Nct Group, Inc. (NCTI) - Description of business

Company Description
General NCT Group, Inc. develops and licenses technologies based upon its portfolio of patents and related rights and extensive technological know-how. We have a strong technology base with approximately 570 domestic and international patents and related rights. We operate in three segments: communications, media and technology. Our major focus is the development of our communications businesses, particularly our Artera Turbo network optimization and Internet acceleration services, and our audio and communications products produced by our majority-owned subsidiary, Pro Tech Communications, Inc. We have strategic licensing relationships with manufacturers for integration of certain of our technologies into their products and applications, from which we earn licensing fees, ongoing per unit royalties and engineering fees. Our strategy is to leverage our existing base of proprietary technologies by licensing our technologies and by developing new products, services and applications. We continue to establish distribution channels and strive to increase consumer awareness of our products, services, applications and technologies. At the same time, we continue to strive to lower the cost of our products and services and to enhance their technological performance. We classify revenue recognized from our product lines in our statements of operations as technology licensing fees and royalties, product sales, advertising, and engineering and development services. Our product lines and licenses that comprised more than 15% of our total revenue in any one of the last three years are as follows: o Flat panel transducer technology licensed to New Transducers Ltd. ("NXT") was accounted for in our media segment and comprised approximately 44% and 39% of our total revenue in 2003 and 2004, respectively; and o Product revenue from the sale of our communications headset products was accounted for in our communications segment and comprised approximately 24%, 22% and 31% of our total revenue in 2003, 2004 and 2005, respectively. We were incorporated in Delaware in 1986 and changed our name to NCT Group, Inc. in 1998. Our principal executive offices are located at 20 Ketchum Street, Westport, Connecticut 06880, our telephone number is (203) 226-4447 and our Internet address is www.nctgroupinc.com. The information on our Internet website is not incorporated into this Annual Report.Operations We operate our business through three segments: communications, media and technology. Each of our operating segments targets the commercialization of products and technologies in specific markets. Please see Notes 24 and 25 to the Notes to Consolidated Financial Statements contained elsewhere in this Annual Report for additional information regarding our operating segments and geographic areas.Communications Segment Our communications segment includes our Artera Group, Inc. and Pro Tech Communications, Inc. subsidiaries. Artera Group develops and markets Artera Turbo, a software-based, network optimization and Internet acceleration service for service providers, ses, enterprises and government networks. Pro Tech engineers, designs and distributes audio and communications solutions and other products for consumers, business users and industrial users. Our communications segment also develops and markets our ClearSpeech noise and echo cancellation algorithms and related microphones and speakers.Artera Turbo Artera Turbo is a software-based service that improves the effective performance of communication lines for Internet-based applications such as web browsing, e-mail and file transfers. The service accomplishes these improvements by employing a number of patent-pending, performance enhancement techniques that decrease the size and increase efficiencies in the movement, storage and delivery of electronic data. Artera Turbo accelerates web browsing, web-based file transfers, uploading and downloading of all native File Transfer Protocol (FTP) file transfers, and all types of e-mail from simple web-based e-mail systems, such as Hotmail and Yahoo Mail, to Post Office Protocol3 (POP3) and Simple Mail Transfer Protocol (SMTP) based e-mail systems, such as Microsoft Outlook, Microsoft Outlook Express and Microsoft Exchange. Artera Turbo provides effective speeds of more than five times the normal speed of a 56k dial-up line, in other words, speeds comparable to digital subscriber lines (DSL). Artera Turbo also accelerates other connections including cable, DSL and integrated services digital networks (ISDN). We have expanded our emphasis beyond the residential market to include opportunities for Artera Turbo in the service provider and enterprise markets. In May 2005, we introduced a new version of Artera Turbo for Internet service providers and other network applications. Our Artera Turbo server software is clientless, meaning no software installation on individual personal computers is required and, therefore, a service provider or other network administrator can implement the service more readily. Artera Turbo server software not only increases data transmission speeds, but also reduces bandwidth utilization. In October 2005, we announced that we have entered into a worldwide distribution agreement with Siemens plc. Siemens intends to distribute our Artera Turbo technology under the name "Siemens Bandwidth Accelerator." Siemens is currently focusing on large-scale service providers and enterprises in the United Kingdom and expects to bundle and integrate Artera Turbo technology as a component of the complete, customized information technology solutions Siemens offers its customers. In addition, we continue to pursue other strategic partnerships for distribution of our clientless version of Artera Turbo in the Americas, Europe, the Middle East and Asia.Rev The Web In April 2005, we commercially introduced a new web accelerator brand, Rev The Web. Rev The Web uses a permission-based, ad-assisted business model that we believe will enable us to compete more effectively in a market fraught with competitive pricing and distribution pressures. Rev The Web is a free service that uses Artera Turbo-based technology to enable users to access the Internet an average of five times as fast through a dial-up line and three times as fast through a broadband connection, such as DSL or a cable modem. This service is targeted to the residential web accelerator market, principally dial-up users. In return for the free services, users are required to complete a survey about their interests and are served a limited number of advertisements based on their responses as well as on behavioral information they authorize us to collect on them. We currently have arrangements with ad serving companies who are responsible for selling Rev The Web's advertising inventory.Pro Tech Pro Tech engineers, designs and distributes audio and communications solutions and other products into the contact center, quick-service restaurant, consumer audio and industrial safety markets. Pro Tech's products include: o Apollo headsets and amplifiers for use in contact centers; o ProCom headsets for use in quick-service restaurants; o NoiseBuster noise canceling consumer audio headphones; and o