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ONSTREAM MEDIA CORP - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion should be read together with the information contained in the Consolidated Financial Statements and related Notes included in the quarterly report. Overview We are a leading online service provider of live and on-demand corporate audio and web communications, virtual event technology and social media marketing, provided primarily to corporate (including large as well as small to medium sized businesses), education and government customers. We had approximately 86 full time employees as of August 8, 2014, with operations organized in two main operating groups: · Audio and Web Conferencing Services Group · Digital Media Services Group Our Audio and Web Conferencing Services Group consists of our Infinite Conferencing ("Infinite") division, our Onstream Conferencing Corporation ("OCC") division and our EDNet division. Our Infinite division, which operates primarily from the New York City area, and our OCC division, which operates primarily from San Diego, California, provide "reservationless" and operator-assisted audio and web conferencing services. Our EDNet division, which operates primarily from San Francisco, California, provides connectivity (in the form of high quality audio, compressed video and multimedia data communications) within the entertainment and advertising industries through its managed network, which encompasses production and post-production companies, advertisers, producers, directors, and talent. Our Digital Media Services Group consists primarily of our Webcasting division and our DMSP ("Digital Media Services Platform") division. The DMSP division includes the related UGC ("User Generated Content") and Smart Encoding divisions. Our Webcasting division, which operates primarily from Pompano Beach, Florida and has a sales and support facility in New York City, provides an array of corporate-oriented, web-based media services to the corporate market including live audio and video webcasting and on-demand audio and video streaming for any business, government or educational entity. As of October 1, 2013, the Webcasting division became responsible for sales of the MarketPlace365 service. Our DMSP division, which operates primarily from Colorado Springs, Colorado, provides an online, subscription based service that includes access to enabling technologies and features for our clients to acquire, store, index, secure, manage, distribute and transform these digital assets into saleable commodities. Our UGC division, which also operates as Auction Video and operates primarily from Colorado Springs, Colorado, provides a video ingestion and flash encoder that can be used by our clients on a stand-alone basis or in conjunction with the DMSP. Our Smart Encoding division, which operates primarily from San Francisco, California, provides both automated and manual encoding and editorial services for processing digital media. This division also provides hosting, storage and streaming services for digital media, which are provided via the DMSP. For segment information related to the revenue and operating income of these groups, see Note 7 to the Consolidated Financial Statements. Recent Developments During October and November 2013 we obtained aggregate net financing proceeds of approximately $246,000 from the issuance of partially secured promissory notes to three investors (the "Working Capital Notes"), with an initial aggregate outstanding balance of $620,000 bearing interest at 15% per annum. Working Capital Note payments are interest only during the first six months (in two quarterly payments), approximately 50% of the principal in equal monthly payments plus interest during the next eleven months and the remaining 50% of the principal balance due eighteen months after the Working Capital Note issuance date. The proceeds of the Working Capital Notes were used to repay $223,812 outstanding principal and interest due on notes previously issued by us. In addition, $125,000 in origination fees and $25,000 for a Funding Commitment Letter were deducted from the proceeds of the Working Capital Notes. In connection with the above financing, we issued, or committed to issue, to the holders of Working Capital Notes or in connection with a related finders agreement, an aggregate of 458,334 restricted common shares. 74 -------------------------------------------------------------------------------- On February 6, 2014, we received a funding commitment letter (the "Funding Letter") from J&C Resources, Inc. ("J&C"), agreeing to provide us, within twenty (20) days after our notice on or before December 31, 2014, aggregate cash funding of up to $800,000. This Funding Letter was obtained solely to demonstrate our ability to obtain short-term funds in the event other funding sources are not available, but does not represent any obligation to accept such funding on these terms and is not expected by us to be exercised. Cash provided under the Funding Letter would be in exchange for our issuance of (a) a note or notes with interest payable monthly at 15% per annum and principal payable on the earlier of a date twelve months from funding or July 1, 2015 and (b) 7.5 million unregistered common shares, which shares would be prorated in the case of partial funding. The note or notes would be unsecured and subordinated to all of our other debts, except to the extent such the terms of such debts would allow pari passu status. During fiscal 2013, we entered into a March 21, 2013 financing transaction with Sigma Opportunity Fund II, LLC ("Sigma"), which was amended on June 14, 2013, under which aggregate gross proceeds of $945,000 were received by us ("Sigma Note 1"). On February 28, 2014, the terms of Sigma Note 1 were amended so that principal and interest payments otherwise due on Sigma Note 1, starting with the December 31, 2013 payment and ending with the September 30, 2014 payment, were eliminated and replaced with monthly principal and interest payments on the last day of October and November 2014 plus a final principal and interest payment on the December 18, 2014 maturity date of Sigma Note 1, such payments aggregating $1,022,314. Sigma has the right to convert up to $395,000 of the outstanding balance of Sigma Note 1 into our common shares at a price of $1.00 per share. On February 28, 2014 we borrowed $500,000 from Sigma (from which were deducted certain fees and we repaid certain debt) pursuant to a senior secured note ("Sigma Note 2") issued to Sigma and collateralized by all of our assets, subordinated only to security interests already held in connection with outstanding financings with Rockridge Capital Holdings LLC ("Rockridge") and Thermo Credit LLC. The $500,000 principal, plus $59,447 interest (based on 17% per annum compounding monthly), is due on October 31, 2014. Sigma shall have the right to convert the Sigma Note 2 (including the accrued interest thereon), in its entirety or partially, and at its option, into our common shares at a price of $1.00 per share. In connection with the Sigma Note 2, we issued 560,000 restricted common shares to Sigma as well as reimbursed $11,354 of Sigma's legal and other expenses related to this financing. We also issued 240,000 restricted common shares to Sigma Capital Advisors, LLC ("Sigma Capital") and paid them $267,857 in advisory fees in connection with a February 28, 2014 Advisory Services Agreement. Upon our receipt of funds in excess of $2.0 million as a result of the sale of any portion of our business, however structured, including, without limitation, sale of assets, subsidiaries or business units, and/or (ii) the issuance of additional equity, debt or convertible debt capital, and/or (iii) our consolidation or merger with or into another entity, all outstanding principal and interest with respect to Sigma Note 1 and/or Sigma Note 2 will be due. See Liquidity and Capital Resources for further details with respect to the financing transactions highlighted in this Recent Developments section. 75 -------------------------------------------------------------------------------- Since November 2013, we have been involved in litigation with Intella2 and its owner, Paul Cohen, in connection with the Intella2 acquisition. On July 29, 2014, the parties entered into a settlement agreement and on August 4, 2014, the lawsuit was dismissed with prejudice by the court. Under the terms of the settlement agreement, we agreed to transfer all free conferencing customers and all associated revenues and expenses to Mr. Cohen, effective July 1, 2014, and we also agreed to pay him $20,000 ($10,000 per month in July and August) with respect to such activity before July 1, 2014. We also agreed to transfer certain computer equipment already owned by us and used to support the free conferencing business, with an estimated net book value of $20,000, to Mr. Cohen. No further purchase price or other amounts will be payable by us under the agreements entered into at the time of the November 30, 2012 acquisition. Based on the litigation settlement, we reduced the approximately $782,000 estimated liability for the unpaid portion of the purchase price to an estimated liability of $40,000, which resulted in our recognition of other income of approximately $742,000 for the nine and three months ended June 30, 2014. Revenue Recognition Revenues from recurring service are recognized when (i) persuasive evidence of an arrangement exists between us and the customer, (ii) the goods or service has been provided to the customer, (iii) the price to the customer is fixed or determinable and (iv) collectibility of the sales price is reasonably assured. Our Audio and Web Conferencing Services Group recognizes revenue from audio and web conferencing as well as customer usage of digital telephone connections. The Infinite and OCC divisions generally charge for audio conferencing and web conferencing services on a per-minute usage rate, although webconferencing services are also available for a monthly subscription fee allowing a certain level of usage. Audio conferencing and web conferencing revenue is recognized based on the timing of the customer's use of those services. The EDNet division primarily generates revenue from customer usage of digital telephone connections controlled by them. EDNet purchases digital phone lines from telephone companies and sells access to the lines, as well as separate per-minute usage charges. Network usage and bridging revenue is recognized based on the timing of the customer's usage of those services. Our Digital Media Services Group recognizes revenues from the acquisition, editing, transcoding, indexing, storage and distribution of its customers' digital media, as well as from live and on-demand internet webcasting and internet distribution of travel information. The Webcasting division charges for live and on-demand webcasting at the time an event is accessible for streaming over the Internet. Charges to customers by the DMSP division are generally based on a monthly subscription fee, as well as charges for hosting, storage and professional services. Fees charged to customers for customized applications or set-up are recognized as revenue at the time the application or set-up is completed. Charges to customers by the Smart Encoding and UGC divisions are generally based on the activity or volumes of such media, expressed in megabytes or similar terms, and are recognized at the time the service is performed. This division also provides hosting, storage and streaming services for digital media, which are provided via the DMSP. We include the DMSP and UGC divisions' revenues, along with the Smart Encoding division's revenues from hosting, storage and streaming, in the DMSP and Hosting revenue caption. We include the EDNet division's revenues from equipment sales and rentals and the Smart Encoding division's revenues from encoding and editorial services in the Other Revenue caption. We add to our customer billings for certain services an amount to recover USF contributions which we have determined that we will be obligated to pay to the FCC, related to those particular services. This additional billing to our customers is not reflected as revenue by us, but rather is recorded as a liability on our books, which liability is relieved upon our remittance of USF contributions as they are billed to us by USAC, an administrative and collection agency of the FCC. 76 -------------------------------------------------------------------------------- Results of Operations Our consolidated net loss for the nine months ended June 30, 2014 was approximately $1.0 million ($0.04 loss per share) as compared to a net loss of approximately $3.4 million ($0.20 loss per share) for the corresponding period of the prior fiscal year, a decrease in our net loss of approximately $2.4 million (70.5%). The decreased net loss was primarily due to an approximately $1.7 million, or 21.9%, decrease in compensation, including compensation paid with equity, as compared to the corresponding period of the prior fiscal year. Our consolidated net income for the three months ended June 30, 2014 was approximately $360,000 ($0.02 per share) as compared to a net loss of approximately $520,000 ($0.03 loss per share) for the corresponding period of the prior fiscal year, an improvement of approximately $880,000. The improvement was primarily due to an approximately $742,000 gain from litigation settlement, for which there was no comparable transaction in the corresponding period of the prior fiscal year. 77 -------------------------------------------------------------------------------- Nine months ended June 30, 2014 compared to the nine months ended June 30, 2013 - The following table shows, for the periods indicated, the percentage of revenue represented by items on our consolidated statements of operations. Nine months ended June 30, 2014 2013 Revenue: Audio and web conferencing 55.4 % 52.1 % Webcasting 27.0 29.4 Network usage 11.2 11.6 DMSP and hosting 5.5 5.5 Other 0.9 1.4 Total revenue 100.0 % 100.0 % Costs of revenue: Audio and web conferencing 15.1 14.5 % Webcasting 7.1 8.2 DMSP and hosting 0.9 0.8 Network usage 4.8 5.7 Other 0.2 0.3 Total costs of revenue 28.1 % 29.5 % Gross margin 71.9 % 70.5 % Operating expenses: Compensation (excluding equity) 42.7 % 45.9 % Compensation (paid with equity) 3.3 11.8 Professional fees 8.0 8.0 Other general and administrative 13.5 14.5 Depreciation and amortization 5.1 7.7 Total operating expenses 72.6 % 87.9 % Loss from operations (0.7) % (17.4) % Other expense, net: Interest expense (11.9) % (7.4) % Debt extinguishment loss (1.0) (1.1) Gain from adjustment of derivative - 0.2 liability to fair value Gain from litigation settlement 5.7 - Other income (expense), net 0.1 (0.2) Total other expense, net (7.1) % (8.5) % Net loss (7.8) % (25.9) % 78-------------------------------------------------------------------------------- The following table is presented to illustrate our discussion and analysis of our results of operations. This table should be read in conjunction with the consolidated financial statements and the notes thereto. For the nine months ended June 30, Increase (Decrease) 2014 2013 Amount Percent Total revenue $ 12,893,960 $ 13,145,441 $ (251,481) (1.9) % Total costs of revenue 3,627,860 3,884,197 (256,337) (6.6) Gross margin 9,266,100 9,261,244 4,856 0.1 % General and administrative expenses 8,699,112 10,535,898 (1,836,786) (17.4) % Depreciation and amortization 662,667 1,008,193 (345,526) (34.3) Total operating expenses 9,361,779 11,544,091 (2,182,312) (18.9) % Loss from operations (95,679) (2,282,847) (2,187,168) (95.8) % Other expense, net (909,617) (1,121,985) ( 212,368) (18.9) Net loss $ (1,005,296) $ (3,404,832) $ (2,399,536) (70.5) % Revenues and Gross Margin Consolidated operating revenue was approximately $12.9 million for the nine months ended June 30, 2014, a decrease of approximately $251,000 (1.9%) from the corresponding period of the prior fiscal year, due to decreased revenues of the Digital Media Services Group, partially offset by increased revenues of the Audio and Web Conferencing Services Group. Digital Media Services Group revenues were approximately $4.3 million for the nine months ended June 30, 2014, a decrease of approximately $404,000 (8.6%) from the corresponding period of the prior fiscal year, primarily due to a decrease in webcasting division revenues. Webcasting division revenues decreased by approximately $379,000 (9.8%) for the nine months ended June 30, 2014 as compared to the corresponding period of the prior fiscal year. We produced approximately 3,000 webcasts during the nine months ended June 30, 2014, which was approximately 800 less than the number of webcasts produced in the corresponding period of the prior fiscal year. The impact on revenue arising from the decreased number of events was partially offset by an increase in the average revenue per webcast event to $1,255 for the nine months ended June 30, 2014, which represented an increase of $182, or 17.0%, from the corresponding period of the prior fiscal year. The number of webcasts reported, as well as the resulting calculation of the average revenue per webcast event, does not include any webcast events attributed with $100 or less revenue, based on our determination that excluding such low-priced or even no-charge events increases the usefulness of this statistic. The average revenue per webcast also includes revenue billed by the webcasting division to its customers but purchased by the webcasting division from another Onstream division and thus included in that other division's reported revenues. 79 -------------------------------------------------------------------------------- We believe that our webcasting division revenues will continue to be favorably impacted during the remainder of fiscal 2014 and into fiscal 2015 by the comprehensive update to our Visual Webcaster webcasting platform (VW4), which we released in January 2013 and have been updating with new features since then. We also expect to see increased sales as a result of our Virtual Conference Center which is a multiple event conference venue with integrated webcasting (and based on our MP365 technology) as well as from iEncode, a service that allows our customers to self-encode their live professional video and attach the streams to the Visual Webcaster system in the cloud. iEncode allows them to take advantage of using their internal staff and facilities while still utilizing all of the Visual Webcaster features. Also in development is another "do it yourself" large audience webcasting product that can be run from the customer's desktop and will be available on a fixed cost monthly subscription basis that can be purchased on-line. Audio and Web Conferencing Services Group revenues were approximately $8.6 million for the nine months ended June 30, 2014, an increase of approximately $153,000 (1.8%) from the corresponding period of the prior fiscal year. This increase arose primarily from the revenues of the Infinite division of approximately $6.4 million for the nine months ended June 30, 2014, which represented an increase of approximately $266,000 (4.3%) as compared to the corresponding period of the prior fiscal year. This was in turn due to a 10.9% increase in the number of minutes billed which was approximately 109.1 million for the nine months ended June 30, 2014, as compared to approximately 98.3 million minutes for the corresponding period of the prior fiscal year. This increase in the number of minutes billed was partially offset by a decrease in average revenue per minute, which was approximately 6.0 cents for the nine months ended June 30, 2014, as compared to approximately 6.4 cents for the corresponding period of the prior fiscal year. The average revenue per minute statistic includes auxiliary services and fees that are not billed to the customer on a per minute basis. The average revenue per minute also includes revenue billed by Infinite to its customers but purchased by Infinite from another Onstream division and thus included in that other division's reported revenues. Although the decrease in average revenue per minute reflects our reactions to competitive pressures on the pricing side, we have been able to reduce our costs for the same reason. We believe that Infinite's alliances with existing and new third party conferencing providers, anticipated internal software development and other sales and marketing initiatives, should continue to favorably impact Infinite division revenues during the remainder of fiscal 2014 and into fiscal 2015. The revenues of our OCC division, which is included in the Audio and Web Conferencing Services Group, were approximately $761,000 for the nine months ended June 30, 2014, which represented an increase of approximately $27,000 (3.7%) as compared to the corresponding period of the prior fiscal year. The OCC division is being managed by our Infinite Conferencing division, which specializes in audio and web conferencing. The OCC division acquired Intella2 Inc., a San Diego-based communications company ("Intella2") on November 30, 2012. Accordingly, nine months of Intella2 revenues were recognized during the nine months ended June 30, 2014 versus just seven months of Intella2 revenues during the corresponding period of the prior fiscal year. The Intella2 acquisition included a list of over 2,500 customers as well as software licenses, equipment and network infrastructure and a non-compete. The service capabilities acquired from Intella2 include audio conferencing, web conferencing, text messaging, and voicemail. The OCC division revenues included approximately $153,000 of free conferencing business revenues for the nine months ended June 30, 2014, as compared to approximately $155,000 for the corresponding period of the prior fiscal year. Since November 2013, we have been involved in litigation with Intella2 and its owner, Paul Cohen, in connection with the Intella2 acquisition. On July 29, 2014, the parties entered into a settlement agreement and on August 4, 2014, the lawsuit was dismissed with prejudice by the court. Under the terms of the settlement agreement, we agreed to transfer all free conferencing customers and all associated revenues and expenses to Mr. Cohen, effective July 1, 2014. 80 -------------------------------------------------------------------------------- Although it appears that our consolidated revenues for fiscal 2014 will not exceed our consolidated revenues for fiscal 2013, we expect, primarily because of our expectations with respect to our recent and anticipated introductions of several new or enhanced products, to achieve revenue growth in the fourth quarter of fiscal 2014 as well as fiscal 2015, as compared to corresponding prior year periods, although this cannot be assured. Consolidated gross margin was approximately $9.3 million for the nine months ended June 30, 2014, an increase of approximately $5,000 (0.1%) from the corresponding period of the prior fiscal year. However, our consolidated gross margin percentage was 71.9% for the nine months ended June 30, 2014, versus 70.5% for the corresponding period of the prior fiscal year. This increase in percentage was primarily due to reductions in audio and web conferencing cost of sales, webcasting cost of sales (proportionally greater than the reduction in revenues) and network usage cost of sales (proportionally greater than the reduction in revenues). Effective June 2014, we renegotiated a supplier contract representing approximately $252,000 in annualized savings, which we expect will cumulatively reduce our cost of sales by approximately $63,000 for the remaining three months of fiscal 2014 as compared to the corresponding prior year period and which we expect will reduce our cost of sales by approximately $168,000 in aggregate for the first eight months of fiscal 2015 as compared to the corresponding prior year period. Primarily because of the anticipated cost savings noted above, we expect our consolidated fiscal 2014 gross margin will exceed our consolidated fiscal 2013 gross margin, although this cannot be assured. Primarily because of these anticipated cost savings as well as our expectations for revenue growth arising from our recent and anticipated introductions of several new or enhanced products, we expect our consolidated fiscal 2015 gross margin will exceed our consolidated fiscal 2014 gross margin, although this cannot be assured. Operating Expenses Consolidated operating expenses were approximately $9.4 million for the nine months ended June 30, 2014, a decrease of approximately $2.2 million (18.9%) from the corresponding period of the prior fiscal year, primarily due to an approximately $1.7 million, or 21.9%, decrease in total compensation. This decrease in total compensation was comprised of an approximately $1.1 million, or 73.1%, decrease in compensation paid with equity, and an approximately $525,000, or 8.7%, decrease in compensation other than amounts paid with equity, both as compared to the corresponding period of the prior fiscal year. In February 2013, we (as authorized by our Board of Directors) established an Executive Incentive Plan, under which the five Executives could receive fully restricted (as defined in the Executive Incentive Plan) common shares ("Executive Incentive Shares"), issued based on the Company achieving certain financial objectives (as defined in the Executive Incentive Plan). In February 2013, the initial issuance authorized under the Executive Incentive Plan was an aggregate of 2,250,000 Executive Incentive Shares, which were issued in connection with meeting certain financial objectives related to fiscal 2011 and fiscal 2012 as well as earned compensation for past service and in recognition that all options previously held by, or promised to, the Executives had been cancelled. These 2,250,000 Executive Incentive Shares were recorded on our financial statements based on their fair value at the time of the February 2013 authorization, which was $1,237,500 (based on $0.55 per share), less the approximately $100,000 Black-Scholes value of the cancelled stock options as calculated immediately before their cancellation. The net amount of approximately $1,137,000 was reflected on our financial statements as non-cash compensation expense for the nine months ended June 30, 2013, which was approximately $1.1 million greater than the approximately $75,000 (based on $0.18 to $0.21 per share) related to Executive Incentive Shares recorded during on our financial statements as non-cash compensation expense for the nine months ended June 30, 2014, in connection with meeting certain identified financial objectives related to fiscal 2014. 81 -------------------------------------------------------------------------------- During the period from June 2013 through January 2014 we made certain headcount reductions representing approximately $1.1 million in annualized savings, which accounted for an approximately $512,000 reduction in cash compensation expense for the nine months ended June 30, 2014, as compared to the corresponding prior year period. We expect these headcount reductions will also reduce our compensation expenditures by approximately $199,000 for the remaining three months of fiscal 2014 as compared to the corresponding prior year period and which we expect will reduce our compensation expenditures by approximately $159,000 in aggregate for the first seven months of fiscal 2015 as compared to the corresponding prior year period. Excluding the impact, if any, arising from any goodwill impairment charges, as well as increased general and administrative expenses related to any increased revenues, we expect our consolidated operating expenses for the remainder of fiscal year 2014 as well as fiscal 2015 to be less than the corresponding prior year amounts, although this cannot be assured. Other Expense Other expense of approximately $910,000 for the nine months ended June 30, 2014 represented an approximately $212,000 (18.9%) decrease as compared to the corresponding period of the prior fiscal year. This decrease was primarily due to an approximately $742,000 gain from litigation settlement, for which there was no comparable transaction in the corresponding period of the prior fiscal year, partially offset by an approximately $555,000, or 56.9%, increase in interest expense for the nine months ended June 30, 2014, as compared to the corresponding period of the prior fiscal year. On November 26, 2013, Intella2 and its owner Paul Cohen filed a civil lawsuit in Florida naming Onstream Media Corporation, Onstream Conferencing Corporation and Infinite Conferencing as defendants. The action alleged breach of contract with respect to payment of certain components of the purchase price for the Intella2 acquisition and related commissions and sought money damages as well as declaratory relief declaring Mr. Cohen's related non-compete agreement with us unenforceable. On December 31, 2013 we filed our response to this lawsuit, which contained various objections to the lawsuit allegations as well as a number of counterclaims. On July 29, 2014, the parties entered into a settlement agreement and on August 4, 2014, the lawsuit was dismissed with prejudice by the court. Under the terms of the settlement agreement, we agreed to transfer all free conferencing customers and all associated revenues and expenses to Mr. Cohen, effective July 1, 2014, and we also agreed to pay him $20,000 ($10,000 per month in July and August) with respect to such activity before July 1, 2014. We also agreed to transfer certain computer equipment already owned by us and used to support the free conferencing business, with an estimated net book value of $20,000, to Mr. Cohen. No further purchase price or other amounts will be payable by us under the agreements entered into at the time of the November 30, 2012 acquisition, including the Asset Purchase Agreement, the Total Free Conferencing Business Revenue Share Agreement and the Master Agent and Non-Compete Agreement. Under the terms of the settlement agreement, Mr. Cohen's non-compete agreement was cancelled and replaced by mutual agreements as to non-disparagement and non-solicitation. Prior to adjustment for the litigation settlement, the unpaid portion of the purchase price reflected as an accrued liability on our financial statements through June 30, 2014 was approximately $782,000. This represented the remaining unpaid portion of the purchase price of approximately $705,000, as determined as of the time of the initial purchase, plus accretion of approximately $74,000 reflected as interest expense on our statement of operations for the year ended September 30, 2013 and accretion of approximately $53,000 reflected as interest expense on our statement of operations for the nine months ended June 30, 2014 and less approximately $50,000 of payments made to Intella2 after closing through June 30, 2014, which were considered to be payment of the accretion (i.e., interest) instead of the purchase price (i.e., principal). 