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FUSION TELECOMMUNICATIONS INTERNATIONAL INC - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion of the Company's financial condition and results of operations should be read together with the Company's consolidated financial statements and the related notes thereto included elsewhere in this Annual Report on Form 10-K. This discussion contains certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1996. Such statements consist of any statement other than a recitation of historical fact and can be identified by the use of forward-looking terminology such as "may", "expect", "anticipate", "intend", "estimate" or "continue" or the negative thereof or other variations thereof or comparable terminology. The reader is cautioned that all forward-looking statements are speculative, and there are certain risks and uncertainties that could cause actual events or results to differ from those referred to in such forward-looking statements (see Item 1A, "Risk Factors"). OVERVIEW Our Business We are a cloud services provider delivering value-added cloud-based solutions to businesses and carriers in the United States and throughout the world. Through our Business Services business segment, we offer business products and services that are device and location agnostic and include cloud-based voice, cloud connectivity and a complement of additional cloud solutions such as storage, security and disaster recovery. Our advanced business services are flexible, scalable and rapidly deployed, lowering customers' costs of ownership and increasing productivity. Through our Carrier Services business segment, we offer domestic and international voice termination services to telecommunications carriers throughout the world, with a particular focus on providing services to and from emerging markets in Asia, the Middle East, Africa, Latin America, and the Caribbean. These services primarily utilize VoIP termination. We currently interconnect with over 270 carrier customers and vendors, who include U.S.-based carriers sending voice traffic to international destinations and foreign carriers sending voice traffic to the U.S. and internationally. Our carrier-grade network, advanced switching systems and interconnections with global carriers on six continents also reduce the cost of global voice traffic termination and expand service delivery capabilities for our Business Services segment. We manage our business segments based on gross profit and gross margin, which represents net revenue less the cost of revenue, and on net profitability after excluding certain non-cash and non-recurring items. The majority of our operations, engineering, information systems and support personnel are assigned to either the Business Services or Carrier Services business segment for segment reporting purposes. Although we believe that the Carrier Services business segment continues to be of significant value to our long term strategy, our growth strategy is focused primarily on the higher margin Business Services business segment and marketing to small and mid-sized businesses, as well as larger enterprises, using both our direct and partner distribution channels. We anticipate that this will assist us in increasing the percentage of the Company's total revenues contributed by the Business Services business segment, which we believe will complement the Company's Carrier Services business segment by providing higher margins and a more stable customer base. Recent Acquisitions On December 31, 2013, through our wholly owned subsidiary Fusion BVX LLC ("FBVX"), we completed the acquisition of substantially all of the cloud services assets used by BroadvoxGO!, LLC and its affiliate Cypress Communications, LLC (collectively, the "Broadvox Sellers") in the operation of their cloud services business. A definitive agreement to purchase these assets, including the assumption of substantially all of the related on-going liabilities incurred in the ordinary course of business (collectively, the "Broadvox Assets") was entered into on August 30, 2013, and amended on November 15, 2013 and December 16, 2013 (the "BVX Purchase Agreement"). For the year ended December 31, 2013, the business constituted by the Broadvox Assets generated unaudited revenues of approximately $32.7 million. The purchase price of the Broadvox Assets of $32.1 million was paid in cash at closing (less the $1 million deposit previously delivered to the Sellers). In accordance with the terms of the BVX Purchase Agreement, (a) the purchase price remains subject to adjustment based on certain working capital measurements described in the BVX Purchase Agreement that we expect will be finalized in the second quarter of 2014, and (b) $3.21 million of the Purchase Price is being held in escrow for a period of up to one year as collateral to secure the accuracy of the Broadvox Sellers' representations, warranties and covenants contained in the BVX Purchase Agreement. 21 -------------------------------------------------------------------------------- FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. 2013 ANNUAL REPORT ON FORM 10-K The Broadvox Assets will be integrated into our existing Business Services business segment. As provided in the BVX Purchase Agreement, we and the Broadvox Sellers entered into a Transitional Services Agreement governing the provision and receipt of certain services between the Company and the Broadvox Sellers for a transition period and covering a range of topics, including our ongoing purchase of VOIP and wholesale services from the Broadvox Sellers; our utilization of the Broadvox Sellers' network infrastructure; temporary use of financial and administrative systems owned by the Broadvox Sellers; the marketing of services offered by the Company by sales representatives of the Broadvox Sellers; and our use of certain of Broadvox Sellers' office facilities and employees. Our consolidated balance sheet as of December 31, 2013 includes the Broadvox Assets, and the results of operations generated by the Broadvox Assets will be reflected in the Company's consolidated statement of operations effective January 1, 2014. On October 29, 2012, through our wholly owned subsidiary, Fusion NBS Acquisition Corp ("FNAC"), we completed the acquisition of Network Billing Systems, LLC and certain assets and liabilities of its affiliate, Interconnect Services Group II LLC (collectively, "NBS"). NBS is a Unified