We are exposed to certain market risks which exist as part of our ongoing business operations. We currently do not engage in derivative and hedging transactions to mitigate the affects of the risks below. In the future, we may enter into foreign currency forward contracts to manage foreign currency risk.

 

Interest Rate Risk.  Because our debt is primarily tied to borrowing rates in the United States, changes in U.S. interest rates would affect the interest paid on our borrowings and/or earned on our cash and cash equivalents. Based on our overall interest rate exposure at December 31, 2007, a near-term change in interest rates, based on historical small movements, would not materially effect our operations or the fair value of interest rate sensitive instruments. Our current debt instruments have fixed interest rates and terms and, therefore, a significant change in interest rates would not have a material adverse effect on our financial position or results of operations; however, changes in interest rates may increase our cost of borrowing in the future.

 

Investment Risk.  As of December 31, 2007, we do not have material amounts invested in other public or privately-held companies and therefore there is minimal associated investment risk with our investment portfolio.

 

Foreign Currency Risk.  We conduct business internationally in two currencies, and as such, are exposed to adverse movements in foreign currency exchange rates. Our exposure to foreign exchange rate fluctuations arise in part from: (1) translation of the financial results of our Gavitec subsidiary into U.S. dollars in consolidation; (2) the re-measurement of non-functional currency assets, liabilities and intercompany balances into U.S. dollars for financial reporting purposes; and (3) non-U.S. dollar denominated sales to foreign customers. Historically, neither fluctuations in foreign exchange rates nor changes in foreign economic conditions have had a significant impact on our financial condition or results of operations. Foreign exchange rate fluctuations did not have a material impact on our financial results for the years ended December 31, 2007 and 2006.

 

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ITEM 8.

Financial statements and supplementary data

 

6. Financing

 

We have entered into a series of Securities Purchase Agreements with Yorkville, as follows:

		August 24,			December 29,			March 27,			August 24,
		2006			2006			2007			2007			Total
Aggregate amount		$	5,000,000		$	2,500,000		$	7,458,651		$	1,775,000		$	16,733,651
Fees paid			-			(270,000	)		(780,865	)		(200,000	)		(1,250,865	)
Accrued interest on prior obligations paid			-			-			(365,972	)		-			(365,972	)
Liquidated damages on prior obligations paid			-			-			(1,311,814	)		-			(1,311,814	)
Net proceeds to us		$	5,000,000		$	2,230,000		$	5,000,000		$	1,575,000		$	13,805,000
Interest rate			10	%		10	%		13	%		14	%
Maturity date (2 years)			8/24/2008			12/29/2008			3/27/2009			8/24/2009
Number of warrants issued			175,000,000			42,000,000			125,000,000			75,000,000			417,000,000
Exercise price of warrants			.05 - .25 *			0.06 *			0.04 *			0.02
Warrant exercisable expiration date (5 years)			8/24/2011			12/29/2011			3/24/2012			8/24/2012
Convertible into our common stock:
conversion price per share		$	0.15		$	0.06		$	0.05		$	0.02
or percent of lowest closing bid price			90	%		90	%		90	%		80	%
of lowest volume weighted average price preceding conversion			30 days			30 days			30 days			10 days
Registration rights agreement:
file registration with SEC			within 30 days			within 150 days			before 4/12/07			30 days of demand
achieve effectiveness of registration statement with SEC			within 90 days			within 90 days			5/10/2007			90 days of demand
Liquidated damages for failure to meet filing or effectiveness requirements			2% of principal, per month			2% of principal, per month			2% of principal, per month			2% of principal, per month
Security pledged as collateral			substantially all of our assets			substantially all of our assets			substantially all of our assets			substantially all of our assets

 

---

* all warrants issued to Yorkville under these Agreements have been subsequently repriced to $0.02 per share.

 

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Current Period Accounting Considerations

 

Due to our previous default position with respect to the convertible financial instruments, the carrying value of each instrument in effect as of December 31, 2006 was written up to the respective full face value during the fourth quarter of 2006. The March 2007 Debenture and the August 2007 Debenture were each initially recorded at their full fair value pursuant to FAS 155. That fair value is marked-to-market each reporting period, with any changes in the fair value charged or credited to income. For the Series C Convertible Preferred Stock and the August 2006 and December 2006 debentures, the embedded derivative instrument, primarily the conversion feature, has been separated and accounted for as a derivative instrument liability (see below). This derivative instrument liability is also marked to market each reporting period. The face value or fair value, as appropriate, of each instrument as of December 31, 2007 and 2006 was:

 

		Face value			Fair value			Total
2007		(in thousands)
Series C Convertible Preferred Stock		$	20,097					$	20,097
August 2006 debenture		$	5,000					$	5,000
December 2006 debenture			2,500						2,500
March 2007 debenture						18,798			18,798
August 2007 debenture						4,401			4,401
		$	7,500		$	23,199		$	30,699

 

		Face value			Fair value			Total
2006		(in thousands)
Series C Convertible Preferred Stock		$	21,657					$	21,657
August 2006 debenture		$	5,000					$	5,000
December 2006 debenture			2,500						2,500
		$	7,500		$	0		$	7,500

 

Derivative financial instruments arising from the issuance of convertible financial instruments are initially recorded, and continuously carried, at fair value. Upon conversion of any derivative financial instrument, the change in fair value from the previous reporting date to the date of conversion is recorded to income (loss), and then the carrying value is recorded to paid-in capital, provided all other criteria for equity classification are met.

 

The following tabular presentation reflects the components of derivative financial instruments related to convertible financial instruments on our balance sheet at December 31, 2007:

 

		Series C
		Convertible			August			December			March			August						Other
		Preferred			2006			2006			2007			2007			Other			Preferred
		Stock			Debenture			Debenture			Debenture			Debenture			Warrants (1)			Stock (1)			Total
		(in thousands)
Liabilities:
Common stock warrants		$	480		$	1,733		$	420		$	1,263		$	833			26			-		$	4,755
Embedded conversion feature(2)			7,930			7,925			3,962			n/a			n/a			-			79			19,896
		$	8,410		$	9,658		$	4,382		$	1,263		$	833		$	26		$	79		$	24,651

 

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(1)    The fair values of certain other derivative financial instruments (warrants) that existed at the time of the issuance of Series C convertible preferred stock were reclassified from stockholders’ equity to liabilities when, in connection with the issuance of Series C convertible preferred stock, we no longer controlled our ability to share-settle these instruments. These derivative financial instruments had fair values of $14.3 million, $0.97 million and $0.026 million on February 17, 2006, December 31, 2006, and December 31, 2007, respectively. The decrease in fair value of these other derivative financial instruments resulted primarily from a decrease in our share price between February 17, 2006, December 31, 2006, and December 31, 2007. The change in fair value is reported as “Gain on derivative financial instruments” on the condensed consolidated statement of operations during each period. These warrants will be reclassified to stockholders’ equity when we reacquire the ability to share-settle the instruments.   (2)     For the March 2007 and August 2007 debentures, the embedded conversion feature is effectively embodied in the fair value of those instruments.

 

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The following table reflects the number of common shares into which the convertible instruments and warrants are convertible or exercisable at December 31, 2007:

 

		Series C
		Convertible			August			December			March			August
		Preferred			2006			2006			2007			2007			Other
		Stock			Debenture			Debenture			Debenture			Debenture			Warrants
		(in thousands)
Common stock warrants			75,000			175,000			42,000			125,000			75,000			22,825
Embedded conversion feature (1)			2,166,031			943,396			471,698			1,420,695			334,906			0
Total			2,241,031			1,118,396			513,698			1,545,695			409,906			22,825

 

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(1) The terms of the embedded conversion features in the convertible instruments presented above provide for variable conversion rates that are indexed to our trading common stock price. As a result, the number of indexed shares is subject to continuous fluctuation. For presentation purposes, the number of shares of common stock into which the embedded conversion feature in the Series C convertible stock was convertible as of December 31, 2007 was calculated as the face value plus assumed dividends (if declared), divided by 97% of the lowest closing bid price for the 30 trading days preceding December 31, 2007. The number of shares of common stock into which the embedded conversion feature in the convertible debentures was convertible as of December 31, 2007 was calculated as the face value of each instrument divided by the lower of $0.01 or 50% of the average closing market price of our common stock for the 10 days prior to December 31, 2007.

