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ACTIVE POWER INC - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations.(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion should be read in conjunction with the financial statements appearing elsewhere in this Form 10-K. This report contains forward-looking statements, within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, that involve risks and uncertainties. Our expectations with respect to future results of operations that may be embodied in oral and written forward-looking statements, including any forward looking statements that may be included in this report, are subject to risks and uncertainties that must be considered when evaluating the likelihood of our realization of such expectations. Our actual results could differ materially. The words "believe," "expect," "intend," "plan," "project," "will" and similar phrases as they relate to us are intended to identify forward-looking statements. In addition, please see the risk factors section above for a discussion of items that may affect our future results. Executive Level Overview Active Power is headquartered in Austin, Texas, where we design, manufacture, and sell our flywheel-based uninterruptible power supply ("UPS") products and modular infrastructure solutions ("MIS"), which are designed to ensure continuity for data centers and other mission critical operations in the event of power disturbances. Our products and solutions are designed to deliver continuous, conditioned ("clean") power during power disturbances and outages, voltage sags and surges, and provide ride-through power in the event of utility failure, supporting operations until utility power is restored or a longer term alternative power source, such as a diesel generator is started. We believe our products offer an advantage over those of our competitors in the areas of power density (less space used), energy efficiency, system reliability, and total cost of ownership. Our flywheel-based UPS products store kinetic energy by constantly spinning a compact steel wheel ("flywheel") driven from utility power in a low friction environment. When the utility power used to spin the flywheel fluctuates or is interrupted, the flywheel's inertia causes it to continue spinning. The resulting kinetic energy of the spinning flywheel generates electricity known as "bridging power" for short periods, until either utility power is restored or a longer term alternative power source, such as a diesel generator, takes over to generate longer-term power in the case of an extended electrical outage. The high energy efficiency our products provide reduces operating costs and provides customers a lower total cost of ownership. We offer our flywheel products with load capabilities up to 8,400kVA. Our flywheel-based UPS systems are marketed under the brand name CleanSource. As of December 31, 2013, we had shipped more than 4,000 flywheels in UPS system installations, delivering more than 900 megawatts of power to customers in more than 50 countries around the world, providing nearly 150 million runtime hours of operation. UPS product revenue may include ancillary components delivered as part of a total UPS solution. In late 2012, we introduced our next generation CleanSource 750/625HD UPS product, which we began shipping in late 2013. We also sell modular infrastructure solutions, which may incorporate our UPS products with other equipment including switchboards and a diesel generator to provide complete short- and long-term protection in the event of a power disturbance. This solution is marketed under the brand name CleanSource PowerHouse. CleanSource PowerHouse can be deployed in an International Shipping Organization ("ISO") or purpose built container depending upon location. These systems are specifically designed to handle the demands of the most technically advanced facilities requiring the highest power integrity available while maximizing up-time, useable floor space and operational efficiency. Designed to offer a highly flexible architecture to respond to a customer's constantly changing environment, our CleanSource PowerHouse systems are offered in eight standard configurations, enabling sizing for infrastructure on demand. These systems are highly differentiated as they offer flexibility in placement, space savings, rapid deployment, high energy efficiency, and just-in-time use of capital deployment. They also deliver significant value to customers as the entire system is integrated and tested prior to delivery for a repeatable simple solution. We also sell modular power infrastructure solutions to customers in a non-containerized format, typically deploying such solutions inside buildings. In 2010 we began to manufacture MIS products that leverage our expertise in containerized solutions and power distribution. These solutions are built in close cooperation with our strategic partners in the technology industry and are designed to specification. These solutions serve as the infrastructure for modular data center products and are in themselves self-contained fully-functional data centers. Modular data centers may be rapidly deployed with other modular infrastructure such as power and cooling to deliver a cost-effective alternative to traditional raised-floor data centers. Active Power designs and delivers the exterior shell and a fully outfitted interior - including electrical, cooling, monitoring, and other elements - ready for the IT channel partner to add its IT racks and servers. After the IT channel partner adds its IT equipment to our modular IT infrastructure solution, the IT channel partner has a functional data center ready for deployment at its end-user site. Finally, we offer services in the form of installation, maintenance, project management, and other professional services. Services are often sold in conjunction with the products above, and are becoming a larger part of our overall revenue. Our headquarters is located in Austin, Texas, with international offices in the United Kingdom, Germany and China. 29 -------------------------------------------------------------------------------- Table of Contents In 2013, 51% of our product revenue came from the sale of UPS systems and 49% from the sale of MIS products. Our total revenue in 2013 decreased by $14.6 million, or 19%, from 2012, primarily driven by a decrease in UPS sales, which were down $12.7 million, or 36%, over 2012. Sales of our MIS products decreased by approximately $5.1 million, or 19%, compared to 2012 as we saw a decrease in demand from our IT channel partners in the U.S. Service revenue increased 23% in 2013 compared to 2012. We sell our products to a wide array of commercial and industrial customers across a variety of vertical markets, including data centers, manufacturing, technology, broadcast and communications, financial, utilities, healthcare, government and airports. However, our primary focus is on data center applications within these vertical markets. We have expanded our global sales channels and direct sales force, selling in major geographic regions of the world, but particularly in North America, Europe and Asia. We sell our products through the following distribution methods: ? Sales made directly by Active Power; ? Manufacturer's representatives; ? Distributors; ? OEM partners; and ? Strategic IT partners. We believe a number of underlying macroeconomic trends place us in a strong position to be one of the leading providers of critical power protection and infrastructure solutions. These trends include: · the increasing cost of downtime; · a rapidly expanding need for data center infrastructure due to constant creation and usage of data; · rising costs of energy worldwide driven by volume of energy used; and · an increasing demand for economically green solutions. We have evolved significantly since the company was founded in 1992. Our early focus was on research and development of the core products that continue to enable our business today. Over the past several years, we have focused our efforts on brand, markets, and channels of distribution. The technological foundation of Active Power has yielded more than 100 worldwide patents and a highly differentiated, cost-efficient product platform that we have evolved into an expanding suite of infrastructure solutions. We have developed and implemented a go-to-market strategy to set the direction for our sales and marketing initiatives and plans around the following components: · Customer: Data center applications across vertical markets · Distribution: Partner enabled distribution strategy transacted locally · Geography: Global Markets served from four centers of operation · Products: Flywheel UPS and MIS · Value: power density, reliability, total cost of ownership · Service: Installation maintenance, project management and other professional services Our revenue derived from the Americas region was $48.6 million, $48.2 million and $50.4 million in 2011, 2012 and 2013, respectively, representing 64%, 63% and 82%, respectively, of our total revenues. Our revenue derived from customers located in EMEA was $19.1 million, $21.9 million and $6.9 million in 2011, 2012 and 2013, respectively, representing 25%, 29% and 11%, respectively, of our total revenues. Our revenue derived from customers located in Asia was $7.8 million, $6.2 million and $4.4 million in 2011, 2012 and 2013, respectively, representing 11%, 8% and 7%, respectively, of our total revenues. Our decrease in revenues in EMEA during 2013 primarily resulted from not having a repeat large order similar to the large single order we shipped in mid-2012. This order was also the reason for the increase in revenue in EMEA in 2012 compared to 2011. Our increase in revenues in the Americas in 2013 was derived from increased sales across all our product lines. The decrease in revenues in Asia was driven by non-repeated business from a small number of large customer orders. Revenue outside the North America for 2011, 2012 and 2013 was $28.4 million, $30.6 million, and $12.6 million, respectively. 