Table of Contents

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

(Mark One)

 

x

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended March 31, 2014

 

OR

 

o

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from                      to                     

 

Commission File Number 0-24752

 

Wave Systems Corp.

(Exact name of registrant as specified in its charter)

 

Delaware

 

13-3477246

(State or other jurisdiction of
 incorporation or organization)

 

(I.R.S.Employer Identification No.)

 

480 Pleasant Street

Lee, Massachusetts 01238

(Address of principal executive offices)

 

Registrant’s telephone number, including area code:

(413) 243-1600

 

Indicate by check mark whether the Registrant:  (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x   No o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x   No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer o

 

Accelerated filer  o

 

 

 

Non-accelerated filer o

 

Smaller reporting company  x

(Do not check if a smaller reporting company)

 

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o   No x

 

The number of shares outstanding of each of the issuer’s classes of common stock as of May 6, 2014: 40,468,024 shares of Class A Common Stock and 8,885 shares of Class B Common Stock.

 

 

 



Table of Contents

 

Wave Systems Corp. and Subsidiaries

Quarterly Report on Form 10-Q for the Quarter Ended March 31, 2014

Index

 

 

 

PAGE NO.

PART I.

FINANCIAL INFORMATION

 

 

 

 

Item 1.

Financial Statements (Unaudited)

 

 

 

 

 

Consolidated Balance Sheets at March 31, 2014 and December 31, 2013

3

 

 

 

 

Consolidated Statements of Operations for the Three Months Ended March 31, 2014 and 2013

4

 

 

 

 

Consolidated Statements of Stockholders’ Deficit for the Three Months Ended March 31, 2014

5

 

 

 

 

Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2014 and 2013

6

 

 

 

 

Notes to Unaudited Consolidated Financial Statements

7

 

 

 

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

18

 

 

 

Item 3.

Quantitative and Qualitative Disclosures About Market Risk

30

 

 

 

Item 4.

Controls and Procedures

30

 

 

 

PART II.

OTHER INFORMATION

 

 

 

 

Item 1.

Legal Proceedings

32

 

 

 

Item 1A.

Risk Factors

32

 

 

 

Item 6.

Exhibits

41

 

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PART I -         FINANCIAL INFORMATION

 

Item 1.          Financial Statements

 

WAVE SYSTEMS CORP. AND SUBSIDIARIES

Consolidated Balance Sheets

(Unaudited)

 

 

 

March 31,

 

December 31,

 

 

 

2014

 

2013

 

Assets

 

 

 

 

 

Current Assets:

 

 

 

 

 

Cash and cash equivalents

 

$

4,343,604

 

$

2,120,102

 

Accounts receivable, net of allowance for doubtful accounts of $-0- at March 31, 2014 and December 31, 2013

 

2,586,640

 

2,730,077

 

Pledged receivables

 

526,765

 

1,683,188

 

Prepaid expenses and other current assets

 

482,451

 

488,656

 

Total current assets

 

7,939,460

 

7,022,023

 

Property and equipment, net

 

530,603

 

596,820

 

Amortizable intangible assets, net

 

2,445,246

 

2,590,920

 

Goodwill

 

1,448,000

 

1,448,000

 

Other assets

 

168,281

 

167,146

 

Total Assets

 

12,531,590

 

11,824,909

 

Liabilities and Stockholders’ Deficit

 

 

 

 

 

Current Liabilities:

 

 

 

 

 

Secured borrowings

 

447,750

 

1,430,710

 

Accounts payable and accrued expenses

 

6,195,125

 

6,789,274

 

Deferred revenue

 

6,944,706

 

6,996,239

 

Total current liabilities

 

13,587,581

 

15,216,223

 

Other long-term liabilities

 

66,838

 

78,618

 

Royalty liability

 

4,434,043

 

4,509,629

 

Long-term deferred revenue

 

981,808

 

1,003,614

 

Total liabilities

 

19,070,270

 

20,808,084

 

Stockholders’ Deficit:

 

 

 

 

 

Common stock, $.01 par value. Authorized 150,000,000 shares as Class A; 40,385,524 shares issued and outstanding at March 31, 2014 and 35,019,740 at December 31, 2013

 

403,855

 

350,197

 

Common stock, $.01 par value. Authorized 13,000,000 shares as Class B; 8,885 shares issued and outstanding at March 31, 2014 and December 31, 2013

 

89

 

89

 

Capital in excess of par value

 

413,591,361

 

407,907,019

 

Accumulated deficit

 

(420,533,985

)

(417,240,480

)

Total Stockholders’ Deficit

 

(6,538,680

)

(8,983,175

)

Total Liabilities and Stockholders’ Deficit

 

$

12,531,590

 

$

11,824,909

 

 

All shares and per share data presented in these consolidated financial statements and accompanying footnotes have been retroactively adjusted to reflect the 1-for-4 reverse stock split.

 

See accompanying notes to unaudited consolidated financial statements.

 

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WAVE SYSTEMS CORP. AND SUBSIDIARIES

Consolidated Statements of Operations

(Unaudited)

 

 

 

Three Months Ended

 

 

 

March 31,
2014

 

March 31,
2013

 

Net revenues:

 

 

 

 

 

Licensing and maintenance

 

$

5,332,539

 

$

4,993,726

 

Services

 

 

800,000

 

Total net revenues

 

5,332,539

 

5,793,726

 

Operating expenses:

 

 

 

 

 

Licensing and maintenance - cost of net revenues

 

312,828

 

2,225,599

 

Services - cost of net revenues

 

 

107,361

 

Selling, general and administrative

 

5,201,968

 

7,179,003

 

Research and development

 

3,064,673

 

3,848,982

 

Impairment of goodwill

 

 

2,590,000

 

Total operating expenses

 

8,579,469

 

15,950,945

 

Operating loss

 

(3,246,930

)

(10,157,219

)

Other income (expense):

 

 

 

 

 

Net currency transaction (loss) gain

 

(1,711

)

1,631

 

Net interest expense

 

(44,864

)

(58,167

)

Total other income (expense), net

 

(46,575

)

(56,536

)

Net loss

 

(3,293,505

)

(10,213,755

)

Loss per common share — basic and diluted

 

$

(0.09

)

$

(0.39

)

Weighted average number of common shares outstanding

 

38,486,897

 

26,347,688

 

 

All shares and per share data presented in these consolidated financial statements and accompanying footnotes have been retroactively adjusted to reflect the 1-for-4 reverse stock split.

 

See accompanying notes to unaudited consolidated financial statements.

 

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WAVE SYSTEMS CORP. AND SUBSIDIARIES

Consolidated Statements of Stockholders’ Deficit

(Unaudited)

 

 

 

Class A Common

 

Class B Common

 

Capital in

 

 

 

 

 

 

 

Stock

 

Stock

 

Excess of Par

 

Accumulated

 

 

 

 

 

Shares

 

Amount

 

Shares

 

Amount

 

Value

 

Deficit

 

Total

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance as of December 31, 2013

 

35,019,740

 

$

350,197

 

8,885

 

$

89

 

$

407,907,019

 

$

(417,240,480

)

$

(8,983,175

)

Net loss

 

 

 

 

 

 

(3,293,505

)

(3,293,505

)

Issuance of Class A common stock at prices ranging from $0.90 - $1.13 per share, less issuance costs of $169,092

 

5,365,784

 

53,658

 

 

 

5,270,059

 

 

5,323,717

 

Stock based compensation

 

 

 

 

 

414,283

 

 

414,283

 

Balance as of March 31, 2014

 

40,385,524

 

$

403,855

 

8,885

 

$

89

 

$

413,591,361

 

$

(420,533,985

)

$

(6,538,680

)

 

All shares and per share data presented in these consolidated financial statements and accompanying footnotes have been retroactively adjusted to reflect the 1-for-4 reverse stock split.

 

See accompanying notes to unaudited consolidated financial statements.

 

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WAVE SYSTEMS CORP. AND SUBSIDIARIES

Consolidated Statements of Cash Flows

(Unaudited)

 

 

 

Three months ended

 

 

 

March 31,

 

March 31,

 

 

 

2014

 

2013

 

Cash flows from operating activities:

 

 

 

 

 

Net loss

 

$

(3,293,505

)

$

(10,213,755

)

Adjustments to reconcile net loss to net cash used in operating activities:

 

 

 

 

 

Depreciation and amortization

 

236,648

 

315,909

 

Compensation associated with issuance of stock options

 

414,283

 

437,706

 

Impairment of goodwill and intangible assets

 

 

4,205,000

 

Accretion of royalty liability

 

24,325

 

20,350

 

Changes in assets and liabilities:

 

 

 

 

 

Decrease in accounts receivable

 

316,900

 

2,407,878

 

Decrease (increase) in prepaid expenses and other current assets

 

6,205

 

(197,640

)

Increase in other assets

 

(1,135

)

(3,304

)

(Decrease) increase in accounts payable and accrued expenses

 

(594,149

)

1,055,164

 

(Decrease) increase in deferred revenue

 

(73,339

)

682,955

 

Decrease in royalty liability

 

(99,911

)

(102,293

)

(Decrease) increase in other long-term liabilities

 

(11,780

)

231

 

Net cash used in operating activities

 

(3,075,458

)

(1,391,799

)

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

Acquisition of property and equipment

 

(24,757

)

(93,923

)

Net cash used in investing activities

 

(24,757

)

(93,923

)

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

Payments on capital lease obligation

 

 

(18,896

)

Proceeds from employee stock option exercises

 

 

42,039

 

Net proceeds from issuance of common stock

 

5,323,717

 

1,172,946

 

Net cash provided by financing activities

 

5,323,717

 

1,196,089

 

 

 

 

 

 

 

Net increase (decrease) in cash and cash equivalents

 

2,223,502

 

(289,633

)

 

 

 

 

 

 

Cash and cash equivalents at beginning of period

 

2,120,102

 

2,112,769

 

 

 

 

 

 

 

Cash and cash equivalents at end of period

 

4,343,604

 

$

1,823,136

 

 

 

 

 

 

 

Supplemental cash flow information:

 

 

 

 

 

Cash paid during the period for:

 

 

 

 

 

Interest

 

$

37,620

 

$

45,229

 

 

See accompanying notes to unaudited consolidated financial statements.

 

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WAVE SYSTEMS CORP. AND SUBSIDIARIES

Notes to Unaudited Consolidated Financial Statements

 

March 31, 2014 and 2013

 

In the opinion of management, the accompanying unaudited consolidated financial statements contain all adjustments (consisting only of normal recurring adjustments) necessary to present fairly the financial position of Wave Systems Corp. (“Wave”) as of March 31, 2014 and December 31, 2013, and the results of its operations and cash flows for the three-month periods ended March 31, 2014 and 2013.  Such financial statements have been prepared in accordance with United States generally accepted accounting principles and the applicable regulations of the Securities and Exchange Commission (the “Commission”).

 

Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been omitted.  It is suggested that these consolidated financial statements be read in conjunction with Wave’s audited financial statements and notes thereto for the year ended December 31, 2013, included in its Form 10-K filed on March 14, 2014.  The results of operations for the three-months ended March 31, 2014 are not necessarily indicative of the operating results for the full year or any future periods.

 

References to “Wave”, “we”, “us”, “our” or “the Company” refer to Wave Systems Corp and its consolidated subsidiaries and include the financial statements of Wave Systems Corp. (“Wave” or “the Company”); Wave Systems Holdings, Inc., a wholly-owned subsidiary; Wavexpress, Inc. (referred to individually, as the context so requires, as “Wavexpress”), a majority-owned subsidiary; and Safend, Ltd. (referred to individually, as the context so requires, as “Safend”), a wholly-owned subsidiary acquired on September 22, 2011.  All intercompany transactions have been eliminated.

 

1.               Critical Accounting Policies

 

Wave’s discussion and analysis of its financial condition and results of operations are based on the Company’s consolidated financial statements which have been prepared in accordance with United States generally accepted accounting principles or GAAP. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported revenues and expenses during the reporting periods. On an ongoing basis management evaluates its estimates and judgments, including those related to revenue recognition, accounts receivable reserves, depreciation and amortization, valuation of long-lived and intangible assets, goodwill, software development, contingencies and share based compensation.  Management bases its estimates on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

 

A detailed description of the accounting policies deemed critical to the understanding of the consolidated financial statements is included in the notes to Wave’s audited financial statements for the year ended December 31, 2013, included in its Form 10-K filed with the Securities and Exchange Commission on March 14, 2014.

 

Revenue Recognition — Wave’s business model targets revenues from various sources including: licensing of the EMBASSY Trust Suite, Safend’s endpoint data loss protection suite, eTMS software products and development contracts.  Many of these sales arrangements include multiple-elements and/or require significant modification or customization of Wave’s software.

 

Wave recognizes revenue when it is realized or realizable and earned. Wave considers revenue realized or realizable and earned when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable and collectability is reasonably assured.  In addition to the aforementioned general policy, the following are the specific revenue recognition policies for each major category of revenue.

 

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Licensing and Maintenance

 

Wave receives revenue from licensing its EMBASSY Trust Suite software through distribution arrangements with its OEM partners, software development and other services.  Wave’s distribution arrangements also give rise to separate software license upgrade agreements with the end users of the products distributed by the OEMs.  Wave applies software revenue recognition guidance to all transactions except those where no software is involved.  Revenue is recognized when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable and collectability is reasonably assured.  Persuasive evidence is generally a binding purchase order or license agreement.  Delivery occurs when product is shipped, for its OEM distribution arrangements, or delivered via a license key, for our license upgrade agreements.

 

Wave enters into perpetual software license agreements through direct sales to customers and indirect sales through its OEM partners, distributors and resellers with the end users of the products distributed by the OEMs.  Wave has defined its two classes of end user customers as large and small based on those with orders in excess of 5,000 licenses and those with less than 5,000 licenses, respectively.  These license upgrade agreements generally include a maintenance component.  For arrangements with multiple elements, including software licenses, maintenance and/or services, revenue is allocated and deferred in amounts equivalent to the vendor specific objective evidence (“VSOE”) of fair value for the undelivered elements and the difference between the total arrangement fee and the amount deferred for the undelivered elements is recognized as license revenue.  VSOE of fair value is based upon the price for which the undelivered element is sold separately.

 

Wave has VSOE of fair value of maintenance for its small class of customers based on independent maintenance renewals.  Wave lacks sufficient independent maintenance renewals to establish VSOE for its large customer class.  As a result, for the small customer class, Wave allocates the arrangement consideration to the elements in multi-element arrangements using the residual method.  Under the residual method, the VSOE of the undelivered elements is deferred and the remaining portion of the arrangement fee for perpetual licenses is recognized as revenue upon delivery of the software, assuming all other revenue recognition criteria are met.

 

When VSOE of fair value for the undelivered elements does not exist, as is the case for Wave’s large customer class, the entire arrangement fee is recognized ratably over the performance period as licensing and maintenance revenue.

