued interest not yet paid. Commencing the fiscal year ending December 31, 2013 and for each fiscal year thereafter, the Borrowers are obligated to make additional annual payments in respect of the East West Note equal to 25% of excess cash flow, which is defined as the Borrowers' EBITDA minus (a) cash taxes, (b) cash interest expense, (c) scheduled principal payments on the East West Note, (d) capital lease payments, (e) unfinanced capital expenditures, and (f) plus or minus changes in working capital. Upon prepayment of the East West Note, the Borrowers are required to pay a premium equal to 1% of the original amount of the East West Note amount so prepaid if such prepayment occurs during the first year of the term of the East West Note. After the first year anniversary of the East West Note, there is no prepayment penalty. The indebtedness under the East West Note is secured by a security interest and lien on substantially all of the Borrowers' assets. The Loan Agreement contains customary affirmative and negative covenants. Among the affirmative covenants is a covenant that the Borrowers will maintain the following financial ratios: (1) a quarterly Fixed Charge Coverage Ratio (as defined in the Loan Agreement) of not less than 1.25 to 1.00 through June 30, 2013, and 1.50 to 1.00 thereafter, (2) a quarterly EBITDA (as defined in the Loan Agreement) of $625,000 for Q4 2012, $725,000 for Q1 2013, and $875,000 thereafter, and (3) a maximum Senior Debt (as defined in the Loan Agreement) divided by trailing 12 months EBITDA of 2.50 to 1.00 through December 31, 2013, and 2.00 to 1.00 thereafter. " Refinancing of Note Obligations On December 14, 2012, using proceeds of the term loan evidenced by the Loan Agreement and East West Note, Senior Secured Notes of Telanetix (and guaranteed by the other Borrowers) respectively in favor of HCP-TELA, LLC ("HCP"), EREF-TELA, LLC ("EREF"), and CBG-TELA, LLC ("CBG") (collectively, the "Lenders") in the original aggregate principal amount of $10,500,000 (collectively, the "2010 Notes") purchased by the Lenders pursuant to that certain Securities Purchase Agreement, dated as of June 30, 2010, by and among Telanetix and the Lenders, were paid in full. In connection with the payment in full of the 2010 Notes, which contractually were not prepayable, an Event of Default Redemption Price (as defined in each 2010 Note) was required to be paid. Accordingly, on December 14, 2012, the Borrowers executed and delivered Subordinated Promissory Notes to the Lenders in the aggregate original principal amount of $1,726,659.72 (collectively, the "Subordinated Notes"). The unpaid balance of the Subordinated Notes accrues interest at the Applicable Interest Rate. The principal and all accrued and unpaid interest under the Subordinated Notes are to be paid on the earliest of (a) June 14, 2017, (b) the date of the acceleration of the Subordinated Notes in accordance with the terms of the Subordinated Notes, and (c) the date of the payment in full of all obligations under the East West Note. The obligations of the Borrowers under the Subordinated Notes are secured by security interests in substantially all of the Borrowers' assets, with HCP serving as collateral agent for the Lenders, which were granted pursuant to a Security Agreement dated December 14, 2012 between the Borrowers and HCP, as collateral agent for the Lenders (the "Security Agreement"). The Security Agreement contains many of the same affirmative and negative covenants as the Loan Agreement, but does not contain any financial covenants. 23 -------------------------------------------------------------------------------- Table of Contents As a condition precedent to East West making the term loan discussed above, the Lenders and HCP, as collateral agent for the Lenders, were required to enter into a Subordination and Intercreditor Agreement (the "Subordination Agreement") with East West (which was acknowledged by the Borrowers) pursuant to which the Borrowers' obligations to the Lenders under the Subordinated Notes (and all liens and security interests granted by the Borrowers to secure those obligations) were subordinated to the obligations of the Borrowers to East West (and all liens and security interests granted by the Borrowers to secure the obligations of the Borrowers to East West). Under the Subordination Agreement, payments cannot be made or received under the Subordinated Notes, the Lenders cannot commence any action to collect on the obligations under the Subordinated Notes, and the Lenders and HCP, as collateral agent, cannot take any Enforcement Action (as defined in the Subordination Agreement) with respect to their collateral until the East West obligations are paid in full. Debenture Repurchase On June 30, 2010, we entered into a securities purchase agreement with the holders of our outstanding debentures in the principal amount of $29.6 million. Under the terms of the agreement, we repurchased all of our outstanding debentures in exchange for payment of $7.5 million in cash, the holder of the debentures exchanged all outstanding warrants they held for shares of our common stock and we issued to such holder an additional number of shares of our common stock, such that the holder collectively and beneficially owned