Communications and cloud services provider offering a wide range of hosted voice and data products, as well as Internet, data networking and cloud services solutions to small, medium and large businesses in the United States. For the year ended December 31, 2013, the NBS customer base contributed approximately $28 million of revenue to our Business Services business segment. The aggregate purchase price for the outstanding membership interests of NBS and the assets of ISG, net of assumed liabilities, was $19.6 million, consisting of $17.75 million in cash, $0.6 million to be evidenced by promissory notes payable to the sellers of the NBS membership interests (the "Seller Notes") and 11,363,636 shares of our restricted common stock valued at $1.25 million. The purchase price has been adjusted for certain working capital measurements described in the purchase agreements. As of March 31, 2014, the Seller Notes have been paid in full. Effective as of the date of the acquisition, NBS became our wholly-owned subsidiary, and during 2013 we completed the integration of our pre-acquisition Business Services business segment into NBS' existing business. In connection with our acquisition of NBS, we entered into an Employment and Restrictive Covenant Agreement with Jonathan Kaufman, the founder and principal operating officer of NBS, and Mr. Kaufman became the President of our combined Business Services business segment. The purchase price of the Broadvox Assets and the cash portion of the NBS Purchase Price were primarily financed through the issuance of senior notes by FNAC in the principal amounts of $25.5 million and $16.5 million, respectively (see "Liquidity and Capital Resources"). The acquisition of the Broadvox Assets (the "Broadvox Transaction") and the acquisition of NBS added approximately 10,000 customer locations to our Business Services segment. These transactions are a significant component of our strategy to increase the percentage of our total revenues contributed by the Business Services business segment, which generally operates at higher profit margins than does our Carrier Services business segment. Our Performance Revenues for the year ended December 31, 2013 were $61.5 million, an increase of $17.2 million, or 38.9%, compared to the year ended December 31, 2012. Our operating loss for 2013 was $3.5 million, compared to $4.8 million in 2012, mainly due to the effects of a full year of NBS reflected in our results of operations for the year ended December 31, 2013. Our net loss was $5.1 million in 2013, compared to $5.2 million in 2012. Our Outlook We expect that the revenues and gross profit in our Business Services business segment will increase significantly in 2014 as a result of the Broadvox Transaction. However, our ability to achieve positive cash flows from operations and net profitability is dependent upon our ability to grow our revenues and successfully integrate the operations associated with the Broadvox Assets into our existing business. We believe that a successful integration would result in synergistic cost savings and operational efficiencies that would significantly narrow our operating losses. Revenues from our Carrier Services business have declined over the last few years due in large part to decreases in market rates for the termination of international traffic. We believe these declines in market rates resulted largely from increased competition, deregulation in many of the markets we serve and the use of lower cost, Internet-based technologies. While the market demand for international voice termination has seen a corresponding increase over the last few years, we have been unable to increase our revenues accordingly due to capacity limitations on our network switching platform and liquidity constraints. We are in the process of implementing new systems and equipment which will bring our network capacity to the levels necessary to compete in the current market and allow us to increase our traffic volumes, and we do not believe we will experience the same liquidity constraints that we have in the past. As a result, while we may experience additional declines in revenue during the early part of 2014, we expect to reverse this trend as we move into the second half of the year and see the results of the implementation of our new systems. 22-------------------------------------------------------------------------------- FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. 2013 ANNUAL REPORT ON FORM 10-K CRITICAL ACCOUNTING POLICIES AND ESTIMATES Our discussion and analysis of financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America ("U.S. GAPP"). The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and the related disclosure of contingent liabilities. We base these estimates on our historical experience and on various other assumptions that we believe to be reasonable under the circumstances, and these estimates form the basis for our judgments concerning the carrying values of assets and liabilities that are not readily apparent from other sources. We periodically evaluate these estimates and judgments based on available information and experience. Actual results could differ from our estimates under different assumptions and conditions. If actual results significantly differ from our estimates, our financial condition and results of operations could be materially impacted. We have identified the policies and significant estimation processes discussed below as critical to our business operations and to the understanding of our results of operations. For a detailed discussion on the application of these and other accounting policies, see Note 2 to the Consolidated Financial Statements included elsewhere in this Annual Report on Form 10-K. Revenue Recognition We recognize revenue when persuasive evidence of a sale arrangement exists, delivery has occurred or services have been rendered, the sales price is fixed and determinable, and collectability is reasonably assured. We record provisions against revenue for billing adjustments, which are based upon estimates derived from factors that include, but are not limited to, historical results, analysis of credits issued and current economic trends. The provisions for revenue adjustments are recorded as a reduction of revenue when incurred. Our revenue is primarily derived from usage fees charged to other telecommunications carriers that terminate voice traffic over the Company's