Notes to Unaudited Condensed Consolidated
Financial Statements
1. Basis of Presentation and Summary of Significant Accounting
Policies
The unaudited condensed consolidated financial
statements of Patriot Scientific Corporation (the “Company”, “PTSC”, “Patriot”, “we”,
“us” or “our”) presented herein have been prepared pursuant to the rules of the Securities and Exchange
Commission (“SEC”) for quarterly reports on Form 10-Q and do not include all of the information and footnotes required
by accounting principles generally accepted in the United States of America. These unaudited condensed consolidated financial statements
should be read in conjunction with our audited consolidated financial statements and notes thereto included in our Report on Form
10-K for our fiscal year ended May 31, 2013.
In the opinion of management, the interim condensed
consolidated financial statements reflect all adjustments of a normal recurring nature necessary for a fair presentation of the
results for the interim period presented. Operating results for the three month period ended August 31, 2013 are not necessarily
indicative of the results that may be expected for the year ending May 31, 2014.
Subsequent events have been evaluated through
the issuance date of these financial statements.
Basis of Consolidation
The condensed consolidated balance sheets at
August 31, 2013 and May 31, 2013 and condensed consolidated statements of operations for the three months ended August 31, 2013
and 2012 includes our accounts and those of our wholly owned subsidiary Patriot Data Solutions Group, Inc. (“PDSG”)
which includes Crossflo Systems, Inc. (“Crossflo”), and our inactive subsidiary Plasma Scientific Corporation. All
significant intercompany accounts and transactions have been eliminated.
PDSG is being presented as discontinued operations
in the condensed consolidated statements of operations for all periods presented. See “Discontinued Operations” below
for additional information.
Reclassification
Certain amounts presented in the prior periods’
condensed consolidated financial statements related to interest and other income have been reclassified to conform to the current
period’s presentation.
Discontinued Operations and Assets Held
for Sale
On February 17, 2012, our board of directors
authorized management to sell the assets of PDSG due to the inability of PDSG to meet its business plan and continuing projected
negative cash flows. In accordance with authoritative guidance we have classified the assets, operations and cash flows of PDSG
as discontinued operations for all periods presented. During March 2012, we entered into an interim agreement with the purchaser
of the assets of PDSG which required the purchaser to pay PDSG $93,450 to subsidize the April 2012 expenses of PDSG during the
sale transaction negotiations. On April 30, 2012, we negotiated a sale transaction in which we sold substantially all of the assets
of PDSG in exchange for a royalty on PDSG revenues for a period of three years. From April 30, 2012 to August 31, 2013, the gain
on the asset sale of PDSG is approximately $44,700.
Patriot Scientific Corporation
Notes to Unaudited Condensed Consolidated
Financial Statements
Discontinued Operations and Assets Held
for Sale (continued)
Summarized operating results of discontinued
operations for the three months ended August 31, 2013 and 2012 are as follows:
|
|
August 31, 2013
|
|
|
August 31, 2012
|
|
Operating loss from discontinued operations
|
|
$
|
–
|
|
|
$
|
(1,387
|
)
|
Gain on sale of discontinued operations
|
|
$
|
40,358
|
|
|
$
|
532
|
|
Income (loss) before income taxes
|
|
$
|
40,358
|
|
|
$
|
(855
|
)
|
Income (loss) from discontinued operations
|
|
$
|
40,358
|
|
|
$
|
(855
|
)
|
PDSG activity for the three months ended August
31, 2013 consists of PDSG royalty revenues.
PDSG activity for the three months ended August
31, 2012 consists of operating expenses for: insurance, taxes and bank fees offset by PDSG royalty revenues.
The following table summarizes the carrying
amount at August 31, 2013 and May 31, 2013 of the major classes of assets of PDSG classified as discontinued operations:
|
|
August 31, 2013
|
|
|
May 31, 2013
|
|
Current assets:
|
|
|
|
|
|
|
|
|
Other current assets
|
|
$
|
70,358
|
|
|
$
|
40,682
|
|
Liquidity and Management’s Plans
Cash shortfalls currently experienced by Phoenix
Digital Solutions, LLC (“PDS”) will have an adverse effect on our liquidity. During the fiscal year ended May 31, 2013,
we and Technology Properties Limited, Inc. (“TPL”) each contributed $1,097,809 in additional capital to fund the operations
of PDS. We and TPL have made no such contributions for the three months ended August 31, 2013. To date, we have determined that
it is in the best interests of the Moore Microprocessor Patent (“MMP”) licensing program that we provide our 50% share
of capital to provide for PDS expenses including legal retainer payments, as well as licensing and litigation support payments
to Alliacense Limited, LLC (“Alliacense”, an affiliate of TPL), in the event license revenues received by PDS are insufficient
to meet these needs. We believe it is likely that contributions to PDS to fund working capital will continue to be required.
PDS has been incurring significant third-party
costs for expert testimony, depositions and other related litigation costs. We could be required to make capital contributions
to PDS for any future litigation related costs in the event that PDS does not receive sufficient licensing revenues to pay these
expenses (see Note 6).
Our current liquid cash resources as of August
31, 2013, are expected to provide the funds necessary to support our operations through at least the next twelve months. The cash
flows from our interest in PDS represent our only significant source of cash generation. In the event of a continued
decrease or interruption in MMP Portfolio licensing we will incur a significant reduction to our cash position. It is highly unlikely
that we would be able to obtain any additional sources of financing to supplement our cash and cash equivalents and short-term
investment position of $7,253,160 at August 31, 2013.