approximately 221,333 shares of our common stock immediately following the completion of the transactions contemplated by the agreement. We paid $7.5 million from the proceeds of our senior secured note private placement described below. After giving effect to the transactions contemplated by the debenture repurchase described above and the transactions contemplated by the senior secured note private placement described below, we issued $10.5 million of the 2010 notes outstanding and all our previously issued debentures, which had a principal balance of $29.6 million, were cancelled. Senior Secured Notes Private Placement On June 30, 2010, we entered into a securities purchase agreement(the "Hale Securities Purchase Agreement") with affiliates of Hale Capital Management, LP (collectively, "Hale") pursuant to which in exchange for $10.5 million, the Company issued to Hale $10.5 million of senior secured notes (the "2010 notes"), and 3,833,356 shares of its common stock. The carrying value assigned to the debt and equity was based on the relative fair value of each component as determined by a third party valuation specialist. The allocation between debt and equity resulted in a $5.7 million debt discount which will be amortized over the term of the 2010 notes using the effective interest method. A summary of the material terms of the 2010 notes, as amended, is set forth in Note 5 - 2010 Notes, below. Under the terms of the Hale Securities Purchase Agreement, the Company agreed to conduct a rights offering. In connection with the rights offering, depending on the amount of capital it raised, the Company and Hale agreed that the Company would either redeem up to $3.0 million of principal of the 2010 notes or that Hale would exchange up to $3.0 million of principal of the 2010 notes for shares of the Company's common stock. As discussed below the Company has cancelled the rights offering and no longer has any obligation to conduct the same. In August 2011, the independent directors of the Company approved, and the Company and Hale entered into a settlement agreement, pursuant to which (1) Hale released the Company from any obligation to conduct the rights offering, and (2) the Company released Hale from its "backstop" obligation to convert up to $3.0 million of the 2010 notes into common stock. As a result of the amendment, the original principal amount of the 2010 notes outstanding remained at approximately $10.5 million, plus accrued interest that was accrued to principal through December 31, 2012. In addition, under the settlement agreement, Hale granted the Company the right to defer cash payment of the interest on up to $3.0 million of principal (plus associated "PIK Interest") through June 30, 2012 and to have any such amounts added to principal. The Company's scheduled payment obligation under the 2010 notes, including accrued interest, will average approximately $343,000 per month through December 31, 2012. On December 14, 2012 the senior secured notes were paid in full. The Company agreed to a number of provisions in the Hale Securities Purchase Agreement that protect Hale's investment, including: Most Favored Nation. For so long as the 2010 notes are outstanding and until Hale ceases to own ten percent of our outstanding common stock, if we (i) issue debt on terms that are more favorable than the terms of the 2010 notes, or (ii) issue common stock, preferred stock, equivalents or any other equity security on terms more favorable than those set out in the Hale Securities Purchase Agreement, then the terms of the 2010 notes and/or the Hale Securities Purchase Agreement shall automatically be amended such that Hale receives the benefit of the more favorable terms. Right of First Refusal. For so long as the 2010 notes are outstanding and until Hale ceases to own ten percent of our outstanding common stock, Hale shall have a right of first refusal on any subsequent placement that we make of common stock or common stock equivalents or any securities convertible into or exchangeable or exercisable for shares of our common stock. 24 -------------------------------------------------------------------------------- Table of Contents Fundamental Transactions. For so long as the 2010 notes are outstanding and thereafter for as long as any of the Hale purchasers continue to own 20% of the common stock that they purchased under the Hale Securities Purchase Agreement, we cannot effect a transaction in which we consolidate or merge with another entity, convey all or substantially all of our assets, permit another person or group to acquire more than 50% of our voting stock, or reorganize or reclassify our common stock without the consent of a majority in interest of the Hale purchasers. Additionally, we cannot effect such a transaction without obtaining the foregoing requisite consent if such transaction would trigger the most favored nation provision in the Hale Securities Purchase Agreement described above or if such transaction would otherwise involve the issuance of any equity securities or the incurrence of debt at a price that is less than the price paid in connection with the transaction consummated pursuant under the Hale Securities Purchase Agreement. Post Closing Adjustment Shares. If at any time prior to July 2, 