Notes to Unaudited Condensed Consolidated
Financial Statements
1. Basis of Presentation and Summary of Significant Accounting
Policies
The unaudited condensed consolidated financial
statements of Patriot Scientific Corporation (the “Company”, “PTSC”, “Patriot”, “we”,
“us” or “our”) presented herein have been prepared pursuant to the rules of the Securities and Exchange
Commission (“SEC”) for quarterly reports on Form 10-Q and do not include all of the information and footnotes required
by accounting principles generally accepted in the United States of America. These unaudited condensed consolidated financial statements
should be read in conjunction with our audited consolidated financial statements and notes thereto included in our Report on Form
10-K for our fiscal year ended May 31, 2015.
In the opinion of management, the interim
condensed consolidated financial statements reflect all adjustments of a normal recurring nature necessary for a fair presentation
of the results for the interim period presented. Operating results for the nine month period ended February 29, 2016 are not necessarily
indicative of the results that may be expected for the year ending May 31, 2016.
Basis of Consolidation
The condensed consolidated balance sheets
at February 29, 2016 and May 31, 2015 and condensed consolidated statements of operations for the three and nine months ended February
29, 2016 and February 28, 2015 and condensed consolidated statements of cash flows for the nine months ended February 29, 2016
and February 28, 2015 include our accounts and those of our wholly owned subsidiary Patriot Data Solutions Group, Inc. (“PDSG”)
which includes Crossflo Systems, Inc. (“Crossflo”), and our inactive subsidiary Plasma Scientific Corporation. All
significant intercompany accounts and transactions have been eliminated.
PDSG is being presented as discontinued
operations in the condensed consolidated statements of operations for all periods presented. See “Discontinued Operations
and Assets Held for Sale” below for additional information.
Liquidity and Management’s Plans
Cash shortfalls currently experienced by
Phoenix Digital Solutions, LLC (“PDS”) will have an adverse effect on our liquidity. To date, we have determined that
it is in the best interests of the Moore Microprocessor Patent (“MMP”) licensing program that we provide our 50% share
of capital to provide for PDS expenses including legal retainers, and litigation related payments in the event license revenues
received by PDS are insufficient to meet these needs. We believe it is likely that contributions to PDS to fund working capital
will continue to be required.
PDS had been incurring significant third-party
costs for expert testimony, depositions and other related litigation costs. We could be required to make capital contributions
to PDS for any future litigation related costs in the event that PDS does not receive sufficient licensing revenues to pay these
expenses.
Our current liquid cash resources as of
February 29, 2016, are expected to provide the funds necessary to support our operations through at least the next twelve months.
The cash flows from our interest in PDS represent our only significant source of cash generation. In the event of a
continued decrease or interruption in MMP portfolio licensing we will incur a significant reduction to our cash position. It is
highly unlikely that we would be able to obtain any additional sources of financing to supplement our cash and cash equivalents
and short-term investment position of $3,724,077 at February 29, 2016.
Patriot Scientific Corporation
Notes to Unaudited Condensed Consolidated
Financial Statements
Liquidity and Management’s Plans
(continued)
On March 20, 2013, Technology Properties
Limited, Inc. (“TPL”) filed a petition under Chapter 11 of the United States Bankruptcy Code. We have been appointed
to the creditors’ committee and have been closely monitoring the progress in this matter as it relates to our interest in
PDS. A Joint Plan of Reorganization (the “Joint Plan”) between TPL and the creditor’s committee was confirmed
by the Bankruptcy Court on February 11, 2015 with the entered confirmation order becoming final on April 2, 2015. In
the event we are required to provide funding to PDS that is not reciprocated by TPL, our ownership percentage in PDS will increase
and we will have a controlling financial interest in PDS, in which case, we will consolidate PDS in our condensed consolidated
financial statements.
Discontinued Operations and Assets Held
for Sale
On February 17, 2012, our board of directors
authorized management to sell the assets of PDSG due to the inability of PDSG to meet its business plan and continuing projected
negative cash flows. In accordance with authoritative guidance we have classified the assets, operations and cash flows of PDSG
as discontinued operations for all periods presented. During March 2012, we entered into an interim agreement with the purchaser
of the assets of PDSG which required the purchaser to pay PDSG $93,450 to subsidize the April 2012 expenses of PDSG during the
sale transaction negotiations. On April 30, 2012, we negotiated a sale transaction in which we sold substantially all of the assets
of PDSG in exchange for a royalty on PDSG revenues for a period of three years. From April 30, 2012 to May 31, 2015, the gain on
the asset sale of PDSG is approximately $101,000.
Summarized operating results of discontinued
operations for the three and nine months ended February 29, 2016 and February 28, 2015 are as follows:
|
|
Three Months Ended
|
|
|
Nine Months Ended
|
|
|
|
February 29,
2016
|
|
|
February 28,
2015
|
|
|
February 29,
2016
|
|
|
February 28,
2015
|
|
|
|
(Unaudited)
|
|
|
(Unaudited)
|
|
|
(Unaudited)
|
|
|
(Unaudited)
|
|
Gain on sale of discontinued operations
|
|
$
|
–
|
|
|
$
|
969
|
|
|
$
|
–
|
|
|
$
|
4,234
|
|
Income before income taxes
|
|
$
|
–
|
|
|
$
|
969
|
|
|
$
|
–
|
|
|
$
|
4,234
|
|
Income from discontinued operations
|
|
$
|
–
|
|
|
$
|
969
|
|
|
$
|
–
|
|
|
$
|
4,234
|
|
PDSG activity for the three and nine months
ended February 28, 2015 consists of PDSG royalty revenues.