Patriot Scientific Corporation
Notes to Unaudited Condensed Consolidated
Financial Statements
Liquidity and Management’s Plans (continued)
On March 20, 2013, TPL filed a petition under
Chapter 11 of the United States Bankruptcy Code. We have been appointed to the creditors’ committee and will be closely
monitoring the progress in this matter as it relates to our interest in PDS. If we provide funding to PDS that is not reciprocated
by TPL, our ownership percentage in PDS will increase and we will have a controlling financial interest in PDS, in which case,
we will consolidate PDS in our consolidated financial statements. If we determine that it is appropriate to consolidate PDS, we
would measure the assets, liabilities and noncontrolling interests of PDS at their fair values at the date that we have the controlling
financial interest.
Investments in Marketable Securities
We determine the appropriate classification
of our investments at the time of purchase and reevaluate such designation at each balance sheet date. Our investments in marketable
securities have been classified and accounted for as available-for-sale based on management’s investment intentions relating
to these securities. Available-for-sale marketable securities are stated at fair market value. Unrealized gains and losses, net
of deferred taxes, are recorded as a component of other comprehensive income (loss). We follow the authoritative guidance to assess
whether our investments with unrealized loss positions are other than temporarily impaired. Realized gains and losses and declines
in fair value judged to be other than temporary are determined based on the specific identification method and are reported in
other income (expense), net in the condensed consolidated statements of operations.
Investment in Affiliated Company
We have a 50% interest in PDS (see Note 3).
We account for our investment using the equity method of accounting since the investment provides us the ability to exercise significant
influence, but not control, over the investee. Significant influence is generally deemed to exist if we have an ownership interest
in the voting stock of the investee of between 20% and 50%, although other factors, such as representation on the investee’s
Board of Directors, are considered in determining whether the equity method of accounting is appropriate. Under the equity method
of accounting, the investment, originally recorded at cost, is adjusted to recognize our share of net earnings or losses of the
investee and is recognized in the condensed consolidated statements of operations in the caption “Equity in earnings (loss)
of affiliated company” and also is adjusted by contributions to and distributions from PDS.
PDS, as an unconsolidated equity investee,
recognizes revenue from technology license agreements at the time a contract is entered into, the license method is determined
(paid-in-advance or on-going royalty), performance obligations under the license agreement are satisfied, and the realization of
revenue is assured which is generally upon the receipt of the license proceeds. PDS may at times enter into license agreements
whereby contingent revenues are recognized as one or more contractual milestones are met.
We review our investment in PDS to determine
whether events or changes in circumstances indicate that the carrying amount may not be recoverable. The primary factors we consider
in our determination are the financial condition, operating performance and near term prospects of PDS. If a decline in value
is deemed to be other than temporary, we would recognize an impairment loss.
Earnings (Loss) Per Share
Basic net loss per share for continuing and
discontinued operations includes no dilution and is computed by dividing loss available to common stockholders by the weighted
average number of common shares outstanding for the period. Diluted earnings per share for continuing and discontinued operations
reflect the potential dilution of securities that could share in the earnings of an entity.
Patriot Scientific Corporation
Notes to Unaudited Condensed Consolidated
Financial Statements
Earnings (Loss) Per Share (continued)
At August 31, 2013 and 2012 potential common
shares of 1,510,000 and 1,575,000, respectively, related to our outstanding options were not included in the calculation of diluted
loss per share for continuing and discontinued operations as we recorded a loss. Had we reported net income for the three months
ended August 31, 2013 and 2012, an additional 575,000 and 650,000, respectively, shares of common stock would have been included
in the calculation of diluted income per share for continuing and discontinued operations using the treasury stock method.
In connection with our acquisition of Crossflo,
which is part of PDSG, we issued escrow shares that are contingent upon certain representations and warranties made by Crossflo
at the time of the merger agreement (see Note 6). We exclude these escrow shares from the basic loss per share calculations and
include the escrowed shares in the diluted loss per share calculations.
Income Taxes
We follow authoritative guidance in accounting
for uncertainties in income taxes. This authoritative guidance prescribes a recognition threshold and measurement requirement for
the financial statement recognition of a tax position that has been taken or is expected to be taken on a tax return and also provides
guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. Under
this guidance we may only recognize tax positions that meet a “more likely than not” threshold.
We follow authoritative guidance to evaluate
whether a valuation allowance should be established against our deferred tax assets based on the consideration of all available
evidence using a “more likely than not” standard. In making such judgments, significant weight is given to evidence
that can be objectively verified. We are assessing our deferred tax assets under more likely than not scenarios in which they may
be realized through future income.
We have determined that it was more likely
than not that all of our deferred tax assets will not be realized in the future due to our continuing pre-tax and taxable losses.
As a result of this determination we have placed a full valuation allowance against our deferred tax assets.
We follow authoritative guidance to adjust
our effective tax rate each quarter to be consistent with the estimated annual effective tax rate. We are also required to record
the tax impact of certain discrete items, unusual or infrequently occurring, including changes in judgment about valuation allowances
and effects of changes in tax laws or rates, in the interim period in which they occur. In addition, jurisdictions with a projected
loss for the year or a year-to-date loss where no tax benefit can be recognized are excluded from the estimated annual effective
tax rate. The impact of such an exclusion could result in a higher or lower effective tax rate during a particular quarter, based
upon the mix and timing of actual earnings or losses versus annual projections.
Assessment of Contingent Liabilities
We are involved in various legal matters, disputes,
and patent infringement claims which arise in the ordinary course of our business. We accrue for any estimated losses at the time
when we can make a reliable estimate of such loss and it is probable that it has been incurred. By their very nature, contingencies
are difficult to estimate. We continually evaluate information related to all contingencies to determine that the basis on which
we have recorded our estimated exposure is appropriate.