NoiseBuster noise canceling safety earmuffs for use in high noise industrial environments. Pro Tech is also pursuing the development of new products to address additional markets of opportunity, including spectator racing, two-way radio communications and aviation. Pro Tech intends to enter many of these markets through the expansion of its NoiseBuster line of electronic noise canceling products as well as passive products designed for higher noise settings.ClearSpeech Our ClearSpeech business specializes in the research and development of signal processing algorithms and related hardware for enhancing voice communications. We have developed solutions for a wide range of communication system challenges, including third generation (3G) cellular video phones, drive-thru service facilities, security and surveillance equipment, hands-free communication systems, Formula 1 and NASCAR racing, digital mobile radios and automotive speech recognition applications. Our ClearSpeech suite of signal processing technology includes echo cancellation and noise reduction algorithms for human listeners and for speech recognition applications.Media Segment Our media segment, through our Hospital Radio Network business, distributed a micro broadcasting system that delivers place-based broadcast and billboard advertising. We used our proprietary digital technology to deliver advertising messages interspersed with CD-quality music programming to hospitals and other health care facilities. In September 2005, we decided to modify the business model for our Hospital Radio Network business. Instead of continuing to directly operate this business, under our modified business model, we are licensing our proprietary technology used in this business to third parties. In exchange, we will receive a percentage of the advertising revenues generated by these third parties through existing and new installations of our Sight & Sound systems in health care facilities.Technology Segment Our technology segment consists of our Advancel Logic Corporation subsidiary, which participates in the native Java embedded microprocessor market. We have licensed certain Advancel-developed technology to STMicroelectronics SA for smart card applications, and since 2003, STMicroelectronics has been shipping orders of its smart cards incorporating this technology.Technology and Intellectual Property We rely on a combination of patent, trademark, copyright and trade secret laws in the U.S. and elsewhere as well as confidentiality procedures and contractual provisions to protect our proprietary technology. We also enter into confidentiality and invention assignment agreements with our employees and confidentiality agreements with our consultants and other third parties. As of February 28, 2006, we held approximately 570 patents and related rights and an extensive library of know-how and unpatented technology. We have patent coverage in the U.S., Canada, Japan, Europe, Korea, Australia, Hong Kong and Taiwan. We hold or have rights to 294 inventions as of February 28, 2006, including 92 U.S. patents and approximately 478 corresponding foreign patents. We have pending 117 U.S. and foreign patent applications. Our engineers have made 164 invention disclosures for which we are in the process of preparing patent applications. Our patents have expiration dates ranging from 2006 through 2019, with the majority of the material patents upon which we rely expiring in 2011 and beyond. We have made substantial investments in our technology and intellectual property and have incurred development costs for engineering prototypes, pre-production models and field-testing of several products and applications. Our intellectual property strategy has been to build upon our base of core technology that we have developed, acquired or exclusively licensed with newer advanced technology patents developed by, purchased by orexclusively licensed to us. In many instances, we have incorporated the technology embodied in our core patents into patents covering specific product applications, including product design and packaging. We believe this building-block approach provides greater protection to us than relying solely on the core patents. Our core patents and advanced patents and patent applications include the following technologies: o Artera Turbo information and traffic optimization management; o electronic noise control for headsets; o filters for signal enhancement and speech filtering; and o our method and apparatus for delivering audiovisual information. Our key technologies include the following: Information and Traffic Optimization Management Software. Our patent-pending Artera Turbo technology enhances the effective speed of Internet activities, including web browsing, e-mail and file transfers, for any residence or small to medium sized business, government facility, Internet service provider or large enterprise. Artera Turbo works via a series of proprietary data management techniques. These involve optimization processes Artera Turbo performs on an information stream to reduce the number of bytes transferred over the network (reduction of the size of data transferred). These techniques are the subject of three patents pending owned by us. We believe that the aspects of our Artera Turbo technology that are patents pending are unique to us. While it is not possible to patent all of our data optimization technology, our patents pending cover the unique implementation techniques we have developed. Electronic Noise Canceling. Our electronic noise canceling technology minimizes low frequency acoustical noise, or rumbling sounds. This technology electronically couples a sound wave with its exact mirror image wave, called anti-noise, resulting in a significant reduction of the offensive noise before it reaches the user's ears. The technology is particularly effective against low frequency noise, such as noise generated by computer fans, HVAC systems and motor or engine-driven equipment. Products incorporating this technology include our NoiseBuster consumer audio headphones and noise canceling safety earmuffs. Signal Enhancement. Our signal enhancement technology can be used to reduce unwanted signals that enter into a communications network, such as when background noise enters telecommunications or radio systems from a telephone receiver or microphone. We have developed a line of patented algorithms called ClearSpeech that perform various signal enhancement functions. Our ClearSpeech Adaptive Speech Filter algorithm removes noise from voice transmissions. The filter is effective against a variety of stationary noises whose amplitude and pitch change slowly compared to the spectral variations characteristic of human speech. Our ClearSpeech Acoustic Echo Cancellation removes acoustic echoes in hands-free, full-duplex communication systems. Acoustic echo cancellation is an adaptive, frequency-based algorithm that continuously tracks and updates the changes in the acoustic path between the loudspeaker and the microphone to eliminate the acoustic echo. Our ClearSpeech Reference Noise Filter isolates and removes interfering signals, such as background radio, television, machine and siren noise, so communications can be heard more clearly. The reference noise