2012, we are required to make payment on certain identified contingent liabilities up to an aggregate amount of $464,831, then we will issue additional shares of common stock to Hale, such that the total percentage ownership of our fully diluted common stock immediately after the payment of such liabilities will equal the same percentage ownership that Hale would have had if the contingent payable had been paid prior to the closing under the Hale Securities Purchase Agreement. To date $464,831 of these contingent liabilities have been incurred as expenses. Accordingly, in April 2011 we issued to Hale and additional 225,576 shares of our common stock under the terms of the Hale Securities Purchase Agreement. As anticipated in our quarterly report on Form 10-Q for the quarter ended September 30, 2012, on November 16, 2012 we issued to Hale the remaining 300,004 shares of common stock as final settlement of the contingent liabilities. On December 14, 2012, Telanetix satisfied and discharged all of its obligations under the 2010 Notes, and the 2010 Notes were cancelled. Registration Rights Agreement In connection with the Hale Securities Purchase Agreement, the Company entered into a registration rights agreement with Hale pursuant to which the Company agreed to file a registration statement with the SEC for the resale of the shares issued and issuable to Hale under the Hale Securities Purchase Agreement. The Company filed that registration statement on September 30, 2010. The registration rights agreement contains penalty provisions in the event that the Company failed to secure the effectiveness of that registration statement by November 29, 2010, fails to file other registration statements the Company is required to file under the terms of the registration rights agreement in a timely manner or if the Company fails to maintain the effectiveness of any registration statement it is required to file under the terms of the registration rights agreement until the shares issued to Hale are sold or can be sold under Rule 144 without restriction or limitation (including volume restrictions) and without the requirement that the company be in compliance with Rule 144 (c)(1). In the event of any such failure, and in addition to other remedies available to Hale, the Company agreed to pay Hale as liquidated damages an amount equal to 1% of the purchase price for the share to be registered in such registration statement. Such payments are due on the date we fail to comply with our obligation and every 30th day thereafter (pro- rated for periods totaling less than 30 days) until such failure is cured. The registration statement covering the resale of the shares issued to Hale has not been declared effective. As part of the settlement discussed above, Hale and the Company have agreed to amend the term "Initial Effectiveness Deadline" set forth in Section 1(o) of the Registration Rights Agreement to read in its entirety as follows "Initial Effectiveness Deadline" December 31, 2012. Impact of Debenture Repurchase and Senior Secured Note Private Placement In connection with the Hale Securities Purchase Agreement the Company received gross proceeds of $10.5 million. The Company incurred expenses of $1.5 million in connection with the transaction contemplated by the Hale Securities Purchase Agreement, resulting in net proceeds of approximately $9.0 million. We used $7.5 million of these proceeds to repurchase our outstanding debentures and allotted the remaining $1.5 million for working capital purposes, including advertising and distribution programs for our Digital Phone Service products. Merriman Curhan Ford acted as our financial advisor in the transaction and we paid them a fee of $682,500 in connection with the transaction. We also issued Merriman Curhan Ford warrants to purchase 31,152 shares of our common stock. The warrants are exercisable at $2.889 per share for a period of 5 years. Stock Award Agreements As a condition to the completion of the transactions contemplated by the Hale Securities Purchase Agreement, on July 2, 2010, the Company entered into stock award agreements with our employees who had earned compensation under our senior management incentive plans that had yet to be paid. The stock award agreements were entered into to eliminate all accrued and unpaid incentive compensation owed to those employees. Under the terms of the stock award agreements, each employee received 30% of his or her accrued incentive compensation in cash, which amounts are being withheld to pay applicable withholding taxes, and the balance in unregistered shares of or common stock, calculated on the basis of one share being issued for every $2.889 of incentive compensation owed. In the aggregate, we paid $147,230 in cash and we issued 118,912 shares of our common stock to employees in cancellation of $490,768 of earned and unpaid incentive compensation. 