82 -------------------------------------------------------------------------------- Authoritative accounting guidance allows one year from the acquisition date for us to make adjustments to the purchase price, in the event that such adjustments are based on facts and circumstances that existed as of the acquisition date that, if known, would have resulted in such adjusted assets and liabilities as of that date. However, changes resulting from facts and circumstances arising after the acquisition date, or after the one year timeframe noted above, would be recognized in our results of operations. Based on the litigation settlement, which was reached more than one year after the acquisition date and was based on facts and circumstances arising after the acquisition date, we reduced the approximately $782,000 estimated liability for the unpaid portion of the purchase price to an estimated liability of $40,000, classified as current, which resulted in our recognition of other income of approximately $742,000 for the nine months ended June 30, 2014. The approximately $555,000 increase in interest expense was primarily attributable to (i) an approximately $329,000 increase for the aggregate of cash and non-cash interest expense recognized for Sigma Note 1 (which was initially funded in March 2013 and funded additionally in June 2013), which was approximately $430,000 for the nine months ended June 30, 2014 and approximately $101,000 for the corresponding period of the prior fiscal year and (ii) approximately $169,000 for the aggregate of cash and non-cash interest expense recognized during the nine months ended June 30, 2014 for Sigma Note 2 (which was funded in February 2014) and for which we recognized no interest expense during the corresponding period of the prior fiscal year. 83 -------------------------------------------------------------------------------- Three months ended June 30, 2014 compared to the three months ended June 30, 2013 - The following table shows, for the periods indicated, the percentage of revenue represented by items on our consolidated statements of operations. Three months ended June 30, 2014 2013 Revenue: Audio and web conferencing 54.4 % 53.0 % Webcasting 29.3 28.4 Network usage 10.2 11.7 DMSP and hosting 5.3 5.4 Other 0.8 1.5 Total revenue 100.0 % 100.0 % Costs of revenue: Audio and web conferencing 14.4 % 14.8 % Webcasting 6.9 7.1 DMSP and hosting 1.0 0.8 Network usage 4.4 4.9 Other 0.1 0.3 Total costs of revenue 26.8 % 27.9 % Gross margin 73.2 % 72.1 % Operating expenses: Compensation (excluding equity) 39.8 % 46.4 % Compensation (paid with equity) 2.5 3.0 Professional fees 7.4 5.8 Other general and administrative 13.1 14.1 Depreciation and amortization 5.1 6.8 Total operating expenses 67.9 % 76.1 % Income (loss) from operations 5.3 % (4.0) % Other income (expense), net: Interest expense (14.0) % (7.6) % Gain from litigation settlement 16.5 - Other income (expense), net 0.2 - Total other income (expense), net 2.7 % (7.6) % Net income (loss) 8.0 % (11.6) % 84 -------------------------------------------------------------------------------- The following table is presented to illustrate our discussion and analysis of our results of operations. This table should be read in conjunction with the consolidated financial statements and the notes thereto. For the three months ended June 30, Increase (Decrease) 2014 2013 Amount Percent Total revenue $ 4,485,330 $ 4,470,402 $ 14,928 0.3 % Total costs of revenue 1,203,614 1,248,482 (44,868) (3.6) Gross margin 3,281,716 3,221,920 59,796 1.9 % General and administrative expenses 2,814,966 3,098,671 (283,705) (9.2) % Depreciation and amortization 227,456 303,512 (76,056) (25.1) Total operating expenses 3,042,422 3,402,183 (359,761) (10.6) % Income (loss) from operations 239,294 (180,263) 419,557 232.7 % Other income (expense), net 120,828 (339,980) 460,808 135.5 Net income (loss) $ 360,122 $ (520,243) $ 880,365 169.2 % Revenues and Gross Margin Consolidated operating revenue was approximately $4.5 million for the three months ended June 30, 2014, an increase of approximately $15,000 (0.3%) from the corresponding period of the prior fiscal year. Digital Media Services Group revenues were approximately $1.6 million for the three months ended June 30, 2014, an increase of approximately $20,000 (1.3%) from the corresponding period of the prior fiscal year, primarily due to an increase in webcasting division revenues. Webcasting division revenues increased by approximately $48,000 (3.8%) for the three months ended June 30, 2014 as compared to the corresponding period of the prior fiscal year. We produced approximately 1,000 webcasts during the three months ended June 30, 2014, which was approximately 300 less than the number of webcasts produced in the corresponding period of the prior fiscal year. The impact on revenue arising from the decreased number of events was offset by an increase in the average revenue per webcast event to $1,368 for the three months ended June 30, 2014, which represented an increase of $343, or 33.4%, from the corresponding period of the prior fiscal year. The number of webcasts reported, as well as the resulting calculation of the average revenue per webcast event, does not include any webcast events attributed with $100 or less revenue, based on our determination that excluding such low-priced or even no-charge events increases the usefulness of this statistic. The average revenue per webcast also includes revenue billed by the webcasting division to its customers but purchased by the webcasting division from another Onstream division and thus included in that other division's reported revenues. 85 -------------------------------------------------------------------------------- Audio and Web Conferencing Services Group revenues were approximately $2.9 million for the three months ended June 30, 2014, a decrease of approximately $5,000 (0.2%) from the corresponding period of the prior fiscal year. The revenues of the Infinite division of approximately $2.2 million for the three months ended June 30, 2014 represented an increase of approximately $142,000 (6.9%) as compared to the corresponding period of the prior fiscal year. This was in turn due to an 8.6% increase in the number of minutes billed which was approximately 37.6 million for the three months ended June 30, 2014, as compared to approximately 34.6 million minutes for the corresponding period of the prior fiscal year. The average revenue per minute was approximately 6.1 cents for the three months ended June 30, 2014, as well as for the corresponding period of the prior fiscal year. The average revenue per minute statistic includes auxiliary services and fees that are not billed to the customer on a per minute basis. The average revenue per minute also includes revenue billed by Infinite to its customers but purchased by Infinite from another Onstream division and thus included in that other division's reported revenues. Although the decrease in average revenue per minute reflects our reactions to competitive pressures on the pricing side, we have been able to reduce our costs for the same reason. The revenues of our OCC division, which is included in the Audio and Web Conferencing Services Group, were approximately $233,000 for the three months ended June 30, 2014, which represented a decrease of approximately $73,000 (23.8%) as compared to the corresponding period of the prior fiscal year. The total revenues from those operations included approximately $44,000 of free conferencing business revenues for the three months ended June 30, 2014, as compared to approximately $61,000 for the corresponding period of the prior fiscal year. As discussed above, as part of a July 29, 2014 settlement of litigation with Intella2 and its owner, Paul Cohen, in connection with the Intella2 acquisition, we agreed to transfer all free conferencing customers and all associated revenues and expenses to Mr. Cohen, effective July 1, 2014. Consolidated gross margin was approximately $3.3 million for the three months ended June 30, 2014, an increase of approximately $60,000 (1.9%) from the corresponding period of the prior fiscal year. In addition, our consolidated gross margin percentage was 73.2% for the three months ended June 30, 2014, versus 72.1% for the corresponding period of the prior fiscal year. This increase in percentage was primarily due to reductions in audio and web conferencing cost of sales and webcasting cost of sales (proportionally greater than the reduction in revenues). Operating Expenses Consolidated operating expenses were approximately $3.0 million for the three months ended June 30, 2014, a decrease of approximately $360,000 (10.6%) from the corresponding period of the prior fiscal year, primarily due to an approximately $288,000, or 13.9%, decrease in compensation other than amounts paid with equity, as compared to the corresponding period of the prior fiscal year. During the period from June 2013 through January 2014 we made certain headcount reductions representing approximately $1.1 million in annualized savings, which accounted for an approximately $219,000 reduction in cash compensation expense for the three months ended June 30, 2014, as compared to the corresponding prior year period. Other Income Other income of approximately $121,000 for the three months ended June 30, 2014 represented an approximately $461,000 increase in income as compared to the approximately $340,000 of other expense for the corresponding period of the prior fiscal year. This increase was primarily due to an approximately $742,000 gain from litigation settlement, for which there was no comparable transaction in the corresponding period of the prior fiscal year, partially offset by an approximately $230,000, or 85.2%, increase in interest expense for the three months ended June 30, 2014, as compared to the corresponding period of the prior fiscal year. As discussed above, based on the conditions of a July 29, 2014 settlement of litigation with Intella2 and its owner, Paul Cohen, in connection with the Intella2 acquisition, we reduced the approximately $782,000 estimated liability for the unpaid portion of the purchase price to an estimated liability of $40,000, classified as current, which resulted in our recognition of other income of approximately $742,000 for the three months ended June 30, 2014. 86 -------------------------------------------------------------------------------- The approximately $230,000 increase in interest expense was primarily attributable to (i) an approximately $78,000 increase for the aggregate of cash and non-cash interest expense recognized for Sigma Note 1 (which was initially funded in March 2013 and funded additionally in June 2013), which was approximately $179,000 for the three months ended June 30, 2014 and approximately $101,000 for the corresponding period of the prior fiscal year and (ii) approximately $139,000 for the aggregate of cash and non-cash interest expense recognized during the three months ended June 30, 2014 for Sigma Note 2 (which was funded in February 2014) and for which we recognized no interest expense during the corresponding period of the prior fiscal year. Liquidity and Capital Resources For the year ended September 30, 2013, we had a net loss of approximately $7.2 million, although cash provided by operating activities for that period was approximately $504,000. For the nine months ended June 30, 2014, we had a net loss of approximately $1.0 million, although cash provided by operating activities for that period was approximately $499,000. Although we had cash of approximately $600,000 at June 30, 2014, we had a working capital deficit of approximately $6.2 million at that date. In December 2007, we entered into a line of credit arrangement (the "Line") with a financial institution (the "Lender") under which we may presently borrow up to an aggregate of $2.0 million for working capital, collateralized by our accounts receivable and certain other related assets. Borrowings under the Line are subject to certain formulas with respect to the amount and aging of the underlying receivables. The outstanding balance (approximately $1.7 million as of June 30, 2014 and as of August 8, 2014) bears interest at 12.0% per annum, adjustable based on changes in prime, plus a weekly monitoring fee of one twentieth of a percent (0.05%) of the borrowing limit. Although the Line expired on December 27, 2013, we and the Lender have been actively working together to complete the documentation for the renewal of that Line and on January 13, 2014 we received a letter from the Lender confirming that they will be renewing the Line through December 31, 2015, with terms materially equivalent to the just expired Line. Those terms include a commitment fee, which is calculated as one percent (1%) per year of the maximum allowable borrowing amount and paid in annual installments. However, pending the formal renewal of the Line, we agreed in August 2014 to pay a commitment fee calculated on a pro-rata basis for eight months payable August 31, 2014 and a pro-rata monthly commitment fee thereafter. The outstanding principal is due on demand in the event a payment default is uncured one (1) day after written notice. The outstanding principal balance due under the Line may be repaid by us at any time, and the term may be extended by us for an extra year, subject to compliance with all loan terms, including no material adverse change, as well as concurrence of the Lender. The Line is also subject to us maintaining an adequate level of receivables, based on certain formulas, as well as our compliance with a quarterly debt service coverage covenant (the "Covenant"). The Covenant requires that the sum of (i) our net income or loss, adjusted to remove all non-cash expenses as well as cash interest expense and (ii) contributions to capital (less cash distributions and/or cash dividends paid during such period) and proceeds from subordinated unsecured debt, be equal to or greater than the sum of cash payments for interest and debt principal payments. We have complied with this Covenant for all applicable quarters through June 30, 2014. The terms of the Line require that all funds remitted by our customers in payment of receivables be deposited directly to a bank account owned by the Lender. Once those deposited funds become available, the Lender is then required to immediately remit them to our bank account, provided that we are not in default under the Line and to the extent those funds exceed any past due principal, interest or other payments due under the Line, which the Lender may offset before remitting the balance. 