filter algorithm was designed to remove interference from a desired signal in applications where a reference signal for the interference is available. Digital Broadcasting Station System Software. Our digital broadcasting station system software technology is utilized in our micro broadcasting systems to deliver customized music programming to each broadcasting site. Advertising is scheduled and updated via a communications link, such as the Internet. The software also performs status checking, play log functions and other diagnostic functions made available to the central control network. Protecting our intellectual property rights is costly and time consuming. Maintenance and annuity fees for our extensive patent portfolio are a significant portion of our expenses and typically range from $300,000 to $600,000 annually. We incur maintenance fees to maintain our granted U.S. patents and annuity fees to maintain foreign patents and the pendancy of patent applications. If, due to financial constraints, we are required to reduce our level of operations, we will not be able to continue to meet the extensive monetary outlay for maintenance and annuity fees to prevent all of our patents and applications from becoming abandoned. If this occurs, we will have to prioritize our portfolio accordingly.Research and Development Our research and development personnel focus on product, software and algorithm development that provides the technological basis for our technology licensing and commercial products, and on basic research that helps provide the scientific advances that ultimately lead to new products and technology. As of February 28, 2006, our product and development team consisted of approximately 20 development engineers and scientists. Our research and development expenses totaled approximately $3.0 million, $3.6 million and $4.0 million for the years ended December 31, 2003, 2004 and 2005, respectively. We anticipate that we will continue to make significant research and development expenditures to maintain and expand our competitive position. This includes improving our current technologies and products and developing newer technologies and products.Marketing and SalesCommunications SegmentArtera Turbo Artera Turbo is available in a single user residential version, a small business local area network (LAN) software gateway version, a service provider version, a clientless server software version that can optimize and enhance speed at the network level and an enterprise version that can support 250 or more concurrent users on a LAN. In the residential market, we market the service through a channel of Internet service providers who generally private label the service. We market our clientless server software directly to Internet service providers. We currently target the enterprise market through our strategic partnership with Siemens.Rev The Web We have arrangements with leading ad serving companies who sell our Rev The Web advertising inventory. We also have the capability of selling our own advertising.Pro Tech We sell our Pro Tech products directly as well as through a network of distributors. Key target markets include consumer audio, industrial safety, call centers and major quick-service restaurant chains.ClearSpeech We license our ClearSpeech algorithms to manufacturers for incorporation into various products. A major customer is OKI Electric Industry Co., Ltd, which incorporates our ClearSpeech noise cancellation algorithm into its large-scale integrated circuits. Our ClearSpeech technology is also incorporated into speaker and microphone products that are sold through a network of distributors.Media Segment Our Hospital Radio Network sales initiatives are targeted to engaging licensees of our micro broadcasting system technology, who, in turn, will work to expand the number of participating health care facilities and to sell advertising on their networks.Technology Segment Our Advancel microprocessor technology is incorporated into smart card applications developed and marketed by STMicroelectronics.Significant Customers Our customers that comprised more than 10% of our total revenue for the year ended December 31, 2005 are Sharp, OKI Electric and NXT at 19%, 16% and 12%, respectively. We did not realize any additional cash from NXT revenue during 2005.Competition We have a number of direct and indirect competitors for our products and services. Our major competition for our Artera Turbo service offering includes Internet accelerator services offered by Propel, Proxyconn and Slipstream. Our primary competitors for Pro Tech's lightweight telephone headsets are Plantronics and GN Netcom, for its NoiseBuster headphones are Bose and Sony and for its NoiseBuster safety earmuffs are Aearo and Bacou. Our major competition for our ClearSpeech noise and echo cancellation algorithms includes Lucent and Texas Instruments. Finally, our Hospital Radio Network business competes against other on-site music providers, such as Muzak, and against other advertising media. In addition, we believe that a number of other large companies, such as major domestic and foreign communications, computer and electronics manufacturers have research and development efforts underway that potentially could be competitive with our products and services. Many of our competitors and potential competitors are well-established companies that have substantially greater financial, technical, production, sales and marketing, and product development resources than we do. We believe that our competitive advantages for our products and services include high performance resulting from our proprietary technology, superior design and construction, and low cost, but that our competitive disadvantages include limited name recognition, limited marketing and distribution resources and long production lead times.Employees As of February 28, 2006, we had 58 employees. These include 20 in engineering and development, 8 in operations and production, 9 in sales and marketing, 8 in management and administration, and 13 in finance, accounting, human resources, legal, information technology and intellectual property. None of our employees is represented by a labor union. We believe our employee relationships are good.Available Information We file reports, proxy statements and other documents with the Securities and Exchange Commission ("SEC"). You may read and copy any document we file at the SEC's public reference room at 100 F Street, N.E., Washington, D.C. 20549. You should call 1-800-SEC-0330 for more information on the public reference room. Our SEC filings are also available to you on the SEC's Internet site at http://www.sec.gov. We maintain an Internet website at www.nctgroupinc.com. Our periodic reports filed with the SEC (including annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and Section 16 reports) are available free of charge on our Investor Information website at www.nctgroupinc.com/investors as soon as reasonably practicable after these reports are electronically filed with the SEC. The information posted on our website is not incorporated into this Annual Report.ITEM 1A. RISK FACTORS You should carefully consider the following information about risks described below, together with the other information