30 -------------------------------------------------------------------------------- Table of Contents We believe our total revenue will grow in 2014 from both our products and services. With the introduction of the CleanSource 750/625 HD UPS products, we expect to increase our competitiveness to better serve the UPS markets. We also believe the global growth in data center demand and from cloud-based computing and storage requirements will lead to higher sales of our UPS products. We are specifically targeting those customers with large IT and power needs who have the ability to make frequent and large UPS purchases as their global operations expand. Our gross margins fluctuate on a quarterly basis depending on changes in the product and geographic mix of our revenues and were as high as 34% during the second quarter of 2013 and as low as 30% in the fourth quarter of 2013. On an annual basis, our gross profit margin decreased to 31% in 2013 from 32% in 2012. Gross margin was 24% in 2011. The decrease in gross profit margin in 2013 from 2012 was driven primarily by the fact that 2012 contained less under-absorption of manufacturing facility costs. Our operating losses were $6.9 million, $1.7 million and $7.6 million in 2011, 2012 and 2013, respectively. Our operating results include non-cash stock based compensation expenses of $1.7 million, $1.4 million and $1.7 million in 2011, 2012 and 2013, respectively. The increase in operating losses from 2012 to 2013 was due to the decline in gross revenue, coupled with a slight decline in gross margin, and a higher level of operating costs which included several unexpected items. Our operating costs increased by 2% or $0.6 million in 2013 compared to 2012, primarily due to increased engineering costs associated with the development of our latest UPS product which we began shipping in late 2013, and general and administrative expenses associated with executive transition costs and legal fee expenses, offset by lower sales and marketing costs. The larger sales price of our CleanSource PowerHouse and modular IT infrastructure orders can cause large quarterly fluctuations in our inventory, receivables and payables balances, depending on the number of such orders in progress at any point in time. This can cause material fluctuations in the level of working capital we require. If the number of such orders increases rapidly or any of these orders have payment terms that are less favorable, we will need access to more working capital to fund the growth of our business and to fulfill these orders. We extended our bank revolving line of credit in 2012 to provide a source of funding, to help fund our growth and manage our working capital requirements. We have a history of operating losses and have not yet reached operating profitability on an annual basis. We believe the success of our flywheel UPS products, our MIS products, and our service offerings combined with our focus on direct sales to customers and a lower overall operating cost base, will help us to further increase our revenues and reduce our level of operating losses. We will need to continue to focus on our operating costs and the management of cash and working capital in 2014 to maintain sufficient funds for our operating activities. Our total cash and cash equivalents at December 31, 2013 were $12.8 million, compared to $13.5 million at December 31, 2012. We believe our cash and cash equivalents and our sources of available liquidity will be sufficient to fund our current operations. In late February 2014, we raised additional funds through an underwritten public offering to provide additional funds for our future anticipated working capital needs. See Footnote 11 to the condensed consolidated financial statements of this Form 10-K for more information. Our sales cycle is such that we generally have some visibility in advance for future orders. However, a sudden change in business volume or product mix, positive or negative, from any of our business or channel partners or in our direct business can significantly impact our expected revenues and impact our ability to quickly respond to opportunities. The continued slow global economic growth has reduced our confidence in the ability to predict future revenues, and even with improving economic conditions, there is still uncertainty and risk in our forecasting. Our limited window of sales visibility does provide us with some opportunity to adjust expenditures or take other measures to reduce our cash consumption if we can see and anticipate a shortfall in revenue. This window may also give us time to identify additional sources of funding if we anticipate an increase in our working capital requirements due to increased revenues or changes in our revenue mix. A significant increase in sales, especially in our MIS business, would likely increase our working capital requirements due to the longer production time and cash cycle of sales of these products. Should additional funding be required or desirable, we expect to raise the required funds through borrowings or public or private sales of debt or equity securities. If we raise additional funds through the issuance of convertible debt or equity securities, the ownership of our stockholders could be significantly diluted. If we obtain additional debt financing, a substantial portion of our operating cash flow may be dedicated to the payment of principal and interest on such indebtedness, and the terms of the debt securities issued could impose significant restrictions on our operations. We do not know whether we will be able to secure additional funding, or funding on terms acceptable to us, to continue our operations as planned. If financing is not available, we may be required to reduce, delay or eliminate certain activities or to license or sell to others some of our proprietary technology. 31 -------------------------------------------------------------------------------- Table of Contents Results of Operations Product Revenue Product revenue primarily consists of sales of our UPS products and our MIS products. Our power quality products are comprised of our CleanSource UPS product lines and our MIS products consist of our modular power infrastructure solutions, including CleanSource PowerHouse (which are comprised of our UPS systems and some combination of third party ancillary equipment, such as diesel generators and switchgear) and our modular IT infrastructure solutions that provide a combination of power distribution, cooling capabilities, security systems, fire suppression and monitoring capabilities for our business partners. The following table summarizes for the periods indicated, a year-over-year comparison of our product revenue (in thousands): Year Annual Amount Change from Prior Year Percent Change 2013 $ 44,158 $ (17,873 ) -29 % 2012 $ 62,031 $ (619 ) -1 % 2011 $ 62,650 $ 7,003 13 % Our product revenue represented 72%, 81% and 83% of total revenue for 2013, 2012 and 2011, respectively. Our product revenue was derived from the following sources (in thousands): Change from Change from 2013 Prior Year 2012 Prior Year 2011 Product Revenue: UPS product revenue $ 22,620 $ (12,746 ) $ 35,366 $ 8,972 $ 26,394 Modular Infrastructure Solutions 21,538 (5,127 ) 26,665 (9,591 ) 36,256 Total product revenue $ 44,158 $ (17,873 ) $ 62,031 $ (619 ) $ 62,650 Our MIS products tend to have larger selling prices and derive sales from a smaller number of customers compared to sales of our UPS products. This smaller number of customers with greater gross revenue can contribute to large quarterly fluctuations in MIS revenue due to the timing of