 

Changes in the fair value of convertible instruments that are carried at fair value (the March 2007 Debenture and the August 2007 Debenture) and changes in the fair values of derivative instrument liabilities (including warrants and the bifurcated embedded derivative features of convertible instruments not carried at fair value) are reported as “Gain (loss) on derivative financial instruments” in the accompanying condensed consolidated statement of operations, as follows:

 

		Year ended December 31,
		2007			2006
		(in thousands)
Series C Convertible Preferred Stock			($447	)	$	18,853
August 2006 debenture			2,284			(6,941	)
December 2006 debenture			(645	)		(1,238	)
March 2007 debenture			(4,641	)		-
August 2007 debenture			(3,796	)		-
Other derivative instruments			(395	)		2,003
			($7,640	)	$	12,677

 

The fair value of derivative financial instrument liabilities recorded as of December 31, 2007 and December 31, 2006 was:

		Year ended December 31,
		2007			2006
		(in thousands)
Warrants and embedded conversion features in preferred stock		$	8,410		$	8,815
Warrants and embedded conversion features in certain debentures			16,136			15,679
Other warrants			26			-
Fair value of future payment obligation			-			564
Special preference stock of Mobot			79			359
Total derivative financial instruments		$	24,651		$	25,417

 

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Fair value considerations for derivative financial instruments:

 

Freestanding derivative instruments, consisting of warrants that were issued in connection with the financings, are valued using the Black-Scholes-Merton valuation methodology because that model embodies all of the relevant assumptions that address the features underlying these instruments. Significant assumptions used in this model as of December 31, 2007 are as follows:

 

	Series C
	Convertible	August	December	March	August
	Preferred	2006	2006	2007	2007
	Stock	Debenture	Debenture	Debenture	Debenture	Other	Total
Holder	Yorkville	Yorkville	Yorkville	Yorkville	Yorkville	Other
Instrument	Warrants	Warrants	Warrants	Warrants	Warrants	Warrants
Exercise price	$0.02	$0.01	$0.01	$0.01	$0.01	$ 0.01 - $3.45
Remaining term (years)	3.13	3.67	4	4.25	4.67	.02 - 3.13
Volatility	93%	110%	107%	108%	160%	90%-172%
Risk-free rate	3.07%	3.07%	3.45%	3.07%	3.45%	2.76% - 3.45%
Number of warrants	75,000,000	175,000,000	42,000,000	125,000,000	75,000,000	22,825,000	514,825,000

 

Embedded derivative financial instruments arising from the convertible instruments consist of multiple individual features that were embedded in each instrument. For each convertible instrument, we evaluated all significant features and, as required under current accounting standards, aggregated the components into one compound derivative financial instrument for financial reporting purposes. For financings recorded in accordance with FAS 133, the compound embedded derivative instruments are valued using the Flexible Monte Carlo methodology because that model embodies certain relevant assumptions (including, but not limited to, interest rate risk, credit risk, and conversion/redemption privileges) that are necessary to value these complex derivatives. For financings recorded in accordance with FAS 155, the entire hybrid instrument is initially recorded at fair value and subsequent changes in fair value are recognized in earnings.

 

Assumptions used as of December 31, 2007 in valuing derivative instruments embedded in financings recorded in accordance with FAS 133 included exercise estimates/behaviors and the following other significant estimates:

 

	Series C
	Convertible	August	December
	Preferred	2006	2006
	Stock	Debenture	Debenture
Conversion prices	$0.011	$0.0053	$0.0053
Remaining terms (years)	1.13	0.67	1.00
Equivalent volatility	213.03%	159.84%	155.04%
Equivalent interest-risk adjusted rate	9.00%	11.21%	11.21%
Equivalent credit-risk adjusted yield rate	71.00%	40.67%	36.83%

 

Significant assumptions included as of December 31, 2006 are as follows:

 

Holder	Cornell Capital Partners		Other
Instrument	Warrants		Warrants
Exercise price	$0.04		$0.01 - $3.45
Term (years)	4.13		0.5 - 4.13
Volatility	158.89% - 165.86%		158.89% - 165.86%
Risk-free rate	3.65%		3.65%

 

Equivalent amounts reflect the net results of multiple modeling simulations that the Monte Carlo Simulation methodology applies to underlying assumptions. The assumptions included in the Monte Carlo Simulation calculation are highly subjective and subject to interpretation.

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Financial instruments recorded at fair value under FAS 155 were valued using the common stock equivalent approach. The common stock equivalent was calculated using the shares indexed to the financial instruments valued at the market rate of our stock and the present value of the coupon.

 

As of December 31, 2006, we were in default of the Investor Registration Rights Agreement pursuant to the August 24, 2006 and the December 29, 2006 Agreements, because the registration statement to register the shares underlying the secured convertible debenture issued on August 24, 2006 was not declared effective by the specified date. Due to the then-default status, Yorkville had certain material additional rights in these financing arrangements that did not previously exist. Specifically,

 

·

The full fair value of the secured convertible debentures was callable in the amount of $5,000,000 and $2,500,000, respectively;

 

·

The warrants could be exercised on a cashless basis;

 

·

We were responsible for liquidated damages of 2% of the principal up to a maximum of $0.5 million on each debenture;

 

·

The requirement for Yorkville to maintain an ownership interest in us of less than 5% was terminated;

 

Our accounting for the secured convertible debentures was updated to take into account certain specific accounting rules and regulations that were applicable under the default provisions as of December 31, 2006.

 

·

We incurred a charge to income from continuing operations at the time of the issuance of the December 29, 2006 secured convertible debenture to recognize the liability of the debenture at redemption value by fully writing off the debt discount.

 

·

Prior to the default, we were accreting the debt discount on the August 24, 2006 secured convertible debenture, using the effective interest method, through periodic charges to interest expense. Due to the default status, we accreted debt discount to the full fair value of the secured convertible debenture as of December 31, 2006, resulting in an additional charge to income from continuing operations of $4.8 million for the year ended December 31, 2006.

 

·

Both of these secured convertible debentures are now reported as debt in the current liabilities section of the balance sheet rather than long term, because the debentures are callable as demand debt due to the default.

 

The following table summarizes the allocation of the components of these instruments on their respective inception dates:

		August 24,			December 29,
		2006			2006
Instrument:			(in thousands	)		(in thousands	)
Convertible debenture		$	-(1)		$	2,500
Common stock warrants (2)			18,507			2,159
Embedded conversion feature			970			1,579
Derivative loss			(14,477	)		(1,238	)
Interest expense(3)			-			(2,770	)
Total net proceeds		$	5,000		$	2,230

 

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(1)

There were insufficient proceeds to allocate amounts to the August 24, 2006 debenture. For purposes of application of the effective interest method, an initial carrying value of 1% of the full amount of the debenture was assumed.

 

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(2)

We issued warrants to purchase 175 million (August 24, 2006) and 42 million (December 29, 2006) shares of common stock in connection with the convertible debenture.

 

(3)

Due to the prior default status, the December 29, 2006 debentures were accreted up to the full face value of $2.5 million at inception and the financing costs of $0.3 million were expensed to interest expense. As a result of the prior default, we recorded total charges to income in the amount of $4.0 million, which is more than the face value of the debenture of $2.5 million.

 

In accordance with FAS 133, ‘Accounting for Derivative Instruments and Hedging Activities’, we determined that the conversion feature of the debenture met the criteria of an embedded derivative. The debenture does not meet the definition of “conventional convertible debt” because the number of shares which may be issued upon the conversion of the debenture is not fixed. Furthermore, there is no cap on the number of shares that could be issued upon conversion. Therefore, the conversion feature fails to qualify for equity classification under EITF 00-19, and must be accounted for as a derivative liability

 

Due to our default position as of December 31, 2006, the August 24, 2006 debenture was written up to the full face value of $5.0 million as of December 31, 2006, which was the carrying value of the convertible debenture as of that date. Derivative financial instruments arising from the issuance of a convertible debenture are initially recorded, and continuously carried, at fair values. Upon conversion of any derivative financial instrument, the change in fair value from the previous reporting date to the date of conversion is recorded to income (loss), and then the carrying value is recorded to paid-in capital, provided we meet all other criteria for equity classification.

 

Series C Convertible Preferred Stock

 

We entered into a Securities Purchase Agreement, dated February 17, 2006 (the “Agreement”) with Yorkville. Pursuant to the Agreement, Yorkville agreed to purchase $22.0 million 8% cumulative Series C convertible preferred stock convertible over a period of three years from the date of issuance. Net proceeds received amounted to $17.9 million, comprised of cash of $14.0 million, marketable securities with a calculated fair value of $0.6 million and a purchase value of $2.0 million, and the extinguishment of $3.2 million of preexisting indebtedness. In addition, Yorkville withheld $2.7 million commitment and structuring fees from the gross proceeds. The Agreement also provided for the issuance to Yorkville of warrants to purchase shares of our common stock. The Agreement also called for Yorkville to acquire an additional $5.0 million of Series C convertible preferred stock on the date a registration statement filed by us was declared effective by the U.S. Securities and Exchange Commission. In connection with the Agreement, we also entered into a registration rights agreement with Yorkville that required us to (i) file a registration statement with the SEC registering the resale of the shares of common stock issuable upon conversion of the preferred stock and the exercise of the warrants, (ii) achieve effectiveness by December 1, 2006, and (iii) maintain effectiveness of the registration statement. We failed to meet these requirements; accordingly we were subject to liquidated damages amounting to 1% of the outstanding amount of Series C preferred stock per month, not to exceed $1.2 million.