Patriot Scientific Corporation
Notes to Unaudited Condensed Consolidated
Financial Statements
Intellectual Property Rights
PDS, our investment in affiliate, relies on
a combination of patents, trademarks, copyrights, trade secret laws, confidentiality procedures and licensing arrangements to protect
our intellectual property rights. PDS currently licenses four unexpired U.S. patents issued dating back to 1997 on our microprocessor
technology in addition to three European and two Japanese patents. The U.S. patents will expire between 2014 and 2015 and the European
and Japanese patents will expire in 2016. PDS also licenses three U.S. patents, six European, and one Japanese patent all of which
expired between August 2009 and June 2013. These patents, while expired, may have certain retrospective statutory benefits that
will fully diminish six years after the patent expiration date (e.g. for the expired U.S. patents). The patent useful life for
purposes of negotiating licenses is finite and these patents are subject to legal challenges, which in combination with the limited
life, could adversely impact the stream of revenues. A successful challenge to the ownership of the technology or the proprietary
nature of the intellectual property would materially damage business prospects. Any issued patent may be challenged and invalidated.
2. Cash, Cash Equivalents, Restricted Cash and Marketable Securities
We consider all highly liquid investments with
original maturities of three months or less to be cash equivalents.
Restricted cash and cash equivalents at August
31, 2013 and May 31, 2013 consist of deposits in a savings account required to be held as collateral for our corporate credit card.
At August 31, 2013 and May 31, 2013, our marketable
securities in the amount of $194,155 and $194,463, respectively, consists of the par value plus accrued interest of our time deposits.
These marketable securities are classified as available for sale and are reported at fair market value.
We follow authoritative guidance
to
account for our marketable securities as available for sale. Under this authoritative guidance we are required to maximize the
use of observable inputs and minimize the use of unobservable inputs when measuring fair value. We determine fair value based on
quoted prices when available or through the use of alternative approaches, such as discounting the expected cash flows using market
interest rates commensurate with the credit quality and duration of the investment or valuations by third party professionals.
The three levels of inputs that we may use to measure fair value are:
Level 1: Unadjusted quoted prices in active
markets that are accessible at the measurement date for identical, unrestricted assets or liabilities;
Level 2: Quoted prices in markets that are
not active or inputs which are observable, either directly or indirectly, for substantially the full term of the asset or liability;
and
Level 3: Prices or valuation techniques that
require inputs that are both significant to the fair value measurement and unobservable (i.e. supported by little or no market
activity).
Patriot Scientific Corporation
Notes to Unaudited Condensed Consolidated
Financial Statements
Cash, Cash Equivalents, Restricted Cash
and Marketable Securities (continued)
The following tables detail the fair value
measurements within the fair value hierarchy of our cash, cash equivalents and investments in marketable securities:
|
|
|
|
|
Fair Value Measurements at August 31, 2013 Using
|
|
|
|
|
|
Quoted Prices
|
|
|
Significant
|
|
|
|
|
|
|
|
|
|
in Active
|
|
|
Other
|
|
|
Significant
|
|
|
|
Fair Value at
|
|
|
Markets for
|
|
|
Observable
|
|
|
Unobservable
|
|
|
|
August 31,
|
|
|
Identical Assets
|
|
|
Inputs
|
|
|
Inputs
|
|
|
|
2013
|
|
|
(Level 1)
|
|
|
(Level 2)
|
|
|
(Level 3)
|
|
Cash and cash equivalents:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Cash
|
|
$
|
108,210
|
|
|
$
|
108,210
|
|
|
$
|
–
|
|
|
$
|
–
|
|
Money market funds
|
|
|
6,950,795
|
|
|
|
6,950,795
|
|
|
|
–
|
|
|
|
–
|
|
Restricted cash
|
|
|
21,044
|
|
|
|
21,044
|
|
|
|
–
|
|
|
|
–
|
|
Marketable securities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Short-term:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Certificates of deposit
|
|
|
194,155
|
|
|
|
–
|
|
|
|
194,155
|
|
|
|
–
|
|
Total
|
|
$
|
7,274,204
|
|
|
$
|
7,080,049
|
|
|
$
|
194,155
|
|
|
$
|
–
|
|
|
|
|
|
|
Fair Value Measurements at May 31, 2013 Using
|
|
|
|
|
|
Quoted Prices
|
|
|
Significant
|
|
|
|
|
|
|
|
|
|
in Active
|
|
|
Other
|
|
|
Significant
|
|
|
|
Fair Value at
|
|
|
Markets for
|
|
|
Observable
|
|
|
Unobservable
|
|
|
|
May 31,
|
|
|
Identical Assets
|
|
|
Inputs
|
|
|
Inputs
|
|
|
|
2013
|
|
|
(Level 1)
|
|
|
(Level 2)
|
|
|
(Level 3)
|
|
Cash and cash equivalents:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Cash
|
|
$
|
197,862
|
|
|
$
|
197,862
|
|
|
$
|
–
|
|
|
$
|
–
|
|
Money market funds
|
|
|
5,225,176
|
|
|
|
5,225,176
|
|
|
|
–
|
|
|
|
–
|
|
Certificates of deposit
|
|
|
2,149,849
|
|
|
|
–
|
|
|
|
2,149,849
|
|
|
|
–
|
|
Restricted cash
|
|
|
21,018
|
|
|
|
21,018
|
|
|
|
–
|
|
|
|
–
|
|
Marketable securities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Short-term:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Certificates of deposit
|
|
|
194,463
|
|
|
|
–
|
|
|
|
194,463
|
|
|
|
–
|
|
Total
|
|
$
|
7,788,368
|
|
|
$
|
5,444,056
|
|
|
$
|
2,344,312
|
|
|
$
|
–
|
|
Beginning in fiscal 2011, we purchased certificates
of deposit with varying maturity dates greater than three months. The following table summarizes the maturities, gross unrealized
gains or losses and fair value of the certificates of deposit as of August 31, 2013:
|
|
August 31, 2013
|
|
|
|
Cost
|
|
|