orders and shipments in any particular period. Comparison of 2013 to 2012 The decrease in our product revenue in 2013 compared to 2012 came lower sales across all product lines, but primarily UPS products. We believe the success of our business resides in a higher mix of sales of our core UPS products and we anticipate the our latest generation product will provide us the opportunity to increase revenues in our core products over the coming years. Product sales from our OEM channels, which were primarily from the sale of UPS systems, represented 16% of our product revenue for 2013 compared to 15% in 2012. Sales of our UPS products are a much smaller part of our OEM partners' total business and subject to more volatility in quarterly sales, particularly during difficult economic periods as the OEM partners focus on their core business. Product revenue from our OEM channels decreased 23% in 2013 relative to 2012, after decreasing 10% in 2012 compared to 2011. These declines reflect decreased performance from our OEM partners, primarily in the U.S. market. We have supported our OEM partners' efforts to sell total solutions to their customers that include generators and switchgear that they manufacture along with our UPS products as a total solution. If our OEM partners are successful with this strategy, we believe it will help drive an increase in our UPS product revenue. Caterpillar remains one of our largest customers and our largest OEM customer. Sales to Caterpillar represented 14% of our total revenue in 2013 compared to 13% in 2012. Product sales from our IT channel partners represented 25% of product revenues for 2013 compared to 37% in 2012. This reduction reflects decreased demand of our MIS products during 2013 from our IT channel partners, primarily by HP. The level of orders may continue to fluctuate depending on our partner's success and need for infrastructure solutions. Product revenue in the Americas was $36.4 million, or 82% of our total product revenue for 2013, compared to $37.8, or 61%, for 2012. Our revenue in the Americas decreased in 2013 compared to 2012, primarily as a result of lower UPS product revenue and the decrease in sales from our OEM channels. We sell products directly to customers in Asia and Europe and we also have a network of international distributors in other territories. In these markets, customers are more likely to purchase a total power solution such as PowerHouse from us rather than a stand-alone UPS system. This usually results in a longer selling cycle making quarterly results from these regions more inconsistent and dependent upon a smaller number of larger value transactions. Thus, the amount of revenue from our international markets can fluctuate significantly on a quarterly and annual basis. Our sales in EMEA decreased by 79% in 2013 to $4.0 million related primarily to a single large order in 2012 that did not repeat in 2013. Revenue in Switzerland was $9.3 million, or 12%, in 2012. We did not have any revenues greater than 10% concentrated in a single country outside of the United States in 2013 or 2011. 32 -------------------------------------------------------------------------------- Table of Contents Our sales in Asia decreased by 30% in 2013 to $3.8 million, which was primarily due to reduced sales in China. As a result of the events that transpired in 2013 with our distributor in China, we have done a reorganization of our sales team in that region. We still see this region as having opportunity for long term growth potential as China represents one of the largest UPS markets in the world and has the potential to become a substantial market for our products. Over time we anticipate increasing sales of our UPS and MIS products in the Asia region. We have historically experienced a lag between adding sales and service capabilities and generating meaningful revenue from a new territory. We continue to invest in sales, service and marketing capabilities in each of these regions and building brand awareness for our company and products globally. Sales of our branded products through our direct and manufacturer's representatives represented 58%, 48% and 45% of our product revenue for 2013, 2012 and 2011, respectively. As direct sales typically have higher profit margins than sales through our OEM and IT channels, we will continue to focus on building our direct sales channel to increase revenue, improve profit margins and decrease our dependency upon any particular channel partner. We believe sales of our Active Power branded products in markets that were not covered by our OEMs will continue to increase over time and will continue to become a larger percentage of our total revenue. Comparison of 2012 to 2011 The decrease of our product revenue in 2012 compared to 2011 came from lower sales of our MIS products, primarily as a result of decreased large customer project orders from our IT channel partners. We were able to partially offset this by an increase in the international sales of our UPS products which included a large amount of ancillary equipment. Product sales from our OEM channels, which were primarily from the sale of UPS systems, represented 15% of our product revenue for 2012 compared to 17% in 2011. In 2012, we saw fewer transactions but larger value transactions from our OEM channel. Product revenue from our OEM channels decreased 10% in 2012 relative to 2011, after decreasing 6% in 2011 compared to 2010. These declines reflect decreased performance from our OEM partners, specifically in the U.S. market. Sales to Caterpillar represented 13% of our total revenue in 2012 compared to 16% in 2011. Product sales from our IT channel partners represented 37% of product revenues for 2012 compared to 39% in 2011. This reduction reflects decreased demand of our MIS products during 2012 from our IT channel partners, primarily HP. North America sales were 57% of our product revenue for 2012, compared to 62% for 2011. Our North America sales decreased by 8% in 2012 compared to 2011, primarily as a result of lower MIS product revenue and the decrease in sales from our OEM channels. Our sales in EMEA increased by 21% in 2012 to $18.8 million from 2011 as we continued to expand our sales force and operations, particularly in Germany and the UK where we have had an increase in UPS sales. Our sales in Asia decreased by 24% in 2012 to $5.4 million, which was primarily due to changing our focus from Japan, after closing our regional office there, to sales in the Asia region. Sales of our branded products through our direct and manufacturer's representative channels represented 48%, 45%, and 53% of our product revenue for 2012, 2011, and 2010, respectively. Service and other revenue Service and other revenue primarily relates to revenue generated from both traditional (after-market) service work and from customer-specific system engineering. This includes revenue from design, installation, startup, repairs or reconfigurations of our products and the sale of spare or replacement parts to our OEM and end-user customers. It also includes revenue associated with the costs of travel of our service personnel and revenues or fees received upon contract deferment or cancellation. Revenue from extended maintenance contracts with our customers is also included in this revenue category. The following table summarizes for the periods indicated a year-over-year comparison of our service and other revenue (in thousands): Year Annual Amount Change from Prior Year Percent Change 2013 $ 17,541 $ 3,257 23 % 2012 $ 14,284 $ 1,452 11 % 2011 $ 12,832 $ 3,524 38 % Service and other revenue increased by 23% for 2013, compared to 2012. This increase comes from primarily increased sales in spare parts, start-up services, and project management. For our MIS customers we provide a full power solution, including site preparation, installation of an entire power solution and provision of all products required to provide a turnkey product to the end user often including maintenance services. In situations where we make sales through our OEM channel, it is typical for the OEM to provide these types of services to their end-user customers directly, so these revenue sources do not exist for our OEM sales. 