 

At any time from the closing date until February 17, 2009, Yorkville has the right to convert the preferred stock, in whole or in part, into our common stock at the then effective conversion price, which varies relative to our trading stock price, as follows: $0.50 per share, or 97% of the lowest closing bid price (as reported by Bloomberg) of the common stock for the 30 trading days immediately preceding the conversion date. The conversions are limited such that the holder cannot exceed 4.99% ownership, unless the holders waive their right to such limitation. The limitation will terminate on any event of default.

 

The following table summarizes the conversions Yorkville has exercised under this agreement:

 

Date		Series C Shares			Common Shares
Issued		Converted			Issued
11/28/2006			378			6,631,579
06/19/2007			245			8,781,362
08/16/2007			500			25,773,196
10/24/2007			600			45,801,527
10/31/2007			180			13,740,458
Total			1,903			100,728,122

 

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The remaining outstanding balance of Series C convertible preferred stock is 20,097 shares as of December 31, 2007.

 

The Series C convertible preferred stock, at the option of the holder, affords Yorkville anti-dilution protection should, at any time while the Series C preferred stock instruments are outstanding, we offer, sell or grant any option to purchase or offer, sell or grant any right to re-price our securities, or otherwise dispose of or issue any common stock or common stock equivalents, entitle any person to acquire shares of common stock at an effective price per share less than the then effective conversion price (excluding employee stock options), as calculated by the formula described above; then, in such instance, the conversion price for the convertible preferred stock shares shall be reduced to the lower price. In case of any such adjustment in the effective conversion price for the convertible preferred shares, this could significantly dilute existing investors.

 

Under the Series C Agreement, Yorkville also received “A” warrants, “B” warrants and “C” warrants to purchase 20 million, 25 million, and 30 million shares of our common stock, respectively, exercisable in three separate tranches at a price of $0.50, $0.40 and $0.35, respectively, per share, subject to adjustment, included under anti-dilution protection similar to that described above. As an inducement to enter into subsequent financing arrangements with Yorkville, the warrants were repriced on December 29, 2006 to $0.04 per share, subject to all the original terms and conditions of the respective warrant agreements, resulting in a charge to income of $0.7 million. The warrants have a five-year contractual life. We can force exercise of the warrants if the closing bid price of our stock is more than $0.10 greater than the exercise price of any of the warrants for 15 consecutive trading days. It is important to note that the warrants held by Yorkville contain a provision that, if at the time of exercise, we are in default of the warrant agreement, the holder can perform a “cashless” exercise of the warrants and in lieu of making payment of the exercise price in cash, elect instead to have shares withheld as consideration for the exercise price. In the event of such a “cashless” exercise, we would not receive any cash proceeds upon the exercise of such warrants. As of December 31, 2007, we are not in default of any of the provisions in the Investor Registration Rights Agreement entered into on February 17, 2006.

 

The 8% cumulative Series C convertible preferred stock contains consequences in case of default. Events of default which could subject us to penalties, damages, and liabilities as specified in the Agreement include:

 

·

Any case or action of bankruptcy or insolvency commenced by us or any subsidiary, against us or adjudicated by a court against us for the benefit of creditors;

 

·

Any default in our obligations under a mortgage or debt in excess of $0.1 million;

 

·

Any cessation in the eligibility of our stock to be quoted on a trading market;

 

·

Failure to timely file the registration statement covering the shares related to the conversion option, or failure to make the registration statement effective timely;

 

·

Any lapse in the effectiveness of the registration statement covering the shares related to the conversion option, the warrants as described and transacted in the securities purchase agreement and accompanying documents;

 

·

Any failure to deliver certificates within the specified time; and

 

·

Any failure, by us, to pay in full the amount of cash due pursuant to a buy-in or failure to pay any amounts owed on account on account of an event of default within 10 days of the date due.

 

Other provisions included in the Agreement include the following:

 

·

The 8% cumulative Series C convertible preferred stock is convertible into common stock, at the option of Yorkville, at any time after the effective date;

 

·

Conversions can be made in increments and from time to time;

 

·

The 8% cumulative Series C convertible preferred stock has voting rights on an “as converted” basis, meaning Yorkville is entitled to vote the number of shares of common stock into which the 8% cumulative Series C convertible preferred stock was convertible as of the record date for a meeting of shareholders;

 

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·

As promptly as practicable after any conversion date and subject to an effective registration statement or an exemption from registration, we shall cause our transfer agent to deliver a certificate representing the converted shares, free of any legends and trading restrictions for the number of shares converted;

 

·

We will reserve and keep available authorized and unissued registered shares available to be issued upon conversion;

 

·

Yorkville will not be responsible for any transfer taxes relative to issuance of shares;

 

·

If we offer, sell or grant stock at an effective per share price less than the then Conversion Price, then the Conversion Price shall be reduced to equal the effective conversion, exchange or purchase price for such common stock or common stock equivalents;

 

As of December 31, 2006, we were in default of the registration rights agreement, and accordingly the accounting for the Series C convertible preferred stock was updated to take into account certain specific accounting rules and regulations that are now applicable under the default provision:

 

·

Prior to the default, we were accreting dividends on the Series C convertible preferred stock, using the effective interest method, through periodic charges to additional paid in capital. Due to the default status, we accreted dividends to the full face value as of December 31, 2006 of the Series C convertible preferred stock, resulting in an additional charge of $18.2 million to net loss attributable to common shareholders for the year ended December 31, 2006.

 

·

The Series C convertible preferred stock is now reported as demand debt in the current liabilities section of the balance sheet, pursuant to the guidance outlined in FAS 150.

 

At the inception date of February 17, 2006, a summary of the allocation of the components of the transaction was as follows:

Instrument:			(in thousands)
Convertible preferred stock (1)		$	1,711
Common stock warrants (2)			16,172
Embedded conversion feature			1,935
Debt extinguishment loss (3)			(1,964	)
Total net proceeds		$	17,854

 

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(1)

The discount to the face value of the 8% cumulative Series C convertible preferred stock that resulted from the allocation along with deferred costs was being accreted through periodic charges to additional paid-in capital using the effective interest method, prior to the accretion to full face value due to our being in default as of December 31, 2006 of the registration rights agreement

 

(2)

We issued warrants to purchase 75 million shares of common stock in connection with the 8% cumulative Series C convertible preferred stock. We also issued 2 million warrants (valued at $0.4 million) as financing fees.

 

(3)

The financing arrangement settled face value $3.2 million of preexisting indebtedness. The debt extinguishment loss was calculated as the amount that the fair value of securities issued (using a relative fair value basis) exceeded our carrying value.

 

In accordance with FAS 133, ‘Accounting for Derivative Instruments and Hedging Activities’, we determined that the conversion feature of the Series C convertible preferred stock met the criteria of an embedded derivative. The Series C convertible preferred stock has certain characteristics, primarily redemption if certain events of default occur, that make it more akin to a debt instrument, rather than an equity instrument. Furthermore, the Series C convertible preferred stock does not meet the definition of “conventional convertible debt” because the number of shares which may be issued upon the conversion of the Series C convertible preferred stock is not fixed. Furthermore, there is no cap on the number of shares that could be issued upon conversion. Therefore, the conversion feature fails to qualify for equity classification under EITF 00-19, and must be accounted for as a derivative liability.

 

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The carrying value of the 8% cumulative Series C convertible preferred stock amounted to $20.1 million and $21.6 million at December 31, 2007 and 2006, respectively. The face value of Series C convertible preferred stock is the same as the carrying value since the instrument was written up to full fair value due to our default position as of December 31, 2006. Derivative financial instruments arising from the issuance of Series C convertible preferred stock are initially recorded and continuously carried at fair values. Upon conversion of any derivative financial instrument, the change in fair value from the previous reporting date to the date of conversion is recorded to income (loss), and then the carrying value is recorded to paid-in capital, provided all other criteria for equity classification are met.

Standby Equity Distribution Agreements with Yorkville

 

On October 27, 2003, we entered into a $20 million Standby Equity Distribution Agreement (the “2003 SEDA”) with Yorkville. The agreement provided for a maximum “draw” of $0.3 million per week, not to exceed $0.8 million in any 30-day period, and Yorkville was obligated to purchase up to $20 million of our common stock over a two-year period. The SEDA became effective during January 2004, and expired after a two-year term in January 2006. During the years ended December 31, 2007 and 2006, we sold shares of our common stock to Yorkville pursuant to the 2003 SEDA as follows:

		Years ended December 31,
		2007			2006
		(in thousands)
Number of shares sold to Yorkville			-			751.9
Gross Proceeds from sale of shares		$	-		$	234
Less: discounts and fees*			-			(24	)
Net Proceeds from sale of shares		$	-		$	210

 

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* Pursuant to the terms of the 2003 SEDA, stock was valued at 98% of the lowest closing bid price during the week it was sold.