Gross Unrealized Gains/(Losses)
|
|
|
Fair
Value
|
|
Maturity
|
|
|
|
|
|
|
|
|
|
|
|
|
Due in one year or less
|
|
$
|
194,155
|
|
|
$
|
–
|
|
|
$
|
194,155
|
|
Patriot Scientific Corporation
Notes to Unaudited Condensed Consolidated
Financial Statements
Cash, Cash Equivalents, Restricted Cash
and Marketable Securities (continued)
The following table summarizes the maturities,
gross unrealized gains or losses and fair value of the certificates of deposit as of May 31, 2013:
|
|
May 31, 2013
|
|
|
|
Cost
|
|
|
Gross Unrealized Gains/(Losses)
|
|
|
Fair
Value
|
|
Maturity
|
|
|
|
|
|
|
|
|
|
|
|
|
Due in three months or less
|
|
$
|
2,149,849
|
|
|
$
|
–
|
|
|
$
|
2,149,849
|
|
Due in one year or less
|
|
$
|
194,463
|
|
|
$
|
–
|
|
|
$
|
194,463
|
|
3. Investment in Affiliated Company
On June 7, 2005, we entered into a Master Agreement
(the “Master Agreement”) with TPL, and Charles H. Moore (“Moore”), the co-inventor of the technology which
is the subject of the MMP Portfolio of microprocessor patents, pursuant to which the parties resolved all legal disputes between
them. Pursuant to the Master Agreement, we and TPL entered into the Limited Liability Company Operating Agreement of PDS (the “LLC
Agreement”) into which we and Moore contributed our rights to certain of our technologies.
We and TPL each own 50% of the membership interests
of PDS, and each member has the right to appoint one member of the three member management committee. The two appointees are required
to select a mutually acceptable third member of the management committee. There has not been a third management committee member
since May 2010. Pursuant to the LLC Agreement, we and TPL initially agreed to establish a working capital fund for PDS of $4,000,000,
of which our contribution was $2,000,000. The working capital fund was increased to a maximum of $8,000,000 as license revenues
are achieved. We and TPL are obligated to fund future working capital requirements at the discretion of the management committee
of PDS in order to maintain working capital of not more than $8,000,000. If the management committee determines that additional
capital is required, neither we nor TPL are required to contribute more than $2,000,000 in any fiscal year. Since there is currently
not a third member of the management committee, working capital contributions made to PDS require the approval of both management
committee members. Distributable cash and allocation of profits and losses will be allocated to the members in the priority defined
in the LLC Agreement.
Pursuant to our June 7, 2005 agreement with
PDS and TPL to license the MMP Portfolio (“Commercialization Agreement”), PDS had committed to pay a quarterly amount
ranging between $500,000 and $1,000,000 (based upon a percentage of the working capital fund balance of PDS) for supporting efforts
to secure licensing agreements by TPL on behalf of PDS. During the three months ended August 31, 2012, PDS expensed $185,000, pursuant
to this commitment. This expense is recorded in the accompanying PDS statement of operations for the three months ended August
31, 2012 presented below. These expenses concluded with the execution of the July 11, 2012 Licensing Program Services Agreement
(the “Program Agreement”).
PDS
reimburses TPL for payment of all legal and third-party expert fees and other related third-party costs and expenses,
although the majority of third-party costs are paid directly by PDS. During the three months ended August 31, 2013 and 2012,
PDS expensed $973,531 and $117,877, respectively, to TPL pursuant to the agreement. These expenses are recorded in the
accompanying PDS statements of operations presented below
net of $309,892 and $3,838,
respectively, of legal fee reversals previousl expensed and recorded as accounts payable to TPL during the three months ended
August 31, 2013 and 2012 as the statute of limitations had expired.
Patriot Scientific Corporation
Notes to Unaudited Condensed Consolidated
Financial Statements
Investment in Affiliated Company
(continued)
On July 11, 2012, we entered into the Program
Agreement with PDS, TPL, and Alliacense, and an Agreement (the “TPL Agreement”) with TPL. Pursuant to the Program Agreement,
PDS engaged Alliacense to negotiate MMP portfolio licenses and to pursue claims against violators of the MMP portfolio on behalf
of PDS, TPL, and the Company. The Program Agreement continues through the useful life of the MMP portfolio patents. Pursuant to
the TPL Agreement, we and TPL agreed to certain allocations of obligations in connection with the engagement of Alliacense.
On July 17, 2012, we entered into an Agreement
with PDS and TPL whereby we agreed to certain additional allocations of obligations relating to the Program Agreement.
Pursuant to the Program Agreement, PDS has
committed to Alliacense a quarterly amount of $500,000 which represents the licensing services fees due Alliacense, subject to
a contingency arrangement which provides for a percentage on future revenues, for its efforts to secure licensing agreements on
behalf of PDS. These payments can be capped at $2,000,000 pursuant to six-month notice from PDS, at which time the PDS management
committee will review and decide the warranting of future payments. These payments replace the quarterly amounts previously paid
to TPL pursuant to the Commercialization Agreement. During the three months ended August 31, 2013 and 2012, PDS expensed $481,353
and $315,000, respectively, pursuant to this commitment. These expenses are recorded in the accompanying PDS statements of operations
presented below. Certain terms of the Program Agreement and the TPL Agreement if enacted could provide for some reductions and/or
limitations to the amount of the quarterly advances provided to Alliacense.