87 -------------------------------------------------------------------------------- On March 21, 2013 (the "Sigma Closing") we closed a transaction with Sigma Opportunity Fund II, LLC ("Sigma"), under which we would receive up to $800,000 pursuant to a senior secured note ("Sigma Note 1") issued to Sigma and collateralized by all of our assets, subordinated only to security interests already held in connection with outstanding financings with Thermo Credit and Rockridge. Sigma remitted $600,000 (net of certain fees and expenses discussed below) to us at the Sigma Closing, and the funding of the remaining $200,000 ("Contingent Financing") was subject to us meeting certain revenue and operating cash flow targets for either the three months ended June 30, 2013 or the six months ended September 30, 2013, as well as making all scheduled principal and interest payments on our indebtedness to Sigma and our other lenders. On June 14, 2013, Sigma Note 1 was amended to provide that we would receive immediate additional funding of $345,000, which would be in lieu of the $200,000 Contingent Financing. Furthermore, this $345,000 would be subject to the same terms as the Contingent Financing, in that it would be repayable as a balloon payment due on December 18, 2014 and prior to repayment, along with the previous balloon payment of $50,000 for a total balloon payment of $395,000, would be convertible into restricted common shares, at Sigma's option, using a conversion rate of $1.00 per share. After the amendment the total gross proceeds received under Sigma Note 1 was $945,000. Interest, computed at 17% per annum on the outstanding principal balance, was payable in monthly installments commencing April 30, 2013 and principal was payable in monthly installments commencing June 30, 2013. The required payments were made through November 30, 2013. On February 28, 2014, the terms of Sigma Note 1 were amended so that principal and interest payments otherwise due on Sigma Note 1, starting with the December 31, 2013 payment and ending with the September 30, 2014 payment, were eliminated and replaced with monthly principal and interest payments on the last day of October and November 2014 plus a final principal and interest payment on the December 18, 2014 maturity date of Sigma Note 1. As of February 28, 2014, the outstanding principal balance under Sigma Note 1 was approximately $895,000 (including accrued interest made a part of that balance) and all other terms of the Sigma Note remain in effect. Interest at 17% per annum will continue to accrue on the outstanding principal balance (including the portion representing these eliminated principal and interest payments), compounding monthly and added to the respective note principal amount until paid. After giving effect to the February 28, 2014 modification, the payments due under Sigma Note 1 are as follows: October 31, 2014 $50,000 principal plus $13,991 interest November 30, 2014 $50,000 principal plus $13,282 interest December 18, 2014 $887,599 principal (including previously accrued interest made part of principal) plus $7,441 interest Sigma Note 1 may be prepaid by us at any time, provided, however, that if Sigma Note 1 is prepaid during the twelve months immediately following the Sigma Closing, we shall pay an additional 90 days of interest on the then outstanding principal as of such prepayment date. If following the Sigma Closing we receive proceeds from the sale of a business unit and/or in connection with the issuance of additional equity, debt or convertible debt capital in the amounts listed in the table below, calculated on an aggregate basis subsequent to the Sigma Closing ("Aggregate Capital Raise"), we are required to immediately repay to Sigma the indicated amount ("Early Repayment Amount"), applied first toward repayment of interest and then toward principal. Aggregate Capital Raise Early Repayment Amount $500,000 to $1,000,000 Lesser of outstanding principal plus interest or 25% of Capital Raise $1,000,001 to $2,000,000 Lesser of outstanding principal plus interest or 50% of Capital Raise (reduced by any amounts previously repaid as a result of a Capital Raise transaction) $2,000,001 or Higher All outstanding principal plus Interest must be paid 88 -------------------------------------------------------------------------------- The Aggregate Capital Raise excludes (i) advances received by us against accounts receivable from Thermo Credit pursuant to the Line, or any successor agreement entered into on materially the same terms, (ii) up to $330,000 of additional subordinated financing obtained by us on materially the same as certain previously-agreed terms and (iii) the additional amounts received in June 2013 from Sigma. In connection with the initial March 2013 financing, we issued 300,000 restricted common shares to Sigma and agreed to reimburse up to $30,000 of Sigma's legal and other expenses related to this financing, $27,500 of which was paid by us at the Sigma Closing. We also issued 60,000 restricted common shares to Sigma Capital Advisors, LLC ("Sigma Capital") and agreed to pay them a $75,000 advisory fee, in connection with an Advisory Services Agreement we entered into with Sigma Capital effective March 18, 2013. $55,000 of the cash fee was paid by us at the Sigma Closing and the remaining $20,000 was paid over the next four months. We also paid finders and other fees to other third parties in connection with this transaction, which totaled 60,000 restricted common shares and $12,000 cash. In connection with the June 2013 amendment, we issued 325,000 restricted common shares to Sigma and made payments aggregating $45,000 to Sigma and Sigma Capital, representing an administrative fee plus reimbursement of Sigma's other cost and expenses related to this financing. We also issued 125,000 restricted common shares to Sigma Capital. Including the value of the common stock issued plus the amount of cash paid for related financing fees and expenses results in an effective interest rate of approximately 56% per annum (which was 60% per annum for the period prior to the June 2013 amendment). Effective February 28, 2014, a portion of the value of the common shares issued and the fees paid in connection with Sigma Note 2, aggregating $124,655, was allocated to Sigma Note 1 and that amount is being amortized as interest over the remaining term of Sigma Note 1. When combined with the amortization of the remaining unamortized discount arising from the initial March 2013 financing and the June 2013 amendment, the resulting effective interest rate as of February 28, 2014 is approximately 66% per annum, which would increase in the event an Early Repayment Amount was required, as discussed above. For so long as Sigma Note 1 is outstanding, if at any time after the Sigma Closing we issue additional shares of common stock (other than as a result of common stock equivalents already issued prior to the Issuance Date) or common stock equivalents in an amount which exceeds, in the aggregate, 25% of our fully diluted shares (as defined) as of the Sigma Closing, whether through one or multiple issuances, then provided the proceeds of such issuance are not being used to pay all outstanding amounts owed under Sigma Note 1, we shall issue to Sigma and Sigma Capital, respectively, such number of shares of common stock as is necessary for Sigma and Sigma Capital to maintain the same beneficial ownership percentage of our capital stock, on a fully diluted basis, after the additional shares issuance as they had immediately before the additional shares issuance. If, at the time of any additional share issuance, Sigma has not converted all or a portion of the amount of Sigma Note 1 eligible for conversion to common shares, we shall reserve for future issuance to Sigma upon any subsequent conversion, and shall issue to Sigma upon any subsequent conversion, such number of shares of common stock as to which Sigma would have been entitled hereunder had Sigma converted the unconverted amount immediately prior to the additional shares issuance. Notwithstanding the above, this provision shall only apply to beneficial ownership resulting from transactions related to Sigma Note 1 or the March 18, 2013 Advisory Services Agreement and shall not apply to our issuance of common stock or common stock equivalents in connection with our acquisition of another entity or the material portion of the assets of another entity, which transaction results in operating cash flow in excess of any related debt service. We completed another transaction with Sigma on February 28, 2014, under which we borrowed $500,000 (from which were deducted certain fees and we repaid certain debt as discussed below) pursuant to a senior secured note ("Sigma Note 2") issued to Sigma and collateralized by all of our assets, subordinated only to security interests already held in connection with outstanding financings with Rockridge and Thermo Credit LLC. The $500,000 principal, plus $59,447 interest (based on 17% per annum compounding monthly), is due on October 31, 2014. Sigma shall have the right to convert Sigma Note 2 (including the accrued interest thereon), in its entirety or partially, and at its option, into our common shares at a price of $1.00 per share. 89 -------------------------------------------------------------------------------- In connection with the February 28, 2014 closing and funding of Sigma Note 2, we issued 350,000 restricted common shares to Sigma as well as reimbursed $11,354 of Sigma's legal and other expenses related to this financing. In connection with a February 28, 2014 Advisory Services Agreement, we also issued 150,000 restricted common shares to Sigma Capital Advisors, LLC ("Sigma Capital") and paid them a $167,857 advisory fee, of which $107,857 was withheld from the gross proceeds of Sigma Note 2 at the time of the February 28, 2014 funding to us and the $60,000 balance was paid in installments of $15,000 per month commencing April 1, 2014. In accordance with the terms of the Sigma Note 2 financing, if by June 30, 2014 we had not signed a definitive agreement calling for receipt of funds in excess of $2.0 million as a result of the sale of all or a part of our operations or assets, we would be obligated to issue Sigma and Sigma Capital, in aggregate, another 300,000 restricted common shares plus pay Sigma Capital an additional cash fee of $100,000. Since those conditions were not met, on June 30, 2014 we recorded the issuance of those additional shares as well as a liability for the additional cash fee, which we paid in July 2014. The value of the common stock issued, plus the amount of cash paid for related financing fees and expenses, was reflected as a $124,655 discount against Sigma Note 1 and a $329,556 discount against Sigma Note 2 (as well as a corresponding increase in additional paid-in capital for the shares) and that amount is being amortized as interest expense over the term of the note, resulting in an effective interest rate of approximately 115% per annum. This effective rate would increase in the event an early repayment was required, as discussed above. Per the terms of the Sigma Note 2 financing, and prior to the termination as discussed below, Sigma and Sigma Capital had the joint right as of December 18, 2014 and for one year thereafter, to require us to purchase up to 1 million of our common shares held by them, at $0.25 per share (the "Sigma Put Right"). Our obligation under the Sigma Put Right was collateralized by all of our assets, subordinated only to security interests already held in connection with outstanding financings with Thermo Credit and Rockridge. We issued Sigma and Sigma Capital an aggregate of 500,000 ONSM common shares on February 28, 2014, which resulted in total holdings by them at that date of 950,000 ONSM common shares, which they still held as of June 30, 2014. In addition, we have recorded the issuance of an additional 300,000 ONSM common shares to them as of June 30, 2014. Accordingly, our financial statements reflect an approximately $214,000 liability as of June 30, 2014, representing the present value of our potential $250,000 liability as of that date for the repurchase of 1 million common shares. Effective August 13, 2014, Sigma and Sigma Capital agreed that the Sigma Put Right was terminated and as a result the related liability discussed above will be reversed by us, effective for our balance sheet as of September 30, 2014. In connection with such termination, we agreed that the right previously granted to us in connection with the Sigma Note 2 financing and extending through December 18, 2015, to purchase any and all of our common shares that were issued to Sigma and still held by them at the higher of (i) a 20% discount to the 15 trading day volume-weighted average share price ("VWAP") or (ii) $0.25 per share, would also be terminated. We also agreed to pay the expenses of Sigma and Sigma Capital, which we estimate will be $2,000, in connection with their private sale of the 1,250,000 ONSM common shares held by them. Upon our receipt of funds in excess of $2.0 million as a result of the sale of any portion of our business, however structured, including, without limitation, sale of assets, subsidiaries or business units, and/or (ii) the issuance of additional equity, debt or convertible debt capital, and/or (iii) our consolidation or merger with or into another entity, all outstanding principal and interest with respect to Sigma Note 1 and/or Sigma Note 2 will be due. The terms of the Sigma Note 2 required that we use at least $107,000 of the related proceeds to pay principal on our outstanding note (the "Rockridge Note") due to Rockridge Capital Holdings, LLC ("Rockridge"), an entity controlled by one of our largest shareholders,. Accordingly, on February 28, 2014 we made a principal payment of $119,615 (plus accrued interest), in exchange for Rockridge's agreement that we would only be obligated to pay interest on a monthly basis until our repayment of the remaining outstanding principal of $400,000 on October 14, 2014. We also agreed to pay the outstanding principal plus any accrued interest upon our receipt of proceeds in excess of $5 million related to the sale of any of our business units or subsidiaries. 