network, and from the monthly recurring and usage fees charged to customers that purchase our business products and services. Variable revenue is earned based on the length of a call, as measured by the number of minutes of duration. It is recognized upon completion of the call, and is adjusted to reflect the allowance for billing adjustments. Revenue for each customer is calculated from information received through our network switches. Our customized software tracks the information from the switches and analyzes the call detail records against stored detailed information about revenue rates. This software provides us with the ability to complete a timely and accurate analysis of revenue earned in a period. We believe that the nature of this process is such that recorded revenues are unlikely to be revised in future periods. Fixed revenue is earned from monthly recurring services provided to the customer, for which the charges are contracted for over a specified period of time. Revenue recognition commences after the provisioning, testing and acceptance of the service by the customer. The recurring customer charges continue until the expiration of the contract, or until cancellation of the service by the customer. To the extent that payments received from a customer are related to a future period, the payment is recorded as deferred revenue until the service is provided or the usage occurs. Cost of Revenues Cost of revenues for our Carrier Services business segment is comprised primarily of costs incurred from other domestic and international communications carriers to originate, transport, and terminate voice calls for our carrier customers. Thus the majority of our cost of revenues for this business segment is variable, based upon the number of minutes actually used by our customers and the destinations they are calling. Call activity is tracked and analyzed with customized software that analyzes the traffic flowing through our network switch. During each period, the call activity is analyzed and an accrual is recorded for the revenues associated with minutes not yet invoiced. This cost accrual is calculated using minutes from the system and the variable cost of revenue based upon predetermined contractual rates. Fixed expenses reflect the costs associated with connectivity between our network infrastructure, including our New York switching facility, and certain large carrier customers and vendors. 23 -------------------------------------------------------------------------------- FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. 2013 ANNUAL REPORT ON FORM 10-K For our Business Services business segment, fixed expenses include the monthly recurring charges associated with certain platform services purchased from other service providers, the monthly recurring costs associated with private line services and the cost of broadband Internet access used to provide service to business customers. Accounts Receivable Accounts receivable is recorded net of an allowance for doubtful accounts. On a periodic basis, we evaluate our accounts receivable and adjust the allowance for doubtful accounts based on our history of past write-offs and collections and current credit conditions. Specific customer accounts are written off as uncollectible if the probability of a future loss has been established, collection efforts have been exhausted and payment is not expected to be received. Impairment of Long-Lived Assets We periodically review long-lived assets, including intangible assets, for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be fully recoverable. If an impairment indicator is present, we evaluate recoverability by a comparison of the carrying amount of the asset to future undiscounted net cash flows expected to be generated by the asset. If the carrying value of the asset exceeds the projected undiscounted cash flows, we are required to estimate the fair value of the asset and recognize an impairment charge to the extent that the carrying value of the asset exceeds its estimated fair value. We did not record any impairment charges for the years ended December 31, 2013 and 2012. Impairment testing for goodwill is performed annually in our fourth fiscal quarter. The impairment test for goodwill uses a two-step approach, which is performed at the reporting unit level. We have determined that our reporting units are our operating segments since that is the lowest level at which discrete, reliable financial and cash flow information is available. The authoritative guidance provides entities with an option to perform a qualitative assessment to determine if the fair value of the reporting unit is less than its carrying value. We performed a qualitative impairment evaluation on the goodwill acquired on October 29, 2012 (see note 3) and determined that no impairment existed. Income Taxes We account for income taxes in accordance with U.S. GAAP, which requires the recognition of deferred tax liabilities and assets for the expected future income tax consequences of events that have been recognized in our financial statements. Deferred income tax assets and liabilities are computed for temporary differences between the financial statement and tax bases of assets and liabilities that will result in future taxable or deductible amounts, based on enacted tax laws and rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established to reduce deferred income tax assets when we determine that it is more like than not that we will fail to generate sufficient taxable income to be able to utilize the deferred tax assets. Property and Equipment In accordance with Accounting Standards Codification 350-40, Intangibles - Goodwill and Other - Internal-Use Software, we capitalize a portion of our payroll and related costs for the development of software for internal use and amortize these costs over three years. During the years ended December 31, 2013 and 2012, we capitalized costs pertaining to the development of internally used software in the approximate amount of $794,000 and $151,000, respectively. Recently Issued Accounting Pronouncements During the years ended 2013 and 2012, there were no new accounting pronouncements adopted by the Company that had a material impact on the Company's consolidated financial statements. Management does not believe there are any recently issued but not yet effective accounting pronouncements that, if currently adopted, would have a material effect on our consolidated financial statements. 