25 -------------------------------------------------------------------------------- Table of Contents Rights Offering Under the terms of the Hale Securities Purchase Agreement, the Company agreed to conduct a rights offering pursuant to which we would distribute at no charge to holders of our common stock non-transferable subscription rights to purchase up to an aggregate 1,038,414 shares of common stock at a subscription price of $2.889 per share. Under the terms of the 2010 notes, the Company agreed to use the gross proceeds of the rights offering to redeem an aggregate of up to $3.0 million of principal amount of the 2010 notes. To the extent the gross proceeds of the rights offering were less than $3 million, the Company and Hale agreed that Hale would exchange the principal amount to be redeemed (up to $3.0 million) for shares of our common stock at an exchange price equal to the subscription price of the subscription rights. The Company paid Hale an aggregate of $60,000 in consideration for the foregoing. In addition, the Company agreed to pay Hale upon completion of the rights offering an amount of cash equal to the accrued and unpaid interest in respect of the principal amount of the senior secured notes redeemed or exchanged for shares of common stock in connection with the rights offering. As discussed below the Company has cancelled the rights offering and related obligations. In August 2011, the independent directors of the Company approved, and the Company and Hale entered into a settlement agreement, pursuant to which (1) Hale released the Company from any obligation to conduct the rights offering, and (2) the Company released Hale from its "backstop" obligation to convert up to $3.0 million of the 2010 notes into common stock. As a result of the amendment, the original principal amount of the 2010 notes outstanding remained at approximately $10.5 million, plus accrued interest that was accrued to principal through December 31, 2012. In addition, under the settlement agreement, Hale granted the Company the right to defer cash payment of the interest on up to $3.0 million of principal (plus associated "PIK Interest") through June 30, 2012 and to have any such amounts added to principal. The Company's scheduled payment obligation under the 2010 notes, including accrued interest, will average approximately $343,000 per month through December 31, 2012. On December 14, 2012 the senior secured notes were paid in full. Outlook During 2012 our focus has been on driving our core business of next generation VoIP services including our Digital Phone Service and our SIP Trunking Service. Our network infrastructure is scalable and capable of supporting significant additional services, without substantial capital expenditure. As we generate additional revenues, we can distribute the fixed costs elements of our business over a greater revenue base, and increase gross profit. During 2012, we continued the growth of our Digital Phone Service and our SIP Trunking Service which grew by 53 percent over revenues for those products during the same period in 2011. Digital Phone Service and our SIP Trunking Service will continue to be core to growth of our revenues going forward. Efforts are being made to expand the related distribution channels to increase penetration into these markets and increase revenues. If we can continue to generate revenue and gross profit in our Digital Phone Service and SIP Trunking Service products consistent with our growth in 2012 and we maintain control of our operating expenses, we believe that our existing capital, taking into account the effect of the two transactions that recapitalized our debt, will be sufficient to finance our operations for at least the next 12 months. However, the uncertainties related to the global economic slowdown and the disruption in the financial markets has impacted our visibility of our business outlook. Weakening economic conditions may result in decreased demand for our products. In addition, we have limited financial resources. Significant unforeseen decreases in revenues or increases in operating costs could impact our ability to fund our operations. We do not currently have any sources of credit available to us. See "Liquidity and Capital Resources" below. Results of Operations Year Ended December 31, 2012 Compared with Year Ended December 31, 2011 Revenues, Cost of Revenues and Gross Profit Fiscal Year Ended December 31, Increase 2012 2011 Dollars Percent Revenues $ 31,852,023 $ 28,706,786 $ 3,145,237 11.0 % Cost of revenues 12,719,644 11,835,530 884,114 7.5 % Gross profit 19,132,379 16,871,256 2,261,123 13.4 % 60.1 % 58.8 % 26-------------------------------------------------------------------------------- Table of Contents Net revenues for 2012 were $31.9 million, an increase of $3.1 million, or 11.0%, over 2011. The increase in revenues is due to our continued success in selling our SIP Trunking Service through direct and agent channels, and strong growth in our Digital Phone Service products as well as our High Volume Services. We expect revenue growth in all three offerings to continue to be strong in 2013. The increases in our core revenue, SIP Trunking Digital Phone Service and high Volume Service revenues more than offset any declines in revenue of our legacy products. Cost of revenues for 2012 were $12.7 million, an increase of $3.1 million, or 7.5%, over 2011. Cost of revenues increased primarily due to the growth in our revenue. Gross profit for 2012 was $19.1 million, an increase of $2.3 million, or 13.4%, over 2011. Gross profit percentage was 60.1% for 2012 compared to 58.8% in 2011. The increase in gross profit is