90 -------------------------------------------------------------------------------- In connection with the issuance of Sigma Note 2, an agreement was executed between Sigma and Rockridge, which included Rockridge's agreement (along with our agreement) that Sigma has the right, but not the obligation, to repay the Rockridge Note at face value at any point after October 14, 2014, and always in case of a default on Sigma Note 1, Sigma Note 2 or the Rockridge Note. Such repayment amount would be added to the principal of Sigma Note 1, would accrue interest at 17% per annum and such amount plus accrued interest would be payable by us on December 18, 2014. In the event of such repayment by Sigma, Sigma would receive fees in cash and shares calculated on a pro-rata basis comparable to the terms of Sigma Note 2, based on the amount repaid to Rockridge and the amount of time the repaid debt would be unpaid by us after such repayment. For example, if $400,000 were repaid to Rockridge by Sigma on October 14, 2014, we would owe Sigma a fee of approximately $30,000 cash plus approximately 106,000 common shares. The Rockridge Note is secured by a first priority lien on all of our assets, such lien subordinated only to the extent higher priority liens on assets, primarily accounts receivable and certain designated software and equipment, are held by certain of our other lenders. We also entered into a Security Agreement with Rockridge that contains certain covenants and other restrictions with respect to the collateral. Upon notice from Rockridge at any time and from time to time prior to the Maturity Date, all or part of the outstanding principal amount of the Rockridge Note may be converted into a number of restricted shares of ONSM common stock. These conversions are subject to a minimum of one month between conversion notices (unless such conversion amount exceeds $25,000) and will use a conversion price of eighty percent (80%) of the fair market value of the average closing bid price for ONSM common stock for the twenty (20) days of trading on the OTCQB (or such other exchange or market on which ONSM common shares are trading) prior to such Rockridge notice, but such conversion price will not be less than $2.40 per share. The Note and Stock Purchase Agreement with Rockridge calls for our issuance of an origination fee, upon not less than sixty-one (61) days written notice to us, of 591,667 restricted shares of our common stock (the "Shares"). The value of those Shares is subject to a limited guaranty of no more than an additional payment by us of $75,000 which will be effective in the event the Shares are sold for an average share price less than the minimum of $1.20 per share (the "Shortfall Payment"). The $71,000 present value of this obligation is recorded as a liability on our financial statements as of June 30, 2014. If the closing ONSM share price of $0.18 per share on August 8, 2014 was used as a basis of calculation, the required Shortfall Payment would be $75,000. Including the fair market value of the Shares at the time they were recorded on our books, plus legal fees paid by us, the effective interest rate of the Rockridge Note was approximately 44.3% per annum, until a September 2009 amendment, when it was reduced to approximately 28.0% per annum, a December 2012 amendment, when it was increased to approximately 29.1% per annum, and the accrual of the Shortfall Payment, which increased it to approximately 31.1% per annum. Effective February 28, 2014, as a result of the inclusion of the remaining unamortized discount in a debt extinguishment loss, the effective rate was reduced to approximately 12% per annum. These rates do not give effect to any difference between the sum of the value of the Shares at the time of issuance plus the Shortfall Payment, as compared to the recorded value of the Shares on our books, nor do they give effect to the variance between the conversion price versus market prices that might be applicable if any portion of the principal is satisfied with common shares issued upon conversion instead of cash. As of June 30, 2014, we were obligated for $200,000 under an unsecured subordinated note issued on March 19, 2013 to Fuse Capital LLC ("Fuse") (the "Fuse Note"). The Fuse Note, which is convertible into restricted common shares at Fuse's option using a rate of $0.50 per share, is payable on March 19, 2015, with interest at 12% per annum payable on a monthly basis. 91 -------------------------------------------------------------------------------- In connection with the original issuance of the Fuse Note, we issued Fuse 80,000 restricted common shares (the "Fuse Common Stock"), which we agreed to buy back under the following terms: If the fair market value of the Fuse Common Stock is not equal to at least $0.40 per share on the date one (1) year after issuance, we will buy back, to the extent permitted by law, up to 40,000 shares of the originally issued Fuse Common Stock from Fuse at $0.40 per share. If the fair market value of the Fuse Common Stock is not equal to at least $0.40 per share on the date two (2) years after issuance, we will buy back, to the extent permitted by law, up to 80,000 shares of the originally issued Fuse Common Stock, less the amount of any shares already bought back at the one year point, from Fuse at $0.40 per share. The above only applies to the extent the Fuse Common Stock is still held by Fuse at the applicable dates. The $26,000 present value of this obligation is recorded as a liability on our financial statements as of June 30, 2014. If the closing ONSM share price of $0.18 per share on August 8, 2014 was used as a basis of calculation, a stock repurchase payment of $32,000 would be required. In connection with the original issuance of the Fuse Note, we also issued 40,000 restricted common shares to another third party for finder and other fees. Including the value of the Fuse Common Stock plus the value of the common stock issued for related financing fees (but excluding a portion of this amount written off as a debt extinguishment loss as a result of the modification, by virtue of its inclusion in the Fuse Note, of a predecessor note) results in an effective interest rate of approximately 19% per annum. During October and November 2013 we obtained aggregate net financing proceeds of approximately $246,000 from the issuance of partially secured promissory notes to three investors (the "Working Capital Notes"), with an initial aggregate outstanding balance of $620,000 bearing interest at 15% per annum. The proceeds of the Working Capital Notes were used to repay (i) $126,000 outstanding principal and interest due on the CCJ Note issued by us on December 31, 2012, (ii) $71,812 outstanding principal and interest due on a Subordinated Note issued by us on June 1, 2012 and (iii) $26,000 outstanding principal and interest due on an Investor Note issued by us on January 2, 2013. In addition, $125,000 in origination fees and $25,000 for a Funding Commitment Letter (discussed below) were deducted from the proceeds of the Working Capital Notes. Working Capital Note payments are interest only during the first six months (in two quarterly payments), approximately 50% of the principal in equal monthly payments plus interest during the next eleven months and the remaining 50% of the principal balance due eighteen months after the Working Capital Note issuance date. In the event that we receive funds in excess of $5 million as a result of a single transaction for the sale of all or a part of our operations or assets, the Working Capital Notes are payable in full within ten (10) days of our receipt of such funds, along with any interest due at that time. The Working Capital Notes are expressly subordinated to the following notes issued by us and outstanding at the time of the issuance of the Working Capital Notes: Thermo Credit LLC, Rockridge Capital Holdings LLC, Sigma Opportunity Fund II, LLC, USAC, and certain capital leases (HP Financial and Tamco), or any assignees or successors thereto, subject to a cumulative maximum outstanding balance of $3.9 million. The Working Capital Notes are secured by a limited claim to our assets, pari passu with up to $775,000 of total indebtedness and related obligations raised and incurred by us during the first quarter of fiscal 2014, subject to all prior liens of the foregoing entities and limited to the extent such a lien is allowable by the terms of the loan documents executed between us and the foregoing entities. In connection with the above financing, we issued to the holders of Working Capital Notes an aggregate of 358,334 restricted common shares (the "Working Capital Shares"), which we have agreed to buy back, to the extent permitted by law, from the holder for $0.30 per share on the maturity dates of the Working Capital Notes, if the fair market value is less than that on that date. The above only applies to the extent the Working Capital Shares are still held by the noteholder on the applicable date and the buyback obligation only applies if the noteholder gives us notice and delivers the shares within fifteen days after the applicable maturity dates. The $81,000 present value of this obligation is recorded as a liability on our financial statements as of June 30, 2014. If the closing ONSM share price of $0.18 per share on August 8, 2014 was used as a basis of calculation, a stock repurchase payment of $107,500 would be required. 92 -------------------------------------------------------------------------------- The fair market value at the time of issuance of the Working Capital Shares, plus 100,000 finders agreement shares we also issued, plus the cash deducted from the proceeds for related origination fees, was $258,260. $88,807 of this amount was reflected as a non-cash debt extinguishment loss. The remainder of $169,453 was reflected as a discount against the Working Capital Notes (as well as a corresponding increase in additional paid-in capital for the shares) and that amount is being amortized as interest expense over the term of the notes, resulting in a weighted average effective interest rate of approximately 33.2% per annum. This effective rate would increase in the event an early repayment was required, as discussed above. As of June 30, 2014, we were obligated for $250,000 under unsecured subordinated notes issued to various lenders from April 2012 through January 2013, which are fully subordinated to the Line and the Rockridge Note. These notes bear cash interest at rates ranging from 12% to 20% per annum and, after allowing for modifications made in January 2014 to the terms of certain of these notes, are due in October 2014. Including the value of common shares issued to the various lenders in connection with these notes results in effective interest rates ranging from approximately 21% to 71% per annum. As of June 30, 2014, we were obligated for $625,000 outstanding principal on unsecured subordinated notes issued in November 2012 to various lenders, which are fully subordinated to the Line and the Rockridge Note. These notes bear cash interest at 12% per annum. Note payments are interest only during the first year, approximately 30% of the principal plus interest during the second year and the remaining principal balance at the end of the second year. During the third quarter of fiscal 2014, three of these notes representing an aggregate of $290,000 principal were amended to provide that the principal balance would not be payable until the November 30, 2014 maturity date, although interest would continue to be payable on a monthly basis. One of the above notes, held by Fuse and having a $200,000 outstanding principal balance, is convertible into restricted common shares at Fuse's option using a rate of $0.50 per share. Including the value of common shares issued to the various lenders in connection with these notes results in effective interest rates ranging from approximately 26% to 43% per annum, except that the effective interest rate of the note held by Fuse is 12% per annum, after the write-off of a portion of the value of these common shares as a debt extinguishment loss, arising from the March 2013 modification of the note held by Fuse to add the conversion feature. In connection with the initial issuance of the above notes, we issued to the holders of the certain of those notes having an initial outstanding balance of $450,000 an aggregate of 180,000 restricted common shares, which we have agreed to buy back, under certain terms. If the fair market value of the stock is not equal to at least $0.40 per share on the final maturity date two (2) years after issuance, we will buy back, to the extent permitted by law, those shares of the originally issued common stock from the investor at $0.40 per share. This only applies to the extent the stock is still held by the investor(s) at the applicable date and only if the investor gives us notice and delivers the shares within fifteen days after the final maturity date. The $58,000 present value of this obligation is recorded as a liability on our financial statements as of June 30, 2014. If the closing ONSM share price of $0.18 per share as of August 8, 2014 was used as a basis of calculation, a stock repurchase payment of $72,000 would be required. In connection with the initial issuance of the above notes, we issued to the holders of certain of those notes having an initial outstanding balance of $200,000 an aggregate of 240,000 restricted common shares, of which we have agreed to buy back up to 35,000 shares, under certain terms. If the fair market value of the stock is not equal to at least $0.80 per share on the final maturity date two (2) years after issuance, we will buy back, to the extent permitted by law, up to 35,000 shares of the originally issued stock from the investor at $0.80 per share. The above only applies to the extent the stock is still held by the investor(s) at the applicable date and only if the investor gives us notice and delivers the shares within fifteen days after the final maturity date. The $25,000 present value of this obligation is recorded as a liability on our financial statements as of June 30, 2014. If the closing ONSM share price of $0.18 per share as of August 8, 2014 was used as a basis of calculation, a stock repurchase payment of $28,000 would be required. 