33 -------------------------------------------------------------------------------- Table of Contents Service and other revenue increased by 11% for 2012, compared to 2011. This increase is primarily due to higher levels of service and contract work from direct product sales and from professional fees associated with MIS sales. We also had increased service revenues from maintenance contracts and repair related activities as our increasing installed base of UPS customers provides greater opportunities to generate such revenues. Cost of product revenue Cost of product revenue includes the cost of component parts of our products; ancillary equipment that is sourced from external suppliers; personnel; equipment and other costs associated with our assembly and test operations; costs from having underutilized facilities; depreciation of our manufacturing property and equipment; shipping costs; warranty costs; and the costs of manufacturing support functions such as logistics and quality assurance. The following table summarizes, for the periods indicated, a year-over-year comparison of our cost of product revenue (in thousands): Year Annual Amount Change from Prior Year Percent Change 2013 $ 32,825 $ (9,685 ) -23 % 2012 $ 42,510 $ (5,154 ) -11 % 2011 $ 47,664 $ 7,619 19 % The cost of product revenue decreased by 23% in 2013, while our product revenues decreased by 29%. This reflects primarily a significant increase in unabsorbed manufacturing costs in 2013. Cost of product revenue also included $0.3 million and $0.2 million of stock-based compensation expense in 2013 and 2012, respectively. The cost of product revenue as a percentage of total product revenue was 74% and 69% in 2013 and 2012, respectively. During 2013 and 2012, we operated a manufacturing facility that has a manufacturing and testing capacity significantly greater than required by our current product revenue levels. Our manufacturing facility is comprised of a large portion of our fixed costs. We incurred approximately $6.9 million and $5.8 million, in 2013 and 2012, respectively, in fixed costs for our manufacturing facility. Our manufacturing capacity is in excess of our current business requirements. We expense the excess costs of the underutilization of this facility as part of our cost of product revenues. The cost of product revenue decreased by 11% in 2012 compared to 2011, while our product revenues decreased by 1%. This reflects improved pricing on our UPS products, a change in product mix towards higher UPS sales, and a focused effort to increase efficiencies by reducing levels of unabsorbed overhead costs. Cost of product revenue also included $0.2 million of stock-based compensation expense in both 2012 and 2011. The cost of product revenue as a percentage of total product revenue was 69% in 2012, compared to 76% for 2011. Cost of service and other revenue Cost of service and other revenue includes the cost of component parts we use in service or sell as spare parts and labor and overhead costs of our service organization. This includes travel and related costs incurred in fulfilling service obligations to our customers and the costs of third party contractors used in completion of some of our professional services. The following table summarizes for the periods indicated a year-over-year comparison of our cost of service and other revenue (in thousands): Year Annual Amount Change from Prior Year Percent Change 2013 $ 9,478 $ 387 4 % 2012 $ 9,091 $ (826 ) -8 % 2011 $ 9,917 $ 3,027 44 % The cost of service and other revenue increased by 4% in 2013 while our service and other revenues increased by 23%. As a percentage of service and other revenues, our costs were 54% of revenue in 2013, compared to 64% in 2012. This decrease in the cost of service and other revenue reflects higher utilization of service personnel and improved margins for MIS systems installations. The utilization of our service personnel will be affected by the number of modular infrastructure solution products implemented in a particular period. Our costs as a percentage of revenue would be expected to increase in periods where we have a low number of installation projects. We continued to expand our service team to broaden the geographic regions where we have service capability as our total business grows. A large portion of the costs involved in operating our service organization are fixed in nature and we incur approximately $0.6 million to $1.0 million in unabsorbed overhead each quarter in 2013. We continue to work on reducing our service overhead through better utilization of our service employees and cost control measures. We believe we can grow our service capabilities substantially by adding direct technical labor only as required, without adding significant additional fixed costs. 34 -------------------------------------------------------------------------------- Table of Contents The cost of service and other revenue decreased by 8% in 2012 while our service and other revenues increased by 11%. As a percentage of service and other revenues, our costs were 64% of revenue in 2012, compared to 77% in 2011. This decrease in the cost of service and other revenue reflects higher utilization of service personnel and improved revenues on professional service work we perform for MIS systems installations. A large portion of the costs involved in operating our service organization are fixed in nature and we incurred approximately $0.4 million to $0.5 million in unabsorbed overhead each quarter in 2012. Gross profit The following table summarizes for the periods indicated a year-over-year comparison of our gross profit in total (in thousands): Year Annual Amount Change from Prior Year Percent Change Gross Margin 2013 $ 19,396 $ (5,318 ) -22 % 31 % 2012 $ 24,714 $ 6,813 38 % 32 % 2011 $ 17,901 $ (119 ) -1 % 24 % The following table shows gross margin by component, product or service, year over year. Change from Change from Year Product Prior Year Service and Other Prior Year 2013 26 % -16 % 46 % 28 % 2012 31 % 29 % 36 % 57 % 2011 24 % -14 % 23 % -12 % The decrease in gross profit margin in 2013 compared to 2012 is related to a few higher margin orders in 2012 that did not repeat in 2013. Generally, we realize lower margins on our MIS products than sales of our UPS products because they include a higher proportion of third party ancillary equipment that we are not able to resell at margins comparable to our internally manufactured UPS products. A change in sales mix driven by an increase in revenues from these higher margin products as a percentage of total revenues will result in a higher gross profit for our business. Our margins were also negatively impacted by higher unabsorbed overhead costs compared to 2012 from our manufacturing operations due to lower UPS product revenue. The increase in gross profit margin in 2012 compared to 2011 reflects the impact of a change in product mix, weighted towards sales of our UPS products and services as a percentage of our total revenue. Our margins were also positively impacted by lower unabsorbed overhead costs in 2012 compared to 2011 from our manufacturing operations due to higher UPS product revenue. Research and development Research and development expense primarily consists of compensation and related costs for employees engaged in research, development and engineering activities, third party consulting and development activities, and an allocated portion of our occupancy and other costs. The following table summarizes, for the periods indicated, a year-over-year comparison of our research and development expense (in thousands): Change from Percent of Total Year Annual Amount Prior Year Percent Change Revenue 2013 $ 7,430 $ 1,990 37 % 12 % 2012 $ 5,440 $ 701 15 % 7 % 2011 $ 4,739 $ 1,327 39 % 6 % Overall our research and development expenses were approximately $2.0 million, or 37%, higher in 2013 compared to 2012. This was primarily related to the final testing and release of our latest generation UPS product. We believe this product will offer greater power modularity and space efficiencies compared to our existing UPS products, especially as we target the higher power market segment. We increased headcount to support the development of this new product and new modular infrastructure products we believe will contribute to future growth for us. It is anticipated that our new UPS product line will allow improved profit margins and provide a larger addressable market for our UPS systems business. Our research and development efforts in 2012 and 2013 were largely focused on new configurations of our existing flywheel technology and refinements and enhancements to the standardization of our modular infrastructure solution products. Research and development expenses included approximately $0.2 million of stock-based compensation expense in both 2013 and 2012. 