Investments in Marketable Securities
We determine the appropriate classification
of our investments at the time of purchase and reevaluate such designation at each balance sheet date. Our investments in marketable
securities have been classified and accounted for as held-to-maturity based on management’s investment intentions relating
to these securities. Held-to-maturity marketable securities are stated at amortized cost. Unrealized gains and losses, net of
deferred taxes, are recorded as a component of other comprehensive income (loss). We follow the authoritative guidance to assess
whether our investments with unrealized loss positions are other than temporarily impaired. Realized gains and losses and declines
in fair value judged to be other than temporary are determined based on the specific identification method and are reported in
other income (expense), net in the condensed consolidated statements of operations.
Patriot Scientific Corporation
Notes to Unaudited Condensed Consolidated
Financial Statements
Investment in Affiliated Company
We have a 50% interest in PDS (see Note
3). We account for our investment using the equity method of accounting since the investment provides us the ability to exercise
significant influence, but not control, over the investee. Significant influence is generally deemed to exist if we have an ownership
interest in the voting stock of the investee of between 20% and 50%, although other factors, such as representation on the investee’s
Board of Directors, are considered in determining whether the equity method of accounting is appropriate. Under the equity method
of accounting, the investment, originally recorded at cost, is adjusted to recognize our share of net earnings or losses of the
investee and is recognized in the condensed consolidated statements of operations in the caption “Equity in earnings (loss)
of affiliated company” and also is adjusted by contributions to and distributions from PDS.
PDS, as an unconsolidated equity investee,
recognizes revenue from technology license agreements at the time a contract is entered into, the license method is determined
(paid-in-advance or on-going royalty), performance obligations under the license agreement are satisfied, and the realization of
revenue is assured, which is generally upon the receipt of the license proceeds. PDS may at times enter into license agreements
whereby contingent revenues are recognized as one or more contractual milestones have been met.
We review our investment in PDS to determine
whether events or changes in circumstances indicate that the carrying amount may not be recoverable. The primary factors we consider
in our determination are the financial condition, operating performance and near term prospects of PDS. If a decline in value
is deemed to be other than temporary, we would recognize an impairment loss.
Earnings (Loss) Per Share
Basic earnings per share for continuing
and discontinued operations includes no dilution and is computed by dividing earnings available to common stockholders by the weighted
average number of common shares outstanding for the period. Diluted earnings per share for continuing and discontinued operations
reflect the potential dilution of securities that could share in the earnings of an entity.
For the three and nine months ended February
29, 2016, potential common shares of 2,760,000 related to our outstanding options were not included in the calculation of diluted
loss per share for continuing and discontinued operations as we recorded a loss. Had we reported net income for the three and nine
months ended February 29, 2016, no shares of common stock would have been included in the calculation of diluted income per share
for continuing and discontinued operations using the treasury stock method.
For the three months ended February 28,
2015 potential common shares of 1,335,000 related to our outstanding options were not included in the calculation of diluted income
per share for continuing and discontinued operations as they were anti-dilutive. For the three months ended February 28, 2015 we
included the PDSG escrow shares of 2,844,630 in the calculation of diluted income per share for continuing and discontinued operations.
For the nine months ended February 28,
2015 potential common shares of 1,335,000 related to our outstanding options were not included in the calculation of diluted loss
per share for continuing and discontinued operations as we recorded a loss. Had we reported net income for the nine months ended
February 28, 2015, no shares of common stock would have been included in the calculation of diluted income per share for continuing
and discontinued operations using the treasury stock method.
Patriot Scientific Corporation
Notes to Unaudited Condensed Consolidated
Financial Statements
Earnings (Loss) Per Share (continued)
In connection with our acquisition of Crossflo,
which is part of PDSG, we issued escrow shares that are contingent upon certain representations and warranties made by Crossflo
at the time of the merger agreement (see Note 6). We exclude these escrow shares from the basic loss per share calculations and
include the escrowed shares in the diluted loss per share calculations.
Income Taxes
We follow authoritative guidance in accounting
for uncertainties in income taxes. This authoritative guidance prescribes a recognition threshold and measurement requirement for
the financial statement recognition of a tax position that has been taken or is expected to be taken on a tax return and also provides
guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. Under
this guidance we may only recognize tax positions that meet a “more likely than not” threshold.
We follow authoritative guidance to evaluate
whether a valuation allowance should be established against our deferred tax assets based on the consideration of all available
evidence using a “more likely than not” standard. In making such judgments, significant weight is given to evidence
that can be objectively verified. We assess our deferred tax assets annually under more likely than not scenarios in which they
may be realized through future income.