93 -------------------------------------------------------------------------------- On June 30, 2014 we were obligated for $110,510 under a letter agreement promissory note with the Universal Service Administrative Company ("USAC"), payable in monthly installments of $19,075 through December 15, 2014 (the "USAC Note"). These payments include interest at 12.75% per annum. This letter agreement promissory note is related to our liability for Universal Service Fund (USF) contribution payments previously reflected as an accrued liability on our balance sheet and therefore resulted in the reclassification of a portion of that accrued liability to notes payable. USAC is a not-for-profit corporation designated by the Federal Communications Commission ("FCC") as the administrator of the USF program. Although they were repaid on March 21, 2013, the terms of the Equipment Notes still provided that on the maturity dates (as established in the December 12, 2012 modification), the Recognized Value of the shares issued as part of such repayment would be calculated as the sum of the following two items - (i) the gross proceeds to the Investors from the sales of the 583,334 shares issued per the December 12, 2012 modification plus (ii) the value of those shares issued and still held by the Noteholders and not sold, using the average ONSM closing bid price per share for the ten (10) trading days prior to the applicable maturity date. If the Recognized Value exceeded the Credited Value, then we would receive 50% (fifty percent) of such excess, although the amount received by us shall not exceed $175,000. If the Credited Value exceeded the Recognized Value, then we would be obligated to pay such excess to the Noteholders. With respect to Equipment Notes held by one of the three Noteholders, the Credited Value exceeded the Recognized Value for 166,667 common shares by approximately $16,000 as of the respective November 15, 2013 maturity date. We recorded no accrual for this matter on our financial statements as of September 30, 2013, based on the immateriality of a $5,000 liability, if calculated based on the September 30, 2013 ONSM closing price of $0.27 per share. However, we recognized the actual liability of approximately $16,000 as of June 30, 2014 and as interest expense for the nine months then ended (zero for the three months then ended). In connection with financing obtained by us in October and November 2013 from the other two Noteholders (see "Working Capital Notes" above), the above terms with respect to settlement of differences between the Credited Value and the Recognized Value were replaced with our agreement to buy back, to the extent permitted by law, the 416,667 common shares issued to those Noteholders, if the fair market value of the shares are not equal to at least $0.30 per share on the maturity dates of the October and November 2013 financing, which are April 24 and May 4, 2015, respectively. The above only applies to the extent the shares are still held by the Noteholders on the applicable date and the buyback obligation only applies if the Noteholders give us notice within fifteen days after the applicable maturity dates of the October and November 2013 financing. The $96,000 present value of this obligation is recorded as a liability on our financial statements as of June 30, 2014. If the closing ONSM share price of $0.18 per share as of August 8, 2014 was used as a basis of calculation, a stock repurchase payment of $125,000 would be required. Furthermore, we have agreed that in the event we receive funds in excess of $5 million as a result of a single transaction for the sale of all or a part of our operations or assets, that those funds will be available to satisfy the above buyback obligation, such availability subject only to prior satisfaction of any claims held by Thermo Credit LLC, Rockridge Capital Holdings LLC, Sigma Opportunity Fund II, LLC, USAC, and certain capital leases (HP Financial and Tamco), or any assignees or successors thereto and pari passu with up to $775,000 of total indebtedness and related obligations raised and incurred by us during the first quarter of fiscal 2014. In addition, we agreed that to the extent the number of outstanding shares of our common stock exceeds 22 million shares, then we will issue the Noteholders additional shares of common stock equal to seventy-six hundredths percent (0.76%, or 0.0076) of the excess over 22 million, times the percentage of the original 416,667 common shares still held by the Noteholders on the six and twelve month anniversary dates of the October and November 2013 financing, as well as the eighteen month maturity date. For clarity, additional issuances based on any particular increase in the number of our outstanding shares over the stated limit will only be made once and so additional issuances on the second and third dates will be limited and related to increases since the first and second dates, respectively. 94 -------------------------------------------------------------------------------- In December 2012, as part of a transaction under which J&C Resources issued us a funding commitment letter, we agreed to reimburse CCJ in cash the shortfall, payable on December 31, 2014, as compared to minimum guaranteed net proceeds of $175,000, from their resale of 437,500 common shares CCJ received on December 31, 2012 upon their conversion of 17,500 shares of Series A-13 and after effecting our agreement as part of the same transaction to reduce the conversion rate on all Series A-13 shares from $1.72 per common share to $0.40 per common share. We recorded an estimated shortfall liability of $43,750 and amortized that amount to interest expense over the one-year term of the funding commitment ending December 31, 2013 (approximately $11,000 for the three months then ended). Based on the closing ONSM price of $0.30 per share on December 31, 2013, we determined that there was no material difference between the present value of this obligation and the accrued liability recorded by us. However, based on the closing ONSM price of $0.20 per share as of June 30, 2014, the gross proceeds would be approximately $88,000 and the shortfall would be approximately $87,000. Therefore, we increased the $43,750 liability initially recorded by us by recognizing approximately $32,000 of interest expense for the six months ended June 30, 2014 which resulted in an approximately $76,000 liability on our financial statements as of that date, representing the present value of this obligation. If the closing ONSM share price of $0.18 per share on August 8, 2014 was used as a basis of calculation, the gross proceeds would be approximately $79,000 and the shortfall would be approximately $96,000. After annual increases in prior years as set forth in the employment agreements, the contractual annual base salaries for the five Executives in aggregate are approximately $1.6 million, subject to a five percent (5%) increase on September 27, 2014 and each year thereafter - a portion of these contractual salaries are presently not being paid to the Executives and we are accruing these unpaid amounts as non-cash compensation expense, with the unpaid portion reflected as an accrued liability under the balance sheet caption "Amounts due to executives and officers". Effective October 1, 2009, in response to our operating cash requirements, the base salary amounts being paid to the Executives were adjusted to be 10% less than the contractual amounts. In addition, until certain actions as discussed below, the amounts representing the subsequent contractual annual increases to those base salary amounts were not paid. Effective September 16, 2012, the base salary amounts being paid to the Executives were reinstated by an amount representing approximately 7.8% of the contractual base salary at that time. As of August 8, 2014, the base salary payments to the Executives are 18.6% less than the contractual base salaries, compared to the 10% reduction instituted in October 2009 and which reduction was initially company-wide but no longer affects a majority of our other employees. A second reinstatement to the Executives, representing approximately 4.5% of the contractual base salary at that time, was approved since January 1, 2013, although as of August 8, 2014, and in recognition of our cash requirements, the second reinstatement has not been implemented. Under the terms of the employment agreements, upon a termination subsequent to a change of control, termination without cause or constructive termination, each as defined in the agreements, we would be obligated to pay each of the Executives an amount equal to three (3) times the Executive's base salary plus full benefits for a period of the lesser of (i) three (3) years from the date of termination or (ii) the date of termination until a date one (1) year after the end of the initial employment contract term. In consideration of the waiver and satisfaction of any remaining unpaid salary due to the Executives through December 31, 2012 under their employment agreements, as well as the waiver and satisfaction of any remaining unpaid amounts due to certain of those Executives in connection with the acquisition of Acquired Onstream, we (as authorized by our Board of Directors) and the Executives agreed, effective January 22, 2013, (i) to pay $100,000 ($20,000 per Executive) of the withheld compensation in cash and (ii) to issue 1,700,000 (340,000 per Executive) fully vested ONSM common shares, subject to certain trading restrictions (the "Executive Shares"). 95 -------------------------------------------------------------------------------- As of August 8, 2014, the Executive Shares have not been issued, due to certain administrative and documentation requirements, nor has the $100,000 in cash been paid. However, since the Executive Shares were committed to be issued by the January 22, 2013 action of the Board, that issuance was reflected in our financial statements as of the date of such commitment. To the extent there is any shortfall from the gross proceeds upon resale by the Executives of the Executive Shares as compared to twenty-nine cents ($0.29) per share, the shortfall will be reimbursed to the Executives by us in cash, or at our option, by the issuance of additional fully vested ONSM common shares (the "Additional Executive Shares"), with the Additional Executive Shares subject to reimbursement by us to the Executives of any shortfall from the gross proceeds upon resale as compared to the fair value used to determine the number of such Additional Executive Shares. All shortfall reimbursements shall be payable by us within ten (10) business days after presentation by reasonable supporting documentation of the shortfall to us by the Executives. The $153,000 present value of this obligation is recorded as a liability on our financial statements as of June 30, 2014. If the closing ONSM share price of $0.18 per share on August 8, 2014 was used as a basis of calculation, our obligation for this shortfall payment would be $187,000, or the equivalent in common shares. On February 20, 2013, we (as authorized by our Board of Directors) and the Executives agreed to certain changes in the Executives' employment agreements, which among other things included the implementation of an executive incentive compensation plan (the "Executive Incentive Plan"). Compensation under the Executive Incentive Plan would be in the form of Fully Restricted (as defined below) ONSM common Plan shares ("Executive Incentive Shares") and is based on the Company achieving certain financial objectives as follows for each of the fiscal years 2014 and 2015: · Increased revenues (as compared to the respective prior year). · Positive operating cash flow (as defined in the Executive Incentive Plan). · EBITDA, as adjusted, (as defined in the Executive Incentive Plan) for at least two quarters. Accomplishment of the objectives for fiscal 2014 and fiscal 2015 would result in an aggregate of 625,000 Executive Incentive Shares issued to the Executives as a group for each of those two years. A lesser amount of Executive Incentive Shares would be issuable for achievement for only one or two of the three objectives set for each year. With respect to fiscal 2014, the Executives have earned an aggregate of 250,000 Executive Incentive Shares for meeting the objective of achieving positive EBITDA, as adjusted, for at least two quarters (the first and second fiscal quarters). Accordingly, those shares have been recorded on our financial statements and reflected as non-cash compensation expense of $52,500 for the nine and three months ended June 30, 2014, based on their fair value of $0.21 per share as of May 20, 2014, the date it was conclusively determined that the objective had been met and the shares had been earned. Also with respect to fiscal 2014, we have determined that it is probable that the Executives will earn an additional aggregate of 250,000 Executive Incentive Shares for meeting the objective of achieving positive operating cash flow (as defined in the Executive Incentive Plan) for fiscal 2014. Accordingly, those shares have been recorded on our financial statements in the amount of $45,000, based on their fair value of $0.18 per share as of August 8, 2014, the date it was conclusively determined that it was probable the objective would be met and the shares would be earned. This amount will be reflected as non-cash compensation expense over the remaining term of service, which is $22,500 during the nine and three months ended June 30, 2014 and the balance during the three months ending September 30, 2014. As of June 30, 2014 the potential issuance of the shares related to the other 2014 objective has not been reflected on our financial statements, since based on the fiscal year 2014 financial results to date the issuance of these shares is not considered probable. The Executive Incentive Shares are subject to a complete restriction on the Executive's ability to access or transact in any way such shares until the restriction is lifted. Upon a change of control, termination of the Executive's employment or the imminently proposed and/or anticipated sale of the Company at a price of $1.00 per common share or more, all restrictions on the Executive Incentive Shares and any other common shares held by the Executives will be lifted. In the case of a sale, all restrictions will be lifted in time for those previously restricted shares to participate in all voting with respect to the proposed sale and will be eligible, at the Executive's option, for inclusion as part of the shares sold in that transaction. Due to the restrictions on the Executive Incentive Shares, we have determined that the issuance thereof will not result in taxable compensation income to the Executives (or tax deductible compensation expense to the Company) until such restrictions have been lifted. 