35 -------------------------------------------------------------------------------- Table of Contents Overall, our research and development expenses were approximately $0.7 million, or 15%, higher in 2012 compared to 2011. Our research and development efforts in 2011 and 2012 were largely focused on new configurations of our existing flywheel technology, and refinements and enhancements to the standardization of our modular infrastructure solution products. Research and development expenses included approximately $0.2 million of stock-based compensation expense in 2011. Selling and marketing Selling and marketing expense primarily consists of compensation, including variable sales compensation; related costs for sales and marketing personnel; travel; selling and marketing expenses; compensation paid to resellers and agents; an allocated portion of our occupancy and other costs; and the cost of our foreign sales operations. The following table summarizes for the periods indicated a year-over-year comparison of our selling and marketing expense (in thousands): Change from Percent of Total Year Annual Amount Prior Year Percent Change Revenue 2013 $ 12,032 $ (2,107 ) -15 % 20 % 2012 $ 14,139 $ 327 2 % 19 % 2011 $ 13,812 $ 719 5 % 18 % Selling and marketing costs were approximately $2.1 million, or 15%, lower in 2013 compared to 2012. The decrease from 2012 is primarily related to a reduction in headcount and lower commissions expense. Selling and marketing expenses include approximately $0.6 million and $0.5 million of stock-based compensation expense in 2013 and 2012, respectively. Selling and marketing expenses also includes $0.3 million in severance for terminated executives. Selling and marketing costs were approximately $0.3 million, or 2%, higher in 2012 compared to 2011. The increase from 2011 is primarily related to an increase in compensation. Selling and marketing expenses also include approximately $0.5 million of stock-based compensation expense in 2011. General and administrative General and administrative expense is primarily comprised of compensation and related costs for board, executive and administrative personnel, and professional fees. The following table summarizes for the periods indicated a year-over-year comparison of our general and administrative expense (in thousands): Change from Percent of Total Year Annual Amount Prior Year Percent Change Revenue 2013 $ 7,551 $ 690 10 % 12 % 2012 $ 6,861 $ 631 10 % 9 % 2011 $ 6,230 $ 911 17 % 8 % General and administrative expenses for 2013 increased approximately $0.7 million, or 10%, compared to 2012. This increase primarily reflects unexpected costs associated with $0.4 million in relocation and temporary living costs for executives and an increase in professional fees of $0.4 million associated with our investigations and pending lawsuits. General and administrative expenses also included approximately $0.5 million in stock-based compensation expense in both 2013 and 2012. General and administrative expenses for 2012 increased approximately $0.6 million, or 10%, compared to 2011. This increase primarily reflects costs associated with a $0.2 million impairment charge associated with tooling and demonstration equipment, a one-time restructuring charge of $0.2 million associated with our reduction in force in the third quarter of 2012, and increased professional fees of $0.2 million associated with a settled lawsuit and special shareholder meeting. General and administrative expenses also included approximately $0.8 million in stock-based compensation expense in 2011. 36 -------------------------------------------------------------------------------- Table of Contents Interest expense, net The following table summarizes the yearly changes in our net interest expense (in thousands): Year Annual Amount Change from Prior Year Percent Change 2013 $ 370 $ 43 13 % 2012 $ 327 $ 102 45 % 2011 $ 225 $ 103 84 % Interest expense in 2013 was relatively flat compared to 2012. We negotiated a $12.5 million revolving credit facility with our bank in August 2010, amended in 2012, that incurs a minimum monthly interest. Our average cash and cash equivalents balance during 2013 increased by $1.0 million, or 8%, compared to the average balance over 2012. The increase in net interest expense in 2012 primarily reflects drawdowns on our line of credit early in 2012. Our average cash and investments balance during 2012 decreased by $0.9 million, or 7%, compared to the average balance over 2011. Other income (expense), net Other income (expense) in the years ended 2013, 2012 and 2011 mostly reflects foreign exchange gains (losses) on bank accounts held in foreign currencies by our subsidiary companies and the foreign exchange impact of the settlement of intercompany balances. Income tax expense Due to operating losses, we have not recorded any income tax expenses, other than minimum or statutory costs. As of December 31, 2013 and 2012, our accumulated net operating loss carry-forward was $218.0 million and $208.0 million, respectively, and our research and development credit carry-forwards were $3.7 million and $3.3 million, respectively. We anticipate these loss carry-forward amounts may offset future taxable income that we may achieve and thus reduce future tax liabilities. However, because of uncertainty regarding our ability to use these carry-forwards and the potential limitations due to ownership changes, we have established a valuation allowance for the full amount of our net deferred tax assets. Critical Accounting Policies and Estimates We consider an accounting policy to be critical if: ? the accounting estimate requires us to make assumptions about matters that are highly uncertain or require the use of judgment at the time we make that estimate; and ? changes in the estimate that are reasonably likely to occur from period to period, or use of different estimates that we could have reasonably used instead in the current period, would have a material impact on our financial condition or results of operations. Management has reviewed the development and selection of these critical accounting estimates with the Audit Committee of our Board of Directors. In addition, there are other items within our financial statements that require estimation, but are not deemed critical as defined above. Changes in these and other items could still have a material impact upon our financial statements. Revenue recognition We generally recognize revenue when four criteria are met: (i) persuasive evidence that an arrangement exists; (ii) delivery has occurred or services have been rendered; (iii) the sales price is fixed or determinable; and (iv) collectability is reasonably assured. Revenue-generating transactions generally fall into one of the following categories of revenue recognition: ? We recognize product revenue at the time of shipment for substantially all products sold directly to customers and through distributors because title and risk of loss pass on delivery to the common carrier. Our customers and distributors do not have the right to return products. If title and risk of loss pass at some other point in time, we recognize such revenue for our customers when the product is delivered to the customer and title and risk of loss has passed. We may enter into bill-and-hold arrangements and when this occurs delivery may not be present, but other criteria are reviewed to determine proper timing of revenue recognition. ? We recognize installation and service and maintenance revenue at the time the service is performed. 37-------------------------------------------------------------------------------- Table of Contents ? We recognize revenue associated with extended maintenance agreements ("EMAs") over the life of the contracts using the straight-line method, which approximates the expected timing in which applicable services are performed. Amounts collected in advance of revenue recognition are recorded as a current liability in the deferred revenue line of the consolidated balance sheet or long-term liability based on the time from the balance sheet date to the future date of revenue recognition. ? We recognize revenue on certain rental programs over the life of the rental agreement using the straight-line method. Amounts collected in advance of revenue recognition are recorded as a current or long-term liability based on the time from the balance sheet date to the future date of revenue recognition. ? Shipping costs reimbursed by the customer are included in revenue. Multiple element arrangements ("MEAs") are arrangements to sell products to customers frequently include multiple deliverables. Our most significant MEAs include the sale of one or more of our CleanSource UPS or CleanSource PowerHouse products, combined with one or more of the following products: design services, project management, commissioning and installation services, spare parts or consumables, and extended maintenance agreements ("EMAs"). Delivery of the various products or performance of services within the arrangement may or may not coincide. Certain services related to design and consulting may occur prior to delivery of the product. Commissioning and installation typically take place within 6 months of product delivery, depending upon customer requirements. EMAs, consumables, and repair, maintenance or consulting services generally are delivered over a period of one to five years. In certain arrangements revenue recognized is limited to the amount invoiced or received that is not contingent