 

On March 30, 2005, we entered into the 2005 SEDA with Yorkville under which Yorkville agreed to purchase up to $100 million of our common stock over a two-year period, with the timing and amount of the purchase at our discretion. The maximum amount of each purchase would be $2.0 million, with a minimum of five business days between advances. The shares would be valued at 98% of the lowest closing bid price during the five-day period following the delivery of a notice of purchase by us, and we would pay 5% of the gross proceeds of each purchase to Yorkville. Based on our current market capitalization and other outstanding securities, we do not believe that the 2005 SEDA is currently a viable source of financing.

 

As a commitment fee for Yorkville to enter into the 2005 SEDA, we issued 50 million warrants to Yorkville with an exercise price of $0.20 per share for a term of three years, and also paid a cash commitment fee of $1 million. During the nine months ended September 30, 2006, Yorkville exercised 40 million of the warrants, generating cash proceeds of $8 million to us. During August 2006, in connection with the Convertible Debenture, we repriced the remaining 10 million warrants to an exercise price of $0.10 per share. We also issued 4 million warrants with an exercise price of $0.227 to a consultant as a fee in connection with the 2005 SEDA, which have not been exercised. We recorded the $13.3 million fair value of the warrants to “Deferred equity financing costs” at inception. This amount was written off during the three months ended September 30, 2006 because we believe that we can no longer consider the SEDA a viable financing source due to the utilization of the preferred stock financing and the debenture financing.

 

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Promissory Note Payable to Yorkville

 

On March 30, 2005, we borrowed from Yorkville the principal amount of $10 million before discounts and fees in the form of a secured promissory note. Yorkville withheld structuring and escrow fees of $68,000 related to the note. The note was originally scheduled to be repaid at a rate of $1.1 million per month commencing May 1, 2005, which was subsequently changed to $0.84 million per month, continuing until principal and interest were paid in full. The note accrued interest at a rate of 8% per annum on any unpaid principal. In connection with the note, we entered into a security agreement with Yorkville under which the note was secured by all of our assets other than our patents and patent applications. During the period from March 30, 2005 through January 9, 2006, we made payments against the principal totaling $7.2 million. On February 17, 2006, we retired the balance of the principal in the amount of $2.8 million, plus accrued interest of $0.4 million, from the proceeds of the Series C convertible preferred financing arrangement with Yorkville. In connection with the payment and issuance of the Series C convertible preferred stock, we recognized a loss on extinguishment of debt of $1.96 million during the year ended December 31, 2006.

 

 

16. Stock based compensation

 

We have five stock option plans, the 2005 Stock Option Plan (the “2005 Plan”), the 2003 Stock Option Plan (the “2003 Plan”), the 2002 Stock Option Plan (the “2002 Plan”), the 1998 Stock Option Plan (the “1998 Plan”), and the 1996 Stock Option Plan (the “1996 Plan”), collectively referred to as the “Option Plans”. Options issued under these Option Plans have an option term of 10 years. Exercise prices of options issued under the Option Plans may be less than the fair market value per share of our common stock on the date of grant. Options may be granted with any vesting schedule as approved by the stock option committee, but generally the vesting periods range from 0 to 5 years. Common shares required to be issued upon the exercise of stock options and warrants would be issued from our authorized and unissued shares.

 

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On December 16, 2005, the stock option committee of our Board of Directors approved the 2005 Plan. We reserved 60 million shares of common stock on December 16, 2005 for issuance under the 2005 Plan. As of December 31, 2007, we have not registered the 60 million shares underlying the options in the 2005 Plan, and as a result all 60 million options remain available for issuance under the 2005 Plan.

 

On September 24, 2003, we adopted our 2003 Plan. The 2003 Plan provides authority to our stock option committee to grant up to 150 million non-qualified stock options. As of December 31, 2007, options to purchase 6.3 million shares of common stock remained available for issuance under the 2003 Plan.

 

On June 6, 2002, we adopted our 2002 Plan. The 2002 Plan provides for authority for the stock option committee of our Board of Directors to grant 10 million non-qualified stock options. As of December 31, 2007, options to purchase 20,000 shares of common stock remained available for issuance under the 2002 Plan.

 

On March 27, 1998, we adopted the 1998 Plan, providing for authority of the stock option committee of our Board of Directors to grant options to purchase up to 8 million shares of our common stock. As of December 31, 2007, options to purchase 165,450 shares of common stock remained available for issuance under the 1998 Plan.

 

On February 1, 1996, we adopted the 1996 Plan, providing 1.5 million shares of our common stock to be available for grant under the Plan. A total of 1,046,048 shares were issued upon the exercise of options granted under the 1996 Stock Option Plan from its inception through December 31, 2006. Effective on February 1, 2006, the 1996 Plan expired.

 

We also have one stock incentive plan, the 2003 Stock Incentive Plan (the “2003 Incentive Plan”). On October 31, 2003, the 2003 Incentive Plan was approved by the stock option committee. Under the terms of the 2003 Incentive Plan, we reserved 30 million shares of common stock to be issued to pay compensation and other expenses related to employees, former employees, consultants, and non-employee directors. As of December 31, 2007, 426,451 shares of common stock remain available for issuance under the 2003 Stock Incentive Plan.

 

On February 1, 2007, we instituted a stock option repricing plan (the “Repricing”) as a retention tool to align our employees with our new vision. Under the Repricing, we repriced 50,178,750 stock options held by current employees, contractors, and directors as follows: (i) options that were vested as of February 1, 2007, were repriced to $0.045 per share, which was the last sale price on February 1, 2007, (ii) options that were scheduled to vest during the remainder of 2007 were repriced to $0.075, (iii) options that vest during 2008 were repriced to $0.125, and (iv) options that vest during 2009 were repriced to $0.175. Options will continue to vest on their regular schedule, which generally is 25% upon the one-year anniversary of grant date and 25% on each subsequent anniversary date.

 

The fair value of stock-based awards was estimated using the Black-Scholes-Merton model with the following weighted-average assumptions:

 

		Years ended December 31,
		2007			2006
Volatility			96 - 115%			56 - 117%
Expected dividends			-			-
Expected term (in years)			3			3
Risk-free rate			4.35%			4.35%

 

As of December 31, 2007, we had approximately 66.9 million shares of common stock reserved for future issuance under our stock option plans and stock incentive plan.

 

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A summary of the transactions during the twelve months ended December 31, 2007 with respect to our stock option plans follows:

 

											Weighted-
											Average
					Weighted-						Contractual Life
					Average			Aggregate			Remaining
		Shares			Exercice Price			Intrinsic Value			in Years
		(In thousands)						(In thousands)
Outstanding at January 1, 2007			105,822		$	0.20
Granted (exclusive of option repricing)			42,328		$	0.03
Exercised			(1,639	)	$	0.01
Forfeited (exclusive of option repricing)			(31,000	)	$	0.25
Original options forfeited in connection with option repricing			(50,149	)		-
Modified options granted in connection with option repricing			50,149			-
Outstanding at December 31, 2007			115,511		$	0.08		$	29			7.7
Exercisable at December 31, 2007			84,725		$	0.06		$	24			7.0

 

A summary of the transactions during the twelve months ended December 31, 2006 with respect to our stock option plans follows:

 

 

											Weight-
											Average
					Weighted-						Contractual Life
					Average			Aggregate			Remaining
		Shares			Exercise Price			Intrinsic Value			in Years
		(In thousands)						(In thousands)
Outstanding at January 1, 2006			100,041		$	0.18
Granted			28,297		$	0.33
Exercised			(2,931	)	$	0.12
Forfeited			(19,585	)	$	0.29
Outstanding at December 31, 2006			105,822		$	0.20		$	1,125			7.3
Exercisable at December 31, 2006			77,920		$	0.17		$	1,125			6.7

 

During the year ended December 31, 2007, a total of 1,639,444 options, with an intrinsic value of $77,316 were exercised, compared to an intrinsic value of $450,139 for the 2,930,975 options exercised during the year ended December 31, 2006. A summary of the status of our non-vested options as of December 31, 2007, and changes during the year ended December 31, 2007 is presented below:

 

					Weighted
					Average
					Grant Date
Nonvested Shares		Shares			Fair Value
		(in thousands)
Nonvested at January 1, 2007			27,902		$	0.30
Granted			35,664		$	0.02
Vested			14,453		$	0.46
Forfeited			(18,327	)	$	0.17
Nonvested at December 31, 2007			30,786		$	0.03

 

Total stock-based compensation expense is attributable to the granting of and the remaining requisite service periods of stock options previously granted. Compensation expense attributable to net stock-based compensation for the year ended December 31, 2007 was $4.7 million. As of December 31, 2007, the total unrecognized compensation cost related to non-vested stock awards was $2.8 million net of expected forfeitures and the related weighted-average period over which it is expected to be recognized is approximately 1.4 years.