primarily due to the growth in revenue in our Digital Phone Service and SIP Trunking Service product lines, which have higher margins than our other product offerings. We expect gross profit to be in the high 50 to 60 percent range in 2013. Net loss from continuing operations at December 31, 2012 was $6.2 million, or a loss of $1.28 per share, compared to net loss from continuing operations of $5.3 million, or $1.12 per share at December 31, 2011. Selling and Marketing Expenses Selling and marketing expenses for 2012 were $6.8 million, a decrease of $0.1 million, or 2.2% over 2011. The decrease was primarily due to a decrease in advertising and sales commissions. We anticipate that selling and marketing expenses for 2013 will be higher than those incurred in 2012 as we increase our marketing programs as part of our effort to increase market share and to promote our Digital Phone Service product line. General and Administrative Expenses General and administrative expenses for 2012 were $8.9 million, an increase of $1.2 million or 15.3%, over 2011. The increase was attributable to bonus accrual, transaction related expenses, and stock option expense related to the refinancing. Research, Development and Engineering Expenses Research, development and engineering expenses for 2012 were $2.0 million as compared to $1.9 million in 2011. The increase is primarily a result of an increase in our staffing. Depreciation Expense We recorded $0.6 million of depreciation expense in both 2012 and 2011. Amortization of Purchased Intangibles We recorded $1.8 million of amortization expense in 2012, a decrease of 19.1% as compared to $2.2 million in 2011 related to the amortization of intangible assets acquired in the AccessLine acquisition. The decrease was related to customer related intangibles being fully amortized. Impairment of Intangibles We do not amortize goodwill and intangible assets with indefinite useful lives. However, we do review these assets for impairment at least annually. We test goodwill for impairment using a two-step process. The first step is a screen for potential impairment, while the second step measures the amount of the impairment, if any. Other intangible assets with finite useful lives consist primarily of developed technology and customer relationships. These intangibles are amortized on the straight-line basis over the expected period of benefit which range from five to ten years. Long-lived assets, including developed technology and customer relationships, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by comparing the carrying amount of the asset to future undiscounted net cash flows expected to be generated by the asset. If an asset is considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of that asset exceeds the fair value of that asset. Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell. We determined that goodwill, intangible assets and other long-lived assets were not impaired at December 31, 2012 and December 31, 2011. 27 -------------------------------------------------------------------------------- Table of Contents Interest Expense Interest expense for 2012 was $5.2 million, an increase of $2.0 million, as compared to $3.2 million in 2011. Interest expense includes stated interest, amortization of note discounts, amortization of deferred financing costs, and interest on capital leases. Interest expense increased in 2012 primarily as a result of the December 2012 refinancing in which a penalty was incurred on the 2010 Notes payoff and the writing down of the original issue discount. The East West Note accrues interest at a rate per annum equal to the daily Wall Street Journal Prime Rate, as quoted in the "Money Rates" column of The Wall Street Journal (Western Edition), rounded to two decimal places, as determined by East West, plus a margin of 1.75 percentage points Provision for Income Taxes Provision for income taxes for the year ended December 31, 2012 and 2011 was $0.0 million and an expense benefit of $0.1 million, respectively. In October 2010, the State of California revised its laws to suspend the use of net operating loss carryovers for the 2010 and 2011 years. As of December 31, 2012, we had net operating loss carryforwards ("NOL's"), net of section 382 limitations, of approximately $8.1 million, some of which, if not utilized, will begin expiring in the 2016. Our ability to utilize the NOL carryforwards is dependent upon generating taxable income. We recognize interest accrued and penalties related to unrecognized tax benefits in tax expense. During the years ended December 31, 2012 and 2011, we recognized no interest and penalties. Liquidity and Capital Resources Our cash balance as of December 31, 2012 was $1.2 million. At that time, we had accounts receivable of $1.7 million and a working capital deficit of $3.9 million. However, current liabilities include certain items that will likely settle without future cash payments or otherwise not require significant expenditures by the Company including: deferred revenue of $1.1 million (primarily deferred up front customer activation fees), and accrued vacation of $0.5 million. The aforementioned items represent $1.6 million of total current liabilities as of December 31, 2012. We do not anticipate being in a