We have determined that it was more likely
than not that all of our deferred tax assets will not be realized in the future due to our continuing pre-tax and taxable losses.
As a result of this determination we have placed a full valuation allowance against our deferred tax assets.
We follow authoritative guidance to adjust
our effective tax rate each quarter to be consistent with the estimated annual effective tax rate. We are also required to record
the tax impact of certain discrete items, unusual or infrequently occurring, including changes in judgment about valuation allowances
and effects of changes in tax laws or rates, in the interim period in which they occur. In addition, jurisdictions with a projected
loss for the year or a year-to-date loss where no tax benefit can be recognized are excluded from the estimated annual effective
tax rate. The impact of such an exclusion could result in a higher or lower effective tax rate during a particular quarter, based
upon the mix and timing of actual earnings or losses versus annual projections.
Assessment of Contingent Liabilities
We are involved in various legal matters,
disputes, and patent infringement claims which arise in the ordinary course of our business. We accrue for any estimated losses
at the time when we can make a reliable estimate of such loss and it is probable that it has been incurred. By their very nature,
contingencies are difficult to estimate. We continually evaluate information related to all contingencies to determine that the
basis on which we have recorded our estimated exposure is appropriate.
Intellectual Property Rights
PDS, our investment in affiliated company,
relies on a combination of patents, trademarks, copyrights, trade secret laws, confidentiality procedures and licensing arrangements
to protect our intellectual property rights. We have three European and two Japanese patents all expiring in October 2016. We also
have seven U.S. patents, six European, and one Japanese patent all of which expired between August 2009 and September 15, 2015. These patents,
while expired, may have certain retrospective statutory benefits that will fully diminish six years after the patent expiration
date. The patent useful life for purposes of negotiating licenses is finite and these patents are subject to legal challenges,
which in combination with the limited life, could adversely impact the stream of revenues. A successful challenge to the ownership
of the technology or the proprietary nature of the intellectual property would materially damage business prospects. Any issued
patent may be challenged and invalidated.
Patriot Scientific Corporation
Notes to Unaudited Condensed Consolidated
Financial Statements
Recent Accounting Pronouncements
In August 2014, the Financial Accounting
Standards Board issued Accounting Standards Update (“ASU”) No. 2014-15, "Presentation of Financial Statements
– Going Concern." ASU 2014-15 provides guidance in generally accepted accounting principles about management’s
responsibility to evaluate whether there is substantial doubt about an entity’s ability to continue as a going concern and
to provide related footnote disclosures. ASU 2014-15 is effective for annual reporting periods ending after December 15, 2016 and
for annual periods and interim periods thereafter (fiscal year 2017 for the Company). Early adoption is permitted. We have not
yet determined the potential effects of the adoption of ASU 2014-15 on our condensed consolidated financial statements.
2. Cash, Cash Equivalents, Restricted Cash and Marketable
Securities
We consider all highly liquid investments
with original maturities of three months or less to be cash equivalents.
Restricted cash and cash equivalents at
February 29, 2016 and May 31, 2015 consist of deposits in a savings account required to be held as collateral for our corporate
credit card.
At February 29, 2016 and May 31, 2015,
the current portion of our marketable securities in the amount of $2,204,920 and $2,455,106, respectively, consists of the par
value plus accrued interest of our time deposits with original maturities of greater than three months and less than one year.
At February 29, 2016, the non-current portion of our marketable securities in the amount of $250,600 consists of the par value
plus accrued interest of our time deposits with original maturities of more than one year. These marketable securities are classified
as held-to-maturity and are reported at amortized cost, which approximates fair market value.
We follow authoritative guidance
to
account for our marketable securities as held-to-maturity. Under this authoritative guidance we are required to maximize the use
of observable inputs and minimize the use of unobservable inputs when measuring fair value. We determine fair value based on quoted
prices when available or through the use of alternative approaches, such as discounting the expected cash flows using market interest
rates commensurate with the credit quality and duration of the investment or valuations by third party professionals. The three
levels of inputs that we may use to measure fair value are:
Level 1: Unadjusted quoted prices in active
markets that are accessible at the measurement date for identical, unrestricted assets or liabilities;
Level 2: Quoted prices in markets that
are not active or inputs which are observable, either directly or indirectly, for substantially the full term of the asset or liability;
and
Level 3: Prices or valuation techniques
that require inputs that are both significant to the fair value measurement and unobservable (i.e. supported by little or no market
activity).