on the delivery of future products and services. When arrangements outside the scope of software revenue recognition guidance include multiple elements, we allocate revenue to each element based on the relative selling price and recognize revenue for each element when the elements have standalone value (separate unit of accounting) and the four criteria for revenue recognition have been met. We establish the selling price of each element based on Vendor Specific Objective Evidence ("VSOE") if available, Third Party Evidence ("TPE") if VSOE is not available, or Best Estimate of Selling Price if neither VSOE nor TPE is available. We generally determine selling price based on amounts charged separately for the delivered and undelivered elements to similar customers in standalone sales of the specific elements. When arrangements include an EMA, we recognize revenue related to the EMA at the stated contractual price on a straight-line basis over the life of the agreement. We allocate our MEAs primarily among revenues for internally manufactured products, externally manufactured ancillary products, and service revenues. We use VSOE to allocate our internally manufactured products, estimated based on a historical analysis of our sales for these products outside of an MEA. We use TPE to allocate externally manufactured ancillary equipment, as these items are generally a pass through from a third party vendor to our end customers. Finally, we use best estimate of selling prices to allocate revenues to the services elements, as some of these services are not sold individually. We estimate the selling price based on a historical analysis of all service revenues sold individually outside of an MEA. Any taxes imposed by governmental authorities on our revenue-producing transactions with customers are shown in our consolidated statement of operations on a net-basis; that is excluded from our reported revenues. Inventories Inventories are priced at the lower of cost (using the first-in, first-out method) or market. We estimate inventory reserves on a quarterly basis and record reserves for obsolescence or slow-moving inventory based on assumptions about future demand and marketability of products, the impact of new product introductions, inventory turns and specific identification of items, such as product discontinuance, damaged goods or engineering/material changes. Warranty liability Estimated warranty liability costs are accrued for each of our products at the time of sale. Our estimates are principally based on assumptions regarding the lifetime warranty costs of each product, including where little or no claims experience may exist. Due to the uncertainty and potential volatility of these estimates, changes in our assumptions could have a material effect on our reported operating results. Our estimate of warranty liability is reevaluated on a quarterly basis. Experience has shown that initial data for a new product can be very volatile due to factors such as product and component failure rates, material usage and service delivery costs in correcting product failures; therefore our process relies upon long-term historical averages until actual data is available. As actual experience becomes available, it is used to modify the historical averages to ensure that the forecast is within the range of likely outcomes. The resulting balances are then compared to current spending rates to help ensure that the accruals are adequate to meet expected future obligations. 38 -------------------------------------------------------------------------------- Table of Contents Stock-based compensation We account for stock-based compensation using a fair-value based recognition method. Stock-based compensation cost is estimated at the grant date based on the fair value of the award and is recognized as an expense ratably over the requisite service period of the award. Determining the appropriate fair-value model and calculating the fair value of stock-based awards at the grant date requires considerable judgment, including estimating stock price volatility, expected option life and forfeiture rates. We develop our estimates based on historical data and market information that can change significantly over time. A small change in estimates used can have a relatively large impact on the estimated valuation. We use the Black-Scholes option valuation model to value employee stock awards. We estimate stock price volatility based upon our historical volatility. Estimated option life and forfeiture rate assumptions are derived from historical data. For stock-based compensation awards with graded vesting, we recognize compensation expense using the straight-line amortization method. Liquidity and Capital Resources Our primary sources of liquidity at December 31, 2013 are our cash and cash equivalents on hand, our bank credit facilities and projected cash flows from operating activities. If we meet our cash flow projections in our current business plan, we expect that we will have adequate capital resources to continue operating our business for at least the next 12 months. Our business plan and our assumptions around the adequacy of our liquidity are based on estimates regarding expected revenues and future costs. However, there are scenarios in which our revenues may not meet our projections, our costs may exceed our estimates or our working capital needs may be greater than anticipated. Further, our estimates may change and future events or developments may also affect our estimates. Any of these factors may change our expectation of cash usage in 2014 and beyond or significantly affect our level of liquidity. In August 2010, we entered into a Second Amended and Restated Loan and Security Agreement (the "Loan Agreement") with Silicon Valley Bank ("SVB") which increased the total line of credit available to $12.5 million subject to certain borrowing bases. This facility expanded our ability to borrow funds from U.S. receivables to include qualifying receivables from our UK operations as well, increased our ability to use inventory as collateral, and also added an ability to borrow against purchase orders. These additional bases of borrowing were designed to allow us to use the credit facility to fund inventory purchases in the event we received large or multiple sales orders that would require a major investment in inventory and work in progress such as our MIS products, to help fund our business and to manage our working capital requirements. This loan facility provides for a secured revolving line of credit in an aggregate amount of up to eighty percent (80%) of the facility amount of $15.625 million, or $12.5 million, subject to certain borrowing bases. In the event we have maintained unrestricted cash and cash equivalents of at least $6.25 million with SVB for at least 30 consecutive days, which is referred to as being in a "Streamline Period", the borrowing base formula is based on eligible accounts receivable, eligible purchase orders and eligible inventory, subject to a sublimit of $5.0 million for U.K. accounts receivable, $3.5 million for inventory and $1.5 million for purchase orders. When we are not in a Streamline Period, our borrowings are limited based on accounts receivable and purchase orders that SVB has specifically agreed to finance and a borrowing base for eligible inventory. We may also request that SVB issue letters of credit on our behalf, of up to $1.5 million, as a portion of our total loan facility. On August 5, 2010, we borrowed approximately $2.5 million in revolving loans, all of which was used to refinance all indebtedness owing from us to SVB under our previous credit facility. The credit facility increased the total credit available from our previous loan facility with SVB, which was $5.0 million, and enables us to borrow against eligible inventory, foreign receivables and customer purchase orders in addition to eligible accounts receivable. In August 2012, we entered into the Second Amendment to Second Amended and Restated Loan and Security Agreement with SVB (the "Amendment") which amends the Second Amended and Restated Loan and Security Agreement, dated as of August 5, 2010, by and between us and SVB. Pursuant to the Amendment, the maturity date of the loan facility was extended by two years, to August 5, 2014, unless earlier terminated by us, subject to any then applicable early termination fee. The Amendment further provides for, among other things, (i) adding a $1.5 million sublimit under the borrowing base formula for 91-120 day aged accounts receivable, (ii) removing eligible purchase orders from the borrowing base formula, and (iii) removing sublimits providing for the issuance of letters of credit and cash management services. Additionally, pursuant to the Amendment, the definition of "Streamline Period" was amended such that the Company will be deemed to be in a Streamline Period in the event that it has a liquidity ratio of greater than or equal to 1.75:1.00 at all times for at least 60 consecutive days; provided that a Streamline Period will automatically be in effect if we achieve such liquidity ratio as a result of the sale of our equity securities. Further, the Amendment provides for, among other things, (i) amending the finance charge on each eligible account financed by SVB to a per annum rate equal to SVB's prime rate, subject to a minimum prime rate of four percent (4.00%), plus (a) one and one-quarter percent (1.25%) when we are in a Streamline Period or (b) one and three-quarters percent (1.75%) for eligible accounts (other than eligible 91-120 day aged accounts) and two percent (2.00%) for eligible 91 to 120 day aged accounts when we are not in a Streamline Period, and (ii) reducing the interest rate upon which each inventory advance accrues interest such that each advance based upon inventory accrues interest at a per annum rate equal to SVB's prime rate, subject to a minimum prime rate of four percent (4.00%), plus (a) one and one-quarter percent (1.25%) when we are in a Streamline Period or (b) three and one half percent (3.50%) when we are not in a Streamline Period. 