 

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The following table summarizes information about our stock options outstanding as of December 31, 2007:

Options Outstanding											Options Exercisable
Range of Exercise Prices		Number of Shares			Weighted- Average Remaining Life			Weighted- Average Exercise Price			Number of Shares			Weighted- Average Exercise Price
		(in thousands)			(in years)						(in thousands)
$0.01 to $0.10			102,392			5.0		$	0.03			72,953		$	0.04
$0.11 to $0.20			6,010			2.9		$	0.12			4,663		$	0.12
$0.21 to $0.30			5,000			1.0		$	0.24			5,000		$	0.24
$0.31 to $0.40			2,109			1.0		$	0.33			2,109		$	0.33
$0.01 to $0.40			115,511			4.7		$	0.05			84,725		$	0.06

 

The following table summarizes information about our stock incentive plan for the years ended December 31, 2007 and 2006:

 

		Year ended December 31,
		2007			2006
		(in thousands)
Shares issued under 2003 Stock Incentive Plan			1,299			18,432
Aggregate grant date fair value of shares issued		$	73		$	2,211
Expense recognized		$	73		$	2,244

 

Warrants 

 

The following table summarizes information about our warrant activity for the years ended December 31, 2007 and 2006:

		Years ended December 31,
		2007			2006
		(in thousands)
Warrants outstanding - beginning balance			316,325			71,375
Warrants issued			200,000			294,000
Warrants exercised			-			(49,000	)
Warrants expired			(1,500	)		(50	)
Warrants outstanding - ending balance			514,825			316,325

 

The following table summarizes information about warrants outstanding at December 31, 2007, all of which are exercisable:

 

					Weighted Average
		Warrants			Remaining
Exercise Prices		Outstanding			Contractual Life
		(In thousands)			(In years)
$0.010			2,500			0.5
$0.020			502,000			3.8
$0.030			50			0.0
$0.048			3,500			1.8
$0.102			100			1.2
$0.110			2,500			1.2
$0.227			2,000			2.2
$0.328			2,000			1.0
$3.450			175			1.3
$0.01 to $3.45			514,825			3.8

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Refer to Note 6 for discussion of warrants issued to Yorkville during 2007. The exercise price of all warrants outstanding to Yorkville as of August 24, 2007 was repriced as an inducement for Yorkville to enter into a financing arrangement with us on that date.

 

On February 14, 2006, we issued 2 million warrants with an exercise price of $0.328 and a term of five years to an unrelated third party as a fee for negotiating and structuring the Series C convertible preferred stock sale.

 

During March 2005, in connection with the signing of the 2005 SEDA, we issued 50 million warrants to Yorkville with an exercise price of $0.20 per share, and 4 million warrants with an exercise price of $0.229 to an independent third party as a fee for negotiating and structuring the SEDA. We charged the fair value of the warrants of $12.3 million to “Deferred equity financing costs.” 40 million warrants were exercised in the first quarter of 2006, generating $8.0 million cash proceeds to us.

 

 

None.

 

Item 9A (T).

Controls and Procedures

 

a) Evaluation of Disclosure Controls and Procedures

 

We are required to maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our reports under the Securities Exchange Act of 1934, as amended (Exchange Act), is recorded, processed, summarized and reported within the time periods specified in the Commission’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer (CEO) and Chief Financial Officer (CFO) as appropriate, to allow timely decisions regarding required disclosure.

 

In connection with the preparation of this Form 10-K for the year ended December 31, 2007, our management, under the supervision of the CEO and CFO, conducted an evaluation of disclosure controls and procedures. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control systems are met. Based on that evaluation, our CEO and CFO concluded that our disclosure controls and procedures were not effective at a reasonable assurance level as of December 31, 2007 due to the material weaknesses discussed below. Because the material weaknesses described below have not been remediated as of the filing date of this Form 10-K, our CEO and CFO conclude that our disclosure controls and procedures are not effective as of the filing date of this Form 10-K.

 

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b) Management’s Annual Report on Internal Control over Financial Reporting

 

Management is responsible for establishing and maintaining adequate internal control structure and procedures over financial reporting (as defined in Rules 13a-15(e) and 15d-15(e)) under the Exchange Act. Our management conducted an assessment of the effectiveness of our internal control over financial reporting as of December 31, 2007 based on the framework set forth in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Internal control over financial reporting cannot provide absolute assurance of achieving financial reporting objectives because of its inherent limitations. Internal control over financial reporting is a process that involves human diligence and compliance and is subject to lapses in judgment and breakdowns resulting from human failures. Because of such limitations, there is a risk that material misstatements may not be prevented or detected on a timely basis by internal control over financial reporting. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

 A material weakness in internal control over financial reporting is defined by the Public Company Accounting Oversight Board’s Audit Standard No.5 as a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company's annual or interim financial statements will not be prevented or detected on a timely basis. A significant deficiency is a deficiency, or a combination of deficiencies, in internal control over financial reporting that is less severe than a material weakness, yet important enough to merit attention by those responsible for oversight of our financial reporting.

 

Our management’s evaluation also included assessing the effectiveness of internal controls over financial reporting at Gavitec AG, which was acquired on February 23, 2006. For our management’s assessment of internal controls over financial reporting as of December 31, 2006, management excluded the entity based upon the SEC’s “Management’s Report On Internal Control Over Financial Reporting and Certification of Disclosure in Exchange Act Periodic Reports, Frequently Asked Question #3 (revised October 6, 2004)”.

 

Our management identified the following material weaknesses as of December 31, 2007 to our internal control over financial reporting:

Entity Level Controls:

·

Our senior management did not establish and maintain a proper tone as to internal control over financial reporting. Specifically, our senior management was unable, due to time and resource constraints, to promptly address control weaknesses brought to their attention throughout this and the previous year’s audit;

 

·

We do not have a financial expert on the Audit Committee, which is currently comprised of only one member of the Board. The lack of a financial expert on the Audit Committee, combined with the complexity of certain financial transactions we engage in, raises the risk of a potential material misstatement to occur and go undetected in the financial statements;

 

·

We, through our senior management, failed to maintain formalized accounting policies and procedures. Once implemented, the polices and procedures should provide guidance to accounting personnel in the proper treatment and recording of financial transactions, as well as proper internal controls over financial reporting.

 

User Access General Controls:

 

·

Our senior management did not maintain sufficient controls related to the establishing, maintaining, and assigning of user access security levels in the accounting software package used to initiate, process, record, and report financial transactions and financial statements. Specifically, controls were not designed and in place to ensure that access to certain financial applications was adequately restricted to only employees requiring access to complete their job functions;

 

·

We failed to maintain proper spreadsheet controls at our Gavitec location. Specifically, critical spreadsheets are password protected and reside on a protected drive, but additional controls, such as critical cell formula testing and locking, logic testing, and input control are missing. Additionally, the Gavitec location did not have the excel policy adopted last year at our headquarters.

 

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 Because of the material weaknesses, our CEO and CFO concluded that we did not maintain effective internal control over financial reporting at a reasonable assurance level as of December 31, 2007 or at the date of this filing.

 

c) Remediation

 

In connection with the material weakness noted in management’s report as of December 31, 2006, management would like to report the following material weaknesses have been remediated:

 

·

We have hired a new CFO, corporate controller, and two new staff accountants, who are deemed sufficiently qualified accounting personnel with the appropriate level of knowledge, experience and training in the application of GAAP and other financial reporting requirements. Additionally, complex transactions are outsourced for GAAP compliance to a third party “expert.”

 

·

Our Board of Directors, at the request of our CFO, adopted and implemented a company-wide risk assessment program. New procedures were communicated to appropriate personnel, and we have taken steps to ensure compliance with the program.

 

·

We have obtained, reviewed and obtained acknowledgment from our employees regarding the Code of Conduct. New employees hired in 2007 were also subject to this requirement.

 

·

We have revised and distributed effective information technology policies and procedures, which addresses financial reporting risks associated with the IT function.

 

·

Our senior management has adopted stronger controls over data back up and off site storage process. The data back up tapes are verified as successful, and are stored offsite in a safe environment.

 

·

We have adopted and maintained a Company-wide anti-fraud program over the initiating and processing of financial transactions, as well as other Company-wide procedures which may have an impact on internal controls over financial reporting.

 

·

We maintain, through a review performed by our Controller and CFO, effective controls over the recording of recurring and non-recurring journal entries. All journal entries are subject to supervisory review and approval of journal entries for the recording of all financial transactions.

 

·

We maintain effective controls over the income tax provision, including deferred tax assets and net operating loss carry-forwards related to foreign acquisitions completed in 2006. Controls are also now deemed effective in the analysis of certain account balances, such as goodwill, which were previously impacted as a result of the control failure.

 

·

We maintain adequate controls over the accuracy, presentation and disclosure in recording revenue. Controls are currently in place to ensure that revenue transactions are analyzed for appropriate presentation and disclosure for recognition of revenue.