Patriot Scientific Corporation
Notes to Unaudited Condensed Consolidated
Financial Statements
Cash, Cash Equivalents, Restricted
Cash and Marketable Securities (continued)
The following tables detail the fair value
measurements within the fair value hierarchy of our cash, cash equivalents and investments in marketable securities:
|
|
|
|
|
Fair
Value Measurements at February 29, 2016 Using
|
|
|
|
Fair Value at February 29,
|
|
|
Quoted Prices in Active Markets for Identical Assets
|
|
|
Significant Other Observable Inputs
|
|
|
Significant Unobservable Inputs
|
|
|
|
2016
|
|
|
(Level 1)
|
|
|
(Level 2)
|
|
|
(Level 3)
|
|
Cash and cash equivalents:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Cash
|
|
$
|
77,129
|
|
|
$
|
77,129
|
|
|
$
|
–
|
|
|
$
|
–
|
|
Money market funds
|
|
|
941,518
|
|
|
|
941,518
|
|
|
|
–
|
|
|
|
–
|
|
Certificates of deposit
|
|
|
500,510
|
|
|
|
–
|
|
|
|
500,510
|
|
|
|
–
|
|
Restricted cash and cash equivalents
|
|
|
21,309
|
|
|
|
21,309
|
|
|
|
–
|
|
|
|
–
|
|
Marketable securities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Short-term:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Certificates of deposit
|
|
|
2,204,920
|
|
|
|
–
|
|
|
|
2,204,920
|
|
|
|
–
|
|
Long-term:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Certificates of deposit
|
|
|
250,600
|
|
|
|
–
|
|
|
|
250,600
|
|
|
|
–
|
|
Total
|
|
$
|
3,995,986
|
|
|
$
|
1,039,956
|
|
|
$
|
2,956,030
|
|
|
$
|
–
|
|
|
|
|
|
|
Fair
Value Measurements at May 31, 2015 Using
|
|
|
|
Fair Value at May 31,
|
|
|
Quoted Prices in Active Markets for Identical Assets
|
|
|
Significant Other Observable Inputs
|
|
|
Significant Unobservable Inputs
|
|
|
|
2015
|
|
|
(Level 1)
|
|
|
(Level 2)
|
|
|
(Level 3)
|
|
Cash and cash equivalents:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Cash
|
|
$
|
297,259
|
|
|
$
|
297,259
|
|
|
$
|
–
|
|
|
$
|
–
|
|
Money market funds
|
|
|
2,382,101
|
|
|
|
2,382,101
|
|
|
|
–
|
|
|
|
–
|
|
Restricted cash and cash equivalents
|
|
|
21,229
|
|
|
|
21,229
|
|
|
|
–
|
|
|
|
–
|
|
Marketable securities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Short-term:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Certificates of deposit
|
|
|
2,455,106
|
|
|
|
–
|
|
|
|
2,455,106
|
|
|
|
–
|
|
Total
|
|
$
|
5,155,695
|
|
|
$
|
2,700,589
|
|
|
$
|
2,455,106
|
|
|
$
|
–
|
|
Patriot Scientific Corporation
Notes to Unaudited Condensed Consolidated
Financial Statements
Cash, Cash Equivalents, Restricted Cash
and Marketable Securities (continued)
We purchase certificates of deposit with
varying maturity dates. The following table summarizes the maturities, gross unrealized gains or losses and fair value of the
certificates of deposit as of February 29, 2016:
|
|
February 29, 2016
(Unaudited)
|
|
|
|
Cost
|
|
|
Gross Unrealized Gains/(Losses)
|
|
|
Fair
Value
|
|
Maturity
|
|
|
|
|
|
|
|
|
|
|
|
|
Due in three months or less
|
|
$
|
500,510
|
|
|
$
|
–
|
|
|
$
|
500,510
|
|
Due in one year or less
|
|
$
|
2,204,920
|
|
|
$
|
–
|
|
|
$
|
2,204,920
|
|
Due in one year or more
|
|
$
|
250,600
|
|
|
$
|
–
|
|
|
$
|
250,600
|
|
The following table summarizes the maturities,
gross unrealized gains or losses and fair value of the certificates of deposit as of May 31, 2015:
|
|
May 31, 2015
|
|
|
|
Cost
|
|
|
Gross Unrealized Gains/(Losses)
|
|
|
Fair
Value
|
|
Maturity
|
|
|
|
|
|
|
|
|
|
|
|
|
Due in one year or less
|
|
$
|
2,455,106
|
|
|
$
|
–
|
|
|
$
|
2,455,106
|
|
3. Investment in Affiliated Company
On June 7, 2005, we entered into a Master
Agreement (the “Master Agreement”) with TPL, and Charles H. Moore (“Moore”), the co-inventor of the technology
which is the subject of the MMP Portfolio of microprocessor patents, pursuant to which the parties resolved all legal disputes
between them. Pursuant to the Master Agreement, we and TPL entered into the Limited Liability Company Operating Agreement of PDS
(the “LLC Agreement”) into which we and Moore contributed our rights to certain of our technologies.
We and TPL each own 50% of the membership
interests of PDS, and each member has the right to appoint one member of the three member management committee. The two appointees
are required to select a mutually acceptable third member of the management committee. There had not been a third management committee
member since May 2010; however, as a result of our initiating arbitration seeking the appointment of a third member, on December
16, 2014, an independent manager to the PDS management committee was selected by the arbitrator. Pursuant to the LLC Agreement,
we and TPL initially agreed to establish a working capital fund for PDS of $4,000,000, of which our contribution was $2,000,000.