96 -------------------------------------------------------------------------------- As of June 30, 2014, we were obligated under operating leases for six office locations (one each in Pompano Beach, Florida, San Francisco, California, San Diego, California and Colorado Springs, Colorado and two in the New York City area), which call for monthly payments totaling approximately $61,000. The leases have expiration dates ranging from 2014 to 2018 (after considering our rights of termination) and in most cases provide for renewal options. The future minimum lease payments required under the non-cancelable operating leases total approximately $1.8 million through June 30, 2019, of which approximately $640,000 relates to the year ending June 30, 2015. We have entered into various agreements for our purchase of Internet, long distance and other connectivity as well as use of the co-location facilities discussed above, for an aggregate remaining minimum purchase commitment of approximately $1.6 million, approximately $1.5 million of that commitment related to the one year period ending June 2015 and the balance of such commitment related to the period from June 2015 through August 2017. Projected capital expenditures for the year ending June 30, 2015 total approximately $800,000, which includes software and hardware upgrades to the webcasting platform (including VW4 and iEncode), the DMSP and the audio and web conferencing infrastructure. Some of these projected capital expenditures may be financed, deferred past the twelve month period or cancelled entirely, depending on our other cash flow considerations. During the period from June 2013 through January 2014 we made certain headcount reductions representing approximately $1.1 million in annualized savings, which we expect will reduce our compensation expenditures by approximately $199,000 for the remaining three months of fiscal 2014 as compared to the corresponding prior year period and which we expect will reduce our compensation expenditures by approximately $159,000 in aggregate for the first seven months of fiscal 2015 as compared to the corresponding prior year period. Effective June 2014, we also renegotiated a supplier contract representing approximately $252,000 in annualized savings, which we expect will cumulatively reduce our cost of sales by approximately $63,000 for the remaining three months of fiscal 2014 as compared to the corresponding prior year period and which we expect will reduce our cost of sales by approximately $168,000 in aggregate for the first eight months of fiscal 2015 as compared to the corresponding prior year period. On February 6, 2014, we received a funding commitment letter (the "Funding Letter") from J&C Resources, Inc. ("J&C"), agreeing to provide us, within twenty (20) days after our notice on or before December 31, 2014, aggregate cash funding of up to $800,000. Mr. Charles Johnston, a former ONSM director, is the president of J&C. This Funding Letter was obtained solely to demonstrate our ability to obtain short-term funds in the event other funding sources are not available. Cash provided under the Funding Letter would be in exchange for our issuance of (a) a note or notes with interest payable monthly at 15% per annum and principal payable on the earlier of a date twelve months from funding or July 1, 2015 and (b) 7.5 million unregistered common shares, which shares would be prorated in the case of partial funding. The note or notes would be unsecured and subordinated to all of our other debts, except to the extent such the terms of such debts would allow pari passu status. Furthermore, the note or notes would not be subject to any provisions, other than with respect to priority of payments or collateral, of our other debts. Upon receipt by us of funds in excess of $5.0 million as a result of a single transaction for the sale of all or a part of its operations or assets, this Funding Letter will be terminated. 97 -------------------------------------------------------------------------------- We have incurred losses since our inception, and have an accumulated deficit of approximately $139.8 million as of June 30, 2014. Our operations have been financed primarily through the issuance of equity and debt, including convertible debt and debt combined with the issuance of equity. During the nine months ended June 30, 2014, our revenues were not sufficient to fund our total cash expenditures (operating, capital and debt service) and as a result we obtained additional funding from the Working Capital Notes and Sigma Note 2 and we also restructured the payment terms of Sigma Note 1 and certain other notes, as discussed above. However, primarily because of our expectations with respect to our recent and anticipated introductions of several new or enhanced products, we expect to achieve revenue growth in the fourth quarter of fiscal 2014 as well as fiscal 2015, as compared to corresponding prior year periods. However, in the event we are unable to achieve the necessary revenue increases to fund our total cash expenditures, we believe that identified decreases in our current level of expenditures that we have already planned to implement or could implement (in addition to the already implemented cost savings discussed above and including a significant reduction in our software development costs and capital equipment purchases) and the raising of additional capital in the form of debt and/or equity and/or the sales of assets or operations would be sufficient to fund our operations through June 30, 2015. We will closely monitor our revenue and other business activity to determine if and when further cost reductions, the raising of additional capital or other activity is considered necessary. The Executives have agreed to defer a portion of their compensation in the past, to the extent we needed that cash to meet other operating expenses and, in the event of extremely critical or urgent requirements in the future, are expected to continue to do so. Our continued existence is dependent upon our ability to raise capital and to market and sell our services successfully. However, there are no assurances whatsoever that we will be able to sell additional common shares or other forms of equity and/or that we will be able to borrow further funds other than under the Line or the Funding Letter and/or that we will be able to sell assets or operations and/or that we will be able to increase our revenues and/or control our expenses to a level sufficient to provide positive cash flow. The financial statements do not include any adjustments to reflect future effects on the recoverability and classification of assets or amounts and classification of liabilities that may result if we are unsuccessful. Cash required to fund our continued operations will be affected by numerous known and unknown risks and uncertainties including, but not limited to, our ability to successfully market and sell our products and services, the degree to which competitive products and services are introduced to the market, our ability to control and/or reduce expenses, our need to invest in new equipment and/or technology, and our ability to service and/or refinance our existing debt and accounts payable. We cannot assure that our revenues will continue at their present levels, nor can we assure that they will not decrease. To the extent our cash flow from sales is insufficient to completely fund operating expenses, financing costs (including principal repayments) and capital expenditures, as well as any acceleration of our repayments of accounts payable and/or accrued liabilities, we will continue depleting our cash and other financial resources. Other than working capital which may become available to us from further borrowing or sales of equity or assets or operations (including but not limited to proceeds from the Line or the Funding Letter, as discussed above), we do not presently have any additional sources of working capital other than cash on hand and cash, if any, generated from operations. As a result of the uncertainty as to our available working capital over the upcoming months, we may be required to delay or cancel certain of the projected capital expenditures, some of the planned marketing expenditures, or other planned expenses. In addition, it is possible that we will need to seek additional capital through equity and/or debt financing or through other activities. If we raise additional capital through the issuance of debt, this will result in increased interest expense. If we raise additional funds through the issuance of equity or convertible debt securities, the percentage ownership of our company held by existing shareholders will be reduced and those shareholders may experience significant dilution. The resolution of debt and other obligations becoming due within the twelve months ended June 30, 2015 (the end of the one year time frame on which our liquidity analysis and conclusions above were based), and in particular those becoming due during October through December 2014, represents a future unknown contingency. 98 -------------------------------------------------------------------------------- Our cash balance increased by approximately $343,000 during the nine months ended June 30, 2014. This was the result of approximately $499,000 provided by operating activities and approximately $270,000 provided by financing activities, partially offset by approximately $426,000 used in investing activities. Cash provided by operating activities of approximately $499,000 for the nine months ended June 30, 2014, represents an approximately $115,000 increase in cash provided as compared to approximately $383,000 cash provided by operating activities for the corresponding period of the prior fiscal year. The approximately $499,000 cash provided by operating activities for the nine months ended June 30, 2014 reflects (i) our net loss of approximately $1.0 million, reduced by approximately $2.1 million of non-cash expenses included in that loss, offset by a non-cash gain on litigation settlement of approximately $742,000 and resulting in net cash provided by operating activities before changes in current assets and liabilities other than cash of approximately $376,000 and (ii) an approximately $123,000 net decrease in non-cash working capital items. The primary non-cash expenses included in our loss for the nine months ended June 30, 2014 were approximately $723,000 of amortization of discount on notes payable and convertible debentures, approximately $663,000 of depreciation and amortization and approximately $417,000 of compensation expenses paid with common shares and other equity. The approximately $123,000 net decrease in non-cash working capital items for the nine months ended June 30, 2014 is primarily due to an approximately $411,000 increase in accounts payable, accrued liabilities and amounts due to directors and officers, partially offset by an approximately $171,000 increase in accounts receivable and an approximately $81,000 increase in prepaid expenses. The approximately $123,000 net decrease in non-cash working capital items was approximately $377,000 less than the net decrease in non-cash working capital items of approximately $500,000 for the corresponding period of the prior fiscal year. The primary sources of cash inflows from operations are from receivables collected from sales to customers. Cash used in investing activities was approximately $426,000 for the nine months ended June 30, 2014 as compared to approximately $1.4 million cash used in investing activities for the corresponding period of the prior fiscal year. Current period investing activities related to the acquisition of property and equipment, including capitalized software development costs. Prior period investing activities related primarily to the November 30, 2012 Intella2 acquisition as well as the acquisition of property and equipment, including capitalized software development costs. Cash provided by financing activities was approximately $270,000 for the nine months ended June 30, 2014 as compared to approximately $1.0 million cash provided by financing activities for the corresponding period of the prior fiscal year. Current year period financing activities, as well as those in the comparable prior year period, primarily related to proceeds from notes payable, partially offset by repayments of notes and leases payable. Most of the cash provided by financing activities for the nine months ended June 30, 2013, excluding accounts receivable based borrowing and repayment activity under the Line, was associated specifically or generally with the November 30, 2012 Intella2 acquisition. Critical Accounting Policies and Estimates Our consolidated financial statements have been prepared in accordance with United States generally accepted accounting principles ("GAAP") and our significant accounting policies are described in Note 1 to those statements. The preparation of financial statements in accordance with GAAP requires that we make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying footnotes. Our assumptions are based on historical experiences and changes in the business environment. However, actual results may differ from estimates under different conditions, sometimes materially. Critical accounting policies and estimates are defined as those that are most important to the management's most subjective judgments. Our most critical accounting policies and estimates are described below. 