contained in this Annual Report and in our other filings with the SEC, before you decide to buy or maintain an investment in our common stock. We believe the risks described below are the risks that are material to us as of the date of this Annual Report. If any of the following risks actually occur, our business, financial condition, operating results and future growth prospects would likely be materially and adversely affected. In these circumstances, the market price of our common stock could decline, and you may lose all or part of the money you paid to buy our common stock. We do not believe we have, and we are unsure whether we will be able to generate, sufficient funds to sustain our operations through the next six months. Our management believes that currently available funds will not be sufficient to sustain our operations at current levels through the next six months. At December 31, 2005, we had $0.5 million in cash and cash equivalents and a working capital deficiency of $136.8 million. Our ability to continue to operate at current levels depends upon, among other things, our ability to generate sufficient revenue from the licensing of our technology, the sale of our products and the receipt of continued funding from Carole Salkind, a beneficial owner of approximately 95% of our common stock. We have been primarily dependent upon funding from Ms. Salkind to sustain our operations during the last three years. As of February 28, 2006, we owed Ms. Salkind approximately $95.5 million under outstandingconvertible notes. Although Ms. Salkind is under no obligation to continue to provide funding to us, we believe that she will continue to do so in the immediate future. This belief is based primarily upon her continued funding of us despite our failure to repay our convertible notes upon maturity. Since January 2001, we have generally defaulted on the repayment of obligations owed to Ms. Salkind as they become due. Ms. Salkind has generally allowed us to refinance maturing notes, along with accrued interest and penalties, into new notes. In addition, Ms. Salkind has continued to provide us with new funds. From time to time, we have obtained oral assurances that Ms. Salkind will continue funding our operations. However, we have no legally binding assurance that Ms. Salkind will continue funding us in the near-term or that the amount, timing and duration of funding from her will be adequate to sustain our operations. In the long-term, our ability to continue as a going concern is dependent on generating sufficient revenue from technology licensing fees and royalties and product sales. Our ability to generate significant revenue from any of these or other sources is uncertain. Historically, our operations have not generated sufficient revenue to cover our costs. In the event that our operations do not generate sufficient cash, we could be required to reduce our level of operations while attempting to raise additional working capital. We can give no assurance that additional financing will be available to us on acceptable terms or at all. The failure to obtain any necessary additional financing would have a material adverse effect on us. If adequate funds are not available or are not available on acceptable terms, our ability to fund our operations and any intended expansion, to take advantage of business opportunities, to develop or enhance products or services or to otherwise respond to competitive pressures would be significantly limited, and we might need to significantly restrict or discontinue our operations. The report of our independent registered public accounting firm for the year ended December 31, 2005 contains a qualification relating to our ability to continue as a going concern. The report of our independent registered public accounting firm on our consolidated financial statements as of December 31, 2005 and for the years then ended contains an explanatory paragraph stating that there is substantial doubt as to our ability to continue as a going concern. Our financial statements do not include any adjustments that might result from the outcome of this uncertainty. This uncertainty may affect our ability to raise additional capital and may also negatively impact our relationships with current and potential suppliers, customers and licensees. We have incurred substantial losses since our inception and expect future losses to continue for the foreseeable future. We have incurred substantial losses since our inception, including losses of $32.7 million, $59.1 million and $40.7 million for the years ended December 31, 2003, 2004 and 2005, respectively, and we had an accumulated deficit of $395.0 million at December 31, 2005. We expect that we will continue incurring a loss until, at the earliest, we generate sufficient revenue to offset the cost of our operations, including our continuing product development efforts. Our future revenue levels and potential profitability depend on many factors, including the demand for our existing products and services, our ability to develop and sell new products and services and our ability to control costs. We can give no assurance that we will experience any significant revenue growth or that we will ever achieve profitability. Even if we do achieve profitability for a fiscal year, we may be unable to sustain profitability on a quarterly or annual basis in the future. It is possible that our revenue will grow more slowly than we anticipate or that operating expenses will exceed our expectations. We have substantial outstanding indebtedness and we generally have been unable to repay our indebtedness as it becomes due. We have substantial levels of outstanding debt. As of December 31, 2005, our consolidated indebtedness was approximately $83.6 million, net of discounts, with stated interest at annual rates ranging from 6% to 12%, including $78.1 million, net of discounts, of convertible notes issued to Carole Salkind. The face amount of debt due Ms. Salkind as of December 31, 2005 was $83.6 million, of which all but $5.0 million will mature in 2006. Our consolidated interest expense, net totaled $16.5 million, $55.7 million and $67.9 million for the years ended December 31, 2003, 2004 and 2005, respectively, primarily resulting from the amortization of debt discounts and beneficial conversion features, mostly attributable to allocation of the fair value of warrants issued in conjunction with the debt and, to a lesser extent, original issue discounts. Our ability to meet our debt service obligations will depend on our future operations, which are subject to prevailing industry and other conditions, many of which are beyond our control. Our indebtedness to Ms. Salkind is secured by substantially all of our assets. In the event of any default on our obligations relating to this indebtedness, Ms. Salkind could declare her indebtedness to be immediately due and payable, and in certain cases, she could then foreclose on our assets. A default relating to our indebtedness could have a material adverse effect on our business and financial condition. To date, as our debt matures, we generally have been unable to repay the principal and interest due on the debt. Typically, the interest rates on our debt increase upon our failure to repay