The working capital fund was increased to a maximum of $8,000,000 as license revenues are achieved. We and TPL are obligated to
fund future working capital requirements at the discretion of the management committee of PDS in order to maintain working capital
of not more than $8,000,000. If the management committee determines that additional capital is required, neither we nor TPL are
required to contribute more than $2,000,000 in any fiscal year. No such contributions were made during the three and nine months
ended February 29, 2016 and February 28, 2015. Distributable cash and allocation of profits and losses have been allocated to
the members in the priority defined in the LLC Agreement.
Patriot Scientific Corporation
Notes to Unaudited Condensed Consolidated
Financial Statements
Investment in Affiliated Company
(continued)
Previously, pursuant to our June 7, 2005
agreement with PDS and TPL to license the MMP Portfolio (“Commercialization Agreement”), PDS reimbursed TPL for payment
of all legal and third-party expert
fees and
other related third-party costs and expenses. Presently the majority of third-party costs are paid directly by PDS. During the
three months ended February 29, 2016 and February 28, 2015, PDS reversed $(11,031) and expensed $669,987, respectively, pursuant
to the Commercialization Agreement and the July 11, 2012 Program Agreement (see below). These expenses are recorded in the accompanying
PDS statements of operations presented below
net of $15,672 and $20,215, respectively, of
legal fee reversals previously expensed and recorded as accounts payable to TPL during the three months ended February 29, 2016
and February 28, 2015 as the statute of limitations had expired. During the nine months ended February 29, 2016 and February 28,
2015, PDS reversed $(5,774) and expensed $1,175,054, respectively, pursuant to the agreements. These expenses are recorded in the
accompanying PDS statements of operations presented below
net of $550,563 and $20,215, respectively,
of legal fee reversals previously expensed and recorded as accounts payable to TPL during the nine months ended February 29, 2016
and February 28, 2015 as the statute of limitations had expired.
On July 11, 2012, we entered into the Program
Agreement with PDS, TPL, and Alliacense, and an Agreement (the “TPL Agreement”) with TPL. Pursuant to the Program Agreement,
PDS engaged Alliacense to negotiate MMP portfolio licenses and to pursue claims against violators of the MMP portfolio on behalf
of PDS, TPL, and the Company. The Program Agreement continued through the useful life of the MMP portfolio patents. Pursuant to
the TPL Agreement, we and TPL agreed to certain allocations of obligations in connection with the engagement of Alliacense. On
July 24, 2014, the Program Agreement was amended with PDS and Alliacense entering into the Amended Alliacense Services and Novation
Agreement (the “Novation Agreement”). Pursuant to the Novation Agreement certain performance goals and incentives were
established for Alliacense. The Novation Agreement also provided for the addition of a second licensing company, which was engaged
on October 10, 2014, to complement the MMP licensing commercialization. However, Alliacense fulfilled only a portion of its obligations
under the Novation Agreement associated with the deployment of the second licensing company and on May 11, 2015, Alliacense was
terminated by PDS.
Pursuant to the Program Agreement, PDS
was contractually obligated to pay Alliacense litigation support fees relating to Alliacense’s special work and effort regarding
internal costs related to MMP maintenance and litigation support including support in the U.S. District Court and the complaints
filed on behalf of TPL, PDS and us with the ITC. During the nine months ended February 28, 2015, PDS reversed $(24,598) pursuant
to this contractual obligation. The Novation Agreement eliminated the Program Agreement’s litigation support activity by
Alliacense. This reversal is recorded net of expenses in the accompanying PDS statement of operations for the nine months ended
February 28, 2015 presented below.
During January 2013, TPL and Moore settled
their litigation. Terms of the settlement include the payment by PDS to Moore of a consulting fee of $250,000 for four years or
until the completion of all outstanding MMP litigation whichever comes first. Per terms of the agreement PDS paid Moore $150,000
on the settlement date and paid Moore $16,667 per month from August 2013 through January 2014 and will pay $20,833 per month beginning
February 2014 through January 2017. During the three months ended February 29, 2016 and February 28, 2015, PDS expensed $62,499
and $62,499, respectively, pursuant to this commitment and during the nine months ended February 29, 2016 and February 28, 2015,
PDS expensed $187,497 and $187,497, respectively, pursuant to this commitment. These expenses are recorded in the accompanying
PDS statements of operations presented below.
Patriot Scientific Corporation
Notes to Unaudited Condensed Consolidated
Financial Statements
Investment in Affiliated Company
(continued)
Based on our analysis of current authoritative
accounting guidance with respect to our investment in PDS, we continue to account for our investment in PDS under the equity method
of accounting, and accordingly have recorded our share of PDS’s net loss during the three months ended February 29, 2016
and the nine months ended February 28, 2015 of $130,553 and $34,364, respectively, as decrease in our investment and we have recorded
our share of PDS’s net income during the three months ended February 28, 2015 and the nine months ended February 29, 2016
of $269,314 and $444,070, respectively, as an increase in our investment. We received distributions of $58,000 and $58,400, respectively,
from PDS during the nine months ended February 29, 2016 and February 28, 2015 and we have recorded these distributions as a decrease
in our investment.
We have recorded our share of PDS’s
net income and loss for the three and nine months ended February 29, 2016 and February 28, 2015 as “Equity in earnings (loss)
of affiliated company” in the accompanying condensed consolidated statements of operations.