 

Wave’s deferred revenue consists of the unamortized maintenance for sales to its small class of customers and bundled license and maintenance arrangements where VSOE does not exist.

 

Safend receives revenue from licensing its endpoint data loss protection products and services through its distribution channels.  Safend applies software revenue recognition guidance to all transactions except those where no software is involved.  Revenue is recognized when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable and collectability is reasonably assured.  Persuasive evidence is generally a binding purchase order or license agreement.  Delivery occurs when product is delivered via a license key.

 

Safend enters into perpetual software license agreements through direct sales to customers and indirect sales through its OEM partners, distributors and resellers.  These license arrangements, generally also include a maintenance component.  For arrangements with multiple elements, including software licenses, maintenance and/or services, revenue is allocated and deferred in amounts equivalent to the VSOE of fair value for the undelivered elements and the difference between the total arrangement fee and the amount deferred for the undelivered elements is recognized as licensing revenue.  VSOE of fair value is based upon the price for which the undelivered element is sold separately.

 

Safend has VSOE of fair value of maintenance for its Protector product.  As a result Safend allocates the arrangement consideration among the elements in its multi-element arrangements using the residual method.  Under the residual method, the VSOE of the undelivered elements is deferred and the remaining portion of the arrangement fee for perpetual licenses is recognized as revenue upon delivery of the software, assuming all other revenue recognition criteria are met.  When VSOE of fair value for the undelivered elements does not exist, as is the case for maintenance for its Encryptor, Inspector, Discover, Reporter and Auditor products, the entire arrangement fee is recognized ratably over the performance period as licensing and maintenance revenue.

 

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Licensing and maintenance - cost of net revenues includes customer support personnel costs, foreign tax withholdings, amortization and impairment expense for the developed technology intangible asset, costs associated with providing consulting services and related share-based compensation expense.

 

Services

 

Services revenue includes revenue earned from fixed-price modifications to a contract awarded by the United States Department of Defense.  Revenue from time and material service contracts is recognized as the services are provided. Revenue from fixed price, long-term service or development contracts is recognized using the percentage of completion method or the completed contract method.  The determination between completed contract method and the percentage of completion method is based on the ability to estimate. The Company measures the percentage of completion by reference to the proportion of contract hours incurred for work performed to date to the estimated total contract hours expected to be incurred.  Losses on fixed price contracts are recognized during the period in which the loss first becomes apparent.

 

Services - cost of net revenues includes non-recurring government time and materials costs incurred in connection with a contract with the United States Department of Defense and related share-based compensation expense.

 

Valuation of Goodwill and Purchased Intangible Assets -  We review goodwill for impairment annually and whenever events or changes in circumstances indicate the carrying value of an asset may not be recoverable. The provisions of the accounting standard for goodwill and other intangibles allow us to first assess qualitative factors to determine whether it is necessary to perform the two-step quantitative goodwill impairment test. For our annual goodwill impairment test at September 30, 2013, we performed a quantitative test for our Safend reporting unit. In the first step, we compare the fair value of the Safend unit to its carrying value. We determine the fair value of Safend using the income approach. Under the income approach, we calculated the fair value of the Safend unit based on the present value of estimated future cash flows. Cash flow projections are based on management’s estimates of revenue growth rates and operating margins, taking into consideration industry and market conditions. The discount rate used is based on the weighted-average cost of capital adjusted for the relevant risk associated with business-specific characteristics and the uncertainty related to the business’s ability to execute on the projected cash flows. If the fair value of the reporting unit exceeds the carrying value of the net assets assigned to that unit, goodwill is not impaired and no further testing is required. If the fair value of the reporting unit is less than the carrying value, then we must perform the second step of the impairment test to measure the amount of impairment loss, if any. In the second step, the reporting unit’s fair value is allocated to all of the assets and liabilities of the reporting unit, including any unrecognized intangible assets, in a hypothetical analysis that calculates the implied fair value of goodwill in the same manner as if the reporting unit was being acquired in a business combination. If the implied fair value of the reporting unit’s goodwill is less than the carrying value, the difference is recorded as an impairment loss.

 

We review purchased intangible assets with finite lives for impairment whenever events or changes in circumstances indicate the carrying value of an asset may not be recoverable. Recoverability of these intangible assets is assessed based on the estimated undiscounted future cash flows expected to result from the use of the asset. If the undiscounted future cash flows are less than the carrying amount, the purchased intangible assets with finite lives are considered to be impaired. The amount of the impairment is measured as the difference between the carrying amount of these assets and the fair value.

 

Determining the fair value of a reporting unit is judgmental in nature and involves the use of significant estimates and assumptions. These estimates and assumptions include revenue growth rates and operating margins used to calculate projected future cash flows, risk-adjusted discount rates and future economic and market conditions. We base our fair value estimates on assumptions we believe to be reasonable but they are unpredictable and inherently uncertain. Actual future results may differ from those estimates.

 

We will continue to evaluate goodwill on an annual basis as of September 30 and whenever events or changes in circumstances, such as significant adverse changes in business climate or operating results or changes in management’s business strategy, indicate that there may be a potential indicator of impairment.

 

Capitalized internal-use software development costs - The Company follows the provisions of ASC Topic 350-40, Intangibles Goodwill and Other—Internal Use Software.  ASC Topic 350-40 provides

 

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guidance for determining whether computer software is internal-use software and also provides guidance on capitalization of the costs incurred for computer software developed or obtained for internal use.  These capitalized costs are related to Wave’s cloud platform that is hosted by the Company and accessed by its clients on a subscription basis.  The Company expenses all costs incurred during the preliminary project stage of development and capitalizes the costs incurred during the application development stage. Costs incurred relating to upgrades and enhancements to the software are capitalized if it is determined that these upgrades or enhancements add additional functionality to the software. Costs incurred to improve and support products after they become available are charged to expense as incurred.  The Company records amortization of the software on a straight-line basis over five years, which is the estimated useful life of the software.  At each balance sheet date, management evaluates the unamortized capitalized software costs for potential impairment by comparing the balance to the net realizable value of the products.

 

Accounting for Transfers of Financial Assets - We derecognize financial assets, specifically accounts receivable, when control has been surrendered in compliance with ASC Topic 860, Transfers and Servicing . Transfers of accounts receivable that meet the requirements of ASC 860 for sale accounting treatment are removed from the balance sheet and gains or losses on the sale are recognized. If the conditions for sale accounting treatment are not met, or are no longer met, accounts receivable transferred are classified as collateralized receivables in the consolidated balance sheets and cash received from these transactions is classified as secured borrowings. All transfers of assets are accounted for as secured borrowings. Transaction costs associated with secured borrowings, if any, are treated as borrowing costs and recognized in interest expense.

 

Share-based Compensation — We recognize compensation expense for all share-based payment awards made to employees and directors including employee stock options and employee stock purchases related to the Employee Stock Purchase Plan. Share-based compensation expense recognized is based on the value of the portion of share-based payment award that is ultimately expected to vest and has been reduced for estimated forfeitures.  We value share-based payment awards at grant date using an option-pricing model.  Our determination of the fair value of the share-based payment award on the date of grant using the option-pricing model is affected by our stock price as well as assumptions regarding a number of highly complex and subjective variables.  These variables include, but are not limited to, our expected stock price volatility over the term of the award and actual and projected employee stock option exercise behaviors.

 

Reclassifications - Certain amounts in the Company’s prior period consolidated financial statements have been reclassified to conform to the current period presentation.

 

2.               Reverse Stock Split

 

On June 28, 2013, our Board of Directors approved a reverse stock split of our common stock at a ratio of 1-for-4, causing each four outstanding shares of Class A common stock and Class B common stock to convert automatically into one share of Class A common stock or Class B common stock, respectively. The par value of Class A common stock and Class B common stock remains $0.01 per share. The reverse split became effective on July 1, 2013.  Stockholders’ equity has been restated to give retroactive recognition to the reverse split for all periods presented by reclassifying the excess par value resulting from the reduced number of shares from common stock to paid-in capital. Except as otherwise noted, all references to common share and per common share amounts (including warrant shares, shares reserved for issuance and applicable exercise prices) for all periods presented have been retroactively restated to reflect this reverse split.

 

3.               Liquidity

 

The accompanying consolidated financial statements have been prepared assuming that Wave will continue as a going concern.  Wave has incurred substantial operating losses since its inception, and as of March 31, 2014, has an accumulated deficit of approximately $420,534,000.  We also expect Wave will incur an operating loss for the fiscal year 2014.  As of March 31, 2014, Wave had negative working capital of approximately $5,648,000.

 

Wave does not expect to generate enough revenue to fund its cash flow requirements for the twelve-months ended March 31, 2015.  As of March 31, 2014, we had approximately $4,344,000 of cash on hand.  Given Wave’s forecasted capital requirements for the twelve-months ending March 31, 2015, and

 

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our cash balance as of March 31, 2014, Wave will be required to raise additional capital prior to March 31, 2015 to continue to fund its operations.  Wave’s ability to raise additional capital is primarily based on three sources:

 

·    Sales of registered Class A Common Stock under a $20,000,000 shelf registration statement filed with the SEC on August 9, 2013 and declared effective by the Commission on September 12, 2013 (“2013 shelf registration statement”);

 

·    Sales of registered Class A Common Stock via the At the Market Sales Agreement with MLV & Co. LLC (“MLV”) entered into during January, 2012.  The At the Market Sales Agreement was amended on September 19, 2013 to authorize the issuance and sale of shares of the Company’s Class A Common Stock under the At the Market Sales Agreement for aggregate gross sales proceeds of up to $15,000,000 in connection with the 2013 shelf registration statement; and

 

·    Sales of Class A Common Stock through private placements.

 

During the three-months ended March 31, 2014, Wave sold 5,365,784 shares of its Class A common stock through its At the Market Sales Agreement with MLV at an average price of $1.02 per share, for net proceeds of approximately $5,324,000 after deducting offering costs of approximately $169,000.  Wave has not sold any shares of its Class A common stock subsequent to March 31, 2014.

 

For registered offerings, Wave is required to calculate the amount of capital the Company is allowed to raise in accordance with the General Instruction I.B.6. on Form S-3 (“the one-third rule”).  The one-third rule restricts the amount of capital that can be raised in a 12-month period provided that the registrant’s aggregate market value of the common equity held by non-affiliates is less than $75 million.  As a result of the application of the one-third rule, the funds available on the 2013 shelf registration statement are reduced.  Until Wave attains an aggregate market value of $75 million or more for shares held by non-affiliates, its available funds under the 2013 shelf registration statement will remain restricted to the one-third rule computation.  To determine the amount available under the one-third rule for future financings, the aggregate market value of the common equity is calculated using the price at which the common equity was last sold, or the average of the bid and asked prices of the common equity as of a date within 60 days prior to the date of filing.  As of May 6, 2014, approximately $11,675,000 in gross proceeds remains under the 2013 shelf registration statement, however Wave is restricted to $10,515,000 as of such date due to the one-third rule.  The total funds available under the 2013 shelf registration statement are currently all allocated to the At the Market Sales Agreement with MLV which may be utilized for future financings.

 

Wave will be required to sell shares of common stock, preferred stock, obtain debt financing or engage in a combination of these financing alternatives, to raise additional capital to continue to fund its operations for the twelve-months ending March 31, 2015.  If Wave is not successful in executing its business plan, it will be required to sell additional shares of common stock, preferred stock, obtain debt financing or engage in a combination of these financing alternatives or it could be forced to reduce expenses which may significantly impede its ability to meet its sales, marketing and development objectives, or cause it to cease operations or merge with another company.  No assurance can be provided that any of these initiatives will be successful.  Due to its current cash position, capital needs over the next year and beyond, and the uncertainty as to whether it will achieve its sales forecast for its products and services, substantial doubt exists with respect to Wave’s ability to continue as a going concern.

 

4.               Secured Borrowings and Pledged Receivables

 

Pursuant to agreements entered into on April 23, 2012 with The Receivables Exchange (“TRE”) and on November 26, 2013 with CapFlow Funding Group Managers LLC (“CapFlow), both of which are unrelated third parties, Wave has transferred certain accounts receivable to buyers which are accounted for as secured borrowings. The transferred receivables are classified as pledged receivables and Wave’s obligation to repurchase the transferred receivables is presented as secured borrowings on the consolidated balance sheet. The carrying value of each secured borrowing approximates 85% of each associated pledged receivable and takes into consideration a 15% holdback provision per the TRE and CapFlow agreements.  The customers’ payment of the pledged receivables constitutes the repayment of the related amounts borrowed. The respective financial institution will then remit the remaining 15% holdback to Wave less interest.  Beginning on November 26, 2013 Wave no longer transfers accounts receivable to TRE and currently utilizes CapFlow exclusively.  The interest rate on the secured borrowings was 1.50% for every thirty days outstanding, or an annual effective rate of approximately 18%.

 

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With Wave’s approval, CapFlow establishes arrangements with buyers providing for borrowings that are secured by our accounts receivable, and for which recourse exists against Wave. Wave can be required to repurchase the receivables under certain circumstances in case of specific defaults by our customers as set forth in the program terms.  CapFlow acts as the servicing agent for receivables transferred to buyers.  CapFlow collects the pledged receivables from Wave’s customers and makes the repayment to the buyers on its behalf once the receivables are collected.

 

At March 31, 2014 and December 31, 2013, receivables totaling $526,765 and $1,683,188, respectively, were transferred to buyers, remain uncollected and are subject to repurchase. The secured borrowings totaled $447,750 and $1,430,710 as of March 31, 2014 and December 31, 2013, respectively. We recognized $20,539 and $37,081 of interest expense associated with the secured borrowings for the three-months ended March 31, 2014 and 2013, respectively.  Proceeds from the transfer of receivables are included in cash provided by operating activities in the consolidated statements of cash flows.  Proceeds from the transfer of pledged receivables were $1,043,920 and $2,423,348 for the three-months ended March 31, 2014 and 2013, respectively.  CapFlow and TRE collected $596,170 and $1,824,168 of pledged receivables in the three-months ended March 31, 2014 and 2013, respectively, which thereby reduced our repurchase obligation and were accounted for as reductions of pledged receivables and secured borrowings on the consolidated balance sheet.  No pledged receivables were repurchased by the Company in the three- months ended March 31, 2014 and 2013.

 

5 .           Loss per Share

 

Basic net loss per common share has been calculated based upon the weighted average number of shares of common stock outstanding during the period.  Diluted net loss per share is also computed using the weighted average number of common shares and excludes dilutive potential common shares outstanding, as their effect is anti-dilutive.  Dilutive potential common shares consist primarily of employee stock options and stock warrants.  Diluted net loss per share is equal to basic net loss per share and is therefore not presented separately in the financial statements.  The weighted average number of potential common shares that would have been included in diluted loss per share, had their effect not been anti-dilutive for each of the quarters ended March 31, 2014 and 2013, were approximately 39,000 shares and 448,000 shares, respectively.  Employee stock options and other stock warrants to purchase a weighted average of approximately 6,299,000 and 4,649,000 shares were outstanding for the quarters ended March 31, 2014 and 2013 respectively, but these shares were not included in the computation of diluted loss per share because the exercise price of these stock options and other stock warrants was greater than the average share price of Wave’s common shares and, therefore, their effect would have been anti-dilutive.