39 -------------------------------------------------------------------------------- Table of Contents Finance charges and interest are payable monthly, and all principal and interest is due on the maturity date of August 5, 2014. However, when we are not in a Streamline Period, we must repay advances based on receivables when we receive the receivable that has been financed, and we must repay advances based on purchase orders within 120 days of the date of the purchase order, together with all finance charges on such advances. The revolving loans made to us under this loan facility are secured by a lien on substantially all of our assets. In addition, on August 5, 2010, Active Power Solutions Limited, a wholly-owned United Kingdom subsidiary of Active Power, entered into a Guarantee and Debenture with SVB (the "Guarantee and Debenture"), pursuant to which Active Power Solutions Limited guarantied all of the obligations of Active Power under the Loan Agreement and secured its obligations under the Guarantee and Debenture with a security interest on substantially all of its assets. The Loan Agreement includes customary affirmative covenants for a credit facility of this size and type, including delivery of financial statements, compliance with laws, maintenance of insurance, and protection of intellectual property rights. Further, the Loan Agreement contains customary negative covenants for a credit facility of this size and type, including covenants that limit or restrict our ability, among other things, to dispose of assets, change our business, change our CEO or CFO without replacing such person within 120 days, have a change in control, make acquisitions, be acquired, incur indebtedness, grant liens, make investments, make distributions, repurchase stock, and enter into certain transactions with affiliates. The Loan Agreement also requires us to maintain a minimum liquidity ratio of 1.25:1. The liquidity ratio is defined as the ratio of unrestricted cash and cash equivalents and marketable securities plus eligible accounts receivable to all indebtedness owed by us to SVB. We are currently in compliance with all loan covenants under the Loan Agreement. The Loan Agreement contains customary events of default that include, among other things, non-payment defaults, covenant defaults, material adverse change defaults, insolvency defaults, material judgment defaults and inaccuracy of representations and warranty defaults. The occurrence of an event of default could result in the acceleration of obligations under the Loan Agreement, in which case we must repay all loans and related charges, fees and amounts then due and payable, and our subsidiary may be required to pay any such amounts under the Guarantee and Debenture. At the election of SVB, upon the occurrence and during the continuance of an event of default, finance charges or interest rates, as applicable, will increase an additional five percentage points (5.00%) per annum above the rate that is otherwise applicable thereto upon the occurrence of such event of default, and the collateral handling fees will increase by one-half percent (0.50%). During 2012, we borrowed amounts under this credit facility based on our short term liquidity requirements. Based on the borrowing base formula, we had an additional $3.9 million available for use at December 31, 2013 under this credit facility. A substantial increase in sales of our CleanSource PowerHouse or our modular IT infrastructure solutions products or a substantial increase in UPS sales may materially impact the amount of liquidity required to fund our operations. The amount of time between the receipt of payment from our customers and our expenditures for raw materials, manufacturing and shipment of products (the cash cycle) for sales of our CleanSource UPS product can be as short as 45 days, and is typically 60 days. However, the cash cycle on a MIS sale can be as much as 210 days, depending upon customer payment terms. We intend to mitigate the financial impact of this longer cash cycle by requiring customer deposits and periodic payments where possible from our customers. This is not always commercially feasible, and in order to increase our MIS sales, we may be required to make larger investments in inventory and receivables. These larger investments may require us to obtain additional sources of working capital, debt or equity financing in order to fund this business. Should additional funding be required or desirable, we would expect to raise the required funds through borrowings or public or private sales of debt or equity securities. If we raise additional funds through the issuance of convertible debt or equity securities, the ownership of our existing stockholders could be significantly diluted. If we obtain additional debt financing, a substantial portion of our operating cash flow may be dedicated to the payment of principal and interest on such indebtedness, and the terms of the debt securities issued could impose significant restrictions on our operations. We do not know whether we will be able to secure additional funding, or funding on terms acceptable to us, to continue our operations as planned. If financing is not available, we may be required to reduce, delay or eliminate certain activities or to license or sell to others some of our proprietary technology. 40 -------------------------------------------------------------------------------- Table of Contents Significant uses of cash Operating Activities The following table summarizes the yearly changes in cash used in operating activities (in thousands): Year Annual Amount Change from Prior Year Percent Change 2013 $ (1,307 ) $ 4,683 78 % 2012 $ (5,990 ) $ 660 10 % 2011 $ (6,650 ) $ (6,582 ) -9679 % Cash used in operating activities was $1.3 million in 2013 compared to $6.0 million in 2012. Cash used in operating activities was primarily related to our net loss of $8.4 million partially offset by changes in our net accounts receivable and deferred revenue. Changes in our net working capital, resulted in cash provided of $4.2 million in 2013, compared to cash used of $6.9 million in 2012. Cash used in operating activities in 2012 primarily related to changes in current assets and current liabilities, specifically accounts receivable. As our business activity changes, we have had to finance a larger level of inventory and receivables to support our business, particularly with our MIS products which have a much longer construction time than our UPS business. Our decrease in receivables resulted in cash provided of $9.0 million 2013, while the increase in inventories used cash of $1.8 million in 2013 and a decrease in accounts payable and accrued expenses resulted in cash used of $0.4 million. These changes reflect the frequent changes in our working capital that can result in very large fluctuation in inventory, payables and receivables, even weekly, based on the large size of some of our orders. Our change in inventory also includes a non-cash change of $0.9 million in 2013 related to items purchased as inventory for our latest generation UPS product, but later capitalized to property and equipment as test units. Our top five customers represented 57% of our total revenue during 2013. In addition, as of December 31, 2013, our five largest receivables were 52% of our total receivables. As a result of this customer concentration, our failure to collect receivables from any of these customers in a timely manner could have a significant adverse effect on our liquidity. This risk may potentially increase as we sell more PowerHouse products