During the three and nine months ended
February 29, 2016, PDS entered into licensing agreements with third parties, pursuant to which PDS received aggregate proceeds
of $0 and $1,450,000, respectively.
During the three and nine months ended
February 28, 2015, PDS entered into licensing agreements with third parties, pursuant to which PDS received proceeds of $1,800,000
and $1,820,000, respectively.
On March 20, 2013, TPL filed a petition
under Chapter 11 of the United States Bankruptcy Code. A Joint Plan of Reorganization (the “Joint Plan”) between TPL
and the creditor’s committee was confirmed by the Bankruptcy Court on February 11, 2015 with the entered confirmation
order becoming final on April 2, 2015. We have been appointed to the creditors’ committee and have been closely monitoring
the progress in this matter as it relates to our interest in PDS. In the event we are required to provide funding to PDS that is
not reciprocated by TPL, our ownership percentage in PDS will increase and we will have a controlling financial interest in PDS,
in which case, we will consolidate PDS in our condensed consolidated financial statements. If we determine that it is appropriate
to consolidate PDS, we would measure the assets, liabilities and noncontrolling interests of PDS at their fair values at the date
that we have the controlling financial interest.
PDS’s balance sheets at February
29, 2016 and May 31, 2015 and statements of operations for the three and nine months ended February 29, 2016 and February 28, 2015
are as follows:
Balance Sheets
Assets:
|
|
February 29, 2016
|
|
|
May 31, 2015
|
|
|
|
(Unaudited)
|
|
|
(Audited)
|
|
Cash
|
|
$
|
941,076
|
|
|
$
|
442,621
|
|
Prepaid expenses
|
|
|
2,629
|
|
|
|
26,644
|
|
Total assets
|
|
$
|
943,705
|
|
|
$
|
469,265
|
|
Patriot Scientific Corporation
Notes to Unaudited Condensed Consolidated
Financial Statements
Investment in Affiliated Company
(continued)
Liabilities and Members’ Equity (Deficit):
|
|
February 29, 2016
|
|
|
May 31, 2015
|
|
|
|
(Unaudited)
|
|
|
(Audited)
|
|
Payables
|
|
$
|
310,249
|
|
|
$
|
607,949
|
|
Members’ equity (deficit)
|
|
|
633,456
|
|
|
|
(138,684
|
)
|
Total liabilities and members’ equity (deficit)
|
|
$
|
943,705
|
|
|
$
|
469,265
|
|
Statements of Operations
|
|
Three Months Ended
|
|
|
Nine Months Ended
|
|
|
|
February 29, 2016
|
|
|
February 28, 2015
|
|
|
February 29, 2016
|
|
|
February 28, 2015
|
|
|
|
(Unaudited)
|
|
|
(Unaudited)
|
|
|
(Unaudited)
|
|
|
(Unaudited)
|
|
Revenues
|
|
$
|
–
|
|
|
$
|
1,800,000
|
|
|
$
|
1,450,000
|
|
|
$
|
1,820,000
|
|
Expenses
|
|
|
261,106
|
|
|
|
901,372
|
|
|
|
561,860
|
|
|
|
1,528,729
|
|
Operating income (loss)
|
|
|
(261,106
|
)
|
|
|
898,628
|
|
|
|
888,140
|
|
|
|
291,271
|
|
Income (loss) before provision for income taxes and foreign taxes
|
|
|
(261,106
|
)
|
|
|
898,628
|
|
|
|
888,140
|
|
|
|
291,271
|
|
Provision for income taxes and foreign taxes
|
|
|
–
|
|
|
|
(360,000
|
)
|
|
|
–
|
|
|
|
(360,000
|
)
|
Net income (loss)
|
|
$
|
(261,106
|
)
|
|
$
|
538,628
|
|
|
$
|
888,140
|
|
|
$
|
(68,729
|
)
|
We review our investment in PDS to determine
whether events or changes in circumstances indicate that the carrying amount may not be recoverable. The primary factors we consider
in our determination are the financial condition, operating performance and near term prospects of PDS. If a decline in value
is deemed to be other than temporary, we would recognize an impairment loss.
4
.
Income Taxes
We have determined that it was more likely
than not that all of our deferred tax assets will not be realized in the future due to our continuing pre-tax and taxable losses.
As a result of this determination we have placed a full valuation allowance against our deferred tax assets. There have been no
changes to our determination during the current fiscal year.
5. Stockholders’ Equity
Share-based Compensation
Summary of Assumptions and Activity
The fair value of share-based awards to
employees and directors is calculated using the Black-Scholes option pricing model, even though this model was developed to estimate
the fair value of freely tradable, fully transferable options without vesting restrictions, which differ significantly from our
stock options.
Patriot Scientific Corporation
Notes to Unaudited Condensed Consolidated
Financial Statements
Stockholders’ Equity (continued)
The Black-Scholes model also requires subjective
assumptions, including future stock price volatility and expected time to exercise, which greatly affect the calculated values.