 

6 .               Share-based Compensation

 

Wave recognized $414,283 and $437,706 of share-based compensation during the three-months ended March 31, 2014 and 2013, respectively.  During the three-months ended March 31, 2014, Wave granted 1,174,400 stock options at a weighted-average estimated fair value of $0.54.  During the three-months ended March 31, 2013, Wave granted 557,981 stock options at a weighted-average estimated fair value of $2.72.

 

The following table summarizes the effect of share based compensation in Wave’s statement of operations, for the three-month periods ended March 31, 2014 and 2013:

 

 

 

Three months ended
 March 31,

 

 

 

2014

 

2013

 

Cost of net revenues

 

$

3,920

 

$

8,434

 

Selling, general & administrative

 

315,495

 

301,609

 

Research & development

 

94,868

 

127,663

 

Total

 

$

414,283

 

$

437,706

 

 

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7.               Goodwill and Amortizable Intangible Assets

 

The following schedule presents the changes in the carrying amount of goodwill during the period ended March 31, 2014:

 

Balances as of December 31, 2013

 

$

1,448,000

 

Impairment loss

 

 

Balances as of March 31, 2014

 

$

1,448,000

 

 

Wave tests goodwill for impairment annually on September 30 and during interim periods whenever events or changes in circumstances indicate the carrying value of goodwill may not be recoverable.  Wave uses a fair value approach in testing goodwill for impairment in accordance with the provisions of ASC Topic 350, Intangibles—Goodwill and Other. The provisions of the accounting standard for goodwill and other intangibles allow us to first assess the qualitative factors to determine whether it is necessary to perform the two-step quantitative goodwill impairment test.  After assessing the qualitative factors, if it is likely that the fair value of the reporting unit is less than its carrying amount, we will then conduct the two-step quantitative goodwill impairment test.  In the first step, we compare the fair value of each reporting unit to its carrying value. If the fair value of the reporting unit exceeds its carrying value, goodwill is not impaired and no further testing is required. If the fair value of the reporting unit is less than the carrying value, we must perform the second step of the impairment test to measure the amount of impairment loss. In the second step, the reporting unit’s fair value is allocated to all of the assets and liabilities of the reporting unit, including any unrecognized intangible assets, in a hypothetical analysis that calculates the implied fair value of goodwill in the same manner as if the reporting unit was being acquired in a business combination. If the implied fair value of the reporting unit’s goodwill is less than the carrying value, the difference is recorded as an impairment loss.

 

During the first quarter of 2013, the Company determined that sufficient indicators of potential impairment existed to require an interim goodwill impairment analysis for the Safend reporting unit.  These indicators included, among others, significantly lower than expected revenue, identification of increased competition for transactions involving Safend products, inability of the combined sales force to close large transactions and downward revisions to management’s short-term and long-term forecast for Safend.  The revised forecast reflected changes related to revenue growth rates, current market trends, expected deal synergies and other expectations impacting the anticipated short-term and long-term operating results of Safend.  Due to the aforementioned indicators, the Company concluded that there were qualitative factors for the Safend unit that indicated it is more likely than not that the fair value of the Safend reporting unit was less than its carrying amount.

 

The Company estimates the fair value of its reporting units using the income approach. Under the income approach, the Company calculates the fair value of a reporting unit based on the present value of estimated future cash flows.  Cash flow projections are based on management’s estimates of revenue growth rates and operating margins, taking into consideration industry and market conditions. The discount rate used is based on the weighted-average cost of capital adjusted for the relevant risk associated with business-specific characteristics and the uncertainty related to the business’s ability to execute on the projected cash flows.  The inputs used for the income approach are significant unobservable inputs, or Level 3 inputs, as described in ASC Topic 820, Fair Value Measurement.

 

When indicators of impairment are present, such as those noted above, the Company tests long-lived assets (other than goodwill) for recoverability by comparing the carrying value of an asset group to its undiscounted cash flows. Based on the results of the recoverability test during the first quarter of 2013 the Company determined that the carrying value of the Safend asset group exceeded its undiscounted cash flows and was therefore not recoverable. The Company estimated the fair value of the intangible assets under an income approach as described above. Based on the analysis, the Company recorded impairment charges of $1.6 million on developed technology intangible assets during the first quarter of 2013.  The decline in the fair value of the Safend intangible assets is attributable to the same factors as discussed above for the fair value of the Safend reporting unit.

 

After adjusting the carrying value of the reporting unit for the impairment of the intangibles noted above in the first quarter of 2013, the Company completed the two step goodwill impairment test for the Safend reporting unit.  This test resulted in an implied fair value of goodwill substantially below the carrying value of the goodwill. As a result, the Company recorded a goodwill impairment charge of $2.6

 

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million during the first quarter of 2013, which resulted in a $1.4 million remaining carrying value of Safend goodwill as of March 31, 2013. The goodwill impairment charge totaling approximately $2.6 million for the three-months ended March 31, 2013 is included in the impairment of goodwill line item in the consolidated statements of operations.  The developed technology impairment charge of approximately $1.6 million for the three-months ended March 31, 2013 is included in the licensing and maintenance — cost of net revenues line item in the consolidated statements of operations.

 

The following schedule presents the details of intangible assets as of March 31, 2014 and December 31, 2013:

 

March 31, 2014

 

Intangible Asset

 

Gross
Carrying
Amount

 

Accumulated
Amortization

 

Accumulated
Impairment
Loss

 

Net

 

Weighted
Average
Remaining
Useful Life
(in years)

 

Developed Technology

 

$

6,426,000

 

$

(1,273,177

)

$

(5,038,100

)

$

114,723

 

4.5

 

Customer Relationships

 

3,972,000

 

(745,327

)

(1,786,673

)

1,440,000

 

7.5

 

Internal-use software

 

726,000

 

(73,810

)

 

652,190

 

4.5

 

Acquired Patents

 

1,100,000

 

(861,667

)

 

238,333

 

1.1

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

$

12,224,000

 

$

(2,953,981

)

$

(6,824,773

)

$

2,445,246

 

 

 

 

December 31, 2013

 

Intangible Asset

 

Gross
Carrying
Amount

 

Accumulated
Amortization

 

Accumulated
Impairment
Loss

 

Net

 

Weighted
Average
Remaining
Useful Life
(in years)

 

Developed Technology

 

$

6,426,000

 

$

(1,266,803

)

$

(5,038,100

)

$

121,097

 

4.8

 

Customer Relationships

 

3,972,000

 

(697,327

)

(1,786,673

)

1,488,000

 

7.8

 

Internal-use software

 

726,000

 

(37,510

)

 

688,490

 

4.8

 

Acquired Patents

 

1,100,000

 

(806,667

)

 

293,333

 

1.4

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

$

12,224,000

 

$

(2,808,307

)

$

(6,824,773

)

$

2,590,920

 

 

 

 

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Amortization expense associated with intangible assets was $145,674 and $182,783 for the three-months ended March 31, 2014 and 2013, respectively. The estimated amortization expense for intangible assets for the next five years and thereafter is as follows (in thousands):

 

Period 

 

Estimated
Amortization
Expense

 

Remainder of 2014

 

$

437

 

2015

 

436

 

2016

 

363

 

2017

 

363

 

2018

 

318

 

Thereafter

 

528

 

Total

 

$

2,445

 

 

8.               Income Taxes

 

Wave has federal and state net operating loss carryforwards of approximately $300.1 million, which expire beginning in 2014 through 2033 and include approximately $8.2 million of net operating loss carryforwards of Safend, Inc., a wholly owned US-based subsidiary of Safend.  Pursuant to Section 382 of the Internal Revenue Code, the annual utilization of Wave’s net operating and capital loss carryforwards may be substantially limited if a cumulative change in ownership of more than 50% occurs within any three-year period.  Wave has not determined whether there have been such cumulative changes in ownership or the impact on the utilization of the loss carryforwards if such changes have occurred.  However, in considering Section 382 of the Internal Revenue Code, Wave believes that it is likely that such a change in ownership has occurred thus raising the likelihood that such net operating and capital loss carryforwards are subject to annual limitations.  In addition, the Company maintains approximately $16.0 million of operating loss carryforwards associated with Safend, Ltd. which may be carried forward indefinitely.

 

9 .   Segment Reporting

 

Wave’s products include the Wave EMBASSY® digital security products and services (“EMBASSY®”) and Safend’s endpoint data loss protection products and services.  These products and services constitute Wave’s reportable segments as of March 31, 2014.

 

Net losses for reportable segments exclude net interest income (expense) and other income (expense), net.  These items are not reported by segment since they are excluded from the measurement of segment performance reviewed by Wave’s Chief Financial Officer.

 

The following sets forth reportable segment data:

 

 

 

Three-months ended
March 31,

 

 

 

2014

 

2013

 

Net revenues:

 

 

 

 

 

EMBASSY digital security products and services

 

$

3,928,035

 

$

4,620,786

 

Safend endpoint data loss protection products and services

 

1,404,504

 

1,172,940

 

 

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Total net revenues

 

5,332,539

 

5,793,726

 

Net income (loss):

 

 

 

 

 

EMBASSY digital security products and services

 

(3,734,576

)

(5,403,917

)

Safend endpoint data loss protection products and services

 

487,646

 

(4,753,302

)

Total segments net loss

 

(3,246,930

)

(10,157,219

)

Net other income (expense), net

 

(1,711

)

1,631

 

Net interest expense

 

(44,864

)

(58,167

)

Net loss

 

(3,293,505

)

(10,213,755

)

 

 

 

 

 

 

Impairment of Goodwill:

 

 

 

 

 

Safend endpoint data loss protection products and services

 

 

2,590,000

 

Total Impairment of Goodwill

 

 

2,590,000

 

 

 

 

 

 

 

Depreciation and amortization expense:

 

 

 

 

 

EMBASSY digital security products and services

 

175,370

 

177,128

 

Safend endpoint data loss protection products and services

 

61,278

 

138,781

 

Total depreciation and amortization expense

 

236,648

 

315,909

 

Capital expenditures:

 

 

 

 

 

EMBASSY digital security products and services

 

23,491

 

92,309

 

Safend endpoint data loss protection products and services

 

1,266

 

1,614

 

Total capital expenditures

 

24,757

 

93,923

 

 

 

 

March 31,

 

December 31,

 

 

 

2014

 

2013

 

Assets:

 

 

 

 

 

EMBASSY digital security products and services

 

$

8,583,865

 

$

7,733,322

 

Safend end point data loss protection products and services

 

3,947,725

 

4,091,587

 

Total assets

 

$

12,531,590

 

$

11,824,909

 

 

The following table details Wave’s sales by geographic area for the three-month periods ended March 31, 2014 and 2013.  Geographic area is based on the location of where the products were shipped or services rendered.

 

 

 

United States
of America

 

Europe

 

Asia

 

Total

 

2014

 

 

 

 

 

 

 

 

 

EMBASSY digital security products and services

 

$

2,834,883

 

$

700,271

 

$

392,881

 

$

3,928,035

 

Safend endpoint data loss protection products and services

 

729,197

 

577,684

 

97,623

 

1,404,504

 

Total

 

$

3,564,080

 

$

1,277,955

 

$

490,504

 

$

5,332,539

 

% of total revenue

 

67

%

24

%

9

%

100

%

2013

 

 

 

 

 

 

 

 

 

EMBASSY digital security products and services

 

$

3,722,988

 

$

746,693

 

$

151,105

 

$

4,620,786

 

Safend endpoint data loss protection products and services

 

544,398

 

558,331

 

70,211

 

1,172,940

 

Total

 

$

4,267,386

 

$

1,305,024

 

$

221,316

 

$

5,793,726

 

 

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% of total revenue

 

 

74

%

 

22

%

 

4

%

 

100

%

 

Approximately 90% of all long-lived assets of Wave are located within the United States of America and approximately 10% are located in the State of Israel.

 

Customers, by segment, from which Wave derived revenue in excess of 10% for the three-month periods ended March 31st are as follows:

 

 

 

 

 

2014

 

2013

 

Customer

 

Segment

 

Revenue

 

 

 

 

 

 

 

 

 

Dell

 

EMBASSY

 

$

2,020,450

 

$

2,458,411

 

% of total revenue

 

 

 

38

%

42

%

 

10 .        Issuance of Common Stock

 

During the three-month period ended March 31, 2014, Wave received net proceeds of $5,323,717 after deducting offering costs of approximately $169,000, in connection with the issuance of 5,365,784 shares of Class A Common Stock in its at the market offerings through MLV.  The shares were sold at prices ranging from $0.90 - $1.13 per share.

 

On March 13, 2013, Wave entered into agreements with certain institutional investors for a private placement of 301,205 shares of its Class A Common Stock at a price of $3.32 per share, yielding gross proceeds of $1,000,000.  Wave agreed to pay Dawson James Securities, Inc., the placement agent, a fee equal to 6% of the gross proceeds of this offering. Wave realized approximately $910,000 in net proceeds after deducting the placement agent fees of $60,000 and additional legal and other fees associated with the issuance of these securities totaling approximately $30,000.  Wave also issued warrants to the subscribers to purchase 150,603 shares of Class A common stock at an exercise price of $3.32 per share.  These warrants expire in October 2018.

 

During the three-month period ended March 31, 2013, Wave received net proceeds of $262,945 after deducting offering costs of approximately $8,700, in connection with the issuance of 94,988 shares of Class A Common Stock in its at the market offerings through MLV.  The shares were sold at prices ranging from $2.80 - $2.92 per share.

 

During the three-month period ended March 31, 2013, Wave received gross proceeds of $42,039 in connection with the issuance of 12,983 shares of Class A Common Stock upon the exercise of employee stock options.  The employee stock options were exercised at $3.24 per share.

 

11.        Fair Value Measurement

 

As of March 31, 2014, Wave’s financial assets that are measured at fair value on a recurring basis are comprised of overnight money market fund investments.  Wave invests excess cash from its operating cash accounts in overnight money market funds and reflects these amounts ($3,566,276 at March 31, 2014) within cash and cash equivalents on the consolidated balance sheet using quoted prices in active markets for identical assets (Level 1) at a net value of 1:1 for each dollar invested.

 

Financial instruments not measured or recorded at fair value in the accompanying unaudited consolidated financial statements consist of accounts receivable, collateralized receivables, accounts payable and secured borrowings. The estimated fair value of accounts receivable, collateralized receivables, accounts payable and secured borrowings approximates their carrying value.

 

Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instrument.  These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision.  Changes in assumptions could significantly affect the estimates.