principal when due, with the default rates of interest ranging from 13% to 18% per annum. In addition, all of our debt held by Ms. Salkind imposes a default penalty of 10% of the principal in default upon our failure to repay the debt when due. Of the $83.6 million in indebtedness held by Ms. Salkind as of December 31, 2005, approximately $42.5 million represents cash loans made by Ms. Salkind (rather than non-cash items such as interest and default penalties rolled into new notes, legal settlements, premiums on equipment loans and original issue discounts). Our current stock price may restrict our ability to raise additional capital through sales of our equity securities. On February 28, 2006, the last reported sales price of our common stock was $0.0029 per share, which is less than the $0.01 par value of our common stock. Delaware law restricts sales of unissued shares of common stock at a price less than the par value of the common stock. The purchaser of such shares may be assessed for any difference between the par value and the sales price at less than par value. As a result, we do not intend to sell newly issued shares of our common stock at any time the purchase price of such shares would be less than the par value of our common stock. Similarly, in the future we do not intend to issue derivative securities with a conversion or exercise price less than par value. These restrictions may inhibit our ability to raise additional capital at times when the market price of our common stock is less than its par value. Furthermore, while we have issued certain convertible and exercisable securities at conversion prices based on fair market value at the time of issuance, which were below par value, we do not intend to fulfill conversion or exercise requests for these securities at conversion or exercise prices less than $0.01 per share unless and until we amend our certificate of incorporation to reduce or eliminate the par value of our common stock. While we intend to seek stockholder approval of such an amendment at our next annual meeting of stockholders, we can give no assurance that our stockholders would approve such an amendment. Holders of certain of our derivative securities may claim a right to contractual liquidated damages if we do not fulfill their conversion or exercise requests. We have committed to reserve, issue and register more shares of our common stock than we are currently authorized to issue and we are accruing liquidated damages as a result. We may be required to seek a further increase in the number of our authorized shares of common stock in order to reduce or eliminate the accrual of liquidated damages and to obtain any available future financing. Through the issuance of convertible debt, convertible preferred stock, options, warrants and other securities, we have made commitments to reserve and issue shares of our common stock that exceed the number of shares we are authorized to issue under our certificate of incorporation. Many of the instruments related to our derivative securities include liquidated damage provisions triggered by our failure to honor valid conversion or exchange requests or to comply with resale registration obligations. We have not complied with certain of our resale registration obligations. As a result of these failures, as of December 31, 2005, we have incurred, but not yet paid, liquidated damages totaling approximately $5.9 million, and we continue to incur liquidated damages of approximately $0.1 million per month. At our 2005 annual meeting of stockholders, held on June 28, 2005, our stockholders approved an amendment to our certificate of incorporation to increase the number of our authorized shares of common stock to 5.622 billion shares. This increase, however, is not sufficient for us to satisfy all of our commitments to reserve, issue and register for resale shares of our common stock. As a result, we can give no assurance that this increase will be sufficient to permit us to substantially reduce or eliminate liquidated damage accruals in any future period. In order to reduce or eliminate the accrual of liquidated damages, we may need to seek stockholder approval of a further increase in the number of our authorized shares of common stock. If approved, any further increase could lead to further dilution for our existing stockholders In addition, we may need to seek a further increase in our authorized shares of common stock in order to obtain future financing, if such financing would be available to us on acceptable terms, or at all. Any additional financing involving our common stock or derivative securities convertible into our common stock could also lead to further dilution for our existing stockholders. We have generated limited revenue from the licensing of our technology and the sale of our products and services and we can provide no assurance regarding future revenue levels. The markets for some or all of our key product lines may not grow or develop. Although we have actively marketed the licensing of our technologies and the sale of our products and services, our operating revenue has been limited and sporadic. Our annual revenue generally decreased in each year from 2000 through 2005, with only a small increase in 2004 over 2003. Some or all of our key product and service lines, such as our Artera Turbo offerings, may not grow or customers may decline or forego use of our products or services in some or all of these areas. Our failure to establish significant demand for our products and services would adversely impact our business, financial condition, operating results and cash flow. Currently, a significant portion of our planned revenue growth is attributable to our Artera Turbo service offerings. Although we believe that demand for these offerings will grow, we can give no assurance as to any level of future demand. Lack of growth in this business will adversely affect our revenue levels. We depend upon our indirect distribution channel to promote and sell many of our products and services. In addition to marketing our products and services directly through our own direct sales force, we market and sell our products and services through indirect channels. Our indirect channel network includes master distributors, resellers, finders and consultants. Conducting business through indirect distribution channels presents a number of risks, including: o our distributors and resellers can cease marketing our products and services with limited or no notice and with little or no penalty; o we may not be able to replace existing or recruit additional distributors or resellers if we lose any of our existing ones; o our distributors and resellers may not be able to effectively sell new products and services that we may introduce; o we do not have control over the business practices adopted by our distributors and resellers; o our distributors and resellers may also offer competitive products and services and may not give priority to marketing our products and services; and o we may face conflicts between the activities of our indirect channels and our direct sales and marketing activities. The failure of our suppliers to provide quality components or products in a timely manner could adversely affect our results. Our