24-------------------------------------------------------------------------------- FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. 2013 ANNUAL REPORT ON FORM 10-K RESULTS OF OPERATIONS Our consolidated results of operations for the year ended December 31, 2013 reflect a full year of operations of NBS, while our consolidated results of operations for the year ended December 31, 2012 include the results of NBS subsequent to the October 29, 2012 acquisition date. Therefore, our results of operations for the year ended December 31, 2013, particularly with respect to our Business Services segment, are not comparable to the prior year. The following table summarizes our results of operations for the years ended December 31, 2013 and 2012: 2013 2012 Revenues $ 61,496,620 100.0 % $ 44,287,509 100.0 % Cost of revenues, exclusive of depreciation and amortization 42,717,176 69.5 % 37,662,371 85.0 % Gross profit 18,779,444 30.5 % 6,625,138 15.0 % Operating expenses: Depreciation and amortization 3,571,974 5.8 % 998,789 2.3 % Selling general and administrative 18,756,325 30.5 % 10,438,967 23.6 % Total operating expenses 22,328,299 36.3 % 11,437,756 25.8 % Operating loss (3,548,855 ) -5.8 % (4,812,618 ) -10.9 % Interest expense (2,638,249 ) -4.3 % (623,460 ) -1.4 % Loss on extinguishment of debt (1,105,283 ) -1.8 % (335,315 ) -0.8 % (Loss) gain on change in fair value of derivative liability (598,292 ) -1.0 % 799,500 1.8 % Other (expenses) income (22,997 ) 0.0 % (276,695 ) -0.6 % Total other (expenses) income (4,364,821 ) -7.1 % (435,970 ) -1.0 % Gain on extinguishment of accounts payable 2,883,660 4.7 % - 0.0 % Provision for income taxes (51,887 ) -0.1 % - 0.0 % Loss from Continuing Operations (5,081,903 ) -8.3 % (5,248,588 ) -11.9 % Income from discontinued operations - 0.0 % 41,345 0.1 % Net loss $ (5,081,903 ) $ (5,207,243 ) Year Ended December 31, 2013 Compared with Year Ended December 31, 2012 Revenues Consolidated revenues were $61.5 million for the year ended December 31, 2013, as compared to $44.3 million for the year ended December 31, 2012, an increase of $17.2 million, or 38.9%. Carrier services revenue of $31.1 million represents a decrease of $6.3 million, or 16.9%, from a year ago, mainly due to a 13% decrease in the number of minutes transmitted over our network and a 4% decrease in the blended rate per minute of traffic terminated. Revenues for the Business Services segment increased by approximately $23.6 million to $30.4 million for the year ended December 31, 2013, as compared to $6.8 million for the year ended December 31, 2012. Substantially all of the increase is due to the acquisition of NBS on October 29, 2012. Cost of Revenues and Gross Margin Consolidated cost of revenues was $42.7 million for the year ended December 31, 2013, as compared to $37.7 million for the year ended December 31, 2012. The increase is largely due the cost of NBS revenues for the full year in 2013, partially offset by the decrease in traffic volume in the Carrier Services business segment. Consolidated gross margin was 30.5% for the year ended December 31, 2013, compared to 15.0% in the year ended December 31, 2012. The increase is mainly due to the higher mix of Business Services revenue in 2013 resulting from the NBS acquisition. We expect this trend to continue in 2014 as revenues from the Business Services segment will comprise a larger proportion of our consolidated revenues as a result of the Broadvox Transaction. Gross margin for the Carrier Services segment was 10.5% for the year ended December 31, 2013, compared to 9.1% for the year ended December 31, 2012. The increase is mainly due to higher margins achieved through more efficient buying and selling, increased focus on more profitable bi-lateral customer/vendor relationships and to $180,000 of business interruption proceeds received in 2013 as a result of Hurricane Sandy which occurred in October of 2012. Gross Margin for the Business Services segment was 51.0% in 2013, compared to 46.8% in 2012. The increase reflects the full year impact of the NBS acquisition, as NBS generates gross margins that are significantly higher than our pre-acquisition Business Services segment. 25-------------------------------------------------------------------------------- FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. 2013 ANNUAL REPORT ON FORM 10-KDepreciation and Amortization Depreciation and amortization expense increased by $2.6 million to $3.6 million during the year ended December 31, 2013, as compared to 1.0 million for the year ended December 31, 2012. The increase is primarily due to $2.2 million of amortization expense in 2013 related to intangible assets acquired in the NBS transaction, compared with $0.4 million of comparable expense in 2012. In addition, depreciation expense on fixed assets acquired from NBS was $1.0 million in the year ended December 31, 2013, compared with $0.2 million of such expense in the prior year. We expect depreciation and amortization expense to increase significantly in 2014 when we commence amortization of the intangible assets and property and equipment acquired in the Broadvox Transaction. Selling, General and Administrative Expenses Selling, general and administrative expenses ("SG&A") increased by $8.3 million from $10.4 million in the year ended December 31, 2012 to $18.7 million in the year ended December 31, 2013. SG&A associated with the Business Services segment, primarily consisting of personnel related expenses and commissions earned by third party agents who sell our products and services, was $10.3 million in the year ended December 31, 2013, as compared with $3.5 million for the year ended December 31, 2012. The increase reflects the full year impact of the NBS acquisition. In addition, consolidated SG&A includes a broker's fee and other costs associated with the Broadvox Transaction in the amount of $0.8 million, non-recurring executive compensation payments in the amount of $0.5 million and additional compensation under the terms of an executive employment agreement in the amount of $0.3 million, none of which were present in the prior year. Operating Loss Our operating loss decreased by $1.3 million, from $4.8 million for the year ended December 31, 2012, to $3.5 million for the year ended December 31, 2013, as the $12.2 million increase in gross profit was largely offset by increases in SG&A and depreciation and amortization expense. Interest