 

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CERTAIN FORWARD-LOOKING INFORMATION:

 

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934.  These statements include, but are not limited to, statements regarding contingencies, future prospects, liquidity and capital expenditures herein under “Part I Financial Information—Item 2 Management’s Discussion and Analysis of Financial Condition and Results of Operations.”  The words “may,” “would,” “will,” “expect,” “estimate,” “anticipate,” “believe,” “intend” and similar expressions and variations thereof are intended to identify forward-looking statements.  Investors are cautioned that any such forward-looking statements are not guarantees of future performance and involve risks and uncertainties, many of which are beyond our ability to control.  Actual results could differ materially from those projected in the forward-looking statements as a result of the risk factors set forth below and detailed in our other filings with the Commission during the past 12 months.  Wave assumes no duty to and does not undertake to update any forward-looking statements.

 

Item 2.          Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is intended to provide a reader of our financial statements with a narrative from the perspective of our management on our financial condition, results of operations, liquidity and certain other factors that may affect our future results. Unless otherwise noted, transactions and other factors significantly impacting our financial condition, results of operations and liquidity are discussed in order of magnitude. Our MD&A is presented in five sections:

 

·                   Overview

·                   Business Update

·                   Results of Operations

·                   Liquidity and Capital Resources

·                   Contractual Obligations

 

Our MD&A should be read in conjunction with our Annual Report on Form 10-K for the year ended December 31, 2013, as well as our reports on Forms 10-Q and 8-K and other publicly available information.  All amounts herein are unaudited.

 

Overview

 

Our Business

 

Wave was incorporated in Delaware under the name Indata Corp. on August 12, 1988.  We changed our name to Cryptologics International, Inc. on December 4, 1989. We changed our name again to Wave Systems Corp. on January 22, 1993.  Our principal executive offices are located at 480 Pleasant Street, Lee, Massachusetts 01238 and our telephone number is (413) 243-1600.

 

Wave develops, produces and markets products for hardware-based digital security, including security applications and services that are complementary to, and work with, the specifications of the Trusted Computing Group, www.trustedcomputinggroup.org (the “TCG”), an industry standards organization comprised of computer and device manufacturers, software vendors and other computing products manufacturers. Specifications developed by the TCG are designed to address a broad range of current and evolving digital security issues.  These issues include: identity protection, data security, digital signatures, electronic transaction integrity, platform trustworthiness, network security and regulatory compliance.

 

The TCG was formed in April 2003 by its promoting founders: AMD, HP, IBM, Intel, and Microsoft.  Wave was initially invited to join the founding group as a contributing member.  Since 2008, Wave has held a permanent seat on the TCG Board of Directors (the “TCG Board”).  Wave has also elevated its membership status to “Promoter,” the highest level of the TCG. Permanent members of the

 

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TCG Board provide guidance to the organization’s work groups in the creation of specifications used to protect personal computers (“PCs”) and other computing devices from attacks and to help prevent data loss and theft.  Wave’s enhanced membership status allows it to take a more active role in helping to develop, define and promote hardware-enabled trusted computing security technologies, including related hardware building blocks and software interfaces.  Wave is eligible to serve on and chair the TCG Board and the Work Groups and Special Committees thereof.  Wave is permitted to submit revisions and addendum proposals for specifications with design guides and is similarly permitted to review and comment on design guides prior to their adoption.

 

The TCG promotes a hardware-based trusted computing platform, which is a platform that uses a semiconductor device, known as a Trusted Platform Module (“TPM”) that contains protected storage and performs protected activities, including platform authentication, protected cryptographic processes and capabilities allowing for the attestation of the state of the platform which provides the first level of trust for the computing platform (a “Trusted Platform”).  The TPM is a hardware chip that is separate from the platform’s main CPU(s) that enables secure protection of files and other digital secrets and performs critical security functions such as generating, storing and protecting “cryptographic keys” which are secret codes used to decipher encrypted or coded data.  While TPMs provide the anchor for hardware security, known as the “root of trust,” trust is achieved by integrating the TPM within a carefully architected trust infrastructure and supporting the TPM with essential operational and lifecycle services, such as key management and credential authentication.

 

The TCG also promotes the use of Self-Encrypting Drives (“SEDs”).  SEDs are based on TCG specifications which enable integrated encryption and access control within the protected hardware of the disk drive.  SEDs are designed to provide advanced data protection technology and they differ from software-based full disk encryption in that encryption takes place in hardware in a manner designed to provide robust security without slowing processing speeds.  Because the drives can be factory-installed, these systems can be configured such that encryption is “always on” for the protection of proprietary information.  The TCG has issued storage specifications over SEDs.  These specifications are based upon the Opal Security Subsystem Class (SSC) specification — an industry standard issued by the TCG.  The SSC specification gives vendors an industry standard for developing SEDs that secure data.

 

The majority of Wave’s TPM and SED related products, as detailed below in Products and Services, utilize the standards and specifications set by the TCG.

 

The overall number of PC models being offered by original equipment manufacturers (“OEMs”) and equipped with a TPM and/or SED, combined with the increased number of OEMs that have introduced TPM and SED equipped models has continued to accelerate the rate at which TPMs and SEDs are being shipped by the PC industry.  The offering of products using TCG specifications to the PC market is an important development in the creation of the market for hardware-based computer security.  Wave is continuing to execute its strategy to leverage its products in an effort to become a leading provider of software, applications and services for this market.

 

Our Products and Services

 

ENTERPRISE PRODUCTS

 

EMBASSY Remote Administration Server (“ERAS”)

 

ERAS is a server platform that provides centralized management and auditing of Trusted Platform Modules (TPMs), self-encrypting drives (SEDs) and Microsoft BitLocker encryption.  Correspondingly, there are three distinct product offerings from ERAS:  ERAS for Device ID, ERAS for SEDs, and Wave for BitLocker® Management.

 

ERAS for Device ID

 

ERAS for Device ID provides device and user identification management by allowing IT administrators to provision TPMs, manage TPMs and create cryptographic keys with the TPMs.  With ERAS for Device ID and a corresponding client, a user can authenticate using the TPM as a virtual smart

 

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card so existing solutions such as Microsoft Windows Login and Remote Desktop may be integrated.  This provides a multi-factor authentication based on using the hardware within the device as an authentication token.  ERAS for Device ID also provides compliance with security regulations, as the software documents which devices and users are on a network. Access to a network can be restricted to only known devices, providing further protection for the corporate network.  ERAS for Device ID is required to configure platforms for the advanced integrity and health reporting that is available through Wave Endpoint Monitor as well.

 

ERAS for SEDs

 

ERAS for SEDs allows for management of SEDs across an enterprise.  Without management, an SED functions as a standard drive and its security capabilities are greatly reduced.  ERAS for SEDs delivers SED drive initialization, user management, drive locking, user recovery and crypto erase for all Opal-based, proprietary and solid-state SEDs.  ERAS for SEDs is designed to provide auditing capabilities that aid in compliance management by controlling and logging SED security settings giving IT administrators the ability to know whether a lost or compromised PC is adequately secure.  ERAS for SEDs is designed to facilitate enterprise adoption of SED technology as it provides IT administrators with tools to utilize the security of these devices while reducing deployment and management costs.

 

Wave for BitLocker® Management

 

Through another capability of ERAS, Wave provides automated turn-key management for Microsoft BitLocker® encryption.  This feature is suitable for organizations that have not yet fully phased SEDs into their environment and who are migrating to Windows 7 that have Microsoft Enterprise Agreements or Software Assurance for Volume Licensing.  Wave for BitLocker® Management allows an organization to set policies and monitor security from a single console — simplifying an organization’s deployment by reducing the need for specialized knowledge or costly systems.  Key features of Wave for BitLocker® Management include centralized policy enforcement, recoverability of data in the event of a PC crash, securing of BitLocker® recovery passwords in an encrypted database, remote discovery and activation of BitLocker® client machines, remote activation of encryption without end-user involvement and a migration path to SED deployment.

 

Wave Endpoint Monitor

 

Wave Endpoint Monitor (“WEM”) detects malware that can go undetected by traditional anti-virus solutions by leveraging the capabilities of the TPM. WEM provides increased visibility into endpoint health to help protect enterprise resources and minimize the potential cost of advanced persistent threats such as rootkits.  Rootkit attacks are particularly harmful in their ability to hide in host systems, evade current mainstream detection methods (such as anti-virus programs or whitelisting at the operating system level) and their capacity to replace legitimate IT system firmware. Such attacks occur before the operating system loads, targeting the system BIOS and Master Boot Record, and can persistently infect higher-level system functions including operating systems and applications.  WEM captures verifiable PC health and security metrics before the operating system loads by utilizing information stored within the TPM. If anomalies are detected, IT is alerted immediately with real-time analytics.  Capabilities of WEM include reporting of PC integrity measurements, ensuring data comes from a known endpoint, alerting IT administrators to anomalous behaviors, providing configurable reporting and query tools, ensuring strong device identity through the use of hardware-based digital certificates and remote provisioning of the TPM.

 

Wave Cloud

 

Wave Cloud is a cloud-based service for managing full disk encryption using SEDs, BitLocker or Mac OSX FileVault 2.  With Wave Cloud, organizations do not need to buy, build and test (or maintain) the server infrastructure as the management of systems for data protection is done using a web interface.  The platform allows enterprises to deploy centrally-managed data encryption on their Windows and Mac systems utilizing SED hardware where available - all without the complexity and cost associated with maintaining on-premise servers. For OPAL-based proprietary and solid-state SEDs, Wave Cloud provides an organization with drive initialization, user management, drive locking and user recovery.  For Windows systems capable of running BitLocker, Wave Cloud provides remote management for fixed and removable

 

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disks with TPM authentication options and user recovery.  For Mac systems, Wave Cloud allows remote enablement of File Vault 2 with password management options.

 

Wave Mobility Pro — Tablet Edition

 

Wave Mobility Pro — Tablet Edition is a combined enterprise product offering comprised of selected products in the Wave portfolio that have been assembled and tested specifically for use on Windows 8 tablets.  For eliminating password authentication on these devices and augmenting strong authentication security, a virtual smart card and/or fingerprint authentication can be used to access the tablet, VPN or corporate network.  For managing encryption, a choice of software-based encryption, BitLocker or an SED is supported depending on the capabilities of the tablet.  Wave’s endpoint data loss protection solution product Protector is another option for securing data on removable devices that are attached to the tablet.

 

Data Protection Suite

 

Wave provides endpoint data loss protection solutions, including port and device control, encryption for removable media and content inspection and discovery, through its wholly-owned subsidiary, Safend - an Israeli-based company acquired on September 22, 2011.

 

Encryptor

 

Encryptor provides hard disk encryption, protecting enterprise data from loss and theft and supporting an enterprise’s attempt to waive disclosure requirements in the event of machine loss or theft with provable encryption.  Encryptor enables compliance with regulatory, data security and privacy standards.

 

Protector

 

Protector provides granular control of ports and devices.  Protector blocks users from connecting to unauthorized devices or using unauthorized interfaces while logging movements of data in and out of an organization.  Protector also blocks or detects both USB and PS/2 hardware keyloggers, turns U3 USB drives into regular USB drives while attached to endpoints, protects against auto-launch programs by blocking autorun, detects and restricts devices by device type, device model or unique serial number, controls transfer of files both to and from external storage devices according to the file types and encrypts data in motion on removable storage devices.

 

Inspector

 

Inspector inspects and blocks leakage of sensitive content through email, instant messaging, Web, external storage and printers.  Inspector enforces a data-centric security policy across multiple channels whether the machine is connected to an organization’s network or a home network or used offline.  Inspector allows for multi-tiered anti-tampering capabilities for permanent control over an organization’s endpoints.

 

Discoverer

 

Discoverer maps, classifies and locates data stored on organizational endpoints and networks.  Discoverer provides insight to unsecured data that can assist an organization in improving security and compliance initiatives.

 

Reporter

 

Reporter creates detailed graphical reports used for compliance assessment.  These reports detail information on endpoint encryption status, show security incidents by type, user and organization unit, give an overview of the most common security incidents, identify endpoints that do not have a valid policy applied to them and list physical devices that were used within a defined time frame.

 

Auditor

 

Auditor scans endpoints for past and present connected devices and Wi-Fi networks.  Auditor queries organizational network endpoints, locating and documenting devices that are or have been locally connected.  Auditor checks all USB, PCMCIA, Firewire and Wi-Fi ports — granularly identifying endpoint

 

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devices connected for each user - both current and historical.  Auditor provides organizations with visibility to identify and mange endpoint vulnerabilities.

 

CLIENT-SIDE APPLICATIONS

 

EMBASSY Trust Suite and EMBASSY Security Center

 

The current version of the EMBASSY Trust Suite consists of a set of applications and services that is designed to bring functionality and user value to TPM-enabled products.  Designed to make the TPM easy for users to set up and use, the EMBASSY Trust Suite includes EMBASSY Security Center (“ESC”), Trusted Drive Manager (“TDM”), Document Manager (“DM”), and Private Information Manager (“PIM”).

 

EMBASSY Trust Suite is the term used when all client applications are included.  More often than not a scaled down version of the client applications are packaged together under the EMBASSY Security Center branding (for example, EMBASSY Security Center — Trusted Drive Edition).

 

ESC allows the user and/or administrator to configure the security settings for their TPM, Windows Login, fingerprint authentication, document encryption and/or SED authentication.  In addition to the basic function of making the TPM operational and backing up TPM keys, ESC is designed to enable the user to manage extended TPM-based security settings and policies, including strong authentication, Windows logon preferences to add biometrics and streamlined TPM password policy management.

 

TDM is the component in ESC software that is utilized for advanced lifecycle management for SEDs.  SEDs are designed to provide advanced data protection technology differing from software-based full disk encryption in that the encryption takes place in hardware in a manner designed to provide robust security without slowing processing speeds.  Because the drives are factory-installed, the systems can be configured such that encryption is “always on” for the protection of proprietary information.  The SED storage specifications are based upon the Opal Security Subsystem Class (SSC) specification — an industry standard issued and published by the TCG.  The SSC specification gives vendors an industry standard for developing SEDs that secure data.  Wave’s products currently support all Opal-based proprietary and solid-state SEDs.

 

DM is offered to provide document encryption, decryption and client-side storage of documents.  PIM uses the TPM to securely store and manage user information, such as user names and passwords, credit card and other personal information.

 

MIDDLEWARE AND TOOLS

 

Wave offers three toolkits to assist software and application developers interested in using a TCG-standards-based platform. These are the TCG-Enabled Toolkit, the Wave TCG-Enabled Cryptographic Service Provider (“CSP”), and the Wave TCG-Enabled Key Storage Provider (“KSP”).

 

For TPM protection using 3rd party applications, ESC includes a CSP and KSP that enable functions such as TPM-based PKI authentication to 802.1x networks, Microsoft DirectAccess, Microsoft Outlook for email and Virtual Private Networks (VPNs).  Applications for the TPM using Wave’s CSP and KSP, however, are not limited to this list and can include various cryptographic functions for authentication, encryption and signing purposes.