growth and ability to meet customer demands depend in part on our capability to obtain timely deliveries of components, subassemblies and products from our suppliers. We buy components and subassemblies from a variety of suppliers and assemble them into finished products. We also have certain of our products manufactured for us by third party suppliers. The cost, quality, and availability of these goods are essential to the successful production and sale of our products. Obtaining components, subassemblies and finished products entails various risks, including the following: o We obtain certain components, subassemblies and products from single suppliers and alternate sources for these items are not readily available. An interruption in supply from any of our single source suppliers in the future would materially adversely affect our business, financial condition and operating results. o Prices of components, subassemblies and finished products may rise. If this occurs and we are not able to pass these increases on to our customers or to achieve operating efficiencies that would offset the increases, it would have a material adverse effect on our business, financial condition and operating results. o Due to the lead times required to obtain certain components, subassemblies and products from certain foreign suppliers, we may not be able to react quickly to changes in demand, potentially resulting in either excess inventories of such goods or shortages of the components, subassemblies and products. Failure in the future to match the timing of purchases of components, subassemblies, and products to demand could increase our inventories and/or decrease our revenues, consequently materially adversely affecting our business, financial condition and operating results. o Most of our suppliers are not obligated to continue to provide us with components and subassemblies. Rather, we buy most components and subassemblies on a purchase order basis. If our suppliers experience increased demand or shortages, it could affect deliveries to us. In turn, this would affect our ability to manufacture and sell products that are dependent on those components and subassemblies. This would materially adversely affect our business, financial condition and operating results. We face significant competition from well-established companies. We face formidable competition in each of the industries in which we operate. Many of our competitors have substantially greater management, technical, financial, marketing and product development resources than we do. In addition, many of our competitors have substantially greater name recognition and shorter production and distribution lead times than we do. For example, our Pro Tech business faces substantial competition from Sony, Bose and Plantronics, and some of our Artera Turbo service offerings compete with other Internet accelerators offered by Propel, Proxyconn and Slipstream. While we believe that the quality of our products and services equals or exceeds those of our competitors, we can give no assurance that we will be able to compete effectively against these companies. Our success depends upon our ability to develop new products and services and to enhance our existing products and services. The industries in which we operate are characterized by rapid technological advances, evolving standards, changing customer needs and frequent new product introductions and enhancements. To keep pace with technological developments, satisfy increasingly sophisticated customer requirements and achieve market acceptance, we must enhance and improve our existing products and services, such as our Artera Turbo service offerings, and we must also continue to introduce new products and services. If we are unable to develop new products and services or adapt our current products and services to meet changes in the marketplace, if we are unable to enhance and improve our products and services successfully in a timely manner, or if we fail to position and/or price our products and services to meet market demand, customers may not buy our products and services and our business and operating results will be adversely affected. If our enhancements to existing products and services do not deliver the functionality that our customers demand, our business and operating results will be adversely affected. In addition, industry adopted and de facto standards for the Internet are rapidly evolving. We can give no assurance that the standards on which we choose to develop new Internet-based products and services will allow us to compete effectively for business opportunities as they arise in emerging areas. Accelerated product and service introductions and short product life cycles require high levels of expenditures for research and development that could adversely affect our operating results. Further, any new products or services we develop may not be introduced in a timely manner and may not achieve the broad market acceptance necessary to generate significant revenue. If we cannot hire enough qualified employees or if we lose key employees, it will adversely affect our ability to manage our business, develop our products and services and increase our revenue. We believe any future success depends to a large extent on the continued service of our senior management and other key employees and the hiring of new qualified employees. In our industries, substantial and continuous competition exists for highly skilled business, product development, technical and other personnel. We may experience increased compensation costs that are not offset by either improved productivity or higher prices. We may not be successful in recruiting new personnel and in retaining and motivating existing personnel. Any changes in management may be disruptive to our operations. We do not have long-term employment agreements with our employees. We might experience significant errors or security flaws in our software offerings. Despite testing prior to release of our software offerings, software products frequently contain errors or security flaws, especially when first introduced or when new versions are released. Software errors in our products and services could affect the ability of our products and services to work with other hardware or software products, could delay the development or release of new products and services or new versions of products and services and could adversely affect market acceptance of our products and services. Security flaws in our products could expose us to claims as well as harm our reputation, which could impact our future sales. The detection and correction of any security flaws can be time consuming and costly. If we experience errors or delays in releasing new products or services or new versions of products or services, we could lose revenue. Software errors could also subject us toproduct liability, performance and/or warranty claims, which could adversely affect our business and operating results. Third parties are asserting rights with respect to certain of our key intellectual property. We may not be able to protect our intellectual property. As more fully described below in Item 3. "Legal Proceedings - Founding Midcore Shareholder Litigation," we are currently