 

The continued remediation of the material weaknesses described above is among our highest priorities. Our Audit Committee will continually assess the progress and sufficiency of these initiatives and make adjustments as and when necessary. As of the date of this report, our management believes that our efforts, when completed, will remediate the material weaknesses in internal control over financial reporting as described above. However, our management and our Audit Committee do not expect that our disclosure controls and procedures or internal control over financial reporting will prevent all errors or all instances of fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control gaps and instances of fraud have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple errors or mistakes. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls is based in part upon certain assumptions about the likelihood of future events, and any design may not succeed in achieving its stated goals under all potential future conditions.

 

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Except as disclosed above, there were no changes in our internal control over financial reporting that occurred during our last fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

This Annual Report does not include an attestation report of our registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by our registered public accounting firm pursuant to temporary rules of the U.S. Securities and Exchange Commission that permits us to provide only management’s report in this Annual Report.

 

d) Subsequent Changes in Internal Control over Financial Reporting

 

Except as disclosed above, there were no changes in our internal control over financial reporting that occurred during our last fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

ITEM 9B.

Other information

 

None.

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PART III

 

ITEM 10.

Directors, executive officers, and corporate governance

 

Directors and Executive Officers

 

As of February 16, 2008, our directors and executive officers were:

 

Name	Age	Position
William J. Hoffman	46	Chief Executive Officer and Chairman of the Board
Christian Steinborn	38	Chief Operating Officer
Frank J. Pazera	47	Chief Financial Officer
James J. Keil	80	Director
George G. O’Leary	45	Director

 

The following is certain summary information with respect to our directors and executive officers:

 

William J. Hoffman, Jr. joined us on June 18, 2007 as our Chief Executive Officer. Prior to joining NeoMedia, Mr. Hoffman was the CEO and co-founder of Uniqua Technologies, Inc, where he led the company to establish the first business-to-business mobile virtual network operator (MVNO) in the United States using GSM technology. Uniqua also provides enterprise mobile commerce and data solutions to businesses. He co-founded Vectorlink Communications Corporation, a subsidiary of Uniqua, which provides licensed and unlicensed broadband and telephony services to government, business, and consumers in Texas.

 

Prior to this, Mr. Hoffman was President and CEO for mBlox, Inc., the world’s largest wireless transaction processing network, from 2002 to 2004. There he focused on reorganizing, restructuring, and then rapidly growing the business to over 180 countries. His responsibilities included capital structure, Board, organization, strategy, and execution of the firm’s business plan. He was instrumental in developing partnerships with more than 500 wireless operators around the globe including Vodafone®, T-Mobile®, Verizon® and Cingular®, and achieving a $75 million annual run-rate in 18 months time for the world’s largest provider of messaging infrastructure.

 

Before joining mBlox, Mr. Hoffman served at the pleasure of numerous large private equity firms who employed his skills to repair and rebuild substantial telephony and global wireless businesses in their portfolios. His successes include Advanced Telcom Group, Nuvox, Krone, and MobileSys, Inc. From 1997 to 2000, Mr. Hoffman served as an officer of Dobson Communications Corporation (NASDAQ: DCEL) and the president and chief operating officer of Logix Communications Enterprises, a business-to-business integrated voice and data service provider for which he led the spin off from Dobson.

 

Mr. Hoffman was Intermedia Communications Division Vice President-Florida from 1995 to 1997, where he grew the company's fiber-optic network and oversaw the creation of the largest competitive local phone and data service provider in Florida. From 1987 to 1995 Mr. Hoffman worked in numerous positions in sales, marketing and management at Sprint's Business Services Unit. He was a Captain in the U.S. Army in Europe working in military intelligence from 1983 to 1987. Mr. Hoffman holds a B.S. in Electrical Engineering from Auburn University.

 

Christian Steinborn joined us upon the acquisition of Gavitec on February 17, 2006, where he had been serving as a Member of the Executive Board since January 2004 and his responsibilities included operations, opening the market for new innovative products, total turnover and results, strategy, reporting and IP coverage. Prior to his election to the Executive Board, Dr. Steinborn held the responsibilities of Head of Business Development and Sales Worldwide at Gavitec for three years. He was promoted to our Chief Operating Officer on September 26, 2007 with the expanded role of global sales and operations for NeoMedia in addition to his ongoing responsibilities at Gavitec. Prior to joining Gavitec, Dr. Steinborn was employed at Scantech BV as Director of Operations, and at Lufthansa in an internship. Dr. Steinborn started his career in a family-owned construction company in Bad Neuenahr, Germany, working for six years in business strategy and loyalty development. Dr. Steinborn studied psychology and law at the University of Bonn and has a PhD in Banking Operations Law and an International MBA from the NIMBAS Graduate School of Management in Utrecht, the Netherlands and Bradford, UK.

 

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Frank J. Pazera joined us on October 19, 2007 as our Chief Financial Officer. Prior to joining us, Mr. Pazera was a partner in the Atlanta office of Tatum LLC, the largest executive services firm in the United States., and held CFO positions in both publicly traded and privately held technology companies. Mr. Pazera began his career at Arthur Andersen & Co. More recently, Mr. Pazera was Interim Chief Executive Officer of Covista Communications, Inc. where he also previously served as Chief Financial Officer and Treasurer. Mr. Pazera has also held Senior Financial Executive positions at Airgate PCS, Inc., Network One, MCI Telecommunications and Turner Broadcasting, among others. Mr. Pazera holds a BBA in Accounting from the University of Wisconsin, Milwaukee and an MBA from the Goizueta Business School at Emory University, Atlanta.

 

James J. Keil has been a Director of NeoMedia since August 6, 1996. Mr. Keil currently is a member of the Compensation Committee, the Stock Option Committee and the Audit Committee. He is founder and President of Keil & Keil Associates, a business and marketing consulting firm located in Washington, D.C., specializing in marketing, sales, document application strategies, recruiting and electronic commerce projects. Prior to forming Keil & Keil Associates in 1990, Mr. Keil worked for 38 years at IBM Corporation and Xerox Corporation in various marketing, sales and senior executive positions. From 1989-1995, Mr. Keil was on the board of directors of Elixir Technologies Corporation (a non-public corporation), and from 1990-1992 was the Chairman of its Board of Directors. From 1992-1996, Mr. Keil served on the board of directors of Document Sciences Corporation. Mr. Keil holds a B.S. degree from the University of Dayton and did Masters level studies at the Harvard Business School and the University of Chicago in 1961/62.

 

George G. O’Leary was named to our board of directors in February 2007, and is currently the President of SKS Consulting of South Florida Corp. Prior to assuming his duties with us, he was and still is a consultant to NeoGenomics (OTCBB:NGNM) and was acting Chief Operating Officer from October 2004 to April 2005 were he helped the turn-around of that organization. He is currently a member the board of directors of NeoGenomics Inc. and ISONICS Corporation, both of which are public companies. Prior to becoming an officer of NeoGenomics, Mr. O’Leary was the President and CFO of Jet Partners, LLC from 2002 to 2004. From 1996 to 2000, Mr. O’Leary was CEO and President of Communication Resources Incorporated (CRI). Prior to CRI, Mr. O’Leary was Vice President of Operations of Cablevision Industries, where he ran $125 million of business for this major cable operator until it was sold to Time Warner.

 

Election of Directors and Officers 

 

Directors are elected at each annual meeting of shareholders and hold office until the next succeeding annual meeting and the election and qualification of their respective successors. Officers are elected annually by our Board of Directors and hold office at the discretion of our Board of Directors. Our By-Laws permit our Board of Directors to fill any vacancy and such director may serve until the next annual meeting of shareholders and the due election and qualification of his successor.

 

Committees of our Board of Directors

 

Our Board of Directors have an Audit Committee, a Compensation Committee and a Stock Option Committee; there is not a standing Nominating Committee.

 

v

Audit Committee – The purpose of the Audit Committee is to provide assistance to our Board of Directors in fulfilling their oversight responsibilities relating to our consolidated financial statements and financial reporting process and internal controls in consultation with our independent registered public accountants and internal auditors. The Audit Committee is also responsible for ensuring that the independent registered public accountants submit a formal written statement to us regarding relationships and services which may affect the auditors’ objectivity and independence. During 2007, members of the Audit Committee were non-employee directors James J. Keil and A. Hayes Barclay. Mr. Barclay resigned from our Board of Directors on July 11, 2007; and as a result, Mr. Keil now serves as the sole member of our Audit Committee. Due to financial constraints, we do not currently have an Audit Committee financial expert serving on our Audit Committee.

 

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v

Compensation Committee – The Compensation Committee is responsible for recommending compensation and benefits for our executive officers to our Board of Directors and for administering our Incentive Plan for our management. Outside directors James J. Keil and A. Hayes Barclay were members of our Compensation Committee during 2007. Upon Mr. Barclay’s resignation, George O’Leary was appointed to the Compensation Committee.

 

v

Stock Option Committee – The Stock Option Committee has responsibility for administering our stock option plans. During 2007, the committee was comprised of non-employee directors James J. Keil and A. Hayes Barclay. Subsequent to Mr. Barclay’s resignation, Mr. O’Leary was appointed to the Stock Option Committee.