 

DIGITAL SIGNATURE AND DOCUMENT MANAGEMENT

 

SmartSAFE Bundle

 

Our SmartSAFE Bundle, previously known as eSign Transaction Management Suite or eTMS, allows enterprises to manage their business processes and transactions online.  Maintaining an electronically signed record is essential to the lifecycle of a legally binding transaction.  Once created, these

 

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electronic records are verified for authenticity and are securely deposited in SmartSAFE.  The SmartSAFE Bundle is comprised of integrated components that provide the functionality necessary to meet the technical and legal requirements of electronic transactions governed by the laws of the United States and international governance bodies.  SmartSAFE consists of three standard capabilities: eDeliver, eSignature and eRetention.  There are several optional modules available to expand the capabilities of SmartSAFE including SmartIDENTITY, SmartFORMS, SmartREPORTING and SmartCLOSE.  Wave’s SmartSAFE Bundle is being independently marketed to insurance, mortgage, banking and governmental institutions, offering electronic signature solutions that are designed to comply with the Electronic Signatures in Global and National Commerce Act and Uniform Electronic Transaction Act.

 

Our Market

 

Software has traditionally secured critical information on networks and PCs and allowed for user access to various applications.  Virus attacks and breaches of security have demonstrated that software, on its own, is not always capable of completely securing a network or platform.  Because of these security concerns we believe that there is a need in the computer industry for the development and deployment of a more robust and reliable security infrastructure including new security hardware in devices to guard against these persistent security risks.  The TCG was formed to define, develop and promote open industry standard specifications for embedded hardware-enabled trusted computing and security technologies, including secure hardware and software interfaces across multiple platforms, peripherals and devices.  The underlying premise of the creation of a Trusted Platform that meets the TCG specification is that only when a platform is secured by hardware, in effect creating a root of trust and a security environment which can be authenticated within the computer itself, will the information stored on the platform be adequately secure.  Wave is seeking to become a software, application and services leader in the hardware-based digital security and e-commerce products markets.  We believe Wave has been a pioneer in developing hardware-based computer security systems and that we are distinctly positioned to take advantage of our unique knowledge, significant technology assets and trusted computing intellectual property.

 

Hardware-based trusted computing solutions can involve a new approach to conducting business and exchanging information using computer systems.  We believe that these solutions will require traditional software-based security to be augmented with next-generation hardware-based security and an enhanced support infrastructure. Working in tandem with our trusted computing solutions are our Data Protection Suite applications, which are software solutions for the market of data leakage prevention.  Intensive marketing and sales efforts have been, and will continue to be, necessary in order to generate demand for products using Wave’s technology and to ensure that Wave’s solution is accepted in this emerging market.  Our objective is to make our products and services the preferred applications and infrastructure for Trusted Platforms.

 

Business Update

 

The past several months have been a period of critical transition for Wave — marked by numerous changes to its operations, a more focused sales and marketing strategy and targeted headcount changes across the organization.  Management has strived to establish ways to improve efficiency across every aspect of Wave’s business, especially in how Wave develops, markets and sells its products.

 

On March 31, 2014, Mr. Gerard T. Feeney was terminated from his positions of Chief Financial Officer and Secretary of the Company, but he remained employed as a non-executive officer through April 30, 2014.  Effective April 1, 2014, Mr. Walter Shephard was appointed as Chief Financial Officer, replacing Mr. Feeney.  Prior to his appointment as Chief Financial Officer, Mr. Shephard, age 60, served as the Chief Financial Officer of Luminus Devices, Inc. from 2010 to November 2013.  From 2004 to 2010, Mr. Shephard served as Chief Financial Officer, Vice President of Finance and Treasurer of Zygo Corporation.

 

In addition to the change in the Company’s Chief Financial Officer, there have been other changes to Wave’s operations that are focused on the Company’s goals of clarity, efficiency and accountability.  The Company has significantly revised its sales and marketing plans to focus its sales efforts on higher margin Wave solutions and products and to target sales efforts toward larger customers with the Wave security message.  With this change, the Company has hired several new sales reps with the background

 

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and skills to help address these sophisticated sales opportunities.  The Company has also reduced sales reps in other areas in order to remain headcount neutral and control costs.

 

We believe that these changes will better position the Company to execute strategies designed to put Wave on the path towards sustained growth and profitability.  This is not a short-term proposition, and it will likely take several quarters before the financial benefits become clear.

 

Results of Operations

 

Three-Months Ended March 31, 2014 and 2013

 

Wave’s products include the Wave EMBASSY® digital security products and services (“EMBASSY®”) and Safend’s endpoint data loss protection products and services.  These products and services constitute Wave’s reportable segments as of March 31, 2014 and 2013.

 

EMBASSY® digital security products and services

 

Net Revenues:

 

 

 

Three- Months
Ended
March 31, 2014

 

Three-Months
Ended
March 31, 2013

 

Increase
(Decrease)

 

%
Change

 

Licensing and maintenance

 

$

3,928,035

 

$

3,820,786

 

$

107,249

 

3

%

Services

 

 

800,000

 

(800,000

)

(100

)%

Total Net Revenues

 

$

3,928,035

 

$

4,620,786

 

$

(692,751

)

(5

)%

 

The increase in licensing and maintenance revenues was due primarily to an increase in revenue recognized on Wave’s license upgrade sales of approximately $245,000 offset by a decrease in OEM revenue of approximately $140,000.

 

The increase in license upgrade revenue of approximately $245,000 primarily related to the recognition of large class orders received subsequent to March 31, 2013.  During the three-months ended March 31, 2014, revenue recognition on these large class customers amounted to approximately $275,000.

 

The decrease in OEM revenue of approximately $140,000 consisted of a decrease in Dell royalty revenue of approximately $323,000, primarily as the result of a decrease in the volume of Dell shipments, offset by an increase in non-Dell OEM revenue of approximately $183,000.

 

Services revenue earned during the three-months ended March 31, 2013 was from fixed-price modifications to a contract awarded by the United States Department of Defense which was completed during 2013.

 

Operating Expenses:

 

 

 

Three- Months
Ended March
31, 2014

 

Three-Months
Ended March
31, 2013

 

Increase
(Decrease)

 

%
Change

 

Licensing and maintenance – cost of net revenues

 

$

291,860

 

$

504,381

 

$

(212,521

)

(42

)%

Services – cost of net revenues

 

 

107,361

 

(107,361

)

(100

)%

Selling, general and administrative

 

4,918,880

 

6,672,578

 

(1,753,698

)

(26

)%

Research and development

 

2,451,871

 

2,740,383

 

(288,512

)

(11

)%

Total operating expenses

 

$

7,662,211

 

$

10,024,703

 

$

(2,362,492

)

(24

)%

 

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The decrease in licensing and maintenance — cost of net revenues during the three-months ended March 31, 2014 as compared to the same period in 2013 was due primarily to a decrease in Wave support costs of approximately $166,000 for consulting services to one of the world’s leading international oil and gas companies.  The consulting services were substantially completed during 2013 with minor work done during the three-months ended March 31, 2014.

 

Services — cost of net revenues incurred during the three-months ended March 31, 2013 was for work performed on fixed-price modifications to a contract with the United States Department of Defense.

 

The decrease in selling, general and administrative expense (“SG&A”) expenses during the three-months ended March 31, 2014 compared to the same period in 2013 was due primarily to (i) a decrease in Wave salaries and related benefits totaling approximately $821,000, (ii) a decrease of approximately $245,000 in travel expenses, (iii) a decrease of $395,000 in Wave professional services expenses, consisting primarily of professional fees and (iv) a decrease of approximately $236,000 in Wave’s trade show and marketing expenses.  These decreases were primarily the result of cost cutting measures implemented during 2013 and continuing during the three-months ended March 31, 2014.  On March 31, 2014, Mr. Gerard T. Feeney was terminated from his positions of Chief Financial Officer and Secretary of the Company, but he remained employed as a non-executive officer through April 30, 2014.  In connection with Mr. Feeney’s employment agreement with the Company, Mr. Feeney is entitled to a lump sum in an amount equal to one year’s annual base salary and a lump sum in an amount equal to the fixed bonus that would have been earned in the one year period following termination.  As a result of Mr. Feeney’s termination, the salary and fixed bonus severance amounts were $275,600 and $137,800, respectively.  The total severance of $413,400 is included in selling, general and administrative expense for the three-months ended March 31, 2014.

 

The activities supported by SG&A expenses include business development, sales, marketing, corporate communications and public relations, information technology and management information systems, human resources, accounting, executive management, corporate governance and general administrative functions.

 

The decrease in research and development (“R&D”) expenses during the three-months ended March 31, 2014 compared to the same period in 2013 was due primarily to (i) a decrease in Wave salaries and related benefits totaling approximately $626,000 as a result of cost cutting measures implemented during 2013, offset by (ii) an increase in professional services expenses of approximately $208,000 relating to outsourced engineering and (iii) an increase of approximately $93,000 in rent expense.

 

Due to the reasons set forth above, the EMBASSY® digital security products and services segment net loss to common stockholders for the three-months ended March 31, 2014 was $3,734,576 as compared to $5,403,917 for the comparable period of 2013.

 

Safend endpoint data loss security products and services

 

Net Revenues:

 

 

 

Three-
Months
Ended March
31, 2014

 

Three-Months
Ended March
31, 2013

 

Increase
(Decrease)

 

%
Change

 

Licensing and maintenance

 

$

1,404,504

 

$

1,172,940

 

$

231,564

 

20

%

Total Net Revenues

 

$

1,404,504

 

$

1,172,940

 

$

231,564

 

20

%

 

The increase in licensing and maintenance revenues was due primarily to an increase in license sales and a higher maintenance base during the three-months ended March 31, 2014 as compared to the same period in 2013.

 

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Operating Expenses:

 

 

 

Three- Months
Ended March
31, 2014

 

Three-Months
Ended March
31, 2013

 

Increase
(Decrease)

 

%
Change

 

Licensing and maintenance – cost of net revenues

 

$

20,968

 

$

1,721,218

 

$

(1,700,250

)

(99

)%

Selling, general and administrative

 

283,088

 

506,425

 

(223,337

)

(44

)%

Research and development

 

612,802

 

1,108,599

 

(495,797

)

(45

)%

Impairment of goodwill

 

 

2,590,000

 

(2,590,000

)

(100

)%

Total operating expenses

 

$

916,858

 

$

5,926,242

 

(5,009,384

)

(85

)%

 

Licensing and maintenance — cost of net revenues consists primarily of foreign tax withholdings, customer support personnel costs, share-based compensation expense, amortization expense on the developed technology intangible asset and impairment on the developed technology intangible asset.  The decrease in licensing and maintenance — cost of net revenues was due primarily to the recognition of a $1,615,000 impairment on the developed technology intangible asset during the three-months ended March 31, 2013.

 

The decrease in SG&A expenses during the three-months ended March 31, 2014 compared to the same period in 2013 was due primarily to a decrease in Safend salaries and related benefits totaling approximately $84,000 and a decrease of approximately $105,000 in Safend professional services expenses, consisting primarily of professional fees.

 

The decrease in R&D expenses during the three-months ended March 31, 2014 compared to the same period in 2013 was due primarily to a decrease in Safend salaries and related benefits totaling approximately $384,000, primarily the result of cost cutting measures implemented during 2013, and a decrease in travel expenses of approximately $50,000.

 

During the first quarter of 2013, the Company determined that sufficient indicators of potential impairment existed to require an interim goodwill impairment analysis for the Safend reporting unit. These indicators included, among others, significantly lower than expected revenue and billings during the first quarter of 2013 and downward revisions to management’s short-term and long-term forecast for the Safend business. The revised forecast reflected changes related to revenue growth rates, current market trends and other expectations impacting the anticipated short-term and long-term operating results of Safend. Due to the aforementioned indicators, the Company concluded that there were qualitative factors for the Safend unit that indicated it is more likely than not that the fair value of the Safend reporting unit was less than its carrying amount.

 

When indicators of impairment are present, such as those noted above, the Company tests long-lived assets (other than goodwill) for recoverability by comparing the carrying value of an asset group to its undiscounted cash flows. Based on the results of the recoverability test, the Company determined that the carrying value of the Safend asset group exceeded its undiscounted cash flows and was therefore not recoverable. The Company estimated the fair value of the intangible assets under an income approach as described above. Based on the analysis, the Company recorded an impairment charge of $1.6 million on developed technology intangible assets. The decline in the fair value of the Safend intangible assets is attributable to the same factors as discussed above for the fair value of the Safend reporting unit.

 

After adjusting the carrying value of the reporting unit for the impairment of the intangibles noted above, the Company completed the two step goodwill impairment test for the Safend reporting unit. The step two goodwill impairment test resulted in an implied fair value of goodwill substantially below the carrying value of the goodwill. As a result, the Company recorded a goodwill impairment charge of $2.6 million, which resulted in a $1.4 million remaining carrying value of Safend goodwill as of March 31, 2013. The goodwill impairment totaling approximately $2.6 million was included in the impairment of goodwill line item in the consolidated statements of operations. The developed technology impairment

 

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charge of $1.6 million is included in the licensing and maintenance—cost of net revenues line item in the consolidated statements of operations.

 

Due to the reasons set forth above, the Safend endpoint data loss security products and services segment net income to common stockholders for the three-months ended March 31, 2014 was $487,646 as compared to a net loss of $4,753,302 for the comparable period of 2013.

 

Liquidity and Capital Resources

 

Summary

 

We closely manage our liquidity and capital resources.  Key variables we use to manage our liquidity requirements include discretionary SG&A and R&D spending, capital expenditures, financing arrangements and working capital management.  We plan to exercise a disciplined approach to liquidity and capital management, while investing in key areas such as product development and research and development.

 

Wave has incurred substantial operating losses since its inception and as of March 31, 2014 has an accumulated deficit of approximately $420,534,000.  We expect to incur an operating loss for 2014.  As of March 31, 2014, we had negative working capital of approximately $5,648,000 and approximately $4,344,000 in cash and cash equivalents.

 

Given Wave’s forecasted capital requirements for the twelve-months ending March 31, 2015, as detailed below in Liquidity requirements and future sources of capital , and our cash balance as of March 31, 2014, Wave will be required to raise additional capital prior to March 31, 2015 to continue to fund its operations.  Wave’s ability to raise additional capital is primarily based on three sources (see Liquidity requirements and future sources of capital below for a discussion of restrictions):

 

·             Sales of registered Class A Common Stock under a $20,000,000 shelf registration statement filed with the SEC on August 9, 2013 and declared effective by the Commission on September 12, 2013 (“2013 shelf registration statement”);

 

·             Sales of registered Class A Common Stock via the At the Market Sales Agreement with MLV & Co. LLC (“MLV”) entered into during January, 2012; and

 

·             Sales of Class A common Stock through private placements.