due to their higher average selling price. We do continue to request deposits and periodic payments from large customers where commercially possible, particularly for projects with multiple deliverables. However, the amount of such advance payments can fluctuate significantly on a quarterly basis, depending on the size and scope of customer orders at any point in time. As a result, we will need to continue to focus on management of cash and working capital in 2014 to manage the level of funds we use in our operating activities. Cash used in operating activities was $6.0 million in 2012 compared to $6.7 million in 2011. Cash used in operating activities was primarily related to changes in current assets and current liabilities, or our net working capital, specifically accounts receivable. Changes in our net working capital, resulted in cash used of $6.9 million in 2012, compared to $3.0 million in 2011. Investing Activities Investing activities primarily consist of purchases of property and equipment. The cash used in investing activities decreased from $1.1 million in 2012 to $0.9 million in 2013 as we invested less in capital improvements in 2013. Capital expenditures decreased in 2013 from 2012 by approximately $0.3 million. Our capital expenditures in 2013 primarily included investments in equipment to support our manufacturing facility, test units of our latest generation UPS product, leasehold improvements, and software. In 2011, we invested in our sales and marketing programs with CleanSource PowerHouse demonstration units in the United States, China and Germany. Financing Activities Funds provided by financing activities during 2013 primarily reflect proceeds from employee stock purchases of $0.7 million. Funds provided by financing activities during 2012 reflect the sale of approximately 2.9 million shares of our common stock, at a purchase price of $3.40 per share, for proceeds, net of issuances costs, of approximately $9.6 million. Proceeds from employee stock purchases were $0.6 million in 2012. Funds provided by financing activities in 2011 primarily reflect the draw on our revolving line of credit of $3.0 million and proceeds from employee stock purchases. 41 -------------------------------------------------------------------------------- Table of Contents Contractual Obligations In our day-to-day operations, we incur commitments to make future payments for goods and services. These arise from entering into operating leases and as we make commitments to vendors to provide us materials and services. The following table summarizes our significant contractual obligations and commitments at December 31, 2013 (in thousands): Payment due by period Less than 1 More than 5 Contractual Obligations Total year 1-3 years 3-5 years years Operating lease obligations $ 3,674 $ 1,228 $ 2,261 $ 185 $ - Purchase obligations $ 3,246 $ 3,246 $ - $ - $ - Other obligations $ 100 $ 25 $ 50 $ 25 $ - Our principal lease commitments consist of our leases for our corporate headquarters, engineering and administration facilities, and our global sales offices. Future uses of cash We believe that our cash and investments, projected cash flows from operations and sources of available liquidity will be sufficient to fund our operations for the next twelve months. However, a sudden change in business volume, positive or negative, from any of our business or channel partners, or in our direct business, or any customer-driven events such as order or delivery deferral, could significantly impact our expected revenues and cash needs. The continuing global economic instability has increased the already present challenge of predicting future revenues. We do have some opportunity to adjust expenditures or take other measures to reduce our cash consumption if we see and anticipate a shortfall in revenue, or give us time to identify additional sources of funding if we anticipate an increase in our working capital requirements due to increased revenues or changes in our revenue mix. A significant increase in sales, especially in our MIS business, would likely increase our working capital requirements, due to the longer production time and cash cycle of sales of these products. We do not expect our level of capital investments to significantly fluctuate in 2014 compared to 2013. Other factors that may affect liquidity Our cash requirements will depend on many factors, including any sales growth, the market acceptance of our products, the gross profit we are able to generate with our sales, the timing and level of development funding, the rate of expansion of our sales and marketing activities, the rate of expansion of our manufacturing processes, and the timing and extent of research and development projects. Although we are not a party to any agreement or letter of intent with respect to a potential acquisition or merger, we may enter into acquisitions or strategic arrangements in the future to help support our growth, which could also require us to seek additional equity or debt financing. Should additional funding be required or desirable, we may need to raise the required funds through borrowings or public or private sales of debt or equity securities. If we raise additional funds through the issuance of convertible debt or equity securities, the percentage ownership of our existing stockholders could be significantly diluted. If we obtain additional debt financing, a substantial portion of our operating cash flow may be dedicated to the payment of principal and interest on such indebtedness, and the terms of the debt securities issued could impose significant restrictions on our operations. We do not know whether we will be able to secure additional funding, or funding on terms acceptable to us, to continue our operations as planned. If financing is not available, we may be required to reduce, delay or eliminate certain activities or to license or sell to others some of our proprietary technology. On February 26, 2014, we entered into an underwriting agreement to sell 3,651,250 shares of our common stock at $3.15 per share in a public offering (including shares subject to the underwriter's over-allotment option). The aggregate net proceeds to us were approximately $10.5 million, after deducting $1.0 million in offering related expenses and underwriting discounts and commissions. The transaction closed on March 3, 2014. Off-Balance Sheet Arrangements During the years ended December 31, 2011, 2012 and 2013, we did not have any relationships with unconsolidated entities or financial partnerships, 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. New Accounting Pronouncements In February 2013, the FASB issued ASU 2013-02, "Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income" (AOCI). ASU 2013-02 requires a roll forward of changes in AOCI by component and information about significant reclassifications from AOCI to Net earnings to be presented in one location, either on the face of the financial statements or in the notes. This new guidance is effective for fiscal years beginning after December 15, 2012 and subsequent interim periods. The requirements of ASU 2013-02 did not have a material impact on our Consolidated Financial Statements. The only reclassification from AOCI to net earnings in 2013 was in relation to the settlement of translation on a liquidated subsidiary which was less than $0.1 million and was reflected in other income (expense), net, in the Consolidated Statement of Operations. 42-------------------------------------------------------------------------------- Table of Contents In March 2013, the FASB issued ASU 2013-05, "Parent's Accounting for the Cumulative Translation Adjustment upon Derecognition of Certain Subsidiaries or Groups of Assets within a Foreign Entity or of an Investment in a Foreign Entity." ASU 2013-05 clarifies the application of GAAP to the release of cumulative translation adjustments related to changes of ownership in or within foreign entities, including step acquisitions. This new guidance is effective for annual reporting periods beginning on or after December 15, 2013 and subsequent interim periods. We do not anticipate this pronouncement to have a material impact on our Consolidated Financial Statements. In July 2013, the FASB issued ASU 2013-11, "Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carry-forward, a Similar Tax Loss, or a Tax Credit Carry-forward Exists." ASU 2013-11 clarifies guidance and eliminates diversity in practice on the presentation of unrecognized tax benefits when a net operating loss carry-forward, a similar tax loss, or a tax credit carry-forward exists at the reporting date. This new guidance is effective for annual reporting periods beginning on or after December 15, 2013 and subsequent interim periods. We are currently assessing the impact, if any, on our Consolidated Financial Statements. |