Director Compensation – Outside directors are currently compensated through a combination of cash and stock options. For independent Directors, our compensation policy for the year ended December 31, 2007 was as follows:

 

$1,000 for each Board of Director meeting attended in person;

$500 for each telephonic meeting attended;

$500 for each Committee meeting attended (whether in person or telephonic); subject to

A maximum amount compensated per day of $1,000.

 

On February 2, 2007, we appointed George O’Leary to our board of directors. Mr. O’Leary is currently the President of SKS Consulting of South Florida Corp. and is working with us under a two year consulting agreement. Due to our payments under the consulting contract with SKS, we did not pay Mr. O’Leary any Director’s fees during the year ended December 31, 2007.

 

Code of Ethics

 

We have adopted a code of ethics, as required by the rules of the SEC (included by reference hereto). This code of ethics applies to all of our directors, officers and employees. The code of ethics, and any amendments to, or waivers from, the code of ethics, is available in print, at no charge, to any shareholder who requests such information.

 

Section 16(a) Beneficial Ownership Reporting Compliance

 

Section 16(a) of the Exchange Act requires our officers and directors, and persons who own more than ten percent of a registered class of our equity securities, to file reports of ownership and changes in ownership with the Securities and Exchange Commission. Officers, directors and greater than ten-percent shareholders are required by SEC regulation to furnish us with copies of all Section 16(a) forms they file.

 

Based solely on a review of the copies of such forms furnished to us, we believe that during the year ended December 31, 2007 all officers, directors and ten percent beneficial owners who were subject to the provisions of Section 16(a) complied with all of the filing requirements during the year.

 

ITEM 11.

Executive compensation

 

Compensation Discussion and Analysis

 

This compensation discussion and analysis is designed to explain our policies and considerations used for determining compensation structure for our principal executive officer, principal financial officer, and other executive officers (collectively, “the Named Executive Officers”). Detailed quantitative disclosures of named executive officer compensation, equity awards, and equity positions relative to the Named Executive Officers follow this compensation discussion and analysis. The purpose of the compensation discussion and analysis is to put into context such compensation disclosures, and to present a qualitative discussion of our compensation matters through the eyes of management.

 

Objectives of compensation structure – We operate in an emerging and highly competitive industry. The primary objective of our executive compensation structure is to attract, motivate, and retain executives who drive our success and industry leadership, and thus create shareholder value. We seek to align our executives’ compensation with performance goals that will create shareholder value through the creation of sales, net income, and increased stock price.

 

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What the programs are designed to reward – The executive compensation structure is designed to reward executives for both near-term individual performance and long-term Company performance. Individual performance is generally evaluated through the completion of periodic performance reviews. Long-term Company performance goals are measured primarily through financial indicators such as stock price, sales, and net income.

 

Elements of compensation – The components of the compensation program for executive officers are as follows:

 

v

Base Salary – Base salaries are determined based on a variety of factors, including the executive’s scope of responsibilities, an assessment of similar roles at other companies, and a comparison of salaries paid to peers within the Company. Base salaries are set at levels that allow us to attract and retain executive employees that will enable us to deliver on our business goals. Base salaries are reviewed from time to time in connection with performance reviews and may be adjusted after considering performance along with the factors noted above. The Compensation Committee is responsible for setting and adjusting salaries of the Named Executive Officers. The Compensation Committee currently consists of James J. Keil, an independent director, and George O’Leary, an outside director, who is compensated through a consulting agreement with us.

 

v

Stock-based Compensation – Under our stock option plans, executives, employees, consultants and directors are eligible to receive stock option awards from time to time as determined by the Stock Option Committee, which currently consists of directors James J. Keil, and George O’Leary. A stock option award is a right to acquire shares of our common stock at a fixed exercise price that is generally equal to the stock price on the date of grant. Stock option awards can vest based on the passage of time, or based on achievement of specific performance goals. Historically, we have primarily issued options to executives with time-based vesting, generally 25% upon grant and 25% on each subsequent anniversary date. The stock option awards guidelines vary by the level of responsibility of the executive. In 2007, new performance based options were granted to certain executives that are tied to achievement of revenue and profit goals during the next four fiscal years.

 

Additionally, we have a stock incentive plan under which unrestricted share-based awards are granted at the discretion of the Compensation Committee, or the Board as a whole. These shares have historically been used to compensate non-executive employees and consultants, and we do not have any plan to issue any such new shares to executives during 2008.

 

v

Bonus – We did not have a formal incentive plan for management in place for the years ended December 31, 2006, and therefore did not pay bonuses for that year. During 2007, we adopted an incentive plan for William Hoffman, who joined us mid-year as our CEO. Mr. Hoffman’s bonus for 2007 was determined by the Board of Directors at the time of his hire, and was based on the achievement of Revenue, Operating Profit, and Operating Metric objectives for the remainder of 2007. The Board reviewed the objectives subsequent to year-end and determined that Mr. Hoffman had met his objectives for the year ended December 31, 2007, and his bonus was paid out in March, 2007.

 

The incentive plan for the year ending December 31, 2008 has been expanded to include an incentive element for all employees of the Company and is based upon the attainment of certain corporate and/or individual performance goals during each quarter throughout the year. The incentive for Named Executive Officers and the management team of the Company is based upon specific revenue and net income goals for 2008 and beyond. The incentive plan is designed to provide additional incentive to our executive management to achieve these growth and profitability goals.

 

Performance goals under the Incentive Plan are determined by the Compensation Committee for both Company and/or the employee's individual performance prior to the beginning of each quarter and year. If performance goals are attained, eligible employees are entitled to an award based upon a specified percentage of their base salary and in some cases may be eligible for performance-based equity awards in addition to cash bonus awards. Historically, the primary performance goals have been financial metrics, specifically our net income.

 

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v

Benefits – During the year ended December 31, 2007, our executives were eligible for the same level and offering of benefits made available to other employees, including health insurance, and a non-matching 401(k) Plan.

 

Why we choose to pay each element – We operate in an emerging market, and have historically reported net operating losses on a year over year basis. As a result, executive compensation packages tend to be weighted more heavily with stock-based rather than cash-based compensation, since our cost of capital is relatively high. We believe that stock based compensation aligns the interest of our executives and employees with the goals of our shareholders, which is to drive shareholder value, primarily through increased stock price.

 

How we determine the amount – We rely primarily on publicly available data to help benchmark levels of base salary, target annual incentives, and stock-based and other long-term incentives. The Compensation Committee and Stock Option Committee determine the executive’s appropriate salaries and stock-based awards based on available information, along with financial considerations such as our liquidity and the impact to shareholder dilution.

 

How each element fits into our overall compensation objectives – The overall goal of our compensation plan is to attract and retain skilled executives who will drive shareholder value. We believe our executives’ competitive base salaries are competitive enough to attract viable leaders committed to our vision. We believe that our stock based compensation plans align the goals of our executives with those of our shareholders.

NeoMedia Technologies, Inc.

Compensation Committee

James J. Keil (Chairman)

George O’Leary

 

Executive Compensation

 

The following table sets forth certain information with respect to the compensation paid to persons serving as our principal executive officer during the last completed fiscal year, the person serving as our principal operating officer during the last completed fiscal, and person serving as our principal financial officer during the last completed fiscal year (collectively, "the Name of the Executive Officers") during the years ended December 31, 2007 and 2006. We did not employ any additional executive officers as of December 31, 2007.

 

											Option
Name and					Salary			Bonus			Awards (1)			Total
Principal Position		Year			($)			($)			($)			($)
William Hoffman		2007			$	140,223		$	68,800		$	312,717		$	521,740
Chief Executive Officer
Christian Steinborn		2007			$	246,794			-		$	12,029		$	258,823
Chief Operating Officer
Frank Pazera		2007			$	56,122			-			-		$	56,122
Chief Financial Officer
Charles W. Fritz (2)		2007			$	106,545			-			-		$	106,545
Interim President and CEO		2006			$	206,334			-			-		$	206,334
David A. Dodge (3)		2007			$	84,732			-			-		$	84,732
Vice President and CFO		2006			$	144,295			-			-		$	144,295
Scott Womble (4)		2007			$	122,332		$	18,000			-		$	140,332
Interim Chief Financial Officer

 

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⁽¹⁾ Dollar value of option awards is based on grant date fair value computed in accordance with FAS 123R; reader should refer to footnote 15 to the accompanying financial statements for detailed description of the assumptions used to calculate fair value.

 

⁽²⁾ Charles W. Fritz resigned as our Chairman of the Board on October 15, 2007.

 

⁽³⁾ David A. Dodge resigned as our Vice President and CFO on June 30, 2007.

 

⁽⁴⁾ Scott Womble resigned as our Interim CFO on December 14, 2007.

 

Grants of Plan-based Awards

 

None.