 

Cash Flows

 

The following table summarizes our cash flows from operating, investing and financing activities for the three-months ended March 31:

 

Total cash provided by (used in):

 

2014

 

2013

 

Operating activities

 

$

(3,075,458

)

$

(1,391,799

)

Investing activities

 

(24,757

)

(93,923

)

Financing activities

 

5,323,717

 

1,196,089

 

Increase (decrease) in cash and cash equivalents

 

$

2,223,502

 

$

(289,633

)

 

Operating Activities

 

The increase in cash used in operating activities in the three-months ended March 31, 2014 compared to the three-months ended March 31, 2013 of approximately $1,684,000 was primarily related to the timing of cash collections from customers.  Cash collections from customers amounted to

 

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approximately $6,205,000 and $9,038,000 for the three-months ended March 31, 2014 and 2013, respectively.  The decrease in cash collections from customers of approximately $2,833,000 during the three-months ended March 31, 2014 as compared to the same period in 2013 was due to (i) the collection of a $1,700,000 three-year maintenance renewal from BASF in 2013, (ii) the collection of $600,000 from the United States Department of Defense related to a fixed-price contract in 2013, (iii) the collection of a $276,000 maintenance renewal from one of the world’s leading international oil and gas companies in 2013 and (iv) a decrease of approximately $323,000 in royalties received from Dell as a result of a decrease in Dell shipments in 2014 as compared to 2013.

 

Investing Activities

 

The decrease in cash used in investing activities during the three-months ended March 31, 2014 compared to the same period in 2013 of approximately $69,000 was the result of a decrease in property and equipment acquisitions.

 

Financing Activities

 

The increase in cash provided by financing activities during the three-months ended March 31, 2014 compared to the same period in 2013 of approximately $4,128,000 was the result of increases in at the market offerings through MLV of approximately $5,060,000, offset by decreases of approximately $910,000 in equity raising transactions and $42,000 in stock option exercises.

 

The significant amount of proceeds received in the three-months ended March 31, 2014 and 2013 from the sale of common stock were necessary in to support Wave’s growth strategy and fund SG&A and R&D capital requirements.

 

Liquidity requirements and future sources of capital

 

Wave estimates that its total expenditures to fund operations for the twelve-months ending March 31, 2015 will be approximately $29,300,000, including research and development, acquisition of capital assets, sales and marketing, general corporate expenses and overhead.

 

Sources of capital may include the following:

 

·                   cash on hand of $4,343,604 as of March 31, 2014;

 

·                   collection of receivables; and

 

·                   additional financings

 

Wave does not expect to generate enough revenue to fund its cash flow requirements for the twelve-months ending March 31, 2015.  As of March 31, 2014, we had approximately $4,344,000 of cash on hand.  Given Wave’s forecasted capital requirements for the twelve-months ending March 31, 2015, and our cash balance as of March 31, 2014, Wave will be required to raise additional capital prior to March 31, 2015 to continue to fund its operations.  Wave has historically raised additional capital from registered share offerings, sales of Class A Common Stock via the At the Market Sales Agreement with MLV and through private placements.

 

For registered share offerings, Wave is required to calculate the amount of capital the Company is allowed to raise in accordance with the General Instruction I.B.6. on Form S-3 (“the one-third rule”).  The one-third rule restricts the amount of capital that can be raised in a 12-month period provided that the registrant’s aggregate market value of the common equity held by non-affiliates is less than $75 million.  As a result of the application of the one-third rule, the funds available on the 2013 shelf registration statement are reduced.  Until Wave attains an aggregate market value of $75 million or more for shares held by non-affiliates, its available funds under the 2013 shelf registration statement will remain restricted to the one-third rule computation.  To determine the amount available under the one-third rule for future financings, the aggregate market value of the common equity is calculated using the price at which the common equity was last sold, or the average of the bid and asked prices of the common equity as of a date within 60 days prior to the date of filing.  As of May 6, 2014, approximately $11,675,000 in gross proceeds remains under the 2013 shelf

 

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registration statement, however Wave is restricted to $10,515,000 as of such date due to the one-third rule.  The total funds available under the 2013 shelf registration statement are currently all allocated to the At the Market Sales Agreement with MLV which may be utilized for future financings.

 

Due to our current cash position, our forecasted capital needs over the next twelve months and beyond, the fact that we will require additional financing and uncertainty as to whether we will achieve our sales forecast for our products and services, substantial doubt exists with respect to our ability to continue as a going concern.

 

We have transferred certain accounts receivable to buyers through CapFlow Funding Group Managers, LLC (“CapFlow”) that are accounted for as secured borrowings because we are required to repurchase the pledged receivables under certain circumstances in case of specific defaults by our customers as set forth in the program terms.  The carrying value of each secured borrowing approximates 85% of each associated pledged receivable taking into consideration a 15% holdback provision per the CapFlow agreement.  The customers’ payment of the pledged receivables constitutes the repayment of the related amounts borrowed. Capflow will then remit the remaining 15% holdback to Wave less interest.  The interest rate on the secured borrowings was approximately 1.50% for every thirty days outstanding, or an annual effective rate of approximately 18%.

 

Known trends and uncertainties affecting future cash flows

 

Because Wave does not have sufficient cash to fund operations for the twelve-months ending March 31, 2015, and there is uncertainty as to whether Wave will generate sufficient revenues to fund its operations over this time period, Wave has been, and will continue to be, actively engaged in financing activities in order to generate additional funding to cover its operating costs for the twelve-months ending March 31, 2015.

 

We will be required to sell additional shares of common stock or preferred stock or engage in a combination of these financing alternatives, to raise additional capital to continue to fund our operations for the twelve-months ending March 31, 2015.  The availability and amount of any such financings are unknown at this time and as a result of the one-third rule as detailed above, proceeds available to us under the 2013 shelf registration statement may not be adequate. Due to our current cash position, our forecasted capital needs over the next year and beyond, the fact that we will require additional financing and uncertainty as to whether we will achieve our sales forecast for our products and services, substantial doubt exists with respect to our ability to continue as a going concern.

 

From time to time Dell updates its hardware platforms with new security solutions packages.  Our bundled software has been included on Dell platforms since 2006 (including on the Dell Data Protection Access solution (DDPA) that is currently shipping).  On March 15, 2013, Dell notified us that it will be replacing the DDPA solution in its next generation of client hardware platforms that began shipping in late 2013.  As it has with other solution upgrades since 2006, Dell has also informed us that it will continue to discuss with Wave opportunities to include our software on new and future Dell platforms. However, Dell has not communicated to us any decisions regarding the next platform and we have no assurance that our software will be included in Dell’s new or future platforms.  Wave plans to continue to work with Dell to offer software solutions to enhance and improve Dell’s hardware platforms.  If we are not successful in continuing to sell our technologies with Dell’s new and future platforms, this could have a material adverse impact on our revenues.

 

Other uncertainties that may impact the future business outlook

 

Because the information security services market and the TCG hardware security category in particular are in early stages of development, customer requirements may change or new competitive pressures can emerge which could require a shift in product development and/or market strategy.  Should such shifts occur, they may require development, marketing and sales strategies to re-start or expand, which

 

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would likely increase operating costs and require additional capital.  Such shifts have occurred several times throughout Wave’s history, requiring significant changes in strategy and business plan.

 

Furthermore, the achievement of sufficient revenue is dependent upon continued significant expenditures, which will likely be required for research and development and sales and marketing to increase market awareness for our products.  Therefore, if Wave is not able to begin to generate significant revenues by March 31, 2015 to cover its operating costs, it will need to generate capital from other sources, including raising funds through the issuance of additional common stock, preferred stock and/or debt to fund its operations beyond March 31, 2015.  The challenges presented by the recent economic climate may have a negative impact on the volume of shipments by our OEM partners of products equipped with our software and general demand for our products.

 

Contractual Obligations

 

Royalty Liability

 

Safend is contractually required to pay back grants received from the Israeli government through the Office of the Chief Scientist of Israel’s Ministry of Industry, Trade and Labor (“OCS”) for the financing of a portion of its research and development expenditures in Israel.  Safend’s repayments are based on a royalty rate of 3.5% of total Safend revenues and there is no termination date for the payments.  Wave determined the fair value of this liability to be $4,043,000 at September 22, 2011.  At March 31, 2014 and December 31, 2013, the liability amounted to $4,598,043 and $4,673,629, respectively, reflecting additional grants received since the acquisition date, less amounts repaid since the acquisition date and accretion of the discount.

 

Operating Leases

 

Wave has no significant long-term contractual obligations other than the royalty liability obligation described above and operating leases for its facilities, which are all listed below:

 

 

 

Within
one year

 

Years two
and three

 

Years four
and five

 

Thereafter

 

Total

 

Operating lease commitments

 

$

893,000

 

$

1,022,000

 

$

12,000

 

$

 

$

1,927,000

 

Total commitments

 

$

893,000

 

$

1,022,000

 

$

12,000

 

$

 

$

1,927,000

 

 

Item 3.          Quantitative and Qualitative Disclosures about Market Risk

 

The exposure to market risk associated with interest rate-sensitive instruments is not material.  Wave’s cash and cash equivalents consist primarily of money market funds that meet high credit quality standards and the amount of credit exposure to any one issue is limited.

 

Item 4.          Controls and Procedures

 

a)   Disclosure controls and Procedures

 

Our management, with the participation of our chief executive officer and chief financial officer, evaluated the effectiveness of our disclosure controls and procedures as of March 31, 2014. The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Securities Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the

 

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SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Securities Exchange Act is accumulated and communicated to the company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure. Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on the evaluation of our disclosure controls and procedures as of March 31, 2014, and due to the material weakness in our internal control over the timely execution in testing the existence of vendor specific objective evidence (“VSOE”) of fair value of maintenance for the Safend unit described in Management’s Report on Internal Control over Financial Reporting included in our Annual Report on Form 10-K for the year ended December 31, 2013 filed with the Securities and Exchange Commission on March 14, 2014, our chief executive officer and chief financial officer concluded that, as of such date, our disclosure controls and procedures were not effective.

 

b)     Changes in Internal Control Over Financial Reporting

 

During the three-months ended March 31, 2014, no changes other than those in conjunction with certain remediation efforts described below, were identified to our internal control over financial reporting that materially affected, or were reasonably likely to materially affect, our internal control over financial reporting.

 

c)     Remediation Efforts

 

In the three-months ended March 31, 2014, we are continuing to implement the following measures, originally described in Item 9A of our Annual Report on Form 10-K for the year ended December 31, 2013 filed with the Securities and Exchange Commission on March 14, 2014, to improve our internal controls over VSOE of fair value of maintenance for the Safend unit. We plan to further enhance these measures in the remaining quarters of 2014:

 

·   Formalize accounting processes to bring the Safend VSOE of fair value of maintenance testing and review in line with the same process that is currently applied to the Wave unit and

 

·   Reallocate resources within the accounting department to ensure that our testing and review of VSOE of fair value of maintenance for the Safend unit can be completed accurately and in a timely manner.

 

If the remedial measures described above are insufficient to address any of the identified material weaknesses or are not implemented effectively, or additional deficiencies arise in the future, material misstatements in our interim or annual financial statements may occur in the future. Among other things, any unremediated material weaknesses could result in material post-closing adjustments in future financial statements. Furthermore, any such unremediated material weaknesses could have the effects described in “Item 1A. Risk Factors—In preparing our financial statements for fiscal 2013, we identified a material weakness in our internal control over financial reporting, and our failure to remedy these or other material weaknesses could result in material misstatements in our financial statements” in Part I of this Form 10-K.

 

d)     Remediation Plans

 

We have made no significant changes in our remediation plans during the three-months ended March 31, 2014 that could materially affect, or are reasonably likely to materially affect, our internal control over financial reporting. For further information with regard to our “Remediation Plans,” please refer to Item 9A of our Annual Report on Form 10-K for the year ended December 31, 2013 filed with the Securities and Exchange Commission on March 14, 2014.

 

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PART II - OTHER INFORMATION

 

Item 1. Legal Proceedings.

 

Brian Berger, a former employee of Wave who was terminated on November 1, 2013, has indicated that he may file a lawsuit against the company for unpaid compensation and penalties in the amount of approximately $182,000.  The parties are currently in discussions regarding Mr. Berger’s claims and the Company is evaluating its defenses.  The Company has also advised Mr. Berger that he may not misappropriate Wave’s proprietary technology and information and that the Company has reserved all of its rights with respect to any such activities.

 

Dell, Inc. tendered to Wave a claim for defense indemnification in connection with a patent infringement lawsuit, MAZ Encryption Technologies LLC v. Dell, Inc. filed on February 22, 2013 in the U.S. District Court for the District of Delaware, case no. 1:13-cv-00300 LPS.  Wave has not been notified of any specific allegation of infringement identifying its technology in the lawsuit.  Wave is not a party to the lawsuit and is evaluating its defenses should any allegations of infringement identifying Wave’s technology arise in the lawsuit.

 

In March 2014, the Company received a notice from DocMagic, Inc. alleging that certain of the Company’s eSignSystems solutions infringe upon a patent held by DocMagic, Inc.  The Company is reviewing this matter and evaluating its defenses should DocMagic bring any claims.

 

Item 1a.  Risk Factors.

 

This report contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from the results contemplated by these forward-looking statements due to certain factors, including those discussed below, and elsewhere in this Quarterly Report on Form 10-Q.

 

In preparing our financial statements for the fiscal year ended December 31, 2013, we identified a material weakness in our internal control over financial reporting, and our failure to remedy this or other material weaknesses could result in material misstatements in our financial statements.

 

Our management is responsible for establishing and maintaining adequate internal control over financial reporting for our company. Internal control over financial reporting is defined in Rule 13a-15(f) and 15d-15(f) promulgated under the Exchange Act. Our management identified a material weakness in our internal control over financial reporting as of December 31, 2013. A material weakness is 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 annual or interim financial statements will not be prevented or detected on a timely basis. The material weakness identified by management as of December 31, 2013 consisted of the failure to effectively execute controls over testing and reviewing vendor specific objective evidence of fair value of maintenance for the Safend unit. See “Item 9A—Management’s annual report on internal control over financial reporting” for further information.  In addition, based on an evaluation of our disclosure controls and procedures as of March 31, 2014, and due to the material weakness in our internal control over financial reporting described above, our chief executive officer and chief financial officer concluded that, as of such date, our disclosure controls and procedures were not effective.

 

We plan to implement remedial measures designed to address this material weakness. If our remedial measures are insufficient to address this material weakness, or if additional material weaknesses or significant deficiencies in our internal control are discovered or occur in the future, our consolidated financial statements may contain material misstatements and we could be required to restate our financial results.

 

Our business, financial condition and results of operations may be adversely affected by the unprecedented economic and market conditions.