99 -------------------------------------------------------------------------------- Goodwill and Other Intangible Assets: Our prior acquisitions of several businesses, including Infinite Conferencing, Intella2, EDNet and Acquired Onstream, have resulted in significant increases in goodwill and other intangible assets. Goodwill and other unamortized intangible assets, which include acquired customer lists, were approximately $8.9 million at June 30, 2014, representing approximately 63% of our total assets and approximately 187% of the book value of shareholder equity. In addition, property and equipment as of June 30, 2014 includes approximately $1.4 million (net of depreciation) primarily related to the capitalized development costs of the DMSP and Webcasting/iEncode platforms, representing approximately 10% of our total assets and approximately 29% of the book value of shareholder equity. In accordance with GAAP, we periodically test these assets for potential impairment. As part of our testing, we rely on both historical operating performance as well as anticipated future operating performance of the entities that have generated these intangibles. Factors that could indicate potential impairment include a significant change in projected operating results and cash flow, a new technology developed and other external market factors that may affect our customer base. We will continue to monitor our intangible assets and our overall business environment. If there is a material adverse and ongoing change in our business operations (or if an adverse change initially considered temporary is determined to be ongoing), the value of our intangible assets could decrease significantly. In the event that it is determined that we will be unable to successfully market or sell any of our services, an impairment charge to our statement of operations could result. Any future determination requiring the write-off of a significant portion of unamortized intangible assets, although not requiring any additional cash outlay, could have a material adverse effect on our financial condition and results of operations. In accordance with ASC Topic 350, Intangibles - Goodwill and Other, which addresses the financial accounting and reporting standards for goodwill and other intangible assets subsequent to their acquisition, goodwill must be tested for impairment on a periodic basis, at a level of reporting referred to as a reporting unit. Although other intangible assets are being amortized to expense over their estimated useful lives, the unamortized balances are still subject to review and adjustment for impairment. There is a two-step process for impairment testing of goodwill and other intangible assets. The first step of this test, used to identify potential impairment, compares the fair value of a reporting unit with its carrying amount, including goodwill. The second step, if necessary, measures the amount of the impairment. The provisions of ASC 350-20-35-3 in certain cases would allow us to forego the two-step impairment testing process based on certain qualitative evaluation. However, based on our assessment as of September 30, 2013 of relevant events and circumstances as listed in ASC 350-20-35-3C, we determined that we were not eligible to employ qualitative evaluation to forego the two-step impairment testing process with respect to our reporting units as of September 30, 2013, as it was not more likely than not that impairment loss had not occurred. These relevant events and circumstances included certain macroeconomic conditions, including access to capital and the ongoing decrease in the ONSM share price. The material portion of our goodwill and other intangible assets are contained in the EDNet reporting unit, the Acquired Onstream/DMSP reporting unit and the audio and web conferencing reporting unit, which includes the Infinite Conferencing and the OCC/Intella2 divisions. Our reporting units were identified based on the requirements of ASC 350-20-35-33 through 350-20-35-46. According to ASC 350-20-35-34, a component of an operating segment is a reporting unit if that component represents a business for which discrete financial information is available and segment management regularly reviews the operating results of that component. This is the case for the EDNet division, the Acquired Onstream/DMSP division, the Infinite Conferencing division and the OCC/Intella2 division. However, ASC 350-20-35-35 provides that two or more components of an operating segment shall be aggregated and deemed a single reporting unit if the components have similar economic characteristics. This is the case for the Infinite Conferencing division and the OCC/Intella2 division, since they are both in the business of audio and web conferencing sold primarily to business customers. Although EDNet is in the same operating segment as the Infinite Conferencing division and the OCC/Intella2 division, it is not considered to be part of the audio and web conferencing reporting unit since EDNet offers a specialized telephone service to the entertainment industry (movies, television, advertising) that also uses a specific type of phone line (ISDN) that is different from the standard telephone lines used by the Infinite Conferencing division and the OCC/Intella2 division. 100 -------------------------------------------------------------------------------- As part of the two-step process discussed above, our management performed discounted cash flow ("DCF") analyses to determine whether the goodwill of our reporting units was potentially impaired and the amount of such impairment. Our management determined the rates and assumptions, including the discount rates and the probability of future revenues and costs, used by it to perform these analyses and also considered macroeconomic and other conditions such as: our credit rating, stock price and access to capital; a decline in market-dependent multiples in absolute terms; telecommunications industry growth projections; internet industry growth projections; entertainment industry growth projections (re EDNet customer base); our historical sales trends and our technological accomplishments compared to our peer group. We analyzed our corporate payroll and other costs to determine their relevance to the reporting units, and to the extent relevant, we allocated such costs when preparing the projections used by us in the above analyses. We determined that approximately 72% of our corporate costs (excluding non-cash expenses) were allocable to our reporting units, including those without goodwill or other intangible assets. The non-allocable corporate costs related to various public company related requirements and expenses as well as the costs of evaluating new business opportunities and products outside the existing divisions. Based on these evaluations, we determined that it was more likely than not that the fair values of the EDNet and Acquired Onstream reporting units were more than their respective carrying amounts as of September 30, 2013 since the carrying value of the each of those reporting units (after reduction for interest-bearing debt) was less than or not material different than the result of the respective DCF analysis. However, we were unable to arrive at the same conclusion as a result of our evaluation of the audio and web conferencing reporting unit, since the carrying value exceeded the results of the DCF analysis (after reduction for interest-bearing debt) for that reporting unit. Accordingly, we performed further calculations in order to determine the amount of the impairment of the goodwill of the audio and web conferencing reporting unit and determined that the carrying value of the audio and web conferencing reporting unit exceeded the results of the DCF analysis (after reductions for interest bearing debt and for an allocation of that amount to recognize an increase in the recorded value of the audio and web conferencing reporting unit customer lists to an updated fair value) for that reporting unit by approximately $2.2 million. Accordingly, this difference was the amount by which the goodwill of the audio and web conferencing reporting unit was impaired as of September 30, 2013, and a $2.2 million adjustment was made to reduce the carrying value of the audio and web conferencing reporting unit's goodwill as of that date. This adjustment was further allocated to our Infinite division. The increase in the recorded value of the audio and web conferencing reporting unit customer lists to an updated fair value as discussed above was not reflected on our books, since in accordance with GAAP that calculation is solely for purposes of determining impairment of goodwill and is not for the purpose of adjusting the carrying value of other intangible assets. In order to address whether any further consideration of ONSM's share price was needed with respect to impairment testing, we performed an analysis to compare our book value (after the impairment adjustment for the audio and web conferencing reporting unit discussed above) to our market capitalization as of September 30, 2013, including adjustments for (i) paid-for but not issued common shares, such as the Rockridge Shares and the Executive Shares and (ii) an appropriate control premium. Based on this analysis, we concluded that there were no conditions with respect to our market capitalization as of September 30, 2013 which would require further evaluation with respect to the carrying values of our reporting units. 101 -------------------------------------------------------------------------------- An annual impairment review of our goodwill and other acquisition-related intangible assets will be performed as part of preparing our September 30, 2014 financial statements. Until that time, we are reviewing certain factors to determine whether a triggering event has occurred that would require an interim impairment review. Those factors include, but are not limited to, our management's estimates of future sales and operating income, which in turn take into account specific company, product and customer factors, as well as general economic conditions and the market price of our common stock. Since the July 2014 litigation settlement discussed above resulted in the discontinuance of a significant portion of the business acquired by us from Intella2, we considered that to be a "triggering event" that would require us to make an interim review of the carrying value of the goodwill of the audio and web conferencing reporting unit (which includes the Intella2 goodwill) as of June 30, 2014. Accordingly, we updated five-year projections that were used in the DCF analysis prepared for the review of the goodwill of the audio and web conferencing reporting unit as of September 30, 2013, taking into account the impact of the litigation settlement as well as other changes since those projections were initially prepared. Based on our determination that the updated projections resulted in anticipated cash flow materially equal to or greater than the initial projections, we concluded that no further evaluation or adjustment with respect to the carrying value of the goodwill of the audio and web conferencing reporting unit was necessary as of June 30, 2014. Although the closing ONSM share price declined from $0.27 per share at September 30, 2013 to $0.20 per share as of June 30, 2014, the comparison of our book value to our market capitalization as of June 30, 2014, including adjustments for (i) paid-for but not issued common shares, such as the Rockridge Shares (see note 4) and the Executive Shares (see note 5) and (ii) an appropriate control premium, supported our conclusion that there were no conditions with respect to our market capitalization as of June 30, 2014 which would require further evaluation with respect to the carrying values of our reporting units. The closing ONSM share price was $0.18 per share on August 8, 2014. EDNet's operations are heavily dependent on the use of ISDN phone lines ("ISDN"), which are only available from a limited number of suppliers. The two telecommunication companies which are the primary suppliers of ISDN to EDNet have made recent public indications of intentions to restrict, or even eventually eliminate, their provision of ISDN. Such actions could have a significant adverse impact on our future evaluations of the carrying value of EDNet goodwill, especially if alternative ISDN suppliers cannot be identified or if an alternative such as Internet based technology is not available or economically feasible as a basis to continue the EDNet operations. However, these two companies have not announced definitive timetables for taking any extensive actions with regard to restricting ISDN and therefore we have not assumed any such actions would take place within the timeframe of our discounted cash flow analyses used by us for these evaluations to date. 102 -------------------------------------------------------------------------------- ITEM 4T. CONTROLS AND PROCEDURES Management's report on disclosure controls and procedures: Our management, with the participation of our Chief Executive Officer and our Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures as of June 30, 2014. The term "disclosure controls and procedures," as defined in Rules 13a - 15(e) and 15d - 15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act, is recorded, processed, summarized, and reported, within the time periods specified in the SEC's rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company's management, including its Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. Based on the evaluation of our disclosure controls and procedures, our Chief Executive Officer and Chief Financial Officer concluded that, as of June 30, 2014, our disclosure controls and procedures were not effective at the reasonable assurance level. Management's report on internal control over financial reporting: Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rules 13a-15 promulgated under the 1934 Exchange Act. Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission in Internal Control - Integrated Framework ("COSO"). Based on our evaluation under the COSO framework, management has concluded that, as of June 30, 2014, our internal control over financial reporting was not effective at the reasonable assurance level. Our internal control system is designated to provide reasonable assurance to our management and Board of Directors regarding the preparation and fair presentation of published financial statements. All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation. Our management has worked, and continues to work, to strengthen our internal control over financial reporting. We are committed to ensuring that such controls are operating effectively. Since identifying the material weakness in our internal control over financial reporting, we are working to enhance the design and operation of our controls by improving our controls and documentation related to our accounting policies and practices to identify, document and periodically assess whether all key judgments, conventions and estimates used conform to U.S. GAAP. Changes in Internal Control over Financial Reporting: Except as noted above, there were no changes in our internal control over financial reporting during the most recent fiscal quarter ended June 30, 2014 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. 103 -------------------------------------------------------------------------------- |