 

Outstanding Equity Awards at Fiscal Year-end

 

The following table sets forth certain information relative to outstanding option awards held by the Named Executive Officers (there are no stock awards outstanding) as of December 31, 2007:

Option Awards
								Equity Incentive Plan
		Number of Securities						Awards: Number of
		Underlying						Securities Underlying			Option
		Unexercised Options						Unexercised			Exercise			Option
		Exercisable			Unexercisable			Unearned Options			Price			Expiration
Name		(#)			(#)			(#)			($)			Date
William Hoffman			7,072,917			12,927,083	(1)		-		$	0.035			06/10/17
Christian Steinborn			100,000	(2)		-			-		$	0.045			02/23/16
			100,000	(2)		-			-		$	0.075			02/23/16
			-			100,000	(2), (3)		-		$	0.125			02/23/16
			-			100,000	(2), (3)		-		$	0.175			02/23/16
			-			-			2,000,000	(4)	$	0.047			02/15/17
			-			400,000	(5)		-		$	0.011			12/19/17
			-			400,000	(5)		-		$	0.011			12/19/17
			-			400,000	(5)		-		$	0.011			12/19/17
			-			400,000	(5)		-		$	0.011			12/19/17
			-			-			400,000	(6)	$	0.011			12/19/17
			-			-			400,000	(6)	$	0.011			12/19/17
			-			-			400,000	(6)	$	0.011			12/19/17
			-			-			400,000	(6)	$	0.011			12/19/17
Charles W. Fritz			10,000,000			-			-		$	0.010			10/19/13
			3,000,000	(2)		-			-		$	0.045			03/08/14
			1,000,000	(2)		-			-		$	0.075			03/08/14
			2,000,000	(2)		-			-		$	0.045			02/08/15
			1,000,000	(2)		-			-		$	0.075			02/08/15
			1,000,000	(2)		-			-		$	0.125			02/08/15
			1,000,000	(2)		-			-		$	0.045			12/16/15
			500,000	(2)		-			-		$	0.075			12/16/15
			500,000	(2)		-			-		$	0.125			12/16/15
David A. Dodge			1,600,000			-			-		$	0.010			10/19/13
			1,500,000	(2)		-			-		$	0.045			03/08/14
			500,000	(2)		-			-		$	0.075			03/08/14
			1,250,000	(2)		-			-		$	0.045			02/08/15
			625,000	(2)		-			-		$	0.075			02/08/15
			1,000,000	(2)		-			-		$	0.045			12/16/15
Scott Womble			17,500	(2)		-			-		$	0.045			06/19/16
			17,500	(2)		-			-		$	0.075			06/19/16
			-			17,500	(2), (7)		-		$	0.125			06/19/16
			-			17,500	(2), (7)		-		$	0.175			06/19/16

 

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⁽¹⁾ 5,000,000 of Mr. Hoffman's options vested immediately upon grant on June 11, 2007, and the remainder vest on a monthly basis over four years.

 

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⁽¹⁾ 5,000,000 of Mr. Hoffman's options vested immediately upon grant on June 11, 2007, and the remainder vest on a monthly basis over four years.

 

⁽²⁾ Effective February 1, 2007, options held by NeoMedia employees, including Mr. Fritz, Mr. Dodge, Dr. Steinborn and Mr. Womble were repriced as follows: all vested options were repriced to $0.045 per share; all unvested options vesting during 2007 were repriced to $0.075; all unvested options vesting during 2008 were repriced to $0.125; and all unvested options vesting during 2009 were repriced to $0.175.

 

⁽³⁾ 100,000 options vested on February 23, 2008 and 100,000 vest on February 23, 2009.

 

⁽⁴⁾ 500,000 performance-based options vested on February 16, 2008 depending on achievement of performance plan for 2007, and 500,000 vest on each subsequent anniversary for three years depending on achievement of performance plans for the previous year.

 

⁽⁵⁾ 400,000 options vest on December 20, 2008, 400,000 options vest on December 20, 2009, 400,000 options vest on December 20, 2010, and 400,000 options vest on December 20, 2011.

 

⁽⁶⁾ 400,000 performance-options vest on February 15, 2009 depending on achievement of performance objectives for 2008, and 400,000 options vest on each subsequent February 15th for three years depending on achievement of performance objectives for the previous year.

 

⁽⁷⁾ Mr. Womble resigned as NeoMedia's Assistant Controller on February 15, 2008 forfeiting as of that date 17,500 options scheduled to vest on June 20, 2008 and 17,500 options scheduled to vest on June 20, 2009.

 

Option Exercises and Stock Vested

 

None.

 

Pension Benefits

 

None.

 

Change in Control Agreements

 

We are currently party to the following employment agreements with our CEO and our CFO:

 

William Hoffman is employed under the terms of an Employment Agreement dated June 18, 2007, whereby if he is terminated without cause or due to a change in control, he is entitled to 18 months' salary, currently valued at $375,000, and accelerated vesting of one-half of any remaining unvested portion of the initial option grant of 20 million options. If Mr. Hoffman resigns his employment with us for good reason, he is entitled to eighteen months' salary per his Employment Agreement. Mr. Hoffman's initial option grant vested 25% on the date of grant, with the remainder vesting in equal monthly installments over 48 months.

 

Frank Pazera is employed under the terms of an Employment Agreement dated January 1, 2008, whereby if he is terminated without cause or due to a change in control, he is entitled to 18 months' salary, currently valued at $300,000, and accelerated vesting of one-half of any remaining unvested portion of the initial option grant of 5 million options. If Mr. Pazera resigns his employment with us for good reason, he is entitled to six months' salary, currently valued at $100,000, per his Employment Agreement. Mr. Pazera's initial option grant vested 25% on the date of grant, with the remainder vesting in equal monthly installments over 48 months.

 

Director Compensation

 

The following table sets forth certain information relative to compensation paid to outside directors for the year ended December 31, 2007:

 

		Fees									(c)
		Earned or			(a)			(1), (b)			All other
		Paid in			Stock			Option			Compen-
		Cash			Awards			Awards			sation			Total
Name		($)			($)			($)			($)			($)
James J. Keil (2)		$	23,500			-			-			-		$	23,500
A. Hayes Barclay (3)		$	4,000			-			-			-		$	4,000
George O'Leary (4) (5) (6)			-		$	18,017		$	7,005		$	2,061		$	27,083

 

 

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(1)

All options held by outside directors are fully vested.

 

(2)

As of December 31, 2007, James J. Keil held 1,500,000 options with an exercise price of $0.045 and 1,000,000 options with an exercise price of $0.075. Effective February 1, 2007, options held by Mr. Keil were repriced as follows: all options with an exercise price less than $0.24 were repriced to $0.045, and all options with an exercise price greater than $0.24 were repriced to $0.075.

 

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(3)

A. Hayes Barclay resigned from our Board on July 11, 2007.

 

(4)

George O'Leary did not receive any compensation as a director of the Company during 2007, but did receive consulting fees under an agreement between SKS Consulting of South Florida Corp. (SKS) and NeoMedia dated December 1, 2006 of $212,000. For further information, see Item 13 - Certain relationships and related transactions.

 

(5)

Under the consulting agreement between SKS and NeoMedia, Mr. O'Leary also receives the following equity-based compensation:

 

(a)

60,000 shares of restricted stock per month from December 2006 - December 2008 (on an anti-dilutive basis),

 

(b)

60,000 options per month for the period December 2006 - December 2008 with a price of $0.04 per share, and

 

(c)

up to 500,000 incentive-based options with a price of $0.10 per share.

 

(6)

In payment of the SKS contract, 25% of the equity-based items are issued to Jay Bonk, an employee of SKS.

 

Compensation Committee Interlocks and Insider Participation

 

From January 1, 2007 through July 11, 2007, the members of the Compensation Committee were James J. Keil and A. Hayes Barclay, both independent directors. Mr. Barclay resigned from the Board of Directors and the Compensation Committee on July 11, 2007 and was replaced by George O’Leary. Mr. O’Leary was not considered an independent director during 2007 due to a consulting agreement between SKS Consulting of South Florida Corp., for which he serves as President, and NeoMedia. Beginning January 1, 2008, Mr. O’Leary’s compensation with us was changed from a consulting agreement to that of an independent director.

 

During fiscal year 2007, none of our executive officers served on the compensation committee (or its equivalent) or board of directors of another entity whose executive officer(s) served on our Compensation Committee or Board of Directors.

 

Compensation Committee Report

 

The Compensation Committee has reviewed and discussed with management the Compensation Discussion and Analysis presented in Item 11 of this Annual Report on Form 10-K. Based on such review and discussion, the Compensation Committee has recommended to our Board of Directors that the Compensation Discussion and Analysis be included in this Annual Report on Form 10-K.

 

James J. Keil (Chairman)

George O’Leary

Ethical Behavior

 

We have adopted a code of ethics, as required by the rules of the SEC (attached as exhibit 14.1 hereto). This code of ethics applies to all of our directors, officers and employees. The code of ethics, and any amendments to, or waivers from, the code of ethics, is available in print, at no charge, to any shareholder who requests such information.