 

The recent global economic downturn could significantly and adversely affect our business, financial condition and results of operation in various ways. The world economy is also facing a number of new challenges, including uncertainty related to the continuing discussions in the United States regarding the U.S. federal debt ceiling, the combination of expiring tax cuts and mandatory reduction in federal spending, along with widespread skepticism about the implementation of any resulting agreements, and recent turmoil and hostilities in the Middle East, North Africa and other geographic areas and countries. The deterioration in the global economy has negatively impacted the demand for our products and services

 

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and our ability to conduct our business, thereby reducing our revenues and earnings. In addition, the economic downturn, has negatively impacted, and/or may negatively impact among other things:

 

·                   the continued growth and development of our business;

 

·                   our liquidity;

 

·                   our ability to raise capital and obtain financing; and

 

·                   the price of our common stock.

 

We have a history of net losses and expect net losses will continue. If we continue to operate at a loss our business will not be financially viable.

 

We have experienced significant losses and negative cash flow from operations since our inception. We have not realized a net operating profit in any quarter since we began our operations.  Wave’s revenue during the three-months ended March 31, 2014 was less than operating expenses as our products have not yet attained widespread commercial acceptance. This is due in part to the early stage nature of the digital security industry in which we operate. As of March 31, 2014, we had an accumulated deficit of approximately $420.5 million and negative working capital of approximately $5.6 million. Given the lack of widespread adoption of the technology for our products and services, there is little basis for evaluating the financial viability of our business and our long-term prospects. You should consider our prospects in light of the risks, expenses and difficulties that companies in their early stage of development encounter, particularly companies in new and rapidly evolving markets such as digital security and online commerce.

 

To achieve profitability we must, among other things:

 

·       continue to convince chip, personal computer motherboard, personal computer and computer peripheral manufacturers to license and distribute our products and services and/or make them available to their customers through their sales channels;

 

·       convince computer end users and enterprise computer customers to purchase our upgrade software and server products for trusted computing;

 

·       convince consumers to choose to order, purchase and accept products using our products and services;

 

·       continue to maintain the necessary resources, especially talented software programmers;

 

·       continue to develop relationships with personal computer manufacturers, computer chip manufacturers and computer systems integrators to facilitate and to maximize acceptance of our products and services; and

 

·       generate substantial revenue, complete one or more commercial or strategic transactions or raise additional capital to support our operations until we can generate sufficient revenues and cash flows.

 

If we do not succeed in these objectives we will not generate revenues; hence our business will not be sustainable.

 

We may be unable to raise or generate the additional financing or cash flow which will be necessary to continue as a going concern for the next twelve months.

 

Since we began our operations we have incurred net losses and experienced significant negative cash flow from operations. This is due to the early stage nature of market development for our products and services and the digital security industry as a whole. Wave expects to continue to incur substantial additional expenses associated with continued research and development and business development activities that will be necessary to commercialize our technology. We may be unable to raise or generate the additional financing or cash flow which will be necessary to continue as a going concern for the next twelve months.

 

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In addition to our efforts to generate revenue sufficient to fund our operations, or complete one or more commercial or strategic transactions, Wave may evaluate additional financing options to generate additional capital in order to continue as a going concern, to capitalize on business opportunities and market conditions and to insure the continued development of our technology, products and services.  We do not know if additional financing will be available or that, if available, it will be available on favorable terms. If we issue additional shares of our stock our stockholders’ ownership will be diluted and the shares issued may have rights, preferences or privileges senior to those of our common stock.  In addition, if we pursue debt financing we may be required to pay interest costs.  The failure to generate sufficient cash flow to fund our forecasted expenditures would require us to reduce our cash burn rate which would in turn impede our ability to achieve our business objectives.  Even if we are successful in raising additional capital, uncertainty with respect to Wave’s viability will continue until we are successful in achieving our objectives. Furthermore, although we may be successful at achieving our business objectives, a positive cash flow from operations may not ultimately be realized unless we are able to sell our products and services at a profit. Given the early stage nature of the markets for our products and services considerable uncertainty exists as to whether or not Wave’s business model is viable.  If we are not successful in generating sufficient cash flow or obtaining additional funding we may be unable to continue our operations, develop or enhance our products, take advantage of future opportunities or respond to competitive pressures. Due to our current cash position, our forecasted capital needs over the next twelve months and beyond, the fact that we will require additional financing and uncertainty as to whether we will achieve our sales forecast for our products and services, substantial doubt exists with respect to our ability to continue as a going concern.

 

A single customer accounts for a significant portion of our revenues and, therefore, the loss of that customer may have a material adverse effect on our results of operations.

 

We expect that a small number of customers will continue to account for a large portion of our revenues for the foreseeable future. We have one customer that accounted for approximately 38% of our revenue for the three-months ended March 31, 2014, as discussed below. If our relationship with any of our significant customers were disrupted we could lose a significant portion of our anticipated revenues which may have a material adverse effect on our results of operations as discussed below.

 

Factors that could influence our relationships with our customers include, among other things:

 

·                   our ability to sell our products at prices that are competitive with our competitors;

·                   our ability to maintain features and quality standards for our products sufficient to meet the expectations of our customers; and

·                   our ability to produce and deliver a sufficient quantity of our products in a timely manner to meet our customers’ requirements.

 

If our OEM customers fail to purchase our components or to sell sufficient quantities of their products incorporating our components or if our OEM customers’ sales timing and volume fluctuates, it may have a material adverse effect on our results of operations.

 

In general, our ability to make sales to OEM customers depends on our ability to compete on price, delivery and quality. The timing and volume of these sales depend upon the sales levels and shipping schedules for the products into which our OEM customers incorporate our products. Thus, even if we develop a successful component, our sales will not increase unless the product into which our component is incorporated is successful.  If our OEM customers decide not to incorporate our products as components of their products or fail to sell a sufficient quantity of products incorporating our components, or if the OEM customers’ sales timing and volume fluctuate, it may lead to a reduction in our sales and have a material adverse effect on our results of operations.

 

Sales to a relatively small number of OEM customers, as opposed to direct retail sales to end customers, comprise a large portion of our revenues.  Dell accounted for approximately 38% of our revenue for the three-months ended March 31, 2014. From time to time Dell updates its hardware platforms with new security solutions packages.  Our bundled software has been included on Dell platforms since 2006 (including the Dell Data Protection Access solution (DDPA) that is currently shipping).  On March 15, 2013, Dell notified us that it will be replacing the DDPA solution in its next generation of client hardware platforms that began shipping in late 2013.  As it has with other solution upgrades since 2006, Dell has also

 

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informed us that it will continue to discuss with Wave opportunities to include our software on new and future Dell platforms. However, Dell has not communicated to us any decisions regarding the next platform and we have no assurance that our software will be included in Dell’s new or future platforms.  If we are not successful in continuing to sell our technologies with Dell’s new and future platforms, this could have a material adverse impact on our future revenues.

 

Our market is in the early stage of development so we are unable to accurately ascertain the size and growth potential for revenue in such a market.

 

The market for our products and services is still developing and is continually evolving. As a result, substantial uncertainty exists with respect to the size of the market for these products and the level of capital that will be required to meet the evolving technical requirements of the marketplace.

 

Wave’s business model relies on an assumed market of tens of millions of units shipping with built-in security hardware. Because this market remains in the early stage of development there is significant uncertainty with respect to the validity of the future size of the market.  If the market for computer systems that utilize our products and services does not grow to the extent necessary for us to realize our business plan, we may not be successful.

 

As this early stage market develops and evolves, significant capital will likely be required to fund the resources needed to meet the changing technological demands of the marketplace. There is uncertainty with respect to the level of capital that may be required to meet these changing technological demands. If the amount of capital resources needed exceeds our ability to obtain such capital, we may not be a viable enterprise.

 

Wave is not established in the industry so we may not be accepted as a supplier or service provider to the market.

 

Wave’s product offering represents a highly complex architecture designed to solve many of the security issues currently present with computer systems such as identity theft, fraudulent transactions, virus attacks, unauthorized access to restricted networks and other security problems that users of computer systems generally encounter. We are uncertain as to whether the marketplace will accept our solution to these security problems. We will not be successful if the market does not accept the value proposition that we perceive to be present in our products and services.

 

Although Wave has expended considerable resources in developing technology and products that utilize our technology and in business development activities in an attempt to drive the development of the hardware security market, we do not have a track record as a substantial supplier or service provider to consumers of computer systems. Therefore, uncertainty remains as to whether we will be accepted as a supplier to the enterprise and consumer markets which will likely be necessary for us to be a successful commercial enterprise.

 

Our products have not been accepted as industry standards which may slow their sales growth.

 

We believe platforms adopting integrated hardware security into the PC will become a significant standard feature in the overall PC marketplace. However, our technologies have not been accepted as industry standards. Standards for trusted computing are still evolving. To be successful we must obtain acceptance of our technologies as industry standards, modify our products and services to meet whatever industry standards ultimately develop and/or adapt our products to be complementary to whatever these standards become. If we fail to do any of these we will not be successful in commercializing our technology; and therefore, we will not generate sales to fund our operations and develop into a self-sustaining, profitable business.

 

If we do not keep up with technological changes our product development and business growth will suffer.

 

Because the market in which we operate is characterized by rapidly changing technology, changes in customer requirements, frequent new products, service introductions and enhancements and emerging industry standards, our success will depend upon, among other things, our ability to improve our products, develop and introduce new products and services that keep pace with technological developments, remain compatible with changing computer system platforms, respond to evolving customer requirements and

 

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achieve market acceptance on a timely and cost effective basis. If we do not identify, develop, manufacture, market and support new products and deploy new services effectively and timely our business will not grow, our financial results will suffer and we may not have the ability to remain in business.

 

We are subject to risks relating to potential security breaches of our software products.

 

Although we have implemented in our products various security mechanisms, our products and services may nevertheless be vulnerable to break-ins, piracy and similar disruptive problems caused by Internet users. Any of these disruptions would harm our business. Advances in computer capabilities, new discoveries in the field of security or other developments may result in a compromise or breach of the technology we use to protect products and information in electronic form. Computer break-ins and other disruptions would jeopardize the security of information stored in and transmitted through the computer systems of users of our products which may result in significant liability to us and may also deter potential customers.

 

A party who is able to circumvent our security measures could misappropriate proprietary electronic content or cause interruptions in our operations and those of our strategic partners. We may be required to expend significant capital and other resources to protect against security breaches or to alleviate problems caused by breaches. Our attempts to implement contracts that limit our liability to our customers, including liability arising from a failure of security features contained in our products and services, may not be enforceable. We currently do not have product liability insurance to protect against these risks. If the security of products or services is breached, our results of operations may be materially adversely affected by the liability resulting from the breach.

 

Competition and competing technologies may render some or all of our products non-competitive or obsolete.

 

An increasing number of market entrants have introduced or are developing products and services that compete with Wave’s. Our competitors may be able to develop products and services that are more attractive to customers than our products and services. Many of our competitors and potential competitors have substantially greater financial, technical and marketing resources than we have. Also, many current and potential competitors have greater name recognition and larger customer bases that could be leveraged to enable them to gain market share or product acceptance to our detriment. Wave’s potential competitors include security solutions providers such as RSA Security, Inc. (a division of EMC), Symantec, Computer Associates, Verisign, Inc., Entrust, Inc., Utimaco (acquired by Sophos), PGP (acquired by Symantec), Credant (acquired by Dell), SafeBoot (acquired by McAfee), SafeNet, WinMagic, Secude (acquired by SAP) and GuardianEdge (acquired by Symantec) and major systems integrators such as IBM, and HP.  In addition, Wave competes with other client security applications companies that are developing trusted computing applications including Softex Incorporated, Phoenix Technologies Ltd., Infineon Technologies AG and Microsoft.

 

Other companies have developed or are developing technologies that are, or may become, the basis for competitive products in the field of security and electronic content distribution. Some of those technologies may have an approach or means of processing that is entirely different from ours. Existing or new competitors may develop products that are superior to ours or that otherwise achieve greater market acceptance than ours. Due to Wave’s early stage and lower relative name recognition compared to many of our competitors and potential competitors, our competitive position in the marketplace is vulnerable.

 

We have a high dependence on relationships with strategic partners that must continue or our ability to successfully produce and market our products will be impaired.

 

Due in large part to Wave’s early stage and lessor name recognition we depend upon strategic partners such as large, well established personal computer and semiconductor manufacturers and computer systems’ integrators to adopt our products and services within the Trusted Computing marketplace. These companies may choose not to use our products and could develop or market products or technologies that compete directly with us. We cannot predict whether these third parties will commit the resources necessary to achieve broad-based commercial acceptance of our technology. Any delay in the use of our technology by these partners could impede or prohibit the commercial acceptance of our products. Although we have established some binding commitments from some of our strategic partners there can be no assurance that we will be able to enter into additional definitive agreements or that the terms of such agreements will be satisfactory. It will be necessary for Wave to expand upon our current business relationships with our partners, or form new ones, in order to sell more products and services for Wave to become a viable, self-sufficient enterprise.

 

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Product defects or development delays may limit our ability to sell our products.

 

We may experience delays in the development of our new products and services and the added features and functionality to our existing products and services that our customers and prospective customers are demanding. If we are unable to successfully develop products that contain the features and functionality being demanded by these customers and prospective customers in a timely manner, we may lose business to our competitors. In addition, despite testing by us and potential customers, it is possible that our products may nevertheless contain defects. Development delays or defects could have a material adverse effect on our business if such defects and delays result in our inability to meet the market’s demand.

 

If we lose our key personnel, or fail to attract and retain additional personnel, we will be unable to continue to develop our products and technology.

 

We believe that our future success depends upon the continued service of our key technical personnel and on our ability to attract and retain highly skilled technical, sales and marketing personnel. Our industry is characterized by a high level of employee mobility and aggressive recruiting of skilled personnel. There can be no assurance that our current employees will continue to work for us or that we will be able to hire any additional personnel necessary for our growth. Our future success also depends on our continuing ability to identify, hire, train and retain other highly qualified technical and managerial personnel. Competition for these employees can be intense. We may not be able to attract, assimilate or retain qualified technical and managerial personnel in the future, and the failure of us to do so would have a material adverse effect on our business.

 

We have a limited ability to protect our intellectual property rights and others could infringe on or misappropriate our proprietary rights.

 

Our success depends, in part, on our ability to enjoy or obtain protection for our products and technologies under United States and foreign patent laws, copyright laws and other intellectual property laws and to preserve our trade secrets. We cannot assure you that any patent owned or licensed by us will provide us with adequate protection or will not be challenged, invalidated, infringed or circumvented.

 

We rely on trade secrets and proprietary know-how which we protect, in part, by confidentiality agreements with our employees and contract partners. However, our confidentiality agreements may be breached and we may not have adequate remedies for these breaches. Our trade secrets may become known or be independently discovered by competitors. We also rely on intellectual property laws to prevent the unauthorized duplication of our software and hardware products. However, intellectual property laws may not adequately protect our technology. We have registered various trademark and service mark registrations with the United States Patent and Trademark Office. Wave may apply for additional name and logo marks in the United States and foreign jurisdictions in the future but we cannot be assured that registration of any of these trademarks will be granted.