defendants in a lawsuit brought by two of the former shareholders of a corporation that became our Midcore Software subsidiary. Among other remedies, the plaintiffs' complaint seeks a declaration that the intellectual property acquired from the plaintiffs by the corporation that became Midcore Software (which intellectual property is currently used in our Artera Turbo service offerings) be held in trust for the benefit of the plaintiffs. If the court were to declare such a trust, the plaintiffs would be entitled to equitable remedies that could include, among other things, all or a portion of the revenues generated by our use of this intellectual property. While we cannot predict the outcome of this proceeding at this time, we intend to defend against the plaintiffs' claims vigorously. In general, we rely on a combination of copyright, patent, trademark, trade secrets, confidentiality procedures and contractual commitments to protect our proprietary information. Despite our efforts, these measures can only provide limited protection. Unauthorized third parties may try to copy or reverse engineer portions of our products or otherwise obtain and use our intellectual property. Any patents owned by us may be invalidated, circumvented or challenged. Any of our pending or future patent applications, whether or not being currently challenged, may be issued with a narrower scope than the claims we seek, if at all. In addition, the laws of some countries do not provide the same level of protection of our proprietary rights as do the laws of the United States. If we cannot protect our proprietary technology against unauthorized copying or use, we may not remain competitive. Our business may be harmed if we are found to have infringed intellectual property rights of third parties. In the future, third parties may assert claims against us alleging that we have infringed their intellectual property rights. If we do not succeed in any such litigation, we could be required to expend significant resources to pay damages, develop non-infringing intellectual property or to obtain licenses to the intellectual property that is the subject of the litigation. However, we cannot be certain that any such licenses, if available at all, will be available to us on commercially reasonable terms. Also, defending these claims may be expensive and divert the time and efforts of our management and other employees. Changes in regulatory requirements may adversely impact our operating results or reduce our ability to generate revenues if we are unable to comply. Many of our products must meet the requirements set by regulatory authorities in the numerous jurisdictions in which we sell them. As regulations and local laws change, we must modify our products to address those changes. Regulatory restrictions may increase the costs to design and manufacture our products, resulting in a decrease in our margins or a decrease in demand for our products if the costs are passed along. Compliance with regulatory restrictions may impact the technical quality and capabilities of our products, reducing their marketability. While we believe that we currently have adequate control structures in place, we are still exposed to potential risks from legislation requiring companies to evaluate controls under Section 404 of the Sarbanes-Oxley Act of 2002. We are working toward evaluating our internal controls systems in order to allow management to report on, and our independent registered public accountants to attest to, our internal controls, as required by the Sarbanes-Oxley Act. We are performing the system and process evaluation and testing (and any necessary remediation) required in an effort to comply with the management certification and public accountant attestation requirements of Section 404 of the Sarbanes Oxley Act. As a result, we expect to incur additional expenses and diversion of management's time. While we anticipate being able to fully implement the requirements relating to reporting on internal controls and all other aspects of Section 404 in a timely fashion, we cannot be certain as to the timing of completion of our evaluation, testing and remediation actions or the impact of those on our operations since there is no precedent available by which to measure compliance adequacy. If we are not able to implement the requirements of Section 404 in a timely manner or with adequate compliance, we might be subject to sanctions or investigation by the SEC. Any such action could adversely affect our financial results. The sale or availability for future sale of substantial amounts of our common stock could adversely affect our stock price. The sale or availability for sale of substantial amounts of our common stock, including shares issuable upon exercise of derivative securities, in the public market could adversely affect the market price of our common stock and materially impair our ability to raise capital through future offerings of our common stock. As noted above, through the issuance of convertible debt, convertible preferred stock, options, warrants and other securities, we have made commitments to reserve and issue shares of our common stock that significantly exceed the number of shares we are currently authorized to issue under our certificate of incorporation. At our 2005 annual meeting of stockholders, held on June 28, 2005, our stockholders approved an amendment to our certificate of incorporation to increase the number of our authorized shares of common stock to 5.622 billion shares. As a result, holders of our derivative securities are entitled to convert at least a portion of these securities into shares of our common stock. The number of shares issuable under many of these derivative securities is a function of the price of our common stock because the number of shares issuable under several of our agreements varies with the market price. At February 28, 2006, based on the closing bid price of $0.0029 per share on that date, our outstanding commitments, including derivative securities were convertible into an aggregate of approximately 35.7 billion shares of our common stock. The issuance and sale into the market of a substantial number of additional shares of our common stock would have a substantial dilutive effect on our current stockholders and could cause a significant reduction in the market price of our common stock. In addition, we have entered into a private equity credit agreement with Crammer Road LLC. This agreement provides that we must put to Crammer Road shares of our common stock having an aggregate value of at least $5.0 million (the minimum commitment amount) and may put to Crammer Road shares of our common stock having an aggregate value of up to $50.0 million (the maximum commitment amount) over the three year term of the agreement. The sale of shares of our common stock to Crammer Road to satisfy the $5.0 million minimum commitment amount under the private equity credit agreement is likely to result in substantial dilution to the interests of our other stockholders. There is no upper limit on the number of shares that we may be required to issue to satisfy our minimum commitment amount. This will have the effect of further diluting the proportionate equity interest and voting power