Expense Interest expense increased by $2.0 million for the year ended December 31, 2013 as compared to the year ended December 31, 2012. The increase is due to $1.8 million of interest in 2013 associated with the senior debt we incurred to finance the NBS transaction, as compared to $0.3 million in 2012, and an increase in amortization of the discount on the senior debt and deferred financing fees of $0.4 million. These amounts will increase significantly in future years due to the issuance of $25.5 million of senior debt on December 31, 2013 to finance the Broadvox Transaction (see "Liquidity and Capital Resources"). Loss on Extinguishment of Debt During the years ended December 31, 2013 and 2012, we recognized losses on the extinguishment of debt of $1.1 million and $0.3 million, respectively. These losses are related to the fair value of warrants we issued in connection with the conversion of our indebtedness into equity. Change in Fair Value of Derivative Liability During the year ended December 31, 2013, we recognized a loss on the change in fair value of our derivative liability in the amount of $0.6 million, and for the year ended December 31, 2012 we recognized a gain on the change in fair value of the derivative liability in the amount of $0.8 million. These gains and losses are related to the derivative associated with the warrants that we issued to our senior lenders in 2012, the terms of which require them to be treated as liabilities and not equity instruments (see Note 11 to the Consolidated Financial Statements). The changes in their fair value are required to be recorded through the statement of operations at each accounting period. The warrants are valued using a Black-Scholes pricing model, such that increases to our stock price result in a higher valuation of the derivative and a charge to our income statement, and decreases to our stock price result in a lower valuation and gain being recorded in our income statement. On December 31, 2013 we issued additional warrants to our senior lenders and to the purchasers of our preferred stock (see Notes 11 and 14 to the Consolidated Financial Statements). Both of these instruments are also classified as derivative liabilities under the applicable accounting guidance. As a result, we expect that we will be subject to more significant fluctuations in our income statement in 2014 and beyond based on changes in our stock price and the corresponding changes in fair value of our derivative liabilities. Other Expenses Other expenses, net of other income, for the year ended December 31, 2013 was $23,000, as compared to $0.3 million for year ended December 31, 2012, as we experienced lower losses on the sale of accounts receivable in 2013 due to reduced activity under our accounts receivable financing arrangement (see Note 4 to the Consolidated Financial Statements). 26 -------------------------------------------------------------------------------- FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. 2013 ANNUAL REPORT ON FORM 10-K Gain on Extinguishment of Accounts Payable During the year ended December 31, 2013, pursuant to the advice of counsel and based on applicable laws, we determined that we no longer had any liability pertaining to a trade payable in the amount $2.9 million. As a result, we derecognized the payable from our consolidated balance sheet and recorded a corresponding gain on the extinguishment of the liability. Discontinued Operations Discontinued Operations pertains to our former consumer segment that we exited in 2009. For the year ended December 31, 2012, we recorded a gain of approximately $41,000 resulting from a change in estimate of remaining liabilities associated with the discontinued business segment, with no comparable amount for the year ended December 31, 2013. Net Loss Net loss for the year ended December 31, 2013 was $5.1 million, as compared to $5.2 million for the year ended December 31, 2012, as the decrease in operating loss and the gain on extinguishment of accounts payable were mostly offset by the higher interest expense, loss on extinguishment of debt and change in fair value of the derivative liability. 27 -------------------------------------------------------------------------------- FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. 2013 ANNUAL REPORT ON FORM 10-K LIQUIDITY AND CAPITAL RESOURCES Since our inception, we have incurred significant operating and net losses. In addition, we have yet to generate positive cash flow from operations. At December 31, 2013, we had working capital of $1.8 million and stockholders' equity of approximately $7.0 million. At December 31, 2012, we had a net working capital deficit of $8.3 million and a stockholders' deficit of $6.1 million. Our consolidated cash balance at December 31, 2013 was $6.2 million, as compared to $0.5 million at December 31, 2012. While we believe that we have sufficient cash to fund our operations and meet our obligations for the next twelve months, we may be required to raise additional capital to support our business plan. There are no current commitments for such funds and there can be no assurances that such funds will be available to the Company as needed. Prior to fiscal 2012, we had been relying upon loans from related and non-related parties, primarily Marvin Rosen, our Chairman of the Board of Directors, and the sale of our equity securities to fund our operations. During fiscal 2012, we relied primarily on the sale of our accounts receivable, including unbilled receivables, under our agreement with Prestige Capital Corporation ("Prestige"), as well as the sale of our equity securities. During fiscal 2013, we relied primarily on the sale of our equity securities and the cash generated from the operations of our Business Services business segment to fund our operations. On December 31, 2013, we issued to a total of 82 accredited investors (the "Investors"), an aggregate of 18,480 shares of our newly designated Series B-2 Cumulative Convertible Preferred Stock, par value $0.01 per share (the "Series B-2 Preferred Stock") and (b) warrants (the "Investor Warrants") to purchase 59,136,000 shares of our common stock (the "Warrant Shares" and together with the Series B-2 Preferred Stock, the "Series B-2 Offering"). The Series B-2 Offering included the issuance of 2,052 shares of Series B-2 Preferred Stock and Investor Warrants to purchase 6,566,400 Warrant Shares upon the conversion of $2.052 million in