positive working capital position in the near future. However, if we continue to generate revenue and gross profit consistent with our growth in 2012 and maintain control of our variable operating expenses, we believe that our existing capital, together with anticipated cash flows from operations, will be sufficient to finance our operations through at least January 1, 2014. However, based on our projected 2013 results and, if necessary, our ability to reduce certain variable operating expenses, we believe that our existing capital, together with anticipated cash flows from operations, will be sufficient to finance our operations through December 31, 2013. Cash generated by continuing operations during 2012 was $3.4 million. This was primarily the result of non-cash charges including amortization of intangible assets of $1.8 million; amortization of note discounts of $2.5 million; depreciation expense of $2.5 million (which includes depreciation expense of $1.9 million in cost of sales); non-cash interest of $1.8 million; stock compensation expense of $1.0 million, and deferred financing costs of $0.1 million. This was offset by the loss generated from operations of $6.2 million and the remaining $0.1 million of cash as used by the changes in working capital. Net cash used by investing activities during 2012 was $0.6 million, which consisted of purchases of property and equipment. Net cash used by financing activities was $3.5 million during 2012, $10.4 million was related to payments on the 2010 Notes, $6.5 million was related to the East West refinancing, $1.0 million was related to debt proceeds, and $0.6 million was used for payments on our capital leases. The East West loan is secured by a lien on all of our assets, and the terms of such notes restrict our ability to borrow funds, pledge our assets as security for any such borrowing or raise additional capital by selling shares of capital stock or other equity or debt securities, without their consent. If our cash reserves prove insufficient to sustain operations, we plan to raise additional capital by selling shares of capital stock or other equity or debt securities. However, there are no commitments or arrangements for future financings in place at this time, and we can give no assurance that such capital will be available on favorable terms or at all. We may need additional financing thereafter until we can achieve profitability. If we cannot, we will be forced to curtail our operations or possibly be forced to evaluate a sale or liquidation of our assets. Any future financing may involve substantial dilution to existing investors. In December of 2012, we refinanced the balance of our term debt in connection with our "2010 notes". The Loan Agreement provided the Company a term loan in the principal amount of $7,500,000 with principal and interest payable on a monthly basis over four years subject to the terms of a Promissory Note by the Company in favor of East West Bank (the "East West Note"). In connection with the East West Note, we entered into a revolving line of credit of up to $1M based on the Company's eligible accounts receivable. 28 -------------------------------------------------------------------------------- Table of Contents Commitments and Contingencies Leases We have non-cancelable operating and capital leases for corporate facilities and equipment. The leases expire through February 20, 2015 and include certain renewal options. Rent expense under the operating leases totaled $1.5 million and $1.6 million for the years ended December 31, 2012 and 2011, respectively Future minimum rental payments required under non-cancelable operating and capital leases are as follows for the years ending December 31: Operating Leases Capital Leases 2013 $ 969,478 $ 886,194 2014 474,016 825,028 2015 96,554 400,096 2016 26,766 2015 8,922 Total minimum lease payments $ 1,540,048 2,147,006 Less amount representing interest (192,540 ) Present value of minimum lease payments 1,954,466 Less current portion (769,717 ) $ 1,184,749 Loan Agreement On December 14, 2012, Telanetix, Inc., a Delaware corporation ("Telanetix"), entered into a Loan and Security Agreement (the "Loan Agreement") by and among itself, its direct and indirect subsidiaries (together with Telanetix, the "Borrowers"), and East West Bank ("East West"). The Loan Agreement provided the Borrowers a term loan in the principal amount of $7,500,000 with principal and interest payable on a monthly basis over four years subject to the terms of a Promissory Note by the Borrowers in favor of East West (the "East West Note"). The unpaid balance of the East West Note accrues interest at a rate per annum equal to the daily Wall Street Journal Prime Rate, as quoted in the "Money Rates" column of The Wall Street Journal (Western Edition), rounded to two decimal places, as determined by East West, plus a margin of 1.750 percentage points (the "Applicable Interest Rate"). Payments on the East West Note are as follows: (i) consecutive monthly principal payments of $125,000, beginning January 2, 2013, (ii) consecutive monthly interest payments, beginning January 2, 2013, and (iii) one principal and interest payment on December 13, 2016 of all principal and accrued interest not yet paid. Commencing the fiscal