 

We conduct a portion of our operations in the State of Israel and, therefore, political, economic and military instability in Israel and its region may adversely affect our business.

 

Safend’s operations are located in the State of Israel which constitutes a material portion of our business.  Accordingly, political, economic and military conditions in Israel and the surrounding region may affect our business. Since the establishment of the State of Israel in 1948, a number of armed conflicts have occurred between Israel and its Arab neighbors. A state of hostility, varying in degree and intensity, has caused security and economic problems in Israel. Although Israel has entered into peace treaties with Egypt and Jordan, and various agreements with the Palestinian Authority, there has been a marked increase in violence, civil unrest and hostility, including armed clashes, between the State of Israel and the Palestinians and others, since September 2000. The establishment in 2006 of a government in the Gaza Strip by representatives of the Hamas militant group has created heightened unrest and uncertainty in the region. In mid-2006, Israel engaged in an armed conflict with Hezbollah, a Shiite Islamist militia group based in Lebanon, and in June 2007, there was an escalation in violence in the Gaza Strip. From December 2008 through January 2009, Israel engaged in an armed conflict with Hamas, which involved missile strikes against civilian targets in various parts of Israel and which negatively affected business conditions in Israel.  Presently, there is great international concern in connection with Iran’s efforts to develop and enrich uranium which could lead to the development of nuclear weapons.  Iran’s successful enrichment of uranium could significantly alter the geopolitical landscape in the Middle East, including the threat of international war, which could significantly impact business conditions in Israel.

 

Recent political uprisings, regime changes and social unrest in various countries in the Middle East and North Africa are affecting the political stability of those countries. This instability may lead to

 

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deterioration of the political relationships that exist between Israel and these countries and have raised new concerns regarding security in the region and the potential for armed conflict. Among other things, this instability may affect the global economy and marketplace through changes in oil and gas prices. Further escalation of tensions or violence might result in a significant downturn in the economic or financial condition of Israel, which could have a material adverse effect on our operations in Israel and the portion of our business related to our operations there.

 

Safend received Israeli government grants for certain of its research and development activities. The terms of these grants may require Safend to meet certain requirements in order to manufacture products and transfer technologies outside of Israel. Safend may be required to pay penalties in addition to repayment of the grants.  Such grants may be terminated or reduced in the future, which would increase our costs.

 

The research and development efforts of Safend have been financed, in part, through grants that Safend has received from the Israeli Office of the Chief Scientist, or OCS. Safend therefore must comply with the requirements of the Israeli Law for the Encouragement of Industrial Research and Development, 1984, and related regulations, or the Research Law regarding the intellectual property and products generated by Safend. The terms of these grants and the Research Law restrict the transfer of know-how if such know-how is related to products, know-how and/or technologies which were developed using the OCS grants, and the transfer of manufacturing or manufacturing rights of such products, technologies and/or know-how outside of Israel without the prior approval, pursuant to the Research Law, of the appropriate authority of the OCS. Therefore, the discretionary approval of an OCS committee will be required for any transfer to third parties outside of Israel of rights related to certain of Safend’s technologies which have been developed with OCS funding. Safend may not receive the required approvals should it wish to transfer this technology and/or development outside of Israel in the future.

 

Furthermore, the OCS may impose certain conditions on any arrangement under which Safend transfers technology or development out of Israel. Overseas transfers of technology, manufacturing and/or development from OCS funded programs, even if approved by the OCS, may be subject to restrictions set forth in the Research Law. We cannot be certain that any approval of the OCS will be obtained on terms that are acceptable to us, or at all. If Safend fails to comply with the conditions imposed by the OCS, including the payment of royalties with respect to grants received, we may be required to refund any OCS payments previously received by Safend, together with interest and penalties, and may also be subject to criminal penalties.

 

We may not be able to realize all of the anticipated benefits of our acquisition of Safend if we fail to integrate Safend successfully, which could reduce our profitability.

 

Our ability to realize the anticipated benefits of our acquisition of Safend will depend, in part, on our ability to integrate the business of Safend successfully and efficiently with our business. The combination of two independent companies is a complex, costly and time-consuming process. The integration process may disrupt the business of either or both of the companies and, if implemented ineffectively, preclude realization of the full benefits expected by us. If we are not successful in this integration, our financial results could be adversely impacted. Our management will be required to dedicate significant time and effort to this integration process, which could divert their attention from other business concerns. In addition, the overall integration of the two companies may result in unanticipated problems, expenses, liabilities, competitive responses, loss of customer and other relationships, a loss of key employees, and diversion of management’s attention, and may cause our stock price to decline. The difficulties of combining the operations of the two companies include, among others:

 

·        challenges associated with minimizing the diversion of management attention from ongoing business concerns;

 

·        addressing differences in the business cultures of Wave and Safend;

 

·        coordinating geographically separate organizations which may be subject to additional complications resulting from being geographically distant from our other operations;

 

·        coordinating and combining international operations, information systems, relationships, and facilities, and eliminating duplicative operations;

 

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·        retaining key employees and maintaining employee morale;

 

·        unanticipated changes in general business or market conditions that might interfere with our ability to carry out all of its integration plans; and

 

·        preserving important strategic and customer relationships.

 

In addition, even if Safend’s operations are integrated successfully with ours, we may not realize the full potential benefits of the transaction, including the leveraging of production and combined research and development that are expected. Such benefits may not be achieved within our anticipated time frame, or at all.

 

Failure to comply with the Foreign Corrupt Practices Act (“FCPA”), and other similar anti-corruption laws, could subject us to penalties and damage our reputation.

 

We are subject to the FCPA, which generally prohibits U.S. companies and their intermediaries from making corrupt payments to foreign officials for the purpose of obtaining or keeping business or otherwise obtaining favorable treatment, and requires companies to maintain certain policies and procedures. Certain of the jurisdictions in which we conduct business are at a heightened risk for corruption, extortion, bribery, pay-offs, theft and other fraudulent practices. Under the FCPA, U.S. companies may be held liable for actions taken by their strategic or local partners or representatives. If we, or our intermediaries, fail to comply with the requirements of the FCPA, or similar laws of other countries, governmental authorities in the United States or elsewhere, as applicable, could seek to impose civil and/or criminal penalties, which could damage our reputation and have a material adverse effect on our business, financial condition and results of operations.

 

Regulation of international transactions may limit our ability to sell our products in foreign markets.

 

Most of our software products are controlled under various United States export control laws and regulations and may require export licenses for certain exports of the products and components outside of the United States and Canada. With respect to our EMBASSY Trust Suite and EMBASSY Trust Server software applications, we have applied for and received export classifications that allow us to export our products without a license and with no restrictions to any country throughout the world with the exception of Cuba, Iran, North Korea, Sudan and Syria.

 

Any new product offerings will be subject to review by the Bureau of Export Administration to determine what export classification they will receive. Enhancements to existing products may be subject to review by the Bureau of Export Administration to determine their export classification.  Some of our partners demand that our products be allowed to be exported without restrictions and/or reporting requirements. Current export regulations have, in part, allowed us to receive the desired classification without undue cost or effort. However, the export regulations may be modified at any time. Currently we are allowed to export the products for which we have received classification in an unrestricted manner without a license. However, modifications to the export regulations could prevent us from exporting our existing and future products in an unrestricted manner without a license. Such modifications could also make it difficult to receive the desired classification. If export regulations were to be modified in such a way, we may be put at a competitive disadvantage with respect to selling our products internationally.

 

In addition, import and export regulations of encryption/decryption technology vary from country to country. We may be subject to different statutory or regulatory controls in different foreign jurisdictions, and as such, our technology may not be permitted in these foreign jurisdictions. Violations of foreign regulations or regulation of international transactions could prevent us from being able to sell our products in international markets. Our success depends in large part to having access to international markets.  A violation of foreign regulations could limit our access to such markets and have a negative effect on our results of operations.

 

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Our stock price is volatile.

 

The price of our Class A Common Stock has been, and likely will continue to be, subject to wide fluctuations in response to a number of events and factors such as:

 

·   quarterly variations in operating results;

 

·   announcements of technological innovations, new products, acquisitions, capital commitments or strategic alliances by us or our competitors;

 

·   the operating and stock price performance of other companies that investors may deem comparable to us; and

 

·   news reports relating to trends in our markets.

 

In addition, the stock market in general and the market prices for technology-related companies in particular, have experienced significant price and volume fluctuations. These broad market fluctuations may adversely affect the market price of our Class A Common Stock and any of our other securities for which a market develops regardless of our operating performance. Securities class action litigation has often been instituted against companies that have experienced periods of volatility in the market price for their securities. It is possible that we could become the target of additional litigation of this kind that would require substantial management attention and expense.  The diversion of management’s attention and capital resources could have a material adverse effect on our business.  In addition, any negative publicity or perceived negative publicity of any such litigation could have an adverse impact on our business.

 

Sales of our common stock in our ATM Program, or the perception that such sales may occur, could cause the market price of our common stock to fall.

 

During January 2012, we entered into an At Market Issuance Sales Agreement, as amended on September 19, 2013, (“2012 ATM”) with MLV & Co. LLC (“MLV”) under which we are able to sell shares of our common stock from time to time through MLV. Continued sales of our common stock, if any, under the 2012 ATM will depend upon market conditions and other factors to be determined by us and may be made in negotiated transactions or transactions that are deemed to be “at the market offerings” as defined in Rule 415 under the Securities Act of 1933, as amended (the “Securities Act”). Future sales of our common stock are not guaranteed, and there are no firm commitments to receive funding under the 2012 ATM. The issuance from time to time of these new shares of common stock, or the perception that such sales may occur, could have the effect of depressing the market price of our common stock.

 

We may be subject to conflicts of interest that could adversely slow our corporate governance process.

 

Our current Board of Directors does not include any representatives of our strategic partners. However, our Board of Directors has included in the past and may include in the future, representatives of our strategic partners. It is possible that those corporations may be competing against us, or each other, directly or indirectly. A director who also represents another company may voluntarily abstain from voting on matters where there could be conflicts of interest. Even if such a director does abstain, his presence on the Board could affect the process or the results of the Board’s deliberations. We have adopted no policies or procedures to reduce or avoid such conflicts. If such conflicts of interest arise they may have a materially adverse effect on our business.

 

Governmental regulation may slow our growth and decrease our profitability.

 

There are currently few laws or regulations that apply directly to the Internet. Because our business is dependent, in significant respect, on the Internet, the adoption of new local, state, national or international laws or regulations may decrease the growth of Internet usage or the acceptance of Internet commerce which could decrease the demand for our products and services and increase our costs or otherwise have a material adverse effect on our business.

 

Tax authorities in a number of states are currently reviewing the appropriate tax treatment of companies engaged in Internet commerce. New state tax regulations may subject us to additional state sales, use and income taxes.

 

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If we make any acquisitions we will incur a variety of costs and may never realize the anticipated benefits.

 

If appropriate opportunities become available we may attempt to acquire businesses, technologies, services or products that we believe are a strategic fit with our business. If we do undertake any transaction of this sort the process of integrating an acquired business, technology, service or product may result in operating difficulties and expenditures and may absorb significant management attention that would otherwise be available for ongoing development of our business. Moreover, we may never realize the anticipated benefits of any acquisition. Future acquisitions could result in potentially dilutive issuances of equity securities, the incurrence of debt, contingent liabilities and/or amortization expenses related to certain intangible assets and increased operating expenses which could adversely affect our results of operations and financial condition.

 

If our common stock ceases to be listed for trading on the NASDAQ Capital Market, it may harm our stock price and make it more difficult to sell shares.

 

Our common stock is listed on the NASDAQ Capital Market.  In order to maintain our NASDAQ listing NASDAQ Marketplace Rule 5550(a)(2) requires that the bid price for our common stock not fall below $1.00 per share for a period of 30 consecutive trading days.  Because of the volatility in our common stock price there can be no assurance that we will be able to maintain compliance with this requirement. If our minimum bid price remains below $1.00 for 30 consecutive trading days, under the current NASDAQ Capital Market rules, we will have a period of 180 days to attain compliance by meeting the minimum bid price requirement for 10 consecutive days during the compliance period. In the event that we do not regain compliance during such 180 day period we would be entitled to an additional 180 day compliance period if we meet the other initial listing requirements of the NASDAQ Capital Market at the end of such initial 180 day period.  In addition to the $1.00 bid price rule, in order to remain listed on the NASDAQ Capital Market, we must also maintain compliance with all of the other required continued listing requirements of the NASDAQ Capital Market, including the $35 million market capitalization requirement.  If our common stock ceases to be listed for trading on the NASDAQ Capital Market we expect that our common stock would be traded on the Financial Industry Regulatory Authority’s Over-the-Counter Bulletin Board (OTC-BB).  The level of trading activity of our common stock may decline if it is no longer listed on the NASDAQ Capital Market.  If our common stock ceases to be listed for trading on the NASDAQ Capital Market for any reason it may harm our stock price, increase the volatility of our stock price and make it more difficult to sell your shares of our common stock.

 

Item 2.   Unregistered Sales of Equity Securities and Use of Proceeds.

 

None.

 

Item 6.   Exhibits.

 

(a)          Exhibits

 

Exhibit No.

 

 

 

Description of Exhibit

10.1

 

 

Letter Agreement, dated December 19, 2013, between William M. Solms and Wave

10.2

 

 

Letter Agreement, dated March 31, 2014, between Walter A. Shephard and Wave

31.1

 

 

Certification of the Chief Executive Officer pursuant to Rule 13a-14a, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

31.2

 

 

Certification of the Chief Financial Officer pursuant to Rule 13a-14a, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32.1

 

 

Certification of the Chief Executive Officer and Chief Financial Officer pursuant to 18.U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

101.1

 

 

XBRL Instance Document

101.2

 

 

XBRL Taxonomy Extension Schema Document

101.3

 

 

XBRL Taxonomy Extension Calculation Linkbase Document

101.4

 

 

XBRL Taxonomy Extension Definition Linkbase Document

101.5

 

 

XBRL Taxonomy Extension Label Linkbase Document

101.6

 

 

XBRL Taxonomy Extension Presentation Linkbase Document

 

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SIGNATURE

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

 

WAVE SYSTEMS CORP.

 

(Registrant)

 

 

 

 

Dated: May 9, 2014

By:

/s/ William M. Solms

 

 

Name:

William M. Solms

 

 

Title:

President and Chief Executive Officer

 

 

 

(Principal Executive Officer)

 

 

 

 

Dated: May 9, 2014

By:

/s/ Walter A. Shephard

 

 

Name:

Walter A. Shephard

 

 

Title:

Chief Financial Officer

 

 

 

(Principal Financial and Accounting Officer)

 

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