indebtedness of the Company, including the conversion of $2.0 million of notes payable to Marvin Rosen and $52,000 of other Company indebtedness payable to Matthew Rosen, our Chief Executive Officer, and another Director of the Company. Gross cash proceeds received in 2013 from the Series B-2 Offering were $16.4 million, approximately $8.1 million of which was used to partially finance the Broadvox Transaction with the remainder, net of offering expenses, available for general corporate purposes. On January 24, 2014 we held a second closing of the Series B-2 Offering and issued to a total of 39 accredited investors an aggregate of 4,358 shares of Series B-2 Preferred Stock and warrants to purchase 13,945,600 Warrant Shares, and we received net proceeds of approximately $4.0 million, which is being used for general corporate purposes. Each share of Series B-2 Preferred Stock has a Stated Value of $1,000, and is convertible into shares of our common stock at a conversion price of $0.10 per share (the "Preferred Conversion Price"), subject to adjustment. Subject to the other terms of the Series B-2 Preferred Stock, the Series B-2 Preferred Stock sold to the Investors is convertible into an aggregate of 228,380,000 shares of our common stock (the "Conversion Shares"). The Investor Warrants may be exercised at any time following the Share Authorization Date (as defined below), for a number of Warrant Shares that is equal to 40% of the Stated Value divided by 125% of the Preferred Conversion Price, as adjusted for stock splits, combinations and reclassifications (the "Investor Warrant Exercise Price"). Following the Share Authorization Date, each Investor Warrant will be exercisable at the Investor Warrant Exercise Price for a five-year term commencing on the date of issuance. The Series B-2 Preferred Stock may not be converted, and the Investor Warrants may not be exercised, until the effective date of an amendment to our Certificate of Incorporation increasing the number of authorized shares of our common stock sufficient to permit all of the outstanding Series B-2 Preferred Stock and Investor Warrants to be converted or exercised, as the case may be, into the Company's common stock (the "Share Authorization Date"). On January 30, 2014, we filed a proxy statement with the Securities and Exchange Commission (the "SEC") seeking stockholder authorization to increase the number of authorized shares of common stock. On March 28, 2014, at our 2013 Annual Meeting of Stockholders, our shareholders ratified an increase to the number of shares of common stock we are authorized to issue to 900,000,000 and we filed the amendment to our Certificate of Incorporation on that day, such that the Share Authorization Date has occurred. Subject to certain exceptions, we also agreed that, within 45 days following the Share Authorization Date, we will file a registration statement with the SEC registering the resale of the Conversion Shares and the Warrant Shares, and to use our reasonable commercial efforts to cause the registration statement to become effective not more than 150 days thereafter. The registration rights agreement with the Investors provides that in the event the Company fails to timely file the registration statement, fails to cause the registration statement to become effective within the time provided, or fails to provide Investors with an effective registration statement permitting re-sales by the Investors, then as liquidated damages and not as a penalty, the Company is required to pay each Investor an amount equal to 1% of the aggregate amount invested by such Investor for each 30-day period or pro rata portion thereof following the date by which such registration statement should have been filed or become effective; provided, that the maximum payment to each Investor shall not exceed 6% of the aggregate amount invested by such Investor. 28 -------------------------------------------------------------------------------- FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. 2013 ANNUAL REPORT ON FORM 10-K Commencing January 1, 2016, we have the right to force the conversion of the Series B-2 Preferred Stock into common stock at the Preferred Conversion Price; provided that the volume weighted average price for our common stock is at least $0.25 for ten consecutive trading days. In addition, shares of Series B-2 Preferred Stock bear a cumulative 6% annual dividend payable quarterly in arrears commencing March 31, 2014, in cash or shares of common stock, at the option of the Company. Also during the year ended December 31, 2013, we entered into subscription agreements with 60 accredited investors, under which we issued an aggregate of 50,257,163 shares of common stock and five-year warrants to purchase 25,128,583 shares of the our common stock for aggregate consideration of $4.1 million. The warrants are exercisable at 125% of the volume weighted-average price of the Company's common stock for the 10 trading days prior to the date of closing. Contemporaneously with the completion of the acquisition of NBS on October 29, 2012, we entered into, and consummated the transactions contemplated by, a Securities Purchase Agreement and Security Agreement (the "SPA") with Praesidian Capital Opportunity Fund III, LP, Praesidian Capital Opportunity Fund III-A, LP and Plexus Fund II, LP (the "Lenders"). Under the SPA the we sold the Lenders (a) five-year senior notes in the aggregate principal amount of $6.5 million, bearing interest at the rate of 10.0% annually (the "Series A Notes"), and (b) five-year senior notes in the aggregate principal amount of $10.0 million bearing interest at the rate of 11.5% annually (the "Series B Notes"). The proceeds from the sale of the Series A Notes and Series B Notes were used to finance the majority of the cash portion of the purchase price of NBS. The Series A Notes and Series B Notes provide for the payment of interest on a monthly basis. The Series A Notes provided for monthly principal payments in the amount of $52,083 each, beginning September 30, 2013, with the outstanding principal balance being due and payable on October 27, 2017. The outstanding principal balance of the Series B Notes was originally due and payable on October 27, 2017. During the year ended December 31, 2013, we made principal payments on the Series A Notes aggregating to $0.2 million. On December 15, 2013, we sold to the Lenders Series C senior notes (the "Series C Notes") in the