year ending December 31, 2013 and for each fiscal year thereafter, the Borrowers are obligated to make additional annual payments in respect of the East West Note equal to 25% of excess cash flow, which is defined as the Borrowers' EBITDA minus (a) cash taxes, (b) cash interest expense, (c) scheduled principal payments on the East West Note, (d) capital lease payments, (e) unfinanced capital expenditures, and (f) plus or minus changes in working capital. Upon prepayment of the East West Note, the Borrowers are required to pay a premium equal to 1% of the original amount of the East West Note amount so prepaid if such prepayment occurs during the first year of the term of the East West Note. After the first year anniversary of the East West Note, there is no prepayment penalty. The indebtedness under the East West Note is secured by a security interest and lien on substantially all of the Borrowers' assets. The Loan Agreement contains customary affirmative and negative covenants. Among the affirmative covenants is a covenant that the Borrowers will maintain the following financial ratios: (1) a quarterly Fixed Charge Coverage Ratio (as defined in the Loan Agreement) of not less than 1.25 to 1.00 through June 30, 2013, and 1.50 to 1.00 thereafter, (2) a quarterly EBITDA (as defined in the Loan Agreement) of $625,000 for Q4 2012, $725,000 for Q1 2013, and $875,000 thereafter, and (3) a maximum Senior Debt (as defined in the Loan Agreement) divided by trailing 12 months EBITDA of 2.50 to 1.00 through December 31, 2013, and 2.00 to 1.00 thereafter. " Aggregate annual principal payments of long-term debt for the period ending December 31: Loan Agreement 2013 $ 1,500,000 2014 1,500,000 2015 1,500,000 2016 3,000,000 Total payments $ 7,500,000 29-------------------------------------------------------------------------------- Table of Contents Repayment of Note Obligations On December 14, 2012, using proceeds of the term loan evidenced by the Loan Agreement and East West Note, Senior Secured Notes of Telanetix (and guaranteed by the other Borrowers) respectively in favor of HCP-TELA, LLC ("HCP"), EREF-TELA, LLC ("EREF"), and CBG-TELA, LLC ("CBG") (collectively, the "Lenders") in the original aggregate principal amount of $10,500,000 (collectively, the "2010 Notes") purchased by the Lenders pursuant to that certain Securities Purchase Agreement, dated as of June 30, 2010, by and among Telanetix and the Lenders, were paid in full. In connection with the payment in full of the 2010 Notes, which contractually were not prepayable, an Event of Default Redemption Price (as defined in each 2010 Note) was required to be paid. Accordingly, on December 14, 2012, the Borrowers executed and delivered Subordinated Promissory Notes to the Lenders in the aggregate original principal amount of $1,726,659.72 (collectively, the "Subordinated Notes"). The unpaid balance of the Subordinated Notes accrues interest at the Applicable Interest Rate. The principal and all accrued and unpaid interest under the Subordinated Notes are to be paid on the earliest of (a) June 14, 2017, (b) the date of the acceleration of the Subordinated Notes in accordance with the terms of the Subordinated Notes, and (c) the date of the payment in full of all obligations under the East West Note. The obligations of the Borrowers under the Subordinated Notes are secured by security interests in substantially all of the Borrowers' assets, with HCP serving as collateral agent for the Lenders, which were granted pursuant to a Security Agreement dated December 14, 2012 between the Borrowers and HCP, as collateral agent for the Lenders (the "Security Agreement"). The Security Agreement contains many of the same affirmative and negative covenants as the Loan Agreement, but does not contain any financial covenants. As a condition precedent to East West making the term loan discussed above, the Lenders and HCP, as collateral agent for the Lenders, were required to enter into a Subordination and Intercreditor Agreement (the "Subordination Agreement") with East West (which was acknowledged by the Borrowers) pursuant to which the Borrowers' obligations to the Lenders under the Subordinated Notes (and all liens and security interests granted by the Borrowers to secure those obligations) were subordinated to the obligations of the Borrowers to East West (and all liens and security interests granted by the Borrowers to secure the obligations of the Borrowers to East West). Under the Subordination Agreement, payments cannot be made or received under the Subordinated Notes, the Lenders cannot commence any action to collect on the obligations under the Subordinated Notes, and the Lenders and HCP, as collateral agent, cannot take any Enforcement Action (as defined in the Subordination Agreement) with respect to their collateral until the East West obligations are paid in full. Minimum Third Party Network Service Provider Commitments We have a contract with a third party network service provider that facilitates interconnectivity with a number of third party network service providers. The contract contains a minimum usage guarantee of $0.2 million per monthly billing cycle and expires in July 2013. The cancellation terms are a 90 day written notice prior to the then current term expiring. Critical Accounting Policies Involving Management Estimates and Assumptions Our discussion and analysis of our financial condition and results of operations is based on our consolidated financial statements. The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities and equity and disclosure of contingent liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Significant estimates include those related to the allowance for doubtful accounts; valuation of inventories; valuation of goodwill, intangible assets and property and equipment; valuation of stock based compensation expense, the valuation of warrants and conversion features; and other contingencies. On an on-going basis, we evaluate our estimates. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results could differ from those estimates under different assumptions or conditions. The following is a discussion of certain of the accounting policies that require management to make estimates and assumptions where the impact of those estimates and assumptions may have a substantial impact on our financial position and results of operations. Internally Developed Software: The Company capitalizes payroll and related costs that are directly attributable to the design, coding, and testing of the Company's software developed for internal use. The Company capitalized $0.5 million related to the development of internal use software during the years ended December 31, 2012 and 2011, respectively. Internally developed software costs, which are included in property and equipment, are amortized on a straight-line basis over an estimated useful life of two years. Amortization of these costs was $0.5 million for the years ended December 31, 2012 and 2011, respectively. 30 -------------------------------------------------------------------------------- Table of Contents Goodwill: Goodwill is not amortized but is regularly reviewed for potential impairment. The identification and measurement of goodwill impairment involves the estimation of the fair value of our reporting units. The estimates of fair value of reporting units are based on the best information available as of the date of the assessment, which primarily incorporate management assumptions about expected future cash flows. Future cash flows can be affected by changes in industry or market conditions or the rate and extent to which anticipated synergies or cost savings are realized with newly acquired entities. Impairment of Long-Lived Assets: Purchased intangible assets with finite lives are amortized using the straight-line method over the estimated economic lives of the assets, which range from five to ten years. Purchased intangible assets determined to have indefinite useful lives are not amortized. Long-lived assets, including intangible assets with finite lives, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. Determination of recoverability is based on an estimate of undiscounted future cash flows resulting from the use of the asset and its eventual disposition. Measurement of an impairment loss for long-lived assets that management expects to hold and use is based on the fair value of the asset. Long-lived assets to be disposed of are reported at the lower of carrying amount or fair value less costs to sell. Revenue Recognition: Revenues from continuing operations are derived primarily from monthly recurring fees, which are recognized over the month the service is provided, activation fees, which are deferred and recognized over the estimated life of the customer relationship, and fees from usage which are recognized as the service is provided. Income Taxes: We account for income taxes using the asset and liability method, which recognizes deferred tax assets and liabilities, determined based on the difference between the financial statement and tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to affect taxable income. Valuation allowances are established to reduce deferred tax assets when, based on available objective evidence, it is more likely than not that the benefit of such assets will not be realized. In addition, FASB guidance requires us to recognize in the consolidated financial statements only those tax positions determined to be more likely than not of being sustained. Stock Based Compensation: We measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. That cost is recognized in the Consolidated Statement of Operations over the period during which the employee is required to provide service in exchange for the award - the requisite service period. No compensation cost is recognized for equity instruments for which employees do not render the requisite service. The grant-date fair value of employee performance based share options and similar instruments is estimated using option-pricing models adjusted for the unique characteristics of those instruments. Recent Accounting Pronouncements See "Note 1 - Description of Business and Summary of Significant Accounting Policies" of the Notes to Consolidated Financial Statements included in "Item 8. Financial Statements and Supplementary Data" of Part II of this report. Off-Balance Sheet Arrangements We did not have any off-balance sheet arrangements as of the year ended December 31, 2012, nor do we have any as of April 1, 2013. |