of holders of our common stock. Holders of our common stock are also exposed to additional market price risks from potential low-risk short selling strategies that may be adopted by third parties and that could contribute to the future decline of our stock price. A substantial number of our convertible and exchangeable securities are convertible or exchangeable at a price per share that is 20% to 25% less than the five-day average closing bid price of our common stock immediately prior to conversion or exchange. In addition, the terms of these derivative securities generally do not prohibit the holders of these securities from short selling our common stock. Short selling is the act of borrowing stock to sell with the expectation of the price dropping and the intent of buying the stock back at a cheaper price to replace the borrowed stock. As a result of these factors, holders of these derivative securities may decide to sell our common stock short in an effort to drive down the price of the common stock by creating an imbalance of sell-side interest. Such a strategy involves low risk to the holder of these derivative securities due to the discounted conversion or exchange prices they enjoy that provide a hedge against potential price increases. The use of such a strategy by one or more of the holders of these derivative securities could cause a significant reduction in the market price of our common stock. In addition, any shares issued to Crammer Road under our private equity credit agreement will be issued at a 7% discount to the average of the three lowest closing bid prices for the ten trading days immediately following the notice date of a put. Based on this discount, Crammer Road has an incentive to sell immediately to realize the gain on the 7% discount. These discounted sales could cause our stock price to decline. A significant downward pressure on the price of our common stock caused by the sale of material amounts of common stock under the private equity credit agreement could encourage short sales by third parties. These sales could place additional downward pressure on the price of our common stock by increasing the number of shares being sold. Our common stock is illiquid and you may have difficulty in selling your shares. Our common stock is traded on the OTC Bulletin Board. As a result, the holders of our common stock may find it more difficult to obtain accurate quotations concerning the market value of our shares. Stockholders also may experience greater difficulties in attempting to sell their shares than if our common stock were listed on a stock exchange or quoted on the Nasdaq Stock Market. Because our common stock is not traded on a stock exchange or Nasdaq and because the market price of our common stock is less than $5.00 per share, our common stock isclassified as "penny stock," subject to the requirements of the penny stock rules of the SEC. The penny stock rules impose additional sales practice requirements on broker-dealers who sell penny stock securities to persons other than established customers or accredited investors. For example, the broker must make a special suitability determination for the purchaser and must have received the purchaser's written consent to the transaction prior to the sale. The rules also require that the broker deliver certain disclosures to purchasers of penny stocks. These additional burdens may discourage brokers from effecting transactions in our common stock, which could severely limit the market liquidity of our common stock and the ability of stockholders to sell our common stock in the market. Our stock price may be volatile and your investment could lose value. Historically, the market price of our common stock has been volatile. The trading price of our common stock could be subject to wide fluctuations in response to various factors, some of which are beyond our control. These factors include: o quarterly variations in our operating results; o announcements by us or our competitors of new products or services, significant contracts, commercial relationships or capital commitments; o our reliance on licensing revenue that is unpredictable and non-recurring; o our ability to develop and market new and enhanced products and services on a timely basis; o commencement of, or involvement in, litigation; o concerns about our liquidity and viability; and o general trends involving the economy or OTC Bulletin Board traded companies. In addition, the stock market in general, and the market for technology companies in particular, have experienced price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of those companies. These market and industry factors may seriously affect the market price of our common stock regardless of our actual operating performance. We do not intend to pay dividends on our common stock for the foreseeable future. We have never declared or paid any cash dividends on our common stock. We currently intend to retain any future earnings and do not expect to pay dividends on our common stock in the foreseeable future. In addition, we may not declare, pay or make any dividends or other distributions upon our common stock unless we give the holder of our series H preferred stock 30 days' prior notice and pay all accrued dividends on our series H preferred shares. Some provisions in our certificate of incorporation and by-laws may deter third parties from acquiring us. Our certificate of incorporation and our by-laws contain provisions that may make the acquisition of our company more difficult without the approval of our board of directors, including the following: o only our board of directors or the chairman of our board of directors may call special meetings of our stockholders; o our stockholders may take action only at a meeting of our stockholders and not by written consent; o we have authorized undesignated preferred stock, the terms of which may be established and shares of which may be issued without stockholder approval; and o we require advance notice for stockholder proposals of up to 90 days prior to a meeting at which stockholder proposals may be introduced.These anti-takeover defenses could discourage, delay or prevent a transaction involving a change in control of us. These provisions could also discourage proxy contests and make it more difficult for you and other stockholders to elect directors of your choosing and cause us to take other corporate actions you desire. Section 203 of the Delaware General Corporation Law may delay, defer or prevent a change in control that our stockholders might consider to be in their best interest. We are subject to Section 203 of the Delaware General Corporation Law which, subject to certain exceptions, prohibits "business combinations" between a publicly-held Delaware corporation and an "interested stockholder," which is generally defined as a stockholder who becomes a beneficial owner of 15% or more of aDelaware corporation's voting stock for a three-year period following the date that such stockholder became an interested stockholder. Section 203 could have the effect of delaying, deferring or preventing a change in control of us that our stockholders might consider to be in their best interests.ITEM 1B. UNRESOLVED STAFF COMMENTS Not applicable.