aggregate principal amount of $0.5 million. The proceeds were used to pay a deposit on the purchase price to the sellers of the Broadvox Assets. On December 31, 2013, the SPA was amended and restated whereby the Company sold to Praesidian Capital Opportunity Fund III, LP, Praesidian Capital Opportunity Fund III-A, LP, Plexus Fund III, L.P., Plexus Fund QP III, L.P. and United Insurance Company of America, (collectively with Plexus Fund II, L.P., the "Senior Lenders") Series D Senior Notes (the "Series D Notes") in the aggregate principal amount of $25.0 million (collectively with the Series A Notes, the Series B Notes and the Series C Notes, the "Senior Notes"). The proceeds from the Series D Notes were used to finance the acquisition of the Broadvox Assets. Under the terms of the SPA, as amended: ? Plexus Fund III, L.P., Plexus Fund QP III, L.P. and United Insurance Company of America became lenders under the SPA. ? The interest rate on all of the Senior Notes was adjusted to 11.15% per annum. ? The maturity date on all of the Senior Notes became December 31, 2018. ? Interest on all of the Senior Notes is payable monthly, and monthly principal payments aggregating $52,083 are required from January 2014 through December 2014. ? Monthly principal payments aggregating $102,083 are required from January 2015 through December 2018, with the remaining principal balance on all of the Senior Notes payable at maturity. The SPA contains a number of affirmative and negative covenants, including but not limited to, restrictions on paying indebtedness subordinate to the Senior Notes, incurring additional indebtedness, making capital expenditures, dividend payments and cash distributions by subsidiaries. In addition, at all times while the Senior Notes are outstanding, we are required to maintain a minimum cash bank balance of no less than $1.0 million in excess of any amounts outstanding under a permitted working capital line of credit and in excess of any and all cash balances held by the entities that comprise our Business Services business segment. The SPA also requires on-going compliance with various financial covenants, including leverage ratio, fixed charge coverage ratio and minimum levels of earnings before interest, taxes, depreciation and amortization. Failure to comply with any of the restrictive or financial covenants could result in an event of default and accelerated demand for repayment of the Senior Notes. We do not have the financial resources to repay the Senior Notes in the event they are accelerated. From time to time since May 15, 2013, we were not in compliance with the $1.0 million minimum cash balance requirement under the SPA. On August 14, 2013 and November 12, 2013, we entered into Waiver and Amendment Agreements to the SPA with the Lenders whereby the Lenders agreed to waive compliance with the $1.0 million minimum cash balance requirement and reduced the minimum cash balance requirement from $1.0 million to $0.5 million for certain periods. Under the SPA, as amended, we are required to maintain a minimum cash bank balance of no less than $1.0 million, in excess of any and all cash balances held at NBS and FBVX, at all times following December 31, 2013. As of and since December 31, 2013, we have been in compliance with all of the covenants contained in the SPA, including the minimum cash bank balance requirement. 29 -------------------------------------------------------------------------------- FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. 2013 ANNUAL REPORT ON FORM 10-K Under the terms of the SPA, as amended, we were required to deposit $3.0 million into an account controlled by the senior lenders, pending receipt of certain regulatory approvals for the pledging of assets as collateral for the Senior Notes. The funds will remain in escrow until such time as the necessary regulatory approvals are obtained. For as long as the funds remain in escrow, the $1.0 million minimum cash bank balance requirement is deemed satisfied. We expect to receive all of the required regulatory approvals during the second quarter of 2014, at which time the funds will be released to us. When the funds are released, we will have an additional $2.0 million of unrestricted cash available. For 2014, monthly principal and interest obligations under the Senior Notes are approximately $0.4 million. In 2015 and beyond, monthly principal and interest obligations are approximately $0.5 million. In conjunction with the sale of the Senior Notes to the Lenders, Marvin Rosen entered into an Intercreditor and Subordination agreement with us and the Lenders (the "Subordination Agreement"), whereby Mr. Rosen agreed, among other things, that the amounts owed to him by the Company would be subordinate to the Senior Notes and our other obligations to the Lenders. In connection with this agreement, on October 25, 2012 Mr. Rosen agreed to consolidate the principal amount all of his outstanding promissory notes aggregating to $3,922,364 into a new single note (the "New Rosen Note"). The New Rosen Note is unsecured, pays interest monthly at an annual rate of 7% per annum, and matures 60 days after the Senior Notes are paid in full. Although we did receive a short-term unsecured advance from Mr. Rosen of $100,000 during the year ended December 31, 2013 which was repaid in the first quarter of 2014, in view of the subordination of our obligations to Mr. Rosen to those of the Lenders, we do not expect to receive new loans or additional short term advances from Mr. Rosen to fund our future liquidity needs. While NBS has historically generated positive cash flow from operations and we expect that with the consummation of the Broadvox Transaction we will be able to generate positive cash flow from operations on a consolidated basis, the terms of the SPA prohibit any cash distributions from NBS to us. On September 12, 2011, we entered into a purchase and sale agreement with Prestige, whereby we may sell certain of our accounts receivable to Prestige at a discount in order to improve our liquidity and cash flow. Under the terms of the purchase and sale agreement, Prestige pays a percentage of the face amount of the receivables at the time of sale, and the remainder, net of the discount, is paid to us within two business days after Prestige receives payment on the receivables, which generally have 15 to 30 day terms. Since the fourth quarter of fiscal 2011 through the first quarter of 2013, this arrangement