The expected term of options granted is derived from historical data on employee exercises and post-vesting employment termination
behavior. The risk-free rate selected to value any particular grant is based on the U.S. Treasury rate that corresponds to the
pricing term of the grant effective as of the date of the grant. The expected volatility is based on the historical volatilities
of our common stock. These factors could change in the future, affecting the determination of share-based compensation expense
in future periods.
No stock options
were granted during the three and nine months ended February 29, 2016 and February 28, 2015.
A summary of option
activity as of February 29, 2016 and changes during the nine months then ended, is presented below:
|
|
Shares
|
|
|
Weighted Average Exercise Price
|
|
|
Weighted Average Remaining Contractual Term (Years)
|
|
|
Aggregate Intrinsic Value
|
|
Options outstanding at June 1, 2015
|
|
|
3,335,000
|
|
|
$
|
0.06
|
|
|
|
|
|
|
|
|
|
Options granted
|
|
|
–
|
|
|
$
|
–
|
|
|
|
|
|
|
|
|
|
Options exercised
|
|
|
–
|
|
|
$
|
–
|
|
|
|
|
|
|
|
|
|
Options forfeited/expired
|
|
|
(575,000
|
)
|
|
$
|
0.10
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Options outstanding at February 29, 2016
|
|
|
2,760,000
|
|
|
$
|
0.05
|
|
|
|
3.65
|
|
|
$
|
–
|
|
Options vested and expected to vest at February 29, 2016
|
|
|
2,760,000
|
|
|
$
|
0.05
|
|
|
|
3.65
|
|
|
$
|
–
|
|
Options exercisable at February 29, 2016
|
|
|
2,760,000
|
|
|
$
|
0.05
|
|
|
|
3.65
|
|
|
$
|
–
|
|
There were no options granted or exercised
during the nine months ended February 29, 2016.
The aggregate
intrinsic value represents the differences in market price at the close of the quarter ($0.0067 per share on February 29, 2016)
and the exercise price of outstanding, in-the-money options (those options with exercise prices below $0.0067 per share) on February
29, 2016.
Patriot Scientific Corporation
Notes to Unaudited Condensed Consolidated
Financial Statements
6. Commitments and Contingencies
Litigation
Patent Litigation
We, TPL, and PDS (collectively referred
to as “Plaintiffs”) are Plaintiffs in ongoing proceedings in the U.S. District Court for the Northern District of California
where the Plaintiffs allege infringement of the US 5,809,336 patent (the “‘336 patent”) by: Huawei Technologies
Co. Ltd., LG Electronics, Nintendo Co. Ltd., Samsung Electronics Co. Ltd., and ZTE Corporation. This litigation is proceeding in
front of District Court Judge Vince Chhabria with U.S. Magistrate Judge Paul Grewal handling all pretrial matters.
These ongoing proceedings relate to the
proceedings filed by the Plaintiffs in February 2008 in the U.S. District Court for the Northern District of California alleging
infringement of the US 5,440,749 patent (the “‘749 patent”), the US 5,530,890 patent (the “‘890 patent”)
and the ‘336 patent against Amazon.com Inc., Barnes & Noble Inc., Garmin Ltd., Huawei Technologies Co. Ltd., Kyocera
Corporation, LG Electronics, Nintendo Co. Ltd., Novatel Wireless Inc., Samsung Electronics Co. Ltd., Sierra Wireless Inc., and
ZTE Corporation. We have settled with all defendants except those named in the first paragraph to this footnote. Litigation and
settlement activity for the quarter ended August 31, 2015 and through the date of this filing is detailed below.
On February 4, 2015, Barnes & Noble,
Inc. filed a motion asserting that our cause of action on the ‘336 patent was barred by the Kessler doctrine because of the
ITC’s finding of non-infringement in 2013. A hearing was held on March 17, 2015 in the U.S. District Court for the Northern
District of California regarding the matter. On May 31, 2015, U.S. Magistrate Judge Grewal denied this motion. Barnes & Noble
asked District Court Judge Chhabria to reconsider this ruling but on July 22, 2015, Plaintiffs and Barnes & Noble filed a notice
of settlement stating that Plaintiffs and Barnes & Noble had reached a settlement in principle. This mooted a hearing in front
of District Court Judge Chhabria regarding Barnes & Noble’s motion.
On April 10, 2015, multiple defendants
in the District Court action filed a motion arguing for invalidity of the ‘749 patent. A hearing was held on May 19, 2015
regarding this matter. On July 27, 2015, Plaintiffs voluntarily dismissed their claims and on July 28, 2015, U.S. Magistrate Judge
Grewal denied this motion as moot.
On June 30, 2015, a hearing was held on
Samsung and LG’s motion to strike Plaintiffs’ infringement contentions. On July 11, 2015, U.S. Magistrate Judge Grewal
granted in part Samsung and LG’s motion and ordered Plaintiffs to provide amended infringement contentions in accordance
with the Court’s order. The Plaintiffs thereafter amended their infringement contentions.
On July 1, 2015, the parties in the Novatel
Wireless, Inc. action filed a stipulated motion to voluntarily dismiss all claims and counterclaims on the basis of a settlement
agreement having been reached. The California district court granted that motion on July 14, 2015.