Pursuant to the
Program Agreement PDS has committed to pay Alliacense litigation support fees relating to Alliacense’s special work and effort
related to MMP maintenance and litigation support including support in the U.S. District Court and the complaints filed on behalf
of TPL, PDS and us with the U.S. International Trade Commission (“ITC”) on July 24, 2012. During the three months ended
August 31, 2013 and 2012, PDS expensed $122,578 and $943,103, respectively, pursuant to this commitment. Future litigation support
payments to Alliacense relating to the ITC litigation are subject to a contingency arrangement which provides for a percentage
of future recoveries in these actions.
These expenses are recorded in the accompanying PDS
statements of operations presented below.
During January 2013, TPL and Moore settled
their litigation. Terms of the settlement include the payment by PDS to Moore of a consulting fee of $250,000 for four years or
until the completion of all outstanding MMP litigation whichever comes first. Per terms of the agreement PDS paid Moore $150,000
on the settlement date and will pay Moore $16,667 per month from August 2013 through January 2014 and $20,833 per month beginning
February 2014 through January 2017. During the three months ended August 31, 2013, PDS expensed $16,667 pursuant to this commitment.
This expense is recorded in the accompanying PDS statement of operations for the three months ended August 31, 2013 presented below.
Patriot Scientific Corporation
Notes to Unaudited Condensed Consolidated
Financial Statements
Investment in Affiliated Company
(continued)
Based on our analysis of current authoritative
accounting guidance with respect to our investment in PDS, we continue to account for our investment in PDS under the equity method
of accounting, and accordingly have recorded our share of PDS’ net loss during the three months ended August 31, 2013 of
$85,184 as a decrease in our investment. We received distributions of $6,250 from PDS during the three months ended August 31,
2013 and we have recorded these distributions as a decrease in our investment.
We have recorded our share of PDS’ net
loss for the three months ended August 31, 2013 and 2012 as “Equity in loss of affiliated company” in the accompanying
condensed consolidated statements of operations.
During the three months ended August 31, 2013,
PDS entered into licensing agreements with third parties, pursuant to which PDS recognized revenues of $1,490,000.
During the three months ended August 31, 2012,
TPL entered into licensing agreements with third parties, pursuant to which PDS recognized revenues of $450,000.
At August
31, 2013, PDS had accounts payable balances of approximately $690,000, $18,000, and $33,400 to TPL, Alliacense, and PTSC, respectively.
At May 31,
2013, PDS had a prepaid balance to Alliacense of approximately $456,000 for advance payment of the June 1, 2013 quarterly payment
less license fees earned. At May 31, 2013, PDS had accounts payable balances of approximately $1,494,000, $34,000, and $17,000
to TPL, Alliacense, and PTSC, respectively.
PDS’ balance sheets at August 31, 2013
and May 31, 2013 and statements of operations for the three months ended August 31, 2013 and 2012 are as follows:
Balance Sheets
Assets:
|
|
August 31, 2013
|
|
|
May 31, 2013
|
|
|
|
(Unaudited)
|
|
|
(Audited)
|
|
Cash
|
|
$
|
1,679,938
|
|
|
$
|
1,320,932
|
|
Prepaid expenses
|
|
|
200,104
|
|
|
|
717,540
|
|
Licenses receivable
|
|
|
–
|
|
|
|
250,000
|
|
Total assets
|
|
$
|
1,880,042
|
|
|
$
|
2,288,472
|
|
Liabilities and Members’ Equity:
|
|
August 31, 2013
|
|
|
May 31, 2013
|
|
|
|
(Unaudited)
|
|
|
(Audited)
|
|
Related party payables
|
|
$
|
1,330,304
|
|
|
$
|
1,544,075
|
|
Income tax payable
|
|
|
–
|
|
|
|
11,790
|
|
Members’ equity
|
|
|
549,738
|
|
|
|
732,607
|
|
Total liabilities and members’ equity
|
|
$
|
1,880,042
|
|
|
$
|
2,288,472
|
|
Patriot Scientific Corporation
Notes to Unaudited Condensed Consolidated
Financial Statements
Investment in Affiliated Company
(continued)
Statements of Operations
|
|
Three Months Ended
August 31,
|
|
|
|
2013
|
|
|
2012
|
|
|
|
(Unaudited)
|
|
|
(Unaudited)
|
|
Revenues
|
|
$
|
1,490,000
|
|
|
$
|
450,000
|
|
Expenses
|
|
|
1,660,369
|
|
|
|
1,564,136
|
|
Operating loss
|
|
|
(170,369
|
)
|
|
|
(1,114,136
|
)
|
Net loss
|
|
$
|
(170,369
|
)
|
|
$
|
(1,114,136
|
)
|
PDS Related Party Balances And Transactions
Balances with related parties as of August
31, 2013 and May 31, 2013 are summarized as follows:
|
|
August 31, 2013
|
|
|
May 31, 2013
|
|
Assets:
|
|
|
|
|
|
|
Prepaid expenses (Advances to Alliacense)
|
|
$
|
–
|
|
|
$
|
456,353
|
|
Liabilities:
|
|
|
|
|
|
|
|
|
Related party payables and accrued expenses (TPL) (1)
|
|
$
|
1,279,088
|
|
|
$
|
1,493,775
|
|
Related party payables (PTSC)
|
|
|
33,400
|
|
|
|
16,538
|
|
Related party payables (Alliacense)
|
|
|
17,816
|
|
|
|
33,762
|
|
Total liabilities
|
|
$
|
1,330,304
|
|
|
$
|
1,544,075
|
|
Transactions with related parties for the three
months ended August 31, 2013 and 2012 are as follows:
|
|
August 31, 2013
|
|
|
August 31, 2012
|
|
Expenses paid or accrued (TPL)
|
|
$
|
973,531
|
|
|
$
|
302,877
|
|
Expenses paid or accrued (Alliacense)
|
|
$
|
603,931
|
|
|
$
|
1,258,103
|
|
|
(1)
|
Pursuant to the terms of the Commercialization Agreement, PDS will reimburse TPL for the payment
of all legal and third party expert fees and other related third party costs and expenses upon TPL’s submission of documentation
supporting that payment by them has occurred.