has been our primary source of liquidity. We expect that we will continue to utilize the agreement with Prestige to supplement our working capital needs until such time as we can consummate a traditional working capital line of credit. In connection with the issuance of the Senior Notes, Prestige and the Lenders entered into an agreement establishing priorities among them and reached certain agreements as to enforcing their respective rights against the Company. From time to time we have also received short term advances from Prestige which are secured by a priority lien on certain of our accounts receivable; however such advances are not attributable to a transfer of specific accounts receivable and are therefore reflected as notes payable to non-related parties in the accompanying consolidated balance sheets. During the year ended December 31, 2013, the Company received advances from Prestige totaling $0.2 million, all of which were repaid during the year, along with advance fees of approximately $12,000. We may receive similar advances on similar terms from time to time during 2014, although Prestige is under no obligation to make such advances. The Prestige agreement is currently due to expire on June 15, 2014, but automatically renews for additional nine month periods unless either party receives written notice of cancellation within 60 days prior to the scheduled expiration date. For as long as the agreement is in effect, Prestige will continue to have a first priority lien on the accounts receivable of our Carrier Services business segment and a second priority lien on the other assets of the Company. 30-------------------------------------------------------------------------------- FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. 2013 ANNUAL REPORT ON FORM 10-K A summary of the Company's cash flows for the periods indicated is as follows: Year Ended December 31, 2013 2012 Cash from continuing operations: Cash used in operating activities $ (2,733,681 ) $ (3,339,558 ) Cash used in investing activities (35,698,688 ) (18,653,468 ) Cash provided by financing activities 44,065,730 22,534,683 Increase in cash and cash equivalents from continuing operations 5,633,361 541,657 Cash from discontinued operations - (1,490 ) Net increase in cash and cash equivalents 5,633,361 540,167 Cash and cash equivalents, beginning of period 543,214 3,047 Cash and cash equivalents, end of period $ 6,176,575 $ 543,214 Cash used in operating activities was $2.7 million during the year ended December 31, 2013, compared to $3.3 million in the year ended December 31, 2012. The following table illustrates the primary components of our cash flows from operations: 2013 2012 Net income (loss) $ (5,081,903 ) $ (5,248,588 ) Non-cash expenses, gains and losses 3,433,131 1,299,330 Accounts receivable (1,514,262 ) 813,380 Accounts payable and accrued expenses 534,098 (103,041 ) Other (104,745 ) (100,639 ) Cash used in operating activities $ (2,733,681 ) $ (3,339,558 ) Cash used in investing activities was $35.7 million for the year ended December 31, 2013, compared to $18.7 million for the year ended December 31, 2012. We paid $32.1 million in cash for the acquisition of the Broadvox Assets in 2013, incurred capital expenditures of $1.3 million and paid $2.3 million for additional security deposits. During the year ended December 31, 2012, we paid $17.3 million of cash, net of cash acquired, for the NBS acquisition, $1.0 million of cash became restricted under the terms of the Senior Notes and we incurred capital expenditures in the amount of $0.4 million. We expect that our capital expenditures for 2014 will be between $2.5 million and $3.0 million. Cash provided by financing activities was $44.1 million for the year ended December 31, 2013, as compared to $22.5 million for the year ended December 31, 2012. During 2013 we raised approximately $20.0 million, net of offering expenses, from the sale of our equity securities and $25.5 million from the sale of Senior Notes, partially offset by $0.9 million of repayments of notes payable and the payment of deferred financing fees in the amount of $0.7 million. During 2012 we raised $6.9 million from the sale of our equity securities and issued the Senior Notes in the principal amount of $16.5 million to finance the NBS acquisition. We also made debt repayments to unrelated parties of approximately $0.6 million during 2012. OTHER MATTERS Inflation We do not believe inflation has a significant effect on the Company's operations at this time. Off Balance Sheet Arrangements Under SEC regulations, we are required to disclose the Company's off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on the Company's financial condition, results of operations, liquidity, capital expenditures or capital resources that are material to investors. Off-balance sheet arrangements consist of transactions, agreements or contractual arrangements to which any entity that is not consolidated with us is a party, under which we have: ? Any obligation under certain guarantee contracts. ? Any retained or contingent interest in assets transferred to an unconsolidated entity or similar arrangement that serves as credit, liquidity or market risk support to that entity for such assets. 31-------------------------------------------------------------------------------- FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. 2013 ANNUAL REPORT ON FORM 10-K ? Any obligation under a contract that would be accounted for as a derivative instrument, except that it is both indexed to the Company's stock and classified in stockholder's equity in the Company's statement of financial position. ? Any obligation arising out of a material variable interest held by us in an unconsolidated entity that provides financing, liquidity, market risk or credit risk support to us, or engages in leasing, hedging or research and development services with us. As of December 31, 2013, the Company has no off-balance sheet arrangements that have, or are reasonably likely to have, a current or future effect on the Company's financial condition, results of operations, liquidity, capital expenditures or capital resources that is material to investors. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. Not applicable for smaller reporting companies. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The Company's consolidated financial statements required by this Item are included after Item 15 of this report. |