On July 22, 2015, Plaintiffs and Barnes
& Noble filed a notice of settlement stating that Plaintiffs and Barnes & Noble had reached a settlement in principle.
On July 27, 2015, Plaintiffs and defendants
filed a stipulation whereby each party withdrew their claims regarding the ‘749 and ‘890 patents with prejudice.
Patriot Scientific Corporation
Notes to Unaudited Condensed Consolidated
Financial Statements
Commitments and Contingencies (continued)
On August 26, 2015, Plaintiffs and Garmin
entered into a settlement and license agreement.
On August 31, 2015, Plaintiffs and Barnes
& Noble entered into a settlement and license agreement.
On September 18, 2015, a Markman hearing
was held before U.S. Magistrate Judge Grewal and, on September 22, 2015, he issued a claim construction report and recommendation.
On September 25, 2015, as a result of the claim construction report and recommendation, Plaintiffs and defendants, with the exception
of Huawei Technologies Co. Ltd., (“Huawei”) agreed to stay all proceedings pending resolution of Plaintiffs’
objections to the claim construction report and recommendation. Plaintiffs further stipulated that, under the claim construction
provided by the report and recommendation, defendants’ products do not infringe the ‘336 patent, and, in the event
that the district judge did not materially modify the claim construction, Plaintiffs and defendants agreed to ask that the Court
enter a final judgment of non-infringement to facilitate proceeding to appeal. After Plaintiffs and Huawei filed opposing letter
briefs with the Court, U.S. Magistrate Judge Grewal stayed the action against Huawei pending resolution of Plaintiffs’ objections
to the claim construction. On October 6, 2015, Plaintiffs filed objections to the claim construction with District Court Judge
Chhabria. Judge Chhabria rejected those objections on November 9, 2015. Based on that order, the parties stipulated to a judgment
of non-infringement as to the ‘336 patent and such judgment was entered on November 13, 2015.
On December 7, 2015, Plaintiffs filed notices
of appeal with the U.S. Federal Circuit appealing the district court’s claim construction. Plaintiffs filed their opening
appellate brief on March 10, 2016. The appeal is pending.
PDS Arbitration - Alliacense Performance
In June 2015, our representative to the
PDS management committee filed with the Judicial Arbitration and Mediation Services (“JAMS”) a demand for arbitration
pursuant to Alliacense’s non-performance under terms of the Novation Agreement. The demand seeks a declaration of the respective
rights and obligations of the parties under the Novation Agreement. Alliacense has filed counterclaims seeking compensatory and
punitive damages. This matter is set for three days of arbitration currently commencing on September 20, 2016.
401(k) Plan
We have a retirement plan that complies
with Section 401(k) of the Internal Revenue Code. All employees are eligible to participate in the plan. We match 100% of elective
deferrals subject to a maximum of 4% of the participant’s eligible earnings. Our participants vest 33% per year over a three
year period in their matching contributions. Our matching contributions during the three months ended February 29, 2016 and February
28, 2015 were $5,524 and $4,370, respectively. Our matching contributions during the nine months ended February 29, 2016 and February
28, 2015 were $15,459 and $11,327, respectively.
Patriot Scientific Corporation
Notes to Unaudited Condensed Consolidated
Financial Statements
Commitments and Contingencies (continued)
Guarantees and Indemnities
We have made certain guarantees and indemnities,
under which we may be required to make payments to a guaranteed or indemnified party. We indemnify our directors, officers, employees
and agents to the maximum extent permitted under the laws of the State of Delaware. In connection with our facility lease, we have
indemnified our lessor for certain claims arising from the use of the facility. The duration of the guarantees and indemnities
varies, and in many cases is indefinite. These guarantees and indemnities do not provide for any limitation of the maximum potential
future payments we could be obligated to make. Historically, we have not been obligated to make any payments for these obligations
and no liabilities have been recorded for these guarantees and indemnities in the accompanying condensed consolidated balance sheets.
Escrow Shares
On August 31, 2009 we gave notice to the
former shareholders of Crossflo and Union Bank of California (the “Escrow Agent”) under Section 2.5 of the Agreement
and Plan of Merger between us and Crossflo (the “Agreement”), outlining damages incurred by us in conjunction with
the acquisition of Crossflo, and seeking the return of 2,844,630 shares of our common stock held by the Escrow Agent. Subsequently,
former shareholders of Crossflo representing a majority of the escrowed shares responded in protest to our claim, delaying the
release of the escrowed shares until a formal resolution is reached. In the event we fail to prevail in our claim against
the escrowed shares, we may be obligated to deposit into escrow approximately $256,000 of cash consideration due to the decline
in our average stock price over the one year escrow period, calculated in accordance with the Section 2.5 of the Agreement.
We have evaluated the potential for loss regarding our claim and believe that it is probable that the resolution of this issue
will not result in a material obligation to the Company, although there is no assurance of this. Accordingly, we have not
recorded a liability for this matter.
7. Subsequent Events
We have evaluated subsequent events after
the balance sheet date and based on our evaluation, management has determined that no subsequent events have occurred that would
require recognition in the accompanying condensed consolidated financial statements or disclosure in the notes thereto other than
as disclosed in the accompanying notes.