|
Significant Contractual Legal Relationship
PTSC through its unconsolidated affiliate,
PDS has incurred litigation related costs from an unrelated law firm and legal subcontractors to provide substantial legal services
for the commercialization of the MMP portfolio of microprocessor patents.
Accounts payable balances due this law firm
and legal subcontractors as of August 31, 2013 and May 31, 2013 were $589,420 and $518,694, respectively.
Patriot Scientific Corporation
Notes to Unaudited Condensed Consolidated
Financial Statements
Investment in Affiliated Company (continued)
Transactions with this law firm and legal subcontractors
for the three months ended August 31, 2013 and 2012 were as follows:
|
|
August 31, 2013
|
|
|
August 31, 2012
|
|
Legal costs
|
|
$
|
1,123,916
|
|
|
$
|
108,090
|
|
|
|
|
|
|
|
|
|
|
Contractual Commitments
In January 2013, PDS entered into a contractual
commitment with a related party entity to provide consulting services at a cost of $250,000 per year for a duration of four years
or the completion of all outstanding MMP litigation, whichever comes first.
For the three months ended August 31, 2013,
PDS expensed $16,667 related to this agreement.
In connection with the Program Agreement, PDS
is required to make payments to Alliacense of $500,000 no later than three days prior to the start of each calendar quarter. Such
payments are non-accountable and non-recoupable, but are offset against the licensing series fees owed to Alliacense pursuant to
the Program Agreement. Upon six-months notice to Alliacense, and in conjunction with a proportionate reduction in the scope of
the Project Description, as defined, PDS may determine to implement a maximum of advances not-yet-offset of $2,000,000.
We review our investment in PDS to determine
whether events or changes in circumstances indicate that the carrying amount may not be recoverable. The primary factors we consider
in our determination are the financial condition, operating performance and near term prospects of PDS. If a decline in value
is deemed to be other than temporary, we would recognize an impairment loss.
4
.
Income Taxes
We have determined that it was more likely
than not that all of our deferred tax assets will not be realized in the future due to our continuing pre-tax and taxable losses.
As a result of this determination we have placed a full valuation allowance against our deferred tax assets. There have been no
changes to our determination during the current fiscal year.
5. Stockholders’ Equity
Equity Transactions
The following table summarizes equity transactions
during the three months ended August 31, 2013:
|
|
Common Stock
|
|
|
Additional
|
|
|
Accumulated
|
|
|
Treasury
|
|
|
|
Shares
|
|
|
Amounts
|
|
|
Paid-in Capital
|
|
|
Deficit
|
|
|
Stock
|
|
Balance June 1, 2013
|
|
|
405,247,405
|
|
|
$
|
4,382
|
|
|
$
|
77,338,434
|
|
|
$
|
(54,801,249
|
)
|
|
$
|
(14,404,394
|
)
|
Share-based compensation
|
|
|
–
|
|
|
|
–
|
|
|
|
62,418
|
|
|
|
–
|
|
|
|
–
|
|
Net loss
|
|
|
–
|
|
|
|
–
|
|
|
|
–
|
|
|
|
(486,890
|
)
|
|
|
–
|
|
Balance August 31, 2013
|
|
|
405,247,405
|
|
|
$
|
4,382
|
|
|
$
|
77,400,852
|
|
|
$
|
(55,288,139
|
)
|
|
$
|
(14,404,394
|
)
|
Patriot Scientific Corporation
Notes to Unaudited Condensed Consolidated
Financial Statements
Stockholders’ Equity (continued)
Stock Option Activity
As of August 31, 2013, we had 1,510,000 fully
vested options outstanding pursuant to our 2006 Stock Option Plan exercisable at a range of $0.10 to $0.12 per share expiring through
2018.
On June 4, 2013, we issued 760,000 stock options
from our 2006 Stock Option Plan with an exercise price of $0.12 to our employees and directors. The options vested immediately
upon issuance.
During the three months ended August 31, 2013,
we recorded $62,418 of share-based compensation expense related to the stock options granted to PTSC directors and employees.
Share-based Compensation
Summary of Assumptions and Activity
The fair value of share-based awards to employees
and directors is calculated using the Black-Scholes option pricing model, even though this model was developed to estimate the
fair value of freely tradable, fully transferable options without vesting restrictions, which differ significantly from our stock
options. The Black-Scholes model also requires subjective assumptions, including future stock price volatility and expected time
to exercise, which greatly affect the calculated values. The expected term of options granted is derived from historical data on
employee exercises and post-vesting employment termination behavior. The risk-free rate selected to value any particular grant
is based on the U.S. Treasury rate that corresponds to the pricing term of the grant effective as of the date of the grant. The
expected volatility for the three months ended August 31, 2013 is based on the historical volatilities of our common stock. These
factors could change in the future, affecting the determination of share-based compensation expense in future periods.
|
|
Three Months Ended
August 31,
2013
(Unaudited)
|
|
Three Months Ended
August 31,
2012
(Unaudited)
|
Expected term
|
|
5
|
years
|
|
*
|
years
|
Expected volatility
|
|
88
|
%
|
|
*
|
%
|
Risk-free interest rate
|
|
1.05
|
%
|
|
*
|
%
|
* No stock options
were granted during this period.
Patriot Scientific Corporation
Notes to Unaudited Condensed Consolidated
Financial Statements
Stockholders’ Equity (continued)
A summary of option
activity as of August 31, 2013 and changes during the three months then ended, is presented below:
|
|
Shares
|
|
|
Weighted Average
Exercise
Price
|
|
|
Weighted Average Remaining Contractual
Term
(Years)
|
|
|
Aggregate Intrinsic
Value
|
|
Options outstanding at June 1, 2013
|
|
|
750,000
|
|
|
$
|
0.10
|
|
|
|
|
|
|
|
|
|
Options granted
|
|
|
760,000
|
|
|
$
|
0.12
|
|
|
|
|
|
|
|
|
|
Options exercised
|
|
|
–
|
|
|
$
|
–
|
|
|
|
|
|
|
|
|
|
Options forfeited
|
|
|
–
|
|
|
$
|
–
|
|
|
|
|
|
|
|
|
|
Options outstanding at August 31, 2013
|
|
|
1,510,000
|
|
|
$
|
0.11
|
|
|
|
3.11
|
|
|
$
|
5,750
|
|
Options vested and expected to vest at August 31, 2013
|
|
|
1,510,000
|
|
|
$
|
0.11
|
|
|
|
3.11
|
|
|
$
|
5,750
|
|
Options exercisable at August 31, 2013
|
|
|
1,510,000
|
|
|
$
|
0.11
|
|
|
|
3.11
|
|
|
$
|
5,750
|
|
The weighted average grant date fair value
of options granted during the three months ended August 31, 2013 was $0.08 per option. There were no options granted during the
three months ended August 31, 2012.
There were no options exercised during the
three months ended August 31, 2013 or 2012.
The aggregate intrinsic
value represents the differences in market price at the close of the quarter ($0.11 per share on August 31, 2013) and the exercise
price of outstanding, in-the-money options (those options with exercise prices below $0.11) on August 31, 2013.
The following table
summarizes our employee share-based compensation for the three months ended August 31, 2013 and 2012, which was recorded in selling,
general and administrative expense as follows:
|
|
Three Months Ended
|
|
|
Three Months Ended
|
|
|
|
August 31, 2013
|
|
|
August 31, 2012
|
|
Selling, general and administrative expense
|
|
$
|
62,418
|
|
|
$
|
–
|
|
Patriot Scientific Corporation
Notes to Unaudited Condensed Consolidated
Financial Statements
6. Commitments and Contingencies
Litigation
Patent Litigation
On February 8, 2008, we, TPL and Alliacense
Ltd. were named as defendants in separate lawsuits filed in the United States District Court for the Northern District of California
by HTC Corporation, and Acer, Inc., and affiliated entities of each of them. (Those cases were deemed related and are referred
to herein as the “N.D. Cal. Case”). HTC and Acer
sought declaratory relief that their products did not infringe
enforceable claims of the '336 patent. We alleged counterclaims for patent infringement of the '336 and '890 patents as to certain
of their products.
The Court issued a first claim construction
ruling in the N.D. Cal. Case on June 12, 2012, which preserved our ability to proceed on our infringement claims against Acer and
HTC. Thereafter, Chief District Judge James Ware retired and the N.D. Cal. Case was reassigned to Magistrate Judge Paul S. Grewal,
who held a supplemental claim construction hearing on November 30, 2012. Judge Grewal then issued a supplemental claim construction
ruling on December 5, 2012, which preserved our ability to proceed with our infringement claims. On September 6, 2013 Acer entered
into an MMP Portfolio license agreement that also provided for the dismissal of all claims in the N.D. Cal Case, as well as the
filing of a joint motion to terminate Acer as a respondent in the ITC 853 Investigation (described more fully below). On September
19, 2013 the ‘890 patent was dropped from the N.D. Cal Case pursuant to stipulation by all parties. A jury trial was held
in the N.D. Cal. Case against HTC, beginning on September 23, 2013. On October 3, 2013, the jury returned a verdict in favor of
us and TPL, finding that HTC had infringed the ‘336 patent with damages of $958,560.
On July 24, 2012 complaints were filed on behalf
of us, TPL, and PDS against Acer, Inc., Amazon.com, Inc., Barnes & Noble, Inc., Garmin, Ltd., HTC Corporation, Huawei Technologies
Co., Ltd., Kyocera Corporation, LG Electronics, Nintendo C., Ltd., Novatel Wireless, Inc., Samsung Electronics Co., Ltd., Sierra
Wireless, Ltd. and ZTE Corporation with the U.S. International Trade Commission ("ITC") (ITC Investigation No. 337-TA-853,
or the “853 Investigation”) alleging infringement of the ‘336 patent. We also filed new parallel proceedings
in the U.S. District Court for the Northern District of California alleging infringement of the ‘749, ‘890 and ‘336
patents against Amazon.com Inc., Barnes & Noble Inc., Garmin Ltd., Huawei Technologies Co. Ltd., Kyocera Corporation, LG Electronics,
Nintendo Co. Ltd., Novatel Wireless Inc., Samsung Electronics Co. Ltd., Sierra Wireless Inc., and ZTE Corporation. We subsequently
reached a settlement with Sierra Wireless, Inc. Trial proceedings before the ITC began on June 3, 2013 and concluded the following
week. Settlements were subsequently reached with Kyocera Corporation, Amazon.com, Inc., and Acer, Inc. An Initial Determination
was rendered on September 6, 2013 finding that none of the remaining Respondents had infringed the ‘336 patent. We filed
a petition for review of the Initial Determination with the full ITC on September 23, 2013. We expect to learn within 45 days of
the date of the Initial Determination if the petition for review will be granted. If granted, the ITC could potentially reconsider
the finding of noninfringement. If we prevail in a review by the full ITC such that the ‘336 is found to be infringed, then
the target date in the ITC proceeding in which the ITC could potentially issue an importation ban on infringing products, is January 6,
2014. All of the district court actions against the new parties (i.e., all respondents other than Acer and HTC) that have not previously
settled are currently stayed pending resolution of the 853 Investigation.
Patriot Scientific Corporation
Notes to Unaudited Condensed Consolidated
Financial Statements
Commitments and Contingencies (continued)
Licensing Fee Disputes
In February 2013, PDS received a license fee
installment attributable to the January 2013 satisfaction of a contingency contained in an MMP license agreement entered into in
May 2012. Alliacense has asserted a claim against PDS for $300,000 under the premise that it is owed a percentage of the license
fee installment pursuant to the Program Agreement it entered into with PDS, TPL and us in July 2012. TPL has also asserted a claim
against PDS for $225,000 under the premise that it is owed a percentage of the license fee installment pursuant to the terms of
the June 2005 Commercialization Agreement between PDS, TPL and us. Our position is that no percentage is due Alliacense as it had
not been engaged for services at the time the May 2012 license agreement was entered into, and that it had no role in the satisfaction
of the contingency that triggered the installment fee. Regarding TPL, our position is that a percentage to TPL could be justified,
subject to, and fully offset by, advances previously made to it by PDS. We intend to vigorously defend our interest in PDS against
the assertions made by Alliacense and TPL. While no amounts have been accrued in regards to these matters, we believe pursuant
to the criteria defined in Accounting Standards Codification 450-20-50
Disclosure of Certain Loss Contingencies
, it is reasonably
possible PDS could recognize a charge to earnings in the range of $0 to $300,000.
In September 2013, Alliacense asserted it was
owed amounts pursuant to a contingency provision of the Program Agreement it entered into with PDS, TPL and us in July 2012. We
have requested Alliacense provide additional supporting information. Until such additional information is made available to us
we cannot determine if the amounts as requested are owed. While no amounts have been accrued in regards to these matters, we believe
pursuant to the criteria defined in Accounting Standards Codification 450-20-50
Disclosure of Certain Loss Contingencies
,
it is reasonably possible that as a result of the amounts asserted by Alliacense, PDS could recognize a charge to earnings in the
range of $0 to $201,150 relating to the quarter ended August 31, 2013 and $0 to $421,956 relating to the quarter ended November
30, 2013.
401(k) Plan
Patriot has a retirement plan that complies
with Section 401(k) of the Internal Revenue Code. All employees are eligible to participate in the plan. Patriot matches 100% of
elective deferrals subject to a maximum of 4% of the participant’s eligible earnings. Patriot’s participants vest 33%
per year over a three year period in their matching contributions. Patriot’s matching contributions during the three months
ended August 31, 2013 and 2012 were $3,754 and $3,753, respectively.
Guarantees and Indemnities
We have made certain guarantees and indemnities,
under which we may be required to make payments to a guaranteed or indemnified party. We indemnify our directors, officers, employees
and agents to the maximum extent permitted under the laws of the State of Delaware. In connection with our facility lease, we have
indemnified our lessor for certain claims arising from the use of the facility. The duration of the guarantees and indemnities
varies, and in many cases is indefinite. These guarantees and indemnities do not provide for any limitation of the maximum potential
future payments we could be obligated to make. Historically, we have not been obligated to make any payments for these obligations
and no liabilities have been recorded for these guarantees and indemnities in the accompanying condensed consolidated balance sheets.
Patriot Scientific Corporation
Notes to Unaudited Condensed Consolidated
Financial Statements
Commitments and Contingencies (continued)
Escrow Shares
On August 31, 2009 we gave notice to the former
shareholders of Crossflo and Union Bank of California (the “Escrow Agent”) under Section 2.5 of the Agreement and Plan
of Merger between us and Crossflo (the “Agreement”), outlining damages incurred by us in conjunction with the acquisition
of Crossflo, and seeking the return of 2,844,630 shares of our common stock held by the Escrow Agent. Subsequently, former
shareholders of Crossflo representing a majority of the escrowed shares responded in protest to our claim, delaying the release
of the escrowed shares until a formal resolution is reached. In the event we fail to prevail in our claim against the escrowed
shares, we may be obligated to deposit into escrow approximately $256,000 of cash consideration due to the decline in our average
stock price over the one year escrow period, calculated in accordance with the Section 2.5 of the Agreement. We have evaluated
the potential for loss regarding our claim and believe that it is probable that the resolution of this issue will not result in
a material obligation to the Company, although there is no assurance of this. Accordingly, we have not recorded a liability
for this matter.
7. Subsequent Events
We have evaluated subsequent events after the
balance sheet date and based on our evaluation, management has determined that no subsequent events have occurred that would require
recognition in the accompanying condensed consolidated financial statements or disclosure in the notes thereto other than as disclosed
in the accompanying notes.
During the period September 1, 2013 through
October 9, 2013, we purchased 448,608 